Navigating Mergers and Acquisitions in the Recovery Decade · M&A Paradox •Studies show •70+%...

1

© copyright Matheson Financial Advisors, Inc.

Navigating Mergers and Acquisitions in the Recovery Decade

David S. Cohen, Esq., ASA

508-655-9700

[email protected]


Learning Goals

• The participant will understand the underlying business factors that impact value and how to manage and evaluate these when pursuing M&A deals

• The participant will have a better chance of successfully closing their M&A deals, by learning about firm valuations and deal structuring

• The participant will be educated on the impact of industry consolidation trends and how design firms can best position themselves


M&A Drivers

&

E/A Market

Overview

2


The AEC M&A Market

•Hot from 2004-2007

•Warm from late 2007 to early 2008

•Cooling fast from early 2008 – Q3 2008

• Frigid from Q4 2008 – Q3 2009

• Thawing in Q4 2009

•Warm - Hot from early 2010 to present

• ????? for the future


What’s Changed?

• Once HOT markets that were in trouble, but some have come back

• From a Seller’s market to Buyer’s Market

• Still driven by:• Interest low rates, if you can get the debt

• Nature of our industry – fragmented with low barriers to entry• Attracting private equity – but financing constraints and

‘turn-around’ limitations (risk)


What’s Changed?

• Infrastructure Focus vs. Private• W/WW, Transportation, Energy, Environmental (may depend

on the geography)• Education, Health Care, Commercial• But, local funding issues present problems• Increased competition for smaller projects• Even lower fees w/ price competition

• Tremendous opportunities still here for foreign firms (Arcadis, Bureau Veritas, Dar Al Handasah, GHD, WPP Group, Worley, Cardno, Balfour Beatty…)• Weakened Dollar• Big spenders in power

3


What’s Changed?

• Lower profits and growth prospects mean increased difficulty to complete internal transitions

• leadership and financial capacity constraints

• Alternative to Cold Starts

• Industry is not minting entrepreneurs & capitalists

• Expect more mergers and more buyer stock as consideration


The Current M&A Market

• For Sellers – Maximum value & new opportunities

• Recognition that capital and larger platforms are critical

• Adjusting to new valuations?

• For Buyers - GROWTH remains critical• Higher revenues & earnings = higher value

• Embedded overhead to cover

• Conserving cash


Historical E/A Deal Activity

• Just where you expect:• Frequent Buyers are on the top of the ENR Top 500

• They have financial resources & balance sheets

• “Growth” mindset vs. “Dividend” mindset

• Ability to use stock and tap equity markets

• Typical Targets are 30-100 person firms• They run out of human resources

• Next tier unable to buy out the founders

4


E/A Deal Activity

• $10mm (100-person) Buyers target• $1-3mm (10-30 person) sellers

• $20mm (200-person) Buyers target• $2-6mm (20-60 person) sellers

• $50mm (500-person) Buyers target• $5-20 million (50-150 person) sellers

• Obvious exceptions - like Arcadis & Malcolm Pirnie, Balfour Beatty & PB, WS Atkins & PBSJ, AMEC & MACTEC, AECOM & URS, WSP & PB


Ownership Transition Realities

•Approx. 1 out of 3 firms found to survive a transition to 2nd generation

•About 10% will survive to 3rd

generation


Sellers’ Transition Options

• Liquidate the firm (Minimum/Floor Value)

• Give it to next generation leaders or family members (Low Valuation)

• Internal Management Buy-Out (discounted Fair Value)

• Sale to Third Party (Strategic Buyer or Financial Buyer-Private Equity) (Market Value)

• IPO (Hill Int’l, Willdan Grp., NV5) (Pay Day?)

