December 12, 2002 Commentary # 4

 

Greetings:

 

            The Merrifield Consulting Group, Inc. (MCG) is in a transition process of beginning and circulating a weekly commentary service that will be eventually posted on a new-look, new-function web site at www.merrifield.com. Until the web site is upgraded we will email the entire publication. We will try to keep them short, by referring you to documents elsewhere on the net.

 

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COPIES OF PAST COMMENTARIES, OUR E-BOOKLET AND OTHER REFERENCES

This is our fourth “commentary” edition. If you would like copies of the first three, request them from karen@merrifield.com. If you do request them, you might also want to request our 45 page E-Booklet entitled “New Solutions for a Different Kind of Downturn.” This has 11 articles and a case study exhibit that are not posted on our existing web site at www.merrifield.com. To keep these email documents shorter and to avoid repeating ideas/analysis for regular readers, there will be “for more on this topic” references to: articles and video information found at our site; articles in the E-Booklet; or, topics covered in detail in previous commentaries. This referral process will all be easier when all information is at the new web site; we beg your patience in the meantime.     

 

RE-PURPOSING COMMENTARY CONTENT ON OTHER SITES: The answer is “yes.” What is the possibility?

 

YEAR-END THEME: CHANGE “CHANGE MANAGEMENT”

This is the second of three commentaries that will focus on doing things better in 2003. For better or worse, many companies plan their big initiatives and incentive compensation around calendar numbers making December a month for reviewing THE 2002 PLAN results and re-casting new PLANS FOR 2003. Because success rates for 2002 plans may have fallen short and our 2003 economy may well be challenging, maybe now is a good time to think about how to change how we pursue change. I hope the chosen topics in our last commentary and this one will help 2003 plans be more fruitful.   

 

TOPICS: HOW TO INCREASE FINAL EXIT STRATEGY VALUATIONS

 

1.       A review on the book “A Stake in the Outcome” by Jack Stack. Currency/Doubleday, 2002.

2.       Case Study – “Bruce, what is my building supply distribution company worth? When should I sell?”

3.       Post-Bubble Economics picture story: Why exit options and company valuations are dropping.

 

1.                   BOOK REVIEW of “A STAKE IN THE OUTCOME” by Jack Stack

 

Who’s Jack Stack? For the past 20 years he has been the CEO of what is now an umbrella holding company called SRM in Springfield, MO. In the early ‘80s he and eleven other managers bought Springfield Re-manufacturing Company from a parent organization, International Harvester, which at the time was on its way to bankruptcy. The buyout was financed at an 89 to 1 debt to equity ratio.

 

“A Stake in the Outcome” is a sequel of sorts to one that Stack co-wrote with Inc. Magazine in 1992 entitled: “The Great Game of Business”. The magazine had discovered SRM in 1990 for one of its “fastest growing private companies in the US” stories. The magazine had become smitten with SRM’s style of “open-book management” (OBM) and Jack’s diehard commitment to having every employee have an emotional, financial, stock investment in the company; to literally be “an owner”. In true “intrapreneurial” fashion, SRM developed a spin-out business from the success of “The Great Game of Business”. You can check it out at www.greatgame.com. 

 

I liked the first book that went into the mechanics of their OBM process, but it didn’t look past the survival and now thriving stages of a company’s life cycle. The sequel is much better, because it highlights what was covered in the first book, but then goes on to explain how management should address the following, longer-term, life cycle issues every quarter to avoid longer term valuation, exit and perpetuation problems:

1.       Once you have become a high performance company that grows rapidly to dominate a slow-growing niche, how do you continue to grow fast enough and profitably enough to keep the good, young people on board when the niche will no longer support such growth?

2.       Once you become famous for high performance and deliver premium economic benefits to all stakeholder groups – customers, employees, suppliers and shareholders – how do you keep from backsliding due to arrogance and comfort? How do you stay hungry enough to keep working hard at the risky, messy business of continual innovation to fill new, tangential needs and opportunities that can be launched from your core, platform business without killing the core operation?

3.       What if a lot of the rank and file employees are good at what they do, get continuously better in their job niche, but don’t want to be bothered with the responsibilities of finance, saving to invest and re-skilling to support adaptation to change as well as innovation? 

