Leverage – the favorite son of an efficient capital structure has become the bane of those who relied too heavily on easy flowing, low cost financing. As it turns out in this new economy, the malt flavored punch is proving just as toxic as that served to investors in real estate and virtually every other asset class on the planet. Now, with an almost unprecedented deleveraging of the economy, malt beverage distributors find themselves in a world where financial uncertainty is higher and growth is less visible than at anytime in living memory. Consequently, there have been fewer transactions, less available credit, and ultimately lower valuations for the entire distributor space.
We are not surprised given our wealth of transaction and valuation knowledge amassed from thousands of engagements across hundreds industry platforms and niches during decades of service to business owners and their advisors. The valuations implied by many transactions in the past decade simply never reconciled to the financial realities of the broader marketplace. Much of the guiding information communicated to distributors appeared, from a valuation perspective, to stretch the bounds of reasonable and sustainable expectation. Yet, these transactions helped establish unrealistic valuation norms through a dangerous cocktail of rules-of-thumb and excessive debt. Yes, there have been voices calling for a better understanding, but like the rest of the business world, times were just too busy and the perceived needs and opportunities too great to stand still long enough to hear the encroaching tidal roar. Now we find ourselves in the wake of that great flood with a house whose foundation may be compromised.
What can beer distributors learn from the postmortem? Lots. We submit that a more thorough and comprehensive understanding of business valuation concepts and vocabulary is required to better appreciate the lessons of this recent past, as well as to anticipate the future that will likely unfold for many beer distributors. Therefore, we respectfully offer (from a valuation perspective) the following valuation framework and observations for deciphering the past and anticipating the future.
Regardless of the industry space or business model one may own or manage, the talk at industry trade functions and the casual exchanges with colleagues and pundits often includes rumors about who recently sold their business and for what sum. Drink the malt industry brew and you are likely to witness at least one small fish morph into Moby Dick via a mistaken rule of thumb. This is not a unique phenomenon. Ask the car dealers, the bankers, the internet service providers (among others) about their former rules of thumb. Thankfully, the misfortune that engulfed those industries does not appear absolute for beer distributors, but the lessons are loud and clear. No business model is immune from the forces of market and financial evolution. Just when and who first described a transaction value of a malt beverage distributor using rules of thumb is difficult to pinpoint. But the first misuse of these rules surely occurred at the exact same moment.
What is a rule of thumb? WIKIPEDIA offers the following definition:
A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.
Those familiar with WIKIPEDIA know that it is a collaborative, web-based amalgam of its users’ and contributors’ collective wisdom. Consequently, anything found there is subject to constant review, revision and qualification. Too bad the same principle has not been true of the rules of thumbs for transacting a beer distributorship. From a business valuation perspective, we offer the following addendum to the definition of a rule of rule of thumb:
A business valuation rule of thumb is a simplified metric that converts a financial or operational measure of performance to a value for the subject business. Unless specifically qualified otherwise, a business valuation rule of thumb expresses the value of 100% of the tangible and intangible assets of the enterprise as such would be normally included in a transaction.
If you have a pulse, let alone a multi-million asset at stake, you should have many questions about the origin of any rule of thumb and the specific application of that rule to your business. Let us take this moment to introduce the basic representative equation of business value:
V = P x M
P = A Measure of Profitability
M = Multiple (or Capitalization Factor)
Value is the product of some measure of profit times some multiplier of that profit. This formula appears relatively simple. However, the first mistake is taking this formula for granted. There are numerous underlying definitions and qualifications that must be understood for the results of this equation to be properly framed for the specific question being posed.
The most common rules of thumb for beer distributors use gross profit and/or case volume. Substituting these measures into the basic value equation results in the following equations:
Value = Case Volume x Multiplier
Value = Gross Profit x Multiplier
Simple enough, right? But wait. As beer distributors, don’t countless questions immediately spring to mind?
The combination of answers can result in a far more complicated assessment than the simplicity of the equation suggests. Referring back to the basic value equation, the same questions apply – the vocabulary is simply different and the interaction of the volume/profit measure and the multiplier are highly dynamic because each element of the equation can influence the appropriateness of the other. For example, the use of an adjusted or forward looking measure of case volume or gross profit (assuming growth is occurring) might require a modestly conservative view of the multiplier. Conversely, the use of a conservative volume or profit measure from an unfavorable year might suggest a slightly higher multiplier to capture the upside potential to right-size distributor performance in the market.
