Opinion: Mark Humphries

M&A rumours and the Farnborough Air Show go hand in hand like transfer talk and the World Cup! Today’s chatter is that US acquirors are running the slide rule over Hampson Industries, the UK quoted aerospace tooling and composite and metallic components manufacturer.

Hampson’s shares stood at 52p per share yesterday resulting in a market capitalization of £145 million. Following February’s fund raising net debt is currently £82m and thus the enterprise value is £227 million valuing Hampson at 4.8x March 2009 EBIT and 7.7x 2010 expected EBIT. If I add a typical 30% take over premium to the current share price this would put a 9X 2010 expected EBIT price tag on Hamspon – a good price for today’s shareholders but certainly not a knock out price. If there is substance to this rumour I would certainly expect a number of US suitors and the premium to today’s share price could be much higher.

Hampson may be the first rumour at this week’s show but it won’t be the last! There has been a dearth of M&A activity in the sector over the last 2 years however the aerospace sector is considered to be at the bottom of the cycle and many new deals are expected to be announced this week marking the road to recovery in the sector. UK assets are looking good targets for US acquirors with relatively cheaper pricing compared to similar US assets and the exchange rate helps make UK assets feel more affordable.

A club of Canadian private equity houses has bid 325p per share for UK industrial and automotive focused Tomkins. This bid values Tomkins at an enterprise value of £3.2bn – 6.9x 2009 EBITDA and 4.8x 2010 expected EBITDA.

Tomkins is seen one of the last of the great UK industrial conglomerates although in truth 93% of its products are made outside of the UK and the US represents 52% of its end user markets. Its disappearance from the stock exchange will be more a symbolic one.

However it is encouraging that both Tomkins management and these PE funds see positive signs of sustainable improvement across its markets in automotive, industrial products and building products. Tomkins manufacturers product ranging from drive belts, gears, hydraulic hoses, remote tyre pressure systems and axles for off road vehicles. Tomkins appears to be seeing an increase in end user demand rather than any restocking and margins are improving due to increased volumes with a much tighter cost base. Over the last 18 months Tomkins has closed 25 facilities, reduced its headcount by 4,500 and taken 20% off its sales line by shedding loss making activities.

Although the offer received a cool reception from Tomkin’s major shareholders yesterday it is unlikely that a competing bid will materialize if it looks like the Canadian’s will receive support from the executive team.

Undoubtedly Tomkins will not be the last UK engineering business to be a target from North America – pricing is relatively cheaper than similar US assets, there is more liquidity in the US debt market at the moment giving North American PE funds more fire power and making them more deliverable than their UK counter parts, there is undoubtedly a pent up demand for M&A and the exchange is helping make UK assets feel more affordable.

The coalition government has set out the most radical shift of power and accountability and the largest structural upheaval since the NHS was established.

The White Paper "Equity and Excellence: Liberating the NHS" aims to devolve power from Whitehall requiring GPs to buy secondary care for patients via commissioning consortia by April 2013 – less than 3 years away.

Personally I see a great deal of risk in the transition of commissioning to GPs:

• GPs hold patient care and medicine as their guiding principle. They are rarely business minded, financially astute, commercially savvy or strategists. This feels like a potential disaster waiting to happen and an odd time to introduce an ideological driven policy forcing GPs to become captains of industry at a time when £20bn needs to be taken out of the NHS budget.

• There is already a commissioning knowledge base in the NHS within the PCTs. It will be no surprise when these people form the nucleus of the commissioning consortia so I do think this is a waste of time and probably money whilst the system is re invented using the same people. However, there is universal agreement that the NHS needs to be reformed to be efficient and focused on health outcomes.

The White Paper offers a big opportunity for private providers to drive efficacy and efficiencies in the NHS using its business wide skills developed in other sectors such as education where the private sector has supported education delivery for a long time. As is normally the case, with regulatory change and seismic changes in the landscape, I expect M&A activity to follow as the large healthcare players acquire businesses and re align their services and expertise to take advantage of the changes.

One such area will be in healthcare intelligence. To make intelligent decisions on healthcare provision the commissioning consortia will need clean, reliable and robust outcome based data. In its own right this basic data has limited value. However many private providers are skilled at turning data into knowledge so intelligent decisions can be made by commissioners and patients and ultimately payments can be made based on results.

Expect to see healthcare intelligence providers such as Capita, Dr Foster and undoubtedly new entrants at the heart of the new White Paper implementation and inevitably they will be involved in the land grab to acquire expertise and market position in healthcare outcomes.

