Consolidation--The Juggernaut Hits the Wall

As the consolidation march pauses to take a breath, the sector's leaders are taking the time to prove to Wall Street that they can manage their new empires.

BY CHRISTOPHER CORNELL

About this time two years ago, the trade press were using metaphors like "juggernaut" and "tidal wave" to describe the actions of a half-dozen companies in the graphic arts industry, as they began an awe-inspiring crusade to consolidate one of North America's more fractured business sectors. Any metaphor that implied inevitability seemed appropriate. Announcements of new acquisitions came, at times, weekly; sometimes they even appeared daily.

What a difference two years can make. Now, the metaphors about the consolidators have taken on a battlefield flavor. There is talk of front lines, entrenchment and retreat, all implying that, while victory is still possible, it will have to be hard won. The scent of inevitability is no longer in the air.

Companies that made a habit of announcing new acquisitions on a regular basis have not done so for months; companies that went public with great fanfare have seen their stock's value drop precipitously; and a few companies that once publicly predicted grandiose futures have all but collapsed.

Most of the industry's main players agree that what is taking place now is a vicious cycle being spun by the machinery of Wall Street.

"The consolidation slowdown is a product of reduced valuation for publicly held companies," states Ron Jensen, chairman, president and CEO of San Francisco-based Kelmscott Communications, in a succinct summation of the problem.

"Public companies valued below roughly five times their cash flow dilute their earnings when they buy a company above their public valuation. Therefore, consolidation stops. There is no way a publicly held company can avoid or reverse the situation. The 'arbitrage' between the cost of purchasing a company and the public valuation drives consolidation.

If that arbitrage dis-appears, consolidation stops."

But while the trouble may be most visible on Wall Street, Carl Norton, chairman and CEO at Houston-based Nationwide Graphics, thinks much of the blame belongs in the industry's own back yard.

"Too many companies were getting funding in order to make acquisitions," he explains. "Many were making acquisitions without an adequate amount of due diligence and, along the way, acquisition prices were being pushed up past reasonable levels, requiring significant capital investment. Some companies were more intent on the number of companies that they had acquired, rather than integrating the acquired companies into the acquiring company. Others were acquiring companies without any apparent thought as to where they were located. Companies not located near any other company that has been acquired still have to be managed."

Chris Colville, executive vice president at Houston-based Consolidated Graphics, affirms that view, noting that "a number of the consolidators pushing the pace of acquisitions in 1998 were highly leveraged and/or lacked industry experience to continue the pace in 1999.

We publicly predicted this in the spring of 1999, at one of the major M&A [mergers and acquisitions] conferences."

Graham McLean, CEO of Lincolnshire, IL-based Global DocuGraphiX, points out that competition for acquisitions "drove acquisition prices up and many sellers saw this as a good opportunity to sell." And lenders saw consolidators as "very secure because you could always liquidate the company at fairly high multiples, even if they ran into cash flow problems. So the lenders were willing to give additional capital to both public and private companies to acquire more companies."

Peter Faucetta, CEO of New York-based Integrated Graphics (IGI), blames "lack of control and lack of management awareness.

The day-to-day business operations suffered mainly because management took their eye off the ball. Business looked too much into the market value."

All this, Norton explains, led to companies missing earnings projections or breaching the financial covenants contained in the financing that they received to buy companies. "When the money dries up, so do the acquisitions," he declares.

But Bruce Thompson, senior vice president of corporate development at Englewood, CO-based Mail-Well, adds that Mail-Well views this turn of events as a gift of time: It sees this break in the action as "an opportunity for us to integrate the acquisitions we have made and to focus on extracting the value from these acquisitions."

Nearly all those asked said they were undertaking similar steps. "We responded by re-grouping management and re-focusing on the day-to-day business operations that were so successful before the consolidation," reveals IGI's Faucetta.

The past year has also seen a rough-and-tumble shakeout of the companies involved in printing industry acquisition. The well-managed companies remain on their feet, albeit quietly, but some others have sunk almost out of sight, leaving the companies acquired by them in rather precarious positions.

Mail-Well's Thompson sees these instances as cautionary lessons.

"We all need to be more aware of the challenges we face when we acquire an entrepreneurially managed company and ask these same people to function just as effectively in a much larger organization," he observes. "The effective and value-realizing integration of the acquisitions we make is, in my opinion, one of the biggest management challenges we face."

