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

Continue reading The Art of Wort

• The key issue addressed in the article Security Interest Exists in Economic Value of FCC License parallels an important financing issue for the typical beverage distribution acquisition. The holder of an FCC license cannot offer the license as security but the holder can offer the proceeds of the sale of the license as security. Similarly, a lender typically cannot be given an interest in the distribution rights themselves but they can take an interest in the proceeds from the sale of distribution rights.
• The second excerpt deals with courts appointing their own experts. I find it a somewhat troubling situation for the valuation profession if courts feel compelled to appoint a valuation expert for the sake independence and as a means of avoiding so called “valuation wars”. The stated role and professional standards of valuation experts dictate their independence. Additionally when opposing experts quantify the valuation impact of factual or legal matters under dispute they serve an important function.
• The last excerpt, FASB helps out with ‘market participant’ definitions, notes that fair value guidance could have some relevance for the valuation of private companies. Some of the distinguishing characteristics suggested by the SEC touch on key beverage distributor valuation issues like “financial versus strategic buyers”, “financial capacity”, “acquisition strategy”, and “marketplace synergies”.

Security Interest Exists in Economic Value of FCC License

In re Terrestar Networks, Inc., 2011 WL 3654543 (Bkrtcy. S.D.N.Y.)(Aug. 19, 2011)

The debtors in this Chapter 11 proceeding provide mobile satellite services pursuant to various FCC licenses. Aware that federal law prohibits using the licenses themselves as collateral, in 2008 the debtors granted their secured noteholders an interest in all economic proceeds from the “sale, transfer, or other disposition” of the

Continue reading Valuation Tales: 2011 – Q4

• GDP rose 2.8% in the fourth quarter of 2011 according to the advance estimate. The increase was the best in a year and half and strong enough to improve the employment situation. Good news certainly, but a comparison of real GDP at the end of 2007 and 2011 provides a slash of cold water. 2007 GDP was $13,206.4 (in billions of chained 2005 dollars). Four years later 2011 GDP was $13,313.4. That’s a compound annual change of only 0.2%.
• The Unemployment rate dropped to 8.5% in December 2011. That made it four months in a row with a decline in the employment rate. The markets responded positively but looking past the headline rate drop many analysts delivered tempered optimism because the drop in the unemployment rate was partially due to a decline in the labor force. In fact, BLS data indicates that the December 2011 labor force was slightly smaller than the December 2007 labor force (153,887,000 vs. 153,918,000), despite census estimates suggesting the nation’s population grew 3% during this period. The unemployment rate stood at 5.0% in December of 2007 with roughly 7.65 million people unemployed. At year-end 2011, roughly 13.1 million people were unemployed; a 70%+ increase in the number of unemployed.
• Inflation wise, the CPI All Items index finished up 3.2%. Carbonated Drinks, Beer, Wine and Spirits prices

  Continue reading M4 – Malted Minds Macro Minute: 2011 – Q4

  ]]> The final quarter of 2011 offered an assortment of positive economic results. This collection of encouraging data generated a fresh round of green shoots talk, and a slightly more hopeful economic outlook as 2012 began. However, serious economic headwinds and risks persist and even the typical optimist still only expects a protracted recovery. In this context I have chosen to take a where are we now (pre-recession v. post-recession) approach for this quarter’s Macro Minute.
  • GDP rose 2.8% in the fourth quarter of 2011 according to the advance estimate. The increase was the best in a year and half and strong enough to improve the employment situation. Good news certainly, but a comparison of real GDP at the end of 2007 and 2011 provides a slash of cold water. 2007 GDP was $13,206.4 (in billions of chained 2005 dollars). Four years later 2011 GDP was $13,313.4. That’s a compound annual change of only 0.2%.
  • The Unemployment rate dropped to 8.5% in December 2011. That made it four months in a row with a decline in the employment rate. The markets responded positively but looking past the headline rate drop many analysts delivered tempered optimism because the drop in the unemployment rate was partially due to a decline in the labor force. In fact, BLS data indicates that the December 2011 labor force was slightly smaller than the December 2007 labor force (153,887,000 vs. 153,918,000), despite census estimates suggesting the nation’s population grew 3% during this period. The unemployment rate stood at 5.0% in December of 2007 with roughly 7.65 million people unemployed. At year-end 2011, roughly 13.1 million people were unemployed; a 70%+ increase in the number of unemployed.
  • Inflation wise, the CPI All Items index finished up 3.2%. Carbonated Drinks, Beer, Wine and Spirits prices all lagged the comprehensive index in 2011. The story is different if you look at the 2007 to 2011 time frame. Over this time period price increases for carbonated drinks, beer, wine away from home and spirits away from home all grew substantially faster than the All Items Index; wine and spirits at home grew notably slower. See chart at bottom of post.
  • The DOW finished the year up but the S&P 500 was flat and the NASDAQ was down 1.8%. Versus their 2007 closing points the DOW, S&P and NASDAQ were down 13.7%, 14.4% and 1.8%, respectively. Clearly unimpressive performance, but if you were brave and bright enough to have jumped on these indexes near their March 9, 2009 lows you’d have about doubled your money.
  • Interest rates finished the year the way they started it – low. When 2011 came to a close the price rate was still 3.25% and the fed funds target rate upper limit remained at 0.25%. During 2011 3-month T-Bill rates fell from a nominal 0.15% rate to an absurd 0.01% rate and 10-year bonds went from 3.39% down to 1.98% (as of 12-1-11). Based on Federal Reserve expectations, low rates will be around for a couple more years. To continue the comparisons at the end of 2007, the prime rate was about 7%, 3-month T-Bills were yielding about 2.75%, and 10-year bonds were about 3.75%. The low rates have inspired bond offerings and some analysts predict low rates will help drive M&A activity.
  • Bureau of Labor Statistics Major Sector Productivity and Cost data shows business output was up 2%, employment was up 1.3%, hours were up 1.5%, labor productivity was up 0.6% and unit labor costs were up 0.7% on a year over year basis (Qtr3 comparisons; 2011 data revised). Again, relatively good news, but employment, hours, and output remained down relative to 2007 levels; -6.9%, -7.4%, and -0.5%, respectively. Labor productivity and unit labor costs were up versus 2007 levels, +7.5% and +1.2% respectively.
  • Per capita disposable income fell 50% in 2011; from $1,800 to $900, which is over 60% below the $2,400 figure BEA shows for 2007.
  • Finally, a smattering of other noteworthy 2007-2011 comparisons:
    - December sales of new single family were down about 50%; 307,000 vs. 604,000.
    - Construction spending was down about 30% ($1.165 billion vs. $807 million)
    - In 2011 Monthly Sales for Retail and Food Services were only about 4% higher than they were in 2007.
    - In December 20110 Industry Production was about 95% of what it was 2007, and capacity utilization was down (78.1 v. 81.4).

   

  ]]> http://www.dmgfinancial.com/macro-minute-2011-q4.html/feed 0 http://www.dmgfinancial.com/random-links-2011-q4.html http://www.dmgfinancial.com/random-links-2011-q4.html#comments Wed, 01 Feb 2012 17:01:11 +0000 tim http://www.dmgfinancial.com/?p=426 The 2011 yearend version of Random Links has a slightly different look. There are more links and some of the links are grouped within topics. Topics include: 2012 trends and predictions, tax and regulatory issues, profitability and productivity tips, merger & acquisition news, and an odd New Year’s resolution.

