When Things aren’t Quite what they Seem - Distressing Commercial Due Diligence Close-calls
I thought I’d share some instructive discoveries we’ve had in commercial due diligence recently. I’m curious to hear yours. If you’re inspired, send me a quick reply with a couple of diligence events that surprised you (and that you hopefully caught). Here are a few from the past year:
“It’s just secular headwinds [and bad performance].” Turns out that market turn-downs sometimes hide problems rather than reveal them. We found a components manufacturer to large construction equipment manufacturers (“heavy iron”) who had – unbeknownst to management – let in several low-cost import suppliers to their top-notch, but consolidated manufacturing base. When the market turned back up, sales were unlikely to follow.
“Revenue is growing [and mix is changing].” Some investors use “constant margins assumptions” to simplify revenue to earnings projections at least until later in diligence. We looked at an oilfield service company with growing revenues in a growing market; it turned out that the projects on the horizon were going to be in a category whose EBITDA margins were half those of the current projects. Once the “constant margins” assumptions were removed for the valuation, the haircut on value was substantial.
“It’s an engineer’s decision [or at least it used to be].” Component suppliers love it when product selection happens to be “the engineer’s decision.” This statement suggests that engineers will compel procurement to purchase the higher-priced, higher-quality product. We recently looked at a pipe manufacturer that had the leading brand in the industry, and was using technology that was widely perceived as the “strongest and best.” Unfortunately, as engineers retired from their customers, customers began outsourcing decision-making to contractors. These new decision-makers preferred to work with an alternative technology that they perceived as more efficient to install and safer for their crews. With the bulk of engineers reaching retirement age, a more material shift was likely to occur soon.
“We are a one-stop shop [kind of like a convenience store].” Revenue synergies from horizontally integrating the supply base are a common value driver for a platform-and-add-on play. In the best-case scenario, broad portfolios can allow for value-adding bundles. In a recent building materials project, however, most tradesmen making the purchases wanted best-of-breed rather than the “integrated system” management imagined as part of the integrated portfolio. We also found that the answer differed dramatically by country – whether it be Russia, Germany, France or the U.S., all exhibited unique characteristics.
No one likes to find negative news in their due diligence, but always better today than tomorrow – especially if it can inform the value creation plan, rather than kill a deal. I focused on Industrials for this time around, but we plan to share examples from other sectors.
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