K.White book

Innovation for Business: a 21st Century Development Model for Russia

Part XV

A case study    

Let’s take a look at a specific case study example from the cosmetic sector.

This is a project which we worked on some years ago; the company from Siberia was a successful regional cosmetics maker. We wanted to help the owner develop his investment strategies, find a valuation, and bring investment into the company.

When we started the process, the CEO of the company owned 100% of the shares and simply wanted to get bank credit. We spoke to him about different alternatives and what the valuation of his company would be if instead of a $5m bank loan he got $5m in equity. We also presented him two more scenarios of what the development of his company would be like if he agreed to sell shares in order to raise $10m or $20m.

In the end we created with the CEO a series of financial models to help him determine the best strategy for the company maximizing the value of the firm for the shareholder.

The guiding multiples

We started by making an assessment of an equivalent Western company in developed markets, such as L’Oreal, Colgate Palmolive, etc. We also looked at companies in developing markets in Asia and Latin America. And we looked last at Russian companies, specifically Kalina that had once received investment from the EBRD in the late 1990s and eventually went public with the help of Troika Dialog.               

We analyzed valuations based on sales multiples, EBITDA multiples, and profit multiples. We could clearly see for developed markets that an average sales multiple was 2.1.

What does that mean? If Avon, for example, had $1bn in sales, the valuation would be somewhat over $2bn. The sales multiple means you take an amount of sales and multiply it by a multiplier, and that becomes a market value of your company. Western companies had an average of 2.1.

For developing markets the multiple is lower because transparency is lower, the companies are younger, have less history, less liquidity in the market, and so on. So in that case their average was 1.9.

For Russia, we saw that Kalina’s sales multiple was just 0.9. Back in 2005 Russia had a much higher level of systemic inflation, mafia problems, excessive currency controls, over-reliance on its oil sector, less diversified federal macro-economy, less sophisticated financial services, and so on. The confidence and risk levels were quite different from the other markets meaning the discount factor was higher. So evaluation for Kalina was half that for other emerging markets.

Looking at our client we applied a discount factor even higher and showed that the company was not 0.9 times sales but rather 0.75 because compared to Kalina our particular client was not a publicly traded company, did not have other investors, did not have transparent accounting, and had only one shareholder. So the risks were simply higher.

Analyzing other multipliers, we could see that for Western companies EBITDA was an average of 11.1; emerging markets had an average of 7.3; and Kalina had 5.9. Our client had 5.

If we look at profit multiples, then the multiplier for transparent Western companies was 37.8; for developing markets it was 11.2; for Kalina it was 10.4; and for our client it was 8.0.

Low profitability means management inefficiency

We then looked in more detail at a specific company example, which was Beiersdorf, a Western, fully transparent company; we looked again at Kalina; and at our client. How did these companies compare from direct statistics?

For Germany’s Beiersdorf the sales were very significant: EUR4.5bn in 2004 and EUR4.8bn in 2005. It’s a very serious company. But the sales were not growing very fast.

The EBITDA margin, however, showed very good results. So, the Western European company had slow sales growth but very nice 14.4 and 14.5 EBITDA margins for 2004 and 2005. It had net profit margins of 6.7 and 7.0 in 2004 and 2005.

What does that mean? It is a very large Western company with not very fast sales growth but very high marginal profitability. The company had made itself very efficient, transparent, productive and profitable, and it achieved a very good valuation at international stock markets.

With Kalina, we could see that the sales proceeds in 2003 were RUR4.8bn, but in 2004 they jumped to RUR5.2bn and in 2005 to RUR8.1bn. So the sales growth was phenomenal. The firm achieved more than a 30% increase and was rapidly expanding.

At the same time the Russian company was able to maintain in excess of 15% EBITDA margins and more than 10% profit margins. The firm was obviously being run very efficiently. It had fast growth and, at the same time, high marginal profitability.

This made it a perfect candidate for an IPO, which took place later and was very successful; the EBRD was considering Kalina one of its greatest success stories in Russia.  

