Remember the financial meltdown of 2009? Markets were plummeting and companies were jettisoning jobs like a dog shaking off fleas. Industrials, which includes companies in mining, chemicals, transportation and packaging, recovered faster than most groups. In fact, industrials began outperforming the S&P 500 starting in August 2009 and kept this up until first quarter of this year, according to Bill Peluchiwski, who is co-head of the industrials group at Houlihan Lokey.
Yesterday, I spoke to Peluchiwski, who founded Houlihan’s industrials group roughly a decade ago. Peluchiwski has recently worked on such deals as the sale of ASIMCO, the Chinese truck components company, to Bain Capital and advised Delphi in its $3.8 billion buyback of a stake held by GM.
Q: How did industrials outperform the S&P for so long?
A: The large global industrials led the economic recovery, with global capex demand from emerging markets, like India and China, etc. Companies such as Caterpillar, Deere, Joy Global, led the way with export sales. In part, the emerging markets have higher GNP growth, and coupled with the commodity boom, it resulted in good performance for companies like these.
Q: How are industrials now?
They’re performing fairly well. There are two types of industrial companies. First are those that benefited [from the downturn] back in 2009 and are still doing well. There is lesser growth opportunities for those doing well. They didn’t fall as far.
But there are a slew of other industrials that are tied to the U.S. economy, particularly the construction market, that haven’t really shown much performance yet. This other group of underperforming industrials—which includes major metals companies like A.K. Steel, U.S. Steel and Newcor—this whole complex really had to recover. That is the opportunity we’re seeing. We will see those stocks do better. That has the most opportunity to recover. When it will happen, that is the $64 million question.
Q: What are the multiples right now for industrials?
A: Ironically, the average multiple is closer to 8x plus. In part, this is because of the soft earnings of companies I just described. Earnings are pretty low but stock prices remains pretty high. I would anticipate multiples declining as earnings start catching up. At some point they will exceed expectations. Right now, earnings are lower for more cyclical types of companies, and I expect earnings to increase and multiples to decrease to more sustainable levels of about 6x EBITDA compared to 8x now.
Q: What were the multiples during the downturn?
A: Lots of people showed losses. Multiples tend to go up when earnings go down, because stock prices stay relatively sticky and so multiples go much higher. We had multiples in the teens. Sensata, owned by Bain, is currently trading at 10x. It went public just recently. It’s difficult to say what the multiples were during the downturn, because a lot depends on individual stock performance and a lot of those earnings were quite depressed in 2009. We can’t look at 2009 as an indicator of how far things went. I hope we only see that once in a lifetime.
Q: We just reported that lower middle market deals saw a 52% drop in Q1 compared to Q4. What’s happening with middle market deals?
A: First quarter was close to 25% down and second quarter will be down 50% compared to Q4. We anticipated a gap in deal activity based on deal activity in Q4. Everyone was working on closing deals. We have a six month delay. I think this Q2 will be lower than Q1 because of the gap. None of this was unexpected. We will have a run for the roses for the balance of year. We will have a strong June and the summertime will not have the traditional break. I don’t see that happening. [Deals] will be hard and heavy. I see all that being very busy.
Q: What are equity contributions now?
A: We’re seeing that it’s somewhere in the 40% to 50% [range] in industrial deals. Financing has come back to some degree but not all the way. Pricing hasn’t come back down that much. One of the surprises is that pricing has been fairly resilient. Financing has come back but not yet to levels it was before. People are writing bigger equity checks. Thirty percent was the level of 2007, but now it’s up to 40% to 50% currently.
Q: So who is more active now, PE or strategics?
I think the PE community made very few investments in the 2007 to 2008 time frame. Those that didn’t make investments have unreasonable pressure to employ capital within their time horizon. They’re being quite aggressive in today’s horizon. Corporates have taken as much costs out as possible, and they need to show growth. I would anticipate it being still pretty evenly matched. But I’m still giving the advantage to corporates, because they have more money and more ability to make a deal work.
Q: What can you tell me about the movement for a repatriation tax holiday?
A: U.S. corporates are sitting on $2 trillion. Much of that is held off shore. Right now there is no incentive to bring it back to the U.S. In part the politicians do not want to give the big corporates a tax break as it looks bad. But the reality is if there is no tax incentive or holiday, [the money] will never come back. There is some discussion on Capital Hill to offer a tax reprieve, from 34% to 5 percent. This would free up as much as $1 trillion. It likely would offset any stimulus decline from QE2 stopping and increase cash for capital expenditures, and fuel M&A activity.