Going the Distance

Sept. 1, 1999
Many equipment companies would be content with selling 20 pieces of heavy machinery to the lead contractor on a $330 million earthmoving project. After

Many equipment companies would be content with selling 20 pieces of heavy machinery to the lead contractor on a $330 million earthmoving project. After all, the package of new excavators, dozers and wheel loaders for New Jersey's Atlantic City-Brigantine Connector project had a combined price tag of several million dollars.

But not Binder Machinery, whose Binder Equipment Rentals subsidiary is ranked No. 58 on the RER 100. Owner Bob Binder and vice president of sales Bill Kretschmer knew the project had the potential to be much more than just a one-time windfall for the Komatsu dealer.

Instead of simply filling the large initial order for equipment, Binder negotiated with the joint-venture lead contractor Yonkers Contracting-Granite Construction to be its preferred provider of all rental equipment, parts, service and equipment sales for the three-year project.

Considering that the job includes constructing a 2,000-foot tunnel, 11 bridges and more than two miles of road, the deal with the lead contractor has provided a substantial boost for both Binder and its 2-year-old rental subsidiary.

"In the past, many companies would have sold the earthmoving equipment and said to themselves, 'Hey, that was a pretty good order,'" says Bill Birch, general manager of Binder Equipment Rentals. "But we looked at it as just the tip of the iceberg."

The preferred provider arrangement between Binder and Yonkers-Granite exemplifies a new reality of the equipment business: With increased competition for contractors' business, few, if any, one-dimensional equipment providers will experience continued success.

For that reason, the trend of distributors and rental companies partnering with contractors and industrial plants is growing. While aerial work platform rental specialists and national chains are generally credited with pioneering the concept of sole-source arrangements, many different types of other rental companies now use the preferred-provider model for heavy equipment.

"Yonkers wanted to be able to pick up the phone and resolve all of their equipment needs immediately," says Birch. "They didn't want to hear about long transit times for equipment. They didn't want to hear, 'My mechanic can be there in three hours.' They didn't want to hear, 'The parts can be there in three days.' They expect us to be here in any capacity at any hour of the day or night to help them get their job done."

The partnership necessitated the expansion of Binder, which is based in South Plainfield, N.J. The company's one branch location - in Voorhees, N.J., about 40 miles from Atlantic City - was deemed too far away to react with immediacy to the contractors' needs. In November 1998, as ground was broken on the project, Binder opened a temporary branch in Atlantic City on a small lot literally across the street from the on-site headquarters for Yonkers-Granite.

"Because this is a design-and-build project, the job is constantly changing as are our equipment needs," says Bruce Carnovale, project engineer for Yonkers-Granite. "On a large project such as this, it is extremely important that we don't have to wait for equipment. With this arrangement, there is no waiting for equipment."

The Binder branch - which is housed in three temporary trailer offices - serves as a makeshift parts-stocking facility. It also houses a limited number of rental pieces on the 1-acre lot. Three Binder employees - a sales/service manager, a sales rep and a customer service rep - staff the temporary branch.

Binder began work earlier this year on a permanent facility on 8 acres about five miles from Atlantic City. It is currently undergoing town-zoning approval to be operational next year.

In addition to expanding its physical presence, Binder also had to expand its product offerings to serve the project.

"We never sold a portable welder in the history of this company until Yonkers wanted to buy five welders recently," Birch says. "We got those welders for them and now there are a total of eight welders on the job. This partnership involves everything and anything they need to get their job done."

One afternoon in March, unforeseen circumstances necessitated a one-time night shift for tunnel construction. Four Binder light towers were on the job before dusk.

"The support we have received by having the satellite office right across the street has been tremendous," says Bob McGee, a job superintendent. "Binder has even anticipated equipment needs that we hadn't even thought about, which is terrific from our point of view."

The commitment from Binder is not only appreciated, but rewarded in the form of more business. About 75 percent of Yonkers-Granite's subcontractors on the tunnel project are using Binder equipment for their short-term rental needs.

"If you are going to be a preferred provider, you have to have a wide range of inventory," Birch says. "And as more and more rental companies evolve into one-stop shops, we'll see more of them in partnerships such as this."

As the rental equipment industry continues its rapid consolidation, company owners are being approached frequently with proposals to purchase their companies.

A recent Wall Street survey indicates that two out of three owners of companies with revenues in excess of $2 million received unsolicited offers to buy their businesses. Regardless of whether owners are contemplating a sale, the valuations being offered by acquirers raise the question: What's it worth?

There is, however, no simple answer to that question. Valuation is a function of many factors, including:

* The quality of the existing management team.

* Historical profitability adjusted for non-recurring and owner items.

* Type and age of fleet.

* Location.

* Customer base and market share.

Acquirers will look at these and other factors in forming a view on a company's future prospects. Historical operating profitability is studied in order to better understand the future earnings outlook. The "high valuations" being paid for companies need to be evaluated in the context of prospective earnings.

To the extent that an acquirer can increase cash flow through purchasing scale, access to lower cost capital and enhancing future revenue streams, the price paid for a strategic acquisition may be quite reasonable. (See Chart A, page 38.)

However, before an owner can evaluate whether an acquirer's proposal constitutes a fair valuation or not, it is useful to be familiar with the various methodologies used by corporate acquirers.