Coming back to our particular client, we could see that sales in Russia in 2003 were RUR1.3bn. In 2004 they were RUR1.4bn. In 2005 they were going to be RUR1.6bn. The firm showed very moderate growth; it was a good and stable company.

But the real problem came when we looked at EBITDA; it was less than half the marginal profitability of Kalina. The net profitability of the company was miserly; in 2003 it was 2%, in 2004 it rose to 5% but then in 2005 it fell to 3%.

What did those numbers tell us? The company had a slow rate of growth; it had a stable market share but not growing; and compared to Kalina—one of its main competitors—its profitability level was extremely low. That told us the company was not being run efficiently.

One can speculate why the company’s profitability was so low but from an investor standpoint the low profitability level meant management inefficiency. This meant that the investments required for restructuring to make the company more profitable and efficient were going to be much more significant from both the capex and management standpoints.

This ranked the firm among those with fundamentally higher risk levels than Kalina, driving valuations down substantially through soaring discounts.

$5m in credit or $10m in equity?

We started making the company’s business plan. We put it into a standard financial format analyzing the past several years and a five-year forecast. We came to an agreement that the valuation of the company at the beginning was approximately $50m.

Then we projected out the client according to the CEO’s assumptions that his company would be valued by 2013 at more than $200m. But that was based on the CEO’s plan to get credit rather than equity.

We made our own assessment and found that over five years the company would not be worth $200m but rather $120m. So our valuation was almost a hundred million dollars less than his, prompting us to conclude than the CEO’s business plan was inaccurate; it wasn’t achievable because the assumptions made would not ensure the results.

There was not enough money to be invested into marketing, branding, quality control, packaging; there was not enough liquidity to develop proper advertising campaigns; too little money was going into R&D; and therefore the company products would suffer, and the firm would not achieve sales results and was likely to lose its market share. The overall economy might be growing dramatically and sales would actually be growing, but the valuation would not be what the CEO wanted.  

We posed a question: what if the company raised not $5m in bank credit but $10m in equity?

What’s the difference? If you get a loan, you will, very quickly, have to start repaying both the principal and the interest. It means your cash flow is drained to pay this loan back; you have less cash to invest in the growth of your company.

Normally, when a company is getting a loan, it wants to buy a large piece of equipment, which, when installed, will within some years generate the cash flow to be used to pay back the principle and the interest on the loan.

But in our case the company needed a dramatic investment into branding, marketing, quality control, packaging, distribution, and sales. There were more working capital requirements. It doesn’t make much sense to take out bank credit to finance working capital needs at such an extreme level.

What looks like a smarter move is to sell equity of the company to equity investors who are not demanding their money back immediately. The investor should be interested in growing the value of your company, and the investments that our particular client needed were required to exactly increase the overall value of that company.

The return could not be seen immediately in cash flow; it takes time. But overtime the growth in the company’s position in the market should be substantial, meaning that theoretically the value of the firm would grow much higher with this type of investment and with the ability to take all the cash flow that comes from the resulting improvement in sales and put that back into the future growth of the company.

Between $10m and $20m: a window of opportunity gets broader     

In this scenario we analyzed that with a $10m investment we would grow the company up significantly more than the previous projections, and the valuation over a five-year period would increase to $165m—not the $120m projected before.

That implied that the company owner was selling around 16% of his shares to new shareholders; with his family he would continue to own 84%. And 84% of $165m was still more than what the CEO had been able to expect with the $120m we had forecasted; by selling shares he would boost the value of his stake to $140m.

Then we went on to set another scenario: what if the owner sold more shares—30% instead of 16%—and raised $20m?

In this situation the owner’s stake was diluted to 72%; he would give up blocking control to a PE fund. But what would the company do with $20m in new money? The company would in this scenario be able to pursue a completely different strategy. It could consider M&A buying a major Russian competitor and entering a new market; it could buy new talented people in marketing and sales and would have enough money to redo all the branding and marketing concepts; it could invest significant amounts of money year after year in R&D for new products.

We calculated that by using a new infusion of $20m today the valuation of the company would grow from $50m to $280m in five years. And the 72% that the CEO would own according to that latest scenario was the $200m he had projected to achieve.

10 Dec '10

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