KeyBanc Capital Markets Industrial Forum: Real-Time Insights

Leadership in a Crisis

While company leadership is always important, a different style of leadership is required during a crisis, including the current moment, discussed the panelists. Having led Materian Corp. through several economic recessions over 16 years, Hipple learned that it’s important to make moves quickly and dramatically, and to plan for the worst.

“Typically, employees are thirsting for leadership to establish priorities for action,” said Hipple. “Leadership has to quickly set the tone, the urgency, the targets. The priorities are really from the top. For example, are you managing for cash? Are you managing for margins?”

Planning for cost reductions and restructuring is inevitable—but leaders also must decide where to draw the line on cuts to have a healthy company when conditions improve. In short, leadership needs to pick up the reins quickly and in a much stronger fashion than normally. Yet, economic disruption can also open the door to positive change.

“When a crisis happens, it’s a fantastic opportunity to accelerate changes in an organization. An organization inevitably has natural friction and inertia that gets wiped away in a crisis,” said Hipple. “You need to be able to take advantage of that.”

Appetite for Risk Provides Competitive Advantage

Coming out of an economic downturn, companies that emerge with strength will be positioned to assume risk and seize opportunities. Those opportunities often revolve around M&A. One way to emerge with strength is to keep leverage at a modest level. Companies that maintain debt discipline and a strong balance sheet will be positioned to move much more quickly when other companies are weaker. A company should be challenged to always operate at the lowest cost structure for its strategy.

“The DNA has to be there so you don’t get frozen in your tracks,” advised Hipple. “The next 12 to 18 months will be a great time for M&A and critical moves.”

In M&A, Strategic Buyers Have the Advantage

The unprecedented circumstances of the pandemic and the challenges of the leveraged finance market are driving new creativity in M&A, according to KBCM’s Jeff Johnston. For instance, private equity sponsors that might previously have assumed majority positions are deploying capital in minority or structured positions instead, while well-capitalized strategic buyers have a competitive advantage not seen in more than a decade.

“Right now, the strategic buyers really have the advantage,” said Johnston. “We have several deals that were taken to market recently that are highly targeted toward strategic buyers because they have the synergies, they have the balance sheets, and they don’t need the leveraged finance market. If sponsors want to win deals, they have to over-equitize, they have to get creative. It’s a real challenge.”

The current environment offers a unique opportunity for well-capitalized strategic buyers to aggressively pursue M&A transactions, said Johnston. Businesses that aren’t impacted or only mildly impacted by the pandemic are getting a lot of interest from both strategic buyers and sponsors in the market.

Optimism in Industrial Trends

Not surprisingly, the initial shock of the pandemic in March and April drove industrial activity down to 2009-2010 levels following the global financial crisis. However, on a year-over-year basis, industrial production has been negative since September 2019, according to the Industrial Production index published by the Federal Reserve Board. The industrial sector had begun to decline long before the pandemic emerged.

Despite the declines, industrial activity recovered somewhat in recent weeks. KBCM’s Steve Barger predicted that it would continue to improve during the remainder of 2020. Barger also expressed optimism based on railcar data, a real-time indicator of industrial activity. Following steep declines in March and April, volume returned to 2010 levels and is continuing to grow. Intermodal rail traffic is leading the pack, while many other categories of rail traffic are well below peak levels.

Barger also saw reasons for optimism in the widely watched Purchasing Managers Index (PMI). Its lowest point in 2020 was 41—still above the trough of 33 reached in December 2008—and in June rebounded above the expansion-contraction inflection point of 50. By late July, PMI had reached 53, exceeding expectations.

“If there’s good news now, it’s that the trough is behind us,” said Barger. “Now the conversation will change to the pace of recovery and the issues or catalysts we should be thinking about next.”

Not All Industrial Companies Are Created Equal

Although the industrial sector overall began to recover in late spring, KBCM has become more selective in its recommendations since then, said Barger.

“Our view is that you want to be more exposed to broadly diversified companies,” Barger explained. “On my list are the distributors and some of the shorter-cycle manufacturers. We’ve been staying away from machinery because we think companies or customers may defer cap-ex decisions until they see better fleet utilization and better end-market visibility.”

