Last Year’s Model and Flawed: A Good Investment for the Operations Warrior

With private equity groups out and about, constantly shopping for luxury goods companies and with the economy not recovering as fast as everyone had hoped, brand valuations are a good sport for buy-out specialists. This is because at the moment most valuations reflect the brand’s profit making ability, which is very low, while private equity firms gamble on the value of the intangibles. According to the Financial Times’ “Special Report on the Business of Luxury” (June 14, 2010), there is a lot of activity in the buying and selling of luxury brands and this reflects the eagerness of several private equity firms whose main goal is to capitalize on their record-low acquisitions of yester year and take advantage of the slightest signs of economic recovery. Luxury goods make for a cyclical industry that requires finance professionals to be bold when it comes to fashion.

In the case of Ferré’s auction one hopes that the results are going to be a little bit different. Gianfranco Ferré, the Italian designer who founded the Ferré Fashion House, passed in 2007, while his firm had already been bought by IT Holding, a luxury brands group that went bankrupt last year due to the economic recession. (The Financial Times, June 17, 2010, http://www.ft.com/cms/s/0/5d55973c-796a-11df-b063-00144feabdc0.html)

But in bankruptcies of that type is when things get interesting, not so much for the sport-loving buy-out shops, but rather for the hard-core operations-driven private equity firms. These are the people who roll-up their sleeves and bring out the operations manual with the goal to turn the firm around and create economic value for the firm, their own team, and the rest of the stakeholders. Their success is based on their ability to identify flaws and work with them, around them, or against them. Whichever the case, here is what the rest of us should keep in mind for ventures of similar kind:

Manufacturing management: Production processes are key, more so than production capital (machines, manpower, or space) to produce the product. Process is what consumes time and resources to produce quality. The latter is a major differentiation point from the competition.

Inventory control: Make inventory control part of your production process or at least try to identify where the two models intersect.

Quality control: Setting standards and inspection systems should happen on both the micro and macro level. Dumb proof checklists will never amount to anything useful if you don’t give your own management breathing space for macro inspection. Rethink your systems on a regular basis. Where your processes fail is where your business model needs tweaking.

Purchasing: Identify supplier sources and work with them to add value to their business model. If you hesitate ask yourself why. This could reveal an opportunity for business expansion for you (vertical or horizontal integration).

Operations skills and management: Don’t be afraid to spend some time in the “production trenches” before holding a meeting at the senior management level. Take some time to reflect on what you learn on the trenches and ask a lot of questions even if, as the company owner or CEO, you are supposed to hold all the answers.

Working with Flaws Part II

It is important to indentify weaknesses in any plan, strategy, or venture. These weaknesses are the cause of business disruptions. If these have to take place, it is better to be the one who provoked them (you: the master planner, strategist, entrepreneur) rather than allow your competitors to disrupt your business. To be the first, you need to know where to look. If you already have a good team in place, you are most likely to identify weaknesses in the following areas: marketing and sales; operations; research, development, and engineering; financial management; general management and administration; personnel management; legal and tax structures.

Knowing that flaws in these areas can bring down a sovereign state (see entry of May 29, 2010) should be enough to motivate you to pay close attention to the specifics. Perhaps it would be best to elaborate in one area at a time, even though the CEO of a company should keep a close eye on all seven simultaneously.

Marketing and Sales

Marketing planning: How are you planning to structure your overall sales, advertising, and promotion programs? What are the determining factors in establishing distribution systems? Who are your sales representatives and why?

Market research and evaluation: Are you or someone on your team able to design and conduct market research studies and to consequently analyze and interpret the results? What is your experience with the fundamentals in the field? Have you worked with questionnaire design and sampling techniques before?

Merchandising and Sales: You must feel able to organize, supervise, and motivate your sales team. You must have an understanding of territory analysis in order to forecast account sales potential and to steadily gain market share in the target market.

Customer generation: How are you developing new customers? How are you identifying sales potential within your network and what is the strength of your sales closing record?

Service: What are the needs that arise from particular products or services you are selling? What is your strategy in handling customer complaints and what is the channel that brings these complaints to the CEO’s attention?

Channel management: Have you planned the flow chart of your product from inception to manufacturing to distribution to the customer? Do you have an understanding of the costs involved in each step of the process? How can you buffer the process if one of the parts fails?

Rethinking marketing as the sum of all the parts listed above will help you avoid pitfalls that can ruin your product, reputation, sales, and ultimately your business. Your skills as the CEO should reflect a thorough understanding across all of the aforementioned areas even if you are not an expert in each one. Someone else on your team should be.