5


From the Seller’s Perspective

• Firm Owners want to maximize value

• Firm owners are tired of running the business

• Internal transition may not be feasible from financial perspective (too much risk)

• Next generation of leaders/managers do not have the capital to invest

• Selling firm may not have developed leadership depth (bench strength) to run the firm

• Larger firm may provide additional opportunities for staff and leaders

• A larger firm may help selling firm compete and win bigger/better projects and clients

• Rescue a sinking ship


What Buyers Want

• To grow their firm’s value through higher revenues and earnings

• To execute their strategic plans for their stakeholders

• Deals that provide access to seller’s clients, geographic markets, services, backlog, processes/technology/experience, market reputation, design excellence…

• Qualified people – talent at project and leadership levels (alternative to recruiting)

• Possible lower cost than cold starts


M&A Paradox

• Studies show• 70+% of deals do not produce financial success, yet 70+% of

CEO’s classify their deals as successful

• Likelihood of successful big firm mergers <30%

• In order to grow into a top tier firm, you probably need to do deals

• Paradox = How to be successful at M&A with odds stacked against you?

6


Doing Deals Successfully

• Like the game of golf, the less you play, the less likely you will get good at it

• So, firms that do more deals tend to be better at doing them• They consistently close with high probability of success b/c they

are pro-active and constantly in the market

• Successful acquirers stick to digestible-sized deals that reinforce their core businesses

• Financial yardstick for measuring success is producing higher total return on investment than firm’s cost of equity (CAPM)


Advice

To

Sellers


Transaction Ready Sellers

• Be pro-active not reactive

• Get your house in order

• Stable leadership/management that stays

• Accrual financials by outside CPA

• Steady earnings

• Accurate backlog report

• Excellent project accounting

• Clean up inter-personal/company affairs

• Clean balance sheet (A/R and WIP)

• Adequate capitalization

7


Transaction Ready Sellers

• Selling owners typically think their firms are worth more than they are

• Get an independent sense of value early

• Make sure systems are in place to reward or keep key people that may not get much out of the deal

• EARNINGS, EARNINGS, EARNINGS

• Steady historic trend and reasonable/attainable future projections


Connecting Profits with Project Management• Profits begin with successfully managed projects

in the design business

• The typical metrics tracked are:

• Utilization Rates (By Hours and Dollars)

• Net Labor Multipliers

• Revenue Factor

• Overhead Rates


Chargeability or Utilization Rate

Direct Hours

Total Hours

Direct Labor ($)

Total Labor ($)

8



• Measure of staff utilization relating Direct Labor ($) charged to projects with Total Labor $ (direct + indirect,

+PTO, but excluding incentive bonuses)

• Median increasing from 2009 low of 57.1%

• Median decreased from 59.7% in 2013 survey (MFA suggested range of 62-64%)



• Watch out for…

• More than 2-3% gap between hourly and dollar based utilization (impact of high dollar leaders with lower utilization; high levels of hourly vs. salaried staff)

• Hourly Utilization: Low-Q=57%, Med & Avg=61%, Up-Q=67%

• Use base hours of 2,080 versus actual hours worked

• Impact of PTO (vacation, sick days, holidays)

• Over & Under reporting of hours billed by employees

• Generally, no reason firms should not achieve Upper Quartile 62-64% dollar utilization!


Net Labor Multiplier

• Measures relationship between net revenue and direct labor (firm wide)

• Since 1993, median rose from 2.75 to 2007 peak of 3.09 (from 2008 Survey)

• 2000 – 2013 range is 2.89 – 3.09

• 2011 is 3.04; 2012 is 3.02; 2013 is 3.07

• Median firm received $3.02 in fees for each $1.00 of direct project labor (down 5¢)

Net Service Revenue

Direct Labor $

9


Improving Your Multiplier

• Being the recognized expert• Private vs. Public• Fixed Fee work allows greater ability to hit higher

multipliers• Fixed Fee leverages superior project management

(bringing in projects below budget)• Increase fees generally• Bill for add-ons, change of scope (don’t give away

the small margin you have)


Net Labor Multipliers

• Watch out for…

• Over and Under reporting of billable hours

• Monthly fluctuations in recognition of revenue


Revenue Factor/Net Payroll Multiplier

Net Service Revenue

Total Labor $

Net Labor Multiplier X Utilization Rate

NSR X DL

DL TL

10


Revenue Factor/Net Payroll Multiplier

• Ratio of net revenue to total payroll dollars (both Direct Labor and Indirect Labor)

