On 12 April 2018 Genuine Parts Company (GPC) and Essendant announced the divestment of GPC’s office products business, SP Richards (SPR), and the merger of the divested business with Essendant.
The pitch deck for the deal and the press releases that announced it include all the familiar, upbeat language that supports transactions of this kind. On the surface of it, this seems to be a clever deal with obvious benefits. It allows GPC to sharpen the focus on its core businesses. The new entity is larger, offers opportunities to harvest synergies, drive growth and has more working capital to boot. All stakeholders benefit. What’s not to like?
Upon closer inspection, however, there appears to be plenty of room to develop a contrarian perspective on this deal. For example, examining some key parameters of Essendant’s historical performance, consider the following:
For at least since the financial crisis of 2008, Essendant has been trying to calibrate, tweak and reinvent its business model. This has taken the form of M&A activity in office and non-office channels and in attempts at providing computer services to its dealer base. This should have had a significant impact on the top line, but after five years of experimentation and at the high watermark experiencing a 6% growth in revenues, in 2017 Essendant was right back to where it was in 2012.
How will the merger move the needle upward and reverse this downward slope, especially since revenues at SPR flatlined as well over the past few years? A reality check may suggest a further erosion of revenues even as the two companies combine. The reduction of wholesaler choice from two to one is anathema to the most fundamental of a merchant’s instincts and many resellers, especially the larger ones, will be voting with their feet and pivot to alternatives. Vendors will tend to do the same and the more agile already have found a pathway to the mid-market of resellers by going direct.
For the past six years, gross margin at Essendant has been on a downward slope, slipping and sliding from 15+% in 2012 to 14% in 2017. Typically, this is a manifestation of a combination of factors, including but not limited to:
- a changing product mix in favour of lower margins (not a good direction to take);
- reduced pricing power in negotiations with key customers (80-20 rule);
- a lack of real-time information about where product margins are on a day-to-day, week-to-week and month-to-month basis. If memory serves me correctly, at Essendant attempts to address this point were squashed several years ago in favour of higher EPS in the short term.
How will all this improve after the merger, and why? And how long will it take the new team to come to grips with a prolonged decline in revenues?
When revenues are decreasing and gross profit is as well, it would make perfect sense to calibrate one’s operating budget accordingly. But throughout the period, there is no evidence that this has been happening with any real measure
Why would the merger magically provide a well-oiled, real-time response mechanism for this crucial aspect of running a business if the company cannot even do it on its own?
EBITDA (before asset impairments)
An important measure of a company’s health, this has been on a downward slope as well, especially from 2015 onwards. In 2017, it was 1.6% of revenues, a far cry from the >5% where it should be. Cost cutting, yes. But not in sync with top line and gross margin declines. How will this change after the merger? And why?
This is the ratio between debt and equity. The higher the ratio, the weaker the company. This ratio has gone up, not down. In other words, the financial infrastructure of the company appears to have become weaker, not stronger.
Repurchase of shares
Despite a weakening balance sheet, the firm found $260 million of cash over a five-year period to spend on the repurchase of shares. Definitely good for EPS. But the health of the firm?
Over a period of six years, Essendant took hits directly against its equity base to the total amount of $425 million. These hits came in the form of asset impairments, the most recent one — recorded at the end of 2017 — coming in at $285 million, a real whopper. It reads like an admission by the management team that most if not all of its acquisitions during this period has failed. How will this change for the better after the merger?
Capital expenditures (CAPEX)
From 2012 to 2017, Essendant made close to $200 million in capital expenditures while booking depreciation and amortisation to the amount of more than $250 million. I am sure there is a good reason for this but nevertheless some people call this “eating your seed corn”.
In 2014, the company was still valued at $1.8 billion, but by the end of 2017 investors did not think it was worth more than $321 million. A whopper if ever there was one.
Lack of substance
In 2015, the firm rolled out its much touted re-branding campaign, spending millions of dollars announcing to the world that it had changed its name from ‘United Stationers’ to ‘Essendant’. This definitely was a clever play on two words — ascending and essential. The problem is that neither seems to be in evidence, at least not from a review of the company’s recent history. At this point, a qualitative observation is in order as well, rounding out a review of the numerical record.
Both Essendant and SPR can be said to nurture ‘conflicted’ loyalties, catering to customer groups that are in a mortal struggle with each other for their very survival. It does not seem unreasonable to speculate that it is these conflicted loyalties that have eroded the very trust among channel partners that was in evidence before the turn of the century. For all intents and purposes, if this trust doesn’t come back soon, the new entity’s entire future hangs in the balance. Not to put too fine a point on this, but the emerging option of Sycamore Capital, the new owner of Staples, acquiring Essendant, would raise this issue of “conflicted loyalties” to an even higher level and reverberate even more disruptively throughout all corners of the industry.
A crucial question is this: will the merger with SPR create a change for the better? Will it include a magical wand guiding the management team on an upward trajectory, a virtuous cycle back to prosperity? In my opinion, it’s not likely. My observations point to the need for a complete overhaul of the business model, beginning with the most fundamental aspects of its value proposition. These include:
- Close some of the logistics centres: SPR’s or Essendant’s? Which ones? Why, when and at what cost?”
- Reduce head-count: Who, why, where? When and at what cost?
- Capital investments: What, how much, where, when, why? Who benefits?
None of these are achievable under the Klieg lights of a public company with quarterly phone calls to a financial community that doesn’t want to hear what needs to be said. But without such an overhaul and continuing with its sales-centric approach, the new organisation structure will be prone to a slow decision-making process:
Are there better options for Essendant? Yes. One such option would have been to take the company private and aggressively reward a new entrepreneurial team on value creation, not just clever financial engineering. Assuming that regulatory approval for this deal is not an obstacle, chances are this better option will need to wait for yet another iteration of the new firm’s structure.
In the meantime, there will be winners and losers. GPC will be among the nominal winners. At least it gets some hard cash out of the deal. But the employees of the two organisations are at risk, especially those who don’t have a ‘golden parachute’ strapped around their waist.
The real losers in this script are the independent dealers, specifically the smaller ones that have been hemmed in by the straitjacket of wholesaler programmes for years. Mid-market dealers still have room to pivot and pursue other options; the smaller ones not so much. In short, not a good way of making America’s mainstream great again!
Thomas Schinkel is an internationally-recognised business adviser who works with senior executives of large and medium-sized businesses on strategic issues that include corporate value improvement, exit planning and growth through acquisition. He has helped establish and co-founded several companies and has served on the board of companies in the software, business products and medical device industry.