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January 2, 2014

Service Center M&A: The New, Cautious, Smarter Strategies

Phones still ring, but market uncertainties prompt fewer deals. 

Not long after Bill Chisholm became CEO of metals distributor and manufacturer Samuel, Son & Co. last summer, a particular type of phone call started coming to his office in Mississauga, Ontario. Chisholm, hired by the $3.4 billion service center and manufacturing company from the $84 billion ArcelorMittal organization, was familiar with corporate growth strategies on a large scale and was struck by the calls.

“I’ve only been in here two months and I’ve already been approached by presidents and CEOs and owners of small service center companies,” he says. He described a typical call: “‘Come down and visit us. I want to talk to you because I have a succession plan problem. My son doesn’t want to get into the business, and I’m 65.’”

Investment bankers call it the “liquidity event”—when the owner of a business or other investment cashes out. The highly fragmented, closely held service center industry in North America should see a steady stream of these events over the next few years, prompted by retirements, illnesses, divorces or succession plans.

But just because an owner wants or needs to cash out doesn’t mean he can make it happen. Each sale requires a buyer, and for now would-be buyers are on the sidelines.

Indeed, in a 2011 Forward interview, Chisholm’s predecessor at Samuel, Son & Co., Wayne Bassett, forecast an active acquisitions program for the company, focused on the southern United States and Mexico. But in 2013, Bassett’s company announced just one deal—the acquisition of Wilkinson Steel and Metals Inc. in Vancouver, British Columbia.

Today, as his company digests the Wilkinson purchase, Chisholm does not foresee any major acquisitions by Samuel, Son in 2014.

“There haven’t been as many opportunities or transactions as we might expect,” says David Hannah, CEO of $8 billion Los Angeles-based Reliance Steel & Aluminum Co. Reliance’s last big-ticket acquisition was a year ago, of Fort Lauderdale-based Metals USA Holdings Corp., with 2012 sales of $2 billion.

In the immediate aftermath of the 2008–2009 recession, M&A activity among North American service centers jumped to 21 deals in 2010 from just eight in 2009, according to data compiled by Chicago-based corporate finance adviser Stout Risius Ross Inc. But the numbers have declined since then, to 13 in 2012 and seven in the first three quarters of 2013.

2012 saw a brief spike in deals near the end of the year, as a few sellers rushed to beat the 2013 increase in U.S. capital gains tax rates, says Vince Pappalardo, managing director for investment banking at the firm.

Each sale requires a buyer, and for now would-be buyers are on the sidelines.

Since then, “there’s not been much activity,” says Andy Pappas, managing director of asset-based lending at BMO Harris Bank in Chicago. Many would-be buyers among metals distributors are “hunkering down,” he says, even though they hold abundant cash on their balance sheets and enjoy solid lines of asset-based credit. 

“It just sits there,” Pappas says. “We go to them and say, why don’t you use some of that money to buy somebody? They’re like, well, we don’t want to do anything crazy right now.”

 

Value Through Synergies, Not Prices

In the context of any economic forecast, the trend in service center M&A deals bears watching for two reasons:

  • Financial confidence among independent, small-order service centers dotting the industrial landscape is vital to the growth of small manufacturers. A healthy M&A market for service centers increases the confidence of business owners.
  • The positive economic value added to the metals supply chain by service centers processing and delivering metal can offset the risks of volatile metal prices. Indeed, the distinct investment appeal of publicly traded service center companies lies in the value of their service more than in the price of metal.

Shale We Dance

Another reason for the current malaise in the service center M&A market is that forecasts of the shale energy boom may have been overly exuberant, at least for the short term. 

Last October, Wall Street cheered when Japanese trading giant Sumitomo Corp. agreed to acquire Baton Rouge-based energy extraction products distributor Edgen Group Inc. for $1.2 billion, or $12 a share. The price represented a 58% premium over the stock’s closing price the day before the announcement.

Edgen is a major player in supplying steel products and other materials to energy companies engaged in the hydraulic fracturing process for releasing natural gas and oil from shale deposits. The deal temporarily countered fears that low natural gas prices were crimping the shale energy investment opportunity.

A second theme emerged in the last few years—that low-cost natural gas would enable North American steel mills to become more competitive and bring the metals supply chain back home. A steelmaking process called direct-reduced iron (DRI), which uses natural gas in the heating process, is being utilized by Charlotte, North Carolina-based steel producer Nucor Corp. 

An analysis by the DTTL Global Manufacturing Industry group, a unit of consultancy Deloitte, projected last summer that the DRI process could transform North American steelmaking and boost the fortunes of service centers, fabricators and other downstream metals suppliers aligned with DRI mills.

