PErspective in Manufacturing

A feature examining the role of private equity in the manufacturing sector.

As the healthcare industry embraces value-based payment models and providers evolve their business models to focus on outcomes, they’re looking to achieve more with less and optimize productivity. All the while, new technologies and automation are opening the door for innovation in manufacturing facilities across industries and enabling faster, smarter production—which is particularly good news for manufacturers serving the healthcare and life sciences industries.

Medical devices are subject to stringent guidance and jurisdictional regulations–and that brings up costs and liability in spades, including false claims liability, potential recalls and costly subsequent regulatory approvals. More compliance changes, including potential reductions in regulation, could be on the horizon. In March, President Trump nominated Scott Gottlieb (former senior fellow with The BDO Center for Healthcare Excellence & Innovation) to FDA commissioner, whose confirmation at press time was pending final Senate vote. Industry change opens opportunities for private equity firms to invest in medical device manufacturers to help them leverage new technologies, streamline processes and achieve cost savings in the face of a turbulent regulatory environment.

Several notable private equity deals and bids emerged recently in the medical device and pharmaceutical manufacturing sectors, including:

  • MedPlast Inc., a global services provider in the medical device industry backed by private equity firms JLL Partners and Walter Street Healthcare Partners, will acquire Vention Medical’s device manufacturing services in a deal expected to close in the second quarter, reports PE Hub. Terms of the deal were not disclosed. According to a press release, the acquisition will more than double MedPlast’s size. The company aims to expand its capabilities in assembly and packaging with the acquisition and increase its global footprint to 22 manufacturing facilities.
  • European private equity firm EQT Mid Market bought conveyor manufacturer Dorner Holding Co. from Pittsburgh-based private equity firm Incline Equity Partners, the owner since June 2012. The deal closed on March 15 and terms were not disclosed. Dorner services the medical and pharmaceutical industries, as well as packaging and food handling. EQT Mid Market targets companies with strong market positions and potential for global growth in the middle market and plans to grow Dorner organically and strategically, according to Milwaukee Business News.
  • On the pharmaceutical manufacturing side, German drug maker Stada Arzneimittel AG has found itself in a red-hot bidding war. Private equity firms Advent International Corp., Permira, Cinven Ltd. and Bain Capital made offers, with Chinese company Shanghai Pharmaceuticals Holding Co. reportedly showing interest as well. Bloomberg reports Stada’s shares have rallied nearly 70 percent in the past year to $55.81, including a jump in mid-February of 13 percent in a single weekend. In an effort to draw in bigger buyout offers, the company has laid out numerous cost-cutting measures, including optimizing its supply chain management and procurement process, reports FiercePharma.

Future PErspectives: What’s Up Next for Manufacturing Investors

President Trump has connected with cabinet members and members of the business community recently to discuss his infrastructure plan, which will likely lean on public-private partnerships, according to Axios. Building materials, steel and equipment manufacturers who’d be tapped for bridge-and-tunnel infrastructure projects could be primed for investment. Axios also reports digital infrastructure could be a focus of the plan, including rural broadband access, meaning opportunities could emerge for investment in manufacturers of mobile and digital infrastructure.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

The Role of CFIUS in Cross-Border Manufacturing M&A

By John Lash

Since the end of World War II, the United States has maintained and enjoyed an open posture toward foreign investment. In 2016, it remained the largest recipient of foreign direct investment (FDI) globally, with an estimated inflow of $385 billion—a marked 11 percent increase from the year prior. 1 Much of this amount stemmed from several multibillion-dollar cross-border merger and acquisition (M&A) deals, whose total value had increased 17 percent from the 2015 levels.

While foreign buyers remain plentiful and varied, China—with its sights are still set on getting a strategic foothold in the U.S.—is likely to continue to be one of the U.S.’ largest investors, a development that has prompted some national anxiety. National security is an ever-present priority for the U.S. government. As foreign deal-making increases, so will the regulatory scrutiny of cross-border transactions.

The CFIUS Review Process

A critical element of FDI is the involvement of the Committee on Foreign Investment in the United States (CFIUS). Chaired by the U.S. Secretary of the Treasury, this interagency task force is responsible for the review of FDI that could result in the control of a U.S. business or U.S. critical infrastructure—defined as “a system or asset, whether physical or virtual… vital to the United States”—as well as the impact these transactions could have on national security. 2

While CFIUS review is not a mandatory process, many companies involved in cross-border deals will voluntarily notify CFIUS and initiate a review to gain the benefits of a safe harbor provision. This provision prevents future government challenges to the transaction, including unwinding it or requiring mitigating actions, should the review be cleared successfully. The review process includes up to three stages. The first stage begins with a 30-day initial assessment period, at which point a determination can be made. If unresolved concerns remain, the committee may initiate the second stage, a 45-day investigation period. Should that yield unsatisfactory results, a 15-day presidential review period begins, with the president rendering a final decision. Actual presidential decisions are rare, with only two transactions blocked during the Obama administration. Rather, most transactions are approved, adapted to mitigate CFIUS’ concerns or withdrawn by the parties if they suspect that the transaction will not be approved.

Cross-Border Manufacturing M&A

CFIUS filings have steadily increased over the last eight years, with manufacturing companies consistently representing the largest share of any industry since 2010. According to the most recent publicly available data, 69 manufacturing companies filed notices with CFIUS in 2014, comprising nearly half (47 percent) of all filings. Per the table to the right, the majority of notices within the manufacturing industry have come from the computer and electronic product, machinery and transportation equipment sectors.

