Within the U.S. manufacturing sector, mergers and acquisitions (M&A) activity slowed slightly in 2016 after a brisk 2015. This downturn was not unexpected and was partially due to uncertainty related to the elections, which delayed transaction decisions.
Post-election, investor optimism has increased with promises from the new administration to strengthen U.S. manufacturing through reduced taxes and regulations. These factors — combined with significant demographic and macroeconomic tailwinds like aging executives and owners, slow organic growth, and corporate and private equity balance sheets flush with cash to invest — point to a likely uptick in manufacturing company deals during 2017 and beyond.
With a more active market, competition among buyers is fierce for good companies looking to sell, and valuations remain well above historic trends. To remain competitive in this market, buyers are “pricing to perfection” on initial bids — that is, bidding at or near maximum valuation but leveraging due diligence procedures in an effort to identify opportunities to retrade after the letter of intent. Specifically, they’re looking more carefully to find undisclosed problem areas that might allow them to structure a deal by offering less cash up front, drop the overall price, etc.
Given these conditions, what we have observed in the market, and considering historical factors from previous cycles, we have developed the following recommendations for manufacturing buyers and sellers to get the best possible deal.
Buyers: Identify Ideal Targets
Because there are so many strong manufacturing companies out there, buyers must remain consciously selective and should thoughtfully determine their objectives with their management teams and advisors. Buyers with poorly defined investment theses are in danger of wasting precious time and money chasing after targets that look good in the moment but are not sufficiently accretive in the short term (or sustainable in the long term). A good sell-side advisor will quickly catch word of these “tire kickers,” and buyers who have a clear plan to finalizing a deal might quickly find themselves out of strategically strong target options. Furthermore, with valuations at an all-time high, patience is a virtue.
Buyers should also be as specific as possible in planning their acquisitions. In addition to providing an overall understanding of the current M&A market, deal trends, and acquisition process steps, transaction advisors help financial (and strategic) buyers consider a wide variety of variables to define the ideal characteristics of target companies. These factors include elements of financial performance; sales dynamics, including markets and customer base diversity; technology considerations around systems and processes; and organizational and cultural elements. Additional areas of emphasis might include intellectual property, geography, and labor.
In addition, manufacturing buyers might consider environmental and distribution matters. Buyers can quickly find themselves in challenging situations after a deal closes if they end up purchasing a facility that requires a major cleanup or if distribution costs unexpectedly escalate.
Sellers: Clean House
While cash is freely available to purchase good companies, it’s much harder for mediocre companies to get buyers’ attention. Therefore, manufacturing owners contemplating selling should take steps to make sure their companies are pristine before engaging in the sales process. This might require a multi-year plan to address issues and strengthen the bottom line prior to actively engaging in a sale process. The following are some examples of issues that buyers are looking at more closely than ever:
· Finances – High working capital or CAPEX investments compared to the industry can be red flags for buyers as they can indicate how well the company has invested and managed its cash flow.
· Management team strength – Who should stay and who should go? Some employees are more critical and irreplaceable than others.
· Inventory obsolescence – Obsolete inventory can be symptomatic of the wrong product choices, inaccurate forecasting, or faulty inventory management.
· Capacity utilization – Using this metric, potential buyers can assess a company’s current operating efficiency and determine future capacity for growth.
· Variability or collection of revenue issues – Revenue problems could indicate flawed accounting or administrative processes or poor product quality.
· Intellectual property – A target company’s value could be diminished in the eyes of a buyer if key intellectual property actually belongs to a contract manufacturer or if it is not properly protected.
· Supply chain risk – Supply chains can be subject to problems such as disruptions due to commodity availability, shipping problems, and border issues. Have a diversified supply chain with multiple options along the chain to mitigate supply and delivery risk.
· Customer concentration – High customer concentration can be undesirable to some buyers. Depending on their intentions, a diverse customer base typically attracts a broader base of potential suitors.
· Contract issues – Buyers review contracts to ensure there are no risks to the transaction, avoid customer duplication, and verify that the contracts are assignable or transferable.
· Vendor relationships and concentration – Buyers want to ensure target companies have strong vendor relationships in place.
· Regulatory issues – Changing or noncompliance with local, state, federal, or international tax regulations can carry heavy penalties for buyers post-close.
· Commodity/raw material risk – Fluctuating prices can have a significant impact on margins. Have plans for mitigating pricing risk and resultant impacts on margins.
Executives at companies looking to sell must assess these factors and others well in advance of a transaction. A qualified investment bank can help identify and position these issues within the confidential information memorandum (CIM) for the best chance of success, but the seller should consider if and how they might mitigate them before going to market. It’s important to note that retrading becomes more difficult after buyers have made the agreement based on disclosed information. Bringing your M&A advisor into the process well in advance of going to market can also help management maintain focus on running the business, which is critical in a sale situation.
Special Considerations for Rocky Mountain Companies
Some trends that might affect sales within manufacturing are regional. In Colorado, for example, finding and affording skilled labor has become more challenging because the cost of living has risen. On the flip side, buyers that have the capacity to be an “employer of choice” can be assured that — because of the high quality of life offered by a mild climate, thriving cities, and ample recreational opportunities — employees could be attracted from other areas.
Another Colorado-specific manufacturing industry transaction consideration is the type of companies that have sprung up here. Brewing, for example, is well-developed. For buyers looking at purchasing a brewery and a choice between Colorado and another location, Colorado is a good bet because of the vibrancy of the industry. The same is true of biotech, aerospace, outdoor and sporting goods, and technology.
With a brisk M&A market in manufacturing, both buyers and sellers have some work to do before launching a process that typically takes 8 to 12 months to close. Buyers must make sure they have a firm understanding of the type of companies they’re looking for, down to very specific and strategic characteristics. Sellers must make themselves as appealing as possible and eliminate or mitigate any issues that could enable buyers to prefer another company or lower their offer. Both buyers and sellers should consider working with an experienced advisor who can navigate them through this complex and risk-prone process.
By Adams Price, EKS&H Capital Advisors LLC, and Kreg Brown, EKS&H LLLP
As part of a tightly integrated investment banking approach, EKS&H Capital Advisors LLC can help manufacturers on both the buy and sell side of a transaction. To learn more, contact EKS&H Investment Banking Team President Adams Price at 303-740-9400 or firstname.lastname@example.org.
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