Vol 6 (2009) - Issue 2

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Distressed M&A: Some Strategic and Financial Trends and Considerations

Today's environment and industry structure

Compared with previous difficult economic circumstances, we have entered the current recession with a very different industry structure. In 1991, Richard Coase received the Nobel Prize in Economics for the theory of the firm which was based on the concept of transaction cost, (i.e., the overriding reason for a firm’s existence is because there are costs of putting together different market participants that might be lower within a single firm structure than in the broader market). With this, supply chain management and cooperation become much more important. In fact, many industries have developed a model where original equipment manufacturers ('OEMs') have become 'platform companies'. A 'platform company', as a concept, was defined by GaveKal in 2005 as companies that:

'produce nowhere but sell everywhere … Platform companies know where the clients are and what they want and where the producers are. Platform companies then simply organise the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery).'

In 2007, Bitran referred to a similar concept as 'supply chain disintegration':

'As supply chains disintegrate, OEMs need to find ways to manage the flow of goods, both inbound from outside suppliers and outbound to distributors and customers.'

So far, platform companies have been very successful in capturing the margin in the value chain. For example, in the computer industry, a typical EBITDA margin for a contract manufacturer (‘CM’) would be 3-5%, for an OEM (that is a 'platform company' in this industry) it would be around 12%, and for a distributor it would be just above 1% (based on selected company data and the author’s estimates). From an inventory standpoint, a CM would hold inventory for 28 days on average, an OEM for just 18, and a distributor for 39 days. On a credit rating scale (Moody’s, for example) this translates to an A2 rating for a platform company and Ba1-Ba2 (5-6 notches down) for both the distributor and the CM.

However, with the financial crisis and the resulting changes taking place in the wider economy, there is a strong likelihood of reversal in this trend as transaction costs are going up substantially, the cost of credit has gone up and even more importantly its availability has been reduced, and finally the ability to mitigate credit risk has been impacted by both the withdrawal of credit insurance and the increased difficulty in obtaining 'traditional' financial products like bank guarantees and letters of credit. A company which has a high degree of consolidation in either sourcing or distribution represents a high concentration in terms of both credit and operational risk. While the platform company model in theory (and normally in contractual terms) should provide substantial risk mitigation, the reality is that often most of its business partners would not have enough capital to absorb a material shock. There is, therefore, a clear incentive for vertical integration of the 'middle part' of the chain (i.e. in the above example, the OEM, distributor and contract manufacturer) so the combined company would have no significant concentration problems (on either the supply or sales side) as it will have multiple buyers (instead of, for example, a master distributor) and multiple suppliers (instead of, for example, a single contract manufacturer purchasing all other components and services). This consolidation could be achieved either through 'build or buy' (most parties having some ability to build the core functions of one or the other) or by acquisition.