Given the prevalence of rules of thumb and reliance on a relatively small universe of advisors and brewery resources, it seems many beer distributors have had little interest in understanding the language and concepts of business valuation. Now that beer distributors are becoming less immune and less differentiated from other distribution platforms (economically that is), they are more curious about the basics of the valuation discipline than ever before. Let’s use the basic valuation equation and pose an abbreviated list of similar questions as noted above but use the vocabulary of a business valuation practitioner. The scope of possible questions and the responses to them include some potentially unfamiliar concepts to distributors and their shareholders but they are critical in order to understand the valuation placed on a given distributorship as a whole or for an ownership interest therein.
Regardless of the rules of thumb used to describe a transaction, these metrics (i.e. case volume or gross profit) can be translated into more meaningful financial expressions. These translations are useful because they can reveal important variables and identify potential sources for common valuation mistakes. Judging from the legacy of transactions represented on the balance sheets of a great many distributors, there has been rampant misunderstanding in determining how much to pay and what the consequent return on investment would be.
The most common (and most crude) distributor valuation rule of thumb is value per case. A common rule of thumb for the value of total assets for a domestic brew house distributor has been approximately ten times annual case equivalent volume (historically speaking). Referring to regularly compiled data reported by Risk Management Associates (“RMA”) and the National Beer Wholesaler Association (“NBWA”), we can make some basic assumptions about a “typical” beer distributor. Such a distributor (statistically) might have an annual case volume of 2.5 million, with net sales of $30-$35 million and a gross profit margin of approximately 25%. Many have a reported earning before interest, taxes, depreciation, and amortization (EBITDA) margin of approximately 5%, but in our experience, this can vary greatly. Often, the transactions between distributors are premised on adjustments to EBITDA on the order of 2%-5% of sales (shareholder compensation) increasing the adjusted EBITDA margin to approximately 8% (if not more). At this level of cash flow, a typical distributor would be expected to deliver $1.00 of EBITDA per case (+/- 8% EBITDA margin 0n net sales per case of approximately $13.50).
Based on the financial profile of a typical distributor, $10 per case translates to a total transaction value of $25 million. Based on an 8% EBITDA margin, the typical distributor would be producing on the order of $2.6 million in adjusted EBITDA. Based on a 25% gross margin, the same distributor reports $8.1 million in gross profit, corresponding to the other commonly used rule of thumb: three to four times gross profit. However, the gross profit rule of thumb implies multiples of EBITDA (10x in this example) that are higher than similar-sized transactions across numerous small-to-middle market sized companies in various industries (typically 5x EBITDA). There may be sound reasons to explain somewhat higher multiples than often exist for many other small-to-mid-market sized businesses, but such reasons should be compelling.
From a valuation perspective, only two underlying characteristics can explain a value at 10 or more times EBITDA: 1) exceptionally low risk, and/or 2) significant growth potential. In the malt beverage world, growth rates in volume and profit are typically limited to inflationary pricing growth and 1%+/- for population growth and other territory factors. Given the rarity of high growth as a supporting rationale for such high multiples, the only value attribute remaining is risk, uncommonly low risk. The assessment and quantification of risk is beyond the scope of this article. However, it should be obvious that the economics commonly applicable to a broad range of industries, some with attractive risk and growth attributes, simply do not correlate to the valuations often paid in beer distributor transactions, either for brand rights or for total assets. Accordingly, a rule thumb at 10 or 12 or higher times case volume seems questionable without unique circumstances. There are always exceptions, but they are few and far between. Ultimately, it is no surprise that recent transaction activity reflects lower valuation multiples than those of the last many years. What is surprising is that it took the worst financial crisis in 75 years to alter valuations in the malt distributor space.
Unfortunately, rules of thumb are not just the folly of the industry but can become habitual in the financial valuation arena as well. It is relatively easy for financial assumptions to become bogged down through the use of near universal assumptions regarding rates of return, capital structure assumptions, and growth rates. Through the years we have had the benefit of reviewing numerous appraisals. As with all analytical works, particularly those requiring elements of judgment, some of these reports have been sound and some, in our view, have been lacking in documentation, clarity, and/or reasonableness. Often, valuation issues emerge from a combination of almost ubiquitous assumptions concerning rates of return and growth rates that often do not reconcile to the transactions and realities of the market place.
