Tag Archives: cash flow statement

When 3,678 Isn’t 5,000…

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Did you know that now there are only about half as many publicly traded companies as there were in 2000? I didn’t.

The number of publicly traded companies always ebbs and flows, but the current number has fallen steadily since 2000. At 3,678, the number of companies available for the public to invest in is much closer to the all time low of 3,069 in February 1971 than to the all time high of 7,562 in July 1998. Granted, there are thousands of stocks traded on “Pink Sheets” and other lightly or unregulated markets, but the Wilshire 5000, which only includes those that trade on an exchange such as the New York Stock Exchange or Nasdaq, can’t even maintain enough companies to reach its namesake number of 5,000. There are now only 3,678 companies in the index, which is down by more than a third in a decade, and off by nearly half from its level in 2000.

But it’s not just a blip with the Wilshire 5000. The total number of listed securities trading on the Nasdaq OMX and NYSE Euronext exchanges was 4,916, according to the World Federation of Exchanges. The number of listed securities on these two critical exchanges has fallen every year since 2009 and is down 32% since 2000 and 39% from the recent peak in 1997.

Why is this? One of the main reasons cited is that corporate acquisitions have eliminated and absorbed scores upon scores of candidate companies. Even during the recession years of 2008 and 2009, 8,778 and 7,415 U.S. companies, respectively, were bought. Those figures have steadily increased to 10,108, 10,518 and 12,194 in 2010, 2011 and 2012, respectively, due to a combination of cheap acquisition debt and relatively lower acquisition multiples during the last three years.

Other hypotheses include the increasing expense/hassle of being public, the prevalence and domination of larger public companies, investor distrust of stocks, and involuntary delisting. There is little new supply of public companies either, of course, as the initial public offering market remains moribund.

No one can say for certain exactly why the number of tradable equities has fallen so precipitously, but the trend for fewer rather than more public companies should continue for the foreseeable future.

Posted by: Mory Watkins; excerpted, in part, from an article recently written by financial reporter Matt Krantz.

The Role of the Board…

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Large financial decisions are the purview of Boards of Directors, and few business decisions are bigger (or have more repercussions) than corporate acquisitions and divestitures. Today’s BODs want to be kept apprised of all material strategic developments, and want more information and more frequent updates than ever before. Considering that 93% of all acquisitions valued over $100 million now result in litigation, I can’t say I blame them.

Today, I’m going to share some thoughts about the interaction between BODs and their corporate dealmakers.

Before I begin, it’d be helpful to first understand a little bit about how BODs work. Boards walk a fine line between protecting and growing corporate assets, and they have a legal duty called the duty of care to make decisions about M&A on behalf of their companies that are “reasonably informed, in good faith and rational judgment, without the presence of a conflict of interest.” The words reasonably informed are key, and the BOD takes this part of its duty especially seriously.

In today’s market, deal professionals can expect lots of questions, a certain amount of conservatism, and even some resistance to acquisitions from their Directors. Communications between the two parties may be further strained by varying degrees of acquisition experience and gaps in M&A knowledge among board members. In short, it can sometimes feel for deal professionals very much like an uphill battle to get a deal approved.

There is no sure-fire recipe for successful interaction with a Board, but I can at least offer some advice on what information they need and some best practices for communicating.

First, let’s address the contents of a standard deal package for Directors. In my experience, there are five principal pieces of deal information that a Board needs and asks for from its Corporate Development staff (roughly in order of importance):

