M&A: CONCEPTS AND THEORIES

NEW YORK INSTITUTE OF FINANCE

Money losing or erratic track record companies

All right. So let's look at money losing companies for a second. You might say, why
do I want to study money losing companies. Why do I want to do that? Why do you
think you want to do that?

Probably cheap.

Yeah. They're cheap. They're cheap relative to money makers. You ever go look for a
house and someone shows you a fixer-upper, they call it? Fixer-uppers are a lot
cheaper than the one where everything's brand new. I didn't know this until I
started teaching this subject, but you know, if you look at the New York Stock
Exchange or the NASDAQ or the FTSE or any of these indexes, about one third of
publicly traded companies lose money, on an accounting basis. It's a surprising
statistic, isn't it?

So there's plenty of them that lose money that you're going to need this for. So how
do you value that? Well, you're going to, sometimes they might have positive
EBITDA but lose money, you know, lose net income. So that's one thing. You could
average the income. We'll talk about these methods, shorthand, multiples. They
might be cyclical. So you know, they lose money. Like a brokerage firm, often, will
break even in the down cycle, then they'll make huge amounts of money in the
upcycle.

And of course, we were talking about high tech companies just a minute ago. A lot
of them lose money. They got huge value. They've gone public every week, some
money loser. So cyclical firms, you know, if it's got a up and down cycle like this,
you know, you might look at the average and then multiply 8 times the average
EBITDA. That's for a cyclical.

Because, you know, you can't-- if the cycle's here, if you multiply this times 8, you're
paying way too much. And here it's losing money. So of course, there's no earnings
to multiply. But you know, a car company is it typical-- like the car companies are

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making huge amounts of money right now. But a few years ago, on the down cycle,
they were losing huge amounts, you know. A couple of them had to be bailed out,
as you were saying, by the government.

So here's an example of a cyclical valuation. Here's our EBITDA. You know, here's the
recession. So the average is 111. You might look at the average EBITDA for a seven
year cycle. What's the average EBITDA ratio that companies are trading for. You
know, multiply it. A little simplistic, but I think it's realistic.

A lot of firms got a fair degree of cyclicality. Or sometimes we might look at the
weighted average, assign most weight to the last couple years. So latest year is
40% weighting, and then less weight. That's another way of figuring out a weighted
average EBITDA number.

So with the money losers that aren't cyclical, you know, just losing money for some
odd reason, the accepted notion tends to be, as I said earlier, you use EV to
revenue, saying, god, the company is doing something right. It's selling product or
services. But just like a fixer-upper in real estate, a fixer-upper in the corporate
world trades at a discount.

So as you can see from this chart, if a good company is trading at 1 times revenue,
the fixer-upper gets a big haircut, or discount. Maybe 40%, 50% is normal. So you
might say, well I don't want to pay anything for a money losing company. But you
know, you would be in the minority because a lot of firms want to buy money losers.
Because as someone had said, they're a bargain. They're much cheaper.

And then optimism being what it is in the M&A business, they say, I'm going to buy
it at half price and then I'm going to reform it. I'm going to take that lousy looking
house, I'm going to put some new paint on it, I'm going to cut the lawn, I'm going to
put in a new kitchen, new bathrooms, and then I'll have a really valuable property.
That's the same mentality here.

So this might be a chart for a money losing company. Here you can see it's got
revenue of a billion, and it's losing $10 million. Here's the profitable comparables
index, right? It's 1-- I got to apply my haircut-- so I'm saying the suspect company
will be 60%, or $600 million in value.

Now that being said-- take it from me-- selling a money loser is tough. If you're an
investment banker for a company that's losing money, it's a tough sell. Many

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companies refuse to buy them. They say it's too risky to buy a money losing
company when they can go out and find a company that makes money. So why
should they take all the risks? That's one issue.

The other issue if you're an investment banker for a company that's losing money,
the first question you always get is why is it losing. So you constantly are put on
the defensive as the seller's advisor. Now the turnaround, you know, again, it's a
money losing company. But this is supposedly what people are thinking when they
buy a money loser, they're going to turn it around.

So here's the share price of the loser. But once we turn it around, we fix it, and it's
going to go up. What happens in reality, a lot of times, the fix up process either
doesn't happen or just takes longer than you think.

I mean, how many TV shows have you watched in real estate where somebody is
going to gut the bathroom and put in a new kitchen? And you know, the contractor
says, OK, Mrs. Smith, this is going to take us six weeks. We're going to be in and
out of here in six weeks. You're going to have your new bathrooms and new kitchen.
And three months later, it's still not done. You know, so the corporate world is not
too different.

Sometimes with these companies, you know, we talked about enterprise value, the
sales as a metric. This is a popular one. If they have EBITDA, maybe you can try
EBITDA. We talked about averaging income if it's cyclical. If it's really got problems,
serious problems, this is another metric that people look at, price to book value,
tangible book value, which means hard assets, inventory receivable.

And so they'll say, you know, if nothing works out and I just got to liquidate the
company and fire everybody, what's it worth. So 1 times net tangible book value is
what some people look at as a downside case. Now I know a couple of you are from
overseas, but in the United States, there's a whole industry devoted to buying
companies that lose money. It's called the distressed private equity industry. And it
must have at least 1 or 200 billion under management.

So you've got all these vultures picking off the dead carcasses of these weak
companies, trying to reform them and buying cheap. And sometimes the companies
have gone bankrupt and they're buying the debt of the bankrupt companies and
then transforming the debt into equity. It's quite interesting. I mean, you're playing
statistical odds here, so.

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Or even the venture capital business. All these private equity guys, you know, if
they do 10 deals, well, they're probably looking at three to four bankruptcies, I don't
know, maybe three to four OK returns, you know, maybe 5% to 15%. So clearly if it's
bankrupt, you get a zero return, right? And then they might get two IPOs or just
huge returns. You know, which might be on the order of 50% a year or something.

So the combined average might be 15% or something. Maybe if they're lucky, 20%. I
mean, a lot of them don't return anything, you know? It's hard if you've got two or
three zeros to make a combined return of 15% or 20%. But as I said, you've got to
be an optimist if you're in this business.

You know, you can't let bankruptcies get you down if you're in the private equity or
buy out business. Same with venture capital. You know, all these guys you read
about in Silicon Valley-- their great successes investing in Facebook-- that was 1 out
of 100. Figure 90 of their deals went bankrupt. That's the venture capital business.

So here's a calculation on net tangible assets value. You can see they're really
looking at current assets, net fixed assets. They got debt and stuff. So the book
equities, as you can see, is 350 here. But you have to subtract out goodwill and
intangibles. Because if this company had any real good will or intangible value, it
wouldn't be losing money. It wouldn't be going bankrupt, would it?

So the net tangible book value is 250. Maybe, if you're lucky, you could liquidate
the company and get face value for those tangible assets. So, you know, this stock's
worth $25 in a liquidation that's trading at $20. So you could say it's a slight
bargain.

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