Our Sites

So you want to buy a metal fabricator

Closing a successful deal involves more than multiples

It’s been a memorable few years for mergers and acquisitions. M&A activity is up in certain markets of metal fabrication. Big shops are getting even bigger, at least according to the Fab 40, The FABRICATOR’s annual June listing of top custom metal fabricators in the U.S. Combined revenue of the top three companies alone has more than tripled in recent years, and much of that comes as a result of M&A.

Doug Nix, vice chairman at Corporate Finance Associates, Oakville, Ont., Canada, attributes much of this activity to the sheer amount of investment money out there. Worldwide, more than a half-trillion dollars in private equity money is looking for a home.

Private equity funds, along with other alternative asset classes, have been ballooning in recent years because of the investment demand from entities like pension funds. With interest rates so low, pension funds can’t meet their pension liabilities investing in Treasuries or other traditional investments. So they turn to alternatives like private equity.

The market turmoil comes in response to low commodity prices and slowing emerging economies worldwide—no news there. But in a broader sense, the market turmoil really is about future uncertainty.

This in turn has been a counteracting force in M&A. “I’ve talked to many buyers, not just the equity groups,” Nix said, “and many are saying that there is still volatility of earnings, and they don’t want to pay a high price for that uncertainty.”

At the last FABTECH® show, held in Chicago Nov. 9-12, 2015, Nix spoke to conference attendees about the current state of M&A in the industry along with common misconceptions about what really drives transactions in sectors like metal fabrication. In a conversation with The FABRICATOR, Nix provided a few basic steps on how a buyer should approach the acquisitions game.

Define Your Business Model

As Nix explained, every company has a business model that usually can be broken down into four related components: the customer value proposition, processes, the profit formula, and the resources (see Figure 1).

The customer value proposition defines customer value—that is, why customers buy from you. The exact value proposition depends on the company, but Nix categorizes value propositions into two broad categories: service- and price-driven. Fabricators with the service-driven proposition have customers who buy from them ultimately because they value the long-term business relationship; the interactions and knowledge gained from that relationship help drive company profits. Fabricators with the price-driven proposition compete on price and price alone.

Of course, price matters in all types of fabrication businesses, Nix said. These days customers will pressure fabricators for a lower price no matter what the fabricator’s value proposition is.

He added that the value proposition affects another business model component, the profit formula, but not necessarily in ways many might expect. A company that competes on price alone may have extremely lean, well-polished processes. It may have shortened its order-to-cash cycle to the point where the company can quote a rock-bottom price and still make a healthy margin. Its processes even may be tuned well enough so that the products it offers are of high quality.

Figure 1
Every business model has four components: customer value proposition, profit formula, processes, and resources.

The type of value proposition really isn’t about price and quality, which are givens for any successful fabricator these days. Instead, the value proposition drives how people in companies interact with each other, their suppliers, and their customers—what Nix defines as the processes component of the business model. Processes also includes research and development, sales strategies, as well as manufacturing best practices like lean manufacturing.

A company with a price-driven value proposition may switch suppliers frequently and scrutinize internal processes always with the defined goal to keep costs as low as possible, so the company can offer a low price. It still treats customers well, but one underlying understanding pervades business relationships: The fabricator is trying to minimize its costs to keep prices low.

Companies with a service-driven value proposition have employees that interact with each other, suppliers, and customers differently. They prioritize long-term business relationships, which people hope will drive profits over the long term. They also scrutinize internal processes to keep costs low—a necessity for survival these days—but the core driver isn’t to allow the company to offer a rock-bottom price; it’s to improve those long-term customer relationships.

Many think fabricators that make highly complex or innovative products must have a service-driven value proposition, while shops that cut simple blanks or other commodity products must have a price-driven value proposition.

As Nix said, this may well be the case. But there’s not always a direct correlation between product complexity and the type of value proposition a company has. Semiconductor manufacturing, for instance, has extraordinary technical complexity and some incredible innovation, but many companies in that space are certainly price-driven. Instead, Nix said, it’s the core values and priorities—price or customer relationships, for instance—that really drive the value proposition.

Next comes the fourth element of the business model: the resources. These include facilities, people, machines, and other technology the company uses to carry out the processes, which in turn fulfills the customer value proposition and profit formula. CAD/CAM, advanced enterprise resource planning platforms, and other business software fall under this category. So do the latest press brakes, fiber lasers, welding cells, and other automated systems.

Nix makes a clear distinction between resources and processes here. A laser cutting automation system with an advanced storage and retrieval system can make a company more successful, but only if the company has the operational processes in place that help this technologically advanced resource fulfill the customer value proposition and profit formula.

For a price-driven company, automated resources combined with lean manufacturing processes can help the fabricator maintain or lower the price for the customer. For a service-driven company, automation and lean processes may help the organization respond faster or more flexibly. Lower cost is always in the equation—it has to be—but for a service-driven company, it’s not at the core of what drives the company to succeed.

