The problem facing management and Boards
Two case studies are outlined below. In the first case, the management and Board needed a clear understanding of the reliability of the future revenue streams of a publicly listed company they were considering to bid for and hopefully acquire. Views around the table were mixed. There was a substantial risk of overpaying if, in an uncertain economic climate, the target’s historic growth rates did not continue.
In the second case, the Board of a listed company was facing a hostile takeover. The domestic and world economy were in the height of a boom… how long could we expect this boom to continue? The target’s Board needed to know if current revenues and hence earnings per share (EPS) were sustainable as it did not want to hold out for an unrealistic bid price and potentially mislead the investor market.
In both cases, forecasting future revenue growth rates were important to understanding business value and its sensitivity to the company’s internal economics, market growth and specific macroeconomic impacts.
The only too familiar situation
In acquisition due diligence, as a key element of an acquisition strategy, and for that matter in any business planning or investment appraisal, revenue usually is the dominant driver of future earnings and hence of future value created. The common shortcoming of most acquisition due diligences, however, is the poor understanding or accuracy of financial model estimates of future revenues and revenue growth rates.
Usually a single revenue growth figure is chosen, naively based on historic growth rates or worse still on some other number the business modeller thinks management want to hear. Little effort goes into quantifying future growth of the target’s market segment and sub-segment growth. Given the impact of small changes in revenue growth rates on enterprise value, this can result in large errors in projected revenues and can lead to overpaying or indeed underbidding for the target business. Equally this error can result in under or over investing in a business plan or competitive strategy.
A further problem is the lack of granularity of this estimate of the target’s future revenue growth. Rarely is account taken of the end users of the target’s products and services. More rarely is account taken of the derived demand of the end users’ of intermediate users, particularly when the target’s products and services are important inputs to end users’ products and services along the value chain. The dynamics of these market sub-segments are often unsighted but their potential impacts along the value chain can be large and need to be well understood.
Finally, relevant economic impacts of leading indicators (such as GDP growth, interest rates, foreign exchange rates, taxes and duties) and environmental factors (such as policy changes on recycling and emission taxes) on industry and hence on target growth are given cursory and qualitative consideration at best.
Case example 1: Industrial market acquisition appraisal
In an acquisition evaluation of a large soda ash (or sodium bicarbonate) producer, this raw material was a critical input to some 15 separate end market segments. In other words, the soda ash company’s future domestic revenue streams depended upon the future performance of many quite diverse business end users and their end users. These market segments included the manufacture of glass for wine, beer, soft drink, RTD and spirit bottles, automotive and construction glass, baking powder, and detergents to name a few. The reliability of these revenue streams was of the utmost importance to the acquiring company and the price they would be willing to pay.
CK Partners, in its analysis, needed to overcome the common but often costly problem of simplifying the revenue growth assumption to a historic rate or some other broad assumption. Our approach to this evaluation required four key elements: a granular understanding of segment growth and the future revenue streams of intermediate and end users of the final products which depended on soda ash or its derivatives; the need to integrate not only competitive market drivers but also macroeconomic drivers to reflect market segment differences, and the impacts of derived end user markets as well as financial and trade-related factors; the likely positive and negative trend effects on future end-user growth (systematic risk such as the increasing use of glass in buildings or increased use of recycled glass in bottles); and possible shocks in end-user growth (such as capacity expansion of a major glass manufacturer or a stronger A$).
The unusual combination of negative trends and shocks can quickly create a ‘Black Swan’ event or a ‘perfect storm’. Some outcomes or events, even though their likelihood may seem low (like the recent global financial crisis!), must be considered in the evaluation, particularly if they could have a large potential impact on the business.
Case example 2: Retail apparel market hostile defence
A major Australian retail apparel company was facing the uncertainty of a hostile takeover bid and the Board needed a clear view of the future revenue streams, costs and hence profits of each of five major brands over the next two years. To communicate to the investor community the logic of its defence strategy, the Board also needed an accurate valuation of the business to understand the sensitivity of overall EPS performance to the key drivers of these brands.
Again, it would have been easy to fall back into the trap of taking a simplistic approach to estimating future growth rates and EPS performance or relying on broker estimates or historic extrapolations to determine future company growth rates. However, the investor community rely on both the acquirer and the target company Boards to provide accurate information about their companies’ current and expected performances.
A four-step approach was taken by CK Partners. The steps involved: identifying and prioritizing the major drivers of revenues and costs for each of the five major retail apparel brands; quantifying for each priority driver the leading indicators and their components; using Monte Carlo analysis to quantify the profit impact and the risk profile of normal input variations on EPS; and then running a ‘shock analysis’ to quantify the profit impact of one-off events and the possibility of a ‘perfect storm’ when a number of major drivers occur together such as a sharp fall in economic growth, sharp decline in the A$, abnormal summer weather and a downturn in consumer confidence and retail demand.
Specific ‘internal’ revenue impacts modelled included brand health (buyer brand position and in-store conversion) and changes in store capacity; specific ‘external’ revenue drivers included GDP-linked clothing market growth and trading up/trading down cycles (driven by consumer sentiment, disposable income and other macro components); and specific ‘cost’ drivers of COGS (where the strength of the A$ impacted the company’s US$ hedged/unhedged position), store expenses and overheads,
Each of these key drivers was quantified to determine their final impact on the level and sensitivity of the company’s future EPS performance. The richness of this approach allowed the firm to forecast and identify the emerging ‘perfect storm’ created by the impact of weakening economic conditions and a downturn in the clothing cycle, a sharply falling A$ and an abnormally cool summer together creating a dramatic cumulative downside impact on EPS.
The rest of the story
In short, the subsequent acquisition appraisal convinced senior management and the Board of the large publicly traded company that there were significant revenue risks that they had not identified about the potential acquisition… as a result the Board decided not to proceed with the bid.
For the hostile takeover, it became clear that the retail apparel market was likely to deteriorate sharply and quickly and, therefore, that the current offer price was attractive and should be accepted. In both cases subsequent market and economic events vindicated the Boards’ decisions.
The rigour of the above methodology can be applied to developing competitive strategies, new market entry strategies and to evaluating existing business portfolios. The approach should also be used to understand and quantify the expected growth rates of important input costs of a business’ products and services. In this way, the key drivers, and growth and behaviour of future costs can be better understood.
If you have an interest in how this methodology might apply in your own business circumstances then feel free to contact CK Partners in Sydney, Australia via Contact Form.