When evaluating manufacturing M&A transactions for potential national security conflicts, there are several issues to consider. Manufacturers are vulnerable to national security risks ranging from physical facility security—including the security of facilities that produce key elements or products for defense, transportation or energy infrastructure—to location security, such as the proximity to military installations. Other major risks include those that may undermine U.S. and global supply chain reliability and security, as well as global trade compliance. Cybersecurity—and cyber espionage, in particular—is also top of mind, with concerns about threats from nation-state actors on the rise. FDI that involves the critical manufacturing sector—defined by the Department of Homeland Security as those manufacturing industries that are the most crucial for the continuity of other critical sectors and have significant national economic implications—is especially susceptible to scrutiny.

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The Future of CFIUS

With the current administration’s heightened focus on national security and its stated “America First” platform, CFIUS could play a larger role in cross-border M&A activity in the year ahead, with potentially more stringent reviews and/or an increased use of mitigation measures. The practical guidance for identifying factors which constitute a national security risk may also be broadened to include economic security, a net U.S.-benefit test. At his January confirmation hearing, Treasury Secretary Steven Mnuchin discussed using CFIUS as a tool for “protecting American workers.”

The administration’s decisions regarding global trade partnerships—including its decision to withdraw from the Trans-Pacific Partnership (TPP) and promises to renegotiate the North American Free Trade Agreement (NAFTA)—may also lead to heavier scrutiny of deals proposed by geopolitical rivals versus those from “friendly” nations. These shifting relationships may also affect if and how the U.S. chooses to participate in parallel national security reviews with other countries. In addition, reciprocal market access may become a greater consideration factor in CFIUS review, with countries that do not “reciprocate,” or allow comparable U.S. investment in the same sector, facing more difficulties in obtaining CFIUS approvals than those who do.

Regardless of what lies ahead, manufacturers must be cognizant of how an M&A transaction may impact the reliability, availability and integrity of their resources, production activity and intellectual property, as well as any direct or indirect impacts on critical infrastructure. And to avoid a compliance bottleneck, manufacturing organizations (and their potential buyers) must proactively address potential national security risks so as to reduce the security optics of the transaction.

 

1 Global Investment Trends Monitor: February 2017 (Vol. 25, Rep. No. 25). (n.d.). United Nations (UNCTAD). Retrieved from http://unctad.org/en/PublicationsLibrary/webdiaeia2017d1_en.pdf

2 Lash, J. (2016, June 6). National Security a Top Priority in Cross-Border Deals. Retrieved from http://www.themiddlemarket.com/news/business_services/national-security-a-top-priority-in-cross-border-deals-260721-1.html

CFIUS Red Flags

What constitutes a national security threat? U.S. businesses that may come under CFIUS scrutiny include those that:

  • Are in the defense, security and national security-related law enforcement sectors.
  • Provide products and services to the government with potential security or defense applications.
  • Constitute “critical infrastructure,” e.g., energy production, telecom or transportation.
  • Have access to classified or sensitive government information.
  • Engage in activities subject to U.S. export controls.
  • Are in proximity to U.S. government facilities.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Middle Market Manufacturers: Surprisingly Suited to Capitalize on IoT Advantages?

By Eskander Yavar

Manufacturers are waking up to the Internet of Things (IoT) opportunity. According to BI Intelligence, companies will spend nearly $6 trillion on IoT solutions in the next five years, and by 2020, 24 billion devices will be IoT-enabled. Whether you’re a large-scale global manufacturer or a middle market company in growth mode, the IoT holds promise. While middle market companies may be slower on the adoption curve than their larger competitors, they have a critical opportunity to drive innovation and evolve as IoT leaders rather than followers.

Manufacturing Industry in Growth Mode

With the new administration in Washington and an expected pro-business agenda, anticipation is high for growth in the manufacturing industry. According to the NAM Manufacturers’ Outlook Survey, more than 93 percent of manufacturers feel positive about their economic outlook, up from 78 percent in December. With opportunities for growth within reach, middle market manufacturers will need to shift focus to battle competition and differentiate in the market. We expect an uptick in deal flow and capital investment, and for many manufacturers, investing in the IoT may be just the competitive edge they need.

IoT Adoption Is Increasing, But Strategy Isn’t Keeping Pace

In the new MPI Internet of Things Study, sponsored by BDO, we found that global manufacturers are making significant progress toward IoT integration. Over half of the 374 manufacturers surveyed characterize themselves as IoT-competitive companies, and 14 percent say they’re IoT leaders. IoT-enabled manufacturers are also seeing impressive returns on their investments: 72 percent increased their productivity and 69 percent increased their profitability in the last year by applying the IoT to plants and processes.

Despite the advantages reported, 40 percent of manufacturers do not yet have a strategy in place to apply the IoT to their processes. Whether your organization lacks an IoT strategy, or is in the midst of putting one into action, there are critical components that should be considered in the early stages. For example, our study found that most manufacturers are missing opportunities to take advantage of research tax credits and build in security features. But middle market manufacturers are uniquely positioned to move on the IoT with the right strategy, people, processes and technology to maximize their advantage.

“Crawl-Walk-Run” Mentality Applies to Technology

It’s no secret that middle market companies have to be wise about how they spend and invest. When it comes to the IoT, middle market companies are too big to ignore it, but must avoid mistakes and missteps they can’t afford. Middle market companies often take a measured approach to embracing new technology. That means investments are often more carefully planned and staged, boding well for success. For executives looking at the IoT, it’s critical to confirm your proposed use cases for the technology will align with your business objectives and drive value. It’s critical to first ensure you have the underlying technology and management systems to enable the IoT, understand its performance and measure KPIs that increase value, margins, sales and shareholder value. You can’t build an effective 21st century technology rollout on 1980s software and systems.

