Equity-based compensation has been a key part of compensation plans for years. When the equity compensation involves a publicly traded company, the current value of the stock is known and so the valuation of share-based payments is relatively straightforward. However, for private companies, the valuation of the enterprise and associated share-based compensation can be quite complex.
The AICPA Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes four criteria that should be considered when selecting a method for valuing equity securities:
With these considerations in mind, let’s take a closer look at the four most common methods used to value private company equity securities.
The Current Value Method estimates the total equity value of the company on a controlling basis (assuming an immediate sale) and subtracts the value of the preferred classes based on their liquidation preferences or conversion values. The residual is then allocated to common shareholders. Because the CVM is concerned only with the value of the company on the valuation date, assumptions about future exit events and their timing are not needed. The advantage of this method is that it is easy to implement and does not require a significant number of assumptions or complex modeling.
However, because the CVM is not forward looking and does not consider the option-like payoffs of the share classes, its use is generally limited to two circumstances. First, the CVM could be employed when a liquidity event is imminent (such as a dissolution or an acquisition). The second situation might be when an early-stage company has made no material progress on its business plan, has had no significant common equity value created above the liquidation preference of the preferred shares, and for which no reasonable basis exists to estimate the amount or timing of when such value might be created in the future.
Generally speaking, once a company has raised an arm’s-length financing round (such as venture capital financing), the CVM is no longer an appropriate method.
The Probability-Weighted Expected Return Method is a multi-step process in which value is estimated based on the probability-weighted present value of various future outcomes. First, the valuation specialist works with management to determine the range of potential future outcomes for the company, such as IPO, sale, dissolution, or continued operation until a later exit date. Next, future equity value under each scenario is estimated and allocated to each share class. Each outcome and its related share values are then weighted based on the probability of the outcome occurring. The value for each share class is discounted back to the valuation date using an appropriate discount rate and divided by the number of shares outstanding in the respective class.
The primary benefit of the PWERM is its ability to directly consider the various terms of shareholder agreements, rights of each class, and the timing when those rights will be exercised. The method allows the valuation specialist to make specific assumptions about the range, timing, and outcomes from specific future events, such as higher or lower values for a strategic sale versus an IPO. The PWERM is most appropriate to use when the period of time between the valuation date and a potential liquidity event is expected to be short.
Of course, the PWERM also has limitations. PWERM models can be difficult to implement because they require detailed assumptions about future exit events and cash flows. Such assumptions may be difficult to support objectively. Further, because it considers only a specific set of outcomes (rather than a full distribution of possible outcomes), the PWERM may not be appropriate for valuing option-like payoffs like profit interests or warrants. In certain cases, analysts may also need to consider interim cash flows or the impact of future rounds of financing.
The Option Pricing Model treats each class of shares as call options on the total equity value of the company, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, common shares would have material value only to the extent that residual equity value remains after satisfaction of the preferred stock’s liquidation preference at the time of a liquidity event. The OPM typically uses the Black-Scholes Option Pricing Model to price the various call options.
In contrast to the PWERM, the OPM begins with the current total equity value of the company and estimates the future distribution of outcomes using a lognormal distribution around that current value. This means that two of the critical inputs to the OPM are the current value of the firm and a volatility assumption. Current value of the firm might be estimated with a discounted cash flow method or market methods (for later-stage firms) or inferred from a recent financing transaction using the backsolve method (for early-stage firms). The volatility assumption is usually based upon the observed volatilities of comparable public companies, with potential adjustment for the subject entity’s financial leverage.
The OPM is most appropriate for situations in which specific future liquidity events are difficult to forecast. It can accommodate various terms of stockholder agreements that affect the distributions to each class of equity upon a liquidity event, such as conversion ratios, cash allocations, and dividend policy. Further, the OPM considers these factors as of the future liquidity date, rather than as of the valuation date.
The primary limitations of the OPM are its assumption that future outcomes can be modeled using a lognormal distribution and its reliance on (and sensitivity to) key assumptions like assumed volatility. The OPM also does not explicitly allow for dilution caused by additional financings or the issuance of options or warrants. The OPM can only consider a single liquidity event. As such, the method does not readily accommodate the right or ability of preferred shareholders to early-exercise (which would limit the upside for common shareholders). The potential for early-exercise might be better captured with a lattice or simulation model. For an in-depth discussion on the OPM, see our whitepaper A Layperson’s Guide to the Option Pricing Model at mer.cr/2azLnB.
The Hybrid Method is a combination of the PWERM and the OPM. It uses probability-weighted scenarios, but with an OPM to allocate value in one or more of the scenarios.
The Hybrid Method might be employed when a company has visibility regarding a particular exit path (such as a strategic sale) but uncertainties remain if that scenario falls through. In this case, a PWERM might be used to estimate the value of the shares under the strategic sale scenario, along with a probability assumption that the sale goes through. For the scenario in which the transaction does not happen, an OPM would be used to estimate the value of the shares assuming a more uncertain liquidity event at some point in the future.
The primary advantage of the Hybrid Method is that it allows for consideration of discrete future liquidity scenarios while also capturing the option-like payoffs of the various share classes. However, this method typically requires a large number of assumptions and can be difficult to implement in practice.
The methods for valuing private company equity-based compensation range from simplistic (like the CVM) to complex (like the Hybrid Method). In addition to the factors discussed above, the facts and circumstances of a particular company’s stage of development and capital structure can influence the complexity of the valuation method selected. In certain instances, a recent financing round or secondary sale of stock becomes a datapoint that needs to be reconciled to the current valuation analysis and may even prove to be indicative of the value for a particular security in the capital stack (see “Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity” on page 6). At Mercer Capital, we recommend a conversation early in the process between company management, the company’s auditors, and the valuation specialist to discuss these issues and select an appropriate methodology.
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
To the lay person, transportation may seem like the farthest end of the spectrum from the technology industry – telephone orders and paper shipment tracking. But those in the know understand just how tech-enabled the industry has become. Advancements in machine learning, artificial intelligence, and predictive technology could have the power to disrupt the way goods are transported, stored, and tracked. And investors are clearly willing to take bets on that.
Over the past few years, FreightTech has emerged as its own category of technology. The level of excitement in the space grew in 2018 as global venture capital investment increased to $2.9 billion from $1.3 billion the prior year. FreightTech is on track for another year of exponential growth in 2019, with $1.6B of funding raised in the first quarter alone.
The willingness of industry participants to adopt logistics technology is evident as well. Corporate players and major OEMs have spun up innovation departments, startup accelerators, and investment arms in order to find and fund new technology. However, it’s not only the companies that directly benefit from this technology that are investing capital in the space. Technology players recognize the potential for returns on transportation investments, too. Alphabet’s venture capital arm, Capital G, led a $185 million investment in Convoy, a tech-enabled freight matching startup, at the end of 2018. The Series C round valued Convoy at $1.0 billion and brought the company’s total capital raise to $265 million. Softbank Vision Fund, known for making big bets on disruptive technology, got in on the game too. The fund invested $1.0 billion in Flexport, a digital platform for freight forwarding and logistics, at the start of the year. The investment valued the company at $3.2 billion.
The table below shows the five largest North American FreightTech investments in the first quarter of 2019 by round size.
Investment in FreightTech has not only grown in terms of aggregate investment, but the average size of deal rounds has increased as well, mirroring the trends in the overall venture capital landscape. According to Morningstar, the average round size for a Series B round in the FreightTech industry increased 78% from $24.5 million in 2014 to $43.6 million in 2017.
The classification of transportation and logistics startups differs, but it is clear that there is growing innovation in many different facets of the industry. It is evident that technological change in the freight transportation industry is about far more than just digitizing processes that once involved paper or fax machines. The application of advanced data and analytics to the transportation and logistics industry has the potential to change the global movement of freight.
Originally published in the Value Focus: Transportation & Logistics, First Quarter 2019.
I recently attended the 2019 Spring Conference of the National Auto Dealers Counsel (NADC) in Dana Point, California. This article provides a couple of key takeaways from the day and a half sessions on the current conditions in the industry.
Car subscription services are becoming a popular alternative to leasing. Each service varies in structure and is operated by dealers, manufacturers, and third parties. Some offer reasonable traditional leases or allow customers to make monthly payments, but allow more flexibility/frequency in swapping vehicles for changing preferences and needs.
Some manufacturers are only initially offering subscription services regionally, or in specific markets (BMW and Mercedes-Benz are offering vehicle subscription services in the Nashville market).
There has been a lot of talk in the news recently about impending tariffs in the auto dealer industry. Many unknowns and questions remain—Will President Trump enact tariffs? How will they affect the auto industry?
The Center for Automotive Research Report has compiled statistics to show the likely effects of tariffs on new/ used vehicle pricing, estimated losses for dealers, and projected employment and GDP loss (as seen below). With so much at stake, the auto dealer industry will keep a close eye on monitoring any new developments.
Amid the many changes that have resulted from the recent tax reform (the Tax Cuts and Jobs Act (TCJA)), here are a few directly impacting the auto dealer industry:
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2018.
This article explains dealership metrics and performance statistics–what they mean, how to evaluate them, and where a particular store stacks up. As always, performance measures are relative. We are relying upon averages provided by NADA as well as our experience working with auto dealers.1
A few key terms help frame our discussion:
Specifically, we are relying upon information from the average dealership profile for 2017 and 2018 from NADA.2
For the average dealership profile, our experience has been that this department comprises between 50% – 60% (58% for 2017-2018 per NADA) of total gross sales. The front-end gross margin on new vehicles can vary over time and is somewhat controlled by the manufacturer. Typically, dealerships track and measure front-end gross margin on a per unit basis and can evaluate the overall performance of that figure by comparing it to prior years. Most domestic, import, or luxury dealerships experience a lower front-end gross margin on new vehicles than on used vehicles. Conversely, most high-line dealerships experience a higher front-end gross margin on new vehicles than on used vehicles.
New vehicles generally have a higher average retail selling price, lower front-end gross margins, and sell fewer units than used vehicles. These factors result in new vehicles comprising approximately 25% of total overall gross profits for an average dealership.
For the average dealership profile, our experience has been that this department comprises between 25% – 40% of total gross sales. These percentages can vary depending on franchise/dealership type and regional location. Like new vehicles, dealerships also track frontend gross profits on used vehicles on a per unit basis. Most domestic, import, or luxury dealerships experience a higher front-end gross margin on used vehicles than on new vehicles.
