Rolling Into Trouble

Consolidating firms promise sellers rewards -- and even independence -- but what they deliver is often quite different

By DEE GILL

In early 1999, Carl Spetzler sold Strategic Decision Group Inc., a profitable, consulting firm in Menlo Park, Calif., that he had built over 18 years, in exchange for shares then valued at $125 million in a bigger company.

It was a huge mistake.

At the time, the sale seemed the logical next step for Mr. Spetzler, an ambitious entrepreneur who wanted to aggressively expand his business but needed a financial backer. The Metzler Group Inc., a consolidator building a national business-services firm by acquiring, or rolling up, small companies, would buy SDI and hire Mr. Spetzler to run its growing consulting division. Metzler would take over the headache of raising money for expansion, while the stock would allow Mr. Spetzler to continue sharing in the profits of his work.

But the shares plunged before Mr. Spetzler, now 59 years old, could sell them. "Our experience clearly was not a happy one," he says. Navigant Consulting Inc., as the Chicago-based consolidator is now called, is selling businesses rather than buying them, and Mr. Spetzler was forced to borrow money to buy back his company. "We got the house back, only now we have a first and second mortgage on it," he says.

His experience isn't unique. Hundreds of entrepreneurs each year sell their businesses for stock -- with restrictions on selling the shares -- in consolidation companies, or roll-ups. And in recent years, a long list of these stocks have tanked in spectacular fashion.

To name a few, consider the recent share tumbles of Comfort Systems USA Inc., an air-conditioning and heating firm; electrical contractor Integrated Electrical Services Inc.; funeral-home company Service Corp. International Inc., all based in Houston, and AutoNation Inc., the Fort Lauderdale, Fla., car-retailing vehicle of investor H. Wayne Huizenga. All traded at lofty levels based on expectations of growth through acquisitions, then plunged, for a variety of reasons, eliminating the companies' acquisition currency.

No acquisitions. No growth. No rising stock price. No acquisitions. The vicious circle turned against the roll-up promoter.

So, an entrepreneur considering a career with a roll-up, or a retirement dependent on the performance of one, should understand how the strategy works and what gets these kinds of companies into trouble.

Restricted Shares

A consolidator buys numerous small businesses as the means of creating one big company that can claim a broad, usually national, service. Typically, a consolidator pays for an acquisition with some combination of stock and cash, and usually puts limits on how quickly the seller can liquidate the shares.

The earliest consolidations were funeral homes such as SCI, and Loewen Group Inc., Vancouver, British Columbia; and trash companies Waste Management Inc. and Browning-Ferris Industries Inc., both now in Houston. They each acquired hundreds of mom-and-pop companies beginning in the 1970s and became famous growth stocks. Both industries hit the skids based on fundamental problems in the 1990s -- fewer than expected deaths along with greater use of cremation, and a glut of dump space, respectively.There have been roll-ups of chiropractors, pest-control services, video stores and personnel firms. Telecommunications cable installers are popular this year (Quanta Services Inc., Houston; and MasTec Inc., Miami). Next year, it's likely that something different will be rolled up.

Roger Ramsey, 61 years old, is a roll-up veteran from Browning-Ferris, and later Allied Waste Industries Inc. in Scottsdale, Ariz. Listening to Mr. Ramsey talk about his latest venture gives some insight into the kinds of things that drive consolidators and how roll-ups are supposed to work.

Mr. Ramsey recently joined VeriCenter, an applications-service provider, or ASP, started by one of his son's friends, with dreams of organizing a high-tech roll-up. ASPs provide business services, such as accounting, allowing companies to outsource such work over the Internet. VeriCenter has made two acquisitions so far. If all goes according to plan, says Mr. Ramsey, an initial public offering next year would fund a run of small-company acquisitions, which he would roll up into a major company that can provide a broad range of Internet-based services to businesses.

But talking technology with Mr. Ramsey is an almost painful experience. Sitting in a strip-center office outside of Houston, he struggles to remember Internet jargon as if he's speaking a foreign language. He has little flair for tech-speak, and he knows it. He also has a sense of humor about it. "When I can correctly define 100 acronyms and use them in a sentence, [the partners] are going to let me grow a ponytail," says the man with the army haircut.