Middle Market Characteristics Create IoT Advantages

Once those initial questions are addressed, middle market manufacturers can capitalize on some of the benefits of their size and market position relative to larger competitors. First, they are nimble and able to get buy-in on transformative projects because change leaders have more access to and attention from the C-suite and board. Projects can move faster because they are one of a few, rather than one of hundreds. Finally, middle market companies have had the benefit of observing competitors’ IoT adaption and can now apply lessons learned and cost-saving strategies to their own initiatives.

But that doesn’t mean manufacturers should charge forward without laying the necessary foundation. Our study found that less than half of manufacturers are considering cybersecurity at the product conceptualization and design stage, missing opportunities to build in security at the ground level. And 58 percent of manufacturers are not planning to claim tax credits and incentives available for IoT investments, meaning many are leaving money on the table that could help fund innovation.

IoT adaption is a marathon, not a sprint. Middle market manufacturers are well-positioned to unlock IoT’s potential given their steady strategic approach and flexibility if they ensure the right systems are in place and the use cases are aligned with value.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Automation In Manufacturing & Distribution: Are Job Cuts The Future?

By Rick Schreiber

We’re at the onset of the next big industrial revolution—and the widespread adoption of new technologies, including Internet-connected devices, machine learning and robotics in the manufacturing industry. Strides in automation have significantly boosted U.S. manufacturers’ output in recent years, and the industry is just beginning to understand and exploit the full potential of technology and disruptive supply chain models to reinvent manufacturing as we know it.

And the future of American manufacturing jobs at the end of this evolution? They’re going to look very different.

The new administration is focused on American jobs lost to offshoring and relatively cheap foreign labor, but over the long run, automation technologies are set to replace far more U.S. manufacturing positions. The new Treasury Secretary Steven Mnuchin isn’t concerned, and was recently quoted saying, “I think that is so far in the future […] I think we’re, like, so far away from that that. [It’s] not even on my radar screen.”

But we’re already seeing it happen. A report from Ball State University found between 2006 and 2013, trade accounted for just 13 percent of lost U.S. factory jobs, while the vast majority of the lost jobs were taken by robots and other domestic factors. But in the same breath that we talk about the elimination of manufacturing and distribution positions, we also talk about a shortage in technology talent. The reality is companies are hiring—but they’re hiring for different skillsets than they were even five years ago. Today’s—and tomorrow’s—advanced manufacturing jobs demand a greater emphasis on technological savvy, ingenuity and engineering skills that can’t be replicated by a machine—yet.

At the same time, public perception of manufacturers’ staffing decisions is changing, triggered by recent high-profile negotiations between manufacturers and the government. The unprecedented use of the Twitter “bully pulpit” to influence corporate decision-making could change the way companies approach and communicate about staffing. The balancing act between reputation management and the need to compete effectively in a global economy could grow more delicate. Still, while layoffs and closures, like those underway at several prominent Indiana factories that plan to move production to Mexico, are front and center in the nation’s collective attention, there are fundamental and permanent changes altering the nature and core capabilities of manufacturing and distribution jobs that have nothing to do with location or immigration status.

On the distribution side, several autonomous vehicle startups are targeting the trucking industry, which they see as ripe for disruption, according to The Wall Street Journal. While the application of autonomous technology into everyday cars for consumer use is drawing far more attention and hype, artificial intelligence experts believe the technology could master highways before city streets. The trucking industry faces a shortage of experienced, safe drivers, as well as heightening regulation limiting the hours those drivers can work in a day. If automation can increase the speed and efficiency with which products can travel and enhance roadway safety, it could be a boon to the industry. However, it’s worth noting this progress is not without setbacks and challenges. Additional technological advancements will be needed to address safety concerns critical to market acceptance of these technologies before car or truck automation goes commercial.

In sectors serving the food and consumer products, we’re seeing many manufacturers reevaluate their distribution models as consumer shopping habits change. Simultaneously, pressures to reduce operating expenses have increased. As a result, those industries are moving from direct store to centralized distribution and real-time inventory management, which allows order points to be less tied to warehouse inventory levels and more responsive to demand.

Not only does this enable companies to cut logistics costs and take advantage of efficiencies of scale, but they can also better compete with e-commerce retailers, online grocers and other alternatives that offer customers more choices, faster than ever before. Today’s retail and manufacturing customers have little tolerance for delayed or incorrect orders, meaning logistics and distribution—from warehousing to order fulfillment to shipping—must happen at lightning speed and be resilient in the face of disruption. If automation can increase speed and reduce costs, while also maintaining order accuracy and quality control, it’s a win-win for manufacturers and their customers. But these optimization strategies may result in closing factories that have been rendered obsolete, leaving the employees who work there in job limbo.

While staffing changes and layoffs may be par for the course during these transitions, long-term cost savings will ultimately come from increased productivity and greater operating efficiencies, which can be driven by a variety of factors. In fact, some of the companies that have been most successful at implementing process improvements have done so without significant layoffs. As the manufacturing industry takes the training wheels off new technologies, certain staffing strategies will remain consistent in ensuring profitability and competitiveness: Implementing and maintaining lean manufacturing principles, minimizing costly labor turnover and selecting staff with the right core capabilities will remain among the most important considerations.

The traditional factory job might be disappearing, but ultimately, greater productivity and lower costs translate into higher profit margins, resulting in more manufacturing jobs, not fewer.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

 

PErspective in Manufacturing

A feature examining the role of private equity in the manufacturing sector.

The new administration’s pro-economic growth agenda has spurred optimism among the investment community, and most agree the coming year is primed for a healthy cadence of deals.

In fact, in a poll BDO conducted in January, 71 percent of fund managers characterized the investment environment as favorable. That represented a 15 percentage point jump from managers who said the same prior to the November election results (56 percent).

While the industry continues to barrel toward innovation, traditional manufacturers of components and parts for a variety of applications—including industrial application and consumer products—continue to garner interest from private equity and strategic buyers. With trade policy front and center and, if proposals aimed at fortifying domestic manufacturing come to fruition, companies in the sector could be poised to see a much bigger influx in private equity investment.