The sale of used vehicles should not be overlooked when assessing the value of a dealership. More often than not front-end gross margins on used vehicles will be higher than new vehicles. Additionally, the sale of both new and used vehicles put more cars in service and help drive profitability to fixed operations (to be discussed in next section). Based on our experience valuing new car dealerships, the range of used retail vehicles sold to new retail vehicles sold is 1.00 to 1.25. This figure can vary by dealership and can also be quite cyclical throughout the year. Further, our experience shows this ratio can climb to 1.5 to 1.6 when considering dealerships with successful wholesale used vehicle sales.
Used vehicles generally have a lower average retail selling price, higher front-end gross margins, and sell more units than new vehicles. These factors result in used vehicles comprising approximately 25% of total overall gross profits for an average dealership, or about even with the total overall gross profit contribution from new vehicles.
The long-term success of a dealership’s fixed operations is often tied to their effectiveness in selling new and used vehicles over time. These activities help to build brand in a market. Another critical factor in the success and level of profitability in the fixed operations is the auto industry cycle. In our last issue, we discussed the cyclicality of the industry not only in terms of certain months during the year, but also year-over-year.
Two such indicators of the auto industry life cycle are the SAAR and the average age of car. As shown on page 14 of the newsletter, the monthly SAAR began to level off in late 2018 and into the first few months of 2019 (despite a slight spike in March 2019) evidencing slower new light vehicle sales. Additionally, per our previous newsletter, the average age of cars in service was approximately ten years.
Both factors foreshadow that fixed operations of successful dealerships should experience an uptick in the short-term and mitigate the moderate/sluggish new vehicle sales. When customers hold onto their cars longer, they are less likely to spend money on a new or used vehicle, but their maintenance needs on their current vehicle will likely increase.
For the average dealership profile, our experience suggests that the service department comprises between 10% – 15% of total gross sales. However, this department is typically the most profitable in terms of a percentage of sales. The combination of much higher margins on lower sales results in the service department averaging 45% – 50% of total gross profits, or a much higher contribution level than new or used vehicles.
All dealerships are not created equally. This article is a general discussion on various dealership metrics and performance statistics. Each statistic is relative and not to be viewed in a vacuum. Hopefully, we have provided a better understanding of the various departments, including fixed vs. variable operations and their contribution to overall profitability and the eventual value of a store. A graphic display of historical profitability and other metrics are discussed later in the newsletter. For an understanding of how your dealership is performing along with an indication of what your store is worth, contact us. We are happy to discuss your needs in confidence.
1 The data and discussion are based generally on average dealership profiles and do not pertain specifically to domestic dealerships, import dealerships, ultra high-line dealerships, etc. Specific types of dealerships and their regional location could have different performance metrics and criteria.
2 It’s important to note that other national sources of Blue Sky multiple data (Haig Partners and Kerrigan Advisors) classify the categories of dealerships slightly different from NADA, so all comparisons and discussion should be done in general terms.
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2018.
Originally presented at the 2019 AAML/BVR National Divorce Conference in Las Vegas, in this session, Z. Christopher Mercer, FASA, CFA, ABAR delves into more than 30 years of experience presenting complex valuation and damages issues to judges and juries. One of the key ideas of effective communication is the KISS principle, or “keep it simple, stupid.” The question is, how can we do that? Chris provides the techniques and templates necessary to communicate your position, and your opponent’s position, in such a way that judges can hone in on and understand the most important information and why it’s important.
The trucking industry is wedged between a rock and a hard place when it comes to driver recruitment. Trucking companies are simultaneously exploring self-driving technology, while still convincing new entrants to the labor market that commercial driving is a career choice that will pay off. Punctuating the less-than-glamorous work and lifestyle conditions of the occupation, those entering the labor force realize that the career path could be upended in the near-term by the economic cycle and disrupted in the long term by the impending evolution of autonomous transportation. With several companies (like Tesla) beginning deployment of self-driving trucks, and numerous others deep in development of the technology, young workers may fear choosing a vocation that trucking companies are actively planning to automate.
Rob Sandlin, CEO of Patriot Transportation, emphasized these challenges in the company’s third quarter earnings call, “Management spends a good deal of time dealing with these issues surrounding driver shortage, including advertising, recruiting, compensation, dispatcher training and productivity among others.” With the tightening of the labor market, companies have found new ways to attract talent including investments in newer and more reliable assets, in-house training programs, incentive bonuses, and, of course, a simple increase in wages.
Executives at many of the largest trucking companies dedicated time in their third quarter investor calls and presentations to this issue. PAM identified several unique recruitment initiatives in its November corporate presentation. The company is taking advantage of temporary visitor qualifications through the B1 Visa program to increase labor capacity. This program allows commercial drivers with Mexican residence temporary entry to the United States for truck delivery. Additionally, the company’s new driver-friendly initiatives promote lifestyle and career improvements. Its “Driver Life-Cycle” program provides dedicated driver experience with a path towards ownership through a lease-to-own set up.
Patriot mentioned significant changes to its recruitment efforts, as well. “In the latter part of fiscal 2018, we implemented a significant change to our hiring process, we added [a] driver advocate position and introduced productivity-based driver pay, all in an effort to attract and retain drivers. We are encouraged by the increased number of drivers hired and in training since these implementations, and we’ll continue to monitor our progress for any needed adjustments to our plan.”
The driver shortage (which is estimated to reach 108,000 by 2026) has sparked major shifts in the way hiring and training are conducted in the industry. While this shortage will hurt shippers until autonomous technology is fully developed, the long-term problem may actually lie in another labor pool: service technicians.
As new truck designs increase the level of technology on board, those who service them will have to develop more tech-focused expertise. Additional sensors, predictive technology, and, of course, autonomy will evolve the role of the truck mechanic as they start spending more time with computers than wrenches. While technical colleges and certificate programs continue to produce a skilled workforce, the supply of service technicians has not kept pace with the increasing demand.
Trucking companies have had to adapt to the shifting labor force trends and find new ways to fulfill maintenance needs. Like driver scarcity, mechanic shortages have caused companies to seek alternatives to traditional labor sourcing, from outsourcing labor needs to developing training programs.
Overall, employment in the transportation and warehousing industry grew 3.5% from October 2017 to October 2018, adding more than 183,700 jobs. Nearly 37,000 of these jobs were in the trucking industry, which experienced a 2.5% increase in employment over the prior year. The transportation industries are adding jobs faster than the overall non-farm economy, which experienced a more modest 1.7% increase in employment.
Despite labor pressures in the industry, economic activity and transportation demand remain strong. While executives will continue to monitor driver and mechanic shortages, the outlook for trucking in 2019 appears optimistic. John Roberts III, CEO of J.B. Hunt, summed up the industry sentiment well on the company’s third quarter earnings call.
Just final comment on the people side of things. Driver hiring has been a challenge. It’s been a challenge in the past. It presented us with the challenge like we have never seen before this year. In fact, our unseated need number got as high as [it’s] ever been. In about the last 60 days, we’ve seen that number come down a little bit through a number of internal efforts. And I think overall pay in the industry is starting to catch up a little bit. And so I think more people are becoming interested. But we’re making progress there and feel confident we’ll continue to get through that. Good year, some challenges, and frankly, we’re looking forward to heading into 2019.
Originally published in the Value Focus: Transportation & Logistics, Fourth Quarter 2018.
Since Bank Watch’s last review of net interest margin (“NIM”) trends in July 2016, the Federal Open Market Committee has raised the federal funds rate eight times after what was then the first rate hike (December 2015) since mid2006. With the past two years of rate hikes and current pause in Fed actions, it’s a good vantage point to look at the effect of interest rate movements on the NIM of small and large community banks (defined as banks with $100 million to $1 billion of assets and $1 billion to $10 billion of assets).
As shown in Figure 1, NIMs crashed in the immediate aftermath of the financial crisis, primarily because asset yields fell much quicker than banks could reprice term deposits. NIMs subsequently rebounded as the asset refinancing wave subsided while banks were able to lower deposit rates. A several year period then occurred in which asset yields grinded lower at a time when deposit rates could not be reduced. This period was particularly tough for commercial banks with a high level of non-interest bearing deposits.
Since rate hikes started, the NIM for both small and large community banks have increased about 20bps through year-end 2018 before experiencing some pressure in early 2019. The nine hikes by the Fed to a target funds rate of 2.25% to 2.50% amounts to a 225bps increase.
At first pass, the expansion in the NIMs is less than might be expected; however, there are always a number of factors in bank balance sheets that will impact the NIM, including:
Recent incremental pressure on NIMs notwithstanding, community banks’ balance sheets were poised to take advantage of rising rates the past several years. The outperformance of bank stocks beginning in November 2016 reflected several factors, including an economic and regulatory backdrop that would allow the Fed to raise rates further and faster, and thereby support NIM expansion.
The underperformance of bank stocks since last fall reflects investor concern that this tailwind is ending in addition to more general concerns about what a possible economic slowdown implies for credit costs. Telltale signs include the inversion of the Treasury yield curve and yields on the two-year and five-year Treasuries that, as of the date of the drafting of this article, are below the low-end of the Fed Funds target range.
Also, the spot and forward curves for 30-day Libor imply the Fed will cut the Funds target rate and other short-term policy rates one or two times by early 2020 (or stated differently, the December rate hike was a mistake).
The Federal Funds rate, the predominant influence on short-term interest rates, has remained unchanged since year-end 2018 at a target range of 2.25%–2.50% due to concerns about lower inflation figures and what they may forewarn about future economic growth as reflected in falling U.S. Treasury yields. The FOMC reiterated its wait-and-see approach on May 1. However, the sand appears to be shifting beneath the Fed’s feet.
The Wall Street Journal’s most recent Economic Forecasting Survey revealed an increasing belief that the Fed’s next move will be to cut rates. 51% of respondents said that a rate cut would be the next move, up from 44% in April. 25.5% replied that the next rate raise would occur in 2020 or later. Fed officials have maintained their stance that a rate move in either direction will not occur soon.