  The Outlook for 2012 is Mixed

  Is Small Business Poised to Increase Hiring and Will Employment Gains Continue?

  Small business owners were more positive in December according to a Small Business Authority Market Sentiment Survey. This upbeat attitude may have been due to better employment figures and robust holiday spending. Unfortunately, employment momentum waned as 2012 began and the bump in consumer spending at yearend was associated with increased debt, suggesting the consumer spending trend won’t continue in 2012 unless employment and wages grow. There are positive signs, like growth in small business lending but the better jobs trend at the end of 2011 wasn’t nearly good enough to produce an employment recovery in the near-term.

  Make 2102 More Profitable and Productive

  Technology is Driving Sales and Warehouse Productivity

  I don’t think the concept of big data (as it is typically used) applies directly to the average beer distributor like it does for major suppliers but the notion of using hard data to overcome personal biases and utilizing today’s powerful IT tools certainly do. Check out the WSJ pieced titled So, What’s Your Algorithm? and consider how your company might drive sales by doing something analogous to what The Schwan Food Co. did with its 6,000 roving sales people. Then check out Raise a glass! and Tips for quicker product picking for warehouse productivity ideas and inspiration. Because “The fact that productivity, or output per employee, has shot up since the beginning of

  Continue reading Random Links For Financial Kinks: 2011 – Q4

  ]]> The 2011 yearend version of Random Links has a slightly different look. There are more links and some of the links are grouped within topics. Topics include: 2012 trends and predictions, tax and regulatory issues, profitability and productivity tips, merger & acquisition news, and an odd New Year’s resolution.

  The Outlook for 2012 is Mixed

  Is Small Business Poised to Increase Hiring and Will Employment Gains Continue?

  Small business owners were more positive in December according to a Small Business Authority Market Sentiment Survey. This upbeat attitude may have been due to better employment figures and robust holiday spending. Unfortunately, employment momentum waned as 2012 began and the bump in consumer spending at yearend was associated with increased debt, suggesting the consumer spending trend won’t continue in 2012 unless employment and wages grow. There are positive signs, like growth in small business lending but the better jobs trend at the end of 2011 wasn’t nearly good enough to produce an employment recovery in the near-term.

  Make 2102 More Profitable and Productive

  Technology is Driving Sales and Warehouse Productivity

  I don’t think the concept of big data (as it is typically used) applies directly to the average beer distributor like it does for major suppliers but the notion of using hard data to overcome personal biases and utilizing today’s powerful IT tools certainly do. Check out the WSJ pieced titled So, What’s Your Algorithm? and consider how your company might drive sales by doing something analogous to what The Schwan Food Co. did with its 6,000 roving sales people. Then check out Raise a glass! and Tips for quicker product picking for warehouse productivity ideas and inspiration. Because “The fact that productivity, or output per employee, has shot up since the beginning of the recession is no secret”.

  New Regulations and Shifting Tax Law

  Moving Targets, Confusion, Uncertainty & Anxiety

  Some of the “sweeping changes to the rules governing federal estate taxes, gift taxes and generation-skipping transfer taxes” for the 2010, 2011 and 2012 are summarized in this Overview of 2011 and 2012 Estate Tax and Gift Tax Laws from about.com. Are you looking for a compact summary of some key 2102 tax facts? Well here it is thanks to some Georgia CPAs. Here is a similar offering from the good people at the IRS. And don’t forget, there are new W-2 reporting requirements for W-2s.

  Cultural and Consumer Shifts Driving Food and Beverage Trends

  Foods/Ingredients: The In and Out Lists

  Marketing Daily kicked of the new year with an article titled 12 Consumer Trends Affecting Food/Beverages. The brief article doesn’t offer a lot of specifics but it does hit on some of the shifts in consumer behaviors that distributors are already confronting like niche products, usage occasions, local sourcing and engendering loyalty among Millennials. The article contains a link if you want to sign up and receive the full report.

  Distribution Deals Get Bigger

  Are Small Deals Less Appetizing or Are Big Deals Just More Satiating?

  Back in October of 2011 Modern Distribution Management noted that Acquirers Were ‘Taking Chunks’ Out of the Middle. The article quoted David Gordon, president of Channel Marketing Group, who said, “Those large companies have historically gone after the smaller players to grow incrementally… Now they’re acquiring larger companies, from about $75 million to $400 million and taking big chunks out of the market.” Think of Southern Beverage and the other big liquor distributors, some of the big Anheuser-Busch distributor acquisitions, and ABI’s branch acquisitions.

  The Most Peculiar 2012 New Year’s Resolution

  It’s Not About Improving Yourself – It’s Protecting Yourself

  Cindy Perman at CNBC suggests we all make improving this skill a new year’s resolution. It is an interesting piece with disturbing statistics on the frequency of lies, myths about the behaviors of liars and a link to a test of your lie detecting skills. Perhaps if we were all better at this skill the world would be a better place.

  ]]> http://www.dmgfinancial.com/random-links-2011-q4.html/feed 0 http://www.dmgfinancial.com/valuation-its-all-relative.html http://www.dmgfinancial.com/valuation-its-all-relative.html#comments Mon, 31 Oct 2011 17:05:04 +0000 Financial Specialist http://www.dmgfinancial.com/?p=158 “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

  Continue reading 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. 

  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.

  ]]> http://www.dmgfinancial.com/valuation-its-all-relative.html/feed 1 http://www.dmgfinancial.com/valuation-tales-2011-q3.html http://www.dmgfinancial.com/valuation-tales-2011-q3.html#comments Mon, 31 Oct 2011 17:04:07 +0000 Financial Specialist http://www.dmgfinancial.com/?p=149 This quarter’s “Valuation Tales” includes four licensed excerpts provided by Business Valuation Resources (BVR).
  • In S. Muoio & Co., LLC v. Hallmark Entertainment Investments, the Delaware Chancery Court stresses the use of multiple methods. The case supports the principle that multiple methods should be used, including cost, income (e.g., DCF), and market (i.e., multiples).
  • A review of several cases involving Lost Profits Damages and Lessons Learned from Daubert, including discussion of comparable cohorts, yardsticks, and other valuation techniques. These cases illustrate how contracts, statutes, and other factors can dictate damages.
  • Hendrix v. Commissioner details a tax court’s decision to uphold a defined value clause. This is the type of case that might provide food for thought if you are working on a buy-sell agreement or shareholders’ agreement.
  • The Estate of Cohen v. Booth Computers asks the question, “Is a Buy-Sell at Book Value Unconscionable, When FMV is 60 Times Greater?” This case offers an out-of-proportion lesson on how not to integrate accounting, valuation, and a buyout provision.

  DE Chancery Advocates ‘Triangular’ Approach to Business Valuation

  S. Muoio & Co., LLC v. Hallmark Entertainment Investments, 2011 WL 863007 (Del. Ch.)(March 9, 2011)

            In its recent letter opinion, In re Hanover Direct, Inc. Shareholders Litigation, Consol. C.A. No. 1969-CC (2010), the Delaware Chancery court confirmed that “there is no single preferred or accepted valuation methodology . . . that establishes beyond question a company’s value.” At the same time, “there are commonly accepted methodologies that a prudent expert should use in coordination with one another to demonstrate the reliability of its valuation,” the court said, in rejecting an expert’s opinion that relied solely on a discounted cash flow (DCF) analysis.

