The Middle East, Beer Battles, and Wholesaler Consolidation...Is it time to go?
It seems the talk of consolidation in the beer wholesaling industry has been going on for years. I wish I had a dollar for every time I received a call asking me to help convince someone else to sell their business. The problem is most people don’t want to leave. The beer wholesaling business is without a doubt a great industry. I speak as a management consultant who started in this industry over 20 years ago. It is a fun, exciting, dynamic industry with great people– owners, employees, and yes, even retailers.
But change is the law of life and it is time for many wholesalers to be leaving. I don’t hope for this to be true. In fact, as a financial and operational management consultant it is in my very real self-interest for it not to be true. But since when did what we wish for change reality? I wish my hair wasn’t falling out and I was better looking. Alas, wishes change nothing.
Let us start first with a primer on value. The value of any financial asset is the present value of future cash flows. To arrive at a present value, these future cash flows are discounted by the sum of:
1. The expected risk-free cost of capital during the relevant time period – this is basically the time value of money. The higher the expected risk-free cost of capital, the less these future cash flows are worth today.
2. A risk premium. The higher the risk of these cash-flows not materializing as planned, the less these future cash flows are worth today. As an example, an IOU from a local criminal does not have the same value as an IOU from the most upstanding person in your community.
It isn’t as complicated as it sounds. A general formula for discounted cash flows (DCF) is
DCF = CF1 + CF2 + … + CFn .
(1 + r)1 (1 + r)2 (1 + r)n
CF = Cash Flow
r = discount rate
Many calculators can make present value calculations and forms are readily available on the web.
However, before cash flows can be discounted, you must first discover the cash flows. Whether you are a potential buyer or seller, you must first model these cash flows. How do you do this? By building this new organization with its associated revenue and cost forecasts on paper. As a buyer you must clearly understand the cash flows you are purchasing and the timing of these cash flows. As a seller you need to clearly understand the cash flows to assist you in both setting the price for your business and for negotiations. If you plan to use a broker to assist in the transaction, the first thing you should ask them is how many beer wholesalers they have actually re-organized in the real world and the short- and long-term results of these re-organizations. Everything is based on these cash flows which are in turn, based on the organizational design required to achieve them.
In addition, as with all things in life, taxes also come into play. It’s not necessarily the amount you sell for that is important; it is what you put in your pocket when the deal is done that really matters.
Let us look at each of these as they relate to beer wholesaling today.
1. Cash flows. Cash flows are impacted by a number of things:
a. Selling price and percent margin give you gross profit dollars. You live and die on gross profit dollars – not selling price, not percent margin. This is a mixed bag for most wholesalers – lots of price and margin pressure on your main brands but the mix is changing with growth in imports/specialty beers. On an apples-to-apples comparison, for most wholesalers around the country the future is not one of increased net gross profit dollars. This pulls values down.
b. Costs – these continue to grow with no end in sight.
i. Fuel costs and fuel/energy related charges. These are most likely not going down significantly anytime soon.
ii. Worker’s Compensation
iii. Health insurance
iv. Other non-controllable or only slightly controllable costs
Since the wholesaler’s ability to pass on cost increases is VERY limited, you will end up eating many of these costs. I’ve had wholesalers tell me “but that can’t happen” and I ask why. “Because I’ll go out of business,” and my black-hearted consultant response is “So what?” Lot’s of businesses are sold or go under each and every day – if one of them is yours it may be a personal tragedy, but the rest of the world will keep humming along. Not to be cruel, but in the end, few care. To hope for someone else to save your business is practicing wishful thinking.
In many cases your only operating options for dealing with these increased costs is to:
a. Cut internal costs as much as is possible – in many cases this has already been done
b. Adjust both type and frequency of sales, delivery, and merchandising service you provide to your retail account base
c. Where possible add new products which are a strategic fit, i.e. their costs (both financial and other) are less than their gross profit contribution.
d. In some situations shared services are possible. Other than these, there aren’t many other options.
In a distribution channel there is competition between channel members for profit. There is only so much available from the time it is brewed until it is sold to the consumer. From an economics viewpoint – it seems as though “excess” profits are going to be squeezed from this channel – and guess what? Most of these “excess” profits are going to come from your hide. Again, the sum of this is a decrease in value – perhaps significant.