As earnings reports continue, KBMC has been proven right. In recent earnings calls with industrial distributors, for example, most have been beating estimates on both revenue and earnings per share, while industrial machinery businesses have been down by 15% to 25%. However, some have seen a huge increase in purchases of safety equipment and janitorial and sanitation products—some exceeding 100% year-over-year growth.

In contrast, the short-cycle manufacturers don’t have revenue offsets and are reporting revenue declines of 20% to 40%. On the positive side, noted Barger, the results are better than the low expectations, because of aggressive cost controls.

Such sectors as defense, food and beverage, and medical products have shown resilience, but Barger expressed caution with regard to oil and gas, aerospace and non-residential construction. Increasingly, KBCM will likely focus on more non-domestic exposure as well, noted Barger, given the weakness in the dollar.

Industrial machinery companies are continuing to work through the economic impact. Recent railcar equipment manufacturers have reported weak orders, shrinking backlogs and significant headcount reductions to right-size their capacity.

“Of the 1.7 million railcars in North America, about one-third of railcars are considered idle right now, which means they haven’t moved in 60 days,” observed Barger. “Until that unwinds, conditions will remain tough.”

Surprising Strength in Housing, Repair and Remodeling Products

The housing, residential construction, building products and repair and remodeling sectors have shown surprisingly strong growth despite declines and record-setting job losses during March and April 2020. Following declines of 30% to 40%, many homebuilders saw demand grow by 30% to 50% over May, June and July, according to KBCM’s Zener. Prices for new and existing homes have also risen.

Repair and remodeling products are also showing positive upward trends, particularly among brands that cater to do-it-yourself consumers rather than to trade professionals impacted by the pandemic. Home Depot and Lowes, for example, have been very active. In Zener’s view, the continuing strength of the housing market should provide further tailwinds for repair and remodel spending going forward, as well as lift prices for key categories of building products and related appliances.

Building product categories across the board are seeing higher than normal demand, especially DIY-oriented products that consumers and contractors are able to pursue. Growth is greater in retail channels that are open, with double-digit growth plus (e.g., 25% same-store comps for Home Depot) signaling rising share of spending as consumers stay home.

Federal Reserve Board Supports Bond Market

As the U.S. economy ground to a halt in March and April, the Federal Reserve Board moved quickly to establish itself as a reliable backstop to the markets. Its actions helped stabilize financial markets and add essential liquidity. Through its secondary market credit facility, the Federal Reserve Board has purchased $10 billion to $12 billion in high-yield bonds at the rate of $200 million per week.

“The Federal Reserve Board has done a fairly brilliant job. Through low rates, bond buying, and a series of targeted programs, the Fed has permanently cast itself as a highly reliable ‘helicopter parent’ to the markets,” said KBCM’s Peiffer. “Most asset classes now benefit from a built-in ‘put option’ provided free of charge by the Fed, and the value associated with a floor under valuation adds incremental value equating to—let’s suppose—at least a turn of EBITDA on equity value and a reduction of more than 5% of required credit spread on most corporate bonds.”

“I hope to never see this kind of Fed action again, but it’s clearly taken us from point A to point B in a very significant way over the last dozen or so weeks,” continued Peiffer.

Moving forward, the question for investors is how active the debt market is going to be. The investment-grade debt market has played itself out, said Peiffer, unless another economic shock leads to companies needing additional credit facilities and liquidity financing. However, the high-yield debt market will continue to function with the Federal Reserve-inspired underpinning of asset values in the sector.

Bond Market Buoyancy Boosts Activity in the Loan Markets

Activity in the bond market has added buoyancy to the high-grade pro rata loan market, as well as to broad market leverage and middle market leverage activity. In pro rata loan transactions, growing bank participation is a noteworthy trend. KBCM has closed numerous inaugural transactions with banks, ranging from a two-bank transaction to as many 10 participating institutions.