A brief example involves the assessment of a near universal cost of capital on the order of 10% and extremely low growth rates. True, growth at the top line of the malt beverage industry is not sexy. That’s why the call of the day for brewers and distributors is consolidation, because defense of margin and prospective growth are largely reliant on increasing efficiencies. It’s true that margin pressures for distributors have been acute in recent years reflecting periods of unusual fuel costs, price competition, declining volumes, and other factors. Ultimately though, a 1%-2% growth rate for cash flow falls short of reconciling to the gross profit and case multiples of even some of the most conservative valuations. Yet in many valuations, 10% seems to be the universally adopted total cost of capital and low growth rates are predominant. The low growth treatments are not so troubling but there are exceptions based on the level of cash flow being used and the nature of the individual distributor being valued.
For example, low-volume growth in a highly leveraged distributor does not automatically equate to low-earnings growth since earnings can increase as debt is retired. Even flat to low growth in cash flow (EBITDA) can facilitate a healthy pace of loan repayment. Based on the realities of present value math, near term earnings growth via the amortization of debt can have a meaningful effect on value which under many valuation methods may best be captured through an appropriately higher growth rate in earnings than might be reasonable for revenue or cash flow.
The capitalization rate resulting from a 10% cost of capital and a 1% growth rate is 9% (10% less 1%% = 9%). The reciprocal of that capitalization rate is a cash flow multiplier of 11.1. Assuming a hypothetical norm of annual net cash flow (after taxes) on the order of $1 million (based on “normal” margins and normal cash flow sources and uses for a typical 2.5 million case house) the 11.1 multiplier explains only half of the valuation such a distributor’s total assets (warehouse, fleet, inventory, brand rights, etc.) would receive. In our example, that’s less than two times gross profit and less than five dollars per case. The primary financial reconciliation of historical deals and historical valuation norms includes a lower cost of capital or a higher growth rate for cash flow, or some combination of both. We’re not suggesting that a 25 multiplier of cash flow is typical, but in relation to $25 million valuation for a 2.5 million case wholesaler, that’s what it would take. Often net cash flow is somewhat higher than our example (via adjustments), and the use of a much higher debt structure in the deal provides the underpinning for the historical financings and valuations we have witnessed for brand and territory acquisitions. Tweaking the cash flow up by 20%, adjusting the capital structure to include more low-cost debt, and using a higher growth rate for net cash flow will collectively explain many of the historical deals. Ultimately, paying more to get a deal done equates to compromising the buyer’s rate of return on the investment.
The additional value push under many historical valuations came from buyers giving their sellers most, if not all, of the synergies of the deal. In the eyes of many strategic buyers are operational and financial enhancements that can increase value. Many of these synergies are limited for financial buyers. Additionally, and perhaps questionable, is the assumption that the IRS will help buyers pay for part of their bite at the apple. The booking of a transaction facilitates a purchase price allocation that provides for favorable tax treatment, namely the amortization of distribution rights over a 15 year period. The most valuable asset for most beer distributors is distribution rights. Using our $25 million example deal, it might not be unusual to see $15 to $20 million in booked distribution rights. Over a 15 year period this can shelter upwards of $1.3 million in annual earnings from income tax. Using typical tax rates, this equates to $500,000 annually in saved taxes for 15 years that can be used to service debt. Until recently, lenders were too happy to oblige and distributors seemingly used this source of cash flow to over-borrow and thus to overpay. However, the notion of a 40% break on the rights portion of the deal and the reality of the time value of money simply don’t reconcile. In truth, the present value of this tax benefit is only about half of the perceived $7 million benefit implied by common observation (40% of the rights). So, not only were buyers dealing away an inflated perception of the tax benefit, perhaps they were giving it all away. Based on our $25 million deal, we would estimate this misunderstanding to explain a portion of the over-valuation in many deals, albeit, a strategic buyer’s compulsions often result in making compromises to get a deal done.
It is important to understand that our perspectives on value are steeped in the concept of fair market value. Fair market value is a concept of financial value in a rational and hypothetical world without unique compulsions for either buyers or sellers and where both are imbued with equal knowledge and negotiating power. In the strategic world, there is often an exception to the fair market value concept. People do things because they are uniquely inclined to do.
While the observations in this piece may seem adverse to the interests of distributors who are seeking to maximize their valuations – fear not. The world has simply changed, and while valuation expectations should be reined in a bit, understanding the financial and financing realities of this market are key to positioning your business for its best result in the market. There are still many valuable franchises in this space. In addition to optimizing your distributorship’s sales and operations, you should seek feedback on the state of your valuation so that expectations may be better aligned with emerging market conditions. Feel free to contact me with your questions and/or comments.
Originally published September 2009.