As deposit costs initially lagged, but more recently moved with short-term interest rate hikes, the composition of a bank’s deposit base and funding structure has become increasingly important. As shown in Figure 4, the percentage of banks experiencing a rising cost of interest bearing deposits has steadily increased. Total funding costs have nearly doubled since year-end 2016 as depositors have reoriented funds toward accounts offering higher rates. Banks searching for funding either must engage in intense deposit competition or tap into higher-cost sources such as wholesale funding.
Going forward community banks may face a modest reduction in NIMs because the yield curve is flat and the cost of incremental funding is expensive. Some community banks will choose to slow loan growth in order to protect margins; others will accept a lower margin. The predicament demonstrates yet again why deposit franchises are a key consideration for acquirers as banks with low cost deposit franchises and excess liquidity are particularly attractive in the current market.
Originally published in Bank Watch, May 2019.
Lucas Parris, CFA, ASA-BV/IA, vice president, co-presented the session, “Employee Benefits Agency Consolidation and Valuation” with Mike Strakhov (Live Oak Bank) at the 2019 Workplace Benefits Renaissance Conference in Nashville, TN (February 20-22, 2019).
A short description of the session can be found below.
Insurance agency merger and acquisition activity has been at historic levels for the past few years. Employee benefit agency transactions represent a significant number of these annually. This session will address the current state of agency consolidation including trends, who’s buying and who’s selling and the overall impact to employee benefits distribution. We’ll also identify and discuss the important characteristics that drive value of an employee benefits agency.
It has been 34 years since the Delaware Supreme Court ruled in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) and thereby made the issuance of fairness opinions de rigueur in M&A and other significant corporate transactions. The backstory of Trans Union is the board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.
Why would the board approve a transaction without extensive review? Perhaps there were multiple reasons, but bad advice and price probably were driving factors. An attorney told the board they could be sued if they did not approve a transaction that provided a hefty premium ($55 per share vs a trading range in the high $30s).
Although the Delaware Supreme Court found that the board acted in good faith, they had been grossly negligent in approving the offer. The Court expanded the concept of the Business Judgment Rule to include the duty of care in addition to the duties to act in good faith and loyalty. The Trans Union board did not make an informed decision even though the takeover price was attractive. The process by which a board goes about reaching a decision can be just as important as the decision itself.
Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties; however, once any of the three duties is breached the burden of proof shifts from the plaintiffs to the directors. In Trans Union the Court suggested had the board obtained a fairness opinion it would have been protected from liability for breach of the duty of care.
The suggestion was consequential. Fairness opinions are now issued in significant corporate transactions for virtually all public companies and many private companies and banks with minority shareholders that are considering a take-over, material acquisition, or other significant transaction.
Although not as widely practiced, there has been a growing trend for fairness opinions to be issued by independent financial advisors who are hired to solely evaluate the transaction as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a fairness opinion.
While the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:
A fairness opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar banks. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders (particularly minority shareholders) provided the analysis leads to such a conclusion.
The fairness opinion is a short document, typically a letter. The supporting work behind the fairness opinion letter is substantial, however, and is presented in a separate fairness memorandum or equivalent document.
A well-developed fairness opinion will be based upon the following considerations that are expounded upon in an analysis that accompanies the opinion:
It is important to note what a fairness opinion does not prescribe, including:
Due diligence work is crucial to the development of the fairness opinion because there is no bright line test that consideration to be received or paid is fair or not. Mercer Capital has nearly four decades of experience in assessing bank (and non-bank) transactions and the issuance of fairness opinions. Please call if we can assist your board.
Originally appeared in Mercer Capital’s Bank Watch, April 2019
The issue of a premium for an S corporation at the enterprise level has been tried in a tax case, and the conclusion is none.
In Kress v. United States (James F. Kress and Julie Ann Kress v. U.S., Case No. 16-C-795, U.S. District Court, E.D. Wisconsin, March 25, 2019), the Kresses filed suit in Federal District Court (Eastern District of Wisconsin) for a refund after paying taxes on gifts of minority positions in a family-owned company. The original appraiser tax-affected the earnings of the S corporation in appraisals filed as of December 31, 2006, 2007, and 2008. The court concluded that fair market value was as filed with the exception of a very modest decrease in the original appraiser’s discounts for lack of marketability (DLOMs).
The company was GBP (Green Bay Packaging Inc.), a family-owned S corporation with headquarters in Green Bay, Wisconsin. The company experienced substantial growth after its founding in 1933 by George Kress. A current description of the company, consistent with information in the Kress decision, follows.
Green Bay Packaging Inc. is a privately owned, diversified paper and packaging manufacturer. Founded in 1933, this Green Bay WI based company has over 3,400 employees and 32 manufacturing locations, operating in 15 states that serve the corrugated container, folding carton, and coated label markets.
Little actual financial data is provided in the decision, but GBP is a large, family-owned business. Facts provided include:
Hoovers provides the following (current) information, along with a sales estimate of $1.3 billion:
Green Bay Packaging is the other Green Bay packers’ enterprise. The diversified yet integrated paperboard packaging manufacturer operates through 30 locations. In addition to corrugated containers, the company makes pressure-sensitive label stock, folding cartons, recycled container board, white and kraft linerboards, and lumber products. Its Fiber Resources division in Arkansas manages more than 210,000 acres of company-owned timberland and produces lumber, woodchips, recycled paper, and wood fuel. Green Bay Packaging also offers fiber procurement, wastepaper brokerage, and paper-slitting services. (emphasis added)
The court’s decision states that the company’s balance sheet is strong. The company apparently owns some 210 thousand acres of timberland, which would be a substantial asset. GBP also has certain considerable non-operating assets including:
GBP was a substantial company at the time of the gifts in 2006, 2007, and 2008. We have no information regarding what portion of the company the gifts represented, or how many shares were outstanding, so we cannot extrapolate from the minority values to an implied equity value.
Plaintiffs James F. Kress and Julie Ann Kress gifted minority shares of GBP to their children and grandchildren at year-end 2006, 2007, and 2008. They each filed gift tax returns for tax years 2007, 2008 and 2009 basing the fair market value of the gifted shares on appraisals prepared in the ordinary course of business for the company and its shareholders. Based on these appraisals, plaintiffs each paid $1.2 million in taxes on the gifted shares, for a combined total tax of $2.4 million. We will examine the appraised values below.
The IRS challenged the gifting valuations in late 2010. Nearly four years later, in August 2014, the IRS sent Statutory Notices of Deficiency to the plaintiffs based on per share values about double those of the original appraisals (see below). Plaintiffs paid (in addition to taxes already paid) a total of $2.2 million in gift tax deficiencies and accrued interest in December 2014. It is nice to have liquidity.
Plaintiffs then filed amended gift tax returns for the relevant years seeking a refund for the additional taxes and interest. With no response from the IRS, Plaintiffs initiated the lawsuit in Federal District Court to recover the gift tax and interest they were assessed. A trial on the matter was held on August 3-4, 2017.
The first appraiser was John Emory of Emory & Co. LLC (since 1999) and formerly of Robert W. Baird & Co. I first met John in 1987 at an American Society of Appraisers conference in St. Thomas. He is a very experienced appraiser, and was the originator of the first pre-IPO studies. Emory had prepared annual valuation reports for GBP since 1999, and his appraisals were used by the plaintiffs for their gifts in 2006, 2007, and 2008.
The Emory appraisals had been prepared in the ordinary course of business for many years. They were relied upon both by shareholders like the plaintiffs as well as the company itself.
The next “appraiser” was the Internal Revenue Service, where someone apparently provided the numbers that were used in establishing the statutory deficiency amounts. The court’s decision provides no name.
The third appraiser was Francis X. Burns of Global Economics Group. He was retained by the IRS to provide its independent appraisal at trial. As will be seen, while his conclusions were a good deal higher than those of Emory (and Czaplinski below), they were substantially lower than the conclusions of the unknown IRS appraiser. The IRS went into court already giving up a substantial portion of their collected gift taxes and interest.
The fourth appraiser was hired by the plaintiffs, apparently to shore up an IRS criticism of the Emory appraisals. Nancy Czaplinski from Duff & Phelps also provided an expert report and testimony at trial. Emory’s report had been criticized because he employed only the market approach and did not use an income approach method directly. Czaplinski used both methods. It is not clear from the decision, but it is likely that Czaplinski was not informed regarding the conclusions in the Emory reports prior to her providing her conclusions to counsel for plaintiffs.
While the court did not agree with all aspects of the work of any of the appraisers, the appraisers were treated with respect in the opinion based on my review. That was refreshing.
The court named all the appraisers, and began with an analysis of the Burns appraisals (for the IRS). In the end, after a thoughtful review, the court did not rely on the Burns appraisals in reaching its conclusion.
After reviewing the essential elements of the Burns appraisals, the court provided a similar analysis of the Emory appraisals. The court was impressed with Emory’s appraisals, and appeared to be influenced by the fact that the appraisals were done in the ordinary course of business for GBP and its shareholders. The court surely noticed that the IRS must have accepted the appraisals in the past since Emory had been providing these appraisals for many years. Other Kress family members had undoubtedly engaged in gifting transactions in prior years.
The court then reviewed the Czaplinski appraisal. While the court was light on criticisms of the Czaplinski appraisals, it preferred the methodologies and approaches in the Emory appraisals.
Interestingly, the entire analysis in the decision was conducted on a per share basis, so there was virtually no information about the actual size or performance or market capitalization of GBP in the opinion. We deal with the cards that are dealt.
As I read the court’s decision, there were ten items that were important in all three appraisals, and an additional item that was important in the December 31, 2008 appraisal. Readers will remember the Great Recession of 2008. It was important to the court that the appraisers consider the impact of the recession on the outlook for 2009 and beyond in their appraisals for the December 31, 2008 date.
In the interest of time and space, we will focus on the appraisals as of December 31, 2008 in the following discussion. The summaries of the other appraisals are provided without comment at the end of this article. The December 31, 2008 summary follows. We deal with the eleven items that were discussed or implied in the subsections below.
There are six columns above. The first provides the issue summary statements. The next four columns show the court’s reporting regarding the eleven items found in the 2008 appraisal based on its review of the reports of the appraisers. Note that there is no detail whatsoever for the rationale underlying the IRS conclusion for the Statements of Deficiency. The final column provides the court’s conclusion. To the extent that items need to be discussed together, we will do so.