Given the private nature of most transactions, it is difficult to say whether the following proved to generate good returns for the sellers or smart investments for the buyers, but here are a few transactions that characterize the pace and breadth of activity in recent weeks:

In a deal announced Jan. 4, Graham Partners sold blow molder Western Industries to Michigan-based Speyside Equity Fund. Terms of the deal were not disclosed, reports Plastics News. Speyside, a 12-year-old fund, targets manufacturing businesses in specialty chemicals, food and metal-forming, among others. Western Industries’ plastics unit, which the company says is home to one of North America’s biggest collections of plastic presses, specializes in large and complex plastics products and components for industrial and consumer end-markets. They also offer assembly, packaging and logistics services.

Gladstone Investment Corporation, a publicly traded business development firm that makes debt and equity investments, has announced plans to sell its equity interest and the prepayment of its debt investment in Behrens Manufacturing to Mill City Capital, a producer of branded metal containers. Gladstone, which acquired Behrens in 2013, has seen its shares rally six percent since that announcement on Dec. 19.

Bain Capital Private Equity, meanwhile, has announced it will buy Innocor Inc. from Sun Capital Partners Inc. in a deal set to close in the first quarter of this year, according to The Middle Market. Innocor, a New Jersey-based manufacturer of polyurethane foam products and home furnishings, owns 22 plants and distribution centers across the U.S. The Middle Market reports that home furnishings manufacturers are the beneficiaries of increased demand tied to an uptick in new home sales. Z Capital Partners’ investment in Twin-Star International and Mattress Firm Holding Corp.’s deal with Sleepy’s are two examples of buyer interest driving deals in this space.

In the food sector, PE Hub reports Charlesbank Capital Partners announced in January the sale of food manufacturer and packaging and supply chain management provider Peacock Foods to Greencore Group plc, an Ireland-based convenience foods producer. Illinois-based Charlesbank focuses on companies in the automation, packaging and processing subsector. The firm operates seven manufacturing facilities.

In December, Platinum Equity completed the acquisition of two Asia-based manufacturing enterprises: Foam Plastics Solutions, a leading maker of protective packaging; and Flow Control Devices, a manufacturer of valves, fittings, sensors and other components, reports PE Hub. The Trump administration’s focus on reshoring American manufacturing, however, could dampen interest in foreign manufacturers in the coming months. This will be a trend for domestic manufacturers to watch as it could add to buy-side demand and drive up valuations for U.S. manufacturing firms.

Future PErspectives: What’s Up Next for Manufacturing Investors

In light of uncertainty around U.S. global trade policy under the new administration, we could see technology companies in particular begin expanding U.S. manufacturing operations, according to Business Insider. For example, Nikkei reports that Japanese manufacturer Sharp, owned by Foxconn—Apple’s top manufacturing partner—is mulling a screen factory in the U.S. Foxconn is an investor in Softbank’s Vision Fund, which insiders report could be leveraged to purchase technology assets or make a private equity deal. U.S.-based factories may be subject to increased costs due to higher labor costs and reliance on Asian parts suppliers. If tech darling Apple begins increasing its manufacturing footprint in the U.S., other companies could follow suit. This trend would likely lead to more private equity dollars investing in the domestic technology sector.

Sources: PE Hub, Benchmark Monitor, Plastics News, Pittsburgh Business Times, The Middle Market, Business Insider, Nikkei

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Software Development Produces Significant Tax Benefits for Manufacturers

By Rick Schreiber, Chai Hoang and Chris Bard

Last year, over 6,000 manufacturers claimed more than an estimated $10 billion in research tax credits (RTCs), with each manufacturer’s average benefit exceeding $1 million. Generated in part by manufacturers’ efforts to develop new and improved products and processes, these benefits were also generated by their continued investment to develop or improve software to manage or automate production processes and business intelligence, among other things.

This year, thanks to new regulations that broaden the range of software development activities eligible for the credit, more manufacturers may be able to take even greater advantage of these dollar-for-dollar offsets against tax liability, enabling them to invest more in new technologies, expand their labor force and finance other business objectives.

RTC Explained

Often also called the “R&D credit,” the research tax credit is an activities-based credit. Federal and state RTCs are available, in general, to businesses that attempt to develop or improve the functionality or performance of a product, process, software or other component using engineering, physics, biology or the computer sciences to evaluate alternatives and eliminate uncertainty regarding the business’ capability or method to develop or improve the component or the component’s appropriate design (Qualified Research). RTCs equal to up to an average of 10 percent of qualified spending, which generally includes taxable wage, supply, contractor and cloud-computing expenses related to these attempts.

More than 6,000 manufacturers reported performing qualified activities last year, and a recent BDO/MPI Survey shows that this number could be double that. More than a majority (57 percent) of survey respondents said they weren’t planning to claim tax incentives like the RTC, even though they were planning to do development work to leverage the Internet of Things to capture and communicate more data more accurately and reliably. This type of work likely qualifies for the RTC, but many respondents said they weren’t going to claim it because they thought they lacked sufficient documentation or weren’t performing qualified activities.

Happily, these aren’t good reasons not to claim the RTC: several court cases have affirmed that oral testimony can be used to claim and support RTCs; and any manufacturer trying to make something better, faster, cheaper or greener is likely to be performing qualified activities, whether the activities succeed or not.

To that point, manufacturers in the following sub-sectors reported RTCs in 2013, the latest year for which IRS statistics are available:

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And although many of these credits related to attempts to design and develop new products and processes, many also related to efforts to develop new or improved software.

Software Development RTC Opportunity Expanded

New final Treasury Regulations issued in October will increase the RTCs manufacturers claim for software development.

