Going Medieval on the Middle-Tier

Forgive me, that title is a bit of a misnomer. My historical reference point is actually the end of High Renaissance, not medieval times. As my tortured readers know, I have been attempting to tackle some of the many books I avoided in my youth. Last spring I decided it was time for “The Prince”. Machiavelli’s classic gives the reader much to consider; perceptions, alliances, ambition, preparation, and fortune; however, the notion of downstream consequences stood out. When my contemplation of downstream consequences commingled with two industry events last summer the result was a desire to express my opposition to the Franchise Reformation™ movement.

I have written before about the potential erosion of the three-tier system; a concern the current system could be undone overtime by a series of attacks that progressively whittle away at the regulatory structure until the three-tier system collapses or is abandoned. Historically that was the nature of the threat, the trajectory of events, and my principal concern. By odds that still should be the principal concern of the middle-tier’s defenders. But Machiavelli’s discussion of Venice’s demise gave me pause. Speaking of the Battle of Vaila, Machiavelli says, “they [Venice] lost that which in eight hundred years they had acquired with so much trouble. Because from such arms conquests come but slow, long delayed and inconsiderable, but the losses sudden and portentous.”

If the three-tier system collapses, the value of beer distributorships will collapse with it. One industry professional recently offered his thoughts on the value implications of franchise protection using non-franchised wine and spirits distributors as an example. Rather than plug that competitor, I instead roughly truncate his suggestion. Without franchise protection distributor values can be halved—with a nothing plus inventory option.

Shatter the notion of a business’ viability as a going-concern and that business’ value is diminished, or perhaps even destroyed. The vast majority of the typical beer distributorship’s value is associated with intangible assets (i.e., distribution rights), and what we valuator types call terminal value. In essence, a huge portion of the business’ value is predicated on the assumption the company’s distribution rights will not go away and those distribution rights will continue to produce earnings in perpetuity. Change the rules from perpetual rights to potential rights and a whole lot of value moves out of the middle.

You know Ohio is the Lombardy of American beer’s middle-tier.”

Really?” comes the reply.

Oh yes,” I say, “and Missouri is Papal Rome.”

That excruciatingly bad joke lacked both humor and historical context. Yet again, I find myself backfilling a humorless joke with selectively chosen facts.

Why did my brain make Ohio into the Lombardy of America’s middle-tier? Because, while I was reading “the impossible to follow and varying fortunes of the Italian Renaissance states,” an assortment of interests and alliances were battling over who would occupy Ohio’s middle-tier. It was a Machiavellian smorgasbord. There were imperial forces seeking to expand their territorial possessions. Perceiving this territorial conquest some were compelled to respond. Others—knowing that they lacked the power to resist the expansion—sought only to preserve their standing. And a few chose to leave the territory with what wealth they could, rather than linger and await an uncertain outcome.

Those who felt compelled to respond saw the expansionary effort for what is was; a tangible indication of the king’s true intentions. That is why Ohio’s princes (not to exclude duchesses) rallied the middle forces for opposition; which provided the essential ingredient of any Machiavellian analog—political intrigue.

The preface to “The Prince” provided what might be called a contextualization of Machiavelli’s sinister reputation. In short, if Machiavelli suggested princes should, on occasion, lie and murder, don’t hold that against Machiavelli or his princes. In Machiavelli’s day, most princes faced a lot of lying and murdering coming at them. Therefore it was essential that princes be up to speed on things like deceit and assassination. In this context Machiavelli was not encouraging immorality per se. He was providing essential tutelage. Thankfully the giant cash-filled pen has replaced the sword. Consequently, I cannot recall there having been a red wedding on St. Valentine’s Day for eons. Nonetheless one can still observe princely acts.

Machiavelli illustrates a variety of circumstances under which it is prudent for a prince to falsely represent his plans and desires so as to conceal his true intentions; basically, whenever the good of the state demands it. Therefore if the empire’s continued prosperity and stability be aided by the acquisition of additional territories, Machiavelli would instruct the king to aggressively pursue those acquisitions but publically dismiss any notion of those ambitions. If Machiavelli were serving the princes of those coveted lands, then Machiavelli would tell those princes that they must prepare as if the proclamations were false. Machiavelli believed that a prince ought never have the subject of war out of his thoughts, and “in peace he should addict himself more to its exercise than in war….” [Machiavelli would recommend colonies not garrisons, btw.]

When ABI says it does not have a specific plan for self-distribution, who in the middle sleeps assured by such qualified declarations? Who does not think that the King of Beers, now ascended to global beer emperor, did not want vast territories and volumes of Buckeye beer? When I contemplate the way ABI must have been looking at Ohio I find myself thinking like a 1970s construction worker staring at a Raquel Welch look-alike. “Wowza! Would you get a look at the cities on that state! And ooh wee fellas, take a gander at the miles of infrastructure. You know what they say about those Buckeyes, their totally C-store and chain driven—just the way I like ’em. And me with my brewery smack in the middle. I would so vertically integrate that state. I can already feel my market share and capacity surging.”

It’s hard to pick on ABI beyond the dubiousness of its carefully qualified non-branch policy declaration. Everybody gets it. There is no official self-distribution policy. The idea of buying up all the large markets possible might have been contemplated, and those markets might also approximate 50% of ABI’s U.S. volume. And, certainly, the synergies and cash flow might look utterly delicious to La Máquina. But there is no official plan. You know, it’s a case by case, market by market, facts and circumstances kind of thing. There’s nothing definitive—per se.

Who can blame ABI for wanting its very own place right there in the heart of it all? As Machiavell said, “The wish to acquire is in truth very natural and common, and men always do so when they can.…” That’s why the distributors in Ohio had to scramble to revise the rules. They moved swiftly and discretely. Props to them! For, as one author put it, “Machiavelli moralizes on the resemblance between Fortune and women, and concludes that it is the bold rather than the cautious man that will win and hold them both.” Now those princes can reflect upon another Machiavellian maxim, “He who thinks new favours will cause great personages to forget old injuries deceives himself.”

Honestly, I don’t have any inside scoop on Ohio. It has been argued the actions taken by the Ohio distributors and Ohio government were mere clarifications and enhancements of existing rules and original intent. There are at least a couple of problems with that line of argument: (1) ABI had a branch in Canton for years; and (2) the distributors were almost at once overtaken by an urgent need to have Ohio law changed (yes, I know, say “clarified”). The fact is if ABI had signed deals with Cleveland, Cincinnati, and Columbus 12 months earlier it would have been legal. ABI would have been playing by the rules. That’s why Luis Edmond could at last year’s Beer Marketers Insights seminar state without qualification that ABI had not pursued a single legislative change since acquiring Anheuser-Busch.

That’s enough about ABI and Ohio. It’s time to move on to Missouri and the sacking of Rome. A popular bit of historical speculation is that after the sacking of Rome in 1527 it was impossible for the Pope to grant Henry VIII the annulment he sought for his marriage to Catherine of Aragon (the Holy Roman Emperor’s aunt) due to his virtual imprisonment at the hands of the Emperor and his fear that Rome might be sacked again. The result was that Henry VIII eventually broke with Rome and created the Church of England. Christian Reformation thus was pushed forward. Well, for some time now I’ve been mulling over the notion of Franchise Reformation, and in Missouri that movement just seized a monumental victory.

In case you missed it, a judge said something like, “Yeah, there’s franchise protection, but that franchise protection doesn’t protect your business’ existence. Suppliers can individually (or perhaps in coordination) lay siege to your business and bring it to ruin. The courts cannot enjoin your destruction; however, the courts will be there should you seek restitution for your now damaged or dispatched business.” Comforting isn’t it? The judiciary that blessed your destruction will be there to determine fair compensation. I insist the process of determining and obtaining fair compensation warrants deeper consideration than it is receiving.

