Company A vs. Company B
Thoughts on quality and price
Here is a description of two companies:
Company A is the clear market leader in its industry. It has a long-tenured and deep management team beyond the retiring founders. It has audited financials and a detailed operating budget that is consistently accurate. Despite some minor seasonal fluctuations, revenue is remarkably predictable and there is no customer concentration to speak of. Capex has been low historically, working capital is structurally negative, and margins are in the high 20% range. Furthermore, much of the free cash generated in the last several years has been reinvested back into the business, which should lay the groundwork for further expansion of revenue and earnings in the future.
Company B is a small player doing single-digit millions of revenue in a $50bn industry. It has two different sets of financials that don’t tie to each other and don’t conform to any known accounting standard. There is no one with any customer relationship, or any finance/accounting experience outside of the owner who is looking to retire. While margins are in the 40% range, earnings appear to fluctuate (sometimes significantly) year to year and the owner doesn’t follow any type of operational budget because at some point “a lot of money is just a lot of money and an extra few 100k doesn’t matter too much”. Oh, and working capital is about 30-40% of revenue.
Let’s say you are running a holding company and you can buy either company A or company B. Each one represents a meaningful percentage of your trailing EBITDA so either would be a pretty significant investment. Which would you choose?
Pretty tough to argue against company A. It certainly presents as a high-quality business and checks a lot of boxes on the “right” type of business to buy.
But, we haven’t talked about price. What if we told you that to buy Company A you’d need to pay over twice the multiple required to buy Company B, and that the valuation of the latter is slightly below the market value of the company’s assets? Does that change anything?
We bring this up because over the last two years we passed on Company A and bought Company B.
How does this make sense? There is no question that Company A was an attractive, professionally run business. But solid businesses of this sort command high prices, and that naturally compresses prospective returns and puts pressure on the diligence process. We need to underwrite close to our hurdle rate to get the deal under LOI and then we need most assumptions about the business to play out exactly as we expect in order to confirm the agreed-upon price is worth paying. Unfortunately, in this case we had several discoveries in diligence that required us to lower our expected return to a level that wasn’t attractive, especially relative to the bet size.
The opposite dynamic existed in the case of Company B. We knew going in that issues existed, but we felt the deal was priced accordingly, well above our hurdle on a probability weighted basis. So, when diligence confirmed that, for example, the accounting was not done particularly well, we felt we were being compensated to take on that issue. We also saw a path to cleaning up many of the finance, accounting, and business intelligence problems, and knew that in an extreme downside scenario, we could sell off assets and get our money back.
The key point is not that low prices beat high prices or that there is some formulaic rule that we must follow at all times. There are plenty of examples of businesses that are “cheap for a reason” that end up being even worse than expected, and there are certainly businesses that are worth every penny of a high valuation.
Instead, the key thing we try to remember is that in any deal, business quality, price, and the associated expected return are all highly nuanced factors that can intersect with each other in ways that can be counterintuitive. Our challenge, or as we like to say, our opportunity, is to be thoughtful and disciplined in how we evaluate all three factors to arrive at the decision we feel is in the best interest of Chenmark.
Are we going to get it right every time? Absolutely not. We have and surely will continue to make errors of both omission and commission. But if we stay committed to our processes and look for ways to gradually improve them, we feel we’ll end up getting it more right than wrong in the long run.
Have a great week,
Your Chenmark Team