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« My wife Barb and leukemia | Main | 2 Big Deals... What Are You Doing? »

Interest rates and their impact on deals

Before we think about the beer distribution business, first a quick paragraph about scale.  When people talk about millions of this or billions of that or the now more used trillions, it is difficult to really comprehend such large numbers… so here is a little example to make the point (stolen from a letter to the editor in the Wall Street Journal).

If one were to spend a dollar a second, in one year you would spend $31,560,000 – we’ll forget about leap years.  At this rate: 

  • If you wanted to spend $1,000,000 (one million dollars) it would take a little over 11.5 days
  • If you wanted to spend $1,000,000,000 (one billion dollars) it would take just under 32 years.
  • If you wanted to spend 1,000,000,000,000 (one trillion dollars) it would take just under 32,000 years!
  • If that doesn’t scare the crap out of you – regardless of your political leanings – then you aren’t paying attention… per CBS news, debt under Obama is forecast to increase just under $6 trillion dollars from the day he took office to 2012!

And to end this part, a spot-on quote from that great American patriot P.J. O’Rourke…

It's not an endlessly expanding list of rights -- the "right" to education, the "right" to health care, the "right" to food and housing. That's not freedom, that's dependency. Those aren't rights, those are the rations of slavery -- hay and a barn for human cattle.

 

Now back to the beer business – interest rates are sneaking up and their impact on deal price could become a more significant factor for 2011 and beyond.  In fact it is difficult to foresee a future without much higher interest rates.  First, interest rates have been at historical lows for quite some time and we may have seen the bottom of the trough… money has been basically free for banks.  Second, although the official inflation rate remains low and the wizards at the Federal Reserve tell us there is nothing to worry about… based on the Fed’s past performance, that statement alone is probably cause for worry… the signs of inflation are everywhere. 

  • Fuel prices up
  • Energy prices up
  • Steel prices up
  • Health insurance costs up
  • Gold and other precious metals up big time
  • Commodity prices up – in fact a significant factor in the recent turmoil in Egypt and other places is serious inflation in food prices… up 15% and more in many places.  If you live in a place where 50%+ of one’s disposable income is spent on food, this is a huge impact on your ability to feed yourself and your family.
  • Beer prices up – other than residential and in some places commercial real estate, I don’t see any sector which isn’t confronting the consumer with higher prices.

Of course high unemployment and excess capacity in many industries is holding down some inflation, but how long can that last?  Wage inflation is held down by the economic situation but employees have long memories… you all know the refrain, “I haven’t had a raise in 3 years”… the pressure is already building on this front. 

And as the world’s reserve currency (at least for now) the US has the advantage that we can export inflation to the rest of the world… something they rightly aren’t overjoyed about.  You can take Federal Reserve Chairman Ben Bernanke’s word that he has "100%" confidence he could prevent runaway inflation” or believe your own lying eyes and wallets.  Many believe inflation is how the government is going to address our present debt situation… they’ll just inflate it away as part of an official strategy.  So it sure seems like a safe bet that interest rates are going to be heading up, the only question being how much. 

What does this have to do with deals and their pricing?  As a seller you want to push the envelope on selling price… but the buyer only has so much flexibility to make a deal work.  From the purchaser’s perspective, the net present value of every dollar in financing cost is a dollar less they can offer for the business.  Thus higher inflation and higher interest rates start putting a cap on deal price… with higher interest rates the “same” price can end up putting a lot less money in the seller’s pocket… the increased financing costs in effect coming directly out of their pocket… Sure one would like to push this off on the purchaser but if they are already at the upper limit of price, their flexibility is going to be fairly limited.