• Pure driver of E/A firm profits

• Avoids “gaming” either the Net Labor Multiplier or the Utilization Rate• High dollar people not billing their time to avoid blowing budgets

• People billing time to jobs to look productive (and then blowing budgets and reducing net labor multipliers)


Overhead Rates

• The ratio (as a percent) of indirect overhead expenses to total Direct Labor costs

• OH excluding incentives/bonuses/profit share

• OH including incentives/bonuses/profit share


Overhead Rates

• Lower is better - OH Rates declined from 2009 level of 172.5% to 160.6% in 2013

• Gap implies level of bonus/incentives in relation to DL

• FAR includes bonuses/incentives as allowable; Unallowable costs include interest, bad debts, owner only, meals, other expenses. Generally higher marketing and admin costs related to government contracting

11


Overhead Rates

• Overhead Expenses (as % of NSR)• Payroll items/benefits are largest piece: Indirect Labor (12.9%),

Payroll Taxes (4.8%), PTO (5.2%) and Group Insurance (4.2%)

• Facility rents are second largest (4.9%)

• Then all other selling, general, and administrative expenses

• Since 1984, median OH Rate Before Bonus/Incentives has basically ranged between 140% - 172% (the 29-year high in 2009).

• Down from 160.6% in 2013 (2014 Survey)

• Basic Rule: Maximize DL to minimize IL and thereby minimize OH Rate


Other Earnings Measures

• EBIT = Earnings Before Interest & Taxes (after normalized bonuses)

• EBITDA = EBIT, Depreciation & Amortization (Cash Flow measure) – typically 10-15% median on NSR

• Free Cash Flow (Net Income after taxes, plus non-cash expenses and after reinvesting)


Liquidity Ratios

• Liquidity refers to convertibility to cash

• Short term measure of firm ability to meet upcoming obligations that must be paid in next 12 months with available assets

• Current Ratio:

Current Assets

Current Liabilities

12


Current Ratio

• Typically, has been between 1.8 – 2.3 withdeferred income taxes

• 2014 survey - improved median of 2.24 and mean of 3.86 compared to 2013

• Higher without deferred income taxes

• 2014 survey – improved median of 2.41 and mean of 3.58 compared to 2013


Working Capital

• Current Assets minus Current Liabilities

• Design firms are working capital intensive

• Majority of assets (70+%) are A/R and WIP + Cash

• To assess quality of assets look at turnover periods


A/R Collection Period

• Measures days of average revenue that are outstanding in unpaid bills (accounts receivable)

365

(Gross Revenue / Avg. A/R)

13


Manage A/R Aggressively

If you don’t collect, you lose money so managing this major asset is one of the most important shared duties between the Accounting Dept. and the Project Manager• Contract terms• Stopping work at 60-days• Prime vs. Sub• Gvt actually pays faster (65 days) • Private commercial clients (100 days)• Industrial (75)• Correct format, correct recipient, timing• Timeline/schedule for invoicing and collections process• Rolling billings• Draft vs. final


Balance Sheet Delivered

• M&A Experience would suggest target normalized equity level of 20% of Fee Revenue (NSR)

• Impacted by performance metrics

• Impacted by A/R & WIP periods


Bottom Line in Managing a Successful Group or Business• Grow wisely – target markets

• Strategic Business Planning - focus

• Increase profits and maximize profit margins• Net labor multiplier (above 3.00)

• $$ Utilization (above 64%)

• Overhead control (below 150%, Upper-Q is 137%)

• Bill and collect your money quickly

• Reinvest prudently in your growth

• Maintain strong balance sheet

• Provide shareholder value & opportunity for A-Players

14


Advice

To

Buyers


Buying Firm Considerations

• Have a Strategic Plan

• Develop M&A goals to fit

• Shore up financial performance and conditions

• Develop leadership in-house to help assimilate/integrate

• Evaluate your own internal stock formula – too low a value vs. market can hinder getting deals done

• Be ready to pay to play


Doing Deals Successfully

• De disciplined in:

• Picking targets• Develop investment thesis/goals

• What deals you actually close• Focus Due Diligence on where it matters

• Where and how you integrate the target• Leaders, Projects, Service Lines, Back-office, Culture

• Developing a back-up plan when set-backs or headaches arise• Lost leader, major client, significant project issue

15


Typical M&A Process

• Define Goals and parameters

• Market research – identify targets

• Screen targets

• Develop profiles of targets and prioritize

• Contact & begin “dating ritual”• Confidentiality & Non-Disclosure Agreement

• Negotiate Letter of Intent/Term Sheet

• Due Diligence

• Legal Documents (Definitive Agreements)

• Integration

• Create Value


Valuation


Most Frequent Valuation Approaches• Asset Approach• Adjusted Net Assets Method

• Market Approaches • Guideline Public Company Method

• Mergers & Acquisition Transaction Method

• Earnings (or Cash Flow) Approaches• Capitalization of Earnings of Cash Flow Method

• Discounted Future Cash Flow Method

16


Valuation Concept 1:

Stock

vs.

Enterprise (or Total Invested Capital)

TIC = Stock Value + Funded Debt

Stock Value = TIC - Funded Debt

Hint: Think of your home less its mortgage


Valuing Your Firm

• The value of a business is based on the present value of future expected cash flows discounted at an appropriate risk adjusted rate of return

• Therefore, one must be able to forecast earnings

• And, determine an appropriate discount rate to measure “risk” of those cash flows not occurring

• Relationship between rate of return and “multiples”


Valuing Your Firm – DCF Sample

• Infrastructure Engineering Firm

• $13+ mm Gross Revenue

• $10+ mm NSR

• $8+ mm backlog

• 13% profit before incentives

17


DCF Model ProjectionsDCF Projections DCF Projections

ABC Engineering, Inc. Environmental Health & Engineering, Inc.

December 31, 2013 December 31, 2012

Discounted Cash Flow Method Discounted Cash Flow Method

Projected

Fiscal Year End, December 31 2014 2015 2016 2017 2018

Gross Revenue 14,121,524 15,816,107 18,188,523 20,916,801 24,054,321

Subconsultant, Reimbursables, and Direct Expenses (2,047,621) (2,293,335) (2,637,336) (3,032,936) (3,487,877)

Net Revenue 12,073,903 13,522,771 15,551,187 17,883,865 20,566,445

Direct Labor 3,899,871 4,327,287 4,914,175 5,543,998 6,272,766

Gross Profit 8,174,032 9,195,484 10,637,012 12,339,867 14,293,679

Indirect Labor 3,187,510 3,475,352 3,856,694 4,274,244 4,730,282

Selling, General, & Administrative Expenses 3,139,215 3,515,921 4,043,309 4,649,805 5,347,276

Depreciation & Amortization Expense 115,000 117,500 135,000 142,500 150,000

401(k) and Profit Sharing Contributions 181,109 202,842 233,268 268,258 308,497

Operating Profit 1,551,199 1,883,870 2,368,741 3,005,060 3,757,625 Interest Income - - - - -

Interest Expense (65,000) (52,000) (49,000) (17,000) -

Other Income (Expense) - - - - -

Pre-tax, Pre-bonus Profits 1,486,199 1,831,870 2,319,741 2,988,060 3,757,625

Bonus Expense 743,099 915,935 1,159,871 1,494,030 1,878,812

ESOP Contributions - - - - -

Pre-Tax Income 743,099 915,935 1,159,871 1,494,030 1,878,812

Tax Benefit (Expense) (298,726) (368,206) (466,268) (600,600) (755,283)

Net Income 444,373 547,729 693,603 893,430 1,123,530

EBIT 808,099 967,935 1,208,871 1,511,030 1,878,812

EBITDA 923,099 1,085,435 1,343,871 1,653,530 2,028,812

Changes in Net Working Capital 113,399 144,887 202,842 233,268 268,258

Capital Expenditures 50,000 50,000 150,000 150,000 150,000


DCF Model AssumptionsDCF Projections DCF Projections

ABC Engineering, Inc. Environmental Health & Engineering, Inc.

