How metal fabricators fund growth

Opinions about debt vary across metal fabrication. But no one argues that fabrication is a capital-intensive business, and access to capital will be even more important in the future. Getty Images

Metal fabrication has always been capital-intensive, and it’s become only more so in recent years. As the pace of technology accelerates—from CO₂ and fiber lasers to automated and autonomous manufacturing systems—so does the industry’s need for capital. Combine insufficient access to capital with high material prices, spotty material availability, and general supply chain uncertainty, and fab shops create a recipe for an unpleasant cash crunch.

“If you look at the asset-intensive nature of this sector, you find hidden value in all that equipment,” said John Felix, the San Francisco-based managing director of White Oak Global Advisors, an alternative debt manager. “It is incumbent on owners, operators, and managers to ensure they have the most efficient capital structure such that they can maximize production and efficiencies, not only on the shop floor but also on the balance sheet.”

The demand boom of 2021 has made the situation more acute, and metal fabricators everywhere must perform a balancing act. To meet demand in a world of prolonged material lead times and unpredictable availability, shops must have the right raw stock available at the right time. They want to buy when they find a deal, but they don’t want to be caught without material, which sometimes means biting the bullet and purchasing expensive material just so they can get their machines running. This balancing act requires cash, which is where liquidity and capital management come into play.

The FABRICATOR magazine spoke with Felix to review the basics of liquidity management, use of debt, and pitfalls to avoid. His insights show, with technology’s unceasing march forward, just how important a fab shop’s access to capital really is.

The Risk of Insufficient Capital

Some fab shops take the conservative route and fund growth (such as purchasing new machines) mostly with cash while taking on minimal debt. Much of this has to do with risk tolerance. “You need to define your risk tolerance and relate it to your perspective on the future of the segments you serve,” Felix said.

The high revenue concentration among some fabricators might drive down that risk tolerance. Averages reported by the “Financial Ratios & Operational Benchmarking Survey,” published annually by the Fabricators & Manufacturers Association, showed that the typical fabricator gets 50% of its revenue from just four to eight customers. When one or a handful of large accounts go south (as many did in 2020), a fabricator’s financial situation can go south in a hurry as well.

Even so, fabricators don’t shy away from all debt. In the same survey, respondents reported a wide range of debt-to-asset ratios. For the 2019 fiscal year (the latest numbers available), some were less than 0.1, others were 0.6 or higher. The average was 0.31—on the low end for capital-intensive businesses. (Editor’s note: For this FMA survey, which dives deep into the fabricator balance sheet, between 35 and 70 private companies participate, depending on the year. While the sample size might be too small to extrapolate industrywide trends, it does give a snapshot into what some fab shop balance sheets look like.)

While opinions vary on debt, most fabricators agree about the accelerating pace of technological advancement. Shops that don’t upgrade get left behind, so no one argues that fab shops need access to capital, whether it’s through equity or debt.

Pouring profits (the owner’s equity in a private company) back into the business has been a hallmark for many successful fabricators. These shops invest in machines, be they automated brakes or fiber lasers, and employ the right people so that they can shorten the order-to-cash cycle and boost throughput and profits, which owners again pour back into the business. And the virtuous cycle continues. Shops might take on a little debt, but it plays a minor role in funding company growth.

“If their success continues, these owners sleep very well at night,” Felix said. “Owners and managers who operate in a very low-leverage environment probably have low risk tolerance.”

Business risk analysis usually focuses on investors (owners) and creditors, those with equity and those who issue debt. When funding business growth, equity is riskier than debt. Even in the worst-case scenario of liquidation, most creditors have a very good chance of being paid. Meanwhile, selling equity shares to fund growth means the current ownership might be giving up some control. And because they’re taking on higher risk, those new equity stakeholders will demand a return much higher than the interest rates that commercial loans and other financial products charge.

So what about the shop that reinvests not by selling shares to outside investors or taking on debt, but by tapping into the owner’s equity? The company keeps reserves for a rainy day, but also builds cash for equipment upgrades and plant expansions. Again, for creditors (if there are any), the risk is low; they’ll likely get paid no matter what.

Outside investors likely would see this as an inefficient use of capital that could lead to lost opportunity and, ultimately, a lower return on investment. But many fabricators don’t have outside investors. They’re closely held companies with just a handful of equity holders, many of them family members. An owner of a small shop probably knows all employees by name. Risk to equity holders matters, but so does the risk to employees.

Sure, the business might be making inefficient use of capital, but if profits remain consistent and the company remains a stable employer, an owner might perceive an inefficient use of capital as a small price to pay.

Still, Felix pointed to two trends that could increase the risks of inefficient capital management—even for seemingly stable, low-leverage, cash-rich companies. The first factor has to do with the pace of technological advancement.

“Considering what’s happening with IIoT [the Industrial Internet of Things] and the technology revolution underway, investing in shop floor technology is only going to accelerate.”