Nationwide's Norton sees a similar lesson to be learned. "An acquired company still has to be operated after it is acquired and there should be a business purpose in the acquisition other than just adding another company to the mix," he says.

Of course, the printing industry is not the only sector that has fallen out of favor on Wall Street; indeed, it is one of many so-called "old economy" industries that is watching with some frustration as investors swoon over newly public dotcoms, regardless of their having achieved little or no real profit.

"There is no question that there currently is a 'herd' mentality in the markets relative to their infatuation with dotcom companies and certain high-tech companies," Jensen states. "This has created reduced demand for small cap and/or 'old economy' stocks, which includes commercial printing stocks. Reduced demand leads to lower valuation."

But Colville believes that "investor infatuation with dotcoms is not the direct cause of low valuations of public printing companies, as much as it is the most visible indicator that investors want fast, organic growth—even to the point of standing operating losses—while the printing industry is seen as a slow growth, 'old economy' industry. To attract investors, we need to continue to grow and improve our companies. It's that simple."

Thompson agrees that the secret to luring investors back is simple: "Investors are not paying for growth by acquisition; rather, they insist that we show 'same store growth,' i.e., that we prove we can manage our business and grow it internally. Over time, good management and enhancement of shareholder value will be rewarded."

And, of course, as in any other industry , it's important that public printing firms "make their numbers."

"Missing an earnings forecast," Norton observes, "is a sin that takes Wall Street a fair amount of time to forget. Negative surprises will keep investors in other investment opportunities."

Global DocuGraphiX's McClean bemoans the perception in the market that the existing players in the printing industry are in danger of being replaced by more nimble, e-commerce companies. "The single, best course of action to woo investors back into the printing industry will be to show how the industry will become stronger as the existing players take advantage of the Internet, rather than being a possible victim," he contends.

All this talk of public companies and stock valuations may seem too narrow to some; after all, several of the major acquisition companies in the graphic arts business are privately held. Kelmscott, for one, "has not slowed its growth," according to Jensen. "We are amply funded and our earnings performance is quite good. Nevertheless, some other companies have slowed their growth. We believe it has to do with their inability to acquire capital or debt, depending on earnings performance or lack of bank confidence."

Faucetta, who heads another privately held consolidator, sees a more controlled and specific consolidation than there was in 1998. "We need to evaluate the opportunities of the company, and ask ourselves: Does it really fit or is it just a revenue producer?"

Private consolidators face one significant, additional issue, Colville explains. "In most cases, the financial sponsor is also looking for an 'exit' option, whether it be going public or building a substantial company and selling it to a larger, usually public, company. The current low valuations for printing companies would seem to likely depress the appetite of financial sponsors to fuel the growth of a private consolidator."

Privately held consolidators also look to the stock market for guidance of what their company may be worth, McClean observes. "They do not have the same pressure to make acquisitions just to show continued growth, so they have decided to stay on the sideline until seller expectations have come more in line with where the buyers think the prices will end up."

So, if the boom times have ended, what's on the horizon? Our experts are cautiously optimistic.

"We believe public valuations will recover as small cap and value stocks come back into favor," Jensen declares. "Until then, only those stocks with superior earnings performance, with good predictability, will be rewarded."

"Well-managed, privately held companies facing leadership transition issues or technology advances will continue to seek out qualified buyers," Colville adds. "Will it be at the 1998 pace? Probably not in the near future. However, the industry remains highly fragmented, and consolidation creates value."

Thompson agrees, noting: "Our challenge is to be disciplined in our approach to capitalizing on these opportunities."

But have some of the very basic realities changed? Some industry observers have long suggested that a point in the consolidation process may occur when the fabled "law of diminishing returns" comes into play: As the revenues of each new acquisition join a larger and larger pool, the impact of each new purchase lessens, and the percentage growth of the industry naturally slows.

"Each acquisition should be evaluated on its own merit," agrees Thompson, "and if one continues to make accretive acquisitions, shareholder value will continue to grow. The mistake that must be avoided is to not allow the company to begin overpaying for acquisitions or otherwise getting away from its proven discipline just to get bigger. In the end, this will never work. We must resist the temptation to acquire without a thorough and objective evaluation, just to satisfy the clamor from Wall Street for more growth. The industry needs to do a better job of managing the expectations of Wall Street to a level of growth that is impressive, but achievable, rather than trying to meet the ever-increasing, quarterly earnings estimates generated by the analysts."

Looking further into the future, many of our experts see a two-tiered industry of large, national companies and small, regional players.

