Putting a price tag on a manufacturer is a rather complicated business. Hi-tech machinery, strong supply contacts, and a diversified risk profile can all add millions to a market cap.
Manufacturing output in the UK surged upwards by nearly 2% in June according to the Office for National Statistics. This is the strongest monthly increase since the end of 2010. This is important – changes in manufacturing output are often a useful barometer for economic growth for the UK as a whole. Given the improvement in manufacturing prospects, owners of manufacturing companies should be thinking about the impact on the value of their businesses.
A key consideration for value is the volume and value of supply contracts. Manufacturing output is driven by contracts to supply. Very few manufacturers produce on a speculative basis, preferring to produce volumes on the basis of orders. If the associated revenues of a manufacturer are not secure, in that there are few contracts in place, or the product itself has a limited or uncertain future, then it is likely that an investor will demand a higher return on any capital invested in return for a shorter business life.
Providing certainty over future revenue generation is positive for valuations. One way that investors will assess the predictability of revenue is by analysing the terms of the existing contracts, looking particularly at size, length and the contractual renewal terms of contracts. Historical, together with current performance may also provide a useful guide when considering the likelihood of renewing contracts, customer churn and the ability to secure new custom.
Clearly, manufacturing businesses with greater certainty over cash flows and long term contracts will be valued more favourably than those that lack this certainty.
‘Concentration risk’ is also a key valuation consideration for prospective buyers. Certain manufacturers, such as apparel manufacturers supplying large retailers, may have it as a condition of their contract that they are exclusive suppliers and, therefore, are not able to supply anyone else in order for them to guarantee supply lines. While contracts may be lucrative and the association with the likes of M&S or Next provide profile, losing a contract would jeopardise the business. Such a risk could weigh heavily in the mind of a prospective investor. This is a particular issue for manufacturing businesses making generic products which could be easily produced by another supplier, and in a cheap labour economy.
As with many other industries, customer relationships may also have an influence on the value of a manufacturing business. A solid relationship with key buyers within large retailers can positively impact value because of the possibilities for future contract wins and the implied stability of existing arrangements.
Investors will also analyse the other major contracts of the manufacturing business, such as operational leases. For example, the business may have a long term lease over its manufacturing premises representing a significant overhead. If there are high costs present within a business alongside uncertain or poor revenue prospects investors will steer well clear.
As one would expect within a manufacturing business, property, plant and equipment usually represent some of the largest items on the balance sheet. Aside from property, these assets typically include all machinery used in the manufacturing process as well as storage, transporting equipment and other assets.
As such, when assessing the value of a manufacturing business overall, plant and machinery is often a major consideration, in particular the maintenance and replacement costs. For example, an investor will need to assess whether and for how long the plant and machinery will suit the business’s needs and strategy. If the underpinning technology of the plant and machinery is dated or soon-to-be obsolete an investor will have to consider the amount of capital expenditure required to keep the business competitive and revise the value downwards.
Understanding the asset base is a key consideration for any prospective investor (who ultimately is the person who determines values.) The intangible assets such as contract values and customer relationship, provides a good indication of a business’s prospects and assessment of existing plant and machinery will provide a useful basis for considering future capital expenditure requirements.