            Another company on the brink. Like the troubled company in Hanover, Crown Media Holdings,

  Continue reading Valuation Tales: 2011 – Q3

  ]]> This quarter’s “Valuation Tales” includes four licensed excerpts provided by Business Valuation Resources (BVR).
  • In S. Muoio & Co., LLC v. Hallmark Entertainment Investments, the Delaware Chancery Court stresses the use of multiple methods. The case supports the principle that multiple methods should be used, including cost, income (e.g., DCF), and market (i.e., multiples).
  • A review of several cases involving Lost Profits Damages and Lessons Learned from Daubert, including discussion of comparable cohorts, yardsticks, and other valuation techniques. These cases illustrate how contracts, statutes, and other factors can dictate damages.
  • Hendrix v. Commissioner details a tax court’s decision to uphold a defined value clause. This is the type of case that might provide food for thought if you are working on a buy-sell agreement or shareholders’ agreement.
  • The Estate of Cohen v. Booth Computers asks the question, “Is a Buy-Sell at Book Value Unconscionable, When FMV is 60 Times Greater?” This case offers an out-of-proportion lesson on how not to integrate accounting, valuation, and a buyout provision.

  DE Chancery Advocates ‘Triangular’ Approach to Business Valuation

  S. Muoio & Co., LLC v. Hallmark Entertainment Investments, 2011 WL 863007
  (Del. Ch.)(March 9, 2011)

            In its recent letter opinion, In re Hanover Direct, Inc. Shareholders Litigation, Consol. C.A. No. 1969-CC (2010), the Delaware Chancery court confirmed that “there is no single preferred or accepted valuation methodology . . . that establishes beyond question a company’s value.” At the same time, “there are commonly accepted methodologies that a prudent expert should use in coordination with one another to demonstrate the reliability of its valuation,” the court said, in rejecting an expert’s opinion that relied solely on a discounted cash flow (DCF) analysis.

            Another company on the brink. Like the troubled company in Hanover, Crown Media Holdings, Inc. (the owner of the Hallmark Channel) was foundering under declining revenues, and it couldn’t find a buyer to cover the $1.1 billion debt to its controlling stockholder, Hallmark Cards. In 2010, a special committee approved recapitalizing the debt, based on an independent appraisal that said the company was worth only $750 million and on the brink of bankruptcy. A single minority stockholder sued to rescind the deal, claiming that both the process and the price of recapitalization were unfair and drastically undervalued the company—which was worth nearly $3 billion, according to its expert’s DCF.

  Under an entire fairness review, however, the Delaware Court of Chancery found that the special committee was independent and had negotiated the Hallmark recapitalization at arm’s length. Further, the plaintiff’s $3 billion DCF valuation failed to explain why no other potential buyer came forward during the company’s bidding process to capture the alleged excess value. It also failed to recognize “the brute facts” of the company’s near-bankruptcy, the court held.

  Finally, the plaintiff’s expert failed to incorporate any other valuation method into his conclusions. In fact, the expert had performed a comparable companies analysis ($803 million) and a comparable transactions analysis ($1.3 billion), but he rejected those approaches as “absurdly low.” Such an outlier valuation reinforced its lack of credibility, the court said, citing Hanover. A DCF approach is only reliable when it can be verified by “alternative methods” or “real world valuations,” particularly valuations by potential third-party buyers, the court explained:

  Thus, it is preferable to take a more robust approach involving multiple techniques—such as a DCF analysis, a comparable transaction analysis . . . and a comparable companies analysis . . . to triangulate a value range, as all three methodologies individually have their own limitations.

  The court also rejected the expert’s DCF for ignoring contemporaneous management projections in favor of his own, and dismissed the plaintiff’s suit.

  Roundup: Lost Profits Damages and Lessons Learned from Daubert

  Three recent decisions illustrate the ways in which a pre-trial Daubert motion can make or break a plaintiff’s case for lost profits damages, based solely on the reliability and relevance of its expert evidence.

  Victory Records, Inc. v. Virgin Records America, Inc., 2011 WL 382743 (N.D. Ill.) (Feb. 3, 2011) In this first case, the plaintiff sought millions of dollars for the defendant’s alleged interference with its multi-album recording contract with a rock ’n’ roll band. Its expert, a music industry accountant, calculated damages based on a “before and after” approach, comparing what the plaintiff’s sales would have been absent the alleged interference, as well as the “yardstick” analysis, which looks to profits produced by industry comparables. Both methods must rest on “adequate” assumptions and “cannot be the product of mere speculation,” the federal district court observed.

  However, the expert’s “before and after” approach relied almost exclusively on the plaintiff’s internal sales projections, without independently verifying whether they were accurate. When a party’s internal projections rest on its “say-so” rather than statistical analysis, they are unreliable under Daubert, the court held. Similarly, the expert relied on the plaintiff to recommend a single rock band to use as a yardstick comparable. This “paltry foundation” failed to meet the reliability requirements of Rule 702 of the Federal Rules of Evidence, the court held, and excluded the expert’s evidence.

  Insignia Systems, Inc. v. News America Marketing In-Store, Inc., 2011 WL 167259 (D. Minn.)(Jan. 14, 2011) The plaintiff’s expert in this case also used two approaches to estimate damages (ranging from $121 million to $214 million) for the defendant’s antitrust violations. Under the first, he selected “a cohort” of comparable, publicly traded firms to serve as a proxy for the plaintiff’s “but for” market performance and market capitalization. Under his second approach, the expert calculated separate categories of the plaintiff’s lost profits based on management’s “best estimates” of future performance.  

  The defendant challenged the evidence under Daubert, claiming that the expert’s market approach used companies from different industries and failed to account for alternative causes of loss; and his projections came from “biased” and unverified sources. In response, the expert noted that in a market with so few players, it would make little sense to compare the plaintiff’s performance against competitors that were unaffected by the defendant’s antitrust violations. Nevertheless, he submitted a supplemental report, which recalculated damages by using a set of comparable companies in the plaintiff’s same industry, resulting in a range of damages similar to his original calculations.

  “The law is clear that comparable companies must be as similar as possible,” the court held. However, in this case, his rebuttal evidence met the required standard. Further, even though the expert attributed the plaintiff’s entire market loss to the defendant’s misconduct (instead of its earnings drop), these determinations were better subject to cross-examination at trial than dismissal under Daubert, the court held. Likewise, the expert may have relied on “optimistic” management forecasts, but any alleged bias could be tested at trial, and the court admitted the expert’s lost profits conclusions.

  The Citrilite Co. v. Cott Beverages, Inc., 2011 WL 284915 (E.D. Cal.)(Jan. 25, 2011) In this last case, the federal district court confirmed that the expert’s use of a statistical regression analysis to calculate losses for breach of a distributorship agreement was both relevant and reliable under Daubert. At the same time, the court rejected any calculations by the expert that were based on a term longer than the contract’s 60-day termination provision. As a result, the expert’s calculations were relevant only to the extent they projected lost goodwill value based on the plaintiff taking over the defendant’s sales after the expiration of the contract. These calculations must be based on “sound” projections and include the plaintiff’s tangible costs, the court ruled, and ordered the parties to submit additional briefing on the merits of the expert’s “lost goodwill value” analysis.

