In a typical summary financial statement, the key items are sales, total cost of sales, gross profit (and resulting gross profit margin, or GPMs), operating expenses, operating income (and other income), and—after calculating interest, taxes, depreciation, and amortization— EBITDA.
Most investors focus on EBITDA, or adjusted EBITDA, which adds back one-time credits and adjustments. The efficiency with which you deliver EBITDA to that bottom line is expressed as an EBITDA margin. For instance, if your EBITDA margin is 10%, that means $100 of every $1,000 in sales ends up as EBITDA.
When considering an acquisition, buyers will focus on the difference between the GPMs and the operating expenses as a percentage of sales (OPEX %), which translates to the operating income margin (OI %). OPEX % is a key performance indicator, and every buyer analyzes it closely. Those same buyers know what the OPEX % should be, and they are quick to pick up when you are out of the “swim lanes,” either in a good sense with low OPEX %, or when OPEX % is above the norm.
Why would an investor focus on that differential? Because a seller that is producing strong GPMs yet falling down on EBITDA presents a genuine opportunity for the buyer. Here’s why: Deals are priced as a multiple of EBITDA (or adjusted EBITDA). Let’s say that the EBITDA multiple in our example is 5X. A company with $50m in sales and a 10% EBITDA margin or $5m in EBITDA would be worth $25m in an acquisition.
But let’s say the acquirer has noticed that OPEX is out of line and the seller is overspending on OPEX as a percentage of sales. This overspending in controlling OPEX has suppressed EBITDA, and therein lies the opportunity.
The buyer sees where he can cut OPEX and feed the EBITDA line more efficiently. Whereas the seller may have an OPEX % of, say, 23%, the buyer does some math, sees some cuts, and thinks he can drive that down to 21%. A $1m decrease in OPEX represents $1m in additional EBITDA (a 20% increase). Without even driving up sales figure or GPM, the buyer can get a 20% improvement on EBITDA by controlling excess OPEX.
The buyer sees that the $5m EBITDA, which at a 5X drove an enterprise value of $25m, can move after the acquisition to an EBITDA of $6m. At 5X $6m, the seller should have gotten $30m, but ended up with $25m. The buyer will pocket $5m “extra” in enterprise value through OPEX reductions.
Now, think in terms of multiples when examined in retrospect after the buyer’s improvements to OPEX. The buyer purchased the company for an effective multiple of 4.16X instead of the 5X they paid. That’s approximately a “one full turn” (5X to 4X) reduction, and on the basis of a $5m EBITDA, it’s truly meaningful money.
Where can OPEX savings be found? Sharpen your own pencil before you even think about selling your company, and take a critical look at each of these categories: Salaries and wages, officer compensation, rent, employee benefits, sales and marketing, outside trucking, office expenses, warehouse expenses, rolling stock repairs, bad debt expense, dues and subscriptions, travel expenses, as well as advertising, and credit and collection expenses. Can you see savings?
If you can improve your OPEX spending in any of these common OPEX line items before you go to sell your company, you’re taking giant steps toward pushing up that EBITDA to where it needs to be and achieving top value for your company in an acquisition.
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