  • Deal Rationale: As a corporate development professional presenting to a BOD, you should always lead with your deal rationale, including relevant info regarding valuation, management, strategy, products/services, market size, etc.  You should describe your deal in the most concise and cogent manner possible. In plain English, you’re trying to answer, “Why should we do this?” Please re-confirm all the points of your deal hypothesis each and every time you bring the Board up to date.
  • Financial Impact Analysis: The near term financial impact of any proposed acquisition will be foremost on the Board’s mind as it listens and evaluates. Here, you must provide just one thing to address the Board’s needs: an accretion analysis. Recall that Directors are notoriously myopic, and near term financial impact will probably be the single most important, and sometimes the only, factor in determining whether your acquisition will go forward or not. Sorry, but that’s life.
  • Process/Timeline Update: You should comment directly on the deal process and anticipated timeline for completing the acquisition. Buying a company is a large, complicated project, and project management of key corporate affairs happens to also be a duty of the Board. Timing is a major deal consideration for the BOD; don’t under estimate its importance.
  • Due Diligence Update: You should provide an update on due diligence. Make it brief if there are no issues, but be sure to mention anything material that has popped up during your inquiries (it’s your duty to keep them informed) and link your comments to details about potential impediments to closing (see above, Timeline).
  • Alternatives: Lastly, and very importantly, you should always provide a couple alternatives to your proposed transaction. “Huh?!?”, you might say. “But why…?” Well, in a nutshell, in corporate development your job is to provide a way to get from point “A” to point “B” via outside (inorganic) means. You must furnish several viable paths to strategic success; everything can’t be riding on one deal or one strategy. Lots of people forget to do this, but by showing the Board several different potential approaches and solutions, you are actually both doing yourself a favor and helping the Board meet its fiduciary duty of care responsibilities.

So those are the key pieces of information the BOD needs…but any deal professional will tell you that the manner in which deal information is conveyed is awfully important too. Here is my advice on how to effectively communicate with your Directors:

  • Simplify, Simplify, Simplify: In all cases where numbers are needed, you should provide high level, much-simplified financial models and analyses to help the Board quickly grasp your point without getting lost in the details. Provide only the big-picture model or analysis, but make sure to mention that full details are available for those desiring more information.
  • Provide Key Assumptions: Yes, I’ve advised simplifying models and analyses above, but that doesn’t absolve you from responsibility for explaining the key assumptions you’ve made running those high level numbers. Include all the relevant assumptions as well as the facts supporting those assumptions.

Market conditions have intensified pressure on BODs, and they are more fully engaged and hands-on in managing enterprise risks, including those in and around strategic M&A. At the same time, however, Directors understand that deal making drives earnings growth and that acquisitions are increasingly necessary in this slow economy. As a deal professional, you can help your Board manage these disparate duties by understanding their information needs and communicating accordingly.

Posted by: Mory Watkins

Due Diligence – How to Avoid Financial “Shenanigans”

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It’s an unfortunate fact of life that there are people out there willing to bend the rules of accounting in order to maintain the illusion of profitability on paper. My posting today discusses how to avoid becoming a victim of accounting gimmicks and financial trickery when evaluating an M&A target.

As I’ve previously discussed, fully understanding a target’s cash flow is the name of the game in corporate M&A. Easier said than done. Components of cash flow come from all areas of the financial statements and encompass the full spectrum of business operations. How then does one go about breaking down and evaluating the veracity of cash flow?

Start by understanding that some of the most important cash flow information comes from the profit and loss statement. Just to state the obvious, if you have a high degree of confidence in a company’s (book) accounting earnings, you’re well ahead of the game in determining the overall truthfulness and reliability of cash flow.

Okay, but how then do you best evaluate whether someone’s cooking the books or playing games with the P&L? Answer: all earnings-related accounting fraud falls into one of just seven categories. Hard to believe, but true. Understand, recognize, and watch out for these seven financial slights-of-hand and you’ll never be fooled.

This nifty idea comes from a book that I consider to be the seminal work on the subject of fraudulent financial statement analysis – Financial Shenanigans (How to Detect Accounting Gimmicks and Fraud in Financial Reports) by Howard Schilit. I’ll come right out and say it: I absolutely love this book. I was first exposed to it back in business school during an early accounting course. Over the course of my career, I’ve come to rely on it as my go-to reference for spotting and diagnosing accounting issues in the companies I buy. The essential elegance of Financial Shenanigans is that it reduces the seemingly limitless ways of fraudulently manipulating accounting earnings into just a couple principles that are easy to remember and use on an every day basis. Moreover, the book illustrates each of the principles with memorable real life corporate vignettes and examples.

