The dynamics in the industrials space have been off kilter for quite some time. An ongoing supply chain crisis, lack of inventory, and labor shortages are among the pain points that operators have been dealing with since the onset of the pandemic. And while many hoped there was an end in sight, recent inflation, geopolitical conflict, and increasing interest rates have amplified the challenges that business owners and operators face daily.
In this month’s virtual roundtable, Axial welcomed both operators and advisors to weigh in on current market dynamics in the industrials space.
Thank you to the following Axial members who participated in the discussion:
Introductions: 00:00 – 03:43
Supply Chain: 02:43 – 15:52
- Peter Lehrman, Axial: What is going on with the supply chain and what phase of the issue are we in now?
- Philip Fioravante, Industrial Opportunity Partners: Everyone is experiencing the challenges of getting raw materials and sub-components. A lot of IOP’s portfolio companies deal with manufacturing around the globe and one of the issues that IOP is finding is that there aren’t actually that many manufacturing companies in the United States that are using raw materials and producing products that the US needs to produce. Things like castings, aluminum, and powdered metals are not produced in the US anymore so companies are having to source products in Asia and the Middle East.
- Peter Lehrman: Are the supply chain disruptions demand driven or supply driven and what are the main drivers that are making things more complicated?
- Philip Fioravante: Some of the drivers include: Availability of people, specifically skilled labor, complexity in getting transportation to locations where raw materials need to be moved, trade dynamics with the Russia and Ukraine war, and tensions between the US and China and the trade imbalances occurring there.
- Keith Dee, Osage Advisors: On the demand side, Osage’s clients are investing heavily in acquiring inventory 6-12 months ahead of time when they are used to purchasing 1-2 months ahead, and so they are tying large sums of money up in inventory in order to plan, and of course the longer you plan outwards, the harder it becomes to predict and determine sales. Keith also agrees with Philip on the labor force issues and oftentimes when sourcing businesses, buyers will look at the age of the labor force to determine its worth. Keith has heard from different sources that concur that the supply chain will most likely not stabilize for another 2-3 years.
- Chris Gallagher, Gallagher Fluid Seals: Gallagher was trying to order inventory ahead of time just like everyone else and they just can’t get ahead. This lack of supply is causing a huge increase in demand for inventory that is only compounding the issues that the world is facing.
- Bill Overbay, Stone Road Partners: Stone Road Partners is having the most trouble with acquiring necessary talent across their portfolio. Companies are bringing in large quantities of inventory but have no labor to manufacture and ship any of the products that they manufacture. These activities are occurring across the globe and are creating a flywheel effect, which hinders the recovery of the supply chain.
- Keith Dee: Exactly, and this makes it necessary for companies to go to the “black market” to get necessary components. The black market is referring to sources that companies don’t know that are charging 10x prices and demanding cash upfront, which greatly increases the risk that businesses are having to take on.
- Chris Gallagher: Gallagher Fluid Seals manufactures a very engineered and specified product and if they are unable to get the product to a customer, there are a limited number of other suppliers that manufacture similar products. This is causing customers to begin dual sourcing in case their manufacturer is not able to produce the product in time.
- Keith Dee: Freight costs are also up 400%, so that, in combination with raw material cost increases creates a difficult dynamic in trying to pass along the costs to your customers.
- Philip Fioravante: A couple of IOP’s companies have begun to look at scenario analysis between air and water shipping. If they can get the materials via air faster to be able to manufacture and get products out on time, it may be worthwhile to pay the premium in order to do so.
Lending during supply chain crisis: 15:52 – 22:31
- Bill Overbay: That also ties into lending concerns, as the materials and components are taking longer and longer to arrive and your products are taking longer to get to your customer, your costs actually increase because most companies are taking out loans to buy the materials. This is a hidden cost associated with the supply chain issue that not many people are considering.
- Philip Fioravante: IOP is also having conversations with their bank to understand what is eligible to be receivables vs. inventory.
- Peter Lehrman: Are there new policies emerging to classify things in banking?
- Philip Fioravante: Cash flow is driving that conversation and conversations with banks have been positive in that they understand the current situation of the markets.
- Bill Overbay: Stone Road Partners is also spending more time with their finance groups on receivables and things outstanding.
- Keith Dee: In two deals that Osage is working on, scrutiny has increased looking at the working capital, debt service coverage, and various ratios.
- Peter Lehrman: Where have the banks become more favorable or receptive?
- Keith Dee: Mostly with sustainability of profit. With increases in inventory it begs the question of whether the company is going to sustain its profitability moving forward.
- Chris Gallagher: Agrees with Keith and also wonders how to normalize net working capital when a company’s inventory is up.
Inventory dynamics: 22:31 – 27:22
- Peter Lehrman: It seems like inventory is either up relative to pre-covi baselines, or it is down because businesses are unable to get any inventory.
- Chris Gallagher: For Gallagher it varies part by part with some items being stockpiled and others being in a deficit. But overall inventory is up, which means business is up – Gallagher is up 21% YoY.
- Keith Dee: The working capital target in a transaction is challenging right now and it is even tougher to normalize because coming out of the pandemic, companies either experienced a Covid bump or trough.
- Chris Gallagher: As Gallagher is beginning to bolt on more and more businesses, taking on debt and getting their balance sheets right continues to become harder and harder.
Automation and technology: 27:22 – 37:53
- Philip Fioravante: IOP is thinking about where they should spend their cash. The question being should they tie it up in inventory or should they begin investing in automation and technology
- Peter Lehrman: What are some of the businesses you have been having these conversations with and how have they handled the question of where to invest their cash?
