MC Tool
Sean Witty, HBS ’00, and his partner Jason Premo acquired South Carolina-based MC Tool in October 2007 for $5 million. The company was a machine shop that manufactured parts for a wide variety of applications in the energy, automotive and industrial equipment industries. It was well known for producing precise, high-quality parts such as gauges, fixtures, and tooling. In their first year of ownership, Witty and Premo focused on improving operations and enhancing sales with impressive results: sales doubled and EBTIDA increased by over 40%. They also prepared the company to become a certified manufacturer of advanced high-tolerance specialty parts for more demanding applications and obtained financing to acquire additional machinery.
But the “Great Recession” had an immediate impact in the fall of 2008 as customers cancelled orders and new sales became scarce. The company was in trouble and partners knew that they would have to work hard for it to survive. Witty and Premo conserved cash, reduced operating costs, and ceased debt amortization payments. The Great Recession also highlighted problems with MC Tool’s core business that made it more cyclical and riskier than the customers it served, who in turn, were more cyclical and riskier than the economy as a whole. The partners believed that the more precise manufacturing business that they wanted to expand into was less cyclical and less risky than MC Tool’s core machine shop business. They wondered whether they should continue to gradually add the precision manufacturing capacity, abandon or postpone those plans to conserve cash, or accelerate the transformation of the company.
The Acquisition of MC Tool
Witty and Premo had been friends and roommates at Georgia Institute of Technology. They had pursued separate careers, Witty in mergers and acquisitions and Premo in manufacturing specialty parts, before teaming up and spending seven months searching for a machine shop manufacturing company located in the Southeast United States to acquire. After reviewing over 30 companies, making numerous plant visits, submitting two purchase offers and one exclusive letter of intent, the partners were introduced to MC Tool through a business broker.1 The husband-and-wife team who founded the company in 1987 and ran it since then wanted to retire. The wife, who had managed the company’s
It is very common for tool makers to name their company after the location where they learned their trade, even if they are working in a new area. The initials MC were an abbreviation for Michigan
- Professor Richard S. Ruback and Senior Lecturer Royce Yudkoff prepared this case. It was reviewed and approved before publication by a company designate. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
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office, had some recent health concerns. The husband, who managed all manufacturing and sales, was willing to stay on for a three-year transitional period but recognized that he did not have the business skills required to grow the company. In fact, for the last year, the company had been turning away business because of capacity constraints.
MC Tool was a precision metal machining company located in Greer, South Carolina, and had most of the characteristics Witty and Premo had sought in an acquisition target. The company specialized in full service design-to-manufacturing production of high precision gauges, fixtures, tooling and custom industrial components on aluminum, stainless steel, titanium, Inconel, Hastelloy, and other exotic materials. Many of the products manufactured by MC Tool were unique and, while large customers tended to be repeat buyers, each time they purchased different products or services. Its largest customer was General Electric Power Systems, located only a few miles away from MC Tool and made up about two-thirds of revenues.
Over the prior several years the company had generated steady revenues and a healthy operating margin. In the prior twelve months, the company had revenues of $2.9 million and EBITDA of a little more than $1.0 million. Revenues were almost $3.0 million in the preceding year and $2.8 million in the year before that. While EBITDA had not been calculated in the two preceding years, Witty and Premo estimated that it was about $1.0 million in each of those years as well.
Witty and Premo believed MC Tool had significant untapped growth opportunities. The company performed all quoting and scheduling on manual spreadsheets so that there was an opportunity to automate and improve these processes, removing existing capacity bottlenecks and reducing overtime expenses. The company’s sales process could also be easily improved. It had hired its first and only salesperson in March 2007. Previously, sales were developed solely through word of mouth and the owners’ personal contacts. The company typically operated with about two months of backlog, but for over a year the company had turned away business because the owners did not want to expand capacity knowing that a sale was imminent. The partners believed that improved operations, additional capacity and more sales resources would increase revenues and profits significantly.