Three-tier advocates can hope that Missouri was an isolated incident, but as I am a non-lawyer and an individual inclined towards paranoid hyperbole, I see the Missouri ruling as a pillar smasher. It appears to me that a judge just said suppliers and their largest distributors can, if they chose to, annihilate those in the middle-tier with whom they no longer wish to do business. If a long-term operator without any material deficiencies falls out of favor or is simply less favored, it can be driven from the middle-tier, so long as the company is compensated.

How preposterously strained is the notion of an independent middle-tier in this context? It’s like telling you that we’ll play a normal chess game only I get to choose the pieces and set them how I wish. When suppliers express their commitment to an “independent” middle-tier and in the next breath talk about the share of mind of aligned anchors, am I the only one wanting to phone Orwell for a ruling?

While I was reading “The Prince” and thinking about downstream consequences I found myself wondering, “If Anheuser-Busch had not become ABI, would the outcome in Missouri have been different?” That was my mind’s link to the sacking of Rome. The historical supposition is that had the Pope not been subjugated to Charles V, then the process of Christian Reformation (and history) would have been markedly different. My franchise analog to that historical speculation being, “Had the King of Beer not been dethroned, would the franchise reformation movement have failed in Missouri?” Presuming the legal outcome would be independent of the king’s circumstance is hopefully logical. The law is the law. However, I think this reasoning denies the practical realities of stately politics, and that is perilous. Machiavelli said, “Men will not look at things as they really are, but they as they wish them to be—and are ruined.”

So that no one thinks I am devoted solely to the inquisition of ABI’s middle-tier intentions, I will turn my attention to other actors in the franchise reformation drama. The undertakings of MillerCoors and craft brewers deserve their own attention.

When the steward of MillerCoors suggests that invoking trademark law was about the brewery’s right of first refusal and then proceeds to note the recently formed joint venture’s right of refusal has never been challenged, one hears Machiavelli’s tutelage. Old Nic would appreciate the sematic sleight of hand. Yes, perhaps MillerCoors’ right of first refusal provision had not been challenged previously. Never mind the allegation that the seller was not being made whole, or the question of whether any supplier’s right of first refusal previously had been adjudicated in Virginia. Ignore the dubiousness of the trademark claim and its questionable relation to the right of first refusal. As a subject of the realm you are obliged to accept these kinds of proclamations with due fidelity.

When craft brewers say they want franchise carve outs based on fair market value, my immediate response is define fair market value (FMV). If you want to get a sense of how slippery the notion of fair market value can be when real facts and circumstances are injected into the argument, go spend some time digging through the IRS code along with all the pronouncements and rulings related to the notion of fair market value. After a fortnight of that most tedious imprisonment you’ll have barely scratched the surface. As you exit your FMV Bridge of Sighs, contemplate the prospect of experts and advocates settling disputes using comparable sales from states with different definitions of fair market value.

Beyond the failure to define fair market value, it is impossible to ignore the fact that a forced sale hardly fits one of the most traditional and elemental conditions of a fair market value transaction. Specifically, fair market value commonly is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell. Sure, I get it. That’s why franchise reformation laws would be written to specify fair market value—because the circumstance under which those laws are to be applied are expected to be so markedly inconsistent with the notion of fair market value.

The paying of fair market value at the time of a causeless termination is offered all too conveniently. No definition is offered. Others are to do that—separately—state by state. Similarly, a carved-out brewer need only initiate the change. Simply state a desire to change; that’s it. Then it’s up to the distributors to work out the price. If the seller’s notion of value is too high in the buyer’s eye, then those distributors get to litigate or arbitrate what is FMV at their mutual expense. The brewer would apparently grab a free seat in the audience section of the courtroom. You know what would make me more receptive to these carve-outs? Forcing brewers terminating without cause to pay both the buyer’s and the seller’s legal fees should a dispute over FMV arise.

I suppose that decrying the franchise reformation movement makes me a craft heretic. I have no doubt some distributors have given small brewers reason to feel constrained and imprisoned by franchise laws. Without question distributors need to be more willing to accommodate the desires of small suppliers to move. I just can’t get comfy with the notion of causeless terminations. Moreover, as America enjoys a brewing renaissance, I find it difficult to believe distributor franchise protections are truly thwarting craft brewer success. That said, I must note that Machiavelli spent some time discussing how fortresses can become a liability and how the greatest security is found in being loved by the people.

Distributors are supporting limited self-distribution throughout the country for a reason. In that context a thwarting notion has legs. If limits on size, market share, and geography are delineated, then every entrepreneur below those limits should have the opportunity to flounder to success unimpeded during their branding adolescence, especially in their home market. I strongly believe that if a small brewer is successful using self-distribution then that brewer ultimately still will want to capitalize on an independent distributor’s infrastructure and customer relationships—especially outside their home market. It’s the economics of broad distribution, and it is how small brewers hitch a ride to the next level.

Now after having too long floundered about the end of the high renaissance, I come back to the notion of Going Medieval on the Middle-Tier. If craft brewers get their franchise carve-ups, I see the possibility of them awakening from their franchise imprisonment rage to find before them the corpse of the three-tier regulatory structure that facilitated their renaissance. Machiavelli said, “It must be considered that there is nothing more difficult to carry out, nor more doubtful of success, nor more dangerous to handle, than to initiate a new order of things.”

I recall one author suggesting that the age of global brewing empires would force supplier-distributor relationships to be more businesslike. I, being a HUGE “Godfather” fan, could not help but think of Michael saying, “It’s not personal, Sonny. It’s strictly business.” Machiavelli believed that a prince must be both man and beast. The same might be said of corporations. It’s a dog-eat-dog world after all.

The global beer powers have made qualified declarations of commitment to America’s three-tier system, and some of their actions have been inconsistent with fidelity to the notion of an independent middle-tier. Some years ago a very smart analyst said something to the effect of “ABI operates to create wealth for its controlling shareholders,” and SABMiller is on record saying its duty is to shareholders, not the American three-tier system. The middle-tier should remember what Machiavelli’s said, “The promise given was a necessity of the past: the word broken is a necessity of the present.”

“Everyone who wants to know what will happen ought to examine what has happened: everything in this world in any epoch has their replicas in antiquity,” was Machiavelli’s instruction. “The Prince” turned 500 this year, so there have been tributes. An exhibit quotes “the great 20th century scholar Isaiah Berlin: Machiavelli, he said, ‘helped cause men to become aware of the necessity of making agonizing choices between incompatible alternatives in public and private life.’” Machiavelli believed, “Wisdom consists of knowing how to distinguish the nature of trouble, and in choosing the lesser evil.” Conflict and change are ever present.

Best of luck Lords and Ladies of Lager.

I apologize to those troubled by my casual and imprecise references to historical era. I do understand Machiavelli wrote “The Prince” at the end of the High Renaissance, after medieval times, and that after the High Renaissance the arts saw Baroque styles and the Mannerist movement. Baroque Mannerism is the title of my next article, which is an exploration of my own socio-political adeptness.

A Priceless Contradiction

In it to stay but not willing to make the long-term play

A decade ago when one encountered a prospective buyer who was willing to offer only half of what they thought their own business was worth, such buyers might be dismissed as non-consolidators and/or disingenuous. When bolder distributors made compelling offers and reaped the rewards of consolidation, it was difficult to have much sympathy for these deal-missers. The gap between what these individuals thought their targets should be paid and notion of their own business’ worth was too glaring to be accepted. Today, it’s different. Today there is another class of buyers who are only willing to go halfway, but I have sympathy for these buyers.

I can have sympathy for the distributor who misses a crucial deal based on any number of reasons. I just can’t muster much sympathy when the reason for missing the deal is a financially baseless value gap created by a would-be acquirer’s notion of self-worth and their perception of a target’s value. However, when a buyer’s reluctance is based on their own financial limits, and not their limited perception of a target’s worth, it’s easy to have sympathy given that very real and practical limitation. That said, I would press any distributor presented with an acquisition opportunity to give the question of their financial limits deep consideration because passing on an acquisition can have fateful consequences. A lot of those deal-missers from the last decade aren’t in the industry anymore.