Under current and former rules, software development activities fall into two categories, depending on whether the software being developed is intended primarily for the taxpayer’s internal use or not. What category the software falls into is important because “internal use software” (IUS) development activities must meet a higher standard to qualify than activities to develop non-IUS software.

The Final Regulations narrow the definition of IUS considerably. This means that considerably more software development activities are eligible for the credit, which means that more manufacturers may claim more RTCs going forward.

IUS is software developed for use in general and administrative (G&A) back-office functions that facilitate or support the conduct of the company’s trade or business. G&A functions are defined as financial management functions, human resource management functions and support services functions. Whether software is IUS depends upon whether the taxpayer, at the beginning of development, intended the software to be used primarily for G&A purposes. Software is not IUS if it is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system.

IUS development may also qualify. The regulations also provide that Qualified Research to develop IUS qualifies if it:

  1. Is intended to develop software that would be innovative, i.e., result in a reduction in cost, improvement in speed or other measurable improvement that is substantial and economically significant;
  2. Involves significant economic risk, as where the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. The focus should be on the level of uncertainty and not the type of uncertainty; and
  3. Is intended to develop software that isn’t commercially available for use by the taxpayer without modifications that would satisfy the first two requirements.

Manufacturers and the RTC Tax Credit

The new regulations apply to a vast array of manufacturers’ activities, and businesses in this space should consider whether they’re missing out on opportunities to benefit from the RTC. Manufacturers have undertaken an effort to digitalize their operations, supply chains and markets. Companies are increasingly engaged in the development and improvement of business-intelligence software systems and enterprise-resource-management tools. The development, optimization and integration of the Internet of Things to enhance manufacturing and related processes also often qualify for RTCs.

Additionally, sales and operations planning require data from all aspects of a business, from production throughput and distribution and warehousing to financial metrics. The development and implementation of software to monitor and manage back-office functions could qualify for the RTC, e.g. activities to develop software related to:

  • Supply chain functionality;
  • Forecasting based on historical baselines, promotions and sales;
  • Pricing optimization, of both sales to consumers and procurement of supplies;
  • Inventory management;
  • Order management;
  • Revenue management;
  • Routing engineering/software development; and
  • Security against cyber-attacks.

Because the final regulations exclude from the definition of IUS software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system, manufacturers should review their software against the new definition and standards. For example, software developed to manage supply orders, sales or production data with third parties, or to enable customers or third parties to track delivery of goods, search inventory, or receive services over the internet, may qualify under the new regulations, without having to meet the higher standards for IUS.

Conclusion

Manufacturers of all sizes have been benefitting from the RTC since its inception in 1981. Now, with the new regulations on software development, many more should be able to benefit more than ever before, thus reducing their taxes, freeing up capital and gaining a competitive advantage. In addition, smaller manufacturers may be able to use the RTC against up to $250,000 of their payroll taxes or even their Alternative Minimum Tax.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Advanced Software Checklist: 4 Steps Manufacturers Should Take Before Investing in ERP in Industry 4.0

By Eskander Yavar

The arrival of Industry 4.0, or the fourth industrial revolution, signifies the next era in manufacturing, in which plants, processes, products and people come together in an entirely new way, enabling decentralized, autonomous decision-making on factory floors. Sometimes used interchangeably with the “Industrial Internet of Things”—a term coined by GE CEO Jeff Immelt—Industry 4.0 refers to digitally connected manufacturing, characterized by “smart” factories and smart supply networks. Born out of a confluence of technology advancements—from the Internet of Things to artificial intelligence to 3-D printing—Industry 4.0 ultimately hinges on the ability to integrate data with physical processes across the entire value chain.

That’s where Enterprise Resource Planning (ERP) and Material Requirements Planning (MRP) come in. ERP is a system for integrating a company’s data from all core business components into a single place to automate decisions and streamline operations.

The question for manufacturers isn’t whether they have an ERP system in place, but whether their ERP system is compatible with the way they use information now and the way they want to use information in the future. Can your ERP software capture information from third-party systems? Can it process and contextualize data in real time? Can you easily add new features when you add new applications or business processes?

The answers to these questions aren’t one-size-fits-all. Most manufacturing companies can orient themselves within a process continuum. One end corresponds to the repetitive and discrete and the other to the highly sophisticated and engineered-to-order. ERP software strategy should align with where the company falls along that spectrum and where it wants to go, informing the level of technological sophistication required in the software and the level of discipline in planning.

For middle-market manufacturers, investing in an ERP and/or MRP system can help manage resources, drive efficiencies and position them to more effectively compete with larger players with more resources. ERP may not be as “sexy” as artificial intelligence or robotics—but it’s a necessary precursor to embarking on any Industry 4.0 journey.

Here are four things manufacturers should do to maximize their investment in an ERP system:

Balance Risk and Reward along the Complexity Continuum

The more complex the manufacturing process, the more rewarding it can be for operations and the bottom line to build and implement strategies for ERP systems to eliminate redundant systems and processes. And conversely, manufacturers with complex operations can also experience more painful financial and operational consequences if they don’t do that well.

Understand what Functionalities you Need

ERP software can afford companies many benefits, including:

  • Managing compliance and regulatory requirements
  • Increasing inventory accuracy and materials planning
  • Increasing on-time deliveries
  • Enabling more efficient and meaningful reporting
  • Improving management decision-making
  • Improving customer service
  • Consolidating databases
  • Enabling a paperless factory

While even the smallest manufacturer can achieve all these benefits, it’s important to consider how ERP needs to work for your business and which vendor’s software will best position you to achieve your goals. Across the board, though, ERP can empower manufacturers to understand how they’ve historically sourced, made and distributed a product, as well as how they can repeat cost-effective processes and drive efficiencies across the entire enterprise.

