M&A Activity Slows in ’99, But Consolidation Still an Industry Trend

NEW YORK—The consolidation trend among natural products manufacturers has continued in 1999, fed jointly by the meltdown of the public-equity markets for natural products stocks and the continued consolidation in the retailing and distribution sectors of the industry.

With the exception of some

e-commerce ventures, few equity offerings for natural products companies have been completed. This situation has opened the door for more consolidation through mergers and acquisitions. Fifty-five transactions have closed year-to-date as compared to 65 during 1998.

Most transactions are now done exclusively on a cash basis because almost all natural products manufacturers have significantly lower stock prices than 15 months ago and are therefore reticent to use stock as transaction consideration. In addition, substantial private-equity capital is available from several investment funds for natural products companies and for entrepreneurs who want to pursue consolidation or company roll-up

strategies.

So, the questions arise: What kinds of companies receive high multiples? What are the characteristics of a company that make it desirable as an acquisition?

There are numerous answers, such as high level of sales, brand strength and synergies that can be exploited by the acquirer. The history of M&A activity in the natural products industry demonstrates that these characteristics lead to higher valuations for those stockholders seeking an exit by selling their companies.

High levels of sales and profitability certainly garner higher multiples, as demonstrated by the enclosed chart. The ratios of valuation to sales and valuation to EBITDA (earnings Before Interest, Taxes, Depreciation and Amortization) are significantly higher, 66.4% and 33.7%, respectively, for companies with revenues greater than $30 million vs. smaller companies. The reason for the higher ratios is that larger companies tend to have stronger brands and are more profitable than their smaller counterparts.

An example is the pending acquisition of Worthington Foods (WFDS) by Kellogg (K). Worthington, with sales of $175 million, is the leader in meat-substitute and related products. Large, multinational companies such as Kellogg prefer to make acquisitions of category leaders. These types of buyers would be less likely to be interested in acquiring Worthington’s smaller competitors on a stand-alone basis, although such companies might fit as add-on businesses.

Another key to attaining higher multiples is whether the acquirer can exploit synergies that result because of the transaction. Often as a result of a merger or acquisition, companies can share various functions, including administrative, product development and finance. This allows for great cost savings that can increase the profitability of both companies.

Such was the case with Richardson Labs when it was purchased by Rexall Sundown (RXSD) for an unusually high valuation.

The strongest reason why certain companies command higher multiples is brand strength. Conventional manufac-turers have made numerous recent transactions in the industry. Mainstream companies are looking to acquire solid brands that singlehandedly generate more than $100 million in sales. This provides acquirers with a solid base from which to market a product as well as a solid and fairly large stream of revenue and cash flow. As a result, companies that possess these brands receive both a premium for high sales and brand recognition.

Recent examples of these transactions are the purchase of Solgar by American Home Products (AHP) and the purchase of General Nutrition Cos. (GNC) by Netherlands-based Royal Numico. Both of these firms were brand leaders and therefore received very healthy valuations when being acquired.

Now that we have seen why some companies receive very high valuations, its time to explain why smaller companies have received lower multiples. Because of inactivity in the public markets, owners of small companies seeking personal liquidity have limited options and therefore receive lower valuations from acquirers. In addition, small manufacturers are at an economic disadvantage when dealing with the top retailers and distributors such as Whole Foods Market (WFMI), Wild Oats Markets (OATS), United Natural Foods (UNFI) and Tree of Life.

As demonstrated by the above discussion, while small companies sell at lower multiples than their larger counterparts, that is not the end of the story. There are clear steps that these companies can take in order to sell at premiums. They may develop strong brands that a larger, more institutionalized food company believes could be greatly expanded or increase sales and profitability. It is important for potential sellers to realize that potential acquirers ultimately value a target on the basis of expected future cash flows, not only on historical performance.

Chuck Slotkin is president of and Alan Jaffe is an associate with Nature’s Equity Inc., a New York-based investment banking and business development firm. Call 212.580.1666 or e-mail info@naturequity.com for information.