2. Capital gains taxes. Right now long-term capital gains taxes are at historic lows, 15% for higher-income earners – although there are many variables which will affect your net long-term capital gains. Present law has these rates expiring on Dec. 31, 2008, returning to 20%. Some in Congress are attempting, with little success, to make these rates permanent or push the expiration back to 2010. Since Congress fiddles with tax rates every year, these rates may change before then and some in Congress are pushing to increase long-term rates to 35%. My political crystal ball isn’t clearer than anyone else’s but if I had to bet, I’d bet those who want to raise taxes (either to reduce the deficit or simply to have more money to spend) will gain in both the 2006 and 2008 elections. Therefore, you may be looking at the lowest long-term capital gains rates (and sadly perhaps many other taxes) that you may see for quite some time. This may have only a minor impact on your business’s value, but it may have a profound impact on the amount you put in your pocket after a sale – the only amount that matters.
3. Risk – There are a number of risk factors directly confronting wholesalers. There are the “normal” issues of increased excise taxes, advertising restrictions, various rules and regulations regarding sales and distribution, and whatever else neo-prohibitionists can generate some support for. We know these people aren’t looking for a compromise nor do they EVER go away. But the big dog of risk is serious erosion of the three-tier system. This isn’t just an issue with beer wholesalers; the soft drink bottling industry is facing similar challenges. Costco will not be the last company to use the courts in an attempt to go direct – and they kicked Washington State’s butt in the recent ruling.
However this ends up, in the long-term one would have to forecast at least some continued erosion of the three-tier system. State associations around the country are actively working to shore up their state laws. But just as with capital gains rates, laws are changed every day. There is no guarantee the politicians will not turn against beer wholesalers – read some of the editorials in Washington State regarding the Costco lawsuit. And politicians being politicians, few will stand against adverse political winds for long. Especially in off-premise chain driven markets, a crack in this dam could unleash a torrent in a relatively short time. The power of grocery/retail chains is certainly not decreasing. Even if the Krogers of the world don’t really want to go direct, if their business is being battered by Costco and Wal-Mart, they will have no choice but to respond. Once these competitive responses begin, it may be VERY difficult to stop, and stopping or slowing it will not be within any wholesaler’s reach. This risk is extremely difficult to quantify, and unless one has a magical crystal ball I’m afraid each of us will have to rely on our “gut” for this one. Remember, this is much like the stock market – when you know this is going to happen – so will everyone else. Literally millions, if not ten’s of millions of dollars of value could evaporate in a very short period of time.
4. Wild Card Risk – Let’s take a quick side-trip and think a little about world events. Don’t think events half-way around the world can batter your business? Think again. Oil prices remain at historic highs, yet domestic oil inventories are very high. In addition to increased demand around the globe, fear and uncertainty about the future are keeping prices high. But the big uncertainty is Iran. Foreign policy is not my specialty but I do pay close attention to events world wide. I have a difficult time seeing how the Iranian situation regarding their drive to acquire nuclear weapons ends well – the Hezbollah fighting with Israel is just a little Iranian muscle flexing. It seems Iran believes they have a winning hand regardless of how it goes. A confrontation is coming and it may be sooner rather than later.
Scenario 1 - Has the world backing down, allowing Iran to acquire nuclear weapons – something this President and Israel have repeatedly stated they will not allow. Estimates are that Iran is within months to three years from a nuclear weapon. If this happens, a Middle East nuclear arms race probably begins. If the mullahs who presently rule Iran remain in power and are true to their word, Israel is sooner or later toast. But of course the Israelis won’t go down without a fight so this leads to a nuclear war in the Middle East. And you think fuel prices are high now?! Far fetched? The current President of Iran belongs to a religious sect which believes the Islamic version of the apocalypse is coming within the next two years. He has also stated that they may gain Allah’s favor by helping it start. Go hug your kids tonight. Look at your income statement and think about $5+/gallon for diesel (could easily be more) – and a possible world-wide recession. If this would remain for any amount of time many of your businesses cease to be viable – and most of your business value simply disappears. I don’t think this scenario is probable but sadly it certainly is possible.
