Marketwatch, May 2010: Microwave M & A
Let the Seller Beware
The microwave components market is large and fast growing, driven foremost by the explosive growth in commercial data communication and defense electronics spending. While the capital requirement for designing and manufacturing active components is high, the requirements for passive components, such as switches, multiplexers, isolators and connectors, is fairly low. Thus, there are numerous small to medium sized companies that compete in the passive components segment of the market.
Over the years, larger companies have strategically broadened their product offering to their customer base by acquiring smaller passive components companies. These acquisitive companies are well-capitalized and staffed by an experience team of M&A experts and outside advisors, whose goal is to identify likely acquisition candidates and acquire them at a discount to their true value.
As a prospective seller of a microwave components company, it is important to understand the true value of your company to such prospective acquirers. In classic terms, the value of a business is the net present value of its future cash flows.
Many buyers use EBITDA as a proxy for cash flow. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. While not perfectly correlated, EBITDA has become synonymous with the earnings by which companies are often valued.
Many passive component companies are privately held, owner/operator businesses. The owners of these companies often pay themselves above market salaries, expense perks (e.g. company paid vacations and dinners, premium car leases), and, in order to minimize income and hence income taxes, expense excess material purchases and capital goods that would otherwise be capitalized on the balance sheet. Therefore, if the valuation of the company is based off of EBITDA, the reported EBITDA of the company is often significantly depressed from its true value, making it critical that the true historical EBITDA of the company be determined prior to entering into a sales process.
Once the true EBITDA of the company is known, it is important to develop a financial model for future EBITDA. The EBITDA model is driven by a revenue forecast, and the development of the underlying costs associated with that revenue. The revenue forecast should be based on historical product, program and customer sales, and new product, program and customer activity based on recent quote and design activity. Once a defendable revenue forecast is prepared, the costs associated with the revenue can be derived. Often times, financial models are developed based on average cost of goods and SG&A percent of revenue. However, while some costs are variable, many are fixed. The cost of goods should be segmented by variable material, variable/direct labor and fixed and variable overhead. Overhead that is fixed should be expected to increase with inflation, not revenue. SG&A should also be divided by fixed and variable (e.g. manufacturer’s rep commissions) costs. By developing a detailed cost model, the forecasted EBITDA should grow at a much quicker rate than revenue, taking advantage of the operating leverage on the fixed costs.
The model below illustrates a sample forecast of a stand-alone business, showing elimination of owner perks and the leverage of increasing revenue on fixed costs:
The performance of an acquired company owned by a strategic buyer should be greater still. On the revenue side, a strategic buyer should be able to increase revenue by leveraging their larger customer base and sales channels. From a cost perspective, there should be significant cost savings, derived from a) achieving economies of scale on material purchases and employee health benefits, b) eliminating duplicative expenses such as field sales, outside legal and accounting expenses, and c) the avoidance of costs to develop products or infrastructure that the acquired company already possesses.
The forecast below assumes that the strategic acquirer can increase revenue by cross selling and leveraging a larger sales/distribution organization, save 10% on material purchases, reduce 5% of variable overhead, eliminate the manufacturers’ rep selling organization and reduce $50K in advertising expenses.
In this scenario, the 2013 EBITDA of the business acquired by a strategic buyer is over twice that if the business operated as a stand-alone entity. The present value of future cash flows is then discounted by a discount rate, which is the financial threshold that an acquiring company expects to earn on its investment. The greater the discount rate, the lower the value of future cash flows (for example, $100 five years from now at a discount rate of 10% is equal to $62 (100/(1.105); at a 20% discount rate, the value is $40 (100/(1.205)).
The discount rate is driven not only by the financial thresholds of acquiring companies, but also the perceived risk of an acquirer to these future cash flows, including customer concentration, the proprietary nature of the company’s products, and the stability of the business, among others.
The chart below summarizes the net present value of the cash flows for the stand-alone entity versus ownership by a strategic acquirer, based on the financial forecasts above, with a range of discount rate assumptions (20 to 35%).
As illustrated, the net present value of the company declines the greater the discount rate. The more strategic the business is to a buyer, the lower their perceived risk of an acquisition and hence the lower their discount rate.
Additionally, the chart illustrates that the greater the operating synergies created through an acquisition, the greater the future profitability (EBITDA), and hence valuation. While acquirers expects to retain the value of the synergies they create, having a competitive sales process necessitates the bidding companies to increase their offer, thus, in effect, transferring a portion of the value of the synergy created.
Lastly, over the past decade, financial buyers (e.g. Private Equity Groups) have targeted microwave businesses. As financial buyers, they expect rates of return greater than strategic buyers; yet do not provide the operating synergies that a strategic buyer can bring to an acquisition. As a result, in competitively bid processes, the financial buyers tend to present the lowest offers. It is for this reason that financial buyers prefer contacting companies that have not yet contemplated a formal sales process.
Given the anticipated number of acquisitions in the microwave components market, it is highly likely that a large acquisitive company may approach your business unsolicited. To maximize the value of a potential transaction, it is critical that you a) understand your true profitability, b) understand the potential profitability your company can provide the strategic acquiring company and c) engage in a competitive sales process in order to convert a portion of the acquirer’s created value to the seller.
About the Author: Kenneth Stern is President of Synxronos LLC, an M&A advisory firm focused on selling privately held technology oriented businesses. www.synxronos.com