4.       As an older generation of shareholders starts to cash out, how do you plan for and finance both the buyouts and recycling of the stock while also funding continuous innovation and growth?

5.       If you ultimately did decide to sell the core company or some of its spin-out divisions to outsiders, how do you make it as valuable as possible to either an outside buyer or a group of insiders who might want to do a next generation leveraged buy-out from the parent?

 

The book is an easy, compelling read, because Jack’s pragmatic, battle-scarred, but determined voice comes through in the telling of a great story. This isn’t a dry, super-researched, theoretically detached, B-school professor tome. For more encouragement to buy it, I recommend that you read the reviews at Amazon.com and ask yourself what you are planning to do in 2003 to move significantly toward solving the five problems above.

 

If you aren’t making new, out-of-the-box changes to move your company towards becoming a thriving business to have to then worry about solving the 5 questions above, we can recommend (besides Jack’s book) our free E-Booklet and our almost free (from resellers) video entitled “High Performance Distribution Ideas for All”. For more on the video, see both the E-booklet and our web site.  

 

2.            COMPANY VALUATION QUESTIONS

 

            A CEO of a wholesale distributor in a building supply channel recently asked me in a tele-consulting session two related questions: “What’s my company worth? And, when should I sell?” The topping out of the housing bubble that has been stoking his sales for the past 4 years had gotten him thinking about these ultimate issues. (For more on the housing bubble see the Nov. 19th Commentary #2, topic 2.)

 

            The correct answer to this question and most other big business questions is unfortunately not a simple one, instead, “it depends” on a lot of inter-related factors such as:

 

1.       Different types of buyers – financial, regional industry consolidators, next generation insiders and liquid fools – who will all use different valuation methods. A distribution business should rationally be worth the most on a present value cash basis to the distributor in the same channel that is in the same or next contiguous geography. The liquid fool from outside the industry who buys at the top of the market may, however, pay the most for the wrong reasons.

 

2.       Acceptable valuation methods to the buyer. Because distribution is a process/service business that is often very dependent on the quality of and hands on presence of whomever is managing it, they generally don’t sell for high multiples of earnings before interest, taxes and depreciation (“EBITDA”) in public or private markets. They will sell instead for within + or – 20% of “book value” or their current assets less debt. But, potential sellers may get more over time if they are willing to shoulder more future risk for more reward. “You name the price and I will name the terms” is a negotiating line that suggests that higher nominal prices are possible with terms involving: future payments, earn-outs, seller asset guarantees and seller financing at low interest rates.

 

3.       Selling at the top of economic valuation cycles for companies is vital. Distributors that sold out to public roll-up companies for cash from ’97 to 99 got peak valuation multiples. Now that we are in the third year of what I think will be as long as a 10-year “secular bear market”, valuations for all companies have dropped and on average will continue to drop over the next 5+ years.

(A dramatic example reported in today’s (12-12-02) New York Times involves Burger King. A London-based conglomerate has been trying to sell it for two years. They had a deal with some financial, buyout funds for $2.5 billion announced in early July based on hitting EBITDA numbers through the June closing. The EITDA came in 12% lower; the deal was canceled and now re-done at a 33% lower price of $1.5 billion. The seller is also providing financing for the deal this time around which suggests that they are assuming more risk through the terms to nominally get a higher deal price than an all cash down deal would yield. The industry/economy story, of course, is not good. Too much capacity and too little demand for fast-food burgers has created an on-going price war with McDonalds, et. al. Here is the URL for the article: http://www.nytimes.com/2002/12/12/business/12BURG.html)

(Back to..) Our case study friend could in theory still cut an OK cash valuation deal right now if the housing bubble, which is just topping, lifted this year’s profits over last. The buyer would also have to assume that:

a)      Housing is a long-term investment vehicle instead of consumer consumption.

b)      Housing volume and prices can, therefore, continue to grow faster than the incomes that must buy them and

c)       The US economy can grow again like it did for most of the nineties when accelerating debt loads at consumer, corporate and government levels were buying consumption and not productive asset investments. But, with total US debt now exceeding $34 trillion or 3x the underlying economy that must service the debt (Nov. 19th Commentary #2-topic 1) and with China’s accelerating manufacturing base continuously causing US factory lay-offs (11-08 Commentary #1, topic 2), growth prospects look weak.