All the appraisers employed the market approach in the appraisals as of December 31, 2008 (and at the other dates). They looked at the same basic pool of potential guideline companies but used different companies and a different number of companies in their respective appraisals.
The court was concerned that the use of only two comparable companies in the Burns report was inadequate to capture the dynamics of valuation. In fact, Burns used the same two guideline companies for all three appraisals, and the court felt that this selective use did not capture the impact of the 2008 recession on valuation (Item 7). He weighed the market approach at 60% and the income approach at 40% in all three appraisals.
Czaplinski used four comparable companies in her 2008 appraisal and weighted the market approach 14% (same in her other appraisals). Her income approach was weighted at 86%.
Emory used six guideline companies in the 2008 appraisal. While he used the market approach only, the court was impressed that “he incorporated concepts of the income approach into his overall analysis.” This comment was apparently addressing the IRS criticism that the Emory appraisals did not employ the income approach.
The case gets interesting at this point, and many readers and commentators will talk about its implications.
At the enterprise level, both Burns and Emory tax-affected GBP’s S corporation earnings as if it were a C corporation. This is notable for at least two reasons:
The Czaplinski report avoided the S corp valuation differential issue by using pre-tax multiples (without tax-affecting, of course). Since the Czaplinski report used pre-tax multiples, there was no differential in value because of the company’s S corporation status.
The Burns report, however, did apply an S corporation premium to its capitalized earnings value of GBP. The decision reports neither the model used in the Burns report nor the amount of the premium. Let me speculate. The premium was likely based on the SEAM Model (see page 35 of linked material), published by Dan Van Vleet, who was also at Duff & Phelps at the time (like Czaplinski). I speculate this because it is the best known model of its kind.
If my speculation is correct, based on tax rates at the time and my understanding of the SEAM Model, it was likely in the range of 15% – 18% of equity value (100%), or a pretty hefty premium in the valuation. Nevertheless, Burns testified to the use of a specific S corporation premium at trial.
Again, if my speculation is correct, the facts that Czaplinski and Van Vleet were both from Duff & Phelps and that Czaplinki did not employ the SEAM Model likely provided for some colorful cross-examination for Czaplinki. If so, she seems to have survived well based on the court’s review.
The court accepted the tax-affected treatment of earnings of both Burns and Emory, and noted that Czaplinski’s treatment had dealt with the issue satisfactorily. The court did not accept the S corporation premium in the Burns report.
What do these conclusions regarding tax-affecting and no S corporation premium mean to appraisers and taxpayers?
Kress v. U.S. will be quoted by many attorneys and appraisers as standing for the appropriateness of tax-affecting of pass-through entities and for the elimination of a specific premium in value for S corporation status.
The treatment of non-operating assets by the appraisers is less than clear from the decision. What we know is the following regarding the substantial non-operating assets in the appraisals:
Since the court sided primarily with the overall thrust of the Emory report, we see little guidance for future appraisals in the treatment of non-operating assets in this decision.
The court noted that Burns had not visited with management, but had attended a deposition of GBP’s CFO. The court was impressed that Emory had interviewed management in the course of developing his appraisals, and had done so at the time, asking them about the outlook for the future each year. It is not clear from the decision whether Czaplinski interviewed management.
The Burns report was criticized for employing a mechanical methodology that, over the three years in question, did not account for changes in the markets (and values) brought about by the Great Recession of 2008. Specifically, it did not consider the future impact in the year-end 2008 appraisal of the recession’s impact on expectations and value at that date.
Both the Emory and Czaplinski reports were noted as having employed methods that considered this landmark event and its potential impact on GBP’s value.
The court’s opinion in Kress provided more than four pages of discussion on the question of whether the Family Transfer Restriction in GBP’s Bylaws should have been considered in the determination of the discount for lack of marketability. This is a Section 2703(a) issue. Ultimately, the court found that the plaintiffs had not met their burden of proof to show that the restrictions were not a device to diminish the value of transferred assets, failing to pass one of the three prongs of the established test on this issue.
Neither the Burns report nor the Czaplinski report considered family restrictions in their determinations of marketability discounts. The Emory report considered family restrictions in a “small amount” in its overall marketability discount determination.
In spite of the lengthy treatment, the court found that the issue was not a big one. In the final analysis, the court deducted three percentage points from the marketability discounts in the Emory reports as its conclusions for these discounts.
With this background, we can look at the various value indications before and after marketability discounts. First, we look at the actual or implied marketable minority values of the appraisers. For the December 31, 2008 appraisals, the Emory report concluded a marketable minority value of $30.00 per share. Czaplinski concluded that the marketable minority value was similar, at $31.33 per share. The Burns report’s marketable minority value was 50% higher than Emory’s conclusion, at $45.10 per share.
The Court concluded that marketable minority value was $30.00 per share, as found in the Emory Report. That was an affirmation of the work done by John Emory more than a decade ago at the time the gifts were made.
The Emory report concluded that the marketability discount should be 28% for the December 31, 2008 appraisal (where previously, it had been 30%). The discount in the Czaplinski report was 20%. The marketability discount in the Burns report (for the IRS) was 11.2%.
There were general comments regarding the type of evidence that was relied upon by the appraisers (restricted stock studies and pre-IPO studies that were not named, consideration of the costs of an initial public offering, etc.). Apparently, none of the appraisers used quantitative methods in developing their marketability discounts. The court criticized the cost of going public analysis in the Burns report because of the low likelihood of GBP going public.
Based on the issue regarding family transfer restrictions, the court adjusted the marketability discounts in each of Emory’s three appraisals by 3% – a small amount. Emory concluded a 28% marketability discount for 2008. The court’s conclusion was 25%.
At this point, we can look at the entire picture from the figure above. We replicate a part of the chart to make observation a bit easier.
It is now possible to see the range of values in Kress. The plaintiffs filed their original gift tax returns based on a fair market value of $21.60 per share for the appraisal rendered December 31, 2008 (Emory). The IRS argued, years later (2014), for a value of $50.85 per share – a huge differential. The plaintiffs paid the implied extra taxes and interest and filed in Federal District Court for a refund.
The expert retained by the IRS, Francis Burns, was apparently not comfortable with the original figure advanced by the IRS of $50.85 per share. The Burns report concluded that the 2008 valuation should be $40.05 per share, or more than 21% lower. Plaintiffs went into court knowing that they would receive a substantial refund based on that difference.
Plaintiffs retained Nancy Czaplinski of Duff & Phelps to provide a second opinion in support of the opinions of Emory. Her year-end 2008 conclusion of $25.06 per share, although higher than the Emory conclusion of $21.60 per share, was substantially lower than the Burns conclusion of $40.05 per share.
The court went through the analysis as outlined, noting the treatment of the experts on the items above. In the final analysis, the court adopted the conclusions of John Emory with the sole exception that it lowered the marketability discount from 28% to 25% (and a corresponding 3% in the prior two appraisals).
The court’s concluded fair market value was $22.50 per share, only 4.2% higher than Emory’s conclusion of $21.60 per share.
Based on this review of Kress, it is clear that Emory’s appraisals were considered as credible and timely rendered. Kress marks a virtually complete valuation victory for the taxpayer. It also marks a threshold in the exhausting controversy over tax-affecting tax pass-through entities and applying artificial S corporation premiums when appraising S corporations (or other pass-through entities).
Kress will be an important reference for all gift and estate tax appraisals that are in the current pipeline where the IRS is arguing for no tax affecting of S corporation earnings and for a premium in the valuation of S corporations relative to otherwise identical C corporations.
When all is said and done, a great deal more will be written about Kress than we have shared here, and it will be discussed at conferences of attorneys, accountants and business appraisers. Some will want to focus on the family attribution aspect of the case, but, as the court made clear, this is a small issue in the broad scheme of things.
For information, below is a summary of the appraisals as of December 31, 2006 and December 31, 2007.
Jay D. Wilson, Jr., CFA, ASA, CBA, Vice President, presented “How to Value an Early-State FinTech Company” at the ICBA ThinkTech Accelerator on February 28th, 2019 in Little Rock, Arkansas.
Learning objectives include:
Karolina Calhoun, CPA/ABV/CFF, Vice President, presented “How to Value a Business & Situations That Give Rise to a Valuation” at the Tennessee Society of CPAs West Tennessee Chapter monthly meeting in Jackson, TN.
The valuation of a business can be a complex process, requiring accredited business valuation and forensic accounting professionals. This session will take a deep dive into the process and methodologies used in a valuation. Also covered will be the situations that give rise to valuation services such as estate/tax planning, ESOP annual valuation, M&A transactions, GAAP/ financial reporting, family law marital dissolution, buy-sell disputes, and corporate litigation.
In traditional divorces, each spouse engages a lawyer who fights hard to “win.” Their weapons can include bringing in their own financial professional to value financial assets. Naturally the neutrality of those valuations may be suspect in the other party’s eyes, even if the valuator follows all proper procedures. In collaborative divorce, each spouse still hires a lawyer, but the goal is to reach a settlement that satisfies each party. Neutral consultants, such as financial and mental health professionals, are also frequently involved. The model is “troubleshoot and problem-solve” rather than “fight and win.”
The collaboration is carried out through a series of meetings in which the couples and their attorneys negotiate over issues such as property division, alimony, child support and custody. The meetings are quarterbacked by the mental health professional, who prioritizes the goals for each session, monitors the emotional climate, and keeps things on track. The attorneys each are responsible to look out for the interests of their clients, but rather than using the law to win, they are more focused on making sure their clients understand the legal issues involved and how a court might view them. The role of the financial professional, who is paid by both parties, is to provide an objective assessment of the financial issues involved. If one of the spouses has a business, the financial neutral provides an arm’s-length valuation and can also serve to educate the other spouse about the business, if needed. After several meetings, the financial neutral produces a marital balance sheet, laying out the couple’s financial landscape.
While collaborative divorce is not for everyone, in the right settings it can have these advantages:
Divorces litigated through the court system can often take a year or more to reach a conclusion. The collaborative process can move faster because there is no waiting for motions to be filed and hearings to be held.
Attorneys likely will have fewer billable hours since there is less engagement with the courts. There is only one financial consultant rather than two. In addition, because litigated cases tend to take more time, there may be a need for revised valuations as economic conditions change while the divorce makes its way through the process.