  Tax Court Upholds Defined-Value Clause

  Hendrix v. Commissioner, T.C. Memo 2011-133, 2011 WL 2457401
  (U.S. Tax Court)(June 15, 2011)

  A wealthy Texas couple wanted to transfer non-voting stock in their private S corporation to their three adult daughters (through trusts) and also to a charitable foundation. Because the stock was difficult to value, their attorney suggested that instead of gifting percentages, they use a formula clause to establish a dollar value at the time of the transfer, which would also fix the value of the stock transfer for federal gift tax purposes.

  Three times appraised. After retaining a reputable appraiser to estimate the value of the non-voting stock (at nearly $37 per share), the couple transferred nearly 288,000 shares pursuant to a defined-value formula clause. The daughters’ trusts retained the same appraiser, and the foundation, represented by independent counsel, also required the donors to obtain an independent review of the appraisal and to assume responsibility for any additional tax liabilities. The foundation and trustees subsequently allocated the transfers amongst themselves according to the $37 per-share value.

  The IRS disputed the validity of the transfers, claiming that their fair market value was closer to $49 per share and, further, that the defined-value clauses were not negotiated at arm’s length and were contrary to public policy.

  The Tax Court rejected the IRS’s arguments on both points. The close relationship between the taxpayers and their daughters (and their trusts) did not necessarily mean that the formula clauses fell short of the arm’s length requirements of the code and case law, the court held. Moreover, the taxpayers had no prior history with the foundation, which assumed the potential risks of receiving the gift, including the loss of its tax-exempt status if it failed to exercise due diligence; thus its insistence on independent counsel, an independent appraisal, and the donors’ assumption of tax liabilities.

  “We also note economic and business risk assumed by the daughters’ trusts as buyers of the stock,” the court said. That is, the trusts could receive less stock if it turned out to be overvalued, which placed them at odds with the taxpayers and the foundation. Finally, the defined-value clauses did not impose a subsequent condition that would defeat the charitable transfers, but actually furthered the fundamental public policy of encouraging charitable gifts, the court held, in confirming the taxpayers’ valuation of the stock transfers to the trusts and the foundation.

  Is a Buy-Sell at Book Value Unconscionable, When FMV is 60x Greater?

  Estate of Cohen v. Booth Computers, 2011 WL 2694288 (N.J. Super) (July 13, 2011)

            A father created an income-producing partnership on behalf of his three grown children, funded in part with Palm Beach property originally purchased for $750,000. In keeping with its closely held nature, the partnership agreement provided that, on a partner’s divorce or death, the remaining partners “shall” repurchase the divorced/deceased partner’s shares at the “true value” of the partnership, defined as “net book value” based on the most recent financial statement, plus $50,000.

            In 1997, one of the partners died, and the partnership paid the estate $97,650 for the decedent’s interest, based on the buyout provision. By the time one of the two remaining partners died in 2007, the oceanfront property had appreciated to $45 million. An appraiser for the deceased partner’s estate estimated the “full” or fair market value of the partnership at just over $23 million, based on the net asset approach, which, when added to the appraised value of all the partnership’s properties, exceeded $68 million.

            Nevertheless, the partnership paid the deceased partner’s estate just over $177,800, based on the buyout provision and the financial information as of the date of death. The estate sued the partnership, requesting specific performance of the buyout provision at its “true value” of $68 million. Given the gross disparity between fair market value and net book value, any other interpretation was unconscionable and voided the buy-sell provision, the plaintiffs said.

            At trial, the partnership presented a CPA expert, who concluded that the purchase price of $177,800 accurately reflected the partnership’s book value. Moreover, the partnership’s books shouldn’t have reflected the fair market value of the Palm Beach property, the CPA expert explained, because the tax code and generally accepted accounting principles require investment property to be recorded at cost.

  The trial court agreed, finding that the partnership had always booked its assets at cost rather than market value. This historic treatment comported with the “plain language” of the partnership agreement, which clearly pegged the buy-out price to book value (as it did when one partner died in 1997). Under these facts, there was nothing “inherently offensive” in the buyout formula, the trial court held, and the estate appealed.

  “We recognize the disparity between net book value and fair market value,” the appellate court observed, yet the disparity, alone, was not was not sufficient to “shock the judicial conscious.” The controlling factor is the language of the partnership agreement, which in this case was clear and comported with standard definitions of book value, the court held, and affirmed the buyout at net book value.

  Valuation Tales

  The “Valuation Tales” portion of the DMG Financial (DMGF) newsletter contains content licensed from Business Valuation Resources. Each quarter, BVR sends DMGF a broad selection of valuation-related excerpts. We wade through them all to provide the best, most relevant excerpts about the range of issues our clients face today. It is important to remember, however, that court proceedings discussed in the newsletter can turn on individual facts and circumstances—which might or might not be conveyed in the condensed excerpts.

  Disclaimer

  All information contained herein is for informational purposes only and is not intended and should not be viewed as legal advice. The purpose of this document is to provide general information to clients. DMG Financial assumes no liability for the contents of any materials provided herein.

  ]]> http://www.dmgfinancial.com/valuation-tales-2011-q3.html/feed 0 http://www.dmgfinancial.com/macro-minute-2011-q3.html http://www.dmgfinancial.com/macro-minute-2011-q3.html#comments Mon, 31 Oct 2011 17:03:33 +0000 Financial Specialist http://www.dmgfinancial.com/?p=153 I can’t pick a single word for 2011’s third quarter (Q3), but my selections include weak, volatile, and unsettling. Those possessing favorable dispositions towards incantations, however, appear to have settled on “mixed.” My warped perception is that retaining a positive disposition presently requires the diligent selection of four-week bright spots as contrasts to long-term bleakness—and little else. So here’s how that’s done.

  Gross Domestic Product (GDP) was weak in the second quarter (Q2) and first-quarter (Q1) was revised down to barely more than zero but based on incomplete data the “advance” estimate for third quarter GDP showed 2.5% growth driven primarily by personal consumption expenditures; a red flag indicative of a drop in the savings rate. Consumer confidence tumbled in August and, despite better-than-expected September jobs data, the unemployment rate remains so high that stories of a decade’s impact continue to abound. Interest rates are amazingly low, however, and—despite a significant jump in the Producer Price Index (PPI)—optimists note that commodity prices are falling. Plus, companies are bound to do something with all that cash, right?

  What does it all mean? These days it’s tough to say. When S&P downgrades U.S. debt, yields drop. It’s a tough time to be a ratings agency, I guess. I heard one commenter suggest—in the context of the U.S. credit downgrade and the notion of the risk-free rate—something along the lines of everything is being re-priced right now.

  • Two great things about GDP numbers: (1) When you get them they are old; and (2) they are revised a couple of times. The 2.5% advance estimate for Q3 growth was Good, Not Great. The gain put GDP above pre-recession levels but per capita GDP was still down. Near the end of August, the Bureau of Economic Analysis (BEA) stated that

    Continue reading M4 – Malted Minds Macro Minute: 2011 – Q3

    ]]> I can’t pick a single word for 2011’s third quarter (Q3), but my selections include weak, volatile, and unsettling. Those possessing favorable dispositions towards incantations, however, appear to have settled on “mixed.” My warped perception is that retaining a positive disposition presently requires the diligent selection of four-week bright spots as contrasts to long-term bleakness—and little else. So here’s how that’s done.