Presently large value gaps are thwarting potential consolidations. This is particularly true for smaller deals. I’d like to pause and acknowledge that part of the gap is seller driven, and then set the seller portion aside because I want to talk about an issue tied to the buyer’s perspective. I want to address the potential conflict between an owner’s desire to stay in the business and their willingness to take on the long-term risks of a substantial acquisition.

I have encountered numerous owners who see a future that mandates grow or go. They acknowledge this imperative. They want to stay in the business and they would very much like to grow via acquisition. However, when they are presented with a consolidation opportunity they fail to pursue the acquisition with appropriate zeal. Higher purchase prices and industry trepidations combine to supplant the owner’s growth ambitions. Effectively these owners decide they will stay in the business for the foreseeable future (aka the long-term), but knowingly pass on doing exactly what they know they need to do to thrive in the long-term.

Beer distributorship prices have risen substantially over the last 10-15 years. Two corollaries of the increased prices are longer payback periods and smaller margins of safety. For buyers the net impact of higher prices are greater financial risks endured over a longer time, and everything else being equal, lower returns.

Current pricing is such that digesting debt from a major acquisition could take more than decade. 10+ years of debt service becomes progressively less appetizing as one goes from their 30s, to their 40s, to their 50s, and beyond. An individual with 15 years to retirement often isn’t eager to spend the last two-thirds of their working life sweating debt service. They’d prefer to just sweat what they absolutely have to – industry threats and supplier relationships. This mindset is understandable, but is it a viable course of action? For many smaller distributors and even some larger operations I expect the answer will turn out to be no.

I believe this mindset is potentially perilous. It’s like dropping into a prevent defense at the beginning of the fourth quarter. You stop playing to win and start playing not to lose. You stop being aggressive and instead start playing it safe. That’s when the opposition starts to pick you apart. The plan is to hold the lead and run out the last fifteen minutes. The result of this overly cautious strategy is often the forfeiture of a healthy lead, followed by a shocking defeat, and profound regrets. An analogous fate awaits the owner who decides to audible out of the acquisition game and ride out the next 15 years of beer industry changes.

The industry faces numerous uncertainties but some sustained trends and informed commentary tell us at least three things:

  1. Retailers will want more from distributors;
  2. Distributors are going to handle more products;
  3. Suppliers are going to reach into distributor profits.

Without considering these three items the typical distributor’s future will likely include low volume growth, modest price increases, and ever growing operating expenses. The net result is modest real earnings growth – before accounting for the items above. Growing scale through acquisition can be the only way to offset these additional costs / investments and produce a healthier and more sustainable earnings trend. Yet, some of those who are fortunate enough to get a look at acquisition don’t pursue the opportunity. The notion of debt kills the acquisition idea.

I have seen owners terminate their pursuit of an acquisition at a very early stage. Distributors generally want to get a look any deal, so they typically don’t balk at debt initially. It’s only after they take their first look at the acquisition and contemplate making a real offer that millions of dollar in debt becomes real, and that is exactly when some owners decide they aren’t willing to take on the debt.

Understand that I am not talking about the owner who drops out of a bidding war because pricing gets too high. I am talking about the owner who drops out the moment acquisition risks become real in their mind. They simply decide $X million of debt is too much for them. They never really dig into the opportunity. They don’t look at synergies. They don’t look at actual debt service. They don’t look at their margin of safety. They just don’t feel good enough about the next ten years to even consider taking on that kind of debt. So that is where their consideration of the acquisition ends. It’s over before they even come up with an offer.

It occurs to me that the reluctance of some would be buyers to generate a purchase offer could be linked to a reluctance to face their own future. If one pursues an acquisition and discovers the only purchase price they find palatable is one based on a weak or highly discounted earnings stream, then certainly there are implications for their existing business. If a distributor finds they are too concerned about the industry’s future to do an acquisition, yet they plan to stay in business another 15 years, there is a conspicuous rational inconsistency between those two positions.

One morning at a Holiday Inn Express buffet I came up with a psychological reason for this inconsistency. The owner doesn’t price the acquisition because they don’t want to contemplate the value of their own operation and their decision to stay in the business. They acknowledge the industry’s grow or go imperative but they aren’t willing to accept the implications of their decision not to grow by acquisition. Consequently, they don’t put a number on either the buy or sell side of the equation. They decide that prices are too high and the industry is too risky to do an acquisition, but the industry is too good to be a seller. It’s a priceless contradiction.

Three M&A related articles are included in this quarter’s Random Links. These articles offer business owners a variety of strategic insights. One article shows that an acquisition strategy based on a series of smaller deals tends to be more successful than a large acquisition strategy. A second addresses the importance of growth when it comes to driving value. The third details how growth can be found in strategic M&A. Taken together there is a suggestion for beer distributors. If you want to increase your business’ value significantly then you need to grow, and growth on that scale will require a strategic acquisition or acquisitions.

These days I have deep sympathy for the intense conflict between an owner’s desire to stay in the industry and their reluctance to swallow a major acquisition. I am particularly sympathetic to the circumstance of smaller wholesalers. Smaller distributors really don’t have a strategy option that involves a series of smaller deals. They don’t have a collection of acquisition targets that are only 30% of their size. Their only acquisition opportunity might be a target larger in size, and that means big-time leverage.

At the end of the day many a smaller wholesaler can find they are simply not in a position to be a consolidator. That’s just a harsh reality. There is no shame in walking away from an acquisition after a thorough look, but missing an opportunity because you weren’t willing to dig in is tragic. It is particularly tragic these days with banks lending money so cheaply. If they were to delve, a lot of distributors would discover their financial capacity is greater than they think. The deal can get done with an adequate margin of safety.

Planning to stay in the industry and failing to explore consolidation opportunities is paradoxical and perilous. If you are too skeptical about the industry and your ability to service acquisition debt to pursue a consolidation opportunity, then you need to ask yourself two questions. Are you correspondingly skeptical about you business’ ability to generate earnings for next 15 years? And, do you think your business will and retain its value over the next 15 years?

If you find that you are too skeptical about debt service to do a deal, but perfectly confident in your ability to ride out the next 15 years, then I suggest you have an inconsistency to reconcile. Putting numbers on both the buy side and sell side of your business can help you resolve the inconsistency. It won’t resolve the tension caused by the grow or go imperative, but you won’t be trapped in a priceless contradiction.

The Art of Wort

One day when I was indulging in some paranoid cynicism concerning assaults on the three-tier system I asked myself, if the King of Wu commanded Sun Tzu to tear down the three-tier system, what would Sun Tzu do? I am not an expert on three-tier legal issues or military strategy, and I don’t have the stake in the three-tier system my clients do, yet the question hooked me.

So I bought myself a copy of Sun Tzu on The Art of War The Oldest Military Treatise in the World by Lionel Giles, M.A. Giles’ work is much more than a translation of Sun Tzu. It contains strategy from other military notables and is a kind of Chinese cultural examination. It kindled my desire to explore the question further.

The Art of War begins, “War is a matter of vital importance to the state. It is a matter of life and death, survival or ruin.” As such, Sun Tzu cautions that, “He who wishes to fight must count the cost.” In the context of a war on the three-tier system these vital precepts present two basic questions. First, who might want to demolish the three-tier system, and second, what would be (or could be) the cost to those who chose to attack.

There are probably a fair number of interests that might seek to ruin the three-tier system. However, a short list would have to include free-market purists, retailers and suppliers. Note these are potential three-tier enemies considered in the context of a hypothetical question. Some of these groups are more likely antagonists than others, and some would be more dangerous adversaries if they chose to beset the three-tier system.