While there certainly can be tension between the two spouses during the collaborative process, the temperature tends to be lower when the working model is problem-solving rather than fighting. The addition of a mental health professional to the team also can serve to defuse tensions, and the neutrality of the financial professional can serve to reduce distrust.
When divorce cases reach the courtroom, subjective judgments by the judge can come into play. While Tennessee law spells out guidelines for judges in divorces, they still have latitude.
Divorce settlements litigated through the courts become public record. Settlements that result from the collaborative process do not. This can be of particular importance when one or both spouses are high-profile.
Collaborative divorce is not for everyone. Sometimes distrust between the parties has become so intense that litigation is the only way out. However, many divorcing spouses have found that a collaborative process can reduce tensions and cost and provide a result satisfactory to both parties. Attorneys can benefit from numerous services provided by financial professionals in litigated and collaborative divorce matters. At Mercer Capital, we have two professionals who are trained in the Collaborative Practice and provide assistance to attorneys in collaborative and litigated divorce matters. Please contact us if we can be of assistance to you and your clients.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
A lifestyle analysis is an analysis of each party’s sources of income and expenses. It is used in the divorce process to demonstrate the standard of living during the marriage and to determine the living expenses and spending habits of each spouse. It is typically a more in-depth analysis than the financial affidavits required in the divorce process and is prepared by a forensic accountant. The details in the analysis serve as verification of net worth and income, and expense statements submitted by both spouses can help a judge determine the equitable distribution of marital assets as well as alimony needs.
The lifestyle analysis pulls together all considerations and provides a visual of income and expenses over the remaining life expectancy. Through illustration of the aggregate sources of income(s) and expenses over time, one can discern what funds are actually required (and if these funds are available) to maintain standard of living, i.e., to fund expenses. The exercise then yields relative analyses (percentage comparisons and trend analyses), and ultimately, an illustration of net worth at a point in time, as well as net worth accumulation over time.
In Tennessee, the Decree for support of spouse is under § 36-5-121(i). Careful consideration must be given to the factors listed in the statute when determining historical lifestyle (standard of living) as well as reasonable need into the future. Twelve factors assist in determining whether the granting of an order for payment of support and maintenance to a party is appropriate, as well as determining the nature, amount, length of term, and manner of payment. Refer to § 36-5-121(i) for the full listing.
Although each of the factors must be considered when relevant to the parties’ circumstances, the first factor, “the relative earning capacity, obligations, needs, and financial resources of each party, including income from pension, profit sharing or retirement plans and all other sources,” has presented the two most important components: the disadvantaged spouse’s need and the obligor spouse’s ability to pay.
Hence arises the “pay & need analysis,” also known as the “lifestyle analysis.”
The following documentation provides financial information used in the analysis and is typically requested during the discovery process.
There are many moving pieces in constructing the lifestyle analysis, and the components can be quite different from case to case. During the preliminary stages, the financial expert/ forensic accountant will obtain pertinent documents from the aforementioned documentation in order to create the marital balance sheet (and potential separate property) and assess historical and current earnings and expenses/spending habits. Additionally, the expert may also assist in building a budget based on historical expenses. The expert will review retirement plans and annual contributions, brokerage accounts, cash & savings accounts, their respective average rates of return as well as varying tax obligations. The risk tolerance of the individuals can even be considered in relation to future rates of return. For example, a person with ample disposable cash may be willing to invest in riskier ventures where the return may be higher, than a person who chooses to invest conservatively due to limited disposable cash.
The investigative process may even lead the parties to establish the “true income” of a spouse who is suspecting of perpetrating fraud and determine any possible hidden assets or dissipation of marital assets.
Ultimately, the lifestyle analysis illustrates the sources of income, tax obligations, and disposable cash before and after expected expenses. This tool is valuable because it leads to further analyses such as relative analyses of gross earnings comparisons and after-tax disposable cash comparisons, among others. The analysis allows comparison on relative terms not just dollar amounts.
Another valuable result of the lifestyle analysis is the ability to assess the parties’ net worth at multiple points in time. The net worth accumulation analysis illustrates the differences of the division of net worth at the date of divorce, and the division of net worth at the date of death. Additionally, it illustrates the net worth accumulation between those two points in time. This process may highlight what appears to be reasonable at a point in time, may or may not be reasonable when extracted over time. When used as trial demonstratives, the illustration can assist the trier of facts in determining the disadvantaged spouse’s need and the obligor spouse’s ability to pay.
For a fact pattern and step-by-step illustration, refer to my Lifestyle / Pay & Need Analysis presentation from the 2018 AICPA Forensic & Business Valuation Conference.
In financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable. The details in the lifestyle analysis can help determine the equitable distribution of marital assets as well as alimony needs.
Because no two cases are alike, all components of the analysis must be carefully assessed. Complexities that may need further consideration include, but are not limited to:
A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion. For more information or to discuss your matter, please don’t hesitate to contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
I ventured into the Arizona desert again this year to Bank Director’s Acquire or Be Acquired Conference (“AOBA”) in Phoenix in late January. This year I was struck by the dichotomous outlook for the banking sector that reminded me of Dicken’s famous line: “It was the best of times, it was the worst of times…”
The weather was lovely. Phoenix/Scottsdale is the place to be in late January, and this year did not disappoint with sunny weather and a high of around 70 each day. At the same time, much of the country was feeling the effects of a severe polar vortex that caused temperatures to plunge well below zero in the Upper Midwest and Great Plains. Many of the attendees from that area were forced to stay a day or two longer due to airline cancellations.
The operating environment for banks reflected a similar analogous dichotomy. Take the market for example. Most banks produced very good earnings in 2018, and many produced record earnings due to a good economy, the reduction in corporate tax rates, and margin relief as the Fed raised short-term interest rates four times further distancing itself from the zero interest rate policy (“ZIRP”) implemented in late 2008.
Nonetheless, bank stocks, along with most industry sectors, were crushed in the fourth quarter. The SNL Small Cap US and Large Cap US Bank Indices declined 16% and 17% respectively. Several AOBA sessions opined that valuations based on price-to-forward earnings multiples were at “financial crisis” levels as investors debated how much the economy could slow in 2019 and 2020 and thereby produce much lower earnings than Wall Street’s consensus estimates.
Within the industry the best of times vs. worst of times (or not as good of times) theme extended to size. Unlike past eras when small (to a point) was viewed as an advantage relative to large banks, the consensus has flipped. Large banks today are seen as having a net advantage in creating operating leverage, technology spending, better mobile products for the all-important millennials, and greater success in driving deposit growth.
Additionally, one presenter noted that larger publicly traded banks that are acquisitive have been able to acquire smaller targets at lower price/tangible book multiples than the multiple at which the shares issued for the target trade in the public market and thereby incur no or minimal dilution to tangible BVPS.
The most thought provoking sessions dealt with the intensifying impact of technology. Technology is not a new subject matter for AOBA, but the increasingly larger crowds that attended technology-focused sessions demonstrated this issue is on the minds of many bankers and directors. While technology is a tool to be used to deliver banking services, I think the unasked question most were thinking was: “What are implications of technology on the value of my bank?”
Several sessions noted big banks that once hemorrhaged market share are proving to be adept at deposit gathering in larger metro markets while community banks still perform relatively well in second-tier and small markets. Technology is helping drive this trend, especially among millennials who do not care much about brick-and-mortar but demand top-notch digital access. The efficiency and technology gap between large and small banks is widening according to the data, while both small and large banks are battling new FinTech entrants as well as each other.
Not all technology-related discussions were negative, however. Digital payment network Zelle (owned indirectly by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, US Bank, and Wells Fargo) has grown rapidly since it launched in 2017. Payment volume in dollar terms now exceeds millennial-favorite Venmo, which is owned by PayPal. Also, JPMorgan Chase rolled-out a new online brokerage offering that offers free trades for clients in an effort to add new brokerage and banking clients while also protecting its existing customer franchise.
In addition to the best of times/worst of times theme, I picked up several ideas about what actions banks large and small can take to create value.
There was a standing room only crowd for the day one FinXTech session: “The Next Wave of Innovation.” This stood in stark contrast to the first AOBA conference I attended which was during the financial crisis. Technology was hardly mentioned then and most sessions focused on failed bank acquisitions. Clearly, this year’s crowd proved that technology is top of mind for many bankers even if the roadmap is hazy. A key takeaway is that a digital technology roadmap must be weaved into the strategic plan so that an institution will be positioned to take advantage of the opportunity that technology creates to enhance customer service and lower costs. Further, emerging trends suggest that technology may help in assessing credit risk beyond credit scores. To assist banks in creating a FinTech roadmap, Bank Director recently unveiled a new project called FinXTech Connect that provides a tool bankers can use to consider and analyze potential FinTech partners.
During our (Mercer Capital) session, Andy Gibbs and I argued for becoming a “triple threat” bank, noting that banks with higher fee income, superior efficiency ratios, and greater technology spending were being rewarded in the public market with better valuations all else equal (see table below). While we do not advocate for heavy tech spending as a means to an ill-defined objective, the evidence points to a superior valuation when technology is used to drive higher levels of fee income and greater operating leverage. For more information, view our slide deck.
While there was a lot of discussion about an eventual slowdown in the economy and an inflection in the credit cycle, several sessions highlighted that a downturn will represent the best opportunity for those who are well prepared to grow. The key takeaway is to have a plan for both the good and the bad economic times to seize opportunity. Technology can play a role in a downturn by helping add customers at very low incremental costs.
On the M&A front, two M&A nuggets from attorneys stood out as well as a note about MOEs (mergers of equals):
We will likely be back at AOBA next year and hope to see you there. In the meantime, if you have questions or wish to discuss a valuation or transaction need in confidence, don’t hesitate to contact us.
By now, many are familiar with the changes from the Tax Cuts and Jobs Act (TCJA), however, specific changes related to family law and alimony deductibility went into effect in 2019.
We discussed many of these in a prior newsletter. The changes are as follows.
For more information, see this helpful reference.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
Andy Gibbs and Jay Wilson presented “Leveraging Fintech to Survive & Thrive in the Digital Age” at Bank Director’s 25th annual Acquire or Be Acquired (AOBA) Conference.