Working with Flaws

Having followed Greece’s financial crisis for the last five months, I realize today that a feasible solution will not be defined for Greece’s woes (or for Spain’s and Portugal’s for that matter) until leadership approaches the issue not just as a financial problem but as an economic one. Country members must find their flaws and accordingly redefine their strategy and their competitive advantage. While German leadership has been honing in, constantly updating Germany’s competitive advantage, the rest of Europe is complacently lagging behind.

No one can compete with Germany’s foresight to deleverage during the pre-crisis years (up to late 2007, early 2008 when most corporates in Italy, Greece, Spain, and Portugal experienced substantial rise in leverage). In retrospect, Germany’s strategy raises an array of issues worth examining further. For example, the German government followed a contrarian strategy within the European markets and adequately reinforced its fiscal and political power within that context.

Simon Nixon (“Why Concern for Greece Wasn’t Just a Singular Worry,” The Wall Street Journal, February 12, 2010) argued that as “the global debt pile from the credit markets [is transferred] to the banks, from the banks to sovereigns and now from weak sovereigns to stronger ones […] once this transfer is complete, the dept pile will have nowhere else to go.”

This means that even though Germany has undertaken a Herculean load of Greece’s debt, the times call for a re-examination of all of the country-members’ flaws as springboards for potential growth. Namely, it is not a fiscal policy that will save country members but rather a structural policy that aims at redefining sovereign strategic aptitude. For Greece this could mean the following:

Look for flaws in the way the public sector works and correct that with a series of privatizations. It has been reported that the Greek socialist government hired investment bank Lazard to advise the country on its public finances. Having worked on the privatization of the state carrier Olympic Airways, Lazard could be the bank restructuring railways and the gaming industry along with other privatization initiatives.

Up to that point, working with flaws (in identifying areas that can be improved and restructured) is a macro-approach to Greece’s financial problem. The micro-approach requires looking at small businesses across sectors and their odds for survival. The odds are not good. The corporate sector is in a particularly difficult position as banks are reducing their capitalization ratios. The prospects of investment from within Europe are minimal. Additionally, this means that the ailing public sector is facing a road to privatization that is going to be long, arduous, and unpredictable.

It’s not just the lack of capital infusion that is hurting corporates and small businesses at the moment but also the respective legal frameworks, most of which antiquated and with an equal share of blame as culprits for the current financial crisis. In Greece, it takes a little over $10,000 to obtain a permit to start a new business, whereas in the US a business owner can incorporate for about $350. But if there are no small businesses, if the public sector contracts, if large corporates have no access to capital how is the economy going to recover? Ideally, a side effect of the current crisis would be a reform of Greece’s corporate law.

It is great to identify the flaws in each one of the European country members. The mistake would be not to do anything with them.

To Buy or To Sell? Techniques in the Valuation of Private Companies

Valuation of private companies is a challenging task. Financial data on private companies is not usually available while the market for private transactions is less liquid than this of publicly traded companies. Yet, it is often imperative to assign a specific value on a private business. This could be part of due diligence before and during a transaction or a necessary internal process for allocation of shares among owners or employees.

Quantitative data must be used in combination with contextual and subjective information on the company. There is no absolute value to be derived with calculations and no mathematical formula that can be used with exact science. Additionally, even when one has been hired internally to conduct research and value the company, which consequently means that one has access to all in-house financial data, the market plays a major role in the final valuation. This has to do with market liquidity at that particular time but also with recent sales transactions of comparable companies. Price-earnings relationships defined in other sales can be applied to value the company.

When I am asked to value a company I prefer a combination of discounted cash flow techniques (DCF) and price-earnings multiples from comparables. Generally, I tend to mistrust appraisers’ approach that is based on industry-specific formulas, which account for financial and operational data and result in an approximate figure. Given that figure, I would still run a DCF valuation because it calculates the underlying economic value of the company based on the company’s ability to generate cash in the future. This method presents inherent difficulties such as forecasting expected cash flows and estimating the cost of capital to be used as the discount rate in the calculations.

Multiplies are based on revenue and earnings figures found on the income statement or on assets found on the balance sheet. For example, one may want to look at Price/Revenues (P/R), Price/EBIT (Earnings Before Interest and Taxes), Price/EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization), Price/Earnings (Net Income, after all expenses and taxes). A valuation based on these numbers may result in a value that needs adjustment up or down by as much as 30%. This often has to do with the size of the company and the premium that is assigned to large companies (larger companies are worth more than small companies in general) or the discount rate applied to private companies to account for the lack of liquidity within the market. Furthermore, a premium may be assigned for substantial assets on the balance sheet, or excess cash, or a superior brand etc. The company is always worth more to a strategic investor who gets involved in managing the business and therefore contributes with value added.