Free market purists would, in all likelihood, support the elimination of the three-tier system. If an anti-regulation stance is at the core of your philosophy, you aren’t going to be a fan of a mandated middle-tier and a host of other important three-tier regulations. Free market purists are individuals who would be inclined to label the businesses constituting the middle-tier as “middle men”. And they are people who willfully ignore ugly historical realities while advocating an absolutist free market approach to anything and everything.

These three-tier antagonists are ideologically driven. As such, they would attempt to lay claim to what Sun Tzu believed was the most important of his five fundamental factors for success in war, “moral influence”. However, their claim to social and economic morality would be strained. Their arguments would be appealing in the abstract but ridiculous in the context of reality.

Interestingly, what some Art of War translations refer to as “moral influence” others refer to as “politics”. Those that use the term politics note that for Sun Tzu “politics is what causes the people to be in harmony with their ruler”. Fortunately, we live in a representative democracy and we don’t have a ruler. Instead we have the rule of law. I am confident the American people believe and will continue to believe alcohol regulations are necessary. The American people will always reject a purely laissez-faire approach to the manufacture, sale and distribution of alcohol – if the proper counter arguments are made.

Free market purists exist and they are clearly not supporters of the three-tier system, but they do not strike me as a significant threat. Their strained ideological arguments can be thwarted with solid factual counter-arguments. They are vocal but they are not numerous. Additionally, economic ideology by itself is typically not enough to muster the resources required for victory. An economic incentive is typically required. Further, their style is not consistent with the strategies of Sun Tzu. Their opposition is forthright. They have absolute faith in their world view, so their assaults are transparent. And this is not what Sun Tzu would do.

I’m going to go out on a limb and suggest that at least one individual at Costco is a student of Sun Tzu. A review of the Costco saga suggests a cognizance of Sun Tzu’s statement that “Those skilled in war bring the enemy to battle. They are not brought by him.” And impressively, they found a way to use the court system to do as Sun Tzu instructed, that is, “forage on your enemy”.

It is now abundantly clear certain retailers are a genuine threat to the three-tier system, and despite representations to the contrary they clearly have an economic incentive to see the system dismantled. Of course, retailers are a highly diverse collection of business entities and their attitudes towards the three-tier system are equally diverse. Some would like to preserve it as is. Some would encourage modifications. Some are ambivalent. And a few do not care for it – at all.

The good news is the retailers who value the three-tier system likely far outnumber those who do not. The bad news is those who do not value it are very powerful and their ranks may grow over time. It is essential that those who value the three-tier system do not mistake a retailer’s favorable disposition towards DSD (direct-store-delivery) for support of three-tier regulations. One is a sales and service methodology. The other is a legal framework. The former does not require the latter. It is entirely conceivable that some large retailers might seek to eliminate three-tier regulations while simultaneously demanding more DSD services.

The last of the possible three-tier adversaries on my short list is suppliers. Suppliers could be the most dangerous potential adversary of the three-tier system. Please note I say possible, could be and potential. This is the most profitable market in the world, so if certain suppliers were to attack the system, then those suppliers would be wise to do as Sun Tzu commanded and “count the cost”.

Certainly, I am not the first individual to consider that the superpowers of alcoholic beverages are global entities and that in the preponderance of their markets their direct control over the distribution and sale of their beverages is not encumbered by a three-tier system. Elsewhere they can exercise control over the process from beginning to end. The notion that one such supplier might decide to end their support of the three-tier system in favor of their own corporate interests is not inconceivable. If that day comes and if the teachings of Sun Tzu were followed, the attack would be upon the middle-tier, and the aggression would look nothing like the undisguised aggression of the free market purists.

Any effort to subjugate the three-tier system conceived by Sun Tzu would not begin with a massive violent assault. Sun Tzu would first attempt to win without fighting. Then if fighting was necessary he would seek to preserve the value of the market. His campaign against America’s three-tier system and its middle-tier would not include a scorched earth policy.

Sun Tzu wrote, “Generally, in war the best policy is to take a state intact; to ruin it is inferior to this. To capture the enemy’s entire army is better than to destroy it… For to win 100 victories in 100 battles is not the acme of skill. To subdue the enemy without fighting is the supreme excellence.” A sovereign superpower supplier would not want to ruin the world’s most profitable market. The sovereign would want to capture the market’s bounty for itself. To achieve this end Sun Tzu would employ the skillful use of “deception, wisdom, and strength”.

Sun Tzu said, “In war, practice dissimulation, and you will succeed.” The ancient Chinese general believed “The whole secret lies in confusing the enemy, so that he cannot fathom our real intent.” Reading these statements I can’t help but think of ABI’s non-existent branch policy and MillerCoors’ three-tier doctrine (CARE Lite – great words, less binding). If the sovereign commanded that Sun Tzu bring down the three-tier system, that intension would not be announced. Sun Tzu would instruct the sovereign to continue professing their support of the three-tier system while they sought to undermine it.

It is worth noting that Sun Tzu did not believe every order of the sovereign should be obeyed. Art of War states, “It is essential for victory that generals are unconstrained by their leaders.” If fighting is sure to result in victory, then you must fight, even though the ruler forbids it; if fighting will not result in victory, then you must not fight even at the ruler’s bidding.” The legendary story of the concubines merits reflection.

Wisdom would suggest a patient approach designed to dissipate the adversary’s strength. Sun Tzu would attempt to “Reduce the hostile chiefs by inflicting damage on them” and “foment intrigue and deceit” among his adversaries and their allies.

If there had to be fighting Sun Tzu would conceal his strategy and objectives. Sun Tzu instructed, “In battle, use a direct attack to engage and an indirect attack to win.” Sun Tzu would “avoid what is strong” and “attack what is weak.” He would force his opponent to reveal himself, so as to find out his vulnerabilities. He would “make you prepare on your left so you would be weak on your right.” I fear the middle-tier might readily fall victim to such tactics.

Lionel Giles’ book had a couple powerful quotes that were not from Sun Tzu. One quote from Frederick the Great’s Instructions to His Generals states, “A defensive war is apt to betray us into too frequent detachment. Those generals who have had but little experience attempt to protect every point, while those who are better acquainted with their profession, having only the capital object in view, guard against a decisive blow.” Another quote attributed to Col. Henderson suggests The highest generalship is to compel the enemy to disperse his army, and then to concentrate superior force against each fraction in turn.

Reading these passages I found myself wondering if these ideas are not something the defenders of the middle-tier should consider. My perception is the middle-tier’s defenders feel every battle must be fought. No protection can be left undefended. The logic being that if X happens, then Y is sure to follow. For example, allowing small brewer self-distribution is a slippery slope [Personally, I’d trade limited self distribution for a stronger franchise law in a heartbeat but that’s another discussion]. Hearing these arguments in the past I’ve quietly thought to myself, they must know the slippery slope argument is on just about every list of logical fallacies ever compiled. Now I know it isn’t just a logical issue. It’s a strategic issue. I find myself wondering what dispensable fortifications are depleting resources from essential protections. I find myself contemplating Sun Tzu’s statement that, “The winning army realizes the conditions for victory first, then fights. The losing army fights first, then seeks victory.

Sun Tzu writes much about the importance of ground. Sun Tzu says, “How to make the best of both strong and weak—that is a question involving the proper use of ground.” “Therefore, the skillful commander takes up a position in which he cannot be defeated…” Laws and regulations could be considered the analog of ground in the context of a war against the three-tier system. Some of these laws and regulations, like “narrow passes”, are easily defended. Others are not easily defended. Rushing to their defense could be as imprudent as marching to battle in a quagmire.

