A curious question has come up among some buyers we deal with who are acquiring LBM businesses. A few buyers have asked why gross profit margins have stayed the same throughout the volatility of lumber prices.
As background, here is what was likely happening on your profit and loss statements as lumber prices changed: When lumber prices spiked (let’s say they ran up 30% for the purposes of discussion), a stick of 2X dimension lumber sold for 30% more. So, a 2X item that would have sold for $10 now sold for $13.
Now, let’s say that your EBITDA margin is 10%. With that EBITDA margin, 10% of your net sales dollars are EBITDA. (That 10% figure, by the way, is pretty much the “mean” for our clients, e.g., half of our clients are above the 10% EBITDA margin, and half are below it.)
When the stick of 2X was $10, and you are operating at a 10% EBITDA margin, you booked $1 in EBITDA on that sale. However, when the same stick was $13, you booked $1.30 in EBITDA. But—and here’s the key concept—the higher priced lumber did not require a corresponding increase in OPEX to deliver it. Even though it cost more to the customer, you used the same staff, the same trucks, the same yard bays, etc., to make the sale. The operating costs did not increase, even though you made an additional 30 cents on the sale. So why would your gross profit margins change, up or down?
In the LBM deals that we sold in both 2021 and 2022 (numbering seven and counting) when our clients were living through the lumber run-ups and run-downs, their gross profit margins did not change. They were largely in a steady state, year-in and year-out.
What did change (to their distinct advantage) was a climb in gross profit dollars. Essentially, they saw more sales dollar volume. And what happens to EBITDA if gross profit margins and EBITDA margins are in a steady state, and you see more sales dollar volume? You see more resulting EBITDA dollars.
In many areas of life and business, when your gross profit dollars go up, there is a feeling that it’s OK for OPEX to increase, because, hey, you’ve got more money coming in. Let’s say you get a bonus at work. You come home and say to your family: “Hey, guess who’s taking everyone out for steak dinner!”
See, gross profit dollars went up (someone got a bonus), and OPEX went up too (in the form of a hefty restaurant bill).
However, for LBM dealers, congratulations are in order! Among our clients, we have not seen reckless spending on OPEX as more gross profit dollars flowed in due to increased commodity prices. In fact, we have seen almost no increase in OPEX at all, except to accommodate organic growth. Gross profit margins stayed steady because owners exercised discipline on OPEX expenditures.
Candidly, it may have been tempting for some business owners to feel flush and run up OPEX during what were (and remain) relatively flush times. But we have not seen that among our clients or even more broadly in the industry. What difference do “steady state” gross profit margins have on a business’ acquisition value? Lots. And in a very positive way. Discipline around OPEX expenditures, and a consistent (or better yet, increasing) gross profit margin shows that the company is well-run and that the owners are watchful of the leading key performance indicators: Net sales, EBITDA, EBITDA as a percent of sales; OPEX, OPEX as a percent of sale; Gross Profit, and Gross Profit margins.
What’s more, the MBAs and CPAs that work for the acquirers watch these same KPIs, and if they see gross profit margins or other KPIs go sour over time, or show lack of OPEX control, they might just recommend to their investment committees that, well, maybe the target company should be valued at 4.5X and not 5X, which can have a serious effect on the purchase price indeed.
