Deal Watch: Why grow through acquisition?

Acquisition and consolidation have been the defining buzzwords of the environmental services industry over the past few years. Each sector of this business has had its own individual consolidators — Waste Management and Allied Waste in the solid waste business; Safety-Kleen/Laidlaw on the hazardous waste side; Thermo Instrument and Danaher in the monitoring and instrumentation sector; URS and the IT Group in engineering and consulting and U.S. Filter in the water industry (until it was itself acquired a year ago by the French water giant Vivendi). We are likely to see this trend toward greater consolidation — and more merger and acquisition activity — continue for at least a few more years.

Given the long-term economic attractiveness of the environmental business, and the fact that equity valuations (market value of all an individual company's shares of stock) are at historically low levels, the prime driver behind many acquisitions is the relative price of the assets. The cost of buying into this business has never been lower. In the past, higher equity valuations implied a relatively small circle of active acquirers, today growth through acquisition is a strategy that every company must at least consider.

As mergers, acquisitions and capacity rationalization continue to dominate the industry's news, practically all firms find themselves in the position of strategically evaluating merger and acquisition (M & A) transactions, either as a buyer or seller and sometimes as both. This urge to merge is alive and well in the environmental services industry, despite clear evidence that bigger is not necessarily better in the environmental business. There has already been considerable consolidation through M & A activity — one recent study estimated that as many as 20 percent of all environmental service firms have "disappeared" through attrition or consolidation over the past three years, yet it is likely that we will see quite a bit more consolidation activity before the economic "re-arrangement" of this industry reaches completion, and the business settles into a more stable and predictable situation.

In a series of upcoming columns, we will examine this merger and acquisition trend in more detail and evaluate its strategic implications for both individual companies and the industry as a whole. In this first article we deal with the "why" issue: Why are so many firms are attempting to grow through M & A strategies? In future columns, we will look at the "what" and "how" issues: What are the key factors companies consider in evaluating transactions and how are deals typically valued, negotiated and structured? Finally, we will evaluate what a newly combined entity can do after the deal is done to make sure the companies are successfully integrated and that original strategic objectives are realized.

Strategic drivers

When company valuations are relatively low — as they are at the moment — all of the other, and perhaps more fundamentally strategic, reasons behind acquisition-based growth strategies become even more attractive.

Diversification into new market niches or new geographic regions. A broader marketing reach, either into new end markets or into new geographic regions, is often the primary driver behind an acquisition. Certainly, many of the transactions seen during the past few years have been geared to filling in geographic "holes" in the acquirer's national coverage. Phrases such as "we need another facility in the northeast to round out our capabilities," or "we have to have a California presence" are heard frequently from growing environmental companies. Along a similar vein is the acquisition of certain types of service capabilities or specific industry expertise. This could include strategic environmental management capabilities or an expertise in the pulp and paper industry. The target firm may have a strong reputation or business concentration in specialized end markets; rapid access to those end markets may be the objective of the acquiring firm.

Simple growth in revenue or earnings. The inexorable drive for greater absolute size and market share has long been a basic tenet of American business. With greater market share, the reasoning goes, comes a broader set of capabilities, a stronger competitive position, greater control over pricing and presumably, the potential for higher long-term profitability. Despite strong evidence that greater size does not necessarily confer greater profitability, the last several years of maturation and shake-out in the environmental industry have led many firms to turn their strategic focus toward growth through acquisition. As industries mature and become more competitive, it is typical to see the financially stronger players consume the smaller and perhaps weaker players. In short, it becomes quicker and more efficient to grow by acquiring assets than by building them internally.


The prime driver behind many acquisitions is the relative price of the assets. The cost of buying into this business has never been lower.

Achievement of greater efficiencies. As a corollary to the above, many acquisitions are fundamentally driven by the desire to achieve greater operating or marketing efficiencies, or to spread a fixed overhead and cost structure across a larger volume of business. Two of the first things evaluated in most potential deals are the possibilities for elimination of redundant overhead expenses and for broader utilization of an existing marketing and distribution infrastructure.

Acquisition of a new and broader customer base. At a time when the internally-generated revenues of most individual companies are flat and the overall environmental business "pie" seems to be shrinking, a key driver behind many transactions is the acquisition of a more extensive and diversified customer base. Many acquirers simply buy the target company's book of business in an effort to build or maintain their own revenue levels.

Acquiring a company and then transferring its business from one group of professionals to another, or even from one physical facility to another, is not always as easy as it sounds. Clients are creatures of habit. Historical personal relationships, the logistics of meetings and service delivery and other routine factors may make the shifting or retention of revenues after an acquisition difficult. It is particularly difficult to shift business in a professional services industry, where it is the people themselves that the customer is buying. Consequently, a prime concern in any acquisition in this industry is the retention of key "rain-makers" and major client contacts.

M & A motivations

Strengthening or broadening the capabilities of the work force. Strategic acquisitions are sometimes driven by the need for additional management or technical expertise. However, this is probably not as critical a factor today as it was several years ago. With the gradual contraction of the industry and the availability of trained staff, today's environmental labor market is a buyer's market. Even when very specific management or technical expertise is required, individuals can often be hired away from the competition.

Acquisition of other capabilities to meet customer needs. Besides professional staff, customers and market access, a buyer may want to acquire patents, computer programs, proprietary technologies and products or other hardware or software that the target firm controls. In the case of equipment manufacturers, the selling firm may wish to access distribution channels provided by the acquiring firm.

Vertical integration into related businesses. Vertical integration and diversification are natural means of growth and survival in any industry. For example, this line of thinking characterized the 1980s-era decision by many engineering and consulting firms to enter the lab business. Many firms reasoned (generally incorrectly, as it turns out) that by acquiring laboratory services, they would not only capture the up-front marketing contact with customers, but also would be able to present a more full-service offering and appearance to the client.

Today, the trend is better characterized as horizontal diversification within the industry, as many consulting firms actively try to diversify into traditional civil, transportation and infrastructure engineering markets. Many engineering firms have also tried to diversify downstream into the construction and remedial contracting business to actually implement and manage the projects they design. Most are having limited success here as well.

Elimination of direct competition. As mature industries tend towards oligopolies, firms sometimes acquire with an intent to consume and eliminate their competition. Although their intentions are not usually stated in such Machiavellian terms, this effect often occurs in industries that have reached a concentration level in which just a few firms dominate the industry.

Conclusion

In a maturing and highly competitive market like most sectors of the environmental business today, most mergers and acquisitions are ultimately driven by either the desire to buy revenues in order to maintain a given size and build a larger and more dominant strategic position for the future or to spread costs over a larger volume of business. Today, many buyers are strategically piecing together organizations that they hope will be successful once more economic stability and predictability returns to the industry. These transactions are facilitated by broadly declining equity valuations. As it becomes cheaper to employ acquisition-based growth strategies, the pace and extent of M & A activities inevitably heats up.

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This article appeared in the June 2000 issue of Environmental Protection magazine, Vol. 11, No. 6, p. 80.

This article originally appeared in the 06/01/2000 issue of Environmental Protection.

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