SOPHISTICATED FINANCE

Building Great Companies--Six Principles

I rarely read books on leadership because I find them confusingly similar to good books on management and strategy. Whether you wish to consider it a matter of leadership, strategy or management, the six principles below are what I believe are necessary to build a great company (such as Coca Cola, Sony or Intel):

1. Vision  A large, panoramic view of how to serve a customer need or how to realize value from an unappreciated asset. This view is almost always based on an asymmetry of information wherein the founder develops an incredibly in-depth knowledge of his subject matter and an intense passion to pursue the goal.. Case example: Amazon
2. Focus   Dedication to a simply defined business concept which stands the test of time (and markets) without the need for diversification, acquisitions or "financial engineering" to generate above average growth. Investment in growth drivers alone is typically sufficient to achieve growth and market share objectives. Case example: Wal-Mart
3. Values  Large groups of people can only succeed where a clear value system is articulated and practiced by the senior management. The key values are honesty, fairness and respect for all people (whether they be employees, customers, shareholders or the community). Case example: JP Morgan
   
4. Customer Focus   Great companies have a unilateral focus on serving their customers and do not place a higher priority on investor expectations or competitor moves. Case example: Johnson & Johnson
5. Low Cost   Capital is invested in the growth drivers of the business and not frittered away on overhead and there is a constant effort to provide the customer with a cheaper, higher value product(s). Case example: Wal-Mart
6. Exceptional People   Great people are hired and retained in the key disciplines for the particular business, such as programming, merchandising or research. Today, almost everything else can be outsourced. Case example: Goldman Sachs
   

The most common mistake I see in entrepreneurs is a lack of focus, usually brought on by a lack of self-discipline. When growth or earnings expectations are not met, too many business owners resort to diversification into new businesses or use acquisitions as a means to improve expected results. Great companies grow organically because they constantly find ways to generate growth in their core business. Successful companies assume there is organic growth and then find the way to achieve it. Such an approach allows them to leverage their strengths and expertise and consequently typically results in lower risk, less capital intensive strategies.

The second common mistake is that the founder is not a good recruiter and ends up with mediocre people in key positions. Founders tend to recruit the wrong people because they fail to give recruiting sufficient priority (usually because they are wasting time micro-managing) or they lack the confidence to recruit people that may challenge them. A founder's vision is improved by the input of other exceptional people.

The most difficult deficiency to overcome is a lack of values, which comes about due to a lack of respect for other people. Without the proper value system a founder can not retain good people and no great company was ever built by just one exceptional founder.

In my experience a lack of customer focus can be overcome by a clearly articulated vision and a relentless pursuit of lower cost, higher value product. However, this approach may only work temporarily if your target customer develops new requirements and demands better quality products or a different type of product value (in which case you better become customer focused).

Many pundits typically list 8-10 qualities of great leaders and then say that no leader has all the qualities.  This type of conclusion suggests to me that the pundits gave up on the analysis half way through. I worked for over ten years with the founders of two great companies--one in Indonesia and one in Japan and have met several other founders who built great companies with revenues in the billions. There is a simple set of key principles to follow to build a great company.

FIU Green Forum on Supply Chain Management

Another excellent seminar at FIU on "green" topics for business

To register for the Green Supply Chain Forum,

please visit http://business.fiu.edu/greensupplychain.

 

Digicel Wins Honduras License

Back in October I posted on the auction taking place in Honduras for the fourth cellular license in that country. I predicted that either Telefonica or Digicel would be the winning bidder and the winning bid for the license would be at least $20 million. Yesterday several sources announced that Digicel had been awarded the license with a winning bid of $80 million or about $10 per capita.

The magnitude of the winning bid for the license prompted me to do a short analysis, which is shown below. Digicel's total investment in Honduras will probably total $300 million based on their previous strategy in similar countries. The initial network buildout will cost $100 million and with success in the market they will expand their network in phase two at an additional cost of $120 million to provide the best network coverage in the country. The license fee brings total investment to $300 million. Assuming that Digicel is targeting a return of 15-25 percent per annum in 5 years, their target exit value for Honduras is $600-900 million. Based on an assumed value per subscriber at exit of $1500-2000 (50-60 percent of a U.S. subscriber), Digicel needs between 300-600,000 subscribers in year 5 to achieve its return target at exit. This level of subscribers is quite realistic given Digicel's performance in markets similar to Honduras.

Digicel's willingness to invest $300 million in a market that already has two strong competitors shows just how attractive the cellular market is in Latin America. It is proof we can expect continued growth in subscribers and new investment in this sector in Latin America.

Acquisitions to Increase EBITDA?

A client called this morning and said he wanted to look at acquisitions next year in order to increase EBITDA. Several warning bells began to ring:

1. Why does the company not have sufficient organic (internal) growth opportunities to increase EBITDA?
2. Why does the company not look at more fundamental ways to improve cash flow, such as better working capital management or improved operating efficiency?
3. Why does the company not look at adding additional product lines or new products to its existing business?