Those who would preserve the middle-tier should consider the question of when and where to fight and with whom they intend to fight. Several of Sun Tzu teachings should be considered:

  • You cannot enter into alliances until you are acquainted with the designs of your neighbors.
  • When the enemy has made a plan of attack against you, you must anticipate the enemy by delivering your own attack first.
  • You will not succeed unless your men have tenacity and unity of purpose, and, above all, a spirit of sympathetic cooperation.
  • On desperate ground fight… If you fight with all your might, there is a chance of life; whereas death is certain if you cling to your corner.”Art of War states, “To move your enemy, entice him with something he is certain to take.” “[H]old out specious allurements and make them rush to any given point. By holding out advantages to him, he can cause the enemy to approach of his own accord; or, by inflicting damage, he can make it impossible for the enemy to draw near.” I worry that vague representations and non-enduring commitments will be sufficient bait for the defenders. I fret over the defenders swallowing the bait, becoming infirmed and compromising their defenses.But these wild thoughts are probably no big deal. I don’t worry about such things every day; only on my more cynical days.
  • In addition to Lionel Giles’ book, Sun Tzu on The Art of War The Oldest Military Treatise in the World, I also utilized a History Channel program title Art of War and this translation of Sun Tzu from the Brooklyn College website.
  • Sometimes I consider the possibility that the three-tier system’s enemies are masters of Sun Tzu. I contemplate the notion that their plans are already underway. I wonder if they are executing a strategy consistent with Sun Tzu’s recommendations; “Let your plans be as dark as night—Then strike like a thunderbolt.” I wonder if they are already charting a patient methodical course designed to minimize the duration of any conflict because they understand “No nation has ever benefited from prolonged war.” I worry that a plot is slowly unfolding and when it is revealed the ending will come swiftly. Sun Tzu says, “When a falcon’s strike breaks the body of its prey, it is because of timing” and ‘When torrential water tosses boulders, it is because of momentum.”
  • Among my cynical concerns is the notion that those not truly committed to the three-tier system are more versed in the teachings of Sun Tzu than those who would defend the system. I fear those who might dismantle the three-tier system appreciate Sun Tzu’s use of bait.

Valuation, It’s All Relative

“So Tim, what is a beer distributorship worth these days?”

For me, this is a recurring question; and I’m sure it’s a recurring question for others who determine the value of beer distributorships.

“It depends,” is the short and somewhat vague response I’ve provided in the past. Making that particular statement is not an attempt to be coy, unresponsive, or irksome. The “it depends” answer is provided because professional standards prohibit analysis-free valuations and, more importantly, because the “right” answer is, “It’s all relative.”

A cynic could suggest that valuation standards prohibit off-the-cuff valuations as a fee-mitigation defense, but that would be wrong. Professional standards prohibit such offerings simply because the old adage about what happens when you assume becomes horrendous when the assumptions profoundly affect someone’s generational enterprise and livelihood.

Simple answers to valuation questions appear compelling but they actually provide a potentially dangerous disservice. Valuation questions cannot be answered without context. The answer, “it depends” is not intended to avoid the question—it is intended to start a conversation.

Historically, I have followed the “it depends” answer with a series of my own questions. Are you talking about your entire business, or are you just asking about a particular brand? What are you contemplating selling, stock or selected assets? Are you asking, “What is the maximum amount that a strategic buyer might possibly pay, or could afford to pay?” If so, who is that buyer? What kind of synergies can be generated by the combination? How much equity can they bring to the table? What is their disposition towards acquisition? Is there a single strategic buyer with material synergies or are there multiple strategic buyers with material synergies? Or are you really asking me what you need to pay for an acquisition, but are doing it in an inverse manner?

This is a conversational dance I’ve performed so many times that I’ve worn a path on my speakerphone. There was a time when I could have the conversation waiting for a cab outside the Denver Convention Center after the Great American Beer Festival, but then came 2008. The gaps between buyers and sellers and risk and reward became chasms. The need for an augmented response hit me. Ultimately, the notion struck me, “it’s all relative.”

If you look up the definition of “relative” you’ll find that Webster’s lists nouns first. At the top of the list of definitions for “relative” is, “a person who is connected with another or others by blood or marriage.” Blood relations are good place to start when you consider the relative nature of valuation perspectives. You can encompass the entire value spectrum (a past DMGF seminar topic) while covering the range of issues a family business might have to deal with over the course of a generation.

At the low-end of the valuation spectrum is the tiny nonvoting stock interest that might be gifted or sold near the beginning of the succession process. The following is an exaggeration (almost a cartoon) of such a situation.

Joe Senior tells Joe Junior that he’s getting a tiny, insignificant stake in the family business for his 21st birthday. Joe Junior can get excited about that tiny, insignificant stake in the company because—for Junior—there is an implicit expectation of increasing interest and ultimately control. Joe Junior might even manage to retain that excitement when Joe Senior explains the details.

“Here’s the deal son. You’re getting one of the 1,000 nonvoting shares in the company. Your mom and I are going to keep the other 999 nonvoting shares and I’ll keep all 100 of the voting shares. I want you to come to the annual board meeting, even though you’re not going to be on the board and won’t be allowed to speak. I want you to see how the chairman of the board, the president, the director of HR, and the compensation committee (i.e., me, me, me, and me) make decisions. As a preview, I can tell you that your annual distribution will only cover your tax liability and your annual bonus will be based on my mood. This, my son, is going to be a great deal for you.” And for Joe Junior, if all goes as planned, in the end it will be.

As a relative of Joe Senior, Joe Junior can be comforted by the intimate knowledge that this first gifting of shares is just the beginning, and that there is a long-term plan to get Junior to a point of significant interest and, ultimately, to a position of control. So, that first control-free, zero-net-divided share he’s getting should have some significant personal value to Junior. If Junior loses sight of his future and decides to liquidate his interest in the family business, however, then he might find that the market value of that single insignificant share is rather disappointing.

One can imagine what might happen if Junior attempted to find a buyer for his single nonvoting share. Junior—knowing that it is a consolidating industry—might decide to reach out to someone he perceives to be a strategic buyer. Let’s call that hypothetical potential buyer John Doe. Further, assume that this John Doe character is known to be an eager beer consolidator. So, in Junior’s mind, John Doe could be a wonderful potential buyer for his single nonvoting share.

Outside of Junior’s mind and in the world of practical reality, however, Mr. Doe is not a relative of Joe Senior. Therefore, Mr. Doe has no expectation of benevolence from Joe Senior and there is no implied path by which Mr. Doe will garner a more significant stock position. John Doe sees Joe Junior’s single share as a nonvoting (discounted), noncontrolling (discounted), and illiquid (discounted) investment. Perhaps more importantly, a single share doesn’t garner the interest of a consolidator like John Doe. Mr. Doe buys whole businesses, not fractional interests. John Doe understands that a single nonvoting share could well be a zero-return investment until Joe Senior decides otherwise. John Doe sees three reasons to discount from what DMGF calls stand-alone fair market value and zero reasons to pay a premium. Relative to John Doe’s perspective, Junior’s single share is about as uncompelling as is possible.

Now let’s move from the low end of the spectrum to the middle of the spectrum, and go from cartoon to conflict.

Imagine that, simultaneous with his gift to Joe Junior, Joe Senior gifted an identical share of stock to Junior’s older sister Kathy. Thereafter, Kathy and Joe Junior work for the distributorship. They both perform well and contribute to the ongoing success of the family business. Ultimately, Joe Senior sees that Junior and Kathy are ready to take over. Through a long, well-planned effort involving gifts to and purchases by his children, Joe Senior liquidates his entire ownership interest in the family business and leaves Joe Junior and Kathy as equal 50-50 partners; each owning 50 voting shares and 500 nonvoting shares. Joe Senior now is free from day-to-day business distractions. He can turn his attention to reducing his golf handicap and improving his fly-tying skills.