Scenario 2 - Has Israel and/or the U.S. attacking Iranian nuclear facilities. If done, Iran and others who hate the West now have what they will claim is justification to “retaliate.” Attacks on U.S. soldiers in Iraq and Afghanistan? Attacks on Israel? Attacks on U.S. soil? It’s anyone’s guess how the other regimes in the area respond. Iran has already said that if they are attacked or even challenged, they will use oil as a weapon. About 90% of oil exported from the Persian Gulf is transited by tanker through the Strait of Hormuz, a narrow strait located between Oman and Iran. Around 20% - 40% of the world’s daily oil supply goes through this narrow waterway. For at least a while, the Iranians can probably stop all oil from flowing through this area – unless the U.S. wants to keep it open with our military might. If Iran chooses to simply sink a few ships in the right areas it won’t matter much what our military does. But of course this probably leads to a serious shooting war between Iran and the U.S. Right now I’d guess a joint U.S./Israel attack is the most likely course of action – after that it is anybody’s guess how it goes.
Scenario 3 - Has the UN applying sanctions and other non-violent measures to force Iran to end their nuclear ambitions. Iran has said they will not fold. Any honest review of the UN in these situations over the past 50 years or so does not fill one with confidence that this will happen. Just getting China and Russia to support this action will be diplomatic magic. In addition, at $60+/barrel oil Iran has plenty of economic might to endure whatever economic sanctions are imposed. As the Oil-For-Food scandal in Iraq shows, there are always willing partners if the money is right; each day delayed is another day Iran is closer to nuclear weapons.
Scenario 4 – Iran is bluffing and backs down – this is unlikely as public as this fight has become and for many Iranians it is a matter of national pride. Or perhaps there is a change in the political power in Iran – the mullah’s are overthrown – again sadly unlikely at least in the short-term. Obviously this is the ideal scenario.
This is where we hope for the best but plan for the worst since a serious explosion in violence could profoundly change the value of your business – and you have absolutely no influence over how it happens. If it starts, it will be far too late to run towards the door. This risk is sadly, very real.
I strongly recommend that all wholesalers, regardless of their future plans, spend at least a little time thinking about how operationally they would respond to a serious problem in the Middle East. If it happens, it may require relatively quick action, especially for those wholesalers with lower market shares or high debt loads. Without proper planning you can hemorrhage a lot of cash in a very short period of time.
Now that I’ve been “Johnny Sunshine” what should you do? For many of you, you’re in the game whether you like it or not. Generally due to size of operations, getting out at an acceptable price may not be an option for these wholesalers – plus they are of a size where they can weather a few serious storms. In addition, I’m not claiming the end of the beer/beverage wholesaling industry, just that if you are not of a certain size and strength you should seriously consider exiting – although to be completely honest, if I were a beer wholesaler and could sell for a premium price today, I’d get out regardless of my situation. The remaining wholesalers are the ones who need to be looking at acquisitions. They are the ones that need to be making the operational improvements necessary to ensure their continued viability. They are the ones who need to be thinking outside the box and re-analyzing every assumption they have about the entire wholesaler/distribution industry – perhaps far beyond beer. Vision, a coherent, well thought strategy and flexibility are imperative.
Then there are the others. The ones who don’t want to leave. I occasionally get a call from one of these wholesalers wanting assistance in succession planning. Succession planning? – I tell them I won’t take their money for this since they must be joking. Many of these wholesalers should not be dreaming about succession planning, but rather ensuring they pass on significant financial assets to their heirs – not their beer wholesaling business which in all likelihood will no longer be around in 5 – 10 years regardless of how hard they fight to keep it.
I know this reality stings. These are family businesses that often go back to prohibition. But in many cases the choice presented is between ensuring substantial financial assets are passed on for generations or to be the one at the helm when millions of dollars of value simply disappear due to your refusing to accept reality. Which do you want to be? Which do you want your heirs to remember you as? Don’t forget what was said at the start of this piece; what we want doesn’t change reality.
As outlined above, any objective analysis regarding the value of beer distributorships comes to one conclusion – their value is only going to decrease on an apples-to-apples basis. How much and how fast I can’t honestly say but the value is heading down. Then throw in the various risk factors and one has to ask, why would you want to postpone the sale of your business? (of course assuming a willing buyer is available – if there isn’t you hunker down and do what you have too to ensure your financial viability). What financial reason exists to hold on another day? There is little to no upside and tremendous downside risk. You all know who you are. Don’t think about selling “in a few years” – race to the door today for an orderly, high-value transaction. From a financial perspective, you will never regret this decision.
But how to proceed? Let’s look at selling and negotiating issues from both a buyer’s and seller’s perspective.