Master the Basics

The flashier and more sophisticated ERP software gets, the more companies will need to be mindful of how the tool can help them solve a specific organizational problem, or their investment could risk going to waste. Before investing in an advanced supply chain planning tool, for example, they need to master the basic modules. Mastery of the basics will be more critical than ever as we look toward the next technological advances—things like Industry 4.0 and widespread adoption of the Internet of Things and more data-driven business intelligence.

Clean up your Data

Successful adoption of Industry 4.0 technologies is predicated on a disciplined process, clean data and organized teams. And at the core of ERP strategy and implementation is the integrity of an organization’s data. There are more opportunities for errors when machines cooperate autonomously with one another based on flawed data.

Because Industry 4.0 fundamentally changes the role of the operator, building systems that maintain the integrity of certain production processes without the same level of human oversight remains one of the main challenges to implementation. If the underlying data or data analysis has errors, the automated decision-making based on that data will be riddled with errors too. This means it’s critical to ensure data is clean, accurate and accessible as part of an overall information governance strategy. Just as a contractor wouldn’t build over a cracked foundation, embracing technological advancements without the right fundamentals of information governance, IT strategy and analytics capabilities could result in a flawed execution.

With these fundamentals in place, ERP can be a useful tool for middle market manufacturers looking to save on time and material costs and drive efficiencies enterprise-wide. And as Industry 4.0 becomes a reality for more manufacturers, smart, strategic use of ERP software can help middle market manufacturers leverage those benefits to maintain their competitive edge.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

 

How Quality of Earnings Can Drive Value To Your Manufacturing Enterprise

By Jerry Dentinger & Ryan McCaslin

Dealmaking in the manufacturing industry is poised to accelerate in 2017, buoyed by investor optimism around proposed pro-growth economic policies. Despite the modest slowdown in volume last year, multiples and valuations stayed high going into 2017. Therefore, buyers remain laser-focused on understanding a target’s profitability model to justify the expensive prices they are paying. The due diligence process continues to be critical to making informed investment decisions and capturing value after closing.

As part of the due diligence process, buyers typically seek out a detailed analysis of a target’s Quality of Earnings (QofE). QofE analyses aren’t new, but attention continues to grow around Big Data and how to navigate the exponential increase in volume and variety of structured and unstructured data in a due diligence process. This development has added a new layer of complexity—demanding a near-forensic level of detail, further increasing the burden on sellers and raising buyers’ appetite for information. For small and mid-sized manufacturers, where QofE processes often start immediately after receiving a Letter of Intent (LOI), introducing another layer of unexpected complexity can add serious anxiety to the sale process.

The proliferation of data, however, is also a major opportunity for both buyers and sellers to analyze and glean meaningful insights and thus gain important leverage during negotiations. For sellers, QofE analysis proactively identifies new areas to create value. For buyers, it helps confirm or challenge value to justify the investment or re-trade the deal.

Increasingly, manufacturers are proactively using data analytics tools to identify new areas where value can be created and proven. No longer viewed as a burden, the QofE process is enabling sellers to take more objective looks at their business and operations prior to sale. It’s crucial to understand where your business generates value well before bringing a buyer into the picture. Data analytics has proven to be an extremely important means to identify, create and hold value for companies going through a sale.

How is Big Data changing the QofE process?

QofE is not simply an accounting function—it also helps a buyer understand how and where a business makes its profits. Buyers request QofE analysis to be performed on targets to help them confirm value and identify areas where they can begin to drive returns post-close. The process requires sellers to disclose a significant amount of company data to allow buyers to drill into profitability by customer, product, SKU, geography, distribution channel and a variety of other metrics to understand where value is generated. Sellers are not always comfortable sharing such sensitive information with potential buyers. This friction has increased with the introduction of data analytics.

Historically, sellers have responded to QofE requests by providing as little information as possible. Today, they provide significant confidential information, most of which is delivered in electronic form with multiple large data extracts from their operating systems. QofE teams analyze these data sets manually through sophisticated spreadsheet modeling. All of this is done under tight time frames and often requires significant effort to reconcile and ensure completeness of the information. Most sellers have never provided or analyzed this volume of data—much less in an electronic form—until entering a sale. This can result in a slow start to the QofE process, delays and sometimes cost overruns if sellers are not prepared.

In the manufacturing industry, embedded sensor technology, wireless connectivity and mobile technologies have given companies access to unprecedented levels of data, enabling more sophisticated reporting and metrics. However, combing through these disparate data sets to create actionable information poses a significant challenge for mid-sized manufacturers unless they use data analytics software that links to their ERP systems. Even then, companies may still struggle to design management reporting that combines operating data with the financial information to meet the rigors of a QofE analysis. Today, few manufacturing companies are able to implement a comprehensive, cost-effective data analytics approach.

But that is changing.

With a variety of Big Data tools available, companies can now obtain greater visibility into key financial variables and their relationships, identify gaps and evaluate business opportunities in significantly less time. For both buyers and sellers, leveraging data analytics in conjunction with a QofE process provides valuable insights into where value is created or exposes whether value is sustainable or if it truly exists.

Manufacturers face unique QofE Challenges

QofE analyses can be more challenging for manufacturers than other industries. Why?