Here are the seven types of accounting shenanigans:

  1. Recording revenue too soon
  2. Recording bogus revenue
  3. Boosting income with one-time gains
  4. Shifting current expenses to a later or earlier period
  5. Failing to disclose all liabilities
  6. Shifting current income to a later period
  7. Shifting future expenses into the current period

And these seven shenanigans can be further reduced to just two fundamental tricks: boosting current profits (numbers 1 through 5) and shifting current profits into future periods (numbers 6 and 7).

This book and its classifications of accounting tricks offers a comprehensive framework for evaluating the real quality of a prospective M&A target’s P&L. Are they too aggressive with revenue recognition issues? Have they recorded unusual or one-time gains on exchanges of assets? Have they properly capitalized certain costs? Have they reasonably accrued for expected and contingent liabilities? Have they set up accurate sales reserves for unearned revenues? The list, and the potential for shenanigans, goes on and on and on…

Common sense is and will always be, of course, your best bet for avoiding being taken by an accounting scam. But remember and use the framework proposed by Schilit in Financial Shenanigans during your financial due diligence. In my opinion, there is no better or easier to use system for heading off “creative” accounting issues that could really crater your acquisition.

Posted by: Mory Watkins

2013 Carve Out Survey

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I just had a quick look at Deloitte’s annual divestiture survey. The survey polled 150 executives at mostly larger and public companies about their plans to either slim down or sell operations (a divestiture or carve-out was defined as the sale of a subsidiary or a portion of a company’s business, whether a plant or other facility, product line, business unit, or division).

From the corporate development perspective, the most informative finding from the survey is that corporate divestitures are now overwhelmingly more about strategy than survival. According to the survey, fully 81% of the executives (up from 68% in ’10) said that pruning non-core assets was part of their strategy and was not influenced (read: “dictated”) by either the need to raise capital or to divest non-performing assets. Said another way, responders now mostly view their divestiture plans as being strategically, rather than purely financially, motivated. This is good news, folks.

Is it then safe to say that this new corporate confidence is indicative of an economic recovery?  I don’t know if I’d go that far, but certainly stronger corporate balance sheets with cash reserves at an all time high have emboldened many of my fellow corp dev execs to believe that they control a bit more of their own destiny when it comes to divestitures.

To me, the other interesting corporate development finding from the survey is that private equity seems to have lost additional favor as buyers of corporate assets. Only 31% of respondents (down from 42% in 2010) said their companies “prefer” or “somewhat prefer” to deal with private equity buyers. The majority (59%) would prefer to sell to a domestic corporation, of course.

Why the relative knock on private equity? My guess is that the slowed rate of private equity activity during the same time period is responsible. There is currently over a trillion dollars of unused capital on the private equity sidelines and, although there is also now a palpable urgency to deploy this dry powder, out of the market means out of favor with sellers. Plain and simple.

You can find the full survey and report here.

Posted by: Mory Watkins

You Can Lead A Horse To Water…

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Here’s something you don’t read every day in an S-1…

“Institutional Venture Partners IV, L.P. is compelling us to register the shares of Class A common stock offered hereby by exercising demand registration rights. While we intend to comply with our obligations under the Master Rights Agreement, our board of directors and executive officers believe that filing the registration statement of which this prospectus is a part and effecting an initial public offering of our Class A common stock are not in the best interests of Applied.”

Huh? I guess you can lead a horse to water, but you can’t make it drink.

This is buried in the Risk Factors section of an S-1 filed by medical device company Applied Medical Corporation, whose largest outside shareholder is Institutional Venture Partners. It seems that IVP is exercising its “demand rights”, where it can contractually obligate AMC to register its shares for a later sale to the general public. The notable thing here, of course, is that AMC, its board, and its management seemingly don’t want to go public…and that raises some very interesting questions. How do you do a roadshow with a company that publicly says, “But seriously, folks, we don’t think this a good idea.”

