Wayne Wilson on Companies in Transition

Borrowers and Lenders

An article in today’s New York Times [1] pointed out the price savers are paying through lower income on their savings as a result of the Federal Reserve’s near-zero interest rate policy. Not only does this policy favor borrowers, it clearly favors banks (at the expense of their depositors) amid the banks’ efforts to rebuild capital and profitability.

Such low rates will be counterproductive, however, if carried on too long in an era when consumers, businesses, and banks must de-leverage to right their balance sheets. Consumer spending, especially, ran way out on the proverbial debt limb. That limb has now broken off, and consumers are scrambling to survive the fall. In fact, the lower the interest rates, the more consumers must save and the less they will spend.

If you are a borrower with good credit and equity support, these are some of the best of times with home mortgage and corporate bond interest rates at record lows.

If you are a net saver, your investment options are poor, bad and worse. Bond yields are low and stock prices stagnant. Hard assets (gold, real estate) may look attractive but low/no inflation or out-right deflation are seldom kind to such assets.

How should owner/CEOs think about their companies’ strategies in this kind of environment?

It’s a time to be cautious but opportunistic:

• There will continue to be winners and losers – The continuing success of Apple’s gadget sales demonstrates that consumers will find the money to buy the things they want. Companies with second-rate or me-too products will likely continue to struggle.

• Nothing lasts forever – Just as the good times came to an abrupt end, the current malaise will also improve but over time. Any sharp economic improvement will require significant catalysts in the form of major innovations and/or dramatically more favorable governmental policy. Look for inflection points; be ready.

• You make money when you buy or invest, not when you sell – While there are “get lucky” exceptions, most investment returns result from buying the right assets at the right price. Be patient. Liquidity is your friend, not your enemy.

---

[1] “Falling Rates Aid Debtors, but Hamper Savers” at http://www.nytimes.com/2010/09/09/business/economy/09rates.html

Banking on banks?

Banking on banks could be hazardous to your health. A recent article in The Economist [1] reports new data indicating that small businesses are a drag on the employment rebound from the recession. Large firms have resumed hiring but small firms continue to shed jobs.

The culprit? According to The Economist, one of the biggest causes is tight credit. With banks still skittish about bad debts, only the most credit-worthy companies can qualify for new loans to expand their businesses – and hire more employees.

While lack of credit is a likely cause, subdued confidence in the future is also at work here. Entrepreneurs and other business owners are almost by definition optimists – who else would take the risks? But investing for the future also requires confidence in a stable business and economic environment. Such confidence has been in short supply.

Continuing upheaval in global financial markets, impending increases in government healthcare mandates, business regulation, and tax rates do little to inspire confidence that investments made today will result in reasonable prospects of returns on those investments in the future.

In this environment business owners must:

• Carefully evaluate current and future market opportunities

• Develop business plans based on conservative financial assumptions

• Establish and guard rainy day funds and backup lines of credit as if there business lives depended on them (which they might)
  

---

[1] May 15, 2010, p. 38

What’s your business worth?

Every business owner dreams about what his/her business might be worth – the bigger the dream, the better they feel. But what is that business really worth? Only as much as someone will pay you for it.

Here then is the real question: how do you figure out what someone might pay you for your business? Investment bankers would say, “Let’s run a process (quietly put the business up for sale) and see who comes and what they offer.” But that’s not practical if you are really not yet ready to sell or if you are worried about the impact on customers and employees if word leaks out that you are shopping the business around. Such processes can also be time consuming, distracting for management, and potentially expensive.

Another avenue is to ask an investment banker or appraisal professional to prepare what’s called a “range of values” study based on comparable company sales, public company trading multiples, and discounted cash flow analyses. Such studies can provide you with indications of your business’ value under various scenarios. The fees charged for these studies may be modest or significant depending on the size and complexity of your business.

And then there are the “rules of thumb” – those quick and dirty formulas for estimating the value of a business based on the ranges of prices other people have paid for similar businesses over time. [1] To be useful, business valuation rules of thumb should be market-driven, that is the result of actual sales. While valuation rules of thumb do not take into consideration all of the factors which might affect the value of a specific business, they are a useful starting point.

Here are two good resources to consider in your search for appropriate rules of thumb:

• 2010 Valuation Survey of Architecture, Engineering, Planning & Environmental Consulting Firms, published by ZweigWhite is an excellent resource for business owners and managers in those professions.

• For a more general resource, check out the 2010 Business Reference Guide: The Essential Guide to Pricing Businesses and Franchises, 20th Edition.

---

[1] In the Introduction to his book Rules of Thumb, Tom Parker calls a rule of thumb “an easy-to-remember guide that falls somewhere between a mathematical formula and a shot in the dark”.

Managing Business Risks

The first risk management problem for both executives and directors is identifying the risks they need to be worried about. Some of the biggest problems are stealth risks – they seem to come out of nowhere.

At a recent seminar for corporate directors, the seminar leader, Dr. Krishna Palepu of Harvard Business School, suggested the following matrix as a good place to start.

Types of Risks

- Strategic – did you pick the right strategy?

- Execution – can you effectively execute the strategy you picked?

- Reputation – how could your corporate reputation be damaged?

- Compliance/Fraud – something bad happened; will it be caught in time?

- Legal – regulators, customers, etc sue the company.

Sources of Risks

Internal

- Pressure to perform – the hill is too high

- Incentives – the compensation system encourages inappropriate behavior

- Rationalization – people have a unique ability to convince themselves that what they are doing is okay when it is not.

External

- Competition/markets – aggressive competitors or changing markets

- Regulatory changes – someone changed the rules or the level of enforcement

- Technology – new technologies make what you are doing obsolete

- Society – the larger society decides it does not like something you are doing

While not exhaustive, the above lists can point you in the right direction.

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.

---

[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.

---

[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.

******

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.