Industry Today: The World of Manufacturing

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 Date:7/19/2010

 

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Manufacturing M&A: Doing Deals in a Reset World
Many manufacturing companies are cautiously shifting gears from retrenchment to expansion as business activity revives and credit markets improve. After nearly two years of focusing on cash and liquidity preservation and cost reduction, they are now looking to build capacity and explore growth opportunities. By Dan Schweller, Mark Walsh and Tim Hanley.

With the economic recovery expected to be slow going, and to offer a challenging environment organic growth potential (especially in mature markets such as the United States and Europe), many companies are viewing mergers and acquisitions (M&A) as essential to achieving growth targets. In a recent Deloitte Dbriefs Webcast survey, nearly 45 percent of manufacturing participants said their company is highly likely to, or definitely will, contemplate M&A opportunities in the next 12 to 18 months.

What factors contribute to this more active deal landscape? Many companies have high cash levels, and many businesses remain undervalued despite the rebound in stock prices. Industries integral to manufacturing, such as metals, chemicals, and paper, are considering consolidation to control capacity and gain economies of scale. Some companies are eyeing acquisitions to capture opportunities available through the U.S. Government’s stimulus program or other government initiatives.

Potential acquirers are making their shopping lists, from product line extensions to buying whole companies. Two-thirds of the manufacturing Dbriefs survey respondents say they are most likely to pursue a target company with adjacent product lines, or make a horizontal move on a competitor. Whatever their goals, targets, or tactics, companies returning to the M&A marketplace will find the environment and challenges different from the past in several important ways.

What’s Different?
In today’s economic environment, companies are more likely to proceed cautiously in making acquisitions and taking on leverage. Reaching agreement on transaction price is likely to be harder, as both buyer and seller address the many uncertainties that lie ahead. Deal timeframes will likely continue to be protracted, and deal terms will likely be more aggressively negotiated.

Due diligence has become more important to evaluate the effects of the downturn. Acquirers will likely strive for greater insight into deal value and risks through due diligence so that they can make more informed decisions and better assess opportunities to actively manage the acquired business for value post-closing. They are also likely to have higher degrees of board scrutiny during the approval process. Additionally, the cultural dimensions of integrating acquired operations will demand more attention as companies forge into new geographies and markets.

Many companies appear unprepared to cope with these and other deal aspects. Fewer than half of respondents to the Dbriefs survey indicated that their company is adequately prepared to successfully complete an M&A transaction. However, more companies are investing in internal M&A capability development. These companies are putting in place processes, tools, techniques, and training to prepare their organizations for specific types of transactions that they will likely complete in the next 24 months. As a result, the gap between the prepared and the unprepared is growing at an accelerated pace.

Understanding the array of deal considerations and addressing them early on should help companies be better prepared to pursue opportunities and achieve their M&A objectives.

Getting to the Right Price
We have seen bid-ask spreads in M&A transactions widen amid today’s difficult business conditions. Buyers are valuing targets conservatively, unsure whether they can deliver on growth objectives or because they are concerned about further value erosion. Sellers, meanwhile, are raising their sights as economic conditions improve. Some are seeking higher valuations. Others feel less urgency to deal as their financial health improves. In the public-company arena, price dislocation leads toward more hostile deals. Indeed, in 2009 we saw a sharp increase in hostile deals. Additionally, buyers and sellers have resorted to contingent consideration, such as earnouts, to bridge value gaps.

Earnouts can help bring buyers and sellers closer together to get the deal done. In earnout arrangements, the parties agree to make a portion of the purchase price contingent on the target business meeting future performance measures post-closing. Earnouts can help sellers realize the value they desire, while helping buyers manage their purchase price risk by sharing some of that risk—and potential value—with the seller.

One of the first questions in structuring an earnout is what portion of the purchase price will be at risk in the contingent arrangement. Reaching agreement on the appropriate performance targets or milestones and how they will be measured is also a critical part of earnout negotiations, as it establishes the basis for determining whether and under what circumstances the contingency may be in the money post-closing. Not defining measurable performance targets in detail is one of the most common causes of post-closing disputes.

Factors to consider in fashioning an earnout arrangement include the term of the contingency, the frequency of payments to the seller, the level of post-closing integration, and the need to consider and value potential synergies during earnout negotiations.

Also, companies considering use of earnouts will want to become familiar with Financial Accounting Standards Board (FASB) Statement 141 (revised 2007), Business Combinations, (FAS 141R). FAS 141R has increased the complexity of contingent consideration accounting by requiring that earnouts be fair valued at the time of the transaction and then remeasured each reporting period until the contingency is resolved.