To be sure, you rarely (if ever?) see an investor force the demand registration issue so visibly against the will of the company. IVP says they and their institutional investors simply need to realize on this investment — quite a damning indictment of the pressure institutional investors are currently under to get liquid. But there’s certainly a lot more to it than that. How the company and its investor got to this point is a story within itself with, of course, all the assorted and sundry lawsuits too.

What I find most notable about this story from a corporate development perspective, however, is AMC’s overt aversion to going/being public. The hassles and costs of being public are well documented – a 2012 survey by E&Y shows that it adds over $2.5 million to the average company’s cost structure. AMC’s board and management clearly think that there’s more (ostensibly longer term) value in remaining private and, as implied by their CEO, continuing to groom the company for sale to a strategic buyer. Ironically, they’re now made to say this publicly.

In these types of situations, I normally say to understand the real story all you have to do is follow the money. Here, exceptionally, there are two diametrically opposed views on the best path to ROI, and the story is still evolving. I’ve never seen a rider-less horse be made to drink, but you never know…

Posted by: Mory Watkins

Roll-Ups (Part Two)

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Someone a lot smarter than me once said that there are only 3 ways to make money in roll-ups – improve your margins, use leverage, and arbitrage the difference between private and public markets. Today, I’m going to delve a bit into the first roll-up value creating strategy: improving margins.

I worked for a pretty conspicuous roll-up of a B2B distribution vertical. We started as a so-called “poof” roll-up, and then grew at one of the fastest rates in US business history, joining the Fortune 500 from nothing just three years from start-up. We achieved this amazing growth by buying literally hundreds of smaller and mom & pop companies. Practically overnight, we gained a dominant market share position and “assembled” a company worth billions out of all those acquisitions. Along the way, we also helped bring roll-ups into vogue as a business strategy, and we revolutionized the way roll-up methodology is now applied to highly fragmented industries. In short, nobody previously had ever bought so many smaller companies so quickly.

The real magic, and the secret to our success (in my opinion), was our message. It was particularly cogent. The communication of our strategy was persuasive to our sellers, compelling them to let us buy them, and it made intuitive sense to our investors, who provided us plenty of capital to execute our roll-up strategy. We did a great job of getting across to the market the benefits of joining together.

This was essentially our message: We will begin to double the profitability of the companies we buy from day one — a pretty bold statement. You might fairly ask, “How were you able to do that?” The answer: via in-the-bag efficiencies and cost savings. You see, the average target company in our niche had about 5% cash flow (that is, the ratio of trailing, adjusted cash flow to revenues was usually about 5% or 500 basis points). Admittedly, not too exciting profitability. But, as buyers, we brought a couple important things to the table:

  • More Buying Power: Purchasing discounts we negotiated from our suppliers due to our sales volume typically would lower the COGS of our acquisitions at least 400 basis points in terms of cash flow. Buying better makes a huge difference for a small company.
  • Lowered Facilities Cost: By using a nationwide hub-and-spoke system, most of our acquisitions were able to give up or share a warehouse or some other facility with a nearby sister company under our umbrella. The savings from facilities were less immediate, but they were very certain. The savings could reasonably be expected to average around 300 basis points in terms of cash flow, ceteris paribus, when all was said and done.
  • Lower Administrative Costs: As a multi-billion dollar public company, we were able to negotiate better rates from providers for everything from long distance to insurance. The collective savings in administrative costs were typically at least 200 basis points in terms of cash flow.
  • More Products/More Customers: Most of our acquired companies experienced an immediate boost in sales as a result of now selling more products, carrying more SKUs, and getting more sales leads and cross-selling opportunities as a result of becoming part of a larger company. The immediate, collective revenue boost from these factors was typically at least 100 basis points in terms of cash flow.

There you have it – a full 1,000 basis points improvement in the cash flow/revenues ratio (and those aren’t even all the savings/improvements we promised). We told our sellers and investors that if we were even half right, we would still double the profitability of the companies we bought…and it was true.

