The year 2006 was a robust period in both the equity markets and in merger and acquisition activity for industrial automation and controls companies. To put this in context, we can compare the Cronus Industrial Automation and Control Technology Index to the S&P 500 Index for 2005 and 2006. As illustrated in the table, the Cronus Index, comprising the market capitalization of 16 leading automation public companies, moved up nearly 70 percent over the past 18 months, while the S&P Index rose just 18 percent. The major driver of this increase in the automation and control technology sector was increased capital spending, including heavy investment in China and realization of deferred spending to upgrade systems.
As merger and acquisition (M&A) activity grew broadly in the domestic market, M&A transactions in the sector nearly matched that performance; the number of closed U.S. market transactions in 2006 rose 24 percent over 2005, while the increase in the sector was 18 percent. Significantly, in each of 2005 and 2006, the dollar volume of completed transactions in the sector was more than double the volume in 2004. Despite the slight decrease in average deal size from 2005 to 2006, the increase over 2004 reveals a trend toward not only more, but also larger consolidations.
The financial markets’ method of valuing a company focuses on three main valuation multiples: the revenue multiple, price-to-earnings ratio, and earnings before interest, taxes, depreciation and amortization (EBITDA) multiple. A company’s valuation multiple is the relationship of its enterprise value (or equity value, for the price-to-earnings ratio) to the given metric. While the revenue multiple and price-to-earnings ratio provide important insights into a
company’s valuation, they are often surrogates for the EBITDA multiple. EBITDA is the most useful tool because it captures a firm’s cash flows from operations, excluding financing and tax requirements.
Based on reported financial information, the median revenue multiples were very similar for U.S. transactions as a whole and for the sector (1.4 times versus 1.6 times). However, the median EBITDA multiples were vastly different: 6.4 times and 14.6 times, respectively. Acquirors in the automation and control technology sector may be willing to pay a larger multiple of cash flows than those in the rest of the market because of the risk/reward ratio and intellectual property that are salient to technology companies in particular. Often, the appeal is not just today’s cash flows, but the lure for the future of very high (but risky) growth, broader product offerings, and/or patent-protected products.
For example, Baldor Electric Co., manufacturer of industrial electric motors, drives and generators, announced in November 2006 that it would buy Reliance Electric Co., the principal asset of Rockwell Automation Inc.’s Power Systems business, for $1.8 billion. The transaction is expected to close in the first quarter of 2007. Annual revenues from the Power Systems business are approximately $1 billion; thus Baldor will be making the acquisition at approximately 1.8 times revenues. Moreover, Baldor’s revenues in 2005 were $722 million, making this a transforming event for Baldor, which will benefit from higher margins, a manufacturing base in China and extension of its product line into power generation products—all worthy of a valuation premium.
A company’s EBITDA margin and prospects for future growth are prominent among the many factors that guide acquisition prices. These factors address the primary concerns of most investors: What is the return on my investment, and how quickly will I earn it? Naturally, there are myriad other important factors that go into the mix, such as a company’s intellectual property, customer relationships, brand identity and reputation, defensible competitive advantages, product quality and reliability, and the potential synergies it brings to its acquiror.
Charles R. Carson,
Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.CCarson@CronusPartners.com, is a Managing Director of Cronus Partners LLC, Norwalk, Conn., an investment banking firm specializing in automation technology.