    Gross Domestic Product (GDP) was weak in the second quarter (Q2) and first-quarter (Q1) was revised down to barely more than zero but based on incomplete data the “advance” estimate for third quarter GDP showed 2.5% growth driven primarily by personal consumption expenditures; a red flag indicative of a drop in the savings rate. Consumer confidence tumbled in August and, despite better-than-expected September jobs data, the unemployment rate remains so high that stories of a decade’s impact continue to abound. Interest rates are amazingly low, however, and—despite a significant jump in the Producer Price Index (PPI)—optimists note that commodity prices are falling. Plus, companies are bound to do something with all that cash, right?

    What does it all mean? These days it’s tough to say. When S&P downgrades U.S. debt, yields drop. It’s a tough time to be a ratings agency, I guess. I heard one commenter suggest—in the context of the U.S. credit downgrade and the notion of the risk-free rate—something along the lines of everything is being re-priced right now.

    • Two great things about GDP numbers: (1) When you get them they are old; and (2) they are revised a couple of times. The 2.5% advance estimate for Q3 growth was Good, Not Great. The gain put GDP above pre-recession levels but per capita GDP was still down. Near the end of August, the Bureau of Economic Analysis (BEA) stated that Q1 growth was revised down to 0.4% and Q2 growth was 1%. Economists are loath to make significant model revisions but, as the end of Q3 approached, the Whitehouse and forecasters polled by Consensus Economics were lowering their GDP projections. Growth projections for Q3 fell from 3.2% to 2.2%, and Q4 projections were reduced from 3.2% to 2.5%. Full-year growth for 2011 was dropped to 1.8% from 2.5%. Projections for 2012 also were lowered, but forecasts of 2.5% GDP growth between 2017 and 2021 were left unchanged.
    • The unemployment rate has been between 9.0% and 9.2%, with about 14 million workers unemployed. In advance of actual results, forecasters were predicting that unemployment would average 9.0% in Q3 and 8.8% in Q4, and would average 8.9% for all of 2011. The 2012 unemployment rate has been forecast to average 8.4%. September jobs numbers were surprising on the upside, but the number of long-term unemployed Americans still is about 6 million and this segment comprised more than 40% of the total unemployed workers. The Census Bureau released a poverty report in Q3 that showed that 15.1% of the U.S. population lives in poverty; this was the third consecutive yearly increase. So, if you are charting a premium light beer resurgence inspired by employment, set your horizon at some distant point, or perhaps seek an alternate source of hope.
    • The All-Items CPI has risen 3.74% over the last 12 months (Oct-10 to Sep-11). Going forward consensus forecasts had CPI increasing 3.0% for all of 2011 and 2.1% in 2012. According to the Bureau of Labor Statistics TTM-Sep 2011 beer pricing was up about only about 0.81% at home and about 2.38% away from home. The Producer Price Index was up 6.9% for 12 months through September.
    • The Conference Board Consumer Confidence Index^®, which had improved slightly in July, plummeted in August. The Index at the end of September remained low at 45.4, down from 59.2 in July. The Present Situation Index decreased to 32.5 from 35.7. The Expectations Index for September edged up over August to 54.0, but still was far below the 74.9 reading in July.
    • According to the Bureau of Economic Analysis personal income and disposable personal income (DPI) both increased 0.3% in July, and personal consumption expenditures increased 0.8% but real disposable income decreased 0.1% in July. My Q2 BVR EOU suggests that consumer spending grew at a low 0.1% rate; this micro growth contributed a mere 0.07 percentage points to the Q2 GDP. The 0.1% growth rate was a substantial drop from Q1’s 2.1% rate. So, if you count that 0.1% rate as growth—which, technically, it is—then you get to say, “Consumer spending has now grown for eight consecutive quarters.” Consumer spending (aka personal consumption) accounts for ≈70% of the U.S. GDP.[1]
    • Interest rates remained at historically low levels. August was the 32nd consecutive month having a prime rate of 3.25%. The three-month Treasury Bill rate was 0.02% at the end of Q3, and economists expected the yield would rise to approximately 0.1% at the end of Q4. As October began, the 10-year note yield was slightly more than 2% and the 30-year bond actually dipped to below 3%. Nonetheless, economists expected the 10-year to be at 3.1% at the end of Q4 and rise to 3.7% at the end of 2012. Of course, these projections did not square well with the fact that Treasury Bill yields were at the lowest level since the 1940s.
    • The EIA projections for West Texas Intermediate crude oil spot prices were revised down significantly to $94.40 per barrel in 2011 and $94.50 per barrel in 2012, but these prices still were significantly more than the $79.40 per barrel price in 2010.
      

      ---

    [1]Part of the contents of the economic commentary are quoted from the Economic Outlook Update™ 2Q 2011 and July 2011, published by Business Valuation Resources, LLC, © 2011, reprinted with permission. The editors and Business Valuation Resources, LLC, while considering the contents to be accurate as of the date of publication of the update, take no responsibility for the information contained therein. Relation of this information to this valuation engagement is the sole responsibility of the author of this valuation report.

    ]]> http://www.dmgfinancial.com/macro-minute-2011-q3.html/feed 1 http://www.dmgfinancial.com/random-links-2011-q3.html http://www.dmgfinancial.com/random-links-2011-q3.html#comments Mon, 31 Oct 2011 17:01:29 +0000 Financial Specialist http://www.dmgfinancial.com/?p=155 8 Ways to Sell Against a Lower Price

    A Nice Tactical Review with Price Increases Now Upon Us

    “There are eight basic ways to defend against a lower price. Master them all, and you’ll spend a lot less time negotiating and a lot more time closing deals. These eight, great differentiators are the keys to defending a high price against lower priced competitors,” writes Geoffrey James on BNET.

    Millennials Want Mentors More Than Money

    Yet Another Take on How Motivate Millennials

    “If You Want to Retain the Best Young Workers, Give Them a Mentor Instead of Cash Bonuses. ‘With Generation Y coming into the business, hierarchies have to disappear. Generation Y expects to work in communities of mutual interest and passion—not structured hierarchies.’”

    Top 10 Black Swan Predictions for 2011

    Midway Through at Least One Has Come True

    “Saxo Bank has released its 10 outrageous predictions for 2011 and they include some notable tail-risk possibilities.

    As FT Alphaville points out, Saxo’s list got 3 out of 10 correct in 2010. Not a bad haul for a list meant to find the sort of Black Swans Nassim Taleb writes about.”

    (Post your own guesses and black swan predictions on the DMGF website.)

    Modern Material Handing, “WCS Makes Its Move”

    WCS Is Taking on Traditional WMS Turf

    “One of the many satisfying benefits of covering a market over many years is watching trends evolve into operating procedures that revolutionize how companies conduct business.” Here is the link to Modern Materials Handling article, which itself includes more great links.

    How to Manage Forced Sales Rankings

    Reminiscent of What a Great Man Once Said About Fair Comparisons

    “A vice president of sales recently told us that he drives sales growth by publishing a monthly forced sales ranking of

    Continue reading Random Links For Financial Kinks: 2011 – Q3

    ]]> 8 Ways to Sell Against a Lower Price

    A Nice Tactical Review with Price Increases Now Upon Us

    “There are eight basic ways to defend against a lower price. Master them all, and you’ll spend a lot less time negotiating and a lot more time closing deals. These eight, great differentiators are the keys to defending a high price against lower priced competitors,” writes Geoffrey James on BNET.