The complexities of a multiples-based valuation are numerous but may be clarified when a DCF approach is applied simultaneously. A DCF valuation usually consists of four steps: 1. Forecasting of future cash flows for five years and for a best and worst case projection; 2. Estimating the firm’s value at the end of the forecasted period (residual value); 3. Estimating the cost of capital using the weighted average cost of capital (WACC) formula; 4. Calculating a net present value (NPV) of the firm by discounting the residual value and each year’s cash flow projection by the appropriate discount rate and then adding them together.

It is important to value the company based on both approaches because while its market value is a reflection of the underlying economic value, if the numbers reveal inconsistencies (unusually low or high market value) this may point to a buying or selling opportunity.

The Direction of Independent Research in 2010

A variety of interesting topics were discussed today at The Sixth Annual Investorside Research Conference: Indepedents’ Day 2010 (sponsored by Bloomberg Tradebook and co-sponsored by the New York Society of Security Analysts) at Bloomberg’s headquarters, at 731 Lexington Avenue.

The challenges that have shaped the financial landscape within the last two years are still present. Nevertheless, several of the analysts who participated in the panel discussions agreed that these challenges also present opportunities for investors (primarily hedge funds and private equity firms) who are looking to enter the market with new positions.

There has been an array of regulatory and legislative initiatives but the truth is that research remains fundamentally central in the process of due diligence as well as in later stages of investment. The role of research has functionally persevered for about the last fifty years, it was argued, and its strength remains in the fundamentals. This means that all financial statements are crucially important and that more emphasis needs to be given to the study of the balance sheet. In contrast, think of the Internet bubble of the early 2000s, when analysts were satisfied with information on revenues and cash flows even if these were not giving a complete picture of the company’s health.

While analysts are returning to the fundamentals with a newly found rigor, investors are more willing to invest in equity rather than public/private partnerships because liquidity has become a big concern. No one wants to lock capital for the next ten years and with no provision of certain exit strategies. Equities by contrast offer a more manageable investment in terms of liquidity and timely exit. Analysts are still basing their due diligence for equities on strong fundamentals and they also expect the Fed to provide market surveillance, especially in the areas of interest derivatives, SWAPS, and CDS.

The flux of the financial landscape is evident in its own consolidation, an idea we discussed here in January (See: “Is Uncertainty the New Paradigm?”). It seems that this remains a major concern on everyone’s mind: there are 9000 banks in the US and five in Canada. The proper number of banks in the US is somewhere between 9000 and five, but five is a scary number for the American taxpayer because too few banks would imply that they are also too big to fail. This, in combination with a persistent weakness in risk management, implies that the consolidation in banking will continue within the next two years.

As for risk management, everyone’s trepidation stems from the realization that statistical models do not work and that contextual research is equally and even more important. It is time to think about the norms rather than mathematics. It is also time to think about who is on the managing team of a company, who is on the board, and who is the major player. The presenters unanimously agreed that qualitative research proves far superior to quantitative because behavioral economics must be taken into account.

The case studies presented at this conference confirmed the classic example of unrealistic expectations and bad accounting that leads to elevated risk for the shareholders. (Just to name a few of the companies elaborately discussed: First Solar, Q-Cells, Conergy, Suntech Power, Renewable Energy Corporation among others.) They all responded to unsustainable demand (demand based on temporary incentives to install solar panels for production of alternative power in European countries, mainly Germany and Spain), increased production, and tripled their inventory. This is where research on fundamentals can save shareholders from losses. In the aforementioned cases, growing inventory was coupled with growing receivables. When businesses were questioned what was happening with their balance sheet, the usual answer was that they were in the process of altering their business model. This, they claimed, was normal to show on the balance sheet, which should be excluded from analysts’ reports. Theirs was not a very plausible story, as we all know by now (the time frame of these cases studies was from 2006 to late 2008).

The only remaining issue with analysis of fundamentals and accounting in general is that US GAAP regulations are being tested. It was argued today that US GAAP might be soon going away to be replaced with IFRS rules. This may solve the problems of comparability and transparency within the global economy but also presents a tremendous conundrum for educational institutions with accounting departments. Accountants should definitely know how to work with both the US GAAP and the IFRS system but shaping the curriculum in schools is not an easy task while retroactively adjusting company records may be impossible.

Independent research has been strengthened by technological platforms such as LinkedIn and other forms of social networking, all of which become very useful tools for service providers looking to acquire industry knowledge and specific expertise. This combined with a renewed commitment to fundamentals and an interest in behavioral studies is where Independent Research stands in 2010.

