M&A pickup among U.S. conglomerates may be undercut by prices

M&A pickup among U.S. conglomerates may be undercut by prices
Fri, Mar 21 2014
By Lewis Krauskopf
NEW YORK (Reuters) – When United Technologies Corp (UTX.N: Quote, Profile, Research, Stock Buzz) paid more than $16 billion to buy plane parts-maker Goodrich Corp about two years ago, the U.S. conglomerate’s biggest-ever takeover raised some eyebrows for its rich valuation.But that is nothing compared to what a buyer would need to cough up today for Rockwell Collins Inc (COL.N: Quote,Profile, Research, Stock Buzz), a similar airplane components maker deemed by Morningstar to be one of the most likely takeout candidates in the industrials sector.
While United Tech paid 12.4 times Goodrich’s trailing operating earnings at the time, according to Thomson Reuters data, Rockwell’s shares now trade at about that level, without any deal premium baked into the price. Takeout premiums among industrials companies averaged about 25 percent last year.
Such is the dilemma facing United Tech, 3M Co (MMM.N: Quote, Profile, Research, Stock Buzz), Honeywell International (HON.N: Quote, Profile, Research, Stock Buzz) and other diversified manufacturers that are eager to bolster their businesses through deals and yet may hesitate as the rising stock market drives prices higher.
“There are a lot of companies that want to do deals,” said Jeff Sprague, managing partner at Vertical Research Partners, which focuses on the industrial sector. “The question will be can they really get them done. They’ve been reluctant to pull the trigger because of high valuations, and they’ve only gone higher.”
The valuations for the broadly defined industrials sector have climbed on average from 8 times forward EBITDA to 10 times in the past 18 months, said Michael Santini, global head of Deutsche Bank’s industrials group.
“As the equity markets have driven multiples higher across the industrials sector, we have seen a pick-up in IPOs and spin-offs, but more challenges in getting M&A deals announced,” Santini said.
ACTIVISTS FORCE ‘DISCIPLINE’
Competition from private equity firms, with easy access to capital due to low interest rates, has also buoyed prices for industrials targets. For example, Carlyle Group LP (CG.O: Quote, Profile, Research, Stock Buzz) agreed to buy Illinois Tool Works’ (ITW.N: Quote, Profile, Research, Stock Buzz) industrial packaging unit last month for $3.2 billion.
Many analysts are predicting an increase in deals this year in the industry after a lull in 2013. But high prices will cause companies to pause before striking, as a risky deal could anger their shareholders or even draw an activist investor. The safe route might be to use that capital to buy back shares or increase dividends.
Take SPX Corp (SPW.N: Quote, Profile, Research, Stock Buzz): After the industrial machinery maker’s failed $4 billion bid for rival Gardner Denver in late 2012 sent SPX shares tumbling, activist fund Relational Investors bought a big stake.
“In this environment we are seeing equity investors focused on making sure that companies are being disciplined around capital allocation, both institutional shareholders but also the activists are providing some of that discipline,” Santini said.
At the same time, companies will look closely at deals if they feel they will struggle to grow on a standalone basis.
Multi-industry companies posted sales increases of 3.7 percent on average in the fourth quarter, only “modest improvement” compared to the third quarter, according to William Blair analyst Nick Heymann.
“If you can’t get it organically, what are you going to do? You’re going to have to go buy it,” Heymann said.
RIPE FOR A PICKUP?
Industrial companies reorganize through deals, which allow them to obtain growing products, realize cost savings and find other ways to augment their central businesses.
Such reshaping can include sales or spinoffs by the companies themselves, often in response to investor pressure, to focus on their central businesses. Dover Corp (DOV.N: Quote, Profile, Research, Stock Buzz) made such a move earlier this month with its spin-off of microphones maker Knowles Corp (KN.N: Quote,Profile, Research, Stock Buzz), while General Electric (GE.N: Quote, Profile, Research, Stock Buzz) is exiting its private label credit card business.
Globally, acquisitions by all industrial companies slipped 8 percent last year, more steep than the 6 percent overall decline for global deals, according to Thomson Reuters data.
The value of acquisitions by 10 U.S.-based multi-line industrial companies fell last year to the lowest level since 1998, according to Thomson Reuters data.
“M&A is a core part of what industrials do and that’s how they optimize their portfolios over time,” said Kevin Toney, senior portfolio manager with American Century Investments. “My sense is the buyers wanted to buy, but maybe the prices just weren’t there.”
Because of the diverse lines of business for these manufacturers, potential targets exist in numerous sectors, including aerospace, security or climate control systems, healthcare products or electrical equipment.
Certainly, conditions look ripe for a deal pickup in many ways.
Analysts at Citi Research noted recently that among multi-industry companies, net debt stands at “attractive lows” of only 17 percent of total capital.
“The sector currently holds ample firepower for strategic deals, with a willingness to pull the trigger once the M&A climate improves,” Citi analyst Deane Dray wrote in a research note earlier this month.
The lofty level of the stock market also could be a benefit to potential acquiring companies.
“The average buyer has a stock that has gone up a lot so they have a lot of currency,” said Scott Davis, an analyst at Barclays. “I think we’re going to see a lot more transactions using stock.”
There is no shortage of eager buyers.
Honeywell’s Chief Executive Dave Cote said at the conglomerate’s investor day earlier this month that the company was planning on $10 billion in deals through 2018, more than double what the company spent the previous five years.
3M has expressed a willingness to spend “multi-billion dollars” on individual deals, more than it has in the past, as it eyes $5 billion to $10 billion in acquisitions through 2017.
Danaher Corp (DHR.N: Quote, Profile, Research, Stock Buzz), which has cited $8 billion in “M&A capacity,” is among the other companies expected to be on the prowl this year.
United Technologies last week became the latest company to make noise about bulking up through acquisitions.
Not yet two years removed from closing its Goodrich deal, executives said they did not foresee an acquisition anytime soon. But United Tech has set a target of $50 billion in revenue for its commercial buildings segment by 2020, recognizing that about $8 billion of $21 billion needed for that goal might have to come from acquisitions.
United Tech’s targets could include security companies Allegion (ALLE.N: Quote, Profile, Research, Stock Buzz) and Tyco International (TYC.N: Quote, Profile, Research, Stock Buzz), and electrical and lighting systems company Hubbell Inc (HUBb.N: Quote, Profile, Research, Stock Buzz), according to Credit Suisse.
“We have demonstrated that we do very well on large deals,” United Technologies Chief Executive Louis Chenevert told the investor conference, adding: “Some of you thought I overpaid on Goodrich. I don’t think anybody thinks I overpaid today on Goodrich.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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