Witty and Premo negotiated a purchase price of $4,514,000 for the assets of MC Tool. They also required $375,000 in working capital and an estimated $155,000 in closing costs. As detailed in Exhibit 1, the total required funds equaled $5,044,000. To finance the acquisition, they obtained a $2.0 million senior bank loan from Wachovia Bank. Three quarters of the loan was guaranteed by the U. S. Small Business Administration under its 7(a) program.2 It had a 10 year term with annual amortization and a 10% annual interest rate. Witty and Premo also were required to sign personal guarantees for the bank debt. They also obtained a $375,000 line of credit from Wachovia at 9.75% and a $200,000 Investor Line of Credit at 13.25%. They would use $544,000 of the credit lines in the acquisition. In addition, the sellers were willing to take $1 million of the sales price in the form of a seller note with a 5 year term and an 8% annual interest rate.
Witty and Premo invested $150,000 of their own money in the acquisition and raised an additional
$1.35 million of equity from a group of friends and business associates for a total of $1.5 million. They issued Class B units which entitled investors to receive a 12% annual dividend, return of their original principal, and 40% of the equity of the company. In the partners’ base case presented in Exhibit 2, this produced a 34% IRR for their investors in the Class B Equity and a $3.3 million payoff to the two entrepreneurs.
- The Small Business Administration’s 7(a) program guarantees 75% of the loan amount made by commercial banks to qualifying small businesses up to a $5.0 million total loan
The first year of ownership
Immediately following their acquisition, Witty and Premo began implementing their planned changes. They substantially increased the resources devoted to sales, introduced software systems that improved quoting, accounting and order management, and expanded production capabilities from one shift to a 5-day, 24-hour 3-shift operation. These changes had an immediate favorable impact on the company’s financial performance. Exhibit 3 shows that the revenue between October 2007 and September 2008 exceeded $6 million which was more than twice the Company’s revenue in the year before the acquisition. EBITDA also showed improvement of over 40% from the pre-acquisition results.
Witty and Premo also began to consider moving the company toward manufacturing higher tolerance specialty products. That business was very different from MC Tool’s core business because the contract to produce a part for a major customer such as Boeing or Lockheed had a five year term plus there were generally follow-on orders for spares and maintenance. Also, margins tended to be more attractive, particularly in providing spare parts and when responding to short-term surges in customer demand. These recurring revenues offered much greater predictability and profitability than the shorter run/just-in-time contracts that made up the bulk of the company’s current revenues.
But before Witty and Premo could begin to sell the specialty high tolerance parts, MC Tool had to demonstrate that it had the ability to manufacture the parts at a very high standard and that it had the appropriate machinery and workspace to produce the parts in the required volume. None of MC Tool’s existing machinery would meet aerospace standards so the transition would require all new machinery. MC Tool would also have to move to a new facility because the existing workspace was too small, did not have sufficient power to feed the requirements of the new machinery and lacked high ceilings, reinforced floor, and air conditioning that the more advanced manufacturing required. Some purchasers also required that suppliers have redundant production machinery to assure a steady supply. Each customer would require a very rigorous review that would take 12 to 18 months before MC Tool could become a certified supplier.
Witty and Premo knew that it would take time, effort and investment to transform MC Tool into a certified manufacturer of advanced high tolerance specialty parts. The partners imagined a slow, conservative strategy of transformation. They would slowly transform the employees and technologies from the existing commodity machining focus into more advanced niche machining applications over an extended period of several years. The cash flow from the existing business would fund the transformation, providing resources to purchase the required new machinery and update the physical plant.
The Great Recession
Early in the fall of 2008 MC Tool was preparing to buy two 5-axis CNC machines plus additional advanced tools and CNC software modules that totaled $1.0 million.3 It would be the first step in transforming the company into certified manufacturer of advanced high tolerance specialty parts. They had negotiated a $900,000 dedicated credit facility to purchase the equipment and the remaining
$100,000 would come from the company. Then, late in the fall of 2008, the economy began to go into a tailspin. The effect on MC Tool was immediate. Witty was “afraid to answer the phone” because so many orders were being cancelled by customers’ whose own production volumes declined.