December 31, 2013 December 31, 2012

Discounted Cash Flow Method Discounted Cash Flow Method

Assumptions

Fiscal Year End, December 31 2014 2015 2016 2017 2018

Gross Revenue 10.0% 12.0% 15.0% 15.0% 15.0%

Subconsultants as a % of Gross Revenue 14.5% 14.5% 14.5% 14.5% 14.5%

Direct Labor as a % of Net Revenue 32.3% 32.0% 31.6% 31.0% 30.5%

Indirect Labor as a % of Net Revenue 26.4% 25.7% 24.8% 23.9% 23.0%

SG&A as a % of Net Revenue 26.0% 26.0% 26.0% 26.0% 26.0%

Depreciation & Amortization Expense as a % of CapEx 230.0% 235.0% 90.0% 95.0% 100.0%

401(k) and Profit Sharing Contributions as a % of Net Revenue 1.5% 1.5% 1.5% 1.5% 1.5%

Operating Profit as a % of Net Revenue 12.8% 13.9% 15.2% 16.8% 18.3%

Interest Income as a % of Net Revenue 0.0% 0.0% 0.0% 0.0% 0.0%

Interest Expense as a % of Net Revenue -0.5% -0.4% -0.3% -0.1% 0.0%

Other Income (Expense) as a % of Net Revenue 0.0% 0.0% 0.0% 0.0% 0.0%

Pre-tax, Pre-bonus Profits as a % of Net Revenue 12.3% 13.5% 14.9% 16.7% 18.3%

Bonus Expense as a % of PTPB 50.0% 50.0% 50.0% 50.0% 50.0%

ESOP Contributions as a % of PTPB 0.0% 0.0% 0.0% 0.0% 0.0%

Tax Benefit (Expense) as a % of Pre-Tax Income 40.2% 40.2% 40.2% 40.2% 40.2%

Capital Expenditures as a % of Net Revenue 1.0% 1.0% 1.0% 1.0% 1.0%

EBIT as a % of Net Revenue 6.7% 7.2% 7.8% 8.4% 9.1%

EBITDA as a % of Net Revenue 7.6% 8.0% 8.6% 9.2% 9.9%

Overhead Rate (excluding bonuses) 171.5% 170.2% 169.3% 168.7% 168.0%

Overhead Rate (including bonuses) 190.5% 191.3% 192.9% 195.6% 197.9%

Utilization Rate 55.0% 55.5% 56.0% 56.5% 57.0%

Net Labor Multiplier 3.10 3.13 3.16 3.23 3.28

Revenue Factor 1.70 1.73 1.77 1.82 1.87


DCF Model ValuationABC Engineering, Inc.

Valuation as of December 31, 2013

Discounted Cash Flow Method

Projected

2014 2015 2016 2017 2018

Operating Income (EBIT) 808,099 967,935 1,208,871 1,511,030 1,878,812

Less: Implied Taxes on Operating Income (324,856) (389,110) (485,966) (607,434) (755,283)

After-tax Operating Income 483,243 578,825 722,905 903,596 1,123,530

Plus: Depreciation & Amortization 115,000 117,500 135,000 142,500 150,000

Gross Cash Flow 598,243 696,325 857,905 1,046,096 1,273,530

Net Change in Working Capital (113,399) (144,887) (202,842) (233,268) (268,258)

Capital Expenditures (50,000) (50,000) (150,000) (150,000) (150,000)

Gross Investment (163,399) (194,887) (352,842) (383,268) (418,258)

Free Cash Flow to Invested Capital 434,844 501,438 505,063 662,828 855,272

Weighted Average Cost of Capital 16.70%

Discounting Periods 0.50 1.50 2.50 3.50 4.50

End of year Discount Factor 0.93 0.79 0.68 0.58 0.50

Present Value of Cash Flows 402,530 397,751 343,296 386,058 426,860

Present Values of Interim Cash Flows 1,956,495

Cash Flow Year 5 855,272

Growth Rate 5.0%

Cash Flow Year 6 898,035

Discount Rate less Growth 11.70%

Terminal Value 7,675,516

End of Year Discount Factor 0.50

Present Value of Terminal Year 3,830,793

Marketable, Minority Enterprise Value 5,787,288

Less: Debt (1,412,698)

