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LEAN and COMPANY VALUATIONS

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LEAN and COMPANY VALUATIONS

  1. 1. FOCUS THINK VALUE How Implementing LEAN Manufacturing Increases Company Valuations RE
  2. 2. Coming from years in the private equity industry, primarily on the buy-side, at ShopFlow Solutions we know that industrial companies that have implemented LEAN programs are more valuable than those who do not, usually significantly so. There are a number of reasons this is the case, and we’d like to discuss a couple very important ones here. As always, I look forward to the opportunity to talk with you and share some of my own experiences in how you can make your business more valuable over time… Going back to as late as the early 2000s, private equity firms were able to negotiate favorable terms because business owners and organizations were less sophisticated about valuations, as this was prior to the wealth of information now available to them online. There were also fewer competitors, as the industry was still in its earlier stages of development and expansion. But here in 2016, these advantages have shifted to the target companies instead. These same private equity firms are no longer getting the same deals they once did. And this has led many LEAN-thinking investors to spend a lot more time investigating the day-to-day operating practices of an organization before entering into any sort of agreements, partnerships or acquisitions. There are many thousands of small to mid-sized companies out there who are privately- held and will eventually investigate selling their business. As part of the due diligence and valuation of those companies, it’s not difficult to make the case for higher worth for those companies with LEAN-type principles in place. And knowledgeable business owners are really starting to take notice of the huge potential advantages they can generate with enhanced productivity programs and initiatives, not just from the standpoint of higher revenues now, but also higher valuations for their companies when it comes time to sell their business as well. One clear reason is a major shift in focus from growth to current profitability taking place throughout the business world right now, which is also the focus of LEAN – finding ways to save capital and maximize resources to streamline the operations you have right now - producing for your current, existing customer base. The outspoken Bill Gurley, general partner at Benchmark Capital and an astute, well- respected analyst on the buy-side of private equity, has never been one to sugarcoat his thoughts and opinions. He was particularly blunt at a 2015 Wall St Journal WSJDLive conference when he stated that the valuations of privately-held companies are “fake.” FROM GROWTH….TO PROFITABILITY $$
  3. 3. Gurley has been one of the leading voices sounding caution about the overheated state of the tech startup market and the need to return to solid business fundamentals. In other words, aggressive focus on ‘offense’ is being replaced by playing great ‘defense’ with these companies and in the business world as a whole, again the forte of LEAN and similar enhanced-productivity programs. This would be a 180 degree turn from recent years. ‘Growth, at all costs’ has been the mantra since the early 2010s as an unprecedented amount of investment has flooded into private companies – creating a large segment of businesses valued at $1 billion and beyond. Difficult times ensued in 2001 related to the dot.com bubble and debt market problems, and the financial crisis of 2008 shook the markets all around the world once again. But it didn’t take long before private equity purchases began to accelerate once again following that recovery. And that relative ease of access to cash can explain why fresh, ambitious organizations have been ever eager to lavish more money on marketing and sales than they’ve generated in actual revenue. Gurley sees this as a hindrance to the market, not a positive influence. When money is hard to raise, he said, innovators can still find funding for their great ideas. “In this market, they can raise a ton of money, but so can a lot of [less capable] competitors that wouldn’t be in business otherwise,” he told MIT Tech Review. Executives have been incentivized to focus on building market share, even as steep operating losses continue to mount. But the shift has begun towards the more traditional focus on current profitability. Growth has and always will be a prized metric. A good analogy would be a comparison to wins in for your local pro sports team. That’s what fans care about - what’s your record, how many wins you have. As rudimentary as it may sound, that’s typically all that Wall Street (and thus, PE firms) cares about as well - growth. But that thought process and resulting philosophy are changing. One need look not further than Uber for the reason(s) why. Uber's estimated market valuation is insanely high (between $40 billion and $50 billion by various estimates), exceeding the valuation of established airlines and car- rental companies. This is driven by confidence in Uber and accepting its staggering expectations of growth. However, the sheer size of the backing is going to make it difficult for Uber to deliver long term. The fuel for this expansion has been ever- growing sales and marketing budgets. Another poster company of this strategy is the cloud software business Box. Box went public in January 2016, and has said publicly that it doesn’t expect to become profitable until 2018. That’s quite a long time to wait for profits. And of course even then they are based solely upon expectations, certainly not guaranteed. Though not a manufacturer themselves, Box depends directly as do all tech companies on the multitude of manufacturers who build all of the hardware and infrastructures needed to create these incredibly sophisticated networks which support their technology. Thus their own fortunes are tied directly to the success, or failure, of the many tech companies that are operating today as if the potential payoff tomorrow (or next week, or year) is assured, and thus explosive growth is the only metric that matters. An August tweet said “We may be nearing the end of a cycle where growth is valued more than profitability. When capital feels unlimited, you don’t worry about what you get for what you spend. That’s beginning to change.”
