Winning the M&A Game

Strategy and tactics for successful catalog mergers and acquisitions

As mergers and acquisitions heat up the catalog industry, with 19 deals consummated in the third quarter of 2000 alone – if you have been considering buying, selling, or merging with another catalog company – this may be your moment. To prepare to make a deal, though, you must reassess your positioning and consider why one company merges with another and how they typically do it.

First, the buyer’s point of view If you’re shopping for a company to acquire, you must begin with a strong strategy that will lead to dominating a market niche, expanding your distribution channels, or increasing your operating efficiencies. You can do this by buying companies that you already have the expertise to operate or by acquiring a new customer list vital to your growth.

The first step to a winning acquisition program is to either assign or recommend one key executive, typically the vice president of business development, to be accountable for business transactions. This does not mean that other company executives cannot scout acquisitions; it simply ensures that someone is in charge of this important function so that opportunities don’t fall through the cracks. Mergers and acquisitions usually take a collaborative effort to succeed; those in charge lay the groundwork and make recommendations to the CEO, who ultimately makes the final decision.

Securing capital If your business has been generating enough cash, you may be able to finance an acquisition on your own. Or you may have a relationship with a bank that you could turn to for financing. But you should always line up your resources in advance.

It’s a good idea to cultivate relationships with bank investors or board members, but be aware that few lenders or investors understand direct marketing. In fact, most financiers perceive the industry as a risky business, since catalogers offer relatively few tangible assets to back up investments. Investors also tend to be skeptical about the industry’s substantial marketing costs; for example, when a mailer says he will send 1 million catalogs at $1 apiece and expects a 3% response, the average investor sees it as tantamount to throwing an expensive party without knowing who is going to come.

Consequently, you need to find investors who look beyond the security of inventory and accounts receivable to examine projected cash flows. These investors understand that a cataloger’s house file is as valuable an asset as a manufacturer’s customer list. They should also be comfortable with the continual promotional expenditures that drive the catalog business.

Finding an acquisition Sometimes, as you ferret out prospects through networking, cold calling, and referrals, you will be lucky enough to discover a company whose owner will negotiate exclusively with you. For example, if a company reports it is not interested in selling but is willing to talk to you, it’s likely you are the only interested party.

The advantage of one-on-one negotiating is that is generally goes fairly quickly. But sellers most often seek to interest many buyers so that the selling process becomes an auction; after all, sellers are more likely to command a higher price through competition. Not only can this drive up the cost of an acquisition, but it lengthens the negotiating process; it could take more than six months to finalize a deal when multiple prospective buyers are involved.

However extensive your exploratory efforts may be, you are most likely to discover that a company is for sale when an investment banker calls to inquire as to whether you would like to see the “blue book,” or profile, of a particular company. This book describes the company, presents its financial statements, and explains the business opportunity.

If you are interested in receiving the blue book, you will have to sign a confidentiality, or nondisclosure, agreement beforehand, which basically binds your firm to maintain the information’s secrecy. After all, the seller has more at risk, sharing secrets it wouldn’t want to get in the hands of its competitors. Confidentiality agreements are fairly standard and don’t merit a lot of your time or that of your lawyer. In other words, don’t be intimidated by the legal mumbo-jumbo or let it slow the process down.

You might consider preparing a confidentiality agreement of your own in advance so that you have it on hand for any acquisition opportunities that arise. If you do have any concerns about the one you’ve received, you can ask that yours be substituted.

You will find the blue book, compiled by an investment firm, to be a comprehensive and revealing, albeit enthusiastic, company portrait. Its aim is to give you the best first impression. It begins with an executive summary that outlines the nature of the business, its size and key catalogs, financial results, ownership, and reason for being sold. Recent earnings and projected results may be shown right on the first page, so you will know almost immediately if the catalog is a potential fit. The compiler strives to present an accurate, truthful portrait of the company, although the book does include a disclaimer stating that the information is based on the facts provided by the company itself.