    Millennials Want Mentors More Than Money

    Yet Another Take on How Motivate Millennials

    “If You Want to Retain the Best Young Workers, Give Them a Mentor Instead of Cash Bonuses. ‘With Generation Y coming into the business, hierarchies have to disappear. Generation Y expects to work in communities of mutual interest and passion—not structured hierarchies.’”

    Top 10 Black Swan Predictions for 2011

    Midway Through at Least One Has Come True

    “Saxo Bank has released its 10 outrageous predictions for 2011 and they include some notable tail-risk possibilities.

    As FT Alphaville points out, Saxo’s list got 3 out of 10 correct in 2010. Not a bad haul for a list meant to find the sort of Black Swans Nassim Taleb writes about.”

    (Post your own guesses and black swan predictions on the DMGF website.)

    Modern Material Handing, “WCS Makes Its Move”

    WCS Is Taking on Traditional WMS Turf

    “One of the many satisfying benefits of covering a market over many years is watching trends evolve into operating procedures that revolutionize how companies conduct business.” Here is the link to Modern Materials Handling article, which itself includes more great links.

    How to Manage Forced Sales Rankings

    Reminiscent of What a Great Man Once Said About Fair Comparisons

    “A vice president of sales recently told us that he drives sales growth by publishing a monthly forced sales ranking of all salespeople. ‘Salespeople love the competition. They like to see where they stand, what it takes to be #1, and who they beat. Ranking really drives the competitive juices!’ But one of the VP’s salespeople had a different view of published forced ranking: ‘My territory covers a large geography that has less opportunity than other territories. The salespeople in big opportunity territories are always at the head of the leader board. Everybody sees my ranking, but do they ever consider how tough my territory is? I’m sure I’d be close to the top if I had a better territory.’” Follow this link to HBR Blog Network.

    Sarcasm: A New Path to Creativity? (No, Really.)

    Like Shangri-La, I Believe It’s true Because I Want It to be True

    “A new study appearing in the Journal of Applied Psychology finds that snarky co-workers may be doing your workplace an important service—increasing everyone’s creativity.”

    How Much to Brew? Ask These Future MBAs

    An Old Article About a Somewhat New Twist on an Ancient Question

    “It’s called The Beer Game, but don’t let the title fool you. It’s actually a business exercise in ‘lean’ management.

    The Beer Game is deceptively simple. The MBA students were divided into four rows. In each row were four groups representing a brewery, wholesaler, distributor, and retailer. Over the course of 30 weeks, ‘customers’ would buy a certain amount of beer represented by poker chips from the retailer, who would then reorder beer for his store shelves from the distributor. In turn, the distributor would reorder supplies from the wholesaler, who would make similar orders to the brewery.”

    Slideshow: Top 10 U.S. Logistics Hubs

    Memphis Business Journal Offers Independent Perspective on #1 Ranking

    The article has interesting data, and the slideshow’s Top 10 is bound to include one city that you weren’t considering.

    How I Beat the Distribution System

    Honest Tea Started Without Beverage Distributors

    To get his product into more stores, Honest Tea founder Seth Goldman “broke down the supply chain. To get to gourmet stores, he contracted with a cheese distributor, who would bring Honest Tea on his truck along with his cheddars and mozzarellas. To reach delis, he contacted a corned-beef distributor. For grocery stores: a charcoal distributor.” Eventually Honest Tea got enough shelf space that beverage distributors began to give the product a chance. Read the story here: Inc.

    PepsiCo Rank for #1 Sustainability in Food and Beverage Sector

    Named Beverage Sector Leader for Third Consecutive Year

    “PURCHASE, N.Y. — PepsiCo Inc. today announced its inclusion in the 2011 Dow Jones Sustainability Indexes (DJSI). PepsiCo is ranked as the No. 1 company in the DJSI Food and Beverage supersector, the only company based in the United States to earn a top ranking in the 19 supersectors assessed. PepsiCo was also named the beverage sector leader for the third consecutive year.” Click here for the whole story: Convenience Store News.

    Economy Clips Factories

    Growth Prospects Shrink for U.S. Manufacturers Whose Profits Powered Recovery

    “Big industrial companies generally haven’t begun chopping their own forecasts, but analysts are starting to do it for them. The average Wall Street forecast for 2012 earnings growth by 35 industrial companies included in the Standard & Poor’s 500-stock index stood at about 16% Wednesday, down from 19% as of June 30, according to FactSet Research Systems.

    The U.S. economy ‘is clearly not recovering anymore,’ Mr. Linebarger [Cummins CFO] said. ‘We’re just not sure how deep or long [the slowdown] is going to be.’ Cummins already has seen a decline in orders for standby power-generation units used at such facilities as factories, office buildings and hospitals, he said.” Follow this link to the complete WSJ article.

    European Sovereign Debt Crisis, China’s Economy

    Pessimistic Economic Commentary from Down Under

    It’s a no-holds-barred sovereign debt commentary including an observation that the markets in a Groundhog Day delusion and a reference to Bernanke as Python’s Black Knight. Here is the Bloomberg Video Link.

    ]]> http://www.dmgfinancial.com/random-links-2011-q3.html/feed 0 http://www.dmgfinancial.com/bubble-misnomer-newsletter-1.html http://www.dmgfinancial.com/bubble-misnomer-newsletter-1.html#comments Tue, 19 Jul 2011 19:09:22 +0000 Financial Specialist http://www.dmgfinancial.com/develop/?p=28 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

    Continue reading 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 editors 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.

    ]]> http://www.dmgfinancial.com/bubble-misnomer-newsletter-1.html/feed 0 http://www.dmgfinancial.com/valuation-tales-2011-%e2%80%93-q2-newsletter.html http://www.dmgfinancial.com/valuation-tales-2011-%e2%80%93-q2-newsletter.html#comments Tue, 19 Jul 2011 19:08:27 +0000 Financial Specialist http://www.dmgfinancial.com/develop/?p=86 The Valuation Tales portion of DMGF’s newsletter contains content licensed from Business Valuation Resources (BVR). Each quarter BVR sends DMG Financial (DMGF) a broad selection of valuation-related excerpts. We wade through them all to provide the best, most relevant excerpts about the many issues our clients face today. Also included is a discussion of why DMG Financial selected the particular excerpts. It is important to remember, however, that court proceedings discussed in the newsletter can turn on individual facts and circumstances—which might or might not be conveyed in the condensed excerpts.

    DMGF’s Valuation Tales Selections for Second Quarter, 2011:

    Daubert and the Lost Profits Expert: Recent Cases was selected because studies show Daubert challenges are on the rise. Dear little Daubert isn’t a newborn ruling anymore. Daubert has reached the age of majority and the Daubert challenge has started to develop a healthy set of precedents. Yet, as the three cases included in this excerpt show, it still is not abundantly clear what sort of facts result in expert testimony being precluded.

    In Coyne’s v. Enesco tortious interference with a distributor contract and violation of the Minnesota Franchise Act are alleged. The case is interesting because the court decided to allow plaintiff’s expert’s lost-profits calculations even though the court apparently agreed with the defendant’s premise that the expert’s calculations were “simply rudimentary math,” and failed to account for alternative loss causes. The defendant’s Daubert challenge also claimed that the expert failed to corroborate sales data—despite “their ‘material difference’ from the records plaintiff produced in discovery.” The court concluded these factors did not render the expert’s testimony “fundamentally unsound,” and admitted the expert’s opinions, subject to cross-examination at trial.