Buying With the Business Model in Mind

Nix divides buying into four stages: strategize, search, structure the deal (including valuation), and integrate (see Figure 2). The strategy defines why a company wants to acquire a business, which in turn drives which business it acquires (the search), how much it is willing to pay (valuation), and how the new business integrates with the existing enterprise.

During his FABTECH presentation, Nix presented the chart shown in Figure 3, which categorizes various acquisition strategies. Once a company establishes its strategy, it moves forward with a search. The better a seller can help a buyer achieve its strategy, the more the buyer may be willing to pay.

Figure 2
The four stages of an acquisition are the strategy, assessment, valuation, and integration.

But this isn’t the only factor. When looking at companies for sale, buyers analyze the business model components: customer value proposition, processes, profit formula, and resources. The first three determine how well a new business can integrate into the whole.

Nix added that misconceptions about integrating one company into another abound. People tend to think that if a large company buys a small company, then the small company naturally folds into the larger one.

In reality, it’s not the size that dictates integration, Nix said, it’s the buyer’s strategy and business model. If a company’s value proposition, processes, and profit formula align with the buyer’s business model, the new company may integrate well. On the other hand, if the seller has a value proposition, processes, and profit formula that don’t align with the seller’s, then integrating the two businesses closely could spell disaster. For instance, a salesperson from one fabricator selling on a price-driven model may not merge at all with a buyer’s service-driven model.

Having different business models isn’t necessarily a bad thing, Nix said, depending on what the buyer’s integration plans are. For instance, a service-driven buyer may want a new price-driven subsidiary to tackle a market the buyer really couldn’t reach before. But the buyer goes into the deal knowing that the price-driven subsidiary will remain separate and not be folded into the larger company.

In this situation, the only real way for the selling company to be folded into the buyer’s firm is in a bolt-on acquisition; that is, the buyer really is purchasing a business only for its resources, such as machines, facilities, and talent. In this case, the resources need to adapt to serve the buyer’s business model. After the sale, the seller’s original value proposition, processes, and profit formula eventually cease to exist.

Valuation

If the buyer isn’t willing to pay what the seller asks, the deal doesn’t close. So in this sense, the buyer really determines the price—and that price can vary dramatically depending on the buyer’s strategy and all the circumstances surrounding the deal.

For this reason, Nix said, it’s always difficult to base a price solely on the so-called “market rate” of a certain multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). “We are seeing some movement up with some of the larger deals,” he said. “I talked to one business that actually sold for 42 times EBITDA. But those are the exceptions.”

Many multiples in deals today for companies with $25 million in revenue and less are between 3.75 and 6 times EBITDA, Nix said, but this really doesn’t tell anybody very much. Again, the buyer determines the price, and if a seller fulfills the buyer’s strategy well enough, the buyer may be willing to pay top dollar.

The purchase price is pretty straightforward, but the earnings (EBITDA) aren’t. “Say you buy a business at 5 times EBITDA,” Nix said. As a buyer, though, you adjust (or normalize) the earnings to remove all nonrecurring expenses and revenue—that is, anything that’s not likely to recur. “There may have been some sale of equipment that won’t occur, or certain salaries that won’t be on the expense side when under new ownership,” Nix said.

So the buyer reports the purchase price and the normalized EBITDA, but he doesn’t report other details that may have been involved in the transaction. If that normalized EBITDA is less, then the reported earnings and purchase price show a multiple that is actually inflated from the “true” market price of 5 times EBITDA.

The purchase price ideally should be negotiated based not on a market rate, but instead on what the seller’s business is worth to the buyer, what Nix called the buyer’s multiple.

Nix gave the following example: Say the market rate for a business is 4 times normalized EBITDA. A buyer might think, “The seller wants 5. Well, I’m never going to pay 5, because it’s over market value.”

Say 5 times EBITDA is $20 million, with annual earnings being $4 million. But if the buyer has a solid strategy, has analyzed the seller’s business model, and can see how the new company can fit into its business, the buyer might estimate that buying this company could increase its profits by $10 million annually. That’s half the proposed purchase price, giving a buyer’s multiple of 2. “That’s because the profitability of the business could be significantly enhanced under the buyer’s ownership,” Nix said.

He added that this buyer’s multiple ultimately should be what halts or drives a transaction. In this case, if the buyer estimates that the deal would increase annual profits by only $3 million, then a $20 million purchase price is 7 times earnings—a 7 times buyer’s multiple. Is this too much? It may well be, but this again depends on the buyer’s strategy and goals.

The key for the buyer, of course, is to define that buyer’s multiple. The buyer does this by, again, determining its acquisition strategy, analyzing the seller’s business model, and knowing how the company will integrate into the overall business. All this, Nix said, will help a buyer uncover the true challenges and opportunities that lie ahead.

About the Author
The Fabricator

Tim Heston

Senior Editor

2135 Point Blvd

Elgin, IL 60123

815-381-1314

Tim Heston, The Fabricator's senior editor, has covered the metal fabrication industry since 1998, starting his career at the American Welding Society's Welding Journal. Since then he has covered the full range of metal fabrication processes, from stamping, bending, and cutting to grinding and polishing. He joined The Fabricator's staff in October 2007.