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The Advanced Guide to Manufacturing M&A
Matt Duckworth & Patrick Thornton
December 15, 2024
THIS WEEK IN BROKEN DEALS
Here’s what’s in store for this week:
Announcement: How to get a free copy of our new ebook, The 10 Commandments of a Sellable Business
Best Link: The State of Private Equity in 2024 with Charts & Data
The Graveyard: Did you know that about 13% of all deals fail because of management transition issues? This week we go deep on how to avoid the deal graveyard by transitioning smarter.
Work With Us: We just opened up a new program for small growing M&A Advisors and Brokers to get Wall Street level analyst help with their deals on a success-fee basis. Book a call with us below to learn more.
ANNOUNCEMENT
Get our new ebook, The 10 Commandments of a Sellable Business!
This ebook contains the main principles we’ve uncovered analyzing hundreds of broken deals and describes the 10 things you must avoid to close more deals, including:
Why focusing on price is often a mistake and how to use it to your advantage to speed your deal to a closing
How to manage your team through closing so your sales stay strong
The mindset every seller must have to guarantee a successful exit (and why avoiding it can cost you millions)
And more…
THE GRAVEYARD
An Advanced Guide to Manufacturing M&A
U.S. Manufacturing is a $2.3 TRILLION dollar market compared to just a paltry few hundred billion dollar software market. One would think that there would be more interest and expertise in manufacturing as a result, yet very few people understand how to grow manufacturing businesses. Even fewer understand how lucrative the practice can be.
It’s difficult to blame those smart young software engineers from MIT who went into a different field. Manufacturing is rife with challenges and, unlike software companies who can scale quickly with only the threat of a down server or bug, manufacturing businesses face threats of complete product recalls, life-threatening malfunctions, and production-killing equipment failures. As a result, manufacturing business must generally be carefully scaled, and meticulously operated. That’s simply not as fun as coding in a hoodie at 2am.
Due to the challenges with manufacturing scale, it is not uncommon for an acquirer’s dream of revenue growth to be thwarted by the businesses own internal capacity constraints. This creates an interesting phenomena. We’ve observed that these constraints are often misunderstood, even by business owners themselves. This speaks to the complexity of leading a manufacturing operation, but provides a significant opportunity for smart, capable manufacturing investors and operators who can find ways to efficiently increase production capacity.
As a result, manufacturing has attracted very savvy lower middle market investors into the space who have taken advantage of entry multiples of approximately 5x EBITDA (under $2M) who then go on to grow and sell at 8-9x EBITDA (over $10M) while using large amounts of cheap, long term leverage.
Who could ask for anything more?
With this in mind, I’d like to share what we’ve learned over the last several years about investing in manufacturing and, perhaps, encourage you to look more closely at this wonderfully massive segment of our economy. I promise, by the end of this article, you’ll understand how to underwrite a manufacturing business at a level that only a handful of professionals in the world possess and, hopefully, put a few coins in your pocket.
The Graham & Dodd Foundation
In 1934, Benjamin Graham and David Dodd published their best selling investment manual, Security Analysis. In it, they suggested that the underlying foundation of all valuation work is to understand cash. Since that time to today, now almost a century later, their teachings are still regarded as some of the most reliable methods of investment valuation, even among greats like Warren Buffett and Bill Ackman. In hind sight, their success appears obvious. How could one argue that there was something more important than cash when all other metrics are a proxy for it and these proxies frequently change in value based on market conditions?
Graham also make it clear that not only is cash what’s most important, but also that it’s FUTURE cash flow. Although less scrupulous brokers and M&A advisors may persuade you otherwise, Graham emphasized that historical financial performance is only as valuable as its ability to help us understand the future. I concur. After all, understanding future cash flow allows us to do two things.
Avoid losing money.
Compound our money faster.
I believe you’ll agree that both of these are critical to long term wealth generation.
So how do we apply this Graham & Dodd method to manufacturing?
It comes down to only three very simple, important questions.
How stable are the cash flows?
What is the likely and worst case sustainable cash flows of the business?