The section following the executive summary, investment considerations, recaps the salient opening sales points in bullets. This page is a distillation of almost every virtue the business possesses and provides additional information on the expected specific nature of the transaction, such as whether just the catalog buyer list or the entire business is being offered for sale.

With the hard-hitting key facts aside, subsequent blue book chapters cover in a leisurely manner the company’s history, catalogs and Websites, mailing response rates and list results, Internet strategy, production statistics, table of organization, operations, market size and competitors, key management, business projections, and financial results.

Making an offer Ultimately, the purpose of the blue book is to elicit an initial offer. In fact, in a cover letter, the seller’s investment banker or other representative will usually ask you to make a “nonbinding” first offer indicating the price your company is willing to pay. Price may be expressed in a range. If an offer is high enough, your company will qualify for a second round, in which you and other potential acquirers will have the opportunity to meet with company executives and examine company records. Here’s how you can establish a realistic first-offer range:

1. Start with the acquisition’s historic cash flow or EBITDA (earnings before interest, taxes, depreciation, and amortization) stated in the blue book. Typically this information is verified by an auditor. If not, be cautious, as there may be inaccuracies. Adjust for operating efficiencies depending on how you plan to run the catalog; if you can combine purchasing, customer service, and warehousing for example, you may be able to operate it for less.

2. Project future cash flow. Consider how your company will grow this business; for example, you may have a better distribution network than the company that’s up for sale, which should enable you to expand its sales. What do you expect the catalog to earn during the next five years? Adjust the projections stated in the blue book to reflect your own evaluation of the catalog’s potential. Run the various scenarios through your forecasting computer model.

3. Consider qualitative factors. For instance, do you expect the acquired company’s top management to stay? Think about what new sales channels your company may have access to. Remember that it’s better to pay more for a growing business than to buy a declining business at nearly any price. And it’s not usually worth trying to buy a cheap company and turn it around; some businesses are just rotten at the core.

4. Discount your cash flow. Adjust, or discount, the cash flow by an interest factor that represents your evaluation of how much risk exists in achieving these results. If the catalog is showing stable growth, and you believe your own company can make it grow even faster, use a 10% discount factor. If the catalog’s future seems uncertain, use a higher discount factor, such as 15%-20%, which means you would ultimately pay less for the company. If you feel you have to use an even higher discount factor, then reconsider the wisdom of buying the catalog at all; it may not be worth the risk.

5. Establish your highest price. Determine the highest price you would pay for the company by adjusting the present value you arrive at upward by 10%. But in your offer letter, instead cite a lower price range – knowing that you will almost surely be negotiated upward if the seller receives competitive offers or simply demands a higher price. It is only after a detailed investigation of the target company in round two, anyway, that you will feel confident in making your best offer.

Understand the company you are buying In the second-round due-diligence process, you will have an opportunity to thoroughly evaluate the company, meet key executives, and obtain almost any information you want and need. Typically, this is done through the creation of a data room in the soon-to-be-acquired company – a room in which you collect important documents, sample data, and so on for investigation.

At this stage, it’s possible – though unlikely – that you’ll turn up anything shocking such as irregular financial statements. You might, however, find out valuable inside information, such as that certain people have three weeks’ vacation during your busiest season. You might find that inventory has not been liquidated properly, and you could seek a deduction. Or you might find that a company’s printing contract goes a lot longer than you thought it would. All of this knowledge can help guide you through your decision.

Focus on the quality of the management team members as well. Interview them. Observe them. Do they speak knowledgeably about their areas of expertise? Would you hire these people? Are these people capable of carrying out your vision, or will you need to replace key positions? If you are counting on the CEO staying on, pay particular attention to the terms of the proposed transaction and to the CEO’s future role and compensation package.

The reality is that in almost all circumstances, the CEO leaves relatively shortly after the deal is completed, but you may be able to provide incentives to keep him or her on board after the transaction. Also, there is nearly always a contract in which the CEO agrees that he or she can’t start a competing business within a certain length of time after leaving the company.