First question – do you need a broker or can you do it yourself? A broker’s primary value is finding and perhaps negotiating with a willing buyer. In many beer wholesaling deals, the potential seller knows all of the realistic potential buyers. This is almost always the case when talking about an adjacent or overlapping wholesaler. And since these types of sales involve operating efficiencies, these buyers can always pay more than someone purchasing as a stand-alone operation. Now whether they will or not is another issue, but they can if they choose. In these situations I believe a broker adds little value from this perspective. But brokers can help in negotiations and it is often easier for a broker to meet with various individuals without getting the grapevine charged up. And of course brokers act as a buffer between buyer and seller, often very important when they know each other well.
Whether you use a broker or not, the most important aspect of any deal, whether buying or selling, is to build the new organization in detail on paper. Only by doing so, with associated revenue forecasts, can you discover the cash flows which this new business will generate. This is the reason your broker must have a strong operational and re-organization background – this organizational design(s) is the fundamental determinant of future cash flows, and therefore value. If you are a seller you want to build this organization so you can discover these future cash flows and price range, and negotiate accordingly. This is also true for the buyer.
Although I always build a model and perform sensitivity analysis based on various discount rates, I sometimes find a more useful and communicative method of analysis is payback period. Rather than arguing about acceptable risk premiums and future interest rates, instead simply look at how long it will take for the buyer to get their money back from these future cash flows, i.e. the payback period. This is simple, accurate, and something all parties can easily discuss. Is a five year payback enough? Is a fifteen year payback to much? This is where negotiations come into play.
Remember that method of financing does not affect value – it of course affects your ability to pay for the asset but the asset’s fundamental value is in no way affected by how it is financed. A crusty old finance professor called attempting to allow financing to impact value as measuring with a “rubber yardstick” - the value is X if paid for with cash but Y if paid for with debt. No. The value is the value.
In my negotiations I like to start with the general concept of payback period. If representing a seller, I like to begin to nail down what the potential buyer considers a reasonable payback period, before we get into any financial details – and since I have already built my model and know my cash flows – this tells me what the buyer would consider paying, whether he knows it or not. If it is unreasonable, we don’t have to continue and waste anyone’s time. If it is reasonable, we have an excellent starting point.
When representing a buyer I do the same. If the seller is thinking a 15-year payback period is his low-end price, we don’t need to talk anymore.
As negotiations progress and our confidence on being able to conclude a deal increases, I believe in sharing our operational models. I’ve had deals completed where the buyer and seller didn’t argue about price, but rather the organizational design (buyer’s often throwing lots of additional costs on their organizations, seller’s building bare-bone organizations). This changes the entire negotiating scenario. You run a distributorship. You know in general how many cases per day a side loader can put off or how many calls per day a sales rep can make. Building this new organization together – buyer and seller – transforms the negotiations. Instead of arguing “it’s worth this,” “no, it’s worth that” this takes the concept of value down to where it belongs – the revenue and cost projections associated with this new organization. If we have at least a general agreement regarding payback period, this greatly speeds negotiations and takes the “magic” out of value. From a buyer’s perspective it is very useful since it helps them plan and build the actual organization they will be operating (less whatever fat they could put into their model). From a seller’s perspective it is very useful since it allows you to clearly and convincingly show the true value of this acquisition – and the risk to you is minimal in helping do so.
Let’s think a minute about negotiations. Most people’s ideas on negotiations are simply wrong. Unless one of the parties is in significant distress, deals are only done between willing buyers and sellers. If your goal in negotiations is to screw the other guy (or to win), you are probably wasting everyone’s time. Even if the person opposite you at the negotiating table is an idiot (highly unlikely though it may be so), all of their advisors are not idiots so therefore your chance of screwing them is very remote.
The goal of negotiations is first to determine if there is any overlap between the buyer’s and seller’s idea of the value of this deal. If there isn’t, there will be no deal. If there is, negotiations proceed.
I like to think of the process like that old geometry concept of intersection.
Buyer’s Value Range Seller’s Value Range Price Deal Zone
Buyer’s Value Range
Seller’s Value Range
The circles represent the buyer’s and seller’s value ranges. If there is overlap – the first thing to determine during negotiations – then the following negotiations are simply attempting to finalize where on this overlap we finally agree. The buyer of course wants to pull the value to the low-end. The seller wants to pull it to the high-end. But if both parties are being honest, as long as the final value falls within this area of overlap, both parties should be happy with the results.
If there is no intersection, i.e. no place where the buyer’s and seller’s values overlap, then there by definition won’t be a deal.