I've just been given an advance preview of a spectacular picture of Taranis, the UK’s concept demonstrator stealth unmanned combat air vehicle (UCAV).

Developed by BAe, Rolls Royce, QunetiQ and GE Aviation (formerly Smiths Aviation) over the last three and a half years and a million man-hours it keeps the UK at the forefront of worldwide engineering excellence and innovation in aerospace and defence technology.

These are uncertain and unsettling times in the UK aerospace and defence supplier base with a Strategic Defence Review expected in the Autumn and defence spending cuts inevitable.

However, complex, technically demanding and innovative projects such as Teranis demonstrate the skill base in the UK and it is no surprise that UK businesses continue to be attractive to investment either via private equity or overseas buyers.

UCAVs are an interesting development in our armoury and other countries such as the US (X-47B), China (Anjian ‘Dark Sword’), Germany (Barracuda), France (nEUROn) and Russia (SCAT) are all at the stages of developing their own flying demonstrators.

Assuming the MoD commit to buy UCAVs will only form a part of any air forces future capability and Taranis order numbers are likely to be low. UCAVs will probably priced similar to current first strike fast jets such F-35 JSF and Eurofighter at $30-40m each so the only likely savings in this environment of austerity will be training and support.

However, as with most aerospace and defence technology advancements there will undoubtedly be many spin offs into the wider aerospace and defence sectors and then probably into the automotive sector.

The Geneva Car Show is always a great showcase for exotic and fast cars. However last week’s show was host to the early exchanges in the car wars as the major OEMs staked their claims in the development of their electric/hybrid models. Even Porsche, who once stood proud with their rear mounted Boxer engines, were showing off their hybrid concept. Whatever next – a diesel 40 mpg Aston!?

This could all be very exciting news for the UK automotive suppliers who have survived a torrid economic downturn and 15 years of cost downs and process re-engineering.

UK suppliers are at the forefront of automotive engineering and the OEM zero emission car wars will help them restake their claim on the world stage. By 2020, 10% of the world’s car parc is forecast to be electric/hybrid cars and this means we are set for a step change in automotive technology development. Whether the electric car or hybrid win the day in 50 years time no one really knows, however the functionality of the constituent systems of the car won’t fundamentally change in terms of transmission, powertrain, suspension systems and braking. The supply chain is well placed in terms of engineering expertise to harness technology and new materials and develop stronger, lighter and safer components.

I expect the UK winners in the automotive supply chain to become increasingly important to the OEMs. They will either receive a tap on the shoulder and be asked to increase their own critical mass and robustness or they will become the targets of those that do receive the tap on the shoulder. If you are one of these suppliers, now is the time to carefully manage your growth, sensibly fund your development costs and working capital and decide whether down the line you want to be a consolidator or start to eye up your future partner now.

There have been contrasting fortunes for two large UK defence businesses in early January.

Firstly, Qinetiq issued a second profits warning in only seven weeks blaming the significant and rising cost of the war in Afghanistan which is resulting in defence cut backs by the Ministry of Defence and US DoD in Qinetiq’s high tech core markets. This highlights the short-to-medium challenges faced by some businesses focused on providing equipment and services in the defence sector and the importance of being on the right programmes in the short term as a number of departmental budgets are cut and then cut again.

In contrast, Chemring, the UK based ammunition, explosives and countermeasures manufacturer announced the acquisition of US headquartered ADG for £36 million, a multiple of 8x 2008 (2009 results not available) operating profits. This complementary acquisition will assist Chemring access the important Middle East ammunition market and brings with it specialised machining capabilities which can be used throughout the group.

Expect further contrasting announcements such as these as the defence contractors on the larger scale, high cost and technology driven programmes continue to suffer short term pain, whilst those defence contractors supplying equipment and services to the front line perform well and acquire to access new markets and new expertise.

Last month I wrote about the likely impact of public spending cuts on M&A in the outsourcing sector.

On cue, last week end’s press leaked VT’s interest in Mouchel and throughout the week both sides appear to have been locked in meetings with shareholders and advisors working out their next moves on the chess board. Unsurprisingly, there has been further press speculation regarding other potential players interested in Mouchel such Serco and Capita – the UK’s two largest public sector outsourcers. There is clearly a long way to go but there are strong signs that Mouchel will be taken over and at 300p per share this would value Mouchel at 8.4x EBITDA.

It is clear that there will be lower levels of public spending over the next five years and this will result in excellent opportunities for the outsourcing businesses supplying central and local government as a way to drive efficiencies and take out public sector cost. However what is clear from VT’s interest in Mouchel is that the larger players need to get larger themselves so they can drive cost out of their business to retain the profit margins they have become accustomed to.