  • Production volume: Many manufacturers, particularly in sectors like fabricated metals, plastics and components, operate in high-production-volume environments with thin product margins. Analytics and reporting are both critical and challenging because of product costing, hundreds of bills of materials and the sheer number of SKUs. However, this level of complexity presents a significant opportunity to pinpoint value drivers across product lines, channels, geographies and individual customers.
  • Difficulty understanding costs: Manufacturers are proficient at tracking direct costs of production and distribution for specific products, but complications arise when accounting for indirect costs, overhead and allocations of variances, particularly if there is strong seasonality to revenues or volatility in the supply chain or marketplace. Errors can occur in standard costing and overhead allocation methods that affect fully absorbed product costs and thus raise questions about whether a SKU, product family or entire customer relationship is actually profitable. Further challenges arise when companies operate with multiple business lines. Successfully implementing data analytics here generates visibility and adds significant value.
  • Inventory and working capital: Manufacturers typically operate with high inventory levels and overall working capital. In a deal, buyers and sellers negotiate a working capital target or “peg” that will be delivered at closing based on an agreed-upon methodology and historical performance. Data analytics is starting to play a critical role in setting pegs by, for instance, proactively identifying inventory obsolescence issues down to the SKU level. These tools are facilitating stronger negotiating positions for their users.

A Proactive Approach to QofE adds Value

Regardless of whether you’re considering an immediate sale or looking to increase value through process improvements, these three proactive practices will improve your readiness for the eventual, extremely thorough QofE process.

  • Mind the GAAP gap. Keeping your books on Generally Accepted Accounting Principles (GAAP) and as current as possible is prudent if you are considering a sale. Many companies update their ledgers quarterly or even once a year, whether audited or not, and many keep certain accounts on a cash basis. In QofE, you need the historical bookend of a trailing 12-month period on accrual basis, and scopes are usually no less than two full years, often three. Monthly GAAP-based financials and corresponding monthly metrics are key.
  • Be proactive and understand the QofE process. Get ahead of the curve and anticipate the demands you will face in the sale process. A QofE is industry standard, and most third-party debt and equity providers require it. Too often sellers aren’t aware of QofE requirements until they have an LOI, and regardless of whether it is a proprietary sale process or a broad auction, due diligence is extremely detail-oriented, with no topic left off the table. Technology-enabled tools are making the exercise more complex, not less—but they’re also necessary to the process. Thus, QofE preparedness should start no later than 90 days before hiring an advisor.
  • Look in the mirror. The sooner QofE disciplines are introduced, the sooner value creation can begin for selling shareholders. Sellers should consider “reverse due diligence” one or two years before starting a sale process so they can identify and capitalize on process improvement opportunities to increase long-term value, identify lower versus higher profit operations, and generate a higher purchase price. Today, however, sell-side QofE typically begins when the seller hires an advisor, who shortly thereafter assists the company in the selection of an accounting firm. Better late than never, a seller-initiated QofE at the time of sale will be instrumental to holding value during the sale process. Holding value and certainty to close are the two biggest reasons why sell-side QofE has become a necessary part of a seller’s process in the U.S. market—despite being part of the European M&A landscape for decades. Sell-side QofE pays for itself many times over, whether started at the time of sale or years earlier.

Understanding the methodologies behind a QofE analysis, and then approaching it as a best practice—rather than as an accounting function or “check the box” requirement for due diligence—can help sellers maximize value upon exit. Incorporating data analytics solidifies the understanding where value is created and where to drive the business after sale. Sophisticated buyers are already looking to the future on how to drive value in their targets long before they submit an LOI. Sellers who understand that perspective and prepare for diligence accordingly will facilitate greater success for themselves and all parties in the transaction.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

PErspective in Manufacturing

A feature examining the role of private equity in the manufacturing space.

Private equity firms continue to exert influence on manufacturers’ global supply chains. There are a number of lucrative opportunities to create efficiencies and reduce operating costs along the entire supply chain, such as the impact of tax and duty on the bottom line.

Apollo Investment recently announced a partnership with Nike to build a regional apparel supply chain in the Americas for the sporting goods company, in contrast to the firm’s long-term strategy of overseas production. The new manufacturing and logistics company—in which Nike will not invest directly—aims to bring production closer to home, partly in response to growing demand for increased sustainability and domestic manufacturing. The vertically integrated manufacturing hub will enable Nike’s supply chain to be nimbler and will make it better suited to manufacture customized products, Forbes reports.

According to Supply and Demand Chain Executive, Apollo’s Special Situations I fund has so far acquired New Holland, a Pennsylvania-based apparel manufacturer, and ArtFX, a Virginia-based textile screen-printing and logistics company. Apollo plans to buy more apparel suppliers and textile firms in North and Central America, and build out new manufacturing plants, warehouses and logistics networks for Nike, Forbes reports.

In the auto manufacturing sector, Bain Capital is partnering with Japanese airbag manufacturer Daicel Group, and Carlyle Group is teaming up with Ningbo Joyson Electronic Corp.-owned Key Safety Systems to bid for Takata, an airbag supplier up for auction after a massive safety recall. KKR is also said to be mulling a bid, according to the Financial Times. With 70 million Takata airbag inflators globally scheduled for replacement by 2019, some of the bidders are considering bankruptcy proceedings to mitigate liabilities, Bloomberg reports. Because some of the world’s largest automakers are expected to spend the next few years recalling airbag parts, Takata set up a committee in February to negotiate with its carmaker customers and other stakeholders.

Following its 2015 purchase of Chinese plastics injection manufacturer Ying Shing Enterprises, Platinum Equity will acquire Singapore-based industrial parts distributor Broadway Industrial Group’s foam plastics and flow control devices divisions for $111 million, according to Mergers & Acquisitions. Platinum specializes in turning divestitures into stand-alone businesses, and has extensive experience in the Asian markets, according to a press release. The Los Angeles-based PE firm plans to grow the Asian business both organically and through strategic add-on acquisitions, Mergers & Acquisitions reports.

In an unusually large Japanese deal, PE firms Bain Capital, KKR and MBK Partners are submitting second-round bids for Nissan’s 41 percent stake in auto parts maker Calsonic Kansei, according to Reuters. The second bidding round is expected to close in October, so the value of bids cannot be ascertained. However, the parts maker has a market value of $2.4 billion, and therefore represents a rare opportunity for a large deal. The drastic restructuring methods often associated with PE have traditionally been a turn-off for Japanese companies, but Nissan invited buyout firms to submit bids after corporate buyers failed to materialize, Reuters reports.