Depending on the size and the nature of the transaction, Steve and I are seeing some increased interest rate sensitivity on some deals we are trying to complete.  Depending on what your total interest rate is (usually Libor plus bank rate), we estimate using a annual 5.875% interest that an increase of five (5) basis points in monthly interest rates, on a $50 million commercial loan, amortized over 7 years (84 periods) would increase total costs for the period by over $300,000.  Doesn’t sound too bad, but that’s for only 5 basis points or a .05% increase (a basis point being one hundredth of a percentage point, 0.01%).  A .075% total increase or 7.5 basis points in monthly rates could increase total costs exponentially to an estimated $915,000 for the same loan…  And lastly, a highly unlikely in the short term, but never say never total monthly increase of .10% increase or 10 basis points (or 1.2% annually) could increase total loan costs by a whopping $1,500,000

Now I’m not predicting that a 100 basis point increase is right around the corner but as you can see, the impact of waiting or dragging out a deal could be significant… delay and there might go your beach house!  And as I mentioned above, if as a seller you are pushing the upper envelop of price, these increases in financing cost are most likely to come out of your take.  So as I have commented before… if you’re on the fence as a seller, you might want to seriously consider getting out the door now… and if you’re a purchaser, you might want to step to the plate and get that deal done.  If not, an increase in financing costs could effectively put the kibosh on either side being able to get a deal done at an acceptable price for both parties.

Time is money! – Benjamin Franklin

Inflation is most likely coming and it will be ugly.

  • You pay more for equipment and services.
  • Taking on debt is more difficult due to the higher applied interest rates.
  • From an equity standpoint, the value of your company could diminish as well if you don’t change who you are or how you do business.

 For your reference and comparison, the previous two week LIBOR postings shows an upward movement of 10 basis points on the 1 Year and 3 Month LIBOR Rate! I wonder where the numbers will be in the next 26 weeks?

  From the 1/19/2011 Update

the  LIBOR, other interest rate indexes

 

This week

Month ago

Year ago

Bond Buyer's 20 bond index

5.39

5.15

4.31

FNMA 30 yr Mtg Com del 60 days

4.47

4.59

4.80

1 Month LIBOR Rate

0.26

0.26

0.23

3 Month LIBOR Rate

0.30

0.30

0.25

6 Month LIBOR Rate

0.46

0.46

0.39

Call Money

2.00

2.00

2.00

1 Year LIBOR Rate

0.78

0.78

0.88

 

From the 2/2/2011 Update

the LIBOR, other interest rate indexes

 

This week

Month ago

Year ago

Bond Buyer's 20 bond index

5.25

5.08

4.36

FNMA 30 yr Mtg Com del 60 days

4.61

4.46

4.76

1 Month LIBOR Rate

0.26

0.26

0.23

3 Month LIBOR Rate

0.31

0.30

0.25

6 Month LIBOR Rate

0.46

0.46

0.37

Call Money

2.00

2.00

2.00

1 Year LIBOR Rate

0.79

0.78

0.85


Reference: LIBOR | 1 Month Libor 3 Rate 6 Month Rates Bond Index Current One 90 day 30 Day http://www.bankrate.com/rates/interest-rates/libor.aspx#ixzz1BapPHDPx

Want more stuff making a case for moving quickly on that acquisition or sale?

1.      Inelasticity of domestic beer prices is changing the game.

  • Is case volume a thing of the past?
  • Lower volume - higher margin contribution craft beers are growing strong.
  • More of our clients are asking us to value their business for strategic planning purposes.

Not only is this no-frills product an affordable option, it has significant value by providing quantitative industry comparisons while illustrating the financial sensitivity of the current business situation.  Easily updated it can show the impact of current changes in dollar volume, gross profit and operating methods.

2.      The first guy in his area to sell usually can get a better premium.

  • Consolidators can handle limited incremental amounts of debt.
  • By being first, you can sell when you want and push the price.
  • Secondary wholesalers wanting to sell might be dormied due to limited interest in more rural areas and might have to reduce the selling price by millions to affect a transaction.

3.      Uncertainty and a loss of control within the industry by wholesalers is creating a “risk-aversion” operating philosophy for an aging ownership group.

Might be better to take the money and give it to junior versus gambling financial security on the longer term paybacks of most beverage consolidation strategies as directed by the breweries.

 Are interest rates headed up?  Without a doubt.  Is there a fair amount of uncertainty in the beer distribution business?  Heck yes… ABI and SABMiller merging?!... Costco-type moves?... tax pressures… the future of mega-brands.  Impact on values?  We’ll have to see… but remember, once we know it will be too late.

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