Then tragedy strikes: One of the two 50-50 partners dies. Although Joe Senior did a good job taking care of his own estate, Joe Senior, Joe Junior, and Kathy did not concern themselves with the estates of the next generation. Now, a 50-50 partner’s surviving spouse—who has never worked in the business and doesn’t know the industry—wants to be bought out.

The shareholders’ agreement gives the company and existing shareholders a right to buy out the deceased shareholder’s interest at “fair market value.” Unfortunately, however, the shareholders’ agreement does not clearly define “fair market value.” Complicating matters, the shareholders’ agreement includes other language consistent with an investment value standard. Consequently, the intent of the buyout provision is both ambiguous and conflicted.

This is a potentially volatile situation. Especially if you inject some long-standing mistrust and bitterness. This is the type of circumstance that generates what I only half-jokingly call an “everybody hates me engagement.”

Consider a cynical construction of the dynamic. The buyer wants the absolute lowest price and seller wants the highest imaginable price. Both perspectives could have relevance and might well be considered by both parties, but neither might be what Joe Senior had envisioned or intended when he was in control and had the shareholders’ agreement drafted.

As the appraiser, I can assess the value of business and I conceivably could value it using a standard that is favorable to the buyer, a standard favorable to the seller, or some other standard of value. The ultimate question is which standard of value is appropriate (i.e., what Joe Senior had hoped for and intended). Unfortunately, in this case, that answer is unclear.

Sometimes contracts or statutes include terminology that—either by mistake, omission, or intent—is not clearly defined. An appraiser can put parameters on a valuation using potential interpretations, but an appraiser should not attempt to decide which interpretation is appropriate. The appropriate interpretation is a legal question with a valuation consequence. If, perhaps, you are an appraiser with a J.D. and a law license then you could “go there,” but otherwise it’s not the appraiser’s turf.

I’m not a lawyer, so I don’t go there. I can calculate values under multiple interpretations (i.e., using different standards of value), but I decline to opine on which interpretation is the correct legal (e.g., contractual or statutory) conclusion. Consequently, when I refuse to resolve the legal question in favor of either the low-value buyer or the high-value seller, sometimes both parties end up disappointed—even if they understand and accept my reasoning, methodologies, and separate value conclusions.

Family business owners should do their utmost to avoid this unpleasant circumstance. When drafting their buy-sell or shareholders’ agreements, they should have their lawyers seek valuation advice from a qualified appraiser. They also should consider the fundamental purposes of their buyout provisions. If the primary intent is the continuation of the family business via orderly share purchases, then maximizing shareholder value is an element that might need to be subordinated.

In a 50-50 scenario such as that described above, it can be difficult (or even impossible) for an owner to match the price that a strategic buyer might be willing pay for the family business. This is because strategic buyers typically don’t look at the company’s existing earnings stream. Instead, strategic buyers look at their own post-acquisition earnings streams. The acquirer’s post-acquisition earnings can be far greater than the earnings generated by the existing business. For a distributorship with average profitability, the synergistic buyer might be able to double profitability by reducing the seller’s current operating expenses by say 25%. An illustration of this scenario is provided by the table below.
Valuation-All-Relative-Graphic1-150x83

The owner who wants to buy out an equal partner doesn’t possess the means by which reduce operating expenses by 25%. Relative to the synergistic acquirer’s earnings, the current owner’s potential earnings are a mere 50%. If the acquirer offers a price based on a profit of $1,500,000, it would be an extremely dubious financial proposition for an existing owner to attempt to match that offer when having only half these earnings. It could be a bankable transaction for the existing owner, given the existing equity stake, but the payback would be extended and the investment return would be correspondingly (or even absurdly) small.

It is the same at the top end of the value spectrum; valuation is a relative matter. Two eager potential synergistic buyers can price the same target company differently. One of the two companies might have greater synergies. For example, due to the proximity of existing operations one acquirer might be able to eliminate a warehouse. As a result, that buyer might be able to reduce the seller’s operating expense structure by a third. The other buyer might not be so advantageously situated. That second buyer might be able to reduce the seller’s operating expense structure by only 25%. Using the illustration above, that 33% versus 25% difference results in nearly a quarter million dollars a year more profit. This equates to more value for one acquirer relative to the other.

Alternatively, two competing acquirers could perceive a target’s purchase price differently even if their potential synergies are identical. The balance sheets of the two potential consolidators could be the factor that makes the difference. If one potential buyer is debt-free and the other is levered up from one or more recent acquisitions, then the later is going to see the acquisition as a relatively more risky proposition because that buyer has a notably smaller margin of safety. If things unexpectedly go bad, then the company with the tighter balance sheet trips their bank covenants and stumbles into financial difficulties that much sooner.

For sellers there also is a variety of issues relative to value. An often-discussed issue is the attractiveness of dollars in the bank versus the intangible pleasures of owning your own company and staying in a highly enjoyable business. Another long discussed issue for sellers is the “What Next” factor. Historically, this dilemma primarily has related to what a distributor plans do with his or her life after an exit from the business. Recently, however, the financial question of what to do with after-tax sales proceeds has become a more pressing problem. Compared to the beer industry, other investments have become relatively uncompelling.

Finally, I would like to illustrate the relative nature of multiples. The table below shows how three different companies might have different gross profit multiples even if they sold the same number of cases, generated the same amount of EBITDA, and were valued using the same EBITDA multiple. Assume that the three companies all sell a million cases, all generate slightly more than a million dollars worth of EBITDA, and (for illustration purposes) all were valued at 10 times EBITDA. Despite these commonalities Company A garners a higher GP multiple than Company B, and Company B’s GP intangible multiple is greater than that of Company C. This is illustrated in the table (below).

Why the different gross profit multiples? In the case of companies A and B, the difference is entirely attributable to the higher margins and higher operating expense levels of Company B. Company B generates just as much profit as Company A, but a smaller percentage of each gross profit dollar generated by Company B survives operating expenses to become profit. Relative to sales, Company A and Company B each have the same level of profitability. Relative to gross profit dollars, however, there is a notable difference. For Company B and Company C, the difference in intangibles gross profit multiples is entirely attributable to the tangible asset base. In short, Company C needs more tangible assets to generate the same million dollars of earnings (think: accounts receivable in a noncash state). Note that only Company B’s and Company C’s intangible gross profit multiples are different. In terms of the values of the entire companies, Company B and Company C have the same multiple of gross profit.

Answering valuation questions requires perspective; a frame of reference. Questions of value must be answered relative to the interest being sold and the valuation purpose. The relative perspectives and objectives of buyers and sellers need to be considered. Without accounting for these essential elements, a valuation conclusion could be relatively inaccurate and inappropriate.

Portland to Portland: Part 1

Captain Renault might pretend to be shocked to learn this coast-to-coast beer tour was conceived in a bar, but I’m not going to pretend I am—or that you should be. In our case, ’twas Belgians at The Cheeky Monk. I don’t remember who served us that night. It could have been my favorite member of the Capitol the staff, Bingley (Bingley served me my first beer at the Colfax establishment – avec fib), or it could have been Hugh Jackman; I just don’t recall.

Anyhoo, the wife and I started drinking our way through a small portion of The Cheeky’s selection of imported drafts, and talking about beer and my work in the beer business . . . and how it was a practical and pleasant necessity that I embark on a journey across the United States drinking beer, learning about beer, and making friends with people in the beer business. In fact, I had neglected such undertakings—to my professional detriment.

Well, when you start talking about traveling across America to drink beer, Portland, Oregon, often starts that conversation. Then there’s Portland, Maine. I have a former client there, a valuation-profession ninja lives there, and, importantly, a friend of my wife lives in the like-named city on the North Atlantic. Portland to Portland—sounds awesome doesn’t it? [Btw, I’ll be over-using awesome. It’s an inside joke from the vacation and the idea of substituting it for expletives amuses me].

As you might expect, it all was exceedingly compelling, initially—in that location . . . at that time . . . under those circumstances.

