Maximizing Value in Today’s M&A
By John Jazwinski, a managing director in Deloitte’s Corporate Finance Advisory practice and the leader of the 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 email at firstname.lastname@example.org.
It’s hard to believe that barely two years ago, between September 2008 and early 2009, publicly-traded service centers lost over $7.0 billion of shareholder value. This loss was so significant that the industry has spent the time since re-examining and recalibrating its business model. The result is an industry that is primed for a new round of mergers and acquisitions, although transaction activity remains tepid as sellers continue to hold out for higher valuations. As 2011 progresses, however, the growing imperative to create shareholder value is likely to compel service centers to consolidate. Although mid-market service centers remain largely constrained from pursuing M&As, given their modest size, larger competitors are starting to seek out transaction opportunities—and the mid-market is an attractive space.
Mid-market companies, those with annual revenues averaging $50 million, have traditionally served smaller customers by providing a level of service that larger competitors could not economically deliver. Yet, with the economic downturn, competition has intensified within the mid-market. For example, mills that previously sold only to very large customers directly are now leveraging their size and newfound agility to target customers historically served by large service centers. For their part, large service centers are engaging in both M&A and price competition to capture more mid-market customers, as well.
As a result, traditional mid-market service centers are being edged out, especially where they can’t negotiate favorable rates from the mills. To survive, many are cutting prices, seeking out smaller customers and, in some cases, considering the advantages of selling.
Larger service centers are carefully tracking these trends. As market competition heats up, many of these would-be acquirers are pursing transaction opportunities that they may have overlooked a few years ago. In fact, the rationale for making acquisitions no longer hinges on standalone profitability. Instead, service centers with low levels of profitability are potentially attractive targets, particularly if they can:
n Generate consistent profits within the construct of a larger organization
n Provide a larger customer base to pursue
n Enable acquirers to rationalize production and take up capacity at core facilities
n Deliver best practices associated with serving mid-market customers
n Open new markets where the existing brand does not have a presence
n Position acquirers to achieve instant purchasing synergies on material (as high as $3 per hundredweight for some flat-rolled products), as well as incremental savings associated with common office functions.
The value imperative
Beyond the drive to extend their market base, service centers are under exceptional pressure to enhance shareholder value through volume growth and synergies. With the slowdown of government stimulus spending and ongoing malaise in many end industries, it is becoming clear that the path to economic recovery will take much longer than expected. As one auto supplier noted, “the system is built for 18 million cars and we’re at 12 million—so excess capacity will be an issue for some time.”
To grow in this environment, mergers are increasingly critical. In recent divestitures, many companies that have not historically participated in M&A are emerging as first-time buyers. With the level of competition among buyers rising, even for unprofitable service centers, potential sellers will be closer to achieving their expected return. Taken together, these trends are driving valuations up.
Valuations in the public market are a good predictor of the timing of M&A activity and the returns that sellers can achieve. The frequency of activity increases during those times when valuation multiples are at or near the long-term average. This is due 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.
In the first quarter of 2011, the market price to tangible book value for publicly-traded steel service centers was 2.0x and the five-year average was 2.2x (see Figure 1). The recent and clear trend towards the mean suggests that 2011 will be a good year for buyers and sellers to find common valuation ground.
Lessons from recent transactions
In light of the current environment, owners must assess all their options. Before choosing to sell, mid-market service centers should take three steps:
1. Understand value before you sell. Owners often have a strong opinion about the value of their company, frequently maintaining that the latent value of their assets is not fully reflected on the balance sheet or that fair market value is not properly determined by using a standard multiple of EBITDA. Before making this determination, it is critical to understand how to calculate value.
In Figure 2, some simple math is used to illustrate how to easily arrive at a service center’s valuation and potential levers to augment value. In essence, the value of a service center is equal to the fair market value of each tangible asset, plus a reasonable multiple of maintainable earnings for goodwill based on the intangible value of the business, less all liabilities. Any activities that increase the value of assets, EBITDA or the multiple will increase the company’s value. A decrease in the amount of liabilities will also increase value.
2. Don’t be swayed by the price of steel. Steel prices rise and fall—that is the nature of the steel industry. In the current rising price environment, the temptation to delay a sale weighs heavily on service center owners. Should they take profit now and sell at a later date? The issue compounds itself in a declining price environment, as sellers worry that potential buyers will become more averse to transacting. Freeing themselves from the psychological barrier created by shifting metals prices is the most important step owners can take in evaluating the potential to sell their business.
3. Examine potential post-transaction realities. For an owner contemplating a sale, it is important to consider how a buyer will assess the internal workings of the company, then develop a roadmap to make this process easier for them. As a seller, it is also important to assess how a deal may be structured. For instance, if real estate is not included, it may make sense to arrange a sale lease-back with a third party or consider moving production to another facility. In either event, it’s wise to develop a prudent case for both. Similarly, if employees will be severed, statutory notice requirements may be covered through a short-term toll processing arrangement pre-close. Once you have assessed potential issues, be creative in your approach to mitigation.
As M&A activity continues to heat up throughout 2011, service center owners should not be caught unprepared. If you are considering a transaction, now is the time to conduct a diagnostic on your company to better understand its worth and ways to increase its value. By developing a transaction plan in advance, and sticking to it regardless of the price trend, you can position yourself to realize long-term benefits as either a buyer or a seller. n