Weekly Thoughts

Here are three things that caught our eye this week:
 

BizBuySell Insights

As the world’s largest small business listing aggregator website, BizBuySell.com has a unique window into small business acquisition activity. As such, this week we were eager to read BizBuySell’s 2Q 2015 Insight Report, which has consolidated transaction statistics that provide a valuable perspective on the state of this corner of the M&A market.

According to the report, listing activity is healthy, up 12% year-on-year and at its highest point since 2Q 2009. Median sales price remained at $200,000, the same as the previous quarter, but still at six year highs. Of the 1,913 businesses that were sold, median revenue was $450,000 (the highest since 2007), with cash flow of $102,995. Bob House, Group GM of BizBuySell.com, elaborates on these trends:

“We’ve been riding a wave of increasing financial performance and transaction totals for a couple of years now, but it’s great to see the supply of listings increase as well because it shows that small business owners are buying into the trend. As business financials continue to improve, and Baby Boomers reach retirement age, we expect the supply of quality small businesses on the market to remain strong.”

Regarding valuation, average sales price came in around 2.3 times cash flow. Valuations vary widely by location, however, with the cheapest markets like Las Vegas (2.39 times cash flow), Stamford (2.43), Boston (2.50), and San Diego (2.53) discounted significantly compared to the most expensive markets like New Orleans (4.39), St. Louis (3.94), Cincinnati (3.56), and Charlotte (3.55). BizBuySell notes that regional inventory levels and mix, and the presence of local buyers, can drive significant valuation differences between geographies.

Interestingly, the same is not true when you look across business sectors. A summary of the survey data below makes it easy to see that small business transactions are dominated by the retail and service sectors, with valuations generally even across industries.

Despite the disproportionate representation of smaller, retail oriented businesses in the survey, our personal experience suggests that the attractive environment for deal activity continues to exist as one moves slightly higher up the cash flow scale. That said, we also observe that price is exponentially correlated with business size, with kinks at certain cash flow hurdles after which institutional investment becomes involved. As such, we aim to focus on opportunities that stay below the radar of institutional and strategic buyers, while still benefiting from the supply side dynamics outlined in BizBuySell’s report.

BizBuySell
 

The Profit

As a group, we are big fans of CNBC’s reality TV show The Profit, where Camping World Chairman and CEO Marcus Lemonis uses his personal capital to invest in struggling small businesses. Over the past three seasons, Lemonis – who consolidated mom-and-pop RV dealerships into an empire with more than $2.5 billion of sales – has invested more than $23 million in 15 companies, some of which have succeeded, others of which have failed. We particularly enjoy the show because it offers tangible insights into the potential benefits, as well as the trials and tribulations, of small business investing. This week, we took time to read some interviews with Lemonis about his approach to both investments and operations.

According to Lemonis, small business owners tend to make the following five key mistakes when it comes to operating their company: not understanding the importance of people, not knowing their financials, making ego-based business decisions, not picking the right products, and finally, an unwillingness to be vulnerable, honest, and transparent. Lemonis believes that any struggling businesses can be saved, but that in order to do so, the owners must be willing to ask for help, and be open to making drastic changes.

When initially assessing a business, Lemonis needs to ask the right questions to uncover potential issues. In a 2014 Forbes interview, Lemonis provided insights into his approach for gathering information from business owners:

“Usually you can figure out where a person’s mistakes came from if you ask them the genesis of their thought process. Why did you do it this way? As opposed to telling them they did it the wrong way. Understanding their thought process will ultimately help you be able to communicate with them and navigate around them. Then teaching them that their thought process could have been done differently, feels more constructive than destructive. Understanding why it is that people did things a certain way is the most important question.”

While The Profit centers around Lemonis helping companies improve their bottom line by focusing on people, product, and process, it’s not just a one-way transaction. The show has also improved Lemonis’ ability to partner with small business owners. In a recent interview, when asked about the most important thing he’s learned from the show, Lemonis responded:

“The importance of giving someone a second chance. You’ve seen people be rude to me, totally nasty, and I’ve put it into context and understood it’s the circumstances and give them a second chance. It’s taught me to be more willing to stay longer, listen more and build my tolerance when people are just off the wall crazy. I’ve slowed down and it’s made it better for me and the business.”

We take Lemonis’ insights to heart, and aim to refine our ability to create effective partnerships with small businesses by targeting areas that tend to create problems, by asking the right questions about thought process, and by understanding that we have as much to learn from small business owners as they do from us. Along the way, we’ll continue to follow Lemonis’ business adventures, both on and off television.

Forbes, Marcus Lemonis, Mercury News
 

Small Business Optimism

We are excited about the increasing small business deal activity discussed above, but the picture isn’t entirely rosy. While there certainly is a demographic factor contributing to increased listing volume, we’ve also come across evidence that sellers may be putting their companies on the market because it is simply harder to manage a small business today than it was ten or twenty years ago.

We recently started following the National Federation of Independent Business (NFIB) monthly sentiment surveys. Conducted since 1986, these surveys provide insights into small business owner expectations across multiple categories, such as hiring, capital expenditure, inventory, sales, credit, earnings, and expansion plans.

While small business optimism has improved following the Great Recession, the path of recovery has not been typical. Usually, after an economic shock, there will be early, unanticipated surges in optimism, followed by aggressive capital outlays, which eventually taper to average levels (notice the v-shaped bounces in the early ’90s and again in ’03). In contrast, the current recovery path has been a slow, somewhat erratic grind upwards over the past six years as the chart below shows:

Despite the recent upward trend, small business sentiment remains below pre-2008 averages, a figure seemingly at odds with the public markets, which have comfortably exceeded prior 2007 highs. While some finance-minded observers might initially point to lack of credit as a key headwind for this sector, finance is actually the least pressing issue from an owner’s perspective. When it comes to drags on sentiment, NFIB survey respondents reported that the biggest problems facing their business today (in order) are taxes (23%), government regulations and red tape (20%), quality of labor (12%), poor sales (10%), cost/availability of insurance (9%) , competition from large businesses (8%), cost of labor (8%), inflation (4%), and lastly, finance and interest rates (1%). Additionally, as reported by NFIB, “Owner expectations for the economy appear to be for a continuation of ‘under-performance.’ Consequently, investment plans remain historically sub-par and owners have little interest in borrowing to support investment spending that promises little return.”

We all know that the psychology of business sentiment plays a huge role in shaping our economic realities. While we’re pleased to see small business confidence gradually improving, the NFIB survey points to deeper, structural issues plaguing America’s entrepreneurs and by extension, the dynamism of the economy. The survey results suggest that many of the most pressing issues facing small businesses are public policy related. We agree with that notion, but also recognize that true change will only come if the small business space has advocates that are willing to put their money where their mouth is. In doing so ourselves, we hope to play a small contributing role in improving the prospects for small businesses going forward.

Forbes, NFIB
 
Have a great week,

Your Chenmark Capital Team