What's in Store for 2009

While no one could have predicted the tumultuous ride we had in 2008, the question on everyone’s mind is, “What’s next?”

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As we close out the year, we are left wondering to what extent its precarious market situation will trail us into 2009. During the last two years, the equity markets as a whole have lost more than 30 percent of their value. Companies in the automation industry have fared no better, with a loss of more than 25 percent over the same period. In early September, the Lehman Brothers’ bankruptcy and the resulting collapse of the credit markets only accelerated the decline in global economic activity.

Indications of the expected global economic slowdown heading into 2009 have also begun to appear in the manufacturing sector, with the two most recent Manufacturing Institute for Supply Management readings for the Purchasing Managers Index (PMI) at 43.5 percent and 38.9 percent in September and October, respectively. These readings represent a 26 year low in the PMI, its lowest since 1982, when the PMI registered 38.8 percent, and the country was experiencing a recession due to inflation. Currently, we are seeing manufacturers solely focused on capital projects that quickly improve productivity or maintain their current capacity. As a result, we believe automation supplier financial performance should weather the downturn better than most sectors.

Bright spot

A recent bright spot since late September 2008 is that the three-month London Interbank Offered Rate has fallen meaningfully since peaking at more than 4.8 percent. But this is only the beginning of a return to normalized credit markets, as banks will be slow to loosen credit in the near-term. To that end, Congress has begun to distribute significant portions of the $700 billion Troubled Asset Relief Program (TARP). Although TARP will not immediately impact lending, the new infusion of capital will boost confidence in the banking sector, a key contributor to increased lending. Financial buyers who rely heavily on debt to fund their acquisitions have been successful at completing transactions, but funding was secured at a lower leverage level and a higher cost.

Mergers and acquisitions thus far in 2008 total roughly $2.7 trillion, a sharp decline from the record $4.4 trillion in 2007 deals, another result of the volatile economy. Heading into 2009, M&A activity is expected to remain at depressed levels over the next several months, especially for transactions of $500 million or greater.

In spite of economic uncertainty, the demand for quality businesses remains in the market, perhaps to a greater extent than ever before. Diversified industrial manufacturers have generated a significant amount of cash flow during the last few years, and financial buyers have continued to successfully raise equity funds. As a result, many of these traditional acquirers have capital to invest and are looking, albeit more selectively, for good companies to add to their portfolios.

Due to the recent drop in equity markets, public market valuations for attractive companies have fallen dramatically. These public market valuations tend to influence value expectations for both buyers and sellers. However, sellers adjust their expectations at a much more gradual rate. Once this happens, we expect the automation sector to see increasing M&A activity.

As the new administration moves into Washington, we can expect possible changes to taxation, spending and regulatory policies such as antitrust enforcement. The economic impact of these inevitable changes from Washington is likely to not be fully understood for years to come. With this economic and political backdrop for automation suppliers, we expect 2009 to be a year full of challenges, but equally full of opportunities for those industry participants that are well prepared and well capitalized.

Jim Lavelle, JLavelle@HL.com, is Managing Director of the Industrial Technologies practice of Houlihan Lokey.

Eugene Bazemore, EBazemore@HL.com, is Senior Vice President of the Industrial Technologies practice of Houlihan Lokey. For more about Houlihan Lokey, visit www.HL.com
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