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Plante & Moran

The M & A Game

A resurgent economy could spark a renewed interest in automotive M&A transactions.

M&A auto supplier deal activity has been noticeably slower the last two years compared to the go-go years of 1996-2001.

Various industry watchers believe the industry may have already reached a trough in deal activity and the coming year will herald a significant increase in automotive supplier deal announcements.

Various considerations supporting the resurgence in supplier M&A deals include (see Diagram 1):

  • Swollen private equity fund balances that must be invested in “some” deal or seriously drag down the return provided to fund investors
  • Improving confidence by supplier executives in the near- and mid-term economy and enterprise performance
  • Historically patient capital tied up in privately held middle market suppliers is becoming more impatient.
  • Opportunistic strategic positioning options open to suppliers resulting from accelerating supplier consolidation activity.

Poor stock market performance over the last three years has caused many savvy high net worth investors to seek alternatives to traditional stock portfolios. One of the larger beneficiaries of this condition has been private equity funds that have experienced massive fund commitments and inflows of investable capital into these funds.

While auto supplier stocks have not been preferred investment vehicles for most of these funds, the fund commitments and balances have swollen sufficiently that private equity managers can no longer totally shun investments in the automotive industry. The auto industry is just too large, in a dynamic change state, and full of opportunity for wealth creation.

Manufacturing jobs in the U.S. have declined every month for the past 41 months.

Finally it appears the bottom may be near. The National Association of Manufacturers (NAM) recently proclaimed “a full-fledged recovery is underway in manufacturing.”

NAM predicts a 4.1 percent GDP growth rate in 2004, with greater than 6 percent growth in the manufacturing sector (following just 1.4 percent in 2003).

Underpinning this bullish prediction includes strong consumer confidence, low inventory levels in private firms, low Federal Reserve interest rates and cuts in the capital gains tax rate. All of this is strongly favorable to the psyche of CEOs contemplating pulling the trigger on either an acquisition or strategic divestiture.

First and second generation auto supplier entrepreneurs have traditionally had lower investment return requirements than their counterparts in private equity or public equity markets. Capital invested in these tier two and lower supplier businesses is frequently referred to as “patient capital.”

The blood thirsty supplier environment of the past several years has changed the attitude of many of these lower tier supplier owners. Many believe the “good ole days” are gone forever, and the next business cycle upturn (which is now) may be the time to exit the business and diversify their family’s wealth portfolio.

There is a consensus the automotive supply base will shrink through the balance of the decade. Estimates of the reduction vary from as little as 50 percent to as much as 80 percent and more. Our analysis suggests 50 percent is directionally correct, and this consolidation will change the auto supplier landscape significantly in many commodity groups. Well positioned suppliers will look for geographic, product, process and customer extensions and leverage their strong balance sheet into acquisitions that strengthen their competitive position and resultant financial performance. A strong balance sheet and savvy strategic positioning skills are a powerful combination in times of industry consolidation.

If the case has been made for accelerating M&A activity in the supplier sector, let’s look at what may be different during this cycle of transactions compared to 1996-2001. Differences include:

  • Rollups intended to consolidate fragmented industry sectors (such as Metaldyne and Tower Automotive) will become less common .
  • Herd mentality will redirect some capital funding from North American acquisition deals to China greenfield and joint venture deals.
  • Deals will have stronger strategic rationale and be valued based on more conservative growth and economies of scale savings assumptions.
  • More attention will be paid to identifying and realizing post transaction synergies.
Venture capital firms perceived the supplier industry as ripe for consolidation in the mid- 1990s. They observed highly fragmented market segments (such as die casting, machining, injection molding, stamping, outside processors) with incumbents having little market clout and the environment often featuring irrational pricing behavior. These conditions led to attempts by venture capital firms to consolidate the market, develop market power and introduce more rational pricing practices.

This was a great theory, but did not generally work out in execution. Most consolidation plays failed to realize both their promise and potential. Customers continued to have a big and effective pricing stick, scale synergies were difficult to drive and enterprise integration was typically weak.

Don’t expect to see the venture capital firms, managed by bright financial and strategic engineers with long memories, make the same mistake again. Some consolidation transactions will undoubtedly occur, but mostly through bankruptcy and liquidation processes.

The buzz concerning low cost producer locations could not have been louder last year. China in particular received unprecedented press and seminar coverage as the place to locate new plants to leverage favorable labor, overhead and material economics.

Our firm conducted a China conference in Cleveland last year and drew over 400 supplier participants, with the conference being on the heels of a similar conference sponsored by OESA with a like number of participants. The hype became so shrill that some perceived it was “China or perish.”

While this irrational exuberance has begun to die down, certain products certainly make economic sense to source in China. These projects take capital and will siphon off capital that would otherwise be used to fund North American acquisitions. How much? It will certainly be hundreds of millions of dollars in transaction value.

The combination of feeling the need to grow at any cost by CEOs, the availability of capital, and huge transaction fees for corporate finance professionals created a tantalizing elixir that drove hundreds of automotive deals in the second half of the 1990s. In a study performed by Booz Allen Hamilton for the period from 1997- 1998, some 53 percent of the transactions failed to deliver the expected results.

This weak performance will not be repeated again. Expect future deals to have stronger strategic rationale (e.g., extending geographic footprint, new customers, higher level product bundles, strengthening value chain position, and improving strategic control index).

Valuation multiples will improve slightly from today’s historically low levels, but will generally fail to reach the multiples common during the 1996-2001 period. Also greater attention will be paid to identifying realizable synergies, and more effort will go into actively managing the achievement of these synergies. Deal values will better reflect economic reality. Merger mania during the 1996-2001 period failed to realize much of its promise and potential. This condition will not be repeated during this cycle. Fundamental supplier consolidation pressures will cause supplier M&A deal flow to accelerate.

Conditions that will ultimately govern the pace of acceleration for the M&A market for parts suppliers include the extent of fund overhang in the private equity market, the strength and breadth of CEO confidence in the future, the number of owners of middle market supply firms deciding to pack up and take their chips off the board, and the pace and strength of supplier consolidation.

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Mon. July 15th, 2024

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