After the boom and bust cycle of the late 1980s when mergers and acquisitions were fuelled by, and often faltered in, a frenzy of financial engineering, the City and industry are now enjoying a period of comparative sanity.
The force of two recessions over the past decade has stripped out weaker companies, leaving the survivors in stronger positions. The UK’s relatively low cost base compared to the rest of Europe has also stimulated substantial inward investment and merger activity. But bankers agree it is the rise of industrial logic which is the most outstanding feature of today’s British merger climate.
The quick-fire financially driven deals are largely gone, helped by the tougher accounting rules of the past few years. This is especially true in the engineering sector, where there has been a spate of deals over the past 18 months, most of which have as their hallmark strong industrial logic.
Stephen Barrett, who leads the engineering team at KPMG Corporate Finance, sees two reasons behind the drive in merger activity. First, `larger companies are seeking to achieve competitive edge or cost-savings through bolt-ons’.
More important, he says, `merger activity is being stimulated by consolidation on a global stage, driven by the customer’.
The automotive sector has led this move with integration and consolidation among suppliers to serve manufacturers’ global needs. Last year’s £3.2bn merger between Lucas Industries and Varity Corporation is a case in point. Other big engineering companies serving the automotive sector are following a similar strategy. T&N, GKN and TI are among those out to buy companies which have grown as big as they can nationally or regionally and which can take on a global market.
A recent report on mergers and acquisitions in the engineering sector by stockbroker James Capel says: `The most successful engineering companies over the past decade have been those which have built up global leading market positions and offer premium growth characteristics. This strategy is increasingly recognised by others in the sector where globalisation and structural changes have highlighted the importance of strong market positioning. We expect this trend to continue.’
The rise in these strategically driven deals is also meeting companies’ needs for more long-term benefits and financial returns.
`Strategically focused deals are substantially more likely than opportunistic deals to deliver long-term value,’ says Capel. `They bring benefits of new markets without a full incremental rise in costs – so research and development spending can be spread over a wider revenue base and accessing customers globally can help drive the supplier concentration process. This strategy is inherently logical and ultimately will bring higher returns on capital employed across the group.’
Last year’s purchase of Swedish polymer group Forsheda by TI is typical of the type of deal being pursued. John Potter, TI managing director of operations, explains: `Forsheda offered a dominant market share in Scandinavia, good technology but very little global presence. We bought the company with a view to globalising its products, while giving our own polymers business access to the Scandinavian market.’
Siebe’s attempted purchase last year of specialist controls and instruments manufacturer Whessoe is another case in point. Analyst Stephen Williams of stockbroker Williams de Broe explains: `Siebe targeted a company where virtually all the spadework for product change and recovery had been done. It was a perfect fit, with impeccable logic on Siebe’s part.’
Whessoe had transformed itself from a traditional engineering company making basic products such as pipes, to a high-tech instruments business, complementing Siebe’s £1bn-a-year sales control arm. For Siebe the deal also offered expansion potential for Whessoe’s new products through its global network and access for both companies to new markets.
But a rival bid, made jointly by Navia of Norway and Swiss group Endress & Hauser, offered more cash, so Siebe, wary of a bidding spiral, withdrew its £46m offer.
Other companies such as FKI, which abandoned its £186m bid for Newman Tonks when rival US bidder Ingersoll-Rand offered a higher price, are further evidence of a change in management attitude to merger over the past decade, says Capel.
`The majority of corporates in engineering employ more scrutiny over acquisition opportunities, with many deals falling through on price,’ says the broker. However, it warns that, with stronger corporate cashflow and more deals financed from existing resources, financial discipline could yet get lost in pursuit of a winning deal.
While strategically motivated deals can bring long-term returns, they must also bring value to the increasingly powerful institutional shareholder. In the 1980s there was great emphasis on increasing earnings per share and companies could bend accounting rules to achieve this in the short-term. Now institutions are taking a firmer line on underperforming companies in their portfolios, says Michael Ross, head of engineering at Baring Brothers’ corporate finance. There is also a shift towards enhancing shareholder value and the creation of Economic Value Added or EVA, as promoted by Victor Rice, LucasVarity chief executive.
This means not simply achieving post-tax profits after the deduction of capital costs, but building in a targeted return for shareholders above this line. It is also evidence of the greater strength of shareholders. As a leading banker explains: `Shareholders have a choice about where to invest, so they should be given a higher rate of return.’
In the case of LucasVarity, while the City largely acknowledges the strategic synergy of the deal, it may have to wait some time before the financial returns feed through. Restructuring and rationalisation costs of the merger totalling £250m led to a pre-tax loss of £110m for the eight-month post-merger period from May 1996 to January 1997.
While some banks claim that investors are prepared to wait for tangible benefits from a merger, others disagree. `While institutions are measured on a quarterly performance basis, they will always take a short-term view of their holdings,’ says one leading banker.
A feature of the merger scene which may bring more long-termism is the rise in venture capital funded deals. Most venture capital companies are looking for a five-year earn-out period which is comparatively long by the standards of other investors. Recent venture capital backed deals in the engineering sector include Hanson’s sale of its electrical business to a management team backed by venture capitalist Cinven, and the buyout of William Cook by management after a failed bid attempt by Triplex Lloyd.
`Venture capitalists are now also showing themselves as credible buyers of engineering companies,’ says Baring’s Ross. This trend is expected to continue, he says, partly because of the amount of venture capital available in Britain and because an incumbent management has the advantage of a closer and better understanding of a company than a trade buyer.
As for the impact of a new Labour-led Government on merger activity, most banks foresee a slight dampening effect.
Labour has pledged to toughen competition rules but is awaiting the outcome of an inquiry, led by Lord Borrie, former director general of the Office of Fair Trading, before it makes public its recommendations.
For the most part, banks view larger companies, including the privatised utilities, as the main targets of these proposals. Despite consolidation, banks say the engineering sector is still fragmented and should be protected from at least the early measures to tighten merger rules.
So the immediate future for acquisitions in the engineering sector looks busy, with focused deals continuing to lead the way.