And how much value did we create doing these acquisitions? Well, add up all the newly acquired and newly created cash flow and then multiply it times the private market (target) and public market (acquirer) differential. Answer: a lot. And a pretty nifty arbitrage, to say the least.

Posted by: Mory Watkins

Roll-Ups (Part One)

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In corporate development, it often makes sense to buy a company or a competitor for strategic reasons. On occasion, it makes sense to roll-up several, dozens, or hundreds of companies in order to consolidate a niche, a market, or even a whole industry.

I’ve always found it interesting that the term “roll-up” waxes and wanes in terms of its political correctness. Why, to some, is there something inherently distasteful about one company gobbling up a bunch of others?  Is it too greedy? Is it unfair? Does it put too many people out of work?

I’m an unapologetic big fan of roll-ups. I like them as a business strategy, I think they create value for shareholders, and I think they’re consistent with the purest definition of capitalism wherein markets are competitive and the strongest survive. Bigger is often simply better.

Furthermore, no matter what you care to call them, there always have been and there always will be roll-ups. They are sometimes called an aggregation, or a consolidation, or a build-up. Virtually any series of strategic acquisitions, bolt-on acquisitions, or vertical acquisitions could really be called a roll-up. As long as it is more advantageous for businesses to combine than remain apart, there will always be roll-ups – no matter what they’re called.

More than any other factor, industry conditions dictate the terms for roll-ups, of course. There are dozens of reasons why an industry or niche may be ready to consolidate. Perhaps the market is just mature; there is too much capacity and industry participants are struggling financially. Or maybe capital investment has given certain participants advantageous access to a new, game-changing technology. Or, as was the case for a roll-up I recently worked for, changes in government regulation have created an opportunity to roll-up a specific niche.  Any number of industry circumstances could compel companies to strategically align via a roll-up.

Some industries are simply (and empirically) ready to consolidate. Another of my former employers was rapidly rolling-up a B2B industry niche. We bought literally hundreds of mom and pop operators. During my nearly four-year tenure with the company, I never made a single out-bound sales solicitation to a target. You heard that right — every company we bought came to us.  And if that isn’t the definition of a roll-up in a market that is ready to consolidate, I don’t know what is.

Next time, more on roll-ups…

Posted by: Mory Watkins

Middle Market M&A Activity Update

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Today, a quick update on Middle Market (Enterprise Value less than $500M) M&A Activity…

First, the Private Equity Headlines:

  • PE is “leaner” these days, and Middle Market deal volume is lower (1,290 deals announced for LTM Q2 2012; low water mark was 798 in 2009 and high water mark was 1,506 in 2007);
  • From PE perspective, the story is lots of dry powder ($423B) + few good deals = high multiples (the average Enterprise Value/EBITDA multiple is now 8.2x compared to 5.4x in 2009);
  • Also contributing to the high multiples, strategics too have lots of dry powder (cash holdings for the non-financial S&P 500 = $1.2T)

Second, the overall Middle Market Headlines:

  • There were 7,150 deals done ($176B in value) in LTM Q2 2012; this is down 8% and 6%, respectively, from the same period in 2011.
  • Lackluster activity is somewhat surprising given amount of dry powder (both financial and strategic) and prospect of ’12 raise in capital gains.

I would only add that the PE figures above are consistent with the story from PE firms I’m in contact with.  Most are trying to maintain their discipline and believe that deal flow will not return and capital will continue to remain on the sidelines until macro economic confidence increases a bit more.

(The source for all of this information is Thomson Financial. You can find the full report here.)

Posted by: Mory Watkins

Minority Interests

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Over the years, I’ve seen some pretty shrewd minority deals done. A minority interest can be a less risky, more efficient, and cheaper means of making an acquisition than a controlling interest, particularly when they are negotiated in conjunction with an option to purchase a controlling stake later. Corporate investors often acquire minority interests in companies for exactly the same strategic and economic reasons they acquire controlling interests — access to new products, markets, technology, people, etc. Today I’ll touch on some of the valuation theory and accounting I consider during the acquisition of minority interests.

