High Stakes Poker and Consolidation
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I’ll start this post with an acknowledgment that values for beer distributors have not gone as I would have predicted… and I kick myself because what did happen should have been easily predicted… I erred in my analysis by putting too much weight on my own experiences, my own checking account… and I don’t play high stakes poker.
So let’s back up. I would have guessed that values for beer distributors would have been experiencing downward pressure over the recent past. Sure margins are great (thanks to ABI and crafts/imports) but sales are generally flat to down. Lots of uncertainty and risk still remains, COSTCO-type moves, ABI wholesaler margin management, various cost/expense increases, etc.
Yet just the opposite is happening. Values are heading up, big-time. In fact my associate Steve Cook and I were recently discussing the present state of affairs and we both believe the days of buying as a financial asset have gone for good. These deals are all strategic and the prices paid reflect that. And when I say strategic, that doesn’t necessarily mean adjacent or one with a lot of operating synergies, it means fitting into a longer-term plan. These values also reflect what it takes to get a reluctant seller out the door.
So what does this have to do with high stakes poker? At some point in a high stakes poker game the remaining players are all sitting in front of large piles of chips and the bets start getting bigger and bigger. They must if someone wants to win… plus in many cases the person is playing with other people’s money. If the bets don’t increase, everyone simply sits around playing with their chips until something breaks the equilibrium.
Although the analogy is not perfect, this captures the dynamics occurring in beer distributor deals… all those who were primarily concerned about asset protection have already left the game. This is where my previous prediction veered off course… driven by my checking account. Based on my financial position, I would be most concerned with locking in the value. But if you’ve been in this business for years (or generations) you have already accumulated significant financial assets. Thus you will play the poker game much different than me. You will be much gutsier in your bets… for even if they all headed south it would in all likelihood have very little impact on your personal financial situation. Add to that the fact that in many ways you too are playing with other people’s money… this also puts upward pressure on deals.
Thus deal prices are heading up. Now most brokers hold onto the magic number (or range) like it is the only thing of value they bring to a deal. Well I think Steve Cook and I bring a lot more value to the table than a simple number. So here it is… these recent deals are going for north of 4 times gross profit (just for distribution rights)… some pretty far north. And yes, I know how to value a business but we often need a common means of measurement and a multiple of gross profit seems to capture this at a 40,000 foot view… plus it makes unsolicited offers easier since it requires no intimate knowledge of the other distributor’s financial performance.
Unless these are complete vertical integrations (and these aren’t), at these numbers you will almost assuredly have to supplement the earnings of the acquired distributor with cash flow from another operation. The days of having the acquired company pay itself off in 6 to 10 years are long gone. At these multiples the payback will take far too long… possibly into the 15-20+ year range depending on buyer circumstances.
This is one of the advantages of being a consolidator… having multiple operations which can help fund future acquisitions. Folks who made acquisitions years ago now sit on debt-free cash producers which can easily provide cash flow for more and more acquisitions. There is an advantage to always thinking long-term and strategically… and it is not too late to join this club if you have the desire and the stomach for it.
But this isn’t everyone’s cup of tea… but just like that high stakes poker game, you get to play, not set the betting rules for everyone else. The big dogs are out running… if you want to play, get off the porch… if not, sit there and play with your chips. In the next few months we will see a lot of folks who thought they were buyers turning into sellers.
Why? Because the financial incentives strongly point in that direction… mainly because of our ol’ friend taxes. Let’s look at a simple, back of envelope example…
- A distributor with $50 million in annual sales.
- 25% margin, or $12.5 million in gross profit
- Driving 7% to the bottom-line, or $3.5 million in pre-tax profits
- At 4 times gross profit the selling price for distribution rights is $50 million (plus all other assets)
- Assuming a present capital gains tax rate of 15% on 100% of the net value of the distribution rights, this equals $42.5 million in after tax proceeds… plus of course 85% of the selling price of all other assets.
- If one keeps the business you will have annual income of $3.5 million in pre-tax profits; assuming a personal tax rate of 43% (federal + state + local). Thus $2.0 million in after-tax proceeds (plus whatever personal compensation and benefits you take).
- At $2.0 million in annual after-tax proceeds, it will take over 21 years to payback or earn the equivalent of the after-tax sales proceeds… and this ignores the time value of money! If one assumes a 3.25% cost of money (cheap by historical standards) it will take around 35 years to equal the after-tax proceeds of the sale of just distribution rights, we're ignoring the proceeds from the sale of all other assets… but of course, in the end you still own the asset.
- And don’t forget, for those 35 years you aren’t just hiding the sale proceeds under your mattress… they too are earning income. At a 5% rate of return, that’s over $2.1 million annually (pre-tax).
THESE are the reasons it makes sense to consider these offers… whether one wants to or not.
Of course not all things are equal… if one has as much money as one needs or many family members involved in the business it may be the case that no number will make sense for the entire family, thus you remain in business.
So, if you want to run with the big dogs you had better open the check book and move quickly (don’t forget, you can’t hurry brewery approvals and they do take time). After the election the tax situation just might get A LOT bleaker… in fact we may find the entire industry enters a 4 year lull in deal flow. Why would one pass on a sale today yet sell in a year or two when after-tax proceeds will be substantially less? Don’t forget, after-tax proceeds are all that matter. If it doesn’t get done this year (and Obama wins), it would seem to make more sense to wait until the political situation changes in Washington at the end of Obama’s second term.
Lots of moving parts but the big dogs are beginning to up the ante in this little poker game of ours… as I noted, I would have already taken the money and ran for the door… but the question you must face is do you have the stomach for this level of poker? If so, get the deals done this year. If not, you can of course stay put or hope for that unsolicited offer to visit your inbox.
Interesting times in the beer distribution business indeed.