A 5-axis CNC machine is an advanced Computer Numerical Control (CNC) milling machine which is used in the manufacture of complex parts by operating along the traditional XYZ axes and two additional axes. These machines are particularly useful in the manufacture of specialty parts for aerospace
Some of MC Tool’s customers simply postponed the purchase of tools. Others decided not to subcontract the manufacturing of tools to independent machine shops and instead started making their tools internally to use up their own excess capacity and to avoid cutbacks in their own workforce. In addition, the customers that did order products began to prioritize price and value above quality. MC Tool was a high quality precision tool shop; with its highly experienced $18/hour workers, it was difficult to compete on price against less skilled $12/hour workers in other shops. It became apparent during the recession that customers were not willing to pay for the higher quality in tough times and the few orders that occurred were going to low cost competitors. Overall, the fall-off in business for MC Tool was dramatic and seemed much worse than the economy as a whole.
The two partners moved into “save cash overdrive.” Premo looked for revenue while Witty focused on cutting costs and dealing with the banks. The partners reduced their long-tenured workforce from 57 to 23 people and cut average hours from about 40 hours/week to 24-32 hours/week. Salaries were reduced 15%, with Premo and Witty eliminating most of their own salaries. The company looked everywhere for liquidity: for example, they started taking metal scrap to the scrap buyer weekly to get cash. Witty parsed through the company’s vendors, stretching payables where he could and declining to pay anything to their non-critical vendors. It was a very challenging time for the Witty and Premo. Because of the reduction in people they were doing more of the work themselves and there was more to do because of the crisis. The company was watching its cash daily and the financials were being closed weekly instead of monthly.
Financial conditions continued to deteriorate in 2009 and liquidity remained tight. Witty projected that operating cash flow for the year ending September 30, 2009 would fall below $500,000, about a third of its pre-recession performance. He called Wachovia Bank and informed them that MC Tool would only be able to pay interest on its debt and would cease making required amortization payments. The bank threatened to accelerate their loan and to impose additional fees and penalties. Witty also informed the sellers that MC was stopping cash interest payments on their note which would accrue until further notice. The sellers objected. Surprisingly, both the bank and the sellers took no further action.
Next Steps
The recession demonstrated that MC Tool was extremely cyclical because its core business – high quality custom industrial tools and components – depended on the activity of manufacturers. In addition, because manufacturers could substitute internally manufactured or lower quality components for MC Tool’s high quality components, MC was inherently riskier and more cyclical that its customers. The advanced high tolerance specialty parts that Witty and Premo wanted to move MC Tool towards seemed less cyclical and less risky because lower quality alternatives did not exist and manufacturers did not generally have the ability to manufacture them internally. In short, their experiences during the recession convinced Witty and Premo that their idea of transforming MC Tool was the right way forward for the company.
But the plan of using the cash flow from the existing core business to fund that transformation seemed infeasible. The core business was producing barely enough cash to breakeven and had no prospects of returning to the pre-recession level of excess cash flow that the partners had hoped to use to fund the transformation. The partners still had available a $900,000 dedicated equipment line of credit for purchasing the advanced 5 Axis CNC machines to pursue this transformation. However, this initial capital expenditure of $1.0 million seemed enormous relative to the size of the company and to its current cash flow.
Exhibit 1 Sources and Uses of Funds for the acquisition of MC Tool ($000s)
| Sources | Uses | ||
| Bank senior debt | 2,000 | Purchase of M. C. Tool assets | 4,514 |
| Line of credit | 544 | Working capital | 375 |
| Seller subordinated debt | 1,000 | Closing costs | 155 |
| Investor Class B equity | 1,500 | ||
| Total Sources | 5,044 | Total Uses | 5,044 |
Source: Company documents and casewriter estimates.
