Wayne Wilson on Companies in Transition

Where have all the growth companies gone?

A few years ago, a growth company [1] from a public investor perspective [2] was any company whose revenues and earnings per share were growing at rates greater than 20% per year.

Earnings growth drives valuation and revenue growth is the essential precursor for earnings growth. And owners of privately held companies aspired to the same growth rates, especially if they wanted to go public company or sell out to a public company.

Where is the growth bar today?

In a recent conversation with bankers from a major Wall Street firm, I asked that very question. Their answer: “anything in double digits.”

How times have changed. But some things have not changed - above average revenue and earnings growth rates are still the keys to above average valuations.

Management’s three financial priorities remain the same:

1. Keep costs under control
2. Manage cash carefully
3. Plan for growth

Now is the time to set in motion those plans and strategies which will drive growth and profitability when the economy emerges from recession.

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[1] “Any firm whose business generates significant positive cash flows or earnings, which increase at significantly faster rates than the overall economy. A growth company tends to have very profitable reinvestment opportunities for its own retained earnings. Thus, it typically pays little to no dividends to stockholders, opting instead to plow most or all of its profits back into its expanding business.”  Investopedia at http://bit.ly/QIVRc

[2] Excludes companies that have not yet reached operating profitability.

Measuring your ROI on acquisitions

Many CEOs rely on acquisitions of other companies or product lines as an important component of their overall growth strategy. However, they seldom look back through rigorous post-acquisition financial analyses to measure their return on investment (ROI), especially how the deals performed versus expectations at the time of the deal.

I prefer two relatively simple measures: annual cash-on-cash (COC) return on capital invested and cash payback or how long will it take for the buyer to recover its investment on a cash basis. Other methods such as discounted cash flow, while more theoretically pure, suffer from complexity of calculation and estimation bias when trying to determine appropriate discount rates. If not done properly, the analysis is worse than worthless.

A proper analysis should be performed on an annual basis covering all significant acquisitions made by the company (or the current management team). EBITDA (earnings before interest, taxes, depreciation, and amortization), adjusted for significant changes in the level of capital expenditures and working capital, is often a reasonable proxy for cash. Some would argue that free cash flow is a better proxy. Pick a method and use it consistently.

The real question and value is less in the numbers than whether the management team holds itself accountable for results through an open and honest “lessons learned” analysis.

One company recently completed its annual exercise indicating somewhat mixed cumulative returns for several transactions over several years with COC returns barely exceeding the company’s weighted average cost of capital. On the qualitative side, one acquisition was truly transformational and displayed excellent returns.

It’s better to do deals with your eyes wide open than your eyes wide shut.

The recession grinds on

At ground level the recession grinds on, despite recent optimistic comments by various government and other public figures, A recent survey of corporate chief financial officers [1] highlights the gap between hope on the one hand and reality on the other.

Fifty-four percent of U.S. CFOs surveyed were more optimistic this quarter than they were last. But on average, the “CFOs say the recession will last another 10 months,” and they are continuing to maintain tight control over spending.

This is a classic pattern: management actions tend to lag changes in the environment. At the beginning of a recession, managers hope for a quick rebound. They begin to seriously reduce spending only when it becomes clear that the revenue decline is not a brief aberration. On the rebound, managers must be absolutely convinced that revenues are turning up before they ease up on spending controls.

The key strategy is watchful waiting. Those business owners who have the courage to begin investing again before the pack does will have an advantage over their competitors.

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[1] CFOs Hoping for the Best, Planning for the Worst, www.CFO.com, June 3, 2009

How can I protect myself from supply chain failures?

Michael Gonnerman had some great advice for business owners in his “Ask Mike” newsletter this week.

Question: "We depend on a lot of companies in our supply chain, from vendors who supply components to several retail chains who sell our finished goods. I'd love to get an early warning about companies that might be in trouble so a failure won't catch us by surprise. Suggestions?"

Mike: In my experience, there are always warning signs whenever a big manufacturer or distributor begins to have financial problems. Industry rumors, news reports, SEC filings, layoffs, an uptick in "lost" paperwork, declining stock prices, negative opinions by auditors, high turnover among key executives--it's all evidence that you're dealing with a supply chain partner with problems. Especially during tough economic times, you should make a serious effort to track information about all the companies you rely on.

And if you depend on a company that's public, buy a few shares of their stock and attend their annual shareholder meeting. Chances are, you'll be the only customer or creditor there, and you'll have plenty of face-to-face access to the directors, the CEO, and the CFO. Feel free to ask questions like, "Why aren't you paying your bills on time?" or "What are you doing about the defective goods your Oshkosh factory is shipping?" Believe me, you'll get attention.

Bear in mind that your warnings may ruffle some feathers inside your own company. Your purchasing department may be sending too much business to a single vulnerable supplier, or your sales reps may be happily writing big orders to a distributor who can't pay his bills. Make sure your have a company-wide buy-in on reducing supply-chain risk, or the information you collect won't do any good.

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Michael Gonnerman is the Founder and CEO of Michael Gonnerman, Inc. (http://www.gonnerman.com) in Sudbury, Mass. He may be reached at 978/443-1340 or through email at michael@gonnerman.com .

Lingering on the mezzanine financing ledge

Most sources of business financing are in tight supply: bankers are skittish, the IPO and equity markets are almost non-existent, and even the mezzanine players are having trouble moving the money.