Is Angel Investing Irrational?

The Berkley Center For Entrepreneurial Studies at the Stern School of Business is famous for its courses and co-curricular activities in entrepreneurship and innovation. On February 24, 2010, the Berkley Center’s Himelberg Speaker Series featured David Rose, Chairman of the New York Angels (http://newyorkangels.com/), angel investor himself, founder of Angelsoft (back-end infrastructure software) and manager of a proprietary portfolio that consists of no less than 75 companies. Rose was invited to present his strategy in angel investing. He faced an auditorium tightly packed with about 300 entrepreneurs, entrepreneurs in the making, and investors in entrepreneurial ventures. Rose spoke for a good two hours to mainly communicate one idea: angel investing is irrational.

Who are the angels? They are individuals (they are not professional money managers who represent institutions, endowments, or wealthy individuals); they are rich (-ish) people who invest their own money for economic or other reasons; they invest on average amounts that range from $25K to $100K. Yet, compared to Venture Capital investments (that today represent later stage investments), angel investments cover about 49,000 deals (and about $20 billion).

Why are angel investors irrational? Because they know that half of the deals in which they invest will go under and the rest will greatly underperform expectations. While the economics of angel investing is predictably irrational, it is also highly lucrative as long as angels invest in that one deal that will return a 30 times multiple the original investment and will compensate the investor for the losses he incurred with the rest of the deals that flopped or underperformed.

How does one find deals to invest in? Rose insists that there is logic to the madness of angel investing. He usually looks for:

· Large and growing market

· Scalable business model

· Competitive advantage

· External validation

· Reasonable valuation

· GREAT PEOPLE

While every deal comes with a team, the most important person for Rose is the ENTREPRENEUR, someone who has already demonstrated:

· Integrity

· Passion and the desire to create something big

· Experience (but not necessarily in the field of the new enterprise)

· Knowledge

· Skills (how to make it happen)

· Leadership

· Commitment (to her idea)

· Vision (to change the world via her idea)

· Realism

· Coach-ability

Having completely disproven his original point, Rose defined angel investing as a highly complex thought process that focuses less on analytics and fancy presentations and more on the qualities of the people on the team.

Global IPO Market 2010 Outlook: Slow Activity and Strong Exits

If history is ever a good predictor of the future, 2010 is going to remain slow in IPO activity but may showcase a few very strong exits for fundamentally sound companies, Graham Powis, Managing Director and Head of U.S. Equity Capital Markets, Lazard Ltd., asserted on January 28^th during a panel discussion organized by FTSE and Renaissance Capital exclusively for New York Society of Security Analysts members.

Right now, private equity firms affected by credit dislocation and the recession have one primary goal: to ascertain the quality of IPO opportunities as an exit strategy for the global private sector. While other exit considerations include dividends financing in the debt markets and despite the fact that valuations are substantially lower than what the IPO market achieved from 2000 to 2005, General Partners are concerned with returning capital to their LP investors.

Christopher Turner (Warbug Pincus), Phil Drury (Citigroup), and Jonathan Art (Federated Kaufmann Fund) of the same panel, moderated by William Smith, CEO of Renaissance Capital, agreed that uncertain capital origination, market ambiguity, and indeterminate liquidity exemplify an opportunistic market. This type of market has a two-sided effect: on one side, researchers observe low willingness on investors’ part to join in public offerings within volatile markets paired with high preference for less risky deals; on the other side, capital markets participants recognize the IPO market as a highly inefficient category of public equities.

Inefficiency is good. In fact, for sophisticated investors inefficiency is great. Paul Bard, Head of Research for Renaissance Capital, demonstrated that the IPO market presents experts with the opportunity to create investing strategies with remarkable returns. As an indication, while the returns for the Russell 3000 and S&P were -5.8% and -8% respectively in 2009, the IPO index registered returns of 28.5% for the same year.

The inefficiency of the IPO market is based on the following facts: private companies are not well researched; they operate within new industries; their management teams are relatively unknown; private companies have not been traded yet and therefore the predictability of their success in trading is practically impossible. A bottom-up fundamental study of IPOs as well as expertise based on historical data lead researchers to believe that 2010 may be the year for some very strong companies to go public as it happened in the 1970s, another period of slow activity. With an approximate number of 100 to 120 deals in the pipeline, of which 39% in Technology and Healthcare, the sophisticated investor has the advantage of deep discounts in some fundamentally strong, top performing private companies that promise high quality operations, overall growth, and proven profitability.