For LBM companies that are now in the process of seeking acquisition—indeed for almost every company—the COVID-19 pandemic has suppressed sales revenues and resulting EBITDA. Yet there is wide acknowledgement that COVID-19 will not last forever. After some period of time—probably a matter of months—the effects of COVID-19 will diminish, and eventually vanish. Admittedly, the construction economy won’t immediately bounce back. In retrospect, the recovery will likely be compared to a “dimmer switch” that slowly turns up to full power over time. On the far side of the COVID-19 pandemic, there is reason for optimism. Substantial “tail winds” will power the economy. First, interest rates are low and will remain so, which is great for construction. Second, the Fed will remain in an activist posture. Third, adding to serious pent-up demand for consumer goods and services—Federal and State stimulus packages will pump substantial funds and tax incentives to fuel growth.
New ownership after COVID-19 pandemic
If an LBM company seeks acquisition during or soon after the pandemic, the financial reports presented to potential acquirers will surely show suppressed performance caused by COVID-19. Company valuations are often based on the trailing twelve months (TTM) or last calendar/fiscal year EBITDA performance. However, an acquirer is not purchasing a company’s historical performance. That performance is normally a predictor of future revenue and earnings and it demonstrates the company’s overall operational capacity. But an acquirer is buying future earnings. Accordingly, a company’s value should be tied to those future earnings, and not its performance under temporary stressors, albeit extreme ones like COVID-19. Given how long it takes for investment bankers to prepare a company for acquisition (~60 days), the amount of time it takes to “shop a deal” (~30-45 days), select the winning offer, and complete the due diligence process (~90 days), most acquisitions won’t close for a period of approximately six months, assuming they start “today.” Even if a company were to start the process of seeking an acquirer in the thick of the COVID-19 pandemic, it’s likely that an acquirer would assume company ownership when COVID-19 is no longer a factor, or its impact is substantially diminished. Assuming the economy recovers as COVID-19 retreats—a safe assumption indeed—how can a period of suppressed revenues and sup-pressed EBITDA be presented to a potential acquirer?
A multiple of EBITDA, but which EBITDA?
First, a quick backgrounder. The vast majority of companies are valued and acquired using multiples of EBITDA. For example, let’s take a company and call it “LumberCo.” Assume that LumberCo has a 2018 EBITDA of $8 million, a 2019 EBITDA of $10 million, and a projected 2020 EBITDA of a $12 million before COVID-19 hit.
LumberCo has had a consistent rise in EBITDA, year-over-year, from 2018, 2019, and 2020, with 2020 being a blend of actual and projected performance. That should instill confidence that 2020 projections are realistic and attainable. If LumberCo were acquired for a 7X multiple of 2020 EBITDA before the pandemic occurred, LumberCo would be worth $84 million (7 x 12 = 84).
Now, let’s examine how COVID-19 may negatively affect the $12 million projected 2020 EBITDA. Assume that COVID-19 is operative as a negative performance factor for four months. For example, let’s project the EBITDA to drop to $0 (zero) during these four months.
LumberCo was on a path to achieve a $12 million 2020 EBITDA, or $1 million a month. Due to COVID-19, LumberCo would come off that pace by $4 million. The projected EBITDA would drop from $12 million to $8 million. If LumberCo were acquired at 7X $8 million, the resulting total enterprise value (TEV) would be $56 million. That is as opposed to the $84 million resulting from 7X $12 million. Ouch…That’s a $28 million reduction in total enterprise value, and obviously a situation to be avoided at all costs.
Permanent debilitation or a COVID-19 anomaly?
Given LumberCo’s healthy balance sheet and track record, a potential acquirer must recognize that the $4 million in suppressed EBITDA is an anomaly caused by COVID-19. It is not a sign of a permanent debilitation of LumberCo’s ability to achieve the annualized $12 EBITDA once the virus retreats. (If the potential acquirer re-fuses to recognize this, they are trying to use the pandemic to snatch up a company at a bargain.)
How can LumberCo possibly present that $4 million lost EBITDA in a positive light? The investment banker representing Lumber-Co should take the $4 million in suppressed EBITDA and make it an EBITDA adjustment. Call it the “COVID-19 Adjustment to EBITDA.”
Refer to the following charts as this is explained. CHART 1 shows a blend of Lumber-Co’s actual and projected 2020 EBITDA performance before the pandemic hit. The Company was confidently on a path to achieve $12 million in EBITDA.
CHART 2 shows the dramatic effect the pandemic could have on LumberCo. In this ex-ample, COVID-19 has entirely chopped out four months of EBITDA performance. However, in the post-pandemic time period, projected to be fully in force starting in September, LumberCo would be back on track. But with four months of “missing” EBITDA performance, Lumber-Co’s projected EBITDA would be $8,000,000, not $12,000,000.
Given LumberCo’s strong historical performance, it is reasonable to assume—and it should be strongly argued by the seller’s in-vestment banker—that COVID-19’s effects are only temporary. LumberCo will again attain its projected growth pattern. Accordingly, the missing $4 million EBITDA, CHART 3, is a valid credit to LumberCo’s EBITDA.
The total enterprise value of LumberCo should not be $56 million. The $56 million is its “pandemic value,” generated by temporarily suppressed earnings. LumberCo’s true TEV is $84 million, the value that would have been achieved had COVID-19 not occurred. The difference between the pandemic value and the non-pandemic value is a negative $28 million in TEV, so it is well worth the effort to argue for a COVID-19 EBITDA adjustment.
Stick to your guns
Should a potential acquirer insist on a suppressed TEV due to COVID-19, the seller and their investment banker representatives should “stick to their guns” and insist on full value for an COVID-19 EBITDA Adjustment. There is, as always, some middle ground to be found here, should the buyer and seller not entirely agree on the adjustment’s acceptability. Perhaps that middle ground could be to acknowledge the extraordinary circumstances of the pandemic and the use of a risk-allocation mechanism, like the widely used earn-out. But the COVID-19 EBITDA Adjustment is a credit to earnings that is just as valid as any credit to EBITDA (e.g. non-recurring, non-capitalized expenses) that would be accepted in typical deal-point negotiations.
For a seller to insist on a COVID-19 EBITDA Adjustment should not come as a surprise to any serious acquirer. Acquirers recognize the temporality of the pandemic as much as the seller. A COVID-19 EBITDA Adjustment is simply an acknowledgement that a company like LumberCo is as valuable today as it would have been before the pandemic occurred, and that LumberCo will regain its footing, and its full value, in a matter of months.