  4. 4. And the same dependence on future revenues, often times on very extended time horizons, based on massive upfront expense in sales and marketing is certainly not specific to one field or industry, but a philosophy which has taken hold in a vast array of companies. A primary problem here is that the much analyzed ‘burn rate’ of their cash on hand and other liquid assets is often times unsustainable. If there is a market downturn or a tightening up of private investment dollars this becomes even more so. Box and many similar companies could easily find themselves in a serious cash crunch (or worse) in either of these scenarios, and there will certainly be businesses that have made the wrong bet and will simply run out of capital before they can reach the (in their case, unattainable) Golden Age of Profitability. A disproportionate amount of capital is being raised and then going straight into sales and marketing, along with all the other intangibles that lead to a sale. These businesses are operating with the sole objective of telling the story and building awareness, in the endless search for the next new customer. Customer acquisition is critical to any business, but at some point a higher ratio of the capital raised needs to be applied to actually growing the profitability of the customer base which has already been established. And when capital seems unlimited, you don’t need to worry about what you get for what you spend, as long as you are gaining any type of marginal gain. But the size of this margin isn’t a primary concern when companies are flush with cash to make the substantial investments required to buy customers up front. This can lead to a dynamic of a fiscally- irresponsible allocation of revenues. The era of operational thinking based upon the concept of limitless capital and less concern for analysis of reasonable returns on sales and marketing spending is on its last leg. Companies have essentially been playing the “long-game” for quite some time, being willing to absorb substantial - but what they consider to be short-term - losses with the expectation of banking big revenues at some point down the road. They’ve been betting the cost of acquiring new customers now will have a handsome pay off in the future, leading to annual recurring revenue. Companies are continually seeking loyalty from their customers of course, striving for “stickiness” with the hopes of upselling other products and services once the relationship has been forged. This is obviously a sound philosophy. But the prevailing thought of overpaying for a Year One customer, looking towards where they hope that customer might be in Year 2, 3 and beyond is changing. Certainly not everyone can win with everyone playing the same game, but the opportunities in the marketplace are genuine for many companies, so the strategy makes sense on paper. The primary worry is that all of these high, ever- growing valuations exist on paper alone. If or when there is a market downturn these companies will suddenly be facing a much different world. The free ENGAGED CUSTOMERS
  5. 5. spending done to acquire customers is going to come under more intense scrutiny as a strategy for these business executives. Many believe that this is going to create a greater emphasis on accountability, forcing companies to show expected return on investment for these acquisitions in greater detail. In the case of a downturn, we at ShopFlow Solutions think it’s going to be amplified. With limited resources and constraints, companies will be focusing everything on driving its livelihood – which is revenue. This plays directly in favor of enhanced productivity manufacturing initiatives like LEAN and 5S. Instead of the belief in consistent, uninterrupted growth which many marketing plans are built upon, growth through customer base expansion should be seen in its proper cyclical form. Continual improvement in your manufacturing environment however is not cyclical, but rather something your business can address indefinitely. When too many manual interventions and variations are present, the problem is not just one of cutting out non-value-added activity, but also the value-subtracting activity caused by errors that are often repeated every day. In addition, implementing lean manufacturing mandates the need for better balance and faster flow of material through production. In most cases, the company will need to reconfigure its manufacturing processes from large lot, functionally-oriented methods to more flexible, quick changeover smaller lot methods for fast response and higher throughput. Remember, not just labor and inventory costs are saved by higher throughput and reduced cycle time – customers are more satisfied, and that’s where the money is. There are many variables for private equity firms to consider before acquisitions or partnerships, such as overall competitiveness and outlook for the industry, and proprietary technologies the target may possess. And new customer acquisition strategies and their results will always be crucial of course. However, for a LEAN-oriented investor, there are many other questions they will take into account before coming to any determination related to valuation. They seek to evaluate not only the current manufacturing performance of the company, but also how many opportunities there can be for future improvement. They take time to review how much waste or inefficiency exists within the business currently, and how much can this be improved upon, and in what timeframe. This is where many middle-market manufacturing and distribution companies can really shine, if they have the correct best practices in place prior to any investment decisions made by outsiders. Sometimes easily justifiable capital investment is required, but in many cases substantial improvements in flexibility and cycle time reduction can be achieved with current equipment. REVENUE, ANYONE?