I think this is the start of an outsourcing M&A gold rush and there will be more consolidation to come.

For many years some of the highest rated businesses on the stock market such as Capita, Tribal and Serco have built considerable businesses off the back of public sector outsourcing by central and local government and much of this growth was achieved through acquisition. In parallel, many private equity backed businesses have also grown sharply on this outsourced expenditure, acquired further businesses in this area and ultimately sold these businesses to larger corporates or secondary buy-outs and made healthy returns for their investors.

An inevitable consequence of the banks bail out program is the need for central and local government to cut expenditure to help reduce the huge levels of government borrowing. The 2010/11 public sector budgets have already been set and whilst these will be lower than 2009/10, there is very little in truth that a change in government next year can do to further reduce these budgets. However we hear that the Tory shadow treasury team are running their economic models with public spending cut by as much as 35% in 2011/12.

Whilst this will cause real pain to any company focused on public spending budgets – companies focused on healthcare, education and training, local government services, defence – every cloud has a silver lining. For many companies there will be a real opportunity to help central and local government drive its efficiency agenda and drive out costs. In our view companies involved in productivity consultancy, IT services, software and informatics (the use of information to highlight areas for improvement) will do extremely well and on this basis we expect these companies to quickly become the acquisition targets of the support services sector consolidators very soon.

Reductions in defence budgets are an inevitable consequence of the huge increase in government borrowing to bail out the global economy. Many large defence projects are being pushed back and remain unapproved, and several risk being cancelled. In this environment it is all but impossible for suppliers to the defence sector to invest in plant and equipment, people and R&D.

The US is looking to cut defence spending by 10% and the rumours are that the UK will follow with cuts of up to 30%. UK projects at risk include two 65,000 tonne aircraft carriers - £1 billion already spent; 230 Eurofighters - 55 already received at a cost of £3.8 billion; order may reduce to 100 planes; A300M transporter plane – already delayed by 4 years; C130K replacement - £500 million already spent; Trident ballistic missile - £20 billion replacement; 3,000 Future Rapid Effects System (FRES) armoured vehicles - £12 billion order may be reduced to cover only 600 vehicles

The government has to walk a fine line, balancing the short term need for spending cuts with the imperative to provide British troops in Afghanistan and Iraq with the best equipment.

Businesses supplying the defence sector were once popular investments for private equity and multinational industrials owing to their high earnings’ visibility and the strong long term growth drivers. The huge uncertainty around short term defence budgets and the potential impact of a change in government make selling or buying a business exposed to the sector very difficult. Revenue visibility is poor and key investment decisions are on hold. Valuing the business is very difficult and banks will be nervous about agreeing long term facilities. Owners looking to sell their business are best advised to hold their nerve, focus on protecting margins and wait for the sector to settle.

The sector faces two huge challenges when the economy starts to recover – how to fund the increase in working capital as production increases and weak balance sheets will drive customer supply decisions.

Many manufacturing business will have faced some of their greatest challenges over the last 12 months coping with falls in demand for their products by up to 40%. Major costs will have been taken out of the business in terms of people and overhead, suppliers with have gone bust, credit insurance will have been slashed and banks withdrawn funding.

As production increases a business’s working capital funding requirements will grow and this will cause problems for many businesses in a market where banks are still extremely reluctant to lend. Borrowing against working capital will be extremely difficult where a business has a concentrated group of customers or significant overseas sales and ironically more businesses could fail as we come out of the recession compared to when we went in.

Equally important, I expect a further significant shake up in the supply chain as, in addition to quality and price, security of supply becomes an increasingly important factor. I expect the original equipment manufacturers at the top of the supply chain to exert significant influence over their key suppliers to buy financially weak but still very competent suppliers as a way of protecting the production chain.

The engineering and manufacturing sectors were arguably the best prepared sectors in the UK for the down turn.

For many years these sectors have suffered due to competition from low cost economies, lack of investment in infrastructure and capital equipment, and unfavorable foreign exchange rates.

However over the last 15 years these challenges have shaken the sector to the core and as a result the UK engineering and manufacturing sector has needed to focus on what it is good at. This sector is now firmly focused on high value added niches, creating strong and defendable intellectual property, high design-to-build capability, and testing.

In particular these success stories are most prominent in UK automotive, aerospace and defence, and the oil and gas sector.

