Lack of impairment doesn’t necessarily mean that it was a really good deal. All it means is that it wasn’t a bad deal
How to avoid common mistakes made during valuations
This is a session from our M&A Science Virtual Summit which was held on June 10 and 11.
The topic of discussion is avoiding valuation surprises and accounting for M&A, hosted by PJ Patel, Co-CEO and Senior Managing Director at Valuation Research Corporation (VRC).
Our guest for this interview is the Vice President of Corporate Strategy and M&A at Church and Dwight, Brian Buchert.
Together, Brian and PJ discuss how to not overpay in deals, explain why valuing a company 10 years from now is a joke, and explain the effects of a long term recession.
Learn tips on how to avoid common valuation mistakes, what the aftermath of COVID-19 may look like, and how valuation requires their own proprietary metric. Y
ou’ll also hear PJ and Brian’s advice to audience questions asked in real-time.
Being different isn’t bad. Your math is just a little different than everyone else’s. I think what that means is sometimes you say no to deals that people think might be in your sweet spot and on the other hand you end up doing deals that sometimes are surprising”
Text version of interview
PJ Patel: This session is going to focus on valuation. Brian, what’s your background in M&A?
Brian Buchert: I run Corporate Strategy and M&A for Church and Dwight. We are like a mini Procter and Gamble product company and we have been around for 176 years. I have been here for almost 14 years now and during that period we have done 16 acquisitions and 6 or 7 small divestitures. Before that, I worked in a private equity firm doing direct investments and prior to that, I was in investment banking at Morgan Stanley. We don’t have a team at Church and Dwight, so it’s just me.
PJ Patel: I am a Co-CEO of Valuation Research. My focus is on valuation, and with that, I get to see a lot of deals as I have been doing this for 25 years. I have worked on over 1000 deals, worked with public companies and private equity firms. I get to see deals all the way through their life cycle.
PJ Patel: Brain, we’ve seen your deals get bigger and bigger, but we also haven’t seen any impairments. When you are doing deals, how do you ensure that you are not overpaying, that you don’t have an impairment down the road?
Brian Buchert: We do a lot of diligence on deals, but interestingly we do have conversations about impairments in the beginning. We talk about pricing and how we are going to structure a deal and these conversations help us not to overpay for deals. We walk away from a lot of things, even great brands or businesses that we really liked if we feel it’s going to be a risky proposition and we simply don’t want to take an impairment charge someday.
Rightly or wrongly, it is a sort of strategy for us. We are very big on being emotionless about deals and don’t get a deal fever, so if we can’t own a business that we like at the right price and the right structure we simply move on because our base business is strong.
PJ Patel: What I have noticed from working with you as a valuation specialist is that when you are competing against twenty other firms, they are all using the same math, while your math is oftentimes a bit different. Can we talk a little bit about that?
Brian Buchert: Yes, we do different math. We have developed our own proprietary metric that we have studied over. We worked with statisticians, we looked at public companies and our history and determined that traditional metrics of valuing businesses don’t work. For example, we don’t even look at EPS on a deal, and for 14 years our board has never talked about DCF or IRR. Ours is cash on asset metric that’s a little different.
We have determined that the R-square to Church and Dwight stock is around 98 percent and that’s good enough for us. We are just fundamental believers that investors value cash over the mirage of a P&L. The actual income statement is something that can be manipulated to a degree, but you can’t manipulate the balance sheet or cash flow statement, so we are very focused on strong cash-generating businesses. We also believe that having expensive assets is negative and prefer the asset-light type of businesses. We also value things that others don’t as much, such as tax yield.
PJ Patel: When you are talking about cash on return on assets is that all assets? Tangible or intangible assets?
Brian Buchert: It’s tangible assets. Broadly speaking, it is hard assets. To do my math, when we are in a process, I ask for four numbers, and these are inventory, payables, receivables, and Gross PP&E. Based on this, we can say whether we are interested or not.
PJ Patel: Do you do any accretion/dilution analysis?
Brian Buchert: We do. We do all the traditional stuff, such as DCF, IRR, and ROIC. We have 12 power brands, 11 of them acquired, so there is a lot of deep knowledge. We get a lot of questions about the quality of the business, but it’s never around whether IRR seems good enough.
PJ Patel: In the past, you never used an earnout, but your latest deal is almost 50 percent an earnout in terms of total potential. What we see is, in the middle market and below, is that almost 50 percent of the deals that we see today have an earnout. Have your notes been evolving around your notes?
Brain Buchert: Historically, we have been a company that buys, integrates, gets the synergies, puts that in house, and gets running. However, we have started changing that a few years ago. The change started in our non-consumer business with something really small, where maybe 5 percent of the consideration was an earnout and it was meant just bridge a valuation gap.
Then we did another one that was 25 percent of the consideration, after which we had the earnout you are referring to. It was a newish brand that had grown dramatically from 10 million to 180 million in just a few years, which made us nervous and we didn’t want to pay the full value upfront for this business. Their team ended up continuing to run their brand for us in the TSA.
PJ Patel: The lack of goodwill impairment indicates success or, conversely, if you were to have an impairment would that lead you down to a path to say this deal wasn’t necessarily successful?
