Merger-and-acquisition activity remains in line with recent averages, but key changes and trends may affect those deals in 2016. An expert covers the five key factors for this year.

Merger-and-acquisition activity remains in line with recent averages, but key changes and trends may affect those deals in 2016. An expert covers the five key factors for this year.AMID ECONOMIC STRESSES AND HEIGHTENED GLOBAL UNCERTAINTY, the manufacturing sector continues to grow, albeit at a slower rate than in
years past. As measured by the Institute of Supply Chain Management’s Manufacturing Purchasing Managers Index (PMI), the manufacturing sector is experiencing its slowest growth in two years, and production growth in the U.S. is below its 20- year historical average. Deal volume may be down compared to 2014, but it is in line with average M&A activity for the sector since 2010. There is plenty of activity that can be expected in the near future, and in this article we will discuss five key factors that will affect M&A in manufacturing in 2016.

NEED FOR LOGISTICAL INFRASTRUCTURE

North America has a significant infrastructure deficit. In the U.S., infrastructure constraints will have cost the economy over $500 billion in reduced output since 2007 and fully $125 billion in 2015, according to a study published by Bloomberg Law. In Canada, the Federation of Canadian Municipalities has estimated the nation’s infrastructure deficit is $123 billion and growing by $2 billion annually.

Congestion and poor infrastructure have forced manufacturers to keep larger inventories, driving up freight costs and reducing savings from just-in-time manufacturing. In fact, the U.S. Federal Highway Administration estimates that the cost of transporting goods can increase by anywhere from 50 percent to 250 percent due to unexpected delays, negating much of the savings associated with new production methods and disintermediation. As a result, companies that are able to control the supply chain—whether through logistical advantages or a low reliance on outside suppliers— will be attractive for acquirers in 2016.

CYCLICAL DEMAND FOR CAPITAL GOODS

Sales of agricultural machinery in the U.S. and Canada will have fallen by approximately one quarter by the end of 2015. This decline has caused two of the industry’s largest players, Deere & Co. and Caterpillar Inc., to see their market cap shrink by 25.1 percent and 23.1 percent, respectively, while driving the entire heavy machinery sub-segment down 20.5 percent during the third quarter. Deere noted in its most recent quarterly earnings statement that lower demand for agricultural and construction equipment contributed to its poor results. Industrial machinery has similarly struggled, trailing the S&P 500 by roughly 20 percent on a rolling 12-month basis. The struggles of these manufacturers illustrate the cyclical demand for capital goods, and highlight the market’s affinity for recurring revenues. In 2016, companies with a “razor/razorblade” model, selling not only capital goods but also residual revenue generators like parts and service, will be top targets for acquirers.

HOUSING STARTS AND BUILDING MATERIALS

One area of manufacturing that has not languished is building products. In fact, it is the only public manufacturing segment that has grown year to date. With housing starts trending positively in Canada for most of 2015, and hitting an eight-year high in the U.S. before slipping in September, the environment for manufacturers of building components and home improvement equipment will likely continue to be favorable. Geographies with positive net migration demographics, such as Denver; Portland, (is this Oregon? If so, add state.); Salt Lake City; and Austin, Texas, can expect construction activity to remain hot.

SPECIALTY PRODUCERS

Companies with intellectual property that is difficult to duplicate are much less likely to be influenced by systemic pricing pressures. Moreover, businesses with specific industry expertise, including manufacturers of parts that are mission critical to the industry, tend to be better insulated from these pressures and are potentially attractive to acquiring companies.

Berkshire Hathaway’s August acquisition of Precision Castparts Corp., a manufacturer of complex metal components for the aerospace industry, is one example of this trend in action. Medical device company Medtronic has made several acquisitions to address needs for specific conditions, acquiring vascular medical device producer Lazarus Effect in September, as well as companies that produce devices for brain aneurisms, stroke and cardiovascular diseases.

STRONG U.S. DOLLAR

The weakness of economies overseas combined with the strength of the dollar is hurting U.S. manufacturers whether they sell domestically or export, thereby creating more supply domiciled within American borders.

Overall, the strength of the dollar is driving imports, and exports are dwindling. This is evidenced by the steady decline in Chinese producer prices and U.S. import prices. The softness of prices, combined with steadiness in commodity prices and logistical challenges, has caused softness in company financial statements, potentially spurring a “flight to quality.” So far in 2015, acquisitions have been fewer but have featured higher growth, higher margin companies than in the previous two years.

Going forward, we can expect to see U.S.-based companies seeking to acquire companies abroad, thanks to the strong dollar. Specialty manufacturers and companies that possess logistical advantages are well positioned for 2016, and the building products segment should continue to buoy manufacturing overall.

Ben Rudman is a director at SDR Ventures, a Denverbased investment banking firm. Rudman specializes in executing mergers and acquisitions, securing private debt and equity financing, and implementing strategic initiatives aimed at maximizing shareholder value. He’s a member of SDR’s manufacturing and distribution andlogistics teams.More information is available at sdrventures.com.

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