2013 Forecast: Rosy for some, sterling mediocrity for others

Erv Terwilliger, a managing partner at 321 Capital Partners, an M&A firm specializing in the metal fabrication market, predicts 2013 to be a year of continued, steady growth in many local markets.

Sometimes you just have to laugh and shake your head. After the billions spent on local, state, and national campaigns, the balance of political power remains pretty much the same. Before the election, President Obama dealt with a Republican House and a Democratic Senate. After the election, well, Obama must work with a Republican House and a Democratic Senate.

The day after election, the business community was skittish. Stocks plunged, because investors like certainty and election results didn’t give much of it. Can Democrats and Republicans come together to develop a solution to avoid the fiscal cliff? Business leaders aren’t so sure.

Still, the effects of the election may dwindle. In fact, some business watchers just before voting day said that the presidential election itself may not affect economic trends over the long run. “The die is cast for a much stronger recovery,” Mark Zandi, chief economist for Moody’s Analytics in West Chester, Pa., told Bloomberg on Nov. 5. Zandi expects growth next year to be around 2 percent, and then shift to 4 percent in 2014 and 2015.

Consumer spending is up. Even housing is up. Yes, pundits preach global uncertainty, even gloom and doom. But as owners of small or medium-sized businesses, metal fabricators have orders to fill, and next year many expect the volume of orders to continue or even increase a bit.

On Hold

Few expect economic Armageddon. Of course, pundits and politicians have been preaching economic disaster for months, and unless Congress acts by Dec. 31, some draconian cuts will be coming.

“That’s why so many late in 2012 have gone into cautious mode,” said Chris Kuehl, economic analyst for the Fabricators & Manufacturers Association Intl. and managing director of Armada Corporate Intelligence, Lawrence, Kan. “If they expect the worst and don’t get it, they’ll be mildly euphoric and say, ‘How about that—we didn’t shoot ourselves in the foot.’ But if the new Congress decides to deal with it, but it takes months and months, then everybody stays in a holding pattern.”

Because so many members of Congress are keeping their jobs, they must deal with any repercussions from the decisions they make. “It is far less of a lame duck [Congress] than had been expected,” Kuehl said in a newsletter the morning after the election. “If the Senate had gone to the GOP, there would have been a stronger temptation to stall and force the next Congress to deal with the mess. Now, the same people in charge will be in charge next year, and they will have to find a solution or take the blame.”

Still, uncertainty reigns, because, as Kuehl explained, “This is the same Congress that has been incapable of making a decision on this or any other deficit issue, and there is arguably more acrimony and hostility than before.

“Many manufacturers have told me the same thing,” continued Kuehl, explaining the wait-and-see environment. “Orders have not been canceled. They’re being delayed. They think business will remain steady, but those delays may turn into cancellations, so right now they’re in a holding pattern. I’m even being told that people have been offered jobs, but they won’t get a formal offer to start until after the first of the year.”

Extra Credit

Kuehl is also the economist for the National Association of Credit Management, for which he assembles the Credit Managers’ Index, which is analogous to the PMI from the Institute for Supply Chain Management. A rating over 50 indicates growth, and the CMI has stayed that way for months.

Chris Kuehl, economic analyst for the Fabricators & Manufacturers Association Intl., has a phrase for the slow but steady growth expected for next year: “sterling mediocrity.”

While more credit applications are being granted, “you’re seeing a decline in sales, and you’re seeing a little bit of pain in accounts for collection,” Kuehl said. “You now have more movement of credit, but sales have not caught up. There’s more credit activity, but weaker firms are really beginning to suffer. These companies needed a turnaround that was faster and bigger, and that just didn’t happen.”

Ervin Terwilliger has seen this trend firsthand. The managing partner at Elkridge, Md.-based 321 Capital Partners specializes in mergers and acquisitions in metal fabrication, and the transactions often involve distressed properties. In 2011 he said many distressed shops just kept hanging on. They made just enough so they didn’t have to liquidate. At the same time, the banks, still recovering from the recession’s knockout punch, were in no mood to write down even more debt and push deals forward.

This year Terwilliger is singing a different tune. The purge is well under way. The market has fewer players who are just hanging on, perhaps charging below-cost pricing just to get work in the door. Instead, the distressed fabricators that remain are in many respects very healthy enterprises. “These companies have weathered the storm, the owners are engaged, and they poured money back into the business,” he said. “They’re good companies with good orders on the books, but they just don’t have the cash to get across the finish line.”

The lack of access to capital has forced these companies to sell, but moving forward, the sale may not be a terribly painful process. “Now we have buyers who are looking at these companies and saying, ‘Yes, they’re distressed, but the management team is great and the production is great, and it’s a good facility with good product lines,’” Terwilliger said. “It’s a desirable deal. They can put minimal cash and minimal time into it, and turn it around. It’s a balance sheet cleanup.”

In these cases, he said, the company usually is a victim of circumstance. The shop floor has efficient production and quality is topnotch. Part flow is smooth, inventory isn’t excessive, and lead-times are short. The severe order dropoff during the recession simply left balance-sheet wounds that didn’t heal.