Make sure you perform a detailed evaluation of the catalog’s house file to find whether it is really the major asset. Start with something simple, such as comparing a zip code select in a geographic area you know well with that of your own house file. Scrutinize the data, call some customers, and trace entries through the catalog system from initial recording to summary printouts. You want to find out if the company maintains records on its mailings and how sophisticated they are.

Do the same analysis of the cataloger’s IT system. Is it based on a standard software package, or is it home-grown? You should walk away from, or at least strongly reconsider, companies with nightmare systems – those that are outdated, or for which the original programmers have been long gone and took the codes with them. You will never be able to make them compatible with your own systems, and you should anticipate replacing the entire system.

Continue your marketing analysis by examining major response reports. Is it clear by key code which mailing groups have responded to which offers? Has the company tracked its costs? Does it know its current cost per order? Has it at least tried to perform lifetime value analysis?

Purchasing and inventory are the next areas of concern. You should compare the current catalogs with the product in stock. Be sure that proper markdowns have been done and that obsolete inventory is scheduled for liquidation.

If you are buying one catalog out of a multititle catalog company, pay close attention to the overhead being allocated against the catalog you are buying. Some companies may not allocate the costs evenly among catalog titles. Based on your own experience, you may find it suspiciously low and the catalog earnings, as a consequence, inflated.

Now, the seller’s side of the deal In some ways, being a seller is easier than being a buyer. You need to know only one company – your own. If you have numerous suitors, you can exert more control over the merger process and are likely to command a higher price.

The following tactics will help you land a buyer and get the best deal possible:

1. Find the right time to sell. Aside from the obvious fact that you will get a higher price during a booming economy, ideally the best time to sell is when your catalog is growing. Increasing response rates, an expanding house file, and improving margins indicate a healthy catalog.

2. Create an energetic Internet strategy. You face a dilemma with your Internet strategy. On the one hand, a business model that works on the Web will boost your company’s valuation. On the other, your Internet infrastructure investment depresses current earnings – and your valuation. But you can use this dilemma to your advantage.

For starters, when presenting your company for sale, you can segregate your e-commerce infrastructure expenses, thus revealing the “true” profitability of your business. This way, Internet expenditures can be shown as an investment in the future rather than as a current expense of your core business.

Certainly, if your company lacks an e-commerce capability altogether, you are at a distinct disadvantage. Since 15% or more of many catalogers’ sales are now coming through the Web, buyers will argue that a cataloger without this capability is worth at least 15% less.

Still, most of these buyers are just angling to get a lower price; in fact, few buyers will be dissuaded from completing the transaction by a lack of an e-commerce channel. Your company’s catalog brand, product line, management team, list, and financial results are what acquirers really want. Most will plan on integrating your product line into their own Websites, anyway.

3. Have your financials audited. Your sale will go much more smoothly if you can show audited financial statements. The extra expense of the audit of the year-end financials will save you from lengthy negotiations concerning the appropriateness of your numbers.

4. Hire professional representation. It’s useful to enlist the help of an expert to guide you through the sales process. Talk with several investment banking firms that understand direct marketing. They will make the process go smoothly and help you get the highest price for your business, typically charging a fee of 1%-5% of the transaction.

6. Think about after the sale. Are you planning to retire or to stay on? If your continuing leadership is one of your catalog’s prime assets, and you are touting it as such, you have to decide if you will be happy as an employee of the acquiring company. If your expectations and those of the buyer are different, watch out. The merger is destined to be an unhappy one for both of you.

7. Conduct your own due diligence. Take a close look at your suitors’ track records. Which ones have a reputation for following through on their initial nonbinding offers and closing deals? Which are the tire-kickers? If you are asked to take part of your sales proceeds based upon the future performance of the business, are you confident that the new owners can run it?

When your investigation raises any red flags about a buyer’s reliability, move on. If you are torn between two suitors, go with the buyer that has the better reputation, especially if you are concerned about your employees’ welfare.

In the final analysis, whether you are a buyer or a seller, transactions are a mixture of thoughtful strategy, well-orchestrated execution, and a reasonable approach to meeting the other party’s needs.

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