Diamonds in the Rough Set in Platinum
No doubt readers of Going Private will be aware of the value of slurping up suppliers into a business, particularly those that provide high margin products or raw materials (where a steady supply is critical or the commodity is unusually scarce). This sort of vertical integration has been a critical part of business strategy since who knows when, but was probably best typified by Standard Oil in the industrial era. As an interesting aside, the proper use of vertical integration can have substantial anti-trust issues, as was seen with Standard Oil, but, in my view more interestingly, also with DeBeers, of diamond fame.
DeBeers, then controlled by the Cecil John Rhodes (of the notable "Rhodes Scholarship") and Charles Dunhill "C. D." Rudd (almost entirely unnoted for anything but his association with Rhodes and DeBeers), managed to establish its stranglehold on diamond mines by controlling an altogether common and bland asset: water pumps and contracts to pump water from the main mines. Water management being critical to mining, their grip on the water pump business made them a fortune before they even began to take large mining interests.
It is easy to see why a firm like Textron would be interested in owning fastener companies. Particularly those that make expensive, FAA certified fasteners for aircraft, like Cessnas and Bell Helicopter (both firms owned by Textron). Wondering why they would sell Textron Fastening Systems, which makes the lion's share of their high-precision, critical fasteners, to Platinum Equity, one of the larger operation private equity firms out there is, therefore, an interesting study.
Textron had Textron Fastening Systems on the block back before December of 2005. They even went so far as to call it a "discontinued operation" back then. Said the firm in its recent 10-Q:
On May 4, 2006, as a result of the offers received from potential purchasers of substantially all of the business of the segment, and the additional obligations that Textron now estimates will need to be settled as part of the sale, Textron determined that the net assets of discontinued operations related to the Textron Fastening Systems business may exceed the fair value less costs to sell. Consequently, Textron determined that it will incur a non-cash impairment charge in the second quarter of 2006 in the range of $75 million to $150 million.
One wonders aloud what might have been the headache with a well vertically integrated business that supplied critical, quality dependent and expensive parts to a manufacturer. We are given quite a hint in the 10-Q again.
Our business could be adversely affected by strikes or work stoppages and other labor issues. Approximately 18,500 of our employees are unionized, which represented approximately 40% of our employees at December 31, 2005, including employees of the discontinued business of Textron Fastening Systems. As a result, we may experience work stoppages, which could negatively impact our ability to manufacture our products on a timely basis, resulting in strain on our relationships with our customers and a loss of revenues. In addition, the presence of unions may limit our flexibility in responding to competitive pressures in the marketplace, which could have an adverse effect on our financial results of operations.
Yeah. Ouch. In fact, so burdensome were the capital and managerial requirements needed to make a running with a unionized manufacturing entity based in Troy, Michigan that Textron decided to just divest the unit, and take a rather substantial hit to goodwill and related write-downs ($335 million in 2005). They also charged $289 million for restructuring, though some of that is related to their other flagging businesses, InteSys and OmniQuip.
Back in 2002 Textron Fastening Systems had sold its 60% stake Grand Blanc Processing, LLC, a wire processing firm right back to Shinsho American Corporation, its joint venture partner. Grand Blanc had been taking raw wire and supplying Textron with wire prepared (annealed, etc.) for use in Textron's fastener manufacture. Again, another vertical integration play unwound by Textron. And this particular divestiture was the last bit of the rather large wire processing interests Textron had acquired earlier in a big binge that went all the way back to 1996, before Textron bought Valois, a French manufacturer of fasteners. It was also one of three wire processing business located in Michigan that Textron dumped. This was partly because major clients were in automotive, and therefore in Michigan, but partly because Textron Fastening is in Troy. One wonders if Textron was wisely exiting from the automotive industry back in 2002. Not fast enough says their annual report:
During 2005, the Textron Fastening Systems business experienced declining sales volumes and profits. Volumes were down due to soft demand in the automotive market and operating difficulties. Profits were down due to the lower volumes, a lag in the ability to recover higher steel costs and inefficiencies associated with the consolidation of manufacturing operations in North America. Due to the continuation of these conditions, further softening of demand in the North American automotive market and an expected decline in the European automotive market, Textron’s Management Committee initiated a special review at the end of August to consider strategic alternatives for the segment, including the potential sale of all or portions of its operations.
Note how this explanation, low volume and revenue, differs some from their quarterly rationale. Notice also that the reported revenues of the unit were $1.7 billion, $1.9 billion and $1.9 billion for 2003, 2004, 2005. Not exactly a firm in crisis on the revenue side.
Still, Textron has been divesting "non-core" businesses for several years now, and being particularly anxious to rid themselves of Michigan businesses, particularly labor intensive ones, but also carbon manufacturers, fuel management system and flow control manufacturers since 2002.
This isn't a new hunting grounds for private equity firms, large corporations that failed to properly integrate an otherwise sound vertical integration strategy. It is also unsurprising to see union shops being dumped left and right as well as Michigan businesses (are you listening to this Governor?) given the increasingly outsourced manufacturing capacity out there. And what about quality? I suspect Platinum Equity won't think twice about moving manufacture of the less complex products offshore and replacing all that expensive union labor with robust (but less expensive) quality control programs.
It is far cheaper to inspect the hell out of shipments from, e.g., China, in your local facility and just reject delivery of non-compliant product. Who cares if the failure rate triples? You just saved so much by killing off the most expensive labor on the planet (outside of Germany) that the pittance of a price you paid (something like 0.35x revenue), is going to make your IRR look quite yummy.