No Overlap = No Deal Buyer’s Value Range Seller’s Value Range Price
No Overlap = No Deal
Buyer’s Value Range
Seller’s Value Range
If there are operating efficiencies in the deal, the seller wants the buyer to pay for them all – it probably won’t happen. And the buyer doesn’t want to pay the seller for any of them -- again this probably won’t happen. Instead, these efficiencies are shared in the negotiating process – that is if you want to get a deal done. Don’t focus on winning, focus on getting a deal done at a price you find acceptable.
Remember that the SELLER sets where this line is, and the BUYER sets where this line is. Visually I think this shows the illusion of being able to screw the other guy – you can’t since he or she sets the lowest value line.
Buyer’s Walk-Away Price Seller’s Walk-Away Price Price
Buyer’s Walk-Away Price
Seller’s Walk-Away Price
Also in negotiations remember to keep your eye on the ball. Far too many people in negotiations focus on what the other person is getting (or giving), rather than on what they are getting (or giving). I represented one seller where the buyer and I shared our operational models and agreed that at this price, the buyer was looking at less than a four year payback period. But he couldn’t get out of his mind the amount this would give to the seller. He asked me “John, why should I pay this amount for this deal?” And my answer was simple; “because that is what it will take to get them to sell.” It is as simple as that. “And you are looking at less than a four year payback period! Let’s get real, if you can go buy that c-store on the corner and have it pay for itself in less than four years I strongly recommend you do it.” By re-framing the buyer’s thinking on his world, not the fact that he was paying “way too much” to the seller, we got the deal done quickly and the buyer has never regretted his decision. Who cares what the other guy gets? If you get a good deal that has an acceptable payback period AND makes your company stronger, more profitable, and helps ensure your long-term viability, what do you care?
As an extreme example – if you pay the equivalent of $50/case for some product but your payback period is 12 months – why wouldn’t you do the deal? Why would you care what the other guy gets?
In fact many potential buyers, after reading some of the gloom and doom from earlier in this piece will fall into this trap – focusing on “winning,” focusing on the other guy rather than their businesses. They will attempt to low-ball their offers, they will attempt to screw the seller – and guess what? All this means is the deal won’t happen. Remember the graph, the seller and buyer set their own “walk-away” line. I fail to see how attempting this helps strengthen the potential buyer’s world. It often generates ill-will which makes future deals much more difficult to negotiate and actually increases the amount the seller finally decides to accept. Perhaps it is just me, but I find it is difficult to negotiate around the “it’ll be a cold day in hell when…” mindset. Don’t do things that make this mindset more probable.
Whether negotiating a deal or talking to a spouse or child, you must be able to put yourself in their shoes. How would you respond if this was said to you? Would it move you towards the goal, or away from it? If it would make you angry or harden your position, it will probably do the same to them. Stupid negotiating tactics and blatant dishonesty are not the way to get deals done. Would you want to deal with a person who thinks something is worth X if he is a buyer, but the same thing is worth 10X if he is the seller? This person is simply dishonest and not worth wasting time with.
Successful deals are win-win. In a world where both parties have free will, by definition they must be win-win. For buyers, often deals do come down to one question and answer. Question -why should I pay that much? Answer - Because that is what it is going to take to get the seller to sell. If you are happy with your payback period, who cares what the seller is going to take away?
Of course some sellers may not be happy with the value the marketplace puts on their business. In these situations the potential seller needs to take a hard look at their various options. Selling at X price generates this. The upside of this decision is… The downside of this decision is… Not selling and remaining in business under various operating scenarios generates these possible futures. The upside of this is…. The downside of this is…. Depending on your situation, sometimes you may not like any of the choices – in those cases choose the one that is least bad. If you plan to fight on, think outside the box. Are shared services a possibility? Additional products? Remaking your entire business? If you plan to remain, whatever your answer, get moving on it. Now.
Just as all industries throughout the world change, the beer wholesaling world continues to undergo a transformation. This transformation is not like a project with a beginning and ending, it is a process of continuous change – sometimes fast and sometimes slow, but constantly moving. It will not end. Take a hard look at your business; it may be time to cash out your chips. Or it may be time to get a deal or two done. If so, step to the plate and get them done. There are profound strategic implications to every move you make or don’t make. Once gone, these opportunities seldom present themselves again. And if a deal is in your future, focus on your side of the table, not the other person’s. Work to find a win-win scenario and the deal will get done.