Recent financial news is full of warnings about a slowdown in worldwide growth. From Wal-Mart and AT&T, to IBM and Target, it appears that same store sales and unit growth are challenged. This is amazing to me in light of the highly stimulative policies employed by central banks around the world from Japan, to China, to the United States.
This slowdown in unit growth may be a hangover from the governmental interference in the last recession. Many losers never failed and marginal capacity did not shrink enough. You can argue that interruption of business cycle failure, while a miracle of central bank intervention, may be creating an overcrowded competitive landscape.
Illusory Unit Growth
We are seeing the unit growth problem in many of the small manufacturing businesses we review for purchase. On the surface, most of these businesses appear to have recovered to pre-recession sales and profitability levels. A closer look, however, often shows customers catching up on deferred purchases by rebuilding depleted inventories or businesses achieving profit gains through productivity enhancements or cost reductions. In some cases, there have been synergistic tuck-in acquisitions. Unit growth is simply tough to find. We are mindful of this macro trend when we value targets and submit bids. The target’s past compound average growth rates (CAGR) in sales and earnings should be checked against unit growth.
In the industrial world, we are finding pockets of unit growth in “re-shoring” manufacturing activities, companies tied to the currently favorable automotive cycle, commodity manufacturers who are “buying” business by dropping gross margins and service businesses that support industrial productivity. However, in many cases, sales growth may be due to one-time pricing initiatives and profit growth may rely on productivity enhancement and cost reduction. Many businesses are simply holding serve.
Valuation Implications
That creates a math problem for most public and private valuation paradigms, from price earnings multiples and PEG multiples, to discounted cash flow and EBITDA/enterprise value methodologies. Lack of unit growth may eventually lead to lower earnings and less free cash flow. Even paying 6x EBITDA/enterprise value for a company without unit growth but sustained gross margins will lead to a poor return on equity (less than 10% IRR) and a low multiple of invested cash (less than 2.0x) in a capital structure with 3.5x debt/EBITDA.
We remain cautious about valuations in the lower middle market because unit growth is illusory. We are mindful that the most important variable for successful investment returns is an entry price matched to the unit growth. When you consider the probability of changes in other leveraged buyout variables like interest rates and taxes, the case for conservatism is even stronger.
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