Marketable, Minority Equity Value 4,374,590

Less: Marketability Discount of 5% (218,730)

Non-Marketable, Minority Equity Value 4,155,861

18


Firm Value is About

• Expected EARNINGS

• Volatility of Earnings (i.e.., perceived riskiness of achieving projected earnings)

• Adequate capital underlying the business

• Caution with reliance on Net Revenue or book value – they are only one factor


Developing Valuation Expectations

• Multiple could depend on various risk factors

• Counter balanced against other risks, fit, and balance sheet delivered

Profit Net Pre-Distribution Assumed Val Estimated

Firm Performance Margin Revenue Profits Multiple Value

Lower Quartile Profit 6.5% 10,000,000 650,000 x 4 2,600,000$

Median-Mean Profit 14.0% 10,000,000 1,400,000 x 4 5,600,000$

Upper Quartile Profit 21.0% 10,000,000 2,100,000 x 4 8,400,000$


Structuring

the

Transaction

19


Transaction Structures

• Asset Purchase• Over 2/3 of transactions

• Cherry pick assets and liabilities

• Avoid certain liabilities

• Step-up tax basis of hard assets

• Contract novation

• Transfer of title to assets

• Target company continues to exist

• Buyer may need to pay-up to mitigate tax hit to seller

• Tail Insurance for the seller



• Stock Purchase• Target owners sell stock to Buyer corp.

• Target becomes subsidiary of Buyer and continues to operate its assets

• No cherry picking assets and liabilities

• Buyer assumes all liabilities

• Capital Gains Tax to Target owners

• Buyer may offer less to assume risks



• Merger

• A combination of 2 firms where one firm survives and is successor to all assets & liabilities of other

• Two firms become one

• Consolidation – a whole new firm is formed

• Continuity of ownership by target shareholders• At least 50% stock in combined firm

• No tax on stock exchange

• All risks and liabilities convey

• Takes form of Statutory A, B, C, Forward, or Reverse Triangular Reorganizations

20


Other Transaction Items

• Lifetime Capital Gains Exemption• Every shareholder gets this

• What is not used is carried-forward

• 50% of Capital Gains are taxed, but still lower rate than income

• Due to more complex organizations because of tax ramifications related to the small business exemption/deductions• Management fees between “related” companies


What to Expect in a Transaction

• Buyers want to Purchase Assets

• Sellers want to Sell Stock

• Typical consideration:• Cash

• Seller financed note

• Buyer stock



• Buyers will want current management team (or next tier) in place and tied to the deal• Employment Agreements

• Non-Compete & Non-Solicitation Clauses

• Earn-Outs

• Stay Bonuses

• The dating ritual and process takes longer than you think

• Buyers want to limit the Goodwill they put on books

21



• Under-capitalized firms likely to receive lower valuation

• Buyer will have to reinvest

• Due diligence is critical (2-way)

• Integration

• Is there a cultural fit


Q&A - Discussion

• What else can I tell you?


About Matheson Financial Advisors

Matheson Financial Advisors, Inc. (“Matheson Advisors” ) is a boutique corporate

financial advisory services firm providing M&A advisory services, internal ownership

transition and management buy-out consultation, Employee Stock Ownership Plan (ESOP)

solutions, and business valuations for a variety of purposes. Our clientele includes firms in

the engineering, architectural, environmental consulting, construction, and government

contracting industries, as well as other professional service firms. We offer the technical

expertise of larger investment banks, combined with the personal service and relationship

orientation of a smaller boutique advisory firm.

David Cohen, Esq., ASA

Managing Director

Natick, Massachusetts

[email protected]

tel: 508-655-9700

22


Save the date…

Navigating Mergers and Acquisitions in the Recovery Decade · M&A Paradox •Studies show •70+%...

Documents

Transcript of Navigating Mergers and Acquisitions in the Recovery Decade · M&A Paradox •Studies show •70+%...