Interconnect merger-and-acquisition activity should rise in 2010

by Craig Mullett, president, Branison Group

The worst of the economic recession is probably past for the interconnect industry, but many questions now linger for both large and smaller players in the market. The forces underlying the slow economic recovery in 2010 will likely create conditions in which both buyers and sellers will have additional incentives to make deals.

Smaller companies have more reasons to sell
The collapse in sales experienced by many interconnect manufacturers in early 2009 provided an unpleasant reminder of the risks of economic cycles. For smaller businesses in the United States that have recovered, some of the "Baby Boomer" owners may decide to retire and sell before capital gains taxes increase in 2010. These owners can be certain of a high after-tax nest egg, and also diversify their personal portfolios more effectively. Private equity owners of smaller interconnect companies, whose partners pay individual capital gains taxes, will have the same incentives.

For many other smaller interconnect businesses around the world, 2009 proved that inadequate scale can make it difficult to sell to global OEMs. These areas of weakness include the inability to compete against low-cost competition, insufficient revenue to absorb overhead, no global resources (to offer larger customers a worldwide footprint), and lower vendor credibility as large OEMs reduce their supply bases. Businesses that start out filling a market niche are finding it a challenge to expand once they have conquered their selected focus area. Rather than risking owner capital betting on untested markets, many owners will see it as more profitable (and much less risky) to exit at a niche peak through selling to an industry player. A sales-led recovery also requires additional investments in inventory and receivables, with many smaller businesses unable to get working capital funding at the same levels as were available before the economic contraction.

The continued tight debt markets will also encourage more diversified corporations to focus on their core businesses. This could result in some corporate divestitures of smaller non-core interconnect divisions to unlock cash as they focus on growing their mainline businesses to enhance shareholder value.

Larger companies need to accelerate growth
The "new normal" economic forecasts indicate that organic growth will flatten in an ambivalent recovery. With this lack of core growth for larger interconnect companies, M&A will increasingly be the fastest revenue driver identified by management in corporate strategy sessions. Indeed, in a slow growth market, M&A may provide a better return on investment to strategic buyers than internal capital expenditures with uncertain prospects. Investing in "greenfields" in adjacent interconnect markets is difficult when growth is slow and new technologies and customer relationships have to be developed. It is less risky to buy an existing player that has proven its ability to compete in the target market.

The stock market recovery seen over the past year has produced higher pulic company trading multiples for the larger interconnect firms. This will allow for more deals to be accretive than was the case for much of 2009. Global interconnect firms can also achieve more synergies through integrating large-scale production sites and leveraging their sales infrastructure with newly acquired products. These revenue and cost synergies (the latter having more certainty for valuation purposes) should allow for better pricing on deals, helping bridge the valuation divide between buyers and sellers that existed for much of the past year.

Active deal environment in 2010
In 2009, Branison's research indicated that 24 deals were closed in the interconnect market, which is impressive given the fragility of the economy in the first half of the year (as a typical transaction takes 6 to 9 months to close). Most of these 2009 deals were add-on to core product offerings (TSE buying Connect-Tech), while some were adjacencies (Bel-Fuse buying Cinch). The majority were smaller deals, under $50 million, with no transformative large deals. It is expected that 2010 will see a continuation of smaller strategic deals, with some private equity exits (such as Milestone selling IDI to Smiths in March). Private equity firms also continue to show interest in the strong cash flows of interconnect businesses, and with a lot of capital still to be deployed, they could emerge as buyers for those smaller interconnect companies that are too diversified for a strategic buyer.

The increase in M&A volume will be driven by the factors driving both buyers and sellers as outlined above. It is also likely that a number of larger deals, over $100 million, will be closed toward the end of 2010 as the debt markets and trailing twelve-month earnings recover.

As interconnect management teams review their strategy for the remainder of 2010, they could gain significant advantage through proactively thinking about how the industry trend toward consolidation will impact their business in the next few years.

Craig Mullett is president of Branison Group, a buy-side M&A boutique with expertise in the interconnect market.