Supply chain optimization is one of several ways PE firms can create value and efficiencies in the manufacturing industry. Whether it is building a manufacturing backbone that helps reduce transportation costs and import duties, or building a platform by acquiring similar supplier and distributor companies within a given industry across the globe, there are significant opportunities for PE firms with an interest in the sector.

Sources: Bloomberg News, Financial Times, Forbes, Insead, Mergers & Acquisitions, Reuters, Supply & Demand Chain Executive, Supply Chain Digest, Tompkins International

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Fall 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com

How to Keep the Lid on your Finances when a Food Recall Strikes

By Clark Schweers & Rick Schreiber

Some of the biggest names in the grocery aisle have made headlines this year with high-profile recalls, including General Mills and Kellogg, among numerous other household staples. Major food manufacturers, including ConAgra, have also pulled their products from market with nationwide recalls. In fact, this year, the U.S. Department of Agriculture (USDA) has recorded 51 food safety and inspection recalls and alerts through Aug. 30, up a whopping 121.7 percent from the same period in 2015, when it recorded just 23. In 2014, the USDA recorded 39 recalls and alerts over the same time period, a figure approximately 30 percent lower than this year.

Manufacturers have noticed. According to the 2016 BDO Manufacturing RiskFactor Report, 100 percent of the largest publicly traded U.S. food manufacturers cite product quality, contamination issues or recalls as a significant business risk in their regulatory filings, up from 90 percent in 2015.

And it’s clear the stakes are high not just for manufacturers, but for suppliers, retailers and grocers up and down the entire supply chain. It’s important to understand why recalls are growing more common and to implement protective measures to mitigate risk before your supply chain sours.

What’s turning up the heat?

Often, upticks in regulatory action can simply be due to a more watchful eye from regulatory bodies. In 2015, President Obama signed into law the Food Safety Modernization Act (FSMA), arguably the most sweeping reform of food safety in more than 70 years. The FSMA provides the FDA with new legislative authority to establish preventive control standards and enforce compliance, as well as tools to better respond to problems when they do occur.

But while increased regulatory scrutiny is likely a contributor to the increase in product recalls and contamination issues, it’s not entirely to blame. Shifting consumer preferences are prompting dramatic changes in the industry as some food manufacturers remove pesticides, preservatives and other additives from their products to take advantage of the organic craze. While the popularity of organic food is driven by a trend toward greater consciousness of health and wellness, synthetic substances serve an important role in safeguarding against spoilage and foodborne illness. More recently, food manufacturers have also begun removing preservatives and artificial ingredients from non-organic food, in response to demand for “natural” foods. The long-term health benefits of organic or natural foods remain unclear, but there’s no question that the preservatives they exclude prevent bacterial growth during transport and distribution.

Technology has also changed the way we detect and report on foodborne illness. Individual incidents that historically would have been dismissed as one-off episodes and gone unreported can now be tracked and connected by Genome and DNA testing. This allows regulators to better pinpoint the source of foodborne illness outbreaks, which could be contributing to the number of product recalls. Social media and consumer-run websites have also become popular forums for bringing an outbreak to attention.

Gloves on: What protective measures can help?

Food processed at a single plant can be routed far and wide through the market — for example, a large processor’s fruit may be sold in frozen bulk, smoothie mixes and other products under various manufacturers’ brand names nationwide. This makes the process of a product recall potentially extensive and costly. And the consequences can persist long after the financial bleeding stops — reputation can also take a serious bruising.

To shield themselves from the consequences of a contamination incident or recall, food manufacturers should consider these protective measures:

  1. Implement strong supply chain management procedures.
    An ounce of prevention is worth a pound of cure. Thoroughly understanding where risk lies along the supply chain and implementing strong quality controls can help to mitigate and detect food contamination before an outbreak occurs. To proactively manage the risk of a food recall incident, food manufacturers should implement policies and procedures to ensure their suppliers’
    and their own compliance with Current Good Manufacturing Practice regulations and the latest food safety standards, including food allergen controls and routine food safety audits by third-party certification bodies.
  2. Review contracts.
    Heavyweights in the retail industry are increasingly including indemnifications against damages in the event of a product recall or critical incident in their contracts with suppliers and manufacturers. Food manufacturers should thoroughly evaluate their agreements with distributors and retailers to identify where responsibility lies in the event of a recall, and avoid risky business where possible.
  3. Expect the worst.
    Every food facility should have an up-to-date crisis management plan that establishes roles and responsibilities and outlines a strategy for every possible scenario.
  4. Invest in insurance protection.
    Product contamination policies have gained popularity in recent years — not only because of the increased spotlight on food safety, but because investors expect it. Fortunately, as more companies incorporate liability, property and product recall policies within their coverage, more carriers have entered the market and the growing demand has pushed premiums down.

Boiling over: How to limit the damage?

No manufacturer is entirely safe from the risk of a recall or contamination incident. It’s important to have a contingency plan in place to help identify the source of the contamination and isolate the problem to prevent further spread in plants and factories. Manufacturers should also have a response plan prepared to curb potential financial and reputational fallout. Consumers and investors alike are much more forgiving when companies react and respond quickly.

In the event of a contamination incident, it’s also important to factor in potential losses to financial forecasts to staunch the bleeding and avoid future surprises. With recalls on the rise, companies should take a close eye to their insurance policies and contracts with supply chain partners to pinpoint risk, and ensure the right protective measures are in place to keep the supply chain in check and limit damage in the event of a recall.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Fall 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com