Developing a fintech strategy for your bank to enhance profitability, efficiency, shareholder value and customer satisfaction can be challenging. This session helps to navigate fintech and develop a fintech strategy; provides case studies of successful partnerships between community/regional banks and fintechs; and give an overview of fintech valuation and M&A trends.
FinTech companies are the emerging and hyped sector of the financial services industry. Looking at FinTech’s recent activity, people can see that many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn” – an industry term describing a tech company valued at a billion dollars or more. While this business trajectory may seem simple and attractive, FinTech companies usually have a highly complex structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.
Valuing a FinTech company can be very complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all FinTech companies have large differences, including what niche (payments, solutions, technologies, etc.) they operate in or what stage of development the company is in, understanding the value of a FinTech company is critically important. More specifically, within the FinTech industry, an exciting niche termed InsurTech is emerging and threatening to change the traditional state of the insurance industry.
InsurTech is a fast growing niche that operates in a massive global insurance industry with premium revenues of about $5 trillion annually. InsurTech is the term applied to many companies that are using technology to disrupt the traditional insurance industry landscape. InsurTech has high growth prospects and the potential for InsurTech to innovate and disrupt remains large. Funding for InsurTech companies in recent years has spiked, especially for early-stage companies. Incumbents in the insurance industry have been slow to adopt disruptive, high-growth InsurTech, partly because insurance is so massive and has been around for such a long time. Additionally, many traditional insurance companies can benefit from InsurTech solutions that serve to enhance customer satisfaction and improve the efficiency of operations by leveraging technology and enhancing the delivery of certain insurance offerings and solutions through digital channels.
Technology and innovation have disrupted many other long-established industries, such as the impact of medical technology in the healthcare industry. Insurance players, who maintain legacy systems believe that established customer connections will reduce the threat of InsurTech. However, this may not be the best strategy because insurance is often purchased begrudgingly. The historically strained relationship between customers and carriers is a rather vulnerable point along the insurance value chain. InsurTech companies can offer innovative technology that creates more touchpoints for customers and reduces many customer pain points.
Understanding how well a given InsurTech company is doing within this FinTech niche is one of the most important factors in determining its value. Market dynamics such as market size, potential market available, and growth prospects are important to understand. A valuation will consider absolute market value, existing competitors, and existing incumbents.
The regulatory environment is another important consideration when valuing an InsurTech company. Financial services, such as banks and insurance companies, are heavily regulated, so understanding the rules and regulations is necessary for developing an accurate valuation.
Like other FinTech niches, certain solutions within InsurTech are relatively new and have the potential to disrupt the entire insurance industry. Since many industry incumbents have been slow to adopt this new technology, the range of this innovation has yet to be fully felt and rules/regulations have yet to change. While regulatory stability may seem favorable now, concrete rules and regulations are complex and can be hard to predict as regulators react to rising InsurTech involvement. Understanding these complexities is important to valuing InsurTech companies, as these regulations could help or hinder an InsurTech’s growth potential.
When valuing a startup, quantitative information (financial and operating history) is limited; therefore, qualitative information can be extremely important in determining a company’s value. The quality and experience of the management team can be important. Knowledge of the insurance industry including understanding customer preferences, technology integration, the competitive and regulatory environments can enhance an InsurTech’s company value.
An InsurTech company’s ownership of intellectual property and other intangible assets, like strategic partnerships, all else equal, should be considered and could increase a company’s value, assuming they are in place and well documented. When in place and demonstrated, intangibles are an important qualitative consideration.
The stage of development of a FinTech company can also impact its value. Companies typically set milestones and track their own progress, and meeting these milestones might affect their valuation. Milestones usually include initial round financing, proof of concept, regulatory approval, obtaining a significant partner, and more.
Milestones are important to set and track as the more milestones a startup meets, the less uncertainty exists and the more value is created. For example, an InsurTech company with established technology, increased customer touchpoints, and the potential to increase revenues will be more valuable to a potential acquirer than a newer startup. In addition, meeting later stage milestones often provide greater value than meeting early stage milestones. When the valuation considers future funding rounds and the potential dilution from additional capital raises, a staged financing model is often prepared and the valuation will vary at different stages as shown below.
As InsurTech companies enhance business operations and reduce costs, valuations for these companies will become more important. There are three common approaches to determining business value: asset approach, income approach, and market approach. Each valuation approach is typically considered and then weighted accordingly to provide an indicated value or a range of value for the company, and ultimately, the specific interest or share class of the company.
The asset approach determines the value of a business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. This approach is generally inappropriate for technology startups as they are generally not capital intensive businesses until the company has completed funding rounds. However, it can be instructive to consider the potential costs and time that the company has undertaken in order to develop proprietary technology and other intangibles.
The market approach determines the value of a company by utilizing valuation metrics from transactions in comparable companies or historical transactions in the company. Consideration of valuation metrics can provide meaningful indications for startups that have completed multiple funding rounds, but can be complicated by different preferences and rights with different share classes.
Regardless of complications, share prices can provide helpful valuation anchors to test the valuation range. Market data of publicly traded companies and acquisitions can be helpful in determining key valuation inputs for InsurTech companies. For early-stage companies, market metrics can provide valuable insight into potential valuations and financial performance once the InsurTech company matures. For already mature enterprises, recent financial performance can be compiled to serve as a valuable benchmarking tool.
Investors can discern how the market might value an InsurTech company based on pricing information from comparable InsurTech companies or recent acquisitions of comparable InsurTech companies.
The income approach can also provide a meaningful indication of value for a FinTech company. This relies on considerations for the business’ expected cash flows, risk, and growth prospects.
The most common income approach method is the discount cash flow (DCF) method, which determines value based upon the present value of the expected cash flows for the enterprise. The DCF method projects the expected profitability of a company over a discrete period and prices the profitability using an expected rate of return, or a discount rate. The combination of present values of forecasted cash flows provides the indication of value for a specific set of assumptions.
For startup InsurTech companies, cash flow forecasts are often characterized by a period of operating losses, capital needs, and expected payoffs as profitability improves or some exit event, like an acquisition, occurs. Additionally, investors and analysts often consider multiple scenarios for early-stage companies both in terms of cash flows and exit outcomes (IPO, sale to a strategic or financial buyer, etc.), which can lead to the use of a probability weighted expected return model (PWERM) for valuation.
Given their complexity, multiple valuation approaches and methods are often considered to provide lenses through which to assess value of InsurTech and FinTech companies and generate tests of reasonableness against which different indications of value can be evaluated.It is important to note that these different methods are not expected to align perfectly. Value indicators from the market approach can be rather volatile and investors often think longer-term. More enduring indicators from value can often come from income approaches, such as DCF models.
Valuation of an InsurTech company can be vital to measure realistic growth, to plan progression, and to secure employee and investor interest. Given the complexities in valuing private FinTech and InsurTech companies and the ability for the market/regulatory environment to shift quickly, it is important to have a valuation expert who can adequately assess the value of the company and understand the prevalent market trends.
Last week, the Mercer Capital Bank Group headed south for a scenic trip through the fields of the Mississippi Delta, including the town of Clarksdale located about 90 miles from Memphis. Clarksdale’s musical heritage runs deep with such performers as Sam Cooke, John Lee Hooker, Son House, and Ike Turner born there, while Tennessee Williams spent much of his childhood there. Explaining the Delta’s prolific artistic output, Eudora Welty, a Mississippi writer, noted the landscape stretching to the horizon and the juxtaposition of societal elements – all these forces churning like the Mississippi river nearby.
Despite its gritty roots, Clarksdale now is experiencing its own hipster renaissance. It may not be Brooklyn, but the Bank Group noticed signs for last weekend’s Clarksdale Film Festival. Visitors can stay at a refurbished cotton gin, enjoying their Sweet Magnolia Gelato made from locally sourced ingredients. Presumably, craft cocktails are available as well, this being the Delta.
Beyond these recent additions to the tourist landscape, though, one attraction put Clarksdale on the map – the Crossroads. At the intersection of Highways 49 and 61, the bluesman Robert Johnson (who lived from 1911 to 1938), as the story goes, met the Devil at midnight who tuned his guitar and played a few songs. In exchange for his soul, Johnson realized his dream of blues mastery.
The point of this article is not that Lucifer lurked behind the revaluation of asset prices in the fourth quarter of 2018. Instead, the market gyrations laid bare the dichotomy between bank expectations regarding asset quality and the market’s view of mounting credit risk that was overlaid by a need to meet margin calls among some investors. Indeed, credit quality faces its own crossroads.
Along Hwy. 49 lies the town of Tutwiler, about 15 miles from Clarksdale. There, in 1903, the bandleader W.C. Handy heard a man playing slide guitar with a knife, singing “Goin’ where the Southern cross’ the Dog.” Handy adapted the song, which references the juncture of two railroads, thereby making it one of the first blues recordings.
From Call Report data, which includes 3,644 banks with total assets between $100 million and $5 billion, signs of credit quality deterioration remain virtually undetectable.
As they are wont to do, regulatory agencies noted some concerns regarding asset quality. However, consistent with our research into the community banking industry’s asset quality trends, the OCC also observed that “credit quality remains strong when measured by traditional performance metrics.”1 Despite its view of building credit risk, the OCC rated 95% of banks’ underwriting practices as satisfactory or strong in 2018, virtually unchanged from the 2017 level.2 Economic growth, corporate profits, and employment trends also support a sanguine view of credit quality.
While also observing weaker underwriting – for example, covenant concessions – rating agencies predict better credit performance among leveraged loans and commercial mortgage backed securities in 2019. For 2019, Fitch Ratings projects a 1.5% leveraged loan default rate, down from 1.75% in 2018. Further, commercial mortgage-backed security delinquencies, which declined by 103 basis points to 2.19% between year-end 2017 and 2018, are expected to range between 1.75% and 2.00% in 2019. The Amazonification of the retail sector, which led to retail bankruptcies and defaults on loans secured by regional malls, contributed to higher delinquency and default rates in 2018 but may subside in 2019.
The view from Hwy. 49, before reaching the Crossroads, looks favorable from the banking industry’s standpoint.
In the words of the writer David Cohn, the Mississippi Delta begins in the lobby of the Peabody Hotel (in Memphis) and ends on Catfish Row in Vicksburg, Mississippi.3 While his observation alludes to the economic as well as the geographic extremes of the Delta region, Highway 61 is the Delta’s spine connecting Cohn’s poles.
