Driving Value in Manufacturing
February 6, 2019
The M&A market continues its strong trajectory in 2019 fueled by business growth objectives, available resources from raised private equity funds and growing corporate balance sheets, debt financing available from commercial and mezzanine lenders, and an overall positive economy. In addition to local buyers from Wisconsin, the state has also garnered a lot of attention from around the world for its manufacturing activity. Besides the attraction to Wisconsin for its central location, hard-working employees and friendly Midwestern culture, Wisconsin is luring a lot of buyers from around the world because of its concentration of manufacturing businesses and diverse end-markets served.
Manufacturing businesses have long been staples of the Wisconsin and national economy. With over 7,815 manufacturing businesses in Wisconsin alone employing over 474,300 employees (16.0 percent of the state’s workforce) they make up approximately 18.2 percent of Wisconsin’s total output. While many of these businesses are privately owned existing through multiple familial generations, there is a growing volume of transactions and increasing rate of private equity ownership (i.e. businesses in Wisconsin owned by private equity accounted for approximately 14.9 percent of total revenues in 2017 compared to 4.1 percent in 1998). Further, it is expected that M&A volume will continue to increase based on demographics of many baby boomer owners. Accordingly, it’s important that business owners plan for a transaction and understand the value drivers of manufacturing businesses, which can commonly differ from other types of businesses in many ways, including:
- Capacity – Whereas service and distribution businesses are generally more scalable to accommodate growth without significant capital expenditures, manufacturing businesses have a heavier reliance on real estate and equipment capacity. For this reason, buyers desire manufacturing businesses that have adequate capacity for growth and will reduce value should growth be limited by capital requirements. An additional factor relates to sales channels as many lower middle-market manufacturing companies rely on direct or indirect sales channels that are at their capacity, so having complementary or additional channels or relationships with capacity to grow business would have an impact on how realistic buyers see growth potential and timing thereof.
- Collateral base – Manufacturing businesses generally have greater fixed asset needs. This can require significant capital investments from year to year, but also provides a collateral base to increase the availability of debt for acquires looking at leveraging the debt markets to structure a transaction. Though, the ideal scenario in business valuation is that cash flow (and the sustainability thereof) drives value and should be the focus of building company value. Accordingly, it’s important to leverage your asset base to drive cash flow and scrutinize capital expenditures until they have an adequate return on investment.
- Automation – Efficiency is key in any business, but even greater with manufacturing businesses because of the capacity limitations shared herein and the critical nature of cycle times, delivery schedules and labor shortages. For this reason, automation has been a popular topic and will continue to be. While Amazon is impressive with their highly-automated distribution centers, manufacturing today is striving for ways to eliminate repetitive labor positions and secondary processing operations to reduce labor needs in reaction to the tight labor market and improve efficiency to increase cash flow, which any predictable and sustainable cash flow increases will drive business value.
- Proprietary nature – While service businesses offer a unique delivery model because it’s more personal and subjective, the differentiator of a manufacturer can be somewhat more difficult to identify and, even more so, to drive business value. Certain manufacturing businesses with brand names or highly recognized products have already figured this out, but those in contract manufacturing or those that are commonly bid against others generally don’t have as much proprietary features. There are differentiators based on capabilities (e.g. specific equipment), process (e.g. quick response) and people (e.g. on-site engineering), and these capabilities can be considered in a proprietary solution. Any proprietary or differentiated manufacturing products (or services) has a notable impact on future sustainability of the business, and, more importantly, on business valuation.
- Appearance – While service and distribution businesses generally have a focus on appearance and have clean operations, manufacturing businesses have machine oil rushing through equipment, barrels of metal or plastic scrap, or raw materials that are cut, melted or fabricated, all of which creates a facility more challenging to keep clean. After touring hundreds of manufacturing operations with corporate and private equity buyers, it’s apparent how important appearance is in their consideration of an acquisition. While entering a clean, well-lit facility makes you good, comfortable and energetic, it goes further than this. A clean appearance is also an indication of how ownership and management care about the business and how various areas are managed such as the credibility of financial statements, accuracy of ERP systems and condition of equipment. While appearance doesn’t directly drive cash flow or those measures upon which valuation methodologies are based, it is taken into account and has a notable impact on value.
- Job costing – Manufacturing businesses can be more complex businesses to understand costs based on the number of inputs, complexity to operations, and focus on high-precision quality versus costs, but buyers are seeking businesses that can explain this level of detail and have the “story” as to certain financial trends in the business, many of which require getting to the detail of specific job costing and margins. Additionally, job costing can assist with the analysis of certain new equipment, labor, automation or other efficiency expenditures and potentially improve the presentation of profitability by understanding certain unique jobs. Additionally, this level of detail builds credibility in the build-up of financial statements, which is growing in importance during due diligence, especially for private equity buyers.
Manufacturing is an important part of the Wisconsin economy and it always will be. As more and more businesses transact, the above value drivers specific to manufacturing businesses can assist in driving value beyond the traditional drivers of revenue, profitability and growth opportunities that relate to all businesses. Lastly, building value prior to a transaction doesn’t happen overnight. We encourage any business owner to begin planning years ahead of time, understand the value drivers of your specific business and discuss your transition strategy with an experienced advisor that understands how to drive value through the M&A process and is knowledgeable of these and other specifics relating to manufacturing businesses.