Brian Buchert: A lack of impairment doesn’t necessarily mean that it was a really good deal. All it means is that it wasn’t a bad deal. An example is Clorox 10 years ago when they bought a business called Burt’s Bees. We liked that business, but we backed off because everyone else liked it, so Clorox ended up overpaying for it to win, going over almost 20 times EBITDA. Within two to three years they took a 250 or 300 million dollar impairment, which is probably what they should have paid.
Taking an impairment charge on a small enough deal that doesn’t really impact the company wouldn’t be the worst thing in the world. Sometimes we can lose good deals, but also sometimes, we win deals that people underappreciated. Our M&A criteria doesn’t involve categories or types of business. It’s very vague, but it’s very specific. The business has got to fit certain math criteria and this leads us in weird directions, but we have gotten cheaper prices for businesses that others perceived as unappealing, but to us was a diamond in the rough.
PJ Patel: On day zero, everyone is happy that they won the deal, and then reality hits and the work begins. When rubber really hits the road, in our opinion, is in year three or four, when you can see whether it is a good or a bad deal. If it’s bad, a lot of companies will take an impairment. Any thoughts on that? Is that in line with what you see?
Brian Buchert: We are pretty sure what we have day one. We know if something is working or not really quickly. We are really detail-oriented and the business is integrated within three months unless we do structured deals. The impairment charge gets a little weird once you get past a certain period of time. I get that in year three you will see it’s a disaster. If you are going through technical impairment tests every year, there are cases where an impairment charge may seem like an option in the given moment, but it may seem silly a year later.
You really can’t know what’s going to happen for a few years anyway, maybe only the first few. The rest is your choices, what new products are you going to do. That’s where our math looks at history – it looks at what a business really is today and what it does is it keeps us from al, those hot startup fast-growing businesses that don’t make any money. You show me a business that has a 35 percent EBITDA margin, I’ll probably like it and don’t care where it is. Doing impairment tests seven years out after you’ve got an acquisition-based of a DCF model you did makes no sense to me.
PJ Patel: Do you care about how the purchase price allocation looks with the split between the customers and the brand? You are buying companies that are pretty brandy-heavy, so is this part of your discussion?
Brian Buchert: We are very conservative, so we don’t have a lot of conversations about it. We don’t try to get aggressive and we simply follow what the rules are. I have had only a couple of times where I’ve had a seller ask to be more aggressive in where you bucket things. Because we are not an EPS driven company, it doesn’t matter as much.
PJ Patel: Let’s fast forward to the current environments. What is your activity like?
Brian Buchert: There is an activity, but it’s a different kind of activity. After the shutdown that took place in March, now that we are a few months in, I am seeing large companies doing small divestitures, usually international.
I also see businesses that are benefiting from COVID, especially in consumer space. It’s been a crazy time for us, just even supplying. Some people are trying to take advantage of this new situation. Throughout the year, I believe it is going to be very difficult to manage a complex process with a lot of bidders. I am seeing a lot of inquiries. Deal flow is slower and the dynamic of deals has changed, so recently I called a PE firm up and we ended up doing a one-on-one deal.
PJ Patel: Have you seen any changes in valuation? We are seeing a few more proprietary deals and the multiples do seem to be a bit lower than what we’ve seen in the past.
Brian Buchert: I don’t know yet, because it still comes down to the business and how good it is. COVID or no COVID, good business will still be valued highly. The one area I think will be beneficial is private equity competition and the ability to pay is going to be helpful in the days of aggressive leverage. We don’t like things that are stressed, so we’re only going to be interested in businesses that have actually done well during this environment.
We have also seen a lot of fast-growing startups going out and seeing if somebody is going to pay a fortune for. I think this has woken up a lot of entrepreneurs who might be struggling right now and there are many small businesses who may get scared enough by this new environment that they decide to sell their businesses.
PJ Patel: I’d say doing valuations has gotten more complicated. I hear a lot of discussions about what kind of recovery we are going to have. The other thing we are seeing is the calibration approach. Any thoughts on that?
Brian Buchert: I am in the camp that any of these that end up at the same place as before are just wrong. I think that the Nike swoosh might be the closest one where it just gradually gets better but doesn’t get to 100 percent. At the end of a day, people’s behavior is going to be changed in the future and is going to hit certain industries that will come in a big way, but never where they were before. I see the market and think to myself we are in for a big recession, which is why we are deep into recession planning.
PJ Patel: By not focusing on startups, do you miss innovation?
Brian Buchert: Innovation comes in every size, not only through acquisition. A lot of the startups we are seeing in the space don’t really have innovation. We get innovation through different areas and do a very aggressive job when it comes to licensing and working with entrepreneurs.
PJ Patel: The next question is about the importance of accounting treatment of contingent consideration. When there is contingent consideration if the individual is staying employed it becomes an expense, as opposed to if they are no longer employed when it becomes consideration itself.
Brian Buchert: It’s always driven by transaction and value, gaps, and what makes the most sense to both sides. The accounting treatment, though, comes out, but we don’t sweat it too much, because you can talk it away as a sort of an accounting treatment, which comes back to us being a cash company. I want the initial price to be low in case things go sideways, and part of that discussion is to minimize the impairment.
PJ Patel: Do you only do revenue or EBITDA or do you do others?
Brian Buchert: We have only done net sales. It really depends on the level of which you need to do work with them. We want more control over the PNL, we want to be in control of the operations in some areas we really want to integrate. We have avoided doing any kind of EBITDA number because it’s really complicated.
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