“Banks had stepped back for a little bit. Some were very actively in the market supporting existing clients, but what’s different is that we’re now seeing these banks and investors support new deals,” observed Roof. “That means there’s more opportunistic and strategic activity out there.”

The broadly syndicated leveraged finance market is also benefiting from the favorable bond market conditions. “We saw some M&A activity starting to form, leveraged buyout activity, but also stability in trading levels,” said Roof. “We saw a couple of new names in LBO, which is positive. And, with Epicor’s announcement of their proposed dividend recapitalization, we’re now starting to see some opportunistic activity in that market.”

The major indexes support this point of view. As Roof noted, the S&P Loan Syndications and Trading Association (LSTA) U.S. Leveraged Loan Index was under 92 at 91.76—the level Roof had anticipated in a previous KBCM forum. The Credit Suisse Leverage Loan Index is now at 91.11. The IHS Markit index is at 93.

Collateralized loan obligations (CLO) activity has also been revitalized, although not to the same extent as last year. “These are smaller CLOs, with shorter reinvestment periods and less leverage,” said Roof, “but nonetheless allowing us to get activity in the market. For context, we’re at about $10 billion a week now as opposed to about $30 billion a week before [the stay-at-home orders began].” KBCM has managed $41 billion in activity for 95 deals, as opposed to $73 billion for 150 deals last year.

Middle market leverage also has been showing signs of life, albeit at a much smaller volume than previously. “What’s important is that KBCM just launched a new syndicated deal, the third to launch,” said Roof. “Previous activity was about refinancing, but now you’re starting to see some M&A activity.”

“The common theme is that the technicals are unbalanced,” said Roof. “Deals are oversubscribed— especially in the broad market—and you have a very high lack of supply. The market usually takes a little bit of a hiatus around the Labor Day holiday, but I think market activity will continue to go through Labor Day on into October.”

M&A Markets Beginning to Open Up

The dollar volume of M&A deals declined by 55% on a year-over-year basis—but KBCM’s Johnston sees an upswing emerging. The leveraged loan market remains weak relative to prior years, forcing financial sponsors to lower valuations or over-equitize for new platforms.

“A lot of smaller deals are getting done, but they don’t need the leveraged finance market,” explained Johnston. “We’re seeing processes targeted to a select group of buyers who have a strategic rationale for wanting to own the business. We’re seeing more one-off transactions, relative value mergers, and things along those lines.”

One important trend is that new transactions are returning to the market after a second-quarter absence.  Johnston notes pitch activity has picked up substantially with a number of deals headed to market in August and September.

Looking ahead, Johnston anticipates continued growth and working through a backlog of postponed transactions. “We haven’t seen many deals get canceled—they’re mostly just delayed,” he explained.  “We are seeing momentum there. The key thing is going to be the debt markets support.”

One challenge, however, is the disconnect between expectations of buyers and sellers. Yet, Johnston anticipates improvement on that front. “We’re going to be in much better position later this year and into next year,” he predicted. “There’s some level of acceptance that things will never be like they were before. Now people are looking to advance the ball and run their business plans—and a lot of those plans involve M&A.”

New Equity Capital Issues on the Rise

Where M&A fell into a sharp decline in second quarter 2020, equity capital transaction volume rose significantly on a year-over-year basis, primarily in the healthcare and technology sectors, which is where deal backlog has accumulated, explained KBCM’s Wynocker. While Q2 saw a lot of the bridge-to-survival equity trades, today’s equity raises are more opportunistic.

Another major trend has been greater prevalence of special purpose acquisition company (SPAC) IPOs, comprising more than one-third of IPO volume. More than 99 SPACs have almost $25 billion dollars in trust and are looking to deploy capital, which may help rejuvenate the larger M&A market.”

In Wynocker’s view, uncertainty about pandemic relief, stimulus, and the elections may result in continued activity in the equity capital markets. “Many companies think now is a good time to access the equity markets because you don’t know what the fourth quarter will look like,” said Wynocker. “Usually, you see a pause in August, but we may continue to see activity through August and September.”

To discuss how these trends in industrial capital markets impact your business, connect with your KBCM investment banker.