- Philip Fioravante: Automation and robotics always used to be a way to supplement labor. Now it is an essential part of sustaining and maintaining a manufacturing business. IOP is investing in automation in the companies that have less demand rather than the ones who have increased demand because the ones with increases need to focus on manufacturing the actual products.
- Peter Lehrman: What’s the reasoning behind prioritizing it in a downcycle vs an upcycle of demand?
- Philip Fioravante: It is preoperational in nature so investing in automation during down cycles will make production in upcycles more efficient and less labor intensive.
- Peter Lehrman: TGIF and Chili’s now have robot waiters.
- Philip Fioravante: Little Caesars also has automated pizza pick up systems now so automation can be seen everywhere.
- Chris Gallagher: Gallagher is actually designing a facility to be able to take advantage of automated distribution robotics.
- Peter Lehrman: Is that a capitalized expense or are you contracting?
- Chris Gallagher: It’s a capitalized expense where the company would be investing deep within themselves.
- Peter Lehrman: Is the labor that you need to operate the automation fundamentally different from other forms of labor?
- Chris Gallagher: It’s going to have to be different and these automation warehouses will certainly not be human-free.
- Keith Dee: A key question for buyers doing due diligence is plans for automating facilities and factories. Some of the businesses Osage are advising have even begun running their machines in the dark (meaning with no supervision). A lot of times, part of the reason sellers are selling their businesses is because they need the help automating them and so add-ons are most favorable in that scenario.
Revenue forecasting: 37:53 – 43:07
- Peter Lehrman: How is revenue forecasting impacted when you do not have good supply chain visibility?
- Keith Dee: Revenue visibility, not only top line, but by unit and time frame is top of mind. It’s a very challenging exercise but a good one for buyers and sellers to work through.
- Chris Gallagher: At Gallagher, the late backlog is something they have never seen before. If they could ship everything they had, they would greatly increase revenue. However, the backlog is not getting worse, but rather has reached an equilibrium and so revenue is relatively stable but once the backlog clears it will increase.
- Keith Dee: Some portfolio companies of private equity firms that Osage works with are seeing their revenues and profits getting squeezed a little bit.
- Bill Overbay: One of the things Stone Road Partners is seeing in their portfolio companies is a question of how disciplines other companies are in the marketplace. If there is a market where competitors are not disciplined, the whole market tends to struggle financially.
Thinking ahead to the future: 43:07 – 58:45
- Peter Lehrman: How much time is being spent within boardrooms and management teams trying to think about next steps in terms of game theory and how some of the issues might unravel in the future?
- Philip Fioravante: Each one of IOP’s portfolio companies tends to spend about 10% of their meetings discussing the approach of the management teams and their ideas on how to improve the situation and ultimately the bottom line.
- Peter Lehrman: How are prices being pushed through?
- Philip Fioravante: 50% of IOP’s businesses are direct to consumer and the others are B2B. The prices of direct to consumer businesses are easier to push through to the customer than the latter. For B2C companies, they can push prices through pure pricing increases based on raw materials, line item surcharges, and line item freight. However, a lot of the B2B companies are absorbing the raw material price increases.
- Bill Overbay: Education and communication goes hand in hand both to your customers and your suppliers as well. It also very much depends on who your end customer is as well.
- Keith Dee: Totally agrees with Bill that communication is key. One of Osage’s clients was hesitant to raise prices but eventually did and ended up calling all their customers to explain the situation and they understood and accepted the increases in prices. The client was even able to pick up a new contract as one of their competitors was not communicating with their customers.
- Bill Overbay: Bill notes that communication also applies to your financial partners.
- Chris Gallagher: Gallagher has been broadly successful in passing along their price increases to their customers. Some businesses are deciding to keep a lower quantity of business but at a higher profit margin. This is an acceptable decision in 2022 but Chris argues it’s not a good decision in terms of long term growth.
Consequences for the dealmaking environment: 58:45 – 01:07:25
- Peter Lehrman: What is the state of the deal market?
- Keith Dee: Osage has two transactions under LOI and two in market.
- Philip Fioravante: IOP just closed on two deals and has anywhere between 30 and 40 teasers.
- Chris Gallagher: Gallagher is looking at a sizable deal as well.
- Bill Overbay: Stone Road Partners is on the sell side with two deals and looking to acquire three businesses.
- Peter Lehrman: What has changed in the deal making environment from a year ago? Things to consider include a different public equity market environment, interest rates, and federal reserve posture.
- Keith Dee: Osage is seeing the due diligence process being extended a bit and with more scrutiny which causes deal fatigue from both parties. There is still lots of fundraising going on, which Keith hears weekly news about. 70% of Osage’s companies are add-on companies so they are receiving constant inquiries and Keith believes it is still a very good market for the seller.
- Bill Overbay: Stone Road Partners is conservative by nature so they have not changed their strategy significantly. They spend a lot of time and resources on researching their industries and understanding where shocks to the market could come from.
- Peter Lehrman: Do you have debt financing lined up for the three deals?
- Bill Overbay: Not yet but they are working with partners they have worked with in the past and feel very comfortable with them, which goes back to Bill’s earlier point about the importance of communicating.
- Chris Gallagher: Gallagher is also being really conservative when looking at deals and their models over the next couple of years.
- Peter Lehrman: How are sellers reacting to this change in behavior? Is it difficult to cope with the market becoming less of a seller’s market?
- Philip Fioravante: Sellers are reading the same news and doing the same industry research as IOP is doing and so they understand the changes. IOP is spending a little bit of extra time on the diligence piece including labor shortages and how businesses are dealing with it, human resources and their interaction with the company, customer due diligence to understand how different customers behave and may grow or shrink in the future, and whether or not the business will experience organic growth or will need inorganic growth through an add-on.
Conclusions: 01:07:25 – 01:07:46