Revenue is not profit

Dozens of times in my career selling and valuing businesses, a business owner will point to his revenue (a.k.a. “top line”) and say, “Look, my company is doing fantastically well! We had $20 million in revenue per location.”

The potential glitch here is that attaining high revenue is not the same as dropping a meaningful number of those revenue dollars to the EBITDA line. The old saying, “There’s many a slip between cup and lip,” is never more true than when you, as a business owner, realize that the $10,000 sale of a framing package actually lost your company money by the time the package was engineered, the good-customer discounts were applied, the products got to the job site, and you waited 95 days to get paid for it. So, when a business owner says, “we’re doing great!” and cites his top line as the indicator, that operator may not have his eye on the metrics that acquirers find most important when buying a business. Let’s look at those, including:

1.   COGS (Cost of Goods Sold—the dollar amount, and as a percentage of revenues)
2.   Gross profit (expressed as a percentage)
3.   Customer concentration for top 25 customers (expressed as a percentage of overall sales)
4.   OPEX (Operating Expenses—expressed as a percentage)
5.   EBITDA (expressed as a percentage, also, most important)

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In each and every deal we do, potential acquirers will want to know the revenues, sure, because that will show the orders of magnitude of the EBITDA. But the next two questions inevitably are: What’s the EBITDA and what is the percent EBITDA? In other words, how much free-flowing cash does the business kick off under the current operations?

Let’s look at an example. For ease of math, if you have a top-line revenue of $10,000,000, and an EBITDA of $2,000,000, you have an EBITDA percentage of 20%. That means that 20 cents out of every top-line revenue dollar is not spent on cost of goods sold (COGS) or operations (OPEX). Believe it or not, there are some companies that operate in the 50% or higher range of EBITDA, but they are “companies that sell copies,” like software or service providers that have low delivery costs and little cost for inventory. EBITDA margins in the lumber, building material, and building products industries vary by sector. We have seen pure lumber dealers with lots of commodity sales essentially break even, operating at or near 0% EBITDA, or they perform in the low single digits.

As a lumber dealer moves into higher-margin, valued-added services, the EBITDA can climb well into the high teens. Truss and component plants are also putting up solid EBITDA numbers, especially if the operations are automated or have automated elements. For building products companies, EBITDA margins are strong for well-run businesses, often because they may not have the same challenges of weather, inventory, damage/returns, scheduling, and labor. Acquirers aren’t in the business of granting you extra business value just because your workday is full of challenges. They are buying a business for its cash flow, and EBITDA is an expression of that.

For the other metrics mentioned above (COGS, customer concentration, gross profit, OPEX), these are the KPIs that are used to determine the value of your business, because their performance feeds the EBITDA. An acquirer may look at the EBITDA performance and perhaps find it lacking. Then they will look at your performance in COGS, customer concentration, gross profit, and OPEX to determine exactly where your performance is subpar. Some acquirers may spot something amiss in those KPIs and not tell you what they see. That latent value may attract them to the deal, which they will buy as a multiple of current EBITDA, then take ownership and immediately improve the EBITDA, thereby driving down the effective multiple they used to make the acquisition. The best way to prepare for an acquisition that avoids this trap is to make sure your KPIs are all performing within the “swim lanes” of business of your size in your area, and focus on EBITDA performance.

 

John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com.

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