 

4.       For the biggest increase in both the salability and cash value of a distribution business, a company should set out to achieve “high performance distribution” attributes and economics. If all the employees know:

a)      What the number one niche of customers being pursued is.

b)      Who the five+ most profitable customers within that niche are by heart at each branch.

c)       Who the five+ most important target accounts are within that niche.

d)      What the exact service metrics are for defining “perfect service” for that niche and can see them measured daily.

e)      Why and how they are empowered to say “Yes” to any extra service request those key accounts have as well as do any and all jobs necessary to make service metrics happen everyday.

f)        And, what is economically in it for them both short term and long term.  

 

Then, any distributor will be on their way towards:

a)      Growing at a rate that is 2 to 5 times greater than the average industry growth rate.

b)      Making 4 to 6 times the return on investment of the average player in the channel.

c)       Funding future growth opportunities that convert “a job” into “a career”.

d)      And, be able to fund any type of buyout from one generation of shareholders to the next.

 

The bottom 95%+ of all distributors unfortunately have not figured out the answers to the questions above, let alone figured out how to teach them to all employees in a fast, affordable, effective way. If a journey starts out with a first step, then might we ask ourselves: “What are we going to do significantly different in 2003 that will move us beyond survival mode, through the thriving mode to ultimately get to sustainable franchise value mode?” Then, all the stakeholders will have a commonwealth system that will both have a high valuation with a good chance for continuing to be a strong commonwealth system even if the buyer is managerially incompetent. We think the only affordable, distribution-specific, money-back-guaranteed, educational solution to this question is our video, “High Performance Distribution Ideas for All”.

 

3.            Post-Bubble Economics picture story: Why exit options and valuations are dropping.

 

For the first time since 1929, both the stock markets and the economy have not revived in a typical recovery pattern after the Federal Reserve has (this time) massively expanded money supply and reduced interest rates. Why are super and faster-delivered, mega-doses of the traditional, financial stimulation medicine not working? The prescription’s failure has made forecasting fools out of every economist, Wall Street cheerleading analyst and strategist with the notable exception of Stephen Roach at Morgan Stanley. What’s different about our economy this time? Or, perhaps more importantly, what is similar to the bubble economies of both 1929 and Japan in 1990? 

 

Most economists have not been looking at either the liability side of the balance sheets for individuals, corporations and governments here in the US or the China free-market zone effects. For some great economic charts that illustrate the massive increases in money supply, mortgage debt, total debt and the erosion of factory jobs in the US go to this URL:

http://www.prudentbear.com/creditbubblebulletin.asp   (dated 12-6-02)

 

            The author of this document, Doug Noland, does a credit report update every week. His reports may be generally beyond the ken of most of our readers, but try reading the first and last paragraphs of his latest reports and skim a few topic sentences in between. The bottom line is that when a society faces debt exhaustion from buying non-productive assets, there is no additional stimulation that the government can provide. Pumping the money supply to debase the currency and lowering interest rates so people can borrow so they can consume more and inflate the last asset bubble to pop (housing) while maintaining the same monthly payments just adds to the debt pile and the day of reckoning. Instead of chugging another pint, we need to sober up and slog through the debt of this post-bubble economy. 

 

CONCLUSIONS:

 

            Has this commentary been provocative enough to start you re-thinking 2003’s plans? Are you starting to wonder if making incremental cost cuts within the old way of doing business isn’t the answer? Is it time to switch to “high performance distribution principles” which involve educating and signing up all employees to be part of the solution in making customer profitability applications and zero error service economics deliver? If you aren’t sure yet, we encourage you to read through our E-Booklet, “New Tactics for a Different Type of Downturn” which is free via email request. Then, you might take the next, money backed guaranteed step of investing in our video. The downside risk is that you will lose a few hours of your time getting a lot of your unspoken assumptions for how to run your business challenged. Why not? If you have further questions or ideas, please email us!

 

That’s all for this week!

 

                                    Bruce Merrifield   (bruce@merrifield.com or 919-933-7474)