New technology in metal fabrication has made throughput skyrocket in recent years. But new machines don’t come cheap, and they don’t last—not because of shoddy build quality, but because technology is progressing so rapidly. Many shops now purchase new lasers every few years simply to stay competitive. In these scenarios, inefficient capital management could be detrimental.

Boomers are another reason why fab shops might need more access to capital to stay competitive. They’re leading the retirement wave, and fab shop ownership is undergoing a great generational shift. Trends in mergers and acquisitions have their ups and downs, and 2020’s extreme rise in uncertainty put a damper on deals, but the overall trend is clear. With so many shop owners retiring, acquisitions will be on the rise.

M&A has various nonfinancial measures (shop culture, for example) that, if ignored, can have serious financial consequences. But beyond those nonfinancial measures are more objective factors, like a shop’s customer base, how its market position complements the acquirer’s market position, and customer-base diversification strategies. EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples, a proxy for company value, might change. “But whatever the situation, the analysis is the same,” Felix said. “Am I going to get the desired return on my investment for this acquisition?”

Felix described a situation in which a company agreed to sell for 4X EBITDA. The deal fell through, but the interested parties returned to the negotiating table several years later. At that point the company owner wanted 6X EBITDA. The buyer retreated, thinking the M&A market was too hot. He thought he’d wait until the market and multiples cool down.

But will a similar opportunity arise again? Taking on more debt to purchase the business at 6X EBITDA might be less risky than missing out on a timely opportunity, as long as the ROI is there. Of course, all this is a moot point if a fabricator doesn’t have adequate access to capital to make the investment.

Why Debt Gets a Bad Rep

Those successful in metal fabrication, especially companies that specialize in quick-turn job shop work, are masters of cash flow. They ensure work flows smoothly and quickly from the receiving dock to the shipping dock. Machines are maintained, and process knowledge runs deep throughout the organization.

Those who struggle often have long lead times thanks to old or poorly maintained and operated equipment, disengaged employees, and apathetic managers. These struggles often are coupled with high revenue concentration. One large account calls it quits, and the cash crunch ensues. At that point, shops have a hard time paying bills and servicing debt.

As Felix explained, debt is a tool for growth, but it’s not a silver bullet. Debt needs to fund the right things. Taking on debt might allow a shop to invest in an ultrahigh-power fiber laser, but could it also free up funds to build a long-term operator training program (one that might go beyond what’s offered by machine vendors) to keep machines in optimum condition and as productive as possible?

As technology evolves, each fab shop employee is producing more throughput than ever. Having a disengaged button-pusher operating a multimillion-dollar fiber laser machine is risky business, no matter what capital management strategy a company uses.

That said, even operationally sound companies can run into trouble if they don’t manage their capital well. A big problem, Felix said, is mismatching capital sources. Companies have long-term as well as short-term (current) assets and liabilities.

“So many small businesses get themselves into trouble because they mismatch assets and liabilities,” Felix said. “For example, if you have a piece of equipment that is going to be on the shop floor for five to seven years, you should have a piece of debt associated with that equipment that matches the equipment’s life expectancy.

“People should not find themselves in a position of borrowing against short-term assets to finance a long-term asset associated with PP&E [property, plant, and equipment]. For instance, you should not borrow against a revolving line of credit that comes due in one year to finance a piece of equipment that has a life expectancy of seven years.”

So what about fabricators who use cash to pay for a machine?

“Of course, cash is fungible,” Felix said. “It’s a pool of money. But when it comes to liquidity, capital-intensive businesses cannot take their eye off the ball.” The last thing a shop wants is to drain liquid assets significantly to service long-term debt, only to have insufficient funds available when an unexpected opportunity arises.

“Managing liquidity is so paramount in today’s environment,” Felix said. “It gives you the ability to take advantage of bulk purchase discounts. Say a material vendor approaches you with an offer you have to take. You just can’t pass it up because spot prices elsewhere are exorbitant. To take advantage of this, you need to manage liquidity ever so closely.”

Having Optionality for Opportunity

Financing options for a fab shop abound. There are the traditional commercial loans, of course. But they also have access to invoice discounting and factoring, which can give fabricators immediate cash and mitigate cash flow constraints from slow-paying customers. “These are not new offerings,” Felix said, “but many solutions that were available only to very large companies are now being offered to mom-and-pop operations.”

Regardless, smart use of any of these financial products involves optimizing capital efficiency. Traditionally, efficient use of capital calls for a careful balance between what it spends to grow and what it earns. The goal, Felix said, is to work toward what people in the financial world call optionality.

“Having optionality,” he said, “is another way business owners can sleep well at night. It’s a way to put them in a position such that they can either pay cash available on the balance sheet, or they have the ability to borrow to meet a capital need.”

Material price hikes and supply chain shortages are leaving their mark on shops this year, but these headaches probably won’t last forever. Technological change, though, is here to stay, and its pace will only accelerate. The same holds true for acquisition opportunities. These factors have created a world where access to capital is more important than ever. The more options a fabricator has to fuel its growth, the more competitive it will be.