To Do Deal Today, Look To The Future

Lubar & Co. Chief Investment Officer David Bauer says when someone is thinking about buying a business, they’re tasked with trying to predict the future. And today, the outlook into the future is as murky as ever.

“It’s not about the past, it’s about the future,” Bauer says. “What’s the future cash flow? And when you do that, I would say there’s three variables that are under more uncertainty today than I’ve ever seen before in my career.”

That first variable is inflation. He says in every one of the office’s businesses there’s been massive inflation over the past three years.

“We’ve seen the $12 an hour welders become $25 an hour welders,” Bauer says. “We’ve seen wages double in some of our businesses. We’ve seen cost of materials increase — wood, steel, copper, glass, all of that good stuff increased dramatically. We’ve seen insurance go up in terms of the cost. So, we have watched our margins disintegrate in a lot of our businesses, especially those that had fixed price contracts.”

The second variable is price. In some businesses in Lubar’s portfolio, there’s margin deterioration. In one company, he says margins disintegrated to a point where it was negative.

“We were losing money on every case we were selling to one of our customers — like taping money onto it,” he says. “And we had that point where we had to go to the customer and said, The price is going up 32 percent. That’s never happened. Normally, price goes up 2 percent, 3 percent, maybe it’s flat. Thirty two percent price increase or we’re not shipping to you; it got that serious. And that’s that moment where you say, This is a customer that is a third of our business. It’s scary having that conversation. But we were better off not shipping than shipping because we’re losing money.”

The third factor is volume. He says after the first couple months of the pandemic, orders essentially stopped in their portfolio’s manufacturing companies. It came back fast for most of them, but then they encountered supply chain problems that slowed things down, creating record backlogs. Now the question is, what’s the volume doing going forward?

“Every one of our businesses right now they had their best quarter ever in the history of our companies first quarter this year. We’re all waiting for the shoe to drop. And we ask our companies all the time, Volume? Are you seeing the changes in demand? What are your customers saying? And up until two days ago, none of our companies had seen any weaknesses in their demand. And for the first time, I saw it two days ago, one of our companies makes cabinets for retail, and the home improvement market dropped dramatically. So, we had our first layoff. We haven’t had that four years.”

Bauer says he expects the banking industry is going to get stingier and more costly going forward in part because of the deposit runoff and the difficulty maintaining deposits after the recent bank failures.

“I think the depositors are getting much more intelligent about what they’re looking for,” he says. “I think banks are watching capital ratios challenged. I think they’re also watching their cost of funds go through the roof.”

When capital is tight, he says banks are not as open to lending. And he expects that a lot of covenants are about to be a significant concern for banks because as interest rates rise, the fixed charge ratios don’t work and there are more troubled loans. That could also mean the cost of lending could continue to rise.

When it comes to M&A, Bauer says transaction advisers he’s spoken with are being asked to go deeper into diligence, looking, for example, at working capital and the level of inventory. As supply chains expand, companies might buy more inventory than usual.

“So, the question is, well, is that excess inventories? Is it more inventory? Is it going to decline? Can you actually get the terms back down again? Working capital used to be, you had cycles or whatever it had before, but now people are saying, We fundamentally watched it balloon over the last couple years, is that where it’s going to stay or is it going to come back down?”

He says while reps and warranty insurance is becoming more popular, but it’s requiring more diligence to be done.

“They’re being tasked to go a little bit deeper in those areas, including all the cyber risks as well. So they basically say they have difficulties getting a policy without the diligence report coming out to support it.”