But the natural-gas-from-shale phenomenon is a long-term idea, both in terms of selling products to the energy industry and making more competitively priced steel. Much of the shale energy extraction infrastructure is already in place, and growth opportunities in the short term depend mostly on the price structure of shale energy versus more traditional energy.

Reliance Steel & Aluminum Co., for example, already owns several Houston-based suppliers to energy producers. “Many of our acquisitions since 2009 have been related to the oil and gas industry,” CEO David Hannah says. Samuel, Son & Co. already has an active customer base for metal products and manufactured products for North American energy producers, says CEO Bill Chisholm.

“Right now, the shale plays are probably the only longer-term growth story you can talk about in steel,” says James Mulick, president of Ameridan Resources, a corporate advisory firm in Pittsburgh.

But the word is out, says PwC’s Sean Hoover. “A couple of years ago, everybody was optimistic about how it would impact the [metals] industry. Companies are starting to realize that the benefits are not yet significant and not as immediate.” From an M&A perspective, “the overall tone [today] is that the enthusiasm around shale and gas has been tempered,” he says. For one thing, “companies that have these assets are hanging onto them.”

Meanwhile, steel mill conversions to natural-gas energy are slow in coming.

“We think picking stocks that have value-creating business models is a better way to play the distribution sector than trying to pick steel price movements,” wrote steel sector analysts Nathan Littlewood and Hubert Dagbo in a recent investment report for New York-based Credit Suisse Securities Research & Analytics.

Translating this investment analysis to the post-recession M&A scene, steel service companies dedicated to growth through acquisitions are rethinking the strategy of rolling up independent service center companies that maintain their local market profitability, growth and brand loyalty.

“In 2009, when everything went to hell in a handbasket and went fast, you try not to waste a learning experience,” says Reliance’s Hannah. One of the things Reliance learned was to direct certain Reliance companies to sell to other Reliance companies, “to reduce inventories quicker than if they had to do it on their own. It really helped us.”

One result was a greater emphasis on operational synergy among the more than 55 Reliance companies. Synergy has extended beyond inventory control to include expanded product offerings, more centralized metal purchasing and best practice learning, he says.

Optimism persists that manufacturing can play a greater role in driving economic growth in North America. Several factors typically are mentioned: rising wages in China; low borrowing costs thanks to Federal Reserve monetary easing; newly available low-cost natural gas energy for factories; technology innovations in North American manufacturing; domestic consumer demand; and a slow but steady decline in the U.S. dollar versus world currencies.

Supporting an upbeat view, the Manufacturers Alliance for Productivity and Innovation (MAPI), based in Arlington, Virginia, posted strong gains in its September survey of members from the June reading in overall orders, export orders and the MAPI composite business outlook index.

 

Clouded Forecast for M&A

Still, the entire metals sector remains in a post-recession M&A lull, thanks primarily to the slow economic recovery, says Sean Hoover, Pittsburgh-based metals leader for PwC. “We’re lagging behind where we were in 2012,” he says. “The overall M&A environment, particularly in the U.S., is sluggish. Companies are focusing on what they can control.” 

“There are a few companies that are looking at acquisitions because they feel the multiples (company valuations compared to annual cash flow) are lower than they would be in an up cycle, just because there’s so much uncertainty about our economic health in the U.S.,” says Dustin Weinberger, Chicago-based managing director for metals and mining at GE Capital.

A survey of steel executives last spring for PwC showed that mergers and acquisitions fell in 2013 from 2012 in a ranking of important strategic initiatives, while internal information technology projects rose in importance.

A forecast of 2013 steel industry trends by Switzerland-based KPMG International concurred. An M&A surge from 2004 to 2008 has ended “in part … because steel organizations are … preoccupied with cost optimization, the reduction of over-capacity and necessary asset portfolio management decisions,” wrote Rama Ayman, global head of metals and mining corporate finance.

GE Capital’s Weinberger sees the introspection among his customers, who’ve been asking him more eagerly about improving operations than about financing for M&A deals. “It’s internally focused,” he says. “How do we retain (profit) margin and provide value-add for our customers? How do we get the most out of our equipment and employees?”

“The second thing that’s slowing it down is the metal pricing uncertainty,” PwC’s Hoover says. “With commodity pricing like that, there’s a lot of uncertainty about what kind of value you can extract from the metals space, particularly the mills.”

One troubling indicator of the M&A outlook among service centers has been the effort by Los Angeles-based private equity investor Platinum Equity to float public shares of its investment in Chicago-based Ryerson through an initial public offering. Platinum acquired Ryerson for $34.50 a share in 2007 and filed its first notice to issue public shares in early 2010.

A successful IPO by Ryerson would provide useful evidence of company valuation in the service center industry. In its latest SEC filing last May, the company reported that geographic and product expansion, including acquisitions, were primary elements of its business outlook. But at press time, the investment community remained doubtful. Ryerson, which posted $4 billion in sales in 2012, declined to comment for this article, citing the pending IPO.