The valuation and related analyses for a minority interest acquisition are virtually the same as for acquiring the whole entity, except calculations are pro rata, of course. The same methodologies also apply when analyzing accretion/dilution (keeping in mind that balance sheet and P&L treatments may differ according to how much of the target is acquired and whether “control” is established).

Don’t forget, however, that when making a minority investment two important valuation discounts apply:

Discount for Lack of Control: Since minority ownership interests at less than 51% often lack sufficient voting power to control operations, minority shares are inherently less valuable than controlling interests. Minority interests will be valued at significantly less than their pro rata proportion of the entire business. A good rule of thumb is that the average discount for lack of control is about 30 percent less than the value of controlling shares.

Discount for Lack of Marketability: If the minority investment is in a private company, an additional issue is raised. An ownership interest in a business is always worth more if it can be easily sold than if it cannot, and lack of marketability must also be factored into determining the value of a minority interest. A good rule of thumb is that the value of private minority shares should be reduced by an additional 30 to 50 percent relative to the value of controlling shares.

In regards to accounting treatment, a corporate acquirer must account for its minority ownership interest via the cost, the equity, or the acquisition method. The choice of method depends upon how much the acquiring company owns and whether it has control:

If the acquirer owns less than 20 percent of another company’s stock, it uses the cost method for the investment. If it owns between 20 percent and 50 percent, it uses the equity method. These two methods, however, do not lead to actually consolidating the financial statements.

When the acquirer owns over 50 percent of another company, it uses the acquisition method and must consolidate the financial statements. When consolidating, the subsidiary’s equity accounts are eliminated, a non-controlling interest account is created (if it is non-control), the subsidiary’s balance sheet accounts are adjusted to FMV, and goodwill is recognized.

So, minority interests have a lot of positives, but you’ve got to be mindful of (and price in) the associated lack of control and the illiquid nature of minority interests. You also must understand that the accounting presentation (and therefore the accretion/dilution properties) of a minority interest investment will vary according to ownership level and influence.

Posted by: Mory Watkins

Accretion Shortcuts

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Today, a brief posting about shortcuts and practical rules of thumb for figuring out whether a prospective transaction might be accretive or not.

I’ll go ahead and give my caveat emptor right now — these shortcuts are only useful when there’s one type or source of consideration. Well, they can also be used to run sensitivity analysis to establish the relation between accretion/dilution and different types of consideration — but whenever a deal has a mix of consideration, you must follow the complete  analytical process I’ve already described in previous postings (and again summarized below).

So, recall that there are three major ways to pay for a target, each with its own effect on EPS:

  • Cash: foregone interest
  • Debt: new interest paid
  • Stock: dilution due to new shares issued

An All Cash Deal is likely to be accretive if the foregone interest expense is less than the seller’s pre-tax income.  Foregone interest expense may be calculated by multiplying the cash investment rate times the purchase price.

An All Debt Deal is likely to be accretive if the new debt interest expense is less than the seller’s pre-tax income.  New debt interest expense may be calculated by multiplying the interest rate times the new debt (very much the same concept as the All Cash Deal).

An All Stock Deal is likely to be accretive if the buyer has a higher PE ratio than the seller. Here, the buyer is effectively buying “cheaper” earnings.

These methods use differences in consideration to project whether you’re likely to be getting more than you’re paying, all other things being equal.

Unfortunately, there is no shortcut for analyzing accretion if consideration is a mix. You must go through the whole process as described in previous postings:

  • Calculate the EPS effect of each part of consideration (foregone interest, new interest paid, new shares issued);
  • Combine the P&Ls and estimate revenue and cost synergies;
  • Combine the balance sheets and allocate the purchase premium;
  • Step up PPE and expense the projected new depreciation;
  • Write up Intangibles and expense the projected new amortization;
  • Calculate new DTLs.

Done carefully and correctly, this process provides a reasonable preliminary accretion analysis.

Next time, I’ll discuss some of the theory and accounting behind the acquisition of a minority interest.

Posted by: Mory Watkins