The precision manufacturing industry continues to consolidate at a rapid pace, driven in part by growing capital availability and the increasingly high multiples offered by private equity groups. Private equity’s traditional strategy has been to consolidate smaller companies to create larger ones, at the very least because bigger organizations generally attract loftier valuations—i.e., size matters. However, it’s not clear if that strategy will continue to work going forward, if asset values have indeed peaked as the Federal Reserve tightens monetary policy and raises interest rates.
If that’s the case, PE firms will need their portfolio companies to make real operational improvements—and not simply grow in size—to increase their value. The same goes for companies looking to be acquired.
So what must consolidators—and the companies they acquire—do to up their game in 2022 and add more value to what they are creating?
To find out, we asked Patrick Thornton, co-founder and chief financial officer of VFD Technologies Inc. in Bethlehem, PA, for his expert advice. For the past 12 years Thornton has led VfD’s value creation strategy focused on advanced manufacturing. Over his career he has been a principal in more than 16 M&A transactions, mostly on the buy side but most recently on the sell side. In September 2021 FOCUS advised VfD on the sale of its medical device and robotics subsidiaries to Jordan Company backed ARCH Global Precision, a manufacturer of precision medical devices, surgical instruments and robotic components. In addition to remaining as CFO at VfD, Thornton will be vice president of finance at ARCH Medical Solutions – Lehigh Valley.
Here are Thornton’s thoughts on increasing the equity value of your business in 2022.
- Dive into your data
According to Thornton, there are four main objectives of making operational improvements, but they all start with having the right data and being able to analyze it to identify the most significant opportunities for improvement.
“The most capable suppliers are dealing with record order levels that exceed capacity and a shortage of skilled machinists; that dynamic makes it critical to know your business performance with a fact-driven approach,” he told us. “Monthly profit-and-loss statements only give you a snapshot in time, and they don’t really help you analyze the resources that were consumed to serve your customers.”
Instead, he says: “Your decisions must be grounded in the real data of what is happening every day, on every job, on every production machine. Otherwise, how do you really know how you are utilizing your resources? How did you spend those machine hours and for which customers, over a specific period of time? Your capital is your people, your machines and your customers. Every time you quote a part, you are making an investment decision. ‘Will I and how will I deploy my scarce capital on this opportunity?’ Wise investment requires knowledge of your resources and their most efficient allocation.”
While many precision machine shops have an enterprise resource planning (ERP) system in place, most have it only partially implemented. But you don't need an expensive ERP system to do this. Excel can be good enough. “Use the data that you have available, even if imperfect” says Thornton. But you need to be able to track your performance and know how effectively you are using your resources.
“Providing visibility to your team is powerful, we ensure that real time performance is provided to sales, production, engineering, and even the quality function. And the group discussion and review of the performance data really leads to concrete objectives. When you know utilization down to the machine resource level, while also creating a comprehensive understanding of the application of resources over time, you can drive profitability consistently long-term,” Thornton says.
- Focus on your customers
Thornton’s second rule is to focus on your customers. Indeed, like the fact driven approach, all of the strategies Thornton suggests revolve around helping your customers, which in turn helps your own company.
“We call it ‘winning on behalf of the customer,’” Thornton says. “When we win, they win. Our teams produce the most advanced and difficult to manufacture devices. Our ability to do so allows our customers to serve their markets with the best technology, while also securing our future as part of their supply chain.”
“We have a customer-centric strategy,” he continues. “It's not competition-focused. Understand who your customers are and what you can help them achieve, then make that the focus of your business strategy. Once you really understand your customers and the demands of their markets, then you can deploy your resources on their behalf. It creates a true partnership that is hard to replicate.”
- Emphasize resource consumption over cost
The third rule follows closely on Rule 2.
“While we always know our costs and structure our pricing strategy accordingly, a more important approach is to understand the revenue generated per machine hour,” Thornton advises. “Revenue generation per resource hour allows you to focus on the front end of driving value.”
For example, one of Thornton’s companies is a medical device manufacturer of spinal surgery components. They had no ERP system but had served the leading spine companies in the world for more than 20 years. The division was profitable, and while performance appeared acceptable on the surface, digging into the numbers told a different story.
“We implemented an ERP system in 2015 and found that we operated 144,000 machine hours annually, but we were losing money on two-thirds of our customers and spending 20% of our resources on one customer who accounted for only 5% of revenue,” he says. “Over the next three or four years we were able to address this from a lot of different angles.” During that timeframe, machine hours were reduced to 120,000 hours but revenue more than doubled and profit quadrupled.
“You have to have the data to know how you can maximize profit and allocate your resources accordingly,” Thornton says. “You have to know what you shouldn’t do as well as what you should. That doesn't mean you only accept the most profitable opportunities; you don’t want to lose good customers. In a machining business pricing is based on the resources estimated to be consumed to produce a finished product or component. They are all very different, with unique engineering specifications and so much technical complexity. There are hundreds or thousands of different products in many precision machine shops, making it very difficult to understand your product mix and contribution to profitability – but you must. If you're not allocating your resources efficiently, you can’t make it up on price given the competition.”
- Retain your people
Of course, your most valuable resource is your people, no more so than right now, when it’s so difficult to find highly-skilled, experienced machinists, engineering and technical staff. Retaining the talent you have is so critical. You must be profitable enough to retain them while also investing in new technologies, so that you will continue to be the supplier of choice for your most demanding customers.
Again, it all comes back to serving your customer.
“In the context of the MIT Delta Model of strategy, advanced manufacturing companies are a unique collection of resources,” Thornton sums up. “All are different, and they have so much technical knowledge and organizational know how. Not many suppliers can deliver the quality and reliability that you do in such demanding applications. You are an extension of your customers supply chain who is critical to their success. Many metal working companies don't recognize that and its strategic value. They have a tremendous opportunity to recognize their unique collection of resources. The opportunities for value creation are huge.”