“Ryerson changed their business model,” says Bill Peluchiwski, senior managing director for the industrials group at Chicago-based investment banker Houlihan Lokey. “It used to be large orders; now they’re doing small orders.” The new strategy makes Ryerson more similar to the typical North American service center company, he says. 

The outlook for the Ryerson IPO and its new strategy isn’t clear, Peluchiwski says. “I am not going to count them out, but they are going to have to make sure their story holds. Part of the issue is where we are in the economic cycle.”

The post-recession tendency of would-be buyers to focus on operational synergies and cost controls has altered M&A deliberations.

Terms of Endearment

The days of service center M&As being priced and concluded based on the general outlook for metal demand and prices have not ended. But the post-recession tendency of would-be buyers to focus on operational synergies and cost controls has altered M&A deliberations.

The value of a service center can improve in the eyes of a buyer when the seller has a track record of improving productivity, offering more customer services and building management skills.

What matters today, says Olympic Steel Inc. CEO Michael Siegal in Bedford Heights, Ohio, is what happens the day after the deal closes.

“We’re not going to buy somebody who doesn’t fit into the strategy we are trying to implement,” he says. Simply rolling up profitable service center assets into a portfolio of independent businesses isn’t enough “unless you increase my profit margin,” he says.

In 2011, Donald McNeeley and Bob Haigh sold their “lifelong” business, Chicago Tube & Iron Co., in Romeoville, Illinois, to Olympic Steel for $150 million in cash and Olympic’s assumption of $6 million in debt. McNeeley continues to oversee Chicago Tube under a five-year employment agreement.

With Chicago Tube’s concentration on pipe and tubing products, McNeeley says, “there are certain limits to a niche market. I had to compete with general line service centers. More and more customers were looking for one-stop shopping, and I needed to worry about a general line service center using my type of products as a loss leader.”

Almost immediately after the acquisition, Olympic began expanding Chicago Tube’s geographic reach and integrating the Olympic product line into Chicago Tube. “We have 30,000 line items, and there is not one overlap with Olympic,” McNeeley says.

The idea, says Siegal, is to open each “store” under the Olympic umbrella to more products. Chisholm at Samuel, Son agreed. “It’s easy to come to an agreement on a financial transaction. The real success comes in integrating the facilities. It’s really important for people to assimilate into the culture.”

Many service centers with acquisition aspirations lack the resources to conduct due diligence investigations of a prospective M&A target when the job involves more than a macroeconomic outlook and a set of off-the-rack financial metrics, McNeeley says. 

The value of a service center can improve in the eyes of a buyer when the seller has a track record of improving productivity, offering more customer services and building management skills.

The optimal price of a target company—often expressed as enterprise value as a multiple of the latest earnings before interest, taxes, depreciation and amortization (EBITDA)—varies widely when potential synergies enter the equation, he says. “People read multiples in the headlines and think these multiples are universal,” McNeeley says. “They may have an elevated expectation that’s not realistic.”

Two years after the deal, McNeeley says, “we think we made them a better company, and they have made us a better company.”

Looking Forward

A perennial question centers on growth opportunities for North American service centers outside their home country. “You might expect to see export of the U.S. service center distribution business model to other parts of the world,” says Peluchiwski. “To me, that’s where the growth is going to come from.”

But where? Certain companies, including Reliance, Ryerson, Samuel, Son and Olympic, have expanded internationally. But, according to Chisholm, the opportunities may be most compatible in Mexico. He headed ArcelorMittal’s Mexico operations.

Mexico is home to an expanding manufacturing sector and, unlike Europe, a fragmented network of independent service centers, much like the industry in the North America. 

“In Mexico you’ve got a lot of North American predominant players coming down in the flat-rolled carbon area because there’s huge automotive growth in Mexico,” Chisholm says. “The service centers in Mexico have gotten overcrowded in supporting the automotive and flat-rolled carbon group. But the rest of the service center industry in Mexico is pretty fragmented—family-owned businesses.”

Cross-border issues aside, the M&A outlook for North American service centers still can’t ignore the consolidation opportunities closer to home, says Chicago Tube’s McNeeley. “There is no concentration of power in our industry. The top 50 players have a 25% market share.”

After all, he says, “there are an awful lot of independents out there who are happy being independent. The principals of the business are funding a lifestyle out of the company.”

That is, until they need to sell in order to solve an ownership succession problem. Then they pick up the phone.


Bill Barnhart, a Chicago-based financial writer, was a business editor and columnist for the Chicago Tribune for 30 years. He is the author of MSCI’s 100th anniversary history, “Links in the Long Chain.”