Consolidators like Mr. Ramsey appear to be less concerned with the particulars of what an industry does and more concerned with the ins and outs of acquisitions. In fact, many roll-ups are run by mergers-and-acquisitions specialists rather than people with long-term industry experience. Mr. Ramsey and his colleagues look for growth industries filled with mom-and-pop operators and few, if any, big names. The idea is to cobble together these disparate companies and cut their combined costs by buying materials in bulk and centralizing some operations.

So when Mr. Ramsey looked at application-service providers, he didn't see an industry best left to computer experts. He saw something comparable to the trash industry in the 1970s: an industry made up of small niche players and fantastic predictions of growth. (From barely existing to about $20 billion by 2004, according to Mr. Ramsey.) "Everyone is clamoring to be an ASP," he says. "I've never seen a place where I was more sure there was going to be a shakeout in consolidation."

With that in mind, Mr. Ramsey doesn't worry much that his industry lingo isn't up to speed. He says he will bring a translator to Wall Street with him to field questions from ASP analysts.

Indeed, fortunes have been made in the roll-up game. US Filter Corp. had $17 million in sales in 1990. Nine years, 260 acquisitions and a big share-price run-up later, the company sold for $6.2 billion, or $31.50 a share.

Even Waste Management and Service Corp. International -- two of the most spectacular falls in the sector -- gave investors hefty gains before cratering. And today, shares of Quanta and MasTec, two big consolidators that install telecommunications cables, have continued to be strong despite the taint of the sector. Among the lucky shareholders in each of those companies were former small-business owners who sold their companies for stock.

The existence of roll-ups also has been a benefit to small-businesses in some industries, as consolidators competing against each other for acquisitions have boosted the value of their businesses. United Rentals Inc., based in Greenwich, Conn., has paid cash to buy hundreds of small-equipment rental companies in the past few years -- businesses that had few buyers lining up before the consolidator's appearance. Contractors of mechanical equipment, who could have expected to get no more than book value for their businesses a few years ago, now sell for several times that amount in roll-up shares and cash, explains Michael Price, founder and president of First Mergers Group in Potomac Falls, Va.

But whether a small-business owner fares well when he takes stock in a consolidator is a big gamble. It is not uncommon for a roll-up company to soar in the market for a year or two before plunging.

Ignoring the Business

One of the most common reasons for such a swan dive is a lack of focus on actual consolidation. In some cases, consolidators get so caught up in the frenzy of deal making that they never get around to the more mundane business of cutting costs and marketing nationally in ways that would make the big company more profitable than a bunch of little ones.

This slowness to integrate is part of the problem at Comfort Systems, explains Bill Murdy, the new chairman and chief executive who was brought in this summer to restore the company's credibility on Wall Street.

Shares of Comfort Systems were on the rise in early 1998, when it had acquired about 36 companies with nearly $500 million in annual revenues. But then it missed earnings projections -- three times. Shares plunged.

Mr. Murdy says he is now centralizing Comfort Systems' various purchasing and bidding functions. With its size, he says, the company should be able to win regional and national contracts. Volume discounts in purchasing should also help it cut costs, he says. "We're an attractive customer for a vendor, and they are willing to give us savings if we can get our act together," he adds.

It isn't easy. Waste Management, 30 years into the roll-up game, is still trying to centralize its purchasing.

Muddled Books

Analysts that follow consolidators say numerous acquisitions can make sorting out a company's real underlying growth difficult. Costs that are listed as one-time charges for acquisitions sometimes turn out to be recurring expenses that will hurt expected earnings year after year. Or one-time gains are included in earnings without disclosure.

Waste Management, cleaning up its books twice in the past two years, took pretax charges of $3.54 billion and $1.76 billion.

Navigant Consulting was forced in January to restate past earnings downward after the discovery that certain acquisitions booked as "pooling of interest" should have been booked as purchases. Shares plunged and never recovered.

Michael Price, of First Mergers Group, who has represented numerous small businesses in sales to consolidators, has his own warning. "We want them to hold the least amount of stock possible," he says. In other words: get cash.

-- Ms. Gill is a writer in St. Petersburg, Fla.

Write to Dee Gill at breakaway@wsj.com

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