One of the more concerning statistics is the level of corporate debt. Though household debt trended down following the Great Recession (see Figure 4), nonfinancial business debt has reached near record levels as a percentage of GDP.4 According to Morgan Stanley, BBB-rated corporate debt surged by 227% since 2009 to $2.5 trillion. This leaves approximately one-half of the investment grade corporate bond universe on the cusp of a high-yield rating. Moody’s migration data suggests that BBB-rated bonds have an 18% chance of being downgraded to non-investment grade within five years, which may overwhelm the high-yield bond market.5
Regulatory agencies also observed looser underwriting. For new leveraged loans, the Federal Reserve noted that the share of highly leveraged large corporate loans – defined as more than 6x EBITDA – exceeds previous peak levels in 2007 and 2014, while issuers also are calculating EBITDA more liberally by making aggressive adjustments to reported EBITDA.6 From the OCC’s perspective, competitive pressures from banks and non-banks, along with plentiful investor liquidity, have led to weaker underwriting particularly among C&I and leveraged loans. According to the OCC, community banks are not immune. An example of weaker underwriting cited by the OCC is “general commercial loans, predominately in community banks” for which it compiles a list of shortcomings: “price concessions, inadequate credit analysis or loan-level stress testing, relaxed loan controls, noncompliance with internal credit policies, and weak risk assessments.”7
Despite unemployment rates below 4% and some evidence of rising wages, consumer loan delinquency rates have risen in 2018 (Figure 5). Some lenders, such as Discover, already have begun reducing exposure to heated sectors like unsecured personal loans.
Fears of a downturn crystallized in the fourth quarter of 2018 with the Federal Reserve’s December rate increase, trade friction with China, and signs of economic slowdowns in countries such as Germany. Option-adjusted spreads on corporate debt, after remaining quiescent through 2017 and most of 2018, widened suddenly, approaching levels last observed in 2016 when oil prices collapsed (Figure 6). According to Guggenheim, the fourth quarter spread widening implies a 3.2% high yield corporate debt default rate, up from 1.8% for 2018.8
The perspective gleaned from Hwy. 61 is not necessarily alarming, but it does suggest that, directionally, risk is rising.
Credit lies at a crossroads, consistent with a late cycle economic environment. Reported credit metrics are not improving significantly, nor are they worsening; conditions suggest continued low charge-offs and loan loss provisions in the nearterm. However, the market sniffs rising risks in various corners of the economy, most notably in corporate debt. Howlin’ Wolf sang, “Well I’m gonna get up in the morning // Hit the Highway 49.” Where are banks headed? Macroeconomic conditions ultimately will be determinative, but banks should avoid complacency in this environment marked by conflicting signals and aggressive competition. The poorest loans, in retrospect, often are originated in times such as these.
End Notes
1 OCC Semiannual Risk Perspective, Fall 2018, p. 1.
2 OCC Semiannual Risk Perspective, Fall 2018, p. 22.
3 Cohn, David, Where I Was Born and Raised, 1948.
4 Federal Reserve, Financial Stability Report, November 2018, p. 18.
5 Guggenheim Investments, Fixed Income Outlook, Fourth Quarter 2018, pp. 1 and 8.
6 Federal Reserve, Financial Stability Report, November 2018, p. 20.
7 OCC Semiannual Risk Perspective, Fall 2018, pp. 11 and 24.
8 Guggenheim Investments, High Yield and Bank Loan Outlook, January 2019.
This presentation was delivered by Scott A. Womack, ASA, MAFF and Cheryl C. Panther, CPA/PFS, ADFA/CDFA (Panther Financial Planning) 19th Annual Networking and Educational Forum hosted by the International Association of Collaborative Professionals.
This session, “Creativity in Financial Elements of a Collaborative Divorce,” is described below.
Financial creativity is not just for financial professionals. We will highlight actual case examples of how to strategically and efficiently use outside professionals and unique ways to utilize financial information. We’ll provide ideas that professionals from all disciplines can take back to their local practice groups.
This presentation was delivered by Karolina Calhoun, CPA/ABV/CFF at the AICPA 2018 Forensic & Valuation Services Conference.
Learning objectives include:
What a difference a year makes. A year ago corporate tax reform had been enacted that lowered the top marginal tax rate to 21% from 35%. Banks were viewed as one of the primary beneficiaries through a reduction in tax rates and a pick-up in economic growth. Now investors are questioning whether bank stocks and other credit investments are canaries in the U.S. economic coalmine.
As 2018 draws to a close, bank fundamentals are very good; however, bank stock prices have tanked. SNL Financial’s small-, mid-, and large-cap bank indices have fallen by more than 20% since August 31, which meets the threshold definition of a bear market (i.e., down 20% vs. 10% for a correction).
Markets, of course, lead fundamentals, and corporate credit markets lead equity markets. Among industry groups, bank stocks are “early cyclicals”, meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom.
Large cap banks peaked in February while the balance of the industry peaked in the third quarter after having a fabulous run that dates to the national elections on November 8, 2016. The downturn in bank stock prices corresponds with weakening home sales, widening credit spreads in the leverage loan and high yield bond markets, a ~40% reduction in oil prices, and a nearly inverted Treasury yield curve.
To state the obvious: markets—but not fundamentals so far—are signaling 2019 (and maybe 2020) will be a more challenging year than was assumed a few months ago in which the economy slows and credit costs rise. The key question for 2019 then is: how much and is a slowdown fully priced into stocks?
Our next issue of Bank Watch will entail a deep dive into credit, but for this issue, we observe that a global unwind of leverage is underway as the Fed extracts liquidity from the system. Bond buying (QE) and ultra-low rates helped drive asset prices higher. The reverse is proving true, too.
Bank fundamentals are in good-to-great shape. During the third quarter all FDI-Cinsured institutions reported aggregate net income of $62 billion, up 29.3% from 3Q17. Excluding the impact of lower taxes, 3Q18 pro forma net income would have been about $55 billion, up 13.9% from 3Q17. The data is more nuanced once the industry is segregated by asset size, however.
As shown in Figure 3, ROA and ROE have nearly rebounded to the last pre-crisis year of 2006. Importantly, capital has increased significantly and, thereby, provides an additional buffer whenever the next downturn develops.
As it relates to 2019, bank fundamentals are not expected to change much other than credit costs are expected to increase from a very low level in which current loss rates in all loan categories are below long-term averages. Wall Street consensus EPS estimates project mid-single digit EPS growth for the largest banks, primarily as a result of share repurchases and a slightly higher full year NIM, while regional and community bank consensus estimates reflect upper single digit EPS growth from the same factors and somewhat better loan growth.
However, credit and equity markets imply the consensus is too high given the sharp widening in credit spreads and drop in bank stock prices the past several months. Although markets lead fundamentals, market signals about magnitude are less clear. Given continuing growth in the U.S. economy that on balance will be helped by lower oil prices, it seems reasonable that an increase in credit costs the market is forecasting will be modest, and as a result, bank profitability will not be meaningfully crimped in 2019.
Whenever the Fed embarks on an extended rate hiking campaign, the saying goes the Fed hikes until something breaks. The market is signaling that the December rate hike—the ninth in the current cycle—that pushed the Fed Funds target from 2.25% to 2.50% when the yield on the 10-year UST bond was ~2.8% may be one of those moments. What’s unusual about the current tightening cycle is it represents an attempt by the Fed (but not the BOJ, ECB or SNB) to extract itself from radical monetary policies in which the Fed is raising short-term rates and shrinking its balance sheet at the same time.
Given the flat yield curve, it is hard to see how the Fed will hike the Fed Funds another couple of times as planned for 2019, unless the Fed wants to invert the yield curve or unless intermediate- and long-term rates reverse and trend higher. Presumably the $50 billion a month pace in the reduction of its US Treasury and Agency MBS portfolio will continue. Alternatively, perhaps the Fed will bow to the market and not raise rates in 2019 and slow or even halt the reduction in its balance sheet to stabilize markets.
As it relates to bank fundamentals, the impact on net interest margins will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies less pressure to raise deposit rates, and rising wholesale borrowing rates should stabilize. The result, therefore, should be a little bit better NIMs than a slight reduction if the Fed continues to hike given that deposit rate betas for many institutions are well over 50% now. More important for banks if the Fed pauses vs continues to hike would be the impact on asset values (higher all else equal) and, therefore, credit costs.
A synopsis of bank valuations is presented in Figure 4 in which current valuations for the market cap indices are compared to the approximate market top around August 31, November 8, 2016 when the national election occurred, and multi-year medians based upon daily observations. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract.
Bank stocks—particularly mid-cap and large-cap banks—enter 2019 relatively inexpensive to history. The stocks are cheap relative to 2019 consensus earnings with large cap banks trading around 8x and small cap banks at 10x; however, the market’s message is that the estimates are too high. It is hard to envision that estimates are dramatically too high as proved to be the case in 2008 unless the economy is poised to roll-over hard, which seems unlikely. Assuming no recession or a shallow recession, then, the modest valuations may result in bank stocks having a good year even if fundamentals weaken and analysts cut estimates because the limited downside in earnings had been adequately priced into the stocks by late December.
Outwardly, 2018 has been another good year for bank M&A even though activity slowed in the fourth quarter. There were few notable deals other than Fifth Third’s pending acquisition of Chicago-based MB Financial valued at $4.8 billion at announcement and Synovus Financial’s pending acquisition of Boca Raton-based FCB Financial Holding valued for $2.8 billion at announcement. Even before bank stocks rolled over the shares of both Fifth Third and Synovus severely underperformed peers as investors questioned the exchange ratios, cost saving assumptions, credit risk (especially at FCB), and whether the buyers could keep the franchises intact as key personnel defected elsewhere.
The national average price/tangible book multiple expanded to 173% from 166% in 2017 and about 140% in 2014, 2015 and 2016 before the sector was revalued in the wake of the national election. The median P/E of 25x was within the five-year range of 21x to 28x.
The total number of bank and thrift transactions through December 24 totaled 261, which equated to 4.4% of the commercial bank and thrift charters as of year-end 2017. During 2014–2018, the number of acquisitions exceeded 4% each year except for 2016 when activity at the beginning of the year was hampered by weak stock prices as a result of a slowing economy that was marked by a collapse in oil prices and sharply wider credit spreads.
