Strong manufacturing profits portend more M&&A activity

By now you have probably heard the disconcerting news about the negative economic growth in the first quarter of this year. But in case you have not, here is a recap: according to the latest data released by the Bureau of Economic Analysis, total GDP in the U.S. declined by 2.9 percent in the first quarter of 2014. A moderate gain in consumer spending during the first three months of this year was not enough to make up for sharp declines in business inventories and net exports.

But not all of the news from the first quarter GDP data was bad. The latest report from the BEA also included data on U.S. corporate profits from the first quarter. The details here were mixed. And for a few sectors that are important to plastics processors, much of the profits data was downright favorable.

It appears that while total consumer spending was rising slowly in the first quarter, many manufacturers were sharply reducing inventories (thereby pulling down the overall GDP data), and saving the cash (thus generating higher profits). To appreciate this point fully, one needs to “drill down” through the data, but a little patience with the numbers will prove illuminating. Allow me to walk you through it.

As one might expect when total economic activity suffers a significant decline, total corporate profits also posted a substantial drop of roughly 9 percent in the quarter when compared with the previous quarter. Keep in mind that profits were still positive and still quite high, they were just not as positive as they were in the fourth quarter of 2013.

The good news for many plastics processors is that profits total for the entire manufacturing sector decreased by a much more moderate 4 percent, and all of this decline was due to a sharp drop in the non-durable goods data (mostly in the food and petroleum industries). Profit levels for durable goods manufacturers actually increased by a vigorous 10 percent when compared with the previous quarter.

Again, just to be clear: corporate profits for the entire manufacturing sector slipped 4 percent in the first quarter from the record-high levels posted in the fourth quarter of last year. Despite this decline, the first quarter total for manufacturing profits was still the second highest quarterly total ever. The total for the durable goods profits data increased markedly and registered an all-time high in the first quarter.

The surge in profits for the durable goods sector was due primarily to sharp gains in the computer and motor vehicle industries. The auto industry is now making more money than at any other time in this century. The data on auto sales confirms this uptick in the profits data — the sales data have trended higher since hitting a lull in January. The trend in the auto data is a leading indicator for the near-term trend in both the durable goods profits data as well as the data that measures demand for the many types of plastics products. So with the sales and profits data both trending higher through the first half of 2014, the second half of this year is shaping up nicely for many processors.

As this chart illustrates, the trend in corporate profits has been robust throughout the recent recovery period, but persistent uncertainty about aggregate demand has kept a lot of this cash on the sidelines. Since the Great Recession ended, businesses have been reluctant to invest in new plants, equipment, and employees. This has kept wages low, and this in turn has suppressed consumer spending. So in large part the uncertainty about future aggregated demand has been a self-fulfilling prophecy.

Shareholders have started to demand that businesses do something with all of this cash, and in recent years, there has been a noticeable increase in either dividends paid out or stock buy-back programs for many publicly traded companies. This makes investors happy and they have responded by pushing stock prices up to all-time highs. But it has not done much to accelerate the rate of overall economic growth.

Another option for both publicly traded and privately held companies with idle cash on their hands is either a merger or an acquisition. According to data compiled and reported by PwC (a member firm of PricewaterhouseCoopers LLP), industrial manufacturing M&A activity was solid in the first quarter of 2014, but was down when compared to the same period in 2013.

The number of deals in the first quarter that involved companies that manufacture rubber and plastics products was also down a bit when compared with the previous year, but the average size of the deal was higher. For the sake of comparison, PwC reports that there were 70 deals in the rubber and plastics products segment in the first quarter worth a total of $3.9 billion. The number of deals for this industry in all of last year was 300 ($9.4 billion) and in 2012 it was 315 ($7.1 billion).

So while there have not been as many deals in the first quarter of 2014 as there were last year, the average value of the deals that have been done so far this year is up a whopping 81 percent to $56 million. In 2012, the average deal size was $22 million, and last year the average was $31 million. Now without more financial information from the companies involved, it is difficult to read too much into this data. But from what I can see, there is evidence to indicate that valuations for plastics companies are rising at a strong pace.

Looking forward, all of the conditions necessary for an increase in M&A activity are in place for the second half of this year and beyond. Companies have a lot of cash on their balance sheets, and financing rates remain quite low. So there is money available to make deals, now all that is needed is the desire to do so. Up until recently, uncertainty about future growth in the overall economy has caused many business owners and managers to be risk-adverse. But that is starting to change.

Manufacturing activity in the U.S. is clearly expanding, and the rate of expansion is expected to accelerate during the next few years. More rapid growth in household incomes has yet to emerge (though it may start soon), so many managers are currently seeking strategic opportunities for inorganic growth that can be leveraged for stronger profits. They used to refer to this as “synergies,” but I prefer to call it improved productivity.

As M&A activity heats up and valuations for companies start to rise, there will also be a strong increase in the number of companies divesting non-core businesses. Nobody wants to sell a good business for less than it is worth, but there are plenty of businesses that would be for sale at a fair price. As more buyers enter the market, prices will rise and a number of businesses will change hands in deals that are a win for both sides.

Another area that will continue to enjoy a plenitude of deal making in the coming quarters will be the oil and gas sector. Prices in this sector are already quite high, but it will not surprise me to see an increase in the number of plastics industry acquisitions as a result of the changing expectations for the prices of natural gas and other petrochemicals.

Wood is Plastics News' economics editor.