At the same time, the industry now has very healthy companies with access to cash and a desire to invest it. Recent survey data from FMA’s 2013 Capital Spending Forecast shows that capital equipment investment is on the rise, inching up 4 percent. Purchasers at large OEMs are pruning their supplier list to include only top-performing contract fabricators. Those top-performing fabricators who weathered the recession continue to get healthier.

Moving Forward

So what about all the unknowns going into next year? What about that supposed fiscal cliff that Congress will need to deal with? What about China’s slowdown? What about Europe? “I speak with a lot of business owners who are certainly concerned. But they have no choice but to go forward,” Terwilliger said.

He added that business and political leaders who look at the broader economy have a different view, because they look at the economic climate from different perspectives. “When you get into niches of geographies or markets, some have come through quicker than others. If I took a top-down assessment of every industry [321 Capital Partners] deals in, I would have a fairly bleak perspective. But what I’m seeing in metal fabrication in certain markets and in certain geographies, some of the purges that needed to happen over the past couple of years have finally begun.

“Some regional banks are getting healthier, though certainly not all of them. I still think overall there are major problems. But in certain areas of the country, we’re seeing banks getting back to traditional ways of making money, which is lending—making good loans to good companies. And so many businesses have gone under during the past three or four years. In a given market where there were, say, 10 players and you needed only seven to meet demand—well, we’re down to the seven now.”

About Perspective

The purge process has added some widely varying views of business conditions. Obviously, the sellers often have bleaker views than buyers. Terwilliger recalled one recent transaction concerning a fabricator that concentrated in the defense sector.

The owner certainly had a negative outlook about defense spending, but the buyer, also in the defense industry, said business continued to be good. “Views on the economy can depend on your perspective,” he said.

Consolidation Trends

More fabricators are merging with or being acquired by other fabricators that offer complementary products. These have put the resulting combined organizations in stronger market positions, with complementary product lines and intellectual property they didn’t have before.

Bigger players are getting bigger. “The big suppliers need to get better, they need to get bigger and more automated, and this all takes capital,” Terwilliger said. “Hopefully, the banking situation will clear up enough so that it will feed and fuel that growth. This isn’t necessarily good for the little guy. You’re going to see a squeeze on the little guy that was trying to grow to compete against bigger players. So instead of the little guy growing bigger, he may end up getting bought or merged.”

A final trend: More people who have made money in other industries—including banking and finance—will start looking at the contract metal fabrication arena with a careful eye. “These smart people are reassigning themselves to manufacturing,” Terwilliger said. “I get calls all the time from people who aren’t attached to this business. These are people who made money elsewhere and who cashed out at the right time. They now have itchy feet, and they want to get into something else.”

Terwilliger made one more prediction that, he conceded, is based purely on his experience in the field, not on any comprehensive study or trend data. He sees some relatively young, smart people who today act as vice presidents or operations managers. Their companies may have acquired recently by a larger, well-run metal fabricator. In a decade or two, he predicts, these people will go out on their own again and launch good, smart, small companies. “These guys will have learned not from the person who initially hired them, but from the operations managers working for the companies who bought them,” he said.

According to Terwilliger, healthy fabricators he deals with have a calmer view of the future than they once did. Sure, there’s uncertainty, but the postrecession purge has also left a metal fabrication market that may be more rational, one in which strong companies experience gradual but steady growth. In part, this comes from conservative lending practices from banks.

Got a Job?

Kuehl also said he’s seen a return to rationality, especially when it comes to credit. But when the average person thinks about the economy in 2013, they’re not thinking about access to credit. They’re thinking about the unemployment rate, which at this writing (early November) remains stubbornly high, hovering just shy of 8 percent.

A related concern, Kuehl said, isn’t just the fact that the unemployment may actually be higher, if you include underemployed and the unemployed who have simply stopped looking for work. It’s about the implications. A greater percentage of the population is getting older, which means the working-age population is getting smaller. This may change the textbook definition of what the full employment rate should be, historically between 5 and 6 percent. Now, some feel that the natural rate of unemployment actually could be between 4 and 5 percent.

At the same time, the skill gap remains. Those with the right education and technical skill can find good-paying work, while those without skills, or those who have skills that aren’t in demand, continue to struggle. “You have a lot of marginalized people,” Kuehl said.

The state of the economy has always been a matter of perspective, and it’s now becoming even more so. Not all sectors are as busy as certain metal fabrication markets are. And in the fabrication sector itself, it can depend on the local market. Many shop owners have said business is softening, but orders haven’t dropped off a cliff. Meanwhile, other sectors continue to suffer, and people can’t find work.

The Merits of Mediocrity

So what’s the best- or worst-case scenario for next year? “You’re probably looking at the worst-case scenario of less than 1 percent growth in GDP,” Kuehl said. “And the best-case scenario is around 2.5 to 3 percent. So the real expectation is just sterling mediocrity.”

At least from a business planning perspective, fabricators may be just fine with that. “Things were crazy for so long, because the banking institutions were just giving money away,” Terwilliger said. “Credit was too easy. Now the operations that are generating all the profits for the most part are the best and smartest. They’re run by the people who know how to operate their business regardless of the credit situation.

“Yes, it’s much harder to make a steady profit when things aren’t easy,” he added. “But you know what? That’s OK.”