The research team at Catalyst is preparing an in depth study into M&A activity across these sub sectors. The report will identify the key trends shaping M&A strategies of trade buyers and private equity and predict where M&A investment flows will be focused across these sub sectors over the coming years. A summary of this report will be available on our website soon.

The global financial crisis will inevitably result in unprecedented levels of central bank and government intervention and regulation in the future in order to stabalise the financial services sector and put it in on a more robust and sure footing for the future.

The Basel II measures and capital requirements are widely agreed to have failed the banks during the downturn and further ‘Basel’ regulations are expected. In addition Solvency needs implementing across the insurance sector.

Significant investment spend is expected across the financial services sector in order to optimize the existing infrastructure, re-engineer risk management processes, increase transparency, improve analytical capability across multi jurisdictions, and address control issues.

This increased regulatory environment will result in significant growth opportunities for businesses operating in risk and change management advisory, system architecture design, application development, process re-engineering delivery, and performance testing.

A number of the sector BPO providers, consultancies, IT managed services business and private equity businesses are keen to find acquisition opportunities in these areas and take advantage of the inevitable growth wave over the next few years. There will undoubtedly be a sharp increase in M&A in these areas.

The current lack of appetite by the banks to lend debt to management buy outs and the relative performances of different businesses has resulted in private equity sharpening their focus on which businesses they see as an attractive investment opportunity.

I have met a number of the mid market private equity houses in London over the last few weeks and they are very focused on wanting to invest in businesses with the following characteristics:

1. Long term revenue visibility, preferably supported by long term contracts;
2. Strong levels of intellectual property and protected know how;
3. Strong asset backing to underpin a business’s valuation and to make sure debt is easier to raise; and
4. Broad spread of high quality customers to ensure there is no reliance on a small number of customers.

If you are considering a private equity deal in the short term then you will need to make an honest assessment of your business against this criteria.

Healthcare IT continues to be an active space for M&A. This month both UBM and Ascribe have made acquisitions.

Catalyst advised on the sale of Iasist, the leading provider of benchmarking data and software in Spain and Portugal to UBM, the global business media company, for £9m. Iasist will form part of UBM’s medical division, CMP Medica, which provides information and education services to healthcare professionals and patients. Iasist was sold by Healthcare Knowledge International, the private equity backed heathcare IT group, which also sold CHKS its UK subsidiary to Capita plc in February.

Ascribe, the healthcare IT group, which provides a wide range of software to the secondary healthcare market, has acquired iClinix, a software solutions provider to cancer and kindey specialists with its head office in Sydney. Ascribe, completed a £33m public-to-private transaction in January 2009 backed by the mid market private equity fund ECI Partners.

Healthcare IT is very fragmented and clearly remains a very interesting space for the larger acquisitive trade buyers with well capitalised balance sheets as they continue the ‘space race’ to own business in the sector with strong intellectual property and long term contracts.

Catalyst will soon be issuing its healthcare IT report which will be a comprehensive review of M&A trends in this space.

We have recently met a number of interesting business operating in the pay and benefits sector. A number of these businesses are performing very well as companies look to find ways of retaining key talent and using alternative benefits to substitute real cash pay rises. Undoubtedly the larger trade players and private equity will be looking at these businesses as potential acquisition targets knowing that they will possess a number of anti recessionary features and hoping they can find some vendors willing to sell.

Last month the merger between Watson Wyatt and Towers Perrin was announced creating the world’s largest pay, benefits and investment benefits consultancy with 14,000 workers. Despite the successes of the mid-market operators, these large businesses have been struggling since early 2008 as their multinational clients have been through some deep cuts in their own overhead bases. I think we will see a number of these nil premium mergers between larger support services players as they search for cost synergies to keep their profit growth moving forward at levels which their market valuations demand.

The constant uncertainty around Connecting for Heath actually makes it difficult for medium sized business to commit to working on any centrally sponsored IT programme in healthcare.

Connecting For Heath, the electronic patients records programme, is in the news again due to the Tories making reference to a potential strategy of allowing large private companies such as Microsoft or Google to act as the repository for patient records rather than the State. This programme is already four years late and expected to cost £12.4bn.

Many of the healthcare IT businesses we know have actually made a conscious decision not to participate in Connecting for Health and are having good success focussing on locally delivered software, hardware and data solutions in all areas of healthacre which inlcude primary and secondary care, mental health, social care and pharma.

These smaller businesses are successfully accessing the localised healthcare budgets or demonstrating their importance to the large commercial organisations and starting to attract the attention of the acquisitive trade buyers which include McKesson, Capita, Tribal, Reed and IMS.