Back then—in that location, at that time, and under those circumstances—it was, for me, just a conceptual discussion about how, at some point, I should attempt to find a reasonable means by which to mix some personal visits to distributorships with the acquisition of craft-industry knowledge and various other forms of professional development. That’s where I was mentally. The wife, well, she was far beyond initial concept. It had been a leap year since our last vacation grande. As such the wife was long past the contemplation phase. We were going Portland to Portland. There was, shall we say, a slight disconnect between our two perspectives.

In retrospect, it was obvious I was going to the canvas. It was only a question of when. My defense, of course, was pathetic. It is hard to get one’s heart into the anti-travel America whilst drinking beer argument. And, in lack of fairness to my wife, let me suggest that she also took advantage of my need to present insights into The Cheeky’s awesomeness. She feigned listening to me while simultaneously using the sonic “Tim-block” devices she has cultivated since first making my acquaintance. Damn, the lady can multitask!

Writing this now (and assigning blame from the rearview mirror), I’d like to suggest that my wife was plotting points along this country’s northern latitudes while barraging me with compelling “you shoulds” and pummeling me with tough-to-answer “why can’t yous.” Seconds in, and I’m wobbling up against the ropes looking at the exceedingly obvious and notoriously awesome Portland, Oregon, to start the tour and seeing the exceptional Allagash in Portland, Maine, at its end. And, of course, it was all exceedingly compelling in that location . . . at that time . . . under those circumstances.

Portland to Portland—why not? It’s got a nice ring to it and it’s conceptually enticing when abstracted from time, distance, and various other elements of the practical reality. In fact, my wife decided that going from Portland to Portland sounded SO awesome that we need not discuss the continent lying between the Pacific Portland and the Atlantic Portland. Nor should we talk about duration or mode of transit. We’re just enjoying some beers and talking—so I thought; all the while she fixated and plotted. Eventually I caught on to where she was, and decided I needed to corral the conversation with some practicalities.

There is no exceedingly compelling argument for choosing that strategy—in that location . . . at that time . . . under those circumstances. I already had totally “awesomed-up” my wife-proximity mouth-retardant coefficient, and now I was going to pay.

I love vacation travel. Work travel is fine, but not awesome. I’ve done the on-site, “distributor has all you need” no-worries thing (distributors all know of their cities’ finest amenities). Working like that can involve extended and odd hours, but generally it is not chock-full of uncertainty or lacking in pleasantries. I hadn’t worked on the road, hopping from place to place over any meaningful duration. We were going to be crossing some of our country’s vast emptiness, and I wasn’t savoring the idea of struggling to find Internet access in the Northern Rockies. Nor was I excited about playing the “Where is the awesome Kinko’s?” game and being told that it was two awesome hours away, except that the awesome bridge is out. So, motivated by foolish pride coupled with personal and profession away-from-home trepidations, I decided to mount a reason-based argument against taking the trip this year.

My wife doesn’t know everything about my business, but she knows enough to kick my butt in an argument my heart really isn’t in.

“I can’t be out of the office that long.”

“Why not, millions of other people do it every day?”

“I’m not comfortable being away from the extended family for that long right now. I feel like sticking close to home at the moment.”

“It’s really not that long; you have brothers and sisters in Denver and if there’s an emergency you hop on a plane and head home.”

My lackluster defense thus aikido-ed, the wife went immediately to the professional nag and closed with the sentimental kill shot. Think of how good it could be for you professionally and what a great experience it would be for our kids.

It went like that. Flailing jab, flowed by a round house to the ear. In the end she took pity and indicated we could continue the conversation later. That was code for “I’ll inform you as my plans progress.” And so we ate and our night out ended. My wife left the premises thinking how fun our coast-to-coast summer vacation was going to be. I left The Cheeky Monk staggered by the sober reality of the Continental sized folly I had just prattled my way into. Three weeks to travel 3,200 miles while attempting to drink a diversity of beers? When you consider travel, packing and unpacking, there’s beer mitigation at every stop. This thing is going to be more than a conceptual debacle. It’s going to be a logistic nightmare. Even as a team Charlie Sheen and Keith Richards could barely put a dent in Portland, OR’s craft seen with a mere three weeks. So, we’re going to add kids and a second Portland. I thought to myself, this whole damn vacation is going to be nothing but malted mulligans.

The Bubble Misnomer

It’s been said that beer distributorships are experiencing a value bubble. Well, I heartily disagree. I disagree not because I think there are no significant downside price risks, or because I subscribe to the belief that value bubbles don’t really exist (some economists argue historical price collapses are better explained by supply/price imbalances versus mass manias). I disagree because I think the term “value bubble” is an atrocious misnomer.

In the classical sense, “bubbles” are short-lived phenomena and their collapse is inevitable. They must burst under the weight of fictions, fantasies, and/or frauds.

That’s not where beer-distributorship values are.

Mention the word “bubble” and I immediately jump to the classic, Extraordinary Popular Delusions and the Madness of Crowds (it’s nearly free for Kindle download). That’s where you’ll find frames of reference in Charles Mackay’s tales of Tulipmania, The Mississippi Scheme, and perhaps the mania that inspired the phrase “bubble,” The South-Sea Bubble.

Regarding The South Sea Bubble, Mackay writes,

“In the mean time, innumerable joint-stock companies started up everywhere. They soon received the name of Bubbles, the most appropriate that imagination could devise. The populace are often most happy in the nicknames they employ. None could be more apt than that of Bubbles. Some of them lasted a week, or a fortnight and were no more heard of, while others could not even live out that short span of existence. Every evening produced new schemes, and every morning new projects.”

Oh, if you could simply conjure up a beer distributor transaction. What a wonderful duopolistic world it would be. But, sadly, you can’t. Like birth, it’s a struggle. You generally have to persuade a financially secure individual to hand over a family-owned business that has provided cash-flow for years—or, more likely, for generations. On top of that, you could be asking them to give up a totally awesome occupation and watch as friends (akin to family) are forced to seek new employment.

Mackay continues,

“Some of these schemes were plausible enough, and, had they been undertaken at a time when the public mind was unexcited, might have been pursued with advantage to all concerned. But they were established merely with the view of raising the shares in the market. The projectors took the first opportunity of a rise to sell out, and the next morning the scheme was at an end.”

Sellers aren’t traders looking to bolt at the first sign of a profitable exit. They’re grappling with the notion of cashing out at premium price under current tax rates now versus keeping recession-tested cash flows in a world that presently offers few comparably compelling investments. Their state of mind isn’t effervescent, it’s reluctant.

Sitting across from these sellers are buyers who don’t plan to flip their acquisitions or who have dreams of ever-blossoming earnings streams. Consolidators are looking at a near-term earnings pop from synergies followed by a tough slog keeping earnings growth ahead of inflation. Acquirers don’t sign notes at closing feeling certain their investment will pan out. Nope, even in a liability-free asset purchase the acquirer takes possession of all future worries. Consolidators are stepping up to an investment proposition. They know the industry and its history. They are up to speed on the state of the industry. They know about the risks and are concerned by them but, in the end, they like the odds.

Buyers aren’t gorging themselves at some kind of bacchanalian feast; they’re feeding on the limited number of acquisitions available. Acquirers aren’t overindulging, they’re gathering sustenance. They intend to keep their acquisitions and cash flow their debt away over time. They want to promptly replace debt with equity and reposition themselves to capture the next opportunity that presents itself. There is no “greater fool” or “hot-potato” game afoot.

I concede, however, there is a sort of a mania at work. There is a kind of feeding frenzy going on. Industry waters are swirling. Anyone paying attention can see it is eat or be eaten. It is not that every morning new there is a new consolidation project; instead, every month there is perhaps one less potential consolidation project.