What are the likely potential future cash flows of the business, with improvements?
Stability of Cash Flow
Before attempting to understand what the sustainable cash flows of the business are, we must fully understand earnings stability. A review of the historical financials will, to some degree, indicate whether or not we can expect the company's past performance to continue into the future; however, in M&A, where a human capital may very likely walk out the door the moment the ink is dry, never to return, we must also use our best judgment to understand the qualitative aspects of the business.
These qualitative questions are based on the fundamentals that impact the business, such as:
Can we maintain the operation once we’ve taken over?
What part of the process is primarily human capital that can walk out of the building at closing and not come back?
What part of the process is primarily systems that are easily trained and reproduced?
Dwelling on these items can be very helpful. More concretely, for manufacturing, we have found that it is very helpful to construct due diligence questions so as to walk away with a deep understanding of the following four areas:
Dependency of process on human capital
Commodity versus niche positioning / Level of product differentiation
Customer concentration
Sales process, and team
Why these four areas?
Typically, we see that companies with differentiated products who are not dependent on a single person in sales or operations, who are well diversified in their customer base, and who have at least an average sales process will have very stable cash flow post acquisition. This is important when using debt to finance transactions. To put it very simply, if there’s a strong chance you may not be able to service a loan, leave that deal to someone you don’t like. It’s the fools who rush in where angels fear to tread.
And with this first test complete, we move onto the next step of estimating current sustainable cash flow.
Current Cash flow
Understanding current cash flow for a manufacturing company is very similar to all other companies with one great exception… the treatment of capex.
With this knowledge, I’ll skip over the general mechanics of estimating earnings and get right to the point about capex.
Where other industries do not worry about the depreciation of large, expensive pieces of equipment and the potential cash flow nightmares equipment failures can cause, manufacturers must constantly plan ahead for equipment replacement. As a result, there is generally no such thing as a true EBITDA calculation that can approximate true cash flow for a manufacturer.
Fortunately, there’s an easy way to approach this. We frequently use operating income, subtract depreciation, and add back an estimated maintenance capex expense to arrive at likely cash flow. Often enough, this works.
Once this is complete, we can start to truly estimate future cash flow, post-improvements.
Future Cash Flow, Post-Improvements
It’s been said that most of the value created by Private Equity over the next decade will come from operational improvements. If this is the case (and we want great returns), then we should be bloody sure our valuations of future cash flows are accurate.
To do that for a manufacturer, we look at three specific factors:
What is the constraint?
How easily can we exploit the constraint?
What is the impact to sales and costs as a result of the new capacity?
You’ll notice that capacity constraints form the foundation of the questions above. Understanding capacity constraints is, by far, the most important task an Manufacturing M&A pro must understand if they want to be successful long term. This means going beyond simple calculations of cycle time on machines. We must be able to walk into a plant and, through your own observation and questioning, determine what the true constraints of the business are, regardless of the opinion of management, investment pros, etc.
Why?
This is the step no one can afford to get wrong because it forms the basis of your potential upside, downside, and, ultimately, valuation.
Answering these questions correctly gives us a view of the business’s true potential in several important ways. Not only can we understand cash flow after improvements. These cash flow estimates allow us to estimate future valuation multiples. This can’t be over emphasized. Quite often, large increases in capacity lead to large improvements in earnings, which have the wonderful tendency to push the business’s valuation multiple higher.
So in other words, meaningful improvements to manufacturing firms allow acquirers to benefit through
Expanding cash flow
Expanding valuation multiples
Together, these form a powerful value creation machine. We like both a lot!
THAT’S A WRAP
Before you go: Here are 2 ways we can help
Is your deal stuck? We may be able to help. Get a free 30-minute deal assessment here — LINK TO SCHEDULE ASSESSMENT CALL
Are you an M&A Advisor or Broker looking for Wall Street-level financial analysis support for your CIMs and client financial info? If so, we offer a success fee-based program to help you close more deals with less overhead. To learn more, schedule a call here — LINK TO LEARN ABOUT SUCCESS-BASED FINANCIAL ANALYSIS
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