According to Bank of America Business Capital,

"Very few private equity firms will do a [mezzanine] and equity deal; they want senior lending," says Andy Steuerman, a senior managing director with Golub Capital. …the deal market has effectively stalled. Economic uncertainty, on top of the credit woes, has both buyers and sellers retreating to the sidelines until more clarity emerges. …the only deals being pursued are the transactions that are absolutely necessary for a company's survival.

Translation: it’s not yet safe to come out of the financing storm shelter. Companies must continue to rely on their own wits for preserving cash and funding their businesses. As the recession drags on, customer profitability and working capital management remain key pillars of financial stability.

Looking for financing? Community banks have money to lend.

Business owner/CEOs frequently ask about new or alternative sources of financing, especially in the credit crunch of the last year. Community banks can be great sources of funding, but you have to meet them on their terms.

An experienced intermediary can also be helpful. Here’s some recent information from Fantini & Gorga:

"New England alone has over 200 banks with over $500 million in assets. Collectively they’re well capitalized. Many are lending actively in the $1,000,000 - $25,000,000 range.

"But although their focus is local, it can be hard to get the best loan terms from these community banks.  They move in and out of the market. They have very particular – and frequently changing - loan criteria. Often these banks need a participant, or even a small syndicate of banks, to reach the needed loan amount. Terms and pricing vary widely.

"Check out our most recent Out of the Ordinary  to get a composite picture of what this critically important, but highly fragmented source of financing is doing."

Fantini & Gorga can be reached at the following address: *

Fantini & Gorga
265 Franklin Street
Boston , MA 02110
(617) 951-2600
(617) 951-9944 (Fax)

www.fantinigorga.com

* I am familiar with Fantini & Gorga's work, but othersie have no affiliation or arrangement with the firm.

Business Valuations - Here today, gone tomorrow

One of the greatest difficulties selling business owner/CEOs are struggling with these days is the rapid decline in prices which business buyers are willing to pay. The reasons are part financing, part business expectations in a recession, part negative trends in the business, and part the dramatic downward macro re-set in business valuation multiples in the markets at large.

As we have often said, "business valuation is in the eye of the beholder," and today's beholders are likely wearing dark glasses.

Part of the solution to this mis-match between would-be buyers and sellers is a better understanding of the bases for business valuations. Here is a helpful slide deck from Hayes Knight, accountants.

Business Valuations

View more presentations from Pedzel.

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Readers may also find our presentation Business Valuation and Exit Strategies: Planning for the End Game helpful.

Are you tracking your free cash-flow margins?

Every business owner/CEO is watching his/her profit margins closely these days. But are you also keeping a close eye on your company’s free cash flow and cash flow margins?

Free cash flow is the discretionary cash that’s left over after paying all operating expenses, required debt payments, and capital expenditures. It’s the money that can be used for dividends, acquisitions, or for stock buybacks if your company is publicly traded. Cash flow margin is free cash flow divided by revenue.

Free cash flow must also take into account changes in working capital required to support the business. A recent study at Georgia Tech reports that while cash flow margins in several major industries were holding steady in recent months, the study’s authors predict that free cash flows for many industries could sink by 50% over the next year. What is happening here?

Two things:

• First, when revenue growth slows or begins to decline, cash flow actually increases because working capital is being released from operations (receivables decline through a combination of continuing collections and slower sales). Managers often see this as a positive – it may be in the short term but it bodes ill for the longer term because the business is liquidating itself.

• Second, as revenues continue to decline, cash flow quickly turns negative because few managers are able to reduce expenses as quickly as their revenue declines. And the speed of this change in direction can be breath taking. Free cash flow can literally be positive with a cushion one month and turn negative, falling off a cliff the next month.

While tracking your company’s free cash flow is vital, it is not a substitute for carefully scrutinizing and modeling changes in every component of your company’s finances on a continuous real-time basis. And while doing so may be painful and time consuming, the alternative is likely worse.

Maximizing the sale value of your business

Many owner/CEOs have recently despaired about their ability to sell their businesses at acceptable prices under current market conditions. If buyers are interested, it’s often only at depressed prices.

We are always on the lookout for new tips for addressing this challenge. Mark Cadbury recently offered his 10 Ways to Maximize the Sale of Your Business. Here is Mark’s list:

1. Ensure Customer Diversity
2. Develop Management and staff
3. Systematize the business wherever possible
4. Focus on Recurring Revenue
5. Develop Proprietary Products/Technology that cannot be copied easily
6. Engage a Team of outside professionals
7. Broaden Product Diversity
8. Develop and maintain Key Performance Indicators (KPIs)
9. Prepare a Written Growth Plan
10. Invest in a quality accounting system

This list is good advice for any business owner regardless of whether you are currently looking to sell your business.

Read Mark’s article and commentary.

Counting calories

Anyone who has ever attempted to lose weight hates counting calories. And yet the quantity, type and frequency of caloric intake largely govern whether a dieter will reach his/her goal.

Businesses must also count their calories. Spending cash is the business equivalent of calories. Like foods, there are several types of calories:

• Muscle building calories from proteins – strategic investments in products, services, and processes

• High-energy carbohydrates – operating expenses that support effective production, sales and marketing, and customer service

• Empty calories like alcohol – spending on perks and overhead items that do not contribute to the business’ success and which would never be missed by customers

What kind of calories are you feeding your business?