Self-preservation can be quite the motivator. It can cause someone to extend themselves to their absolute limits. It can make a would-be consolidator walk right up to financial suicide and look it straight in the eye. But, in the end, nobody in this industry chooses financial suicide or is allowed to choose financial suicide; not with a major suppliers brands in their grasp. What happens is that a fish big enough and strong enough to capture the acquisition gets stronger after it “feeds”—and the fish that don’t eat start looking more and more like bait. It’s worth noting that some huge predators just now are entering the waters. Billionaires like Buffet and Trott are now trolling through the sea of alcohol distribution chumming up the waters with their cheap and deep capital.

No doubt one could compile historical beer-distributor transaction data and show that values have risen dramatically, but that is not evidence of a value bubble. It also is possible the value of certain beer distributorships or beer distributors in general could fall dramatically; but it won’t be because some delusional mass mania comes to an abrupt and foreseeable end. The truth is that in an examination of recent beer distributor transactions, it’s difficult to see any of the classic features of a so-called value bubble.

There is a valid, readily demonstrable, and compelling economic reason for higher prices—consolidation. Consolidation has been tested extensively and repeatedly, and the results are in. Increases in profitability and the benefits of scale are not dreams, fantasies, or even dangerously overoptimistic assumptions. Synergistic fit is essential; but, if you put two highly complementary distributorships together, the savings are real and substantial.

We’re not talking about some future yet-to-be-developed revenue stream. We’re talking about readily identifiable expense savings that can be implemented and turned into debt service almost immediately. It’s not like the situation where you have the founder of FedEx point to his fleet of planes, trucks, cars, and real earnings and openly mock the ridiculousness of Webvan’s market cap and flawed business model.

The prices and premiums being paid aren’t based on irrational notions of growth and earnings. Buyers might be giving up an atypical proportion of synergies, but they are not obtaining supplier approval and financing with fanciful and unobtainable dreams. When a buyer bites into an acquisition, he tastes cash flow, not smoke and mirrors. Those who have most savored consolidation’s delights are those who have most quickly leveraged their acquisitions into increased effectiveness and profitability.

It seems pretty clear buyers aren’t blundering down a path to inevitable disaster lead on by financial delusions. It is true dreams of empires have inspired eager consolidators to sacrifice synergies and endure more risk and leverage, but the dearth of notorious failures suggests financial reason has not been compromised. Certainly, some impressive empires have been built. Somewhere there is a large and still-healthy dolphin wondering what growth hormone turned his pod-mate into a killer whale.

The term “bubble” does not accurately depict current beer distributorship pricing. And, a statement “profits are good” combined with an absence of financial pain does not support the notion of a bubble.

I don’t contend distributorship prices are currently in a state of perfect price equilibrium. I wouldn’t dispute the current splitting of synergies appears atypical, or that there is a significant gap between buyers and sellers. Nor am I trying to suggest paying premium prices for an acquisition carries no risk. I just think using the term “bubble” is an inaccurate and unconstructive way to describe current pricing and industry risks.

Beer distributorships have proven to be incredibly resilient. In fact, there’s part of me that finds the idea of a beer distributorship bubble slightly comical. The country goes through the worst recession since the Great Depression. Banks fail, Wall Street gets rocked, the auto industry goes up in flames, and the real estate market collapses. Michael Lewis refers to it as “the greatest financial crisis in the history of the world.” Shrapnel is everywhere, but a beer distributorship value bubble persists through it all—due to improved profits, no less.

Don’t get me wrong, the industry hardly is free of risks. There are plenty of downside price scenarios. Industry wide, values could come down; however, it is not inevitable that values will come down. Prices are not destined to collapse under the weight of financial reality. Moreover, if values do drop, they won’t pop like a bubble.

It is highly conceivable values could be eroded slowly over time. It is reasonable to expect the middle-tier’s profits increasingly will look like essential nourishment to first-tier suppliers. It also is conceivable values could take a significant and substantial hit in a short period. In this instance, however, the collapse of values would look more like a catastrophic system failure than a burst bubble.

Beer distributorship price risk does not have the characteristics of a bubble. The price risk looks more like that of a crystal or a gem. Diamonds have emotional value, certainly; but they also have a long history of enduring value and real utility. Each is unique, all are precious, and they are rare. Diamonds are resilient and can withstand tremendous forces. With great thought, vision, and skill diamonds can be refined. Unfortunately, diamonds also can be shockingly fragile. Striking in the wrong place can ruin a diamond’s value instantly. Beer distributorship values clearly are exposed to this kind of catastrophe. It is a frightening scenario but, thankfully, not a high-probability event.

Describing current pricing as a bubble suggests irrational pricing and inevitable correction. As a consequence, those concerned about price risks are pointed in the wrong direction. It doesn’t say the three-tier system has sustained this fracture and now is poised for collapse. It doesn’t say supplier X is going to piranha Y cents per case of your profits over the next five years, and lower your value by Z%.

What using the term bubble does is facilitate a misunderstanding of the ever-present and perhaps expanding gap between buyers and sellers. It almost seems to be intended to be a reason for buyers to offer less. Especially when it is comingled with an observation sellers are looking backward and buyers are looking forward.

Of course, every seller wants a price based on their best years, but a truly willing seller must accept a price influenced by more recent and less positive performance. Sellers absolutely try to point to the best of years when in negotiations but, deep in their hearts and minds, they are more focused on the future years of business they and their children won’t see. Their time horizon is decidedly not quarter to quarter—it’s generational. Sure, sellers sometimes take a painful while to go from lofty to realistic. But that process and the so-called value gap isn’t evidence of a bubble because the value gap isn’t where transactions happen. The value gap is where transactions don’t happen.

It’s not that sellers are looking backward and buyers are looking forward. It’s that buyers and sellers see the exchange from two opposing positions. The seller is often giving up his stable, unlevered, cash-flowing business. The buyer is levering up the business and assuming the risk of uncertain future earnings. The sellers are cashing in their equity; the buyers are putting theirs at risk. That same dairy cow looks extraordinarily different from opposite sides.

Perhaps using the term “bubble” could serve some useful purpose. It could jolt a beer distributor into examining future prospects. That distributor might see the values being paid for the limited number of strategic combinations imply substantial premiums. That distributor might look around and see it didn’t eat earlier when it should have. All the other fish in their waters have grown too large. There’s nothing left for them. They aren’t going to grow anymore. Their future is confined to staying alive and healthy. At that point, perhaps they can see current prices more appropriately, as a window of opportunity.

Prices aren’t irrationally high, but for many wholesalers—especially smaller distributors without realistic acquisition opportunities—there seems to be more downside than upside. As such, sellers should not be deluded by notions of grandeur. The rumor mill passes tales of exceptions most easily. Odds are you’re not as good as—or better than—the best there ever was. A seller that carries unrealistic expectations can get unjustly crushed by time and circumstances if a sale becomes necessary.

I do have some concerns about taking this position. The economy seems to be treading water. High unemployment is expected to continue for years. Our country’s fiscal policies look like a train wreck in the making. I’m troubled by negative volume trends and inter-tier tensions. And, stumbling across John Gerzema’s The Brand Bubble while writing essay this stopped me in my tracks – momentarily.

Nonetheless, I call the beer distributorship value bubble a misnomer. I see risks, not inevitable decline. I see risks that need to be acknowledged, managed, and if possible eliminated. I see industry concerns and brand risks. I don’t see folly destined to end in tragedy.

Tossing out the term “bubble” provides drama, which can be fun, but it also detracts from bona fide insights regarding an industry suffering from an insufficiently competitive state of mind, the trading of long-term brand health for short-term profits, and the courage individuals show when they address threats and issues that others are reluctant to acknowledge.

I want to personally thank Harry Schuhmacher at Beer Business Daily for helping with the early drafts of this article. Always one to sacrifice himself for the industry he took an editor’s bullet so your pain would be lessened. Granted he didn’t leave the pool to do it but I did interfere with beers and family.