    The second case, Truman Arnold Companies v. Hammond and Consultants Enterprises, Inc. , shows that courts may be willing to

    Continue reading Valuation Tales: 2011 – Q2

    ]]> The Valuation Tales portion of DMGF’s newsletter contains content licensed from Business Valuation Resources (BVR). Each quarter BVR sends DMG Financial (DMGF) a broad selection of valuation-related excerpts. We wade through them all to provide the best, most relevant excerpts about the many issues our clients face today. Also included is a discussion of why DMG Financial selected the particular excerpts. It is important to remember, however, that court proceedings discussed in the newsletter can turn on individual facts and circumstances—which might or might not be conveyed in the condensed excerpts.

    DMGF’s Valuation Tales Selections for Second Quarter, 2011:

    Daubert and the Lost Profits Expert: Recent Cases was selected because studies show Daubert challenges are on the rise. Dear little Daubert isn’t a newborn ruling anymore. Daubert has reached the age of majority and the Daubert challenge has started to develop a healthy set of precedents. Yet, as the three cases included in this excerpt show, it still is not abundantly clear what sort of facts result in expert testimony being precluded.

    In Coyne’s v. Enesco tortious interference with a distributor contract and violation of the Minnesota Franchise Act are alleged. The case is interesting because the court decided to allow plaintiff’s expert’s lost-profits calculations even though the court apparently agreed with the defendant’s premise that the expert’s calculations were “simply rudimentary math,” and failed to account for alternative loss causes. The defendant’s Daubert challenge also claimed that the expert failed to corroborate sales data—despite “their ‘material difference’ from the records plaintiff produced in discovery.” The court concluded these factors did not render the expert’s testimony “fundamentally unsound,” and admitted the expert’s opinions, subject to cross-examination at trial.

    The second case, Truman Arnold Companies v. Hammond and Consultants Enterprises, Inc. , shows that courts may be willing to allow expert testimony, even if that testimony is based on imperfect records. The court accepted plaintiff’s admittedly “unusual records” because the plaintiff apparently made “every effort” to obtain better records, but ultimately had to rely on the defendant’s documentation, which “significantly understated profits”. DMG Financial notes the plaintiff’s expert specifically declined to offer a future damages opinion, and plaintiff’s expert simply extended the historical damages amount into the future and then discounted back to present value.

    The third case, Gresh v. Waste Services of America, involves the valuation of a minority interest in a closely held company. This matter shows the importance of appropriately matching the subject interest, standard of value, and measure of damages. It also demonstrates that some calculations just aren’t within the purview of the expert. The premise of the Daubert challenge in this case was that the plaintiff’s expert merely valued the 5% interest at the time the company was sold, rather than determine the value of the entire company under “one of many accepted methods of business valuation,” such as the net assets approach, the income approach, or the market approach. Notably, the court found the market approach would be inappropriate, given the company’s closely held status.

    The second BVR excerpt selected by DMGF has a business appraiser going against an investment banker in a case involving fair value under Colorado law. In addition, this excerpt provides perspective on the cost effectiveness of litigation. This case has what I like to call dollar value judgment irony; an all too frequent litigation phenomena.

    The California DHI, Inc. v. Erasmus tale begins with an $800,000 verdict against the defendant but doesn’t end there. Six months after the initial $800,000 verdict and in the wake of a merger the parties were back in court to settle defendants share purchase demand. As can be the case, the two parties’ experts “proposed widely divergent fair value appraisals” ($3.7 million versus $7.6 million). The court adopted the lower value based in part on the appraiser’s “significant appraisal experience” and the “thoroughness with which she [plaintiff’s expert] explained and duplicated her methodology.” However, the court also specifically noted plaintiff’s expert’s “application of the fair value standard as reflected in Colorado law”. In contrast, the court noted “gaps” in defendant’s expert’s methodology, questioned his comparables, and discredited the investment banker’s growth-rate calculation. The ironic ending has the defendant who owed $800,000 as a result of the initial lawsuit/judgment winning $800,000 for his shares. If anyone came out ahead, was it the plaintiff, the defendant or someone else?

    The last BVR excerpt selected by DMG Financial is titled New Guidance from DE Chancery Court on DCF Inputs, Assumptions This excerpt offers “important insights into the application of DCF analyses in statutory fair value appraisal and related merger proceedings.”

    Presented in this excerpt are three cases touching on valuation concepts and issues potentially relevant to the valuation of beer distributorships. One case illustrates the broad range of capital costs and discount rates that might be used to a value business. Another case deals with the appropriate treatment of merger synergies. And, the third case shows that courts do sometimes calculate their own numbers if neither side can muster a convincing presentation.

    Daubert and the Lost Profits Expert: Recent Cases

    Can a lost profits analysis ever be too “simple” under the Daubert standard? The excerpts suggest answer might be “it depends,” as the following three recent court decisions demonstrate.

    1.    Coyne’s & Co., Inc. v. Enesco, LLC, 2010 WL 3269977 (D. Minn.) (Aug. 16, 2010)

    The plaintiff sued the defendant for tortiously interfering with the contract with its distributor. The defendant challenged the plaintiff’s expert under Daubert. His lost profits calculations were “simply rudimentary math” that failed to account for alternative causes of the plaintiff’s losses, the defendant argued, and he failed to corroborate sales data provided by the plaintiff, despite their “material difference” from the records the plaintiff produced in discovery.

    The court agreed that the plaintiff’s expert used a “simple” analysis that did not address “a number of apparently relevant factors.” For instance, he did not consider incremental costs, the risk and uncertainly of realizing actual sales, competition, supply chain disruptions, and general economic conditions—including the recent recession. Nevertheless, the court found these weaknesses did not render the expert evidence “fundamentally unsound.” Similarly, the differences in the sales data—which amounted to two pages of records—did not undermine his opinion. An expert is not generally required to independently verify all of the underlying records, the court held, and admitted his opinion, subject to cross-examination at trial.

    2.    Truman Arnold Companies v. Hammond and Consultants Enterprises, Inc., 2010
    WL 2982912 (Tex. App.)(July 30, 2010)(unpublished)

    The plaintiff sued the defendant for breach of contract to pay commissions for customer referrals. Before trial, the defendant unsuccessfully challenged the plaintiff’s expert under Daubert, and the jury ultimately awarded the plaintiff approximately $325,000 for actual lost commissions and nearly $500,000 for future losses. The defendant appealed the Daubert ruling as well as the damages, claiming the plaintiff’s expert relied on flawed records of income and expenses.

    The court disagreed, finding that the defendant had produced “unusual” records regarding its customer sales, which significantly understated profits. The plaintiff had made every effort to obtain more specific records, but its expert ended up having to rely on the defendant’s documentation. Any resulting gap between the data and the expert’s analysis did not render it unreliable, and the court sustained its admission under Daubert. It also found the jury’s award of actual damages ($325,000) fell within the range of expert evidence presented at trial.

    At the same time, plaintiff did not establish that any of its current referrals intended to buy from the defendant in the future. Moreover, the plaintiff’s expert had specifically declined to offer an opinion on future damages. Instead, he simply extended the actual damages amount into the future, discounted back to present value, so the jury might use his figures if it determined future damages were warranted. As such, the court found the evidence insufficient to support lost profits damages and reduced the jury’s award by $500,000.

