If you believe the headlines, the U.S. manufacturing sector has been crumbling in recent years, having been chipped away by cheaper, foreign competitors from countries like China, India and Mexico. Evidence of this can be seen in the more than 2.8 million U.S. manufacturing jobs that have been lost since 2001, a number that most expect to grow even as the economy continues to recover. To the casual observer, or more poignantly an out-of-work laborer, things look pretty bleak.
However, from the buyout investor’s point of view, the sector appears to be convalescing. As valuations are still low and demand is starting to show signs of life, some believe the space could now be ripe for investment again. Throw in eight straight months of gains in activity (according to the Institute for Supply Management) and a few high-profile, success stories, and the sector actually starts to look appealing.
“The manufacturing industry is getting stronger, no question,” says Wilbur Ross, head of W.L. Ross & Co. “Not from the point of view of unemployment, but I don’t think productivity gains are slowing, by a long shot.”
From 1980 to 2002, manufacturing investments accounted for 49% of total leveraged buyout volume, according to Piper Jaffray. By comparison, in 2003, manufacturing deals-ranging from engine manufacturers to makers of ice cubes-represented just 36% of total volume. However, some of the biggest LBOs last year were of manufacturing companies, such as The Blackstone Group’s acquisition of car-parts maker TRW Automotive, The Carlyle Group’s purchase of Fiat SPA’s aerospace manufacturing unit and W.L. Ross’s buyout of textile-maker Burlington Industries.
However, as most already know, there are a number of hurdles that need to be cleared to successfully invest in manufacturing, and sponsors now need to consider the offshore threats and retail pricing pressures that are having an increasing effect on the industry. Additionally, the usual suspects, such as union relationships and environmental concerns, remain a key ingredient in a number of manufacturing opportunities.
China the Riveter?
Clearly the biggest threat to domestic manufacturing companies is the pricing pressure applied by foreign competitors. While outsourcing offers plenty of economic advantages, it’s still viewed by some as a controversial, perhaps unpatriotic practice, which is why many private equity firms don’t do it. But no matter what their view on outsourcing, it’s a reality any owner of a U.S. manufacturing company can’t ignore.
“One of the first things we look at is whether there is a China threat,” Morgenthaler General Partner John Lutsi says. “If you find a company where a large component of the cost structure is labor, you will likely be susceptible to cost pressures from China or other foreign competitors. Generally speaking, though, if the cost of labor is below 10%, foreign competition should not be an issue.”
Buyout firms interested in skirting the offshore threat will often pursue companies with a value-added expertise to differentiate themselves from their foreign counterparts. “If the company has the capabilities to provide engineering help, that neutralizes the China threat,” Lutsi says.
Also, other pros believe that the exodus offshore actually helped weed out the less productive manufacturers, leaving the more efficient industry players behind in the U.S. “We have seen a lot of businesses that involve a high component of direct and indirect labor move offshore,” says Angus Littlejohn, chairman and chief executive of Littlejohn & Co. “For those that have survived in the U.S., you’ll find they were already productive and still continue to be.”
Big Box, Big Trouble?
Another threat to the manufacturing industry, in addition to a number of other sectors, would be the pricing pressures applied by the big box retailers such as Wal-Mart or Target. The big grin on Wal-Mart’s trademarked smiley face often comes at the expense of the manufacturers that supply the retailer with its products.
“These big box retailers absolutely have an effect on all factors in the economy,” Brazos Private Equity Partners Co-founder and Partner Patrick McGee says. “One of the first questions we ask is, Who are your top customers?’ And if it is a Wal-Mart or a Home Depot, then frankly the value of the business goes down because [the retailer] can switch to your competitor overnight.”
Littlejohn adds, “It can be scary. If a business gets big enough, the retailers will constantly test the market for direct sourcing from China or Mexico.”
Often times buyout firms will keep the their eyes on a company’s gross margins in order to determine who has the upper hand-the manufacturer or the customers. “If gross margins are north of 30%, we’ll feel pretty comfortable with the business,” Lutsi says. “But if that number dips below 20%, it’s indicative that the customer is in control of the pricing…It usually means there are a lot of suppliers and among them nobody has any advantages [over the competition] other than price.”
Most firms who invest in manufacturing agree that in order to invest successfully, there needs to be a genuine familiarity with the terrain. While this is a common formula for private equity investments in all sectors, market pros say the manufacturing space has an especially narrow margin for error. “If you’re going to be investing in manufacturing, then you better have a really good management team with a successful track record, or you as an investor should have a very good handle on manufacturing,” says Littlejohn.
“You need to target companies that are in the Six Sigma world,” Lutsi adds, referring to the strict performance gauging analysis used by a number of manufacturers. “There needs to be discipline within the organization where people are constantly focused on keeping pace with the pricing pressures put on them by the OEMs and there needs to be a strong, operations-focused CEO or board members.”
The Blueprint
Looking ahead, most expect to see manufacturing jobs continue to flow overseas. “The outlook for employment is not particularly good,” Ross says. “This phenomenon of cost cutting has not remotely run its course yet.”
This does not mean, though, that the sector will no longer appeal to private equity. And while the space has seen a shift in recent years, nobody is expecting the industry to disappear or completely relocate overseas. “Manufacturing businesses are always going to be needed domestically,” McGee says. “That is where you’re going to get your sophisticated products, and suppliers often need something that is just-in-time in nature, and offshore manufacturers can’t provide that.”
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