  6. 6. There’s a maxim that’s been used in aviation for years, “If it looks like it can fly, it probably can. If it doesn't, it probably won't.” This relates well to the first benefit of a LEAN program in regards to the valuation of your business. When seen in your shop or manufacturing floor, it could be best summed up by stating: When potential investors and evaluators walk through the manufacturing floor of a candidate company, a very clean and well-organized shop can’t help but automatically shape their opinions of the manufacturing operation positively right off the hop. This is basic human nature. And knowing that a highly-capable team and executive leadership is already in place can pay huge dividends once it becomes time to analyze your business and its potential worth. Marketing teaches us that most purchases, and most decisions made it general, are first motivated by emotion, and then logic is used to justify them. Even some of the most astute, financially-driven individuals are not immune to this principle. In fact, some of the worst investment decisions ever made were clearly influenced by this philosophy. This fact, as stated here, is by in no means meant to relate to your own business specifically. In working together, our goal of course is to help you create the most efficient and streamlined manufacturing operation possible, generating the highest revenues for your company as well. But this truth can explain in some ways how personal opinions can play a crucial role in determining the valuation of your business. What may seem as small factors of consideration can lead to significant variations on how your company is valued by PE investors. Your company’s P/E ratio, the tried and true method of valuation based on your current share relative to your per-share earnings is always going to be crucial. And this instructs suitors greatly when making their investment decisions. However, as with any other metric, the price-earnings ratio comes with important limitations. Investors may be led to believe that there is a single metric to provide complete insight into an investment decision, which is virtually never the case. Of course LEAN manufacturing principles should improve your P/E ratio significantly when correctly implemented. But the evidence of strong leadership which is displayed by the successful application of waste reduction methods like LEAN is also highly sought by investors. It points towards a reduced need for significant hands-on involvement in what they can view as a complex process in the future to increase the company’s worth. When our customers need help to determine what the best choices should be regarding their waste reduction strategies, we can work as their LEAN manufacturing consultant to make the “What Looks Best, Probably Works Best”
  7. 7. process much simpler than they might assume, based on our many years of expertise. Investors want to know that a successful management team has already been at the helm leading up to the present point. This manufacturing environment, paired with solid KPI’s and metrics in place, clearly displays an effective, pro-active management team. This is something that investors desire now more than ever, given that private equity firms are holding on to portfolio companies for more extended periods than before. This situation creates the potential need for longer-term oversight and management of the business. Buyers certainly have their own strategies for leveraging the unique technologies and other competitive manufacturing advantages that a company possesses when it comes to their investments. This has become a critical acquisition strategy for many individual large tech companies in addition to PE firms. Purchasing smaller businesses that possess an newly-developed technology, or an existing one they’re particularly adept at utilizing, is a growing trend. Advantageous manufacturing techniques, distribution networks, customer base- pairing all of these with their own existing product and service offerings – have created tremendous opportunities for these major tech players. Generating huge valuations for their current business owners, too. When these entities know they don’t have to start fresh with LEAN or similar waste reduction programs to increase efficiency and thus revenues, this can definitely result in larger values placed on your company. Many LEAN consulting companies address the PE industry specifically due to the added value brought to bear when the PE firm employs LEAN in their due diligence pre-acquisition and post-acquisition plans. Which means working in partnership with us here at ShopFlow Solutions you can avoid the trap of being seen as a business which relies solely on growth as your main driver to generate increased revenue. Research shows that a company could make a one-time investment equal to ½ of one employee’s annual wages and impact profitability many times over. This type of investment in your facility can provide the highest ROI impact your can find anywhere, well before the thought of selling your business even enters your mind! “The days of spending $3 to get $1 is going to end,” concluded Gurley.“We’re getting to where the CMO isn’t just blindly signing checks for marketing initiatives and instead asks:‘What is the top line impact?’ And then the CFO asks: ‘What is the bottom line impact?’We’re going to see a readjustment and recalibration of growth expectations as a result.” AHH….SUCCESS! If a candidate business has a clean, well- organized and flowing manufacturing floor, with the right KPI’s and metrics in place, the more aggressive the valuation of the company right off the hop. Through my own extensive experience, I know that many PE firms will publicize the fact they have partners with operating experience, to work with portfolio management teams to increase value by improving operating performance vs. financial engineering.
  8. 8. Implementing time-tested LEAN philosophies in your manufacturing facility saves you time and money, plain and simple. And we’d like to help you get your shop or manufacturing floor running as efficiently – and as profitably – as possible utilizing LEAN within your organization. The products we sell at ShopFlow Solutions are all designed to make your workplace the most productive environment possible, while it continually improves over time. Our heavy-duty, industrial grade products stand up to the harshest working environments, and because we supply directly to OEM and end-users, you get higher quality products than what other pay for lesser alternatives. Visit us online (www.shopflowsolutions.com) or call today at (800) 274-4123, and let us share the wealth of information our company has learned over the years helping organizations just like yours. Brad Stack – Owner, ShopFlow Solutions

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