    3.     Gresh v. Waste Services of America, 2010 WL 3475580 (E.D. KY.)(Sept. 1, 2010)

    The plaintiff held stock options in a closely held company, which amounted to a 5% interest. He sued the majority owners for preventing him from exercising the options until after they sold the company and claimed over $500,000 in damages, including prejudgment interest. The defendants challenged the plaintiff’s damages expert under Daubert, arguing that he’d merely calculated the plaintiff’s 5% interest at the time the company was sold rather than value the entire company under “one of many accepted methods of business valuation,” such as the net assets approach, the income approach, or the market approach.

    The court found the market approach would be inappropriate in this case, given the company’s closely held status. Moreover, the fact that the plaintiff’s expert could have valued his 5% interest in ways “other than a mere computation of his proportionate share” of the company did not make his damages opinion unreliable, the court held. The court struck the expert’s prejudgment interest calculations, however, because applicable state law gave the trial court discretion to decide prejudgment interest for unliquidated damages.

    Court Prefers Expert with BV Experience and Better Application of FV Law

    California DHI, Inc. v. Erasmus, 2010 WL 3278224 (C.A. 10 (Colo.))(Aug. 20, 2010)(unpublished)

    In the early 1990s, a veterinarian formed a company to develop an animal food supplement with two partners, including the defendant. When the company discovered the defendant was creating a competitive supplement based on the same formula, it sued and won an $800,000 verdict. Six months later, the company merged with a California firm and the defendant invoked his statutory right to dissent and demanded purchase of his shares. Not surprisingly, the parties were unable to agree on the fair value of his 33% interest and found themselves back in court.

    The parties’ experts proposed widely divergent fair value appraisals. The company’s expert was an experienced business appraiser who valued the enterprise at approximately $3.7 million. The defendant’s expert, an investment banker with experience in the natural foods industry, valued the company at more than twice that amount—or $7.6 million. The federal district court ultimately adopted the lower value by the company’s expert, finding it more reliable for several reasons, including her “significant appraisal experience; her application of the fair value standard as reflected in Colorado law; her reliance on [the company’s] financial records; and the thoroughness with which she explained and duplicated her methodology.” By contrast, the court noted several “gaps” in the methodology used by the defendant’s expert, questioned his choice of comparable companies and products, and discredited his anticipated growth rate calculation.

    The court accepted the defendant’s assertion that the company’s $800,000 judgment against him was too contingent on collectability to be included as an asset. However, the court declined to subordinate the company’s debt to the defendant’s share, and ultimately reached a going concern value of roughly $2.3 million—or just $800,000 for the defendant’s 33% interest (ironically, just about the same amount as the defendant owed the company in the prior lawsuit).

    After an unsuccessful request for reconsideration, the parties appealed to the U.S. Court of Appeals for the Tenth Circuit. On “careful” review of the record and the applicable state law, the 10th Circuit summarily dismissed all claims. The district court correctly determined the valuation date and the more credible valuation. It also correctly decided that the $800,000 judgment in favor of the company was too contingent to include in the fair value appraisal, but that all corporate debt should be included before an award of the defendant’s proportionate share .

    New Guidance from DE Chancery Court on DCF Inputs, Assumptions

    Three recent decisions by the Delaware Chancery Court—in opinions authored by Vice Chancellor Leo E. Strine, Jr.—provide important insights into the application of the discounted cash flow (DCF) analysis in statutory fair value appraisal and related merger proceedings.

    In Maric Capital Master Fund, Ltd. v. Plato Learning, Inc., 2010 WL 1931084 (Del. Ch.)(May 13, 2010), the court enjoined a proposed merger because the proxy statements were misleading. In particular, V.C. Strine found the company misrepresented how its investment bankers selected the discount rate to use in its DCF and related fairness opinion. The prospectus said the advisors calculated a range of discount rates, 23% to 27%, based on the company’s weighted average cost of capital (WACC) along with the WACC of the target company and market comparables. The court found, however, that the bankers had actually used a loose variation of the capital asset pricing model and a market analysis to generate discounts of approximately 22%, but disclosed the higher range to suggest a “far more attractive” deal.

    Moreover, the court found the proxy statements “inexplicably” omitted the free cash flow estimates prepared by the target’s management and provided to the investment bankers. “In my view, management’s best estimate of the future cash flow of a corporation that is . . . to be sold in a cash merger is clearly material information,” the court held, and ordered a further supplement to shareholder disclosures before the merger vote could proceed.

    In re Dollar Thrifty Shareholder Litigation, 2010 WL 3503471 (Del. Ch.)(Aug. 27, 2010), the court declined to enjoin the proposed merger between Hertz Global Holdings Inc. and the Dollar Thrifty Group at $32.80 per share plus stock. The court saw no evidence of self-dealing by the Dollar Thrifty board and every indication that it had tried to maximize shareholder value.

    In particular, during the negotiations leading up to the Hertz deal, the Dollar Thrifty board performed DCF analyses showing top value ranges hovering at about $43 per share. During litigation, the plaintiffs offered an expert’s DCF that purported to value the company at $44.25 to $57.93 per share. However, the expert arrived at his DCF values by including synergies from the proposed merger. “That is, [the expert] did not present a sound DCF valuation,” the court stated. After backing out the synergies, the plaintiffs conceded their expert’s analysis was “not fundamentally different” from those performed by the board’s investment bankers. “In other words, Dollar Thrifty had pressed Hertz to pay something very near the high end of its own view of its stand-alone value, and a price that would involve synergy sharing if the mid-level of the DCF range was used,” the court said.

    Finally, in WaveDivision Holdings, Inc. v. Millennium Digital Media Systems, LLC, 2010 WL 3706624 (Del. Ch.)(Sept. 17, 2010), the court found that defendant had breached its agreement to sell two of its cable systems to the plaintiff for $157 million by conducting a separate, secret refinancing deal with its unsecured investment note holders (primarily private equity funds). The proper measure of damages was to put the plaintiff in the same position it would have occupied but for the breach, which equaled the value it expected to realize from the acquired systems minus any avoided costs (the contract price) and post-breach mitigation.

    The plaintiff claimed the cable systems would have grown substantially under its stewardship. Its expert used a multiple of EBITDA analysis based on the plaintiff’s recent acquisitions of similar companies to calculate damages in excess of $85 million. By contrast, the defendant’s expert relied primarily on the forecasts the plaintiff provided to its lender to generate DCF values for the systems at the time of sale, between $122 million and $140 million. Because this range was less than the $157 million purchase price, no damages were due.

    The court wasn’t entirely convinced by either expert. A DCF-based, fair market value of the defendant’s systems would deprive the plaintiff of all the expected benefit of the bargain. On the other hand, the plaintiff’s expert extrapolated too much benefit from too small a pool of comparables without grounding his analysis in the systems’ specifics. Instead, the court began with the projections that the plaintiff provided its lenders, which were credible and comparable to those the defendant had relied on in its separate deal with the note holders. The court could have used these projections in either a DCF or multiple of earnings approach, but found the latter was more common in the cable industry. After making certain adjustments for overhead and other costs, the court calculated the defendant owed damages of just over $14.8 million, plus pre-judgment interest

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