Weekly Corporate Growth Report: Valuation of the industrial machinery industry

Industry Overview

The industrial and commercial machinery industry includes establishments engaged in manufacturing machinery and equipment for commercial and industrial use. This diverse industry includes the manufacturing of a wide range of machines including computer equipment, engines, turbines, elevators, conveyors, cranes, monorails, refrigeration equipment, tractors, metalworking machines, power-driven hand tools, and office equipment.

The machinery industry relies on new equipment orders from a wide range of other industry sectors. In 2002, decreased activities in areas such as construction, mining, power generation, agriculture, refrigeration, and aircraft production limited the demand for industrial machinery.

The industry's fortunes may be looking up. The machinery sector saw earnings growth in the first half of 2003. Factory orders for machinery increased in June and July, but slipped slightly in August, falling below July's number but still remaining ahead of June. If the economy improves steadily, as some economist predict it will, the machinery industry should see improvement in sales and earnings as other industry sectors pick up the pace of production. Management predictions for the remainder of the year remain cautious, however.

Cutting Costs to Grow Business

Companies in this industry have made serious cost-cutting efforts in recent years. While most of the available opportunities for cost savings have already been capitalized on, companies in the industry continue to seek ways of controlling expenses. Efforts include reducing production capacity to reflect lower demand, improvement in production design and source materials, and the closure or relocation of plants.

While cost cutting in other industries initially hurt the machinery sector, the industry may benefit as manufacturers in other sectors attempt to maintain their streamlined efficiency while increasing production. As companies in other industries seek to control costs by reducing headcounts and increasing efficiency, the machinery sector benefits from increased demand for industrial automation.

Room to Grow

Another way for the industry to grow is to seek new markets. The machinery industry has room to capitalize on secondary market opportunities. A good example is the industrial cleaning equipment division of Vivendi Universal SA, which was recently purchased by a group of private equity funds. The division, now called International Surface Preparation Corp, or ISPC, makes equipment for scraping rust from bridges, ships, and railcars, sandblasting industrial structures, and resurfacing ice rinks.

The investors believe that ISPC had a great deal of unrealized potential. The company has room to expand into emerging global markets such as Eastern Europe, Latin America, and the Far East. ISPC could also benefit from greater attention to life cycle sales and service, generating additional revenue from selling components and maintenance. The company has no detailed plan for going back to the owners of its machines to sell aftermarket parts and supplies.

Many machines have parts that constantly require replacement, such as abrasives and lubricants, making aftermarket sales a logical extension of the industry's primary business.

Mergers and Acquisitions

The number of M&A deals in the industry decreased steadily between 1999 and 2001. In 2002, the number of deals in the mid cap market saw a slight increase, while the 2002 large cap market held steady with 1999. Careful control of cash expenditures within the industry has limited acquisitions activity and other capital outlays as industry firms use their resources to pay down debt. When the global economy improves, the industry can expect to see increases in acquisition activity and capital spending.

Outlook

The fate of the industry appears tied to improvements in the economy. When manufacturers feel they can afford to increase production, demand for production equipment will rise.

There are other factors that influence demand, of course. Business inventories decreased this August. Inventories of durable goods fell 0.5 percent, and within the durable goods category, machinery inventories fell 0.9 percent and computer equipment inventories decreased by 0.9 percent. The longer corporations can hold onto inventories, the longer they can go without purchasing new equipment.

Private equity firms are also showing an interest in the industry. Investors are gambling that manufacturers, having been forced to limit spending during the economic down-turn, will soon need to replace worn-out machinery and equipment.

Sources: Crain's Detroit Business, Mergers & Acquisitions: The Dealmaker's Journal, Wall Street Journal, Value Line

By Andrew Dolbeck

Editor