Many executives without a lot of experience acquiring companies (and integrating them) see acquisitions as an easy solution to the growth problem. This view is perhaps exacerbated by all the press coverage of the private equity firms and their mega acquisitions. Two points to note about private equity firms:

1. Their principal business is buying and selling companies (their expertise)
2. Usually the PE firms do not face the challenge of integrating their acquisitions into an existing operation

(Previous discussion of private equity firms is here.)

I think many management teams use acquisitions because they either do not have the talent or the discipline to build their companies organically. Also, many companies become frustrated by the pace of their growth and see acquisitions as an easy way to accelerate growth.

Acquisitions should not be viewed as a panacea. Acquisitions make the most sense when it is cheaper to buy than to build. In fact, this is usually the first question that sophisticated investors ask about an acquisition and they expect a thorough analysis to prove that the acquisition is cheaper than building it yourself. Even if you do not work with sophisticated investors, you should do the buy versus build analysis when considering an acquisition.

Inability to generate organic growth does not mean that acquisitions, by default, are the solution. Most companies would be better off analyzing why they can not grow organically rather than jumping into the risky world of acquisitions. Resorting to acquisitions frequently signals a more fundamental management issue and you would be well advised to discover it rather than hiding it with an acquisition.

My Workshop Video

My workshop in October on "Financial Modeling for Business Plans" for the Pino Global Entrepreneurship Center was recorded by WPBT Channel 2 in Palm Beach, FL. The station has a website, uVu, where they feature videos of local interest and focus on lectures and performances. My colleagues at Pino selected my workshop as the video to give the community a better understanding of the resources available through FIU and Pino in the area of entrepreneurship. The video starts here and continues here. (uVu does not yet permit the videos to be embedded in blogs, but the plan is to have this functionality available soon.)

The woman who introduces me in Part 1 of the video is Colleen Post, a Founder and the Assistant Director of the Pino Global Entrepreneurship Center. Colleen is also an Adjunct Professor at FIU and does a workshop several times each year on "Developing a Business Plan".

Presentation slides are below

Private Equity Leverage Buyouts 1990-2006

A new paper, Do Buyouts (Still) Create Value, by academics Shoroun Guo, Edith S. Hotchkiss and Weihong Song analyzes 176 private equity firm leveraged buyouts (with pre and post deal public information) from 1990-2006. While the writers acknowledge that results have changed in the more recent years of the period analyzed (due to larger deals involving better quality companies), their key findings for the sixteen year period are summarized below:

• Median size of a deal was $460 million
• In 62.9% of the deals management had equity
• Management had a median equity of 5.3% 
• Median premium paid for publicly traded companies was 29.23%
• Purchase price/EBITDA was 8.8
• Ratio of equity/capital was 30% (equity includes both common and preferred stock)
• Debt/EBITDA was 6.2 (Debt does not include preferred stock)
  
• EBITDA/Interest Expense coverage was 1.6 times
• Return on capital was 48% (capital is debt plus equity)

The writers present five factors to explain these impressive levels of return:

1. The benefit of the tax shield from higher debt leverage
2. Increased monitoring from banks and sponsors (private equity firms)
3. Disciplining effect of debt (less cash to put in value reducing activities)
4. Better management incentives
5. Lower costs for SEC registrations
6. Pre-buyout characteristics (opportunity for improvement)

I think the authors over emphasize the value of senior debt lenders as monitors given their principal concern with debt repayment and not value creation. The value of sponsor monitoring is clearly an important contributor to these impressive return levels. The value of the sponsors is perhaps best demonstrated by the mean 22% of total assets that are divested by private equity firms post closing.

Of course returns at these high levels explain the large amounts of new money moving into leveraged buyouts. Also interesting, the returns in this study exceed the returns of all but the best venture capital firms.

The paper has a lot more useful information and is worth reading in its entirety. Click on the link to download the complete paper. Download ssrnid1009281_pe_firm_perf.pdf

I found this paper at Finance Professor.

Choosing Charts in Excel

How many times have you seen people choose the wrong type of chart to present their data? The folks at Juice Analytics have developed a "chart chooser" and it is available here. Juice Analytics is a consulting firm that provides heavy duty data analysis and their blog is an excellent source of useful tips on Excel and data presentation.

Chart Chooser begins by asking you to pick the purpose of your data and offers six alternatives:

1. Comparison
2. Distribution
3. Composition
4. Trend
5. Relationship
6. Table

Based on your choice, the app selects the appropriate charts from a universe of seventeen chart types.  You then pick the chart form you want to use and can download a template (Excel or Powerpoint) to create that chart using your own data. The templates are particularly useful if you do not know how to create bubble charts in Excel or scatterplot charts in Powerpoint.

Now that Juice Analytics has taken the guess work out of chart selection, maybe those Powerpoints will not be so confusing.

I found Chart Chooser on the Extreme Presentation blog, an excellent source of advice on presentations.