Weak bank stock prices crimp the ability to negotiate deals because most sellers are focused on absolute price rather than relative value when taking the buyer’s shares as consideration; and, buyers usually are unwilling to increase the number of shares being offered given a limitation on minimum acceptable EPS accretion and maximum acceptable TBVPS dilution. A notable late year exception occurred when Cadence Bancorporation opted to increase the number of shares it will issue to State Bancorp by 9.6% because the double trigger in the merger agreement signed during May when Cadence’s share price was much higher came into play.
Although there is no change in the driver of consolidation such as succession issues, shareholder liquidity needs, and economies of scale, a slowdown in M&A activity in 2019 is likely because bank stocks will enter the year depressed. Deals that entail some amount of common share consideration will be tough to structure unless sellers will be willing to take less, which most will not do with operating fundamentals in good shape for now. All cash deals will be impacted less, but all cash deals are more prevalent among very small institutions in which pricing usually occurs at a discount to those that entail some proportion of common shares.
The market is shouting fundamentals will weaken in 2019 after a long period of gradual improvement following the Great Financial Crisis, which most likely will be reflected in sluggish loan growth and modestly higher credit costs; however, bank stocks may surprise to the upside as they did to the downside in 2018 provided a) there is no recession or a shallow one; and, b) the Fed relents and does not hike further and potentially slows the run-off of its excess bonds (and liability reserves). For clients of Mercer Capital who obtain year-end valuations, rising stock prices since the presidential election may be reversed partially, given the compression in market price/earnings and price/tangible book value multiples that occurred in 2018.
The extensive use of core versus reported earnings by public companies has been a widespread phenomenon for at least 25 years. During the past decade, the practice also has become widespread among companies (and their bankers who market deals) that are issuing debt in the leverage loan and high yield markets.
The practice is controversial. The SEC periodically will crack down on companies it thinks are pushing the envelope. Bank regulators have raised the issue of questionable adjustments to borrowers’ EBITDA for widely syndicated leverage loans.
Investors are aware of the issue, too, but have not demanded the practice to stop. In mid-2017, I attended a conference on private credit. One session dealt exclusively with adjusted EBITDA. One panelist offered that adjustments in the range of 5-10% of reported EBITDA were okay, but the consensus was the adjustments were out of control. Covenant Review reported that as of mid-2017 the average leverage for middle market LBOs over the prior two years was 5.5x based upon the target’s adjusted EBITDA compared to reported EBITDA of ~7x. The issue is no better, and perhaps worse, in 2018 judging from market sentiment.
If investors are solely relying upon company defined adjusted EBITDA, then they may be vacating their fiduciary duties when investing capital. That said, an analysis of core versus reported earnings is a critical element of any valuation or credit assessment of a non-early stage company with an established financial history.
Table 1 below provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed.
Adjustments typically consist of items that are non-recurring, unusual, and infrequent. They also may entail elements for a change in business operations, such as the addition of a new product or the discontinuation of a division. This is where judgment is particularly important because we have noticed a trend among some investors to credit businesses with future earnings for initiatives such as stepped-up hiring of revenue producers in which a favorable outcome is highly uncertain.
Adjustments considered should take into account whether the valuation is on a minority interest or controlling interest basis. An adjustment for an unusual litigation expense will not be impacted by the level-of-value; however, other potential adjustments—particularly synergies a buyer could reasonably be expected to realize would only apply in a control valuation.
The development of the adjusted earnings analysis should allow one to identify the source of revenue growth and the trend in margins through a business cycle. The process also will facilitate comparisons with peers both historically and currently to thereby make further qualitative judgments about how the business is performing.
The adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question should be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?
Core earnings differ from earning power. Core earnings represent earnings after adjustments are made for non-recurring items and the like in a particular year. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and, therefore, requires examination of adjusted earnings ideally over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.
Companies that are executing a roll-up strategy can be particularly nettlesome from a valuation perspective because there typically is a string of acquisitions that require multiple adjustments for transaction related expenses and the expected earnings contribution of the targets. The math of adding and subtracting is straightforward, but what is usually lacking is seasoning in which a several year period without acquisitions can be observed in order to discern if past acquisitions have been accretive to earnings. Public market investors struggle with this phenomenon, too, but often the high growth profile of roll-ups will trump questions about earning power and what is an appropriate multiple until growth slows.
In addition to providing insight into how a business is performing, the adjusted earnings statement will “feed” multiple valuation methods. These include the Discounted Cash Flow and Single Period Earning Power Capitalization Methods that fall under the Income Approach, and the Guideline (Public) Company and Guideline (M&A) Transaction Methods that constitute Market Approaches.
It may be obvious, but we believe an analysis of adjusted (and reported) earnings statements for a subject company over a multi-year period is a critical, if not the critical element, in valuing securities that are held in private equity and credit portfolios. Mercer Capital has nearly 40 years of experience in which tens of thousands of adjusted earnings statements have been created. Please call if we can help you value investments held in your portfolio.
Originally published in Mercer Capital’s Portfolio Valuation Newsletter.
Auto dealers, like most business owners, are constantly wondering about the value of their business. It’s easy to see how this issue moves to the forefront around certain events such as a transaction, buy-sell agreement, litigation, divorce, wealth-transfer event, etc. As our previous article “Six Different Ways to Look at a Dealership” points out, there are many other instances when a dealer can evaluate the condition, progress, or value of their store. Dealers can actually influence the value of their store prior to these obvious events by understanding the value drivers of a store valuation and addressing them on a consistent basis. So what are some of the value drivers of a store valuation?
A store’s particular franchise affiliation has a major impact on value. Each franchise has a different reputation, selling strategy, target consumer demographic, etc. Public and value perception of franchises can be unique and are most easily illustrated through blue sky multiples. As the Haig Report and Kerrigan’s Blue Sky Report indicate, these blue sky multiples can vary over time and from period to period. Often stores and franchises are grouped into broader categories, such as: luxury franchises, mid-line franchises, domestic franchises, import franchises and/or high line franchises.
Typically, most store locations and dealership operations are held in one entity, and the underlying real estate is held by a separate, often related, entity. Several issues with the real estate can affect a store valuation. First, an analysis of the rental rate and terms should be performed to establish a fair market value rental rate. Since the real estate is often owned by a related entity, the rent may be set higher or lower than market for tax or other motivations that would not reflect fair market value. Second, the quality and condition of the facilities are crucial to evaluate. Most manufacturers require facility and signage upgrades on a regular basis, often offering incentives to help mitigate these costs. It’s important to assess whether the store has regularly complied with these enhancements and is current with the condition of their facilities.
The quality and depth of management can have a positive impact on a store valuation. Stores with greater management depth and less dependence on several key individuals will generally be viewed as less risky by an outside buyer. Also, a store’s CSI (Customer Service Index) and SSI (Service Satisfaction Index) rating can also influence incentives from the franchise and the overall perception of the consumer. A strong CSI and SSI are also a reflection of a strong service department and a commitment to quality customer service.
Like most industries, the auto industry is dependent on the national economy. We report later on the current SAAR (Seasonally Adjusted Annual Rate) which is an indicator of economic performance and future sales in the auto industry. Current conditions of rising interest rates and a leveling out of the SAAR compared to October 2017 could be predictors of stabilizing values and less activity in the M&A market in the months to come. In addition to monitoring and understanding the current month’s SAAR, the longer-term history of the SAAR and its trends also provide insight into the auto industry and a store valuation. Below is a long-term graph of the SAAR from 2000 to 2017.
This visual evidence demonstrates the cyclicality of the auto industry. Unlike some industries that may be seasonal or cyclical in a given year, the auto industry tends to be cyclical over a longer period of several years. For instance, it’s common for a store to have stronger volumes and profitability for a period of 4-5 years, before experiencing a sluggish year or two. Store valuations should consider the cyclicality of the industry and not overvalue a store during a strong year, or undervalue it during a sluggish year.
Another indicator of economic performance is an analysis of the auto cycle and where we are in that cycle based upon the average age of cars owned. The figure below illustrates the peak and trough of the auto cycle and where we sit today.
A store’s value and performance can be greatly influenced by the local economy as well as the national economy–sometimes more so. Certain markets are dominated by local economies of a certain trade or industry. Examples can be store locations near oil & gas refining areas, mining areas, or military bases. Each is probably more dependent on local economy conditions than national economy conditions.
Buyer demand in the transaction market can illustrate the value climate for store valuations. Typically, buyer demand is measured by the deal activity in the M&A market. The Haig Report indicated that the second quarter of 2018 transaction activity increased by 87% compared to second quarter of 2017. Further, the activity for the first six months of 2018 increased by 23% over the same six months of 2017. Similarly, Kerrigan’s figures reflect an increase in M&A activity of 13% in the first six months of 2018 compared to their data for the first six months of 2017.
The value of a store location can be more complex than urban vs. rural or major metropolitan city vs. minor metropolitan city. Each store location is assigned a certain area or group of zip codes referred to as an “area of responsibility” or “AoR”. Particularly, how does a location’s demographic characteristics line up with a certain franchise? For example, a high line store would perform better and seemingly be more valuable in a major metropolitan area with a high median income level, such as Beverly Hills or South Beach in Miami than in a mid western city. Conversely, mid-line stores would probably fare better in areas with more moderate median income levels.
The amount of competition in a store’s AoR, as well as the nearest location of a similar franchised store can also have an impact. It’s important to make the distinction that we are talking about a market and not a single-point store. A single-point market refers to a market where there is only one store of a particular franchise. An over-franchised market would be a larger market that may contain several stores of a particular franchise within a certain radius. Often, a store in a single-point market would be viewed as more valuable than one in an over-franchised market that would be competing with its own franchise for the same consumers. Additionally, the stores of the same franchise in the same market could be drastically different in size. One may be part of a larger auto group of stores, while the other may be a single-point dealership location, meaning its owner only owns that one location.
As we’ve discussed, the value of a store can be influenced by a variety of factors. Some of the factors are internal and can be affected by the owner, and some are external and are out of the control of the owner. To find out the value of your store, contact one of the automotive industry professionals at Mercer Capital.
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2018.