M&A Activity to Accelerate in 2010
By John Jazwinski
Transaction activity in the service center industry came to a virtual halt over the last 14 months as buyers and sellers were either unable to find common ground on valuation or opted to be patient and wait for a better time or opportunity. The majority of transactions during this period were motivated either by secured creditors collecting on their security—the largest example being J.P. Morgan and CIBC, which wrote off over $200 million on Barzel Industries—or by vendors that simply desired to exit and re-deploy capital into other areas, such as the recent Gibraltar sale to Worthington Industries.
Unfortunately, 2009 was also marked by dramatic declines in the price of steel and aggressive pricing by larger service centers, which limited the ability of mid-market businesses to emerge from the recession in a position of strength. Many owners are now repairing damage and readying for a transaction. The good news for all is that the industry and the M&A environment will likely be favorable in 2010 as:
n Public service center valuations are increasing and are near or above the long-term average;
n The availability of debt capital is increasing; and
n There is pent-up demand to transact, as there are motivated buyers and sellers.
Valuations are progressing towards the mean
Publicly traded North American service centers are currently valued at an average of 8.2x EBITDA. Like all industries in 2009, the service center industry traded much lower than historical averages and hit a low point of 2.8x EBITDA in the second quarter (see Figure 1). The rapid increase in the multiple since that time is a signal from the investment community that the service center industry is expected to perform well in 2010. Clearly, the end industries of automotive and construction are already showing signs of improvement.
The value of private companies is always lower than public companies due to a discount for not being freely traded or liquid. This discount is typically around 25 percent. Deloitte has arranged several private transactions in the range of 6.0x EBITDA, which is consistent with publicly traded service centers after applying a discount.
It is important to note that the frequency of merger activity increases during those times when the EBITDA multiple is at or near the long-term average. This relates to the fact that buyers want to purchase at or below the long-term average and sellers are only willing to transact at or above the long-term average. The recent growth in the multiple, similar to 2007, is again one of those times where the expectations of buyers and sellers are closely aligned.
During a period of unsatisfactory EBITDA, it is difficult to estimate the value of a company. Given that so much of the value of a service center is in its assets, buyers are increasingly looking to a company’s book value, instead of EBITDA, as the primary valuation metric. For private companies, buyers first adjust the working capital and fixed assets to market values (intangible assets are generally not valued), deduct liabilities and then apply a premium of 15 to 30 percent, depending on the attractiveness of the company.
In the first quarter of 2010, the price to book value for publicly traded steel service centers was 1.1x and the five-year average was 1.5x. The recent and clear trend towards the mean again suggests that 2010 will be a good year for buyers and sellers to find common valuation ground (see Figure 2).
The availability of debt is increasing
The inability of many buyers to access debt in 2009, especially private equity investors, frustrated many transactions. The good news is that this challenge appears to be coming to an end. While bankers typically include a variety of covenants when lending money, one of the most important covenants is the ratio of senior debt to EBITDA. This ratio is also a good indicator of potential transaction activity when applied to the broader market. In general terms, when the ratio increases, there are more buyers who can afford to transact. This translates into greater competition amongst buyers who compete for good opportunities. Competition for your business drives up the value.
The average senior debt to EBITDA ratio for mid-market companies fell dramatically from 3.7x in 2007 to 2.6x in 2009, the peak of the credit crisis. However, in fourth-quarter 2009 the ratio increased to 2.7x, and our recent experience with banks tells us that this figure will trend higher in 2010. With an increase in the availability of debt, more buyers will have access to capital and will be actively searching for acquisitions this year (see Figure 3).
Industry realities continue to motivate transactions
The following realities of the steel service center industry in North America will continue to motivate mergers:
n A fragmented market: There are hundreds of privately owned service centers that must compete with ever-larger competitors for customers and with mills for supply. Becoming part of a larger business brings the scale necessary to ensure relevance in the industry;
n Demographic reality: Many owners of service centers are over 50, are contemplating retirement and are frustrated by the challenges of being small in an increasingly large industry; and
n Buyers have capital: Public service centers have immediate access to significant amounts of debt as well as public equity. These companies must continue to create value for shareholders via growth, and acquisitions are the only option in a mature industry.
Lessons for increasing the value of your business
In advising service center clients, we are often asked for ways that owners can augment value in advance of a transaction. Here are some recommendations:
n Expand niche sales: Expand into desirable, non-commoditized industries such as health, food, chemicals and energy, which provide high margins;
n Scale up: Hire sales executives in new markets that you feel have good potential and use toll processors until you have established a beachhead. If you experience growth, set up a permanent processing base with affordable used equipment and a rented facility;
n Consider a merger: Engage in merger discussions with a friendly competitor. It is likely in a similar financial position and would recognize that size matters to customers, suppliers and ultimately buyers of your combined company; and
n Look like the buyer: Buyers like complementary businesses and will value more those businesses that have similar financial metrics, such as working capital turnover and margin, and that have a similar culture of generating sales.
Given that valuations are trending toward the long-term average, that debt capital is increasingly available and that the dynamics of the service center industry continue to motivate buyers and sellers, we expect 2010 to be a year of renewed interest in M&A. Most importantly, if you are considering a sale in 2010, ensure that your business is optimally positioned for value by making the right strategic and operational changes in advance of any transaction.
John Jazwinski is a managing director in Deloitte’s Corporate Finance Advisory practice and the leader of its Primary Metals group. In this role, he counsels clients on a wide variety of transactions in the service center industry. Based in Toronto, he can be reached at 416-602-1174 or by e-mail at firstname.lastname@example.org.