New Optimism for M&A Activity within the Metal Fabrication Industry
Managing Director, TrueNorth Capital Partners
December 19, 2017 – Given that my firm TrueNorth Capital Partners (“TrueNorth”) serves the investment banking needs of middle-market companies in a broad range of industries, it’s notable that two of our recent transactions involve companies in the relatively small machining-services industry. Based on this recent, concentrated activity with machining companies, and continued interest by clients in this space, we believe that M&A activity for the broader metals fabrication industry will continue to match, if not exceed, national M&A market activity.
By way of background, TrueNorth was the financial advisor for the seller of Michigan-based Avon Gear, a manufacturer of large, complex parts for OEMs serving the oil & gas, agriculture, and construction end-markets and the buyer of Indiana-based C&A Tool Engineering, a manufacturer of custom components for the aerospace, fuel system, and industrial markets, as well as surgical implants and instruments. Interestingly, in both transactions, our client was a Japanese company. As an aside, Japan supplanted the U.K. in 2017 as the leading foreign country of buyers of U.S. metal fabrication companies. In managing these transactions, we talked to dozens of potential strategic and financial buyers focused on the metals fabrication industry and valued machining companies based on the most recent industry research and company projections.
For many years, it has been evident that the metal fabrication industry, including casting, forging, precision components, machining and related companies – while volatile and containing out-performing segments – has been in general contraction. This trend has continued during the current post-recession recovery, as key end-markets such as oil & gas production, agriculture, and off-road vehicles suffered due to weak oil, corn, and other key commodity prices. The economic impact of the contraction in the metal fabrication and other industries is evident in the loss of jobs and increasingly depressed economic conditions in large sections of the U.S. Not surprisingly, the goal of revitalizing the U.S. manufacturing sector, including the metal fabrication industry, was a platform issue in last year’s presidential election.
Despite the difficult market conditions for much of the metal fabrication industry during and after the Great Recession, the annual volumes of M&A transactions in the metal fabrication industry during the past five years has mirrored national M&A market volumes. M&A transaction volumes in the metal fabrication industry and national M&A markets increased to record highs in 2015. In 2016 and, so far in 2017, the number of transaction levels have shown annual declines. In part, these volume declines are attributable to the long duration of the economic recovery, now completing its eighth year. For the first six years of the recovery, during which time companies’ earnings and valuations generally increased – while interest rates were maintained by the Federal Reserve at historically low levels – M&A activity soared. As the duration of the recovery lengthened, the growth in the supply of companies ready, willing, and able to enter the M&A market subsided. Essentially, demand now exceeds supply. Many corporate and financial buyers remain flush with cash and seek the growth of their businesses via acquisitions to bolster organic growth. Thus, acquisition pricing for middle-market companies, in terms of multiples of earnings, have remained at historically high levels.
The strong M&A pricing trend impacts all industries. Additionally, for the metal fabrication industry, consolidation is a key driver of M&A volume and pricing. In the face of lower product demand and increased product pricing pressures, metal fabrication companies have been forced to improve profitability, often by gaining economies of scale through acquisition and rationalization. A number of large OEMs, often the major customers for metal fabrication companies that supply them, have, in effect, encouraged the consolidation of their supplier networks. These OEMs, also facing strong economic pressures, seek supplier networks that are financially strong and more-easily managed.
Based on TrueNorth’s recent machining company deals, industry consolidation has served to relieve increasing instances of supplier-customer product pricing issues. This trend is the direct result of under-budget production volumes. As expected volumes declined, customers (including major OEM customers) sought to make purchase orders at quantities below the established minimum order quantities (“MOQ”) upon which the suppliers have set their prices. In filling an increasing amount of orders below the MOQ volume, suppliers’ margins eroded and customer-supplier relationships become strained if not terminated altogether. Industry consolidation has changed this industry dynamic. In some cases, smaller suppliers were sold to larger suppliers. Sometimes, prior the sale of a supplier, the prospective buyer settles its pricing issues with its supplier to enable the transaction to close. In summary, as consolidating suppliers gained volume and pricing power, minimum order quantity issues have been resolved – often to the satisfaction of the suppliers and their profit margins.
With respect to the buyers driving industry consolidation, corporate strategic buyers, as expected, have accounted for the bulk of industry acquisitions. Financial buyers, however, also have been significant drivers of industry consolidation. Financial buyers, primarily consisting of private equity groups, have been very active across most sectors of the economy, but the extent of their activity within the metals fabrication industry is notable given that a number of companies within this industry have attributes – such as slowed or declining revenue growth, narrowing and more-volatile operating margins, capital intensity, and high customer concentrations – that often cause private equity groups to become less competitive buyers than corporate buyers. For example, in the sale of Avon Gear, our client certainly did not expect that the buyer would be a private equity group. But, after a competitive sale process involving corporate and financial buyers located throughout North America, the buyer that emerged was a private equity group, Speyside Equity, a group that has made a number of other acquisitions in the metals fabrication industry.
Over the past five years, financial buyers have accounted for nearly 20% of all acquisitions in the metals fabrication industry. After making a “platform” acquisition, financial buyers often make “add-on” acquisitions. As with corporate buyers’ strategic acquisitions, financial buyers’ add-on acquisitions seek to expand market share, create economies of scale, and generate various synergies. Over the past five years, these add-on acquisitions have accounted for nearly another 15% of all acquisitions in the metal fabrications industry. Thus, the impact of financial buyers on the M&A market has been, and will continue to be, significant.
In conclusion, since the Great Recession, the metal fabrication industry has not performed as well as most industries. Still, M&A activity in this industry mirrored national market volume trends. It appears, then, that the currently strong M&A market believes in the prospects for successful acquisitions in the metals fabrication industry. Some of the reasons for this optimism are summarized below:
- The recent and overdue cyclical uptrend in commodity prices will drive increased demand from key end-markets for production in the metal fabrication industry. During the course of our recent transactions, we saw the meaningful impact on customer demand – and buyer interest – of rising oil and commodity prices. Due in part to the need to restock depleted parts inventories, the increased commodities pricing and improved pricing prospects resulted in an immediate pick-up in orders. Whether this surge is temporary or not, the cycle is bound to turn upward for the long-depressed end-markets that have created difficult market conditions of the metal fabrication industry.
- Expected increase in infrastructure spending improves the long-term prospects for the metal fabrication industry. The nation’s infrastructure is in need of repair and expansion. The Federal government, with apparent broad-based political support, may take action in 2018 with legislation to stimulate infrastructure spending.
- The expected Federal tax legislation will increase the tax-benefits resulting from accelerated depreciation of capital expenditures. This, in turn, would have a positive impact on the metal fabrication industry – which serves capital-intense industries. And, the proposed 21% corporate tax rate, down substantially from the current 35% tax rate, would help improve earnings, valuations, and M&A buyer interest.
- The current administration in Washington is determined to bring jobs back to the U.S. As the metal fabrication industry lost many jobs to overseas competitors, the Federal government’s success in this endeavor would signify improved prospects for overall financial success of the metal fabrication industry.