"We continue to believe that industry consolidation makes sense and that it will continue steadily until a few major companies dominate," Colville asserts. "Additionally, a merger of excess capacity in 'old economies' with productivity gains of 'new economy' technologies may accelerate the pace of consolidation."

"We believe there will be a small group of consolidators that will control an increasing portion of the industry," McClean reveals. "However, there will continue to be thousands of small players in 2010. Local service will keep many in business; low overhead and low labor costs will keep many short-run companies profitable. Many owners like their freedom and don't want to sell out."

Faucetta echoed that view. "There will still be a lot of the 'mom-and-pop shops' that spring up as entrepreneurs develop within the larger organizations," he predicts. "Will there be as many as we had in the 1980s? I doubt it."

Norton agrees. "Ultimately, I believe that there will be five or six large consolidated companies, but there will always be some number of smaller companies in the industry. It will just take longer than originally predicted to get to that point. However, I think that major consolidation will have taken place by 2010. If an economic slowdown occurs, it will help eliminate some of the companies in the industry, thereby concentrating more of the industry into five or six large companies."

The industry requires more than one service strategy, Jensen stresses. "When you consider the size and dynamism in the industry, it is likely there will always be many players providing superior service. Within that condition, however, consolidators that execute the new business model effectively will garner an increasing amount of market share."

"It is anybody's guess as to the number of companies that will be around in 2010," Thompson admits. "I doubt that there will be only five or six companies left. Our capitalistic system is a wonderful mechanism for preventing that type of dominance. Every time an organization becomes unresponsive to its customers, the opportunity to serve the customer better is presented—and there always seems to be somebody anxious to do it."

How We Got Here

One of the leading roles in the consolidation of the printing industry has been played by investment bankers, which serve as middle-men between buyers and sellers. One of the most prominent of these has been New York-based Berenson Minella & Co. Leading that team has been industry veteran Gregg Feinstein, who offers his observations on the industry's state of affairs.

Size matters. "The printing industry has gotten much smaller during the past year. World Color and Big Flower are no longer publicly traded, while R.R. Donnelley has almost halved in value. As a result, the total market capitalization of the five largest printing companies has gone down by about one-half. There are just not enough equity securities available in the industry for it to be a factor in today's stock market.

The industry's leadership is in transition. "Industries are often defined by their leaders. Exxon, International Paper, AOL, Intel, Cisco—these are industry bellweathers. The printing industry's bellweather was always R.R. Donnelley. A few weeks ago, R.R. Donnelley's stock was at an eight-year low. We have had the greatest bull market this country has ever known, and the industry bellweather—and now its second largest company—is trading at an eight-year low."

The Internet is not the enemy. "Print, like every other industry, is evolving at a more rapid pace than ever. Every year there are more magazines, more books, more catalogs and more direct mail. Radio did not replace newspapers; TV didn't replace radio; home shopping on TV didn't replace catalogs; the computer didn't create a paperless society. And, the Internet won't replace the printed word."

Don't count on being public. "My firm spent the better part of a year helping Big Flower Holdings explore its strategic alternatives, before concluding that the public market would not reward them for what they had built and what they were building. Except during the past five years, the printing industry has been essentially a private industry. It is clear that we are trending that way again.

"The private printers with whom I speak say business is good and that they are growing. The public companies, on the other hand, are reacting to short-term moves in their stock price, often announcing whatever they think will please 'the Street.' Their public status and stock price has become a handicap, crimping their M&A strategy and making stock options a less effective tool for attracting and retaining employees. My advice to them is to run the business like it was private and assume that the stock price will take care of itself if they do a good job. Or, if they can't wait, take the business private to use leverage to enhance the return to equity holders."

Go for scale. "Think bigger rather than smaller. People ask why Big Flower, World Color and Merrill Corp. were sold for comparatively high valuation ratios. Although each had their individual rationales, they had one thing in common: scale. If you're thinking of doing an acquisition, do one slightly larger than you think you should, rather than slightly smaller. Larger companies often have deeper management and better systems that are not as vulnerable to the loss of a single customer or employee, or to softness in any one of the markets they serve."

Build upon that which makes your company unique. "Is it a certain product niche or a certain market that you serve well? Can you become a leader in some aspect of your business? Can you build, organically or through acquisitions, a business with scale and staying power?"

If you're looking to sell, know why. "Companies need to now ask themselves: Why would someone want to own me? If you cannot answer that question yourself, it is probable that no buyer will find this reason for you."