Ramping up Due Diligence
A dominant theme of the manufacturing M&A revival is the need for greater due diligence. Anxious to avoid a bad deal—and the wrath of their board and shareholders—potential acquirers want to dig deeper to determine if a target is healthy, what it is worth, whether it is a good strategic fit, and what the risks are in pursuing and completing a transaction. These questions are leading companies to take a more holistic approach to their due diligence that examines financial, commercial, and organizational factors.

Companies are directing a significant amount of effort toward evaluating cost-reductions made by a target to survive the economic downturn. For example, the target may have severely cut staffing levels during the recession and now may be representing these reductions as a sustainable cost elimination for which value should be attributed. Careful consideration should be given to evaluating whether, in fact, these reductions may have created an unscalable, unsustainable cost structure, requiring additional incremental outlays simply to return to normal operational levels.

Not surprisingly, distressed targets have become more prevalent and may represent good value. However, buyers should proceed with caution. Such businesses may be saddled with issues related to employee retention and compensation, customer retention, and deferred repairs, maintenance, working capital, and capital investment. Tax-related issues, such as levies that get discharged and which stay with the company, can also be complex post-bankruptcy.

Companies pursuing a distressed target should assess the target’s level of distress, the reasons for distress—for example, financial, market, or operational—and the consequences of management actions that have been taken to survive in the crisis environment. It is also important to assess the impact on customers and other key stakeholder relationships, as well as brand and market position, to determine the possible actions and costs associated with reviving the target’s market position. Specialized skills are required to address these issues, along with sufficient funding to restore the business to health.

New Geography Means New Risks
International transactions are on the upswing as potential buyers look beyond mature markets for growth. An array of new due diligence issues and risks arise when considering a cross-border deal.

For example, governments may constrain ownership by foreign firms for security and other policy reasons. Labor policies may limit a company’s ability to align its workforce to meet demand. Land ownership and licenses require scrutiny, and repatriation of profits may be difficult and costly. All these matters should be carefully layered into the buyer’s investment model.

U.S. companies pursuing targets abroad should also be mindful of laws and regulations aimed at preventing corruption. These include the anti-money laundering provisions of the USA PATRIOT Act and the Foreign Corrupt Practices Act (FCPA), which prohibits bribing foreign government officials to obtain or keep business. As U.S. companies strive for low-cost production and a global footprint, additional due diligence regarding these matters becomes paramount.

One key to success in cross-border deals is to use local resources that understand the business culture, speak the local language, and provide perspective on governmental considerations. Also, careful attention should be paid to variances in business practices and accounting policies. Even the application of International Financial Reporting Standards can differ from country to country.

Conducting the intense due diligence needed to deal with the matters described here may be difficult for some companies. As M&A activity has waned in the last several years, many companies have redeployed deal resources, including financial and tax due diligence teams and integration specialists, to other areas of the business. Redevelopment of internal M&A capabilities may be required.

Integrating the Acquisition
Once a deal is completed, attention and effort should shift to integrating the acquisition. Several factors can complicate the process.

In some cases, there is a disconnect between diligence and integration. To smooth the transition and enhance knowledge sharing between the two processes, it is important to have some of the same people involved in both processes.

Similar to due diligence, integration can be a substantially greater hurdle when the target is a competitor. While duplicative back-office functions such as finance, IT, and HR must be addressed, the decisions that will most strongly affect deal success are those that go to the heart of the business. What do you do with overlapping products and customers? How do you deal with pricing? What do you do with redundant supply chains and manufacturing bases?

Often, such issues can be addressed between due diligence and regulatory approval by establishing a “clean team,” perhaps comprising retirees from the two companies, which can review information on customers, products, pricing, and other matters that cannot be shared between the buyer and seller pre-closing. A clean team can help difficult decisions be made quicker and improve positioning relative to competitors.

Perhaps the most difficult integration issue to handle is blending the cultures of the buyer and the target company (see Figure 1). Forty-five percent of the manufacturing participants in the Deloitte Dbriefs survey considered managing corporate culture and change to be the biggest challenge in completing a successful integration.1
However, in our experience, culture and change management, ironically, are given little attention during integration planning and execution. With the changing characteristics and challenges in the M&A marketplace, prudence would suggest increased focus in this area.

Capitalizing on Emerging Opportunities
Encouraged but cautious, manufacturers are venturing back into the M&A arena to position themselves for an upswing in business activity. Whether the target is a product line or an entire company, understanding the changing marketplace and related challenges and addressing these deal issues can help companies in their efforts to manage risk and improve the probability that they will achieve their intended benefits from the transaction in a still-challenging business environment.

This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication.

For more information about Deloitte LLP, visit www.deloitte.com. To access its merger and acquisitions library, go to www.deloitte.com/us/MAlibrary.
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