On Wall Street, there are three commonly used methods for determining a company's value: discounted cash flow, "multiples" analysis, and liquidation or adjusted net worth analysis. Acquirers will typically review each of these valuation methods, in addition to other subjective factors such as those in Chart A, to determine the price they are willing to pay for a rental equipment company.

Discounted cash flow Discounted cash flow analysis, although more complex than other valuation techniques, is the most analytically rigorous method used by financial and strategic acquirers.

In DCF valuation, acquirers value the projected future stream of cash payments, net of income taxes, working capital investments and capital expenditures. By ignoring how a company is capitalized (debt versus equity), the DCF analysis allows acquirers to calculate the present value of all future, unleveraged cash flows. The discount rate at which the future payments are calculated reflects an appropriate weighted average cost of capital.

In order for a DCF valuation to be meaningful, an acquirer must have access to realistically developed five-year financial projections. Typically, the target company's management team prepares the cash-flow projections. It is important that these projections be developed, as much as possible, from the bottom up.

Ideally, a five-year projection incorporates sales by customer or customer type; fleet utilization rates; rental/sale mix and rates; detailed operating expenses and business cycles.

Of course, through due diligence, an acquirer will test the assumptions underlying the target company's "management forecast." To the extent that certain assumptions appear overly optimistic, an acquirer will modify the projections to reflect a "base-case scenario."

Any prospective cost savings or revenue enhancements that an acquirer may have should be reflected in this analysis. While the acquirer's DCF incorporates all these benefits, what an acquirer will propose to pay for a business is also a function of the selling process, transaction structure (see "Seller Beware!" page 42) and form of purchase consideration.

One way acquirers may build a margin of error into their base-case projections is to increase the rate used to discount the projected cash flows. In other words, the higher the discount rate used in the calculation, the lower the enterprise value - and, accordingly, the lower the residual equity value. Acquirers calculate this rate differently, but in each case the discount rate reflects an acquirer's view of the risks related to securing future cash flows, weighted to reflect how the company will be capitalized using debt and equity.

By applying the discount rate to "base-case" free cash flows, an acquirer can calculate the unleveraged present value of a future cash-flow stream.

Additionally, the acquirer needs to calculate a "terminal value" to reflect the enterprise value in excess of the initial annual cash flows. In many cases, acquirers will determine the terminal value based on applying a multiple to the terminal year projected base-case operating earnings. The terminal value is discounted back to the present and added to the present value of the annual cash flows to calculate the total "unleveraged" enterprise value. By subtracting any funded net debt from the enterprise value, an acquirer arrives at a change-of-control value for the firm's equity.

While the DCF is the most analytically defensible valuation methodology, it is also an approach that is not always viable. In order to be meaningful, a DCF valuation typically requires not less than a reasonable five-year forecast.

Given the uncertainty of business cycles and lack of reliable forecasts, DCF valuations in the rental equipment industry are not common.

Earnings multiples Given the limitations of the DCF analysis, many acquirers estimate value using multiples of operating earnings (earnings before interest and taxes, or EBIT) or operating cash flow (earnings before interest, taxes, depreciation and amortization, or EBITDA).

Simply stated, multiple analysis applies a number or range of numbers to a relevant financial operating figure. The multiple range reflects an acquirer's overall assessment of the various factors that affect valuation. For an acquirer, the valuation derived from these earnings multiples is tied to achieving certain target financial hurdle rates, including:

* Expected return on invested capital (adjusted operating income divided by total invested capital).

* Return on equity (net income divided by total equity).

* Cash-on-cash returns (expected cash flow after fleet replenishment investment divided by total invested capital).

Among the most common multiples relied on by investors are price-to-earnings multiples, or P/Es. For example, an investor may contemplate buying a certain stock because its P/E multiple is less than a comparable market peer or relevant market index multipAssuming comparable growth pros-pects, investors might conclude the lower multiple stock is undervalued. In the rental equipment industry, investors seem to prefer using EBIT or EBITDA, in part because it offers operating earnings, which are less vulnerable to variations as a result of differences in tax rates, leverage and depreciation policies. Chart B (below) reviews current public "going concern" multiples of after-tax earnings, EBIT and EBITDA.

At any given time, earnings multiples of publicly traded rental equipment firms may be higher or lower than multiples paid in private "change-of-control" transactions.

The current high valuation levels of many of the publicly traded rental equipment companies, fueled in part by the market's expectations for future growth rates in excess of 20 percent per year, should not lead owners to assume that such high valuation levels are achievable.

However, these valuations indicate that public investors have a favorable view of the industry's prospects. In light of the ongoing consolidation, certain of these companies will be able to grow rapidly over the next few years and improve profit margins with increased purchasing scale.

It should be noted that applying a multiple to any of the pre-interest operating figures (EBIT or EBITDA) in Chart B results in an estimated business value or "total enterprise value" (TEV). In order to derive an equity value, it is necessary to subtract existing debt from the enterprise value.

Lastly, acquirers will evaluate various "non-financial" characteristics of a business. Rental equipment companies with higher "strategic value" - such as those viewed as platform companies - and higher revenues, particularly those with significant rental revenue, are more likely to command valuation multiples toward the high end of the range.

Certain change-of-control valuation data is available from the active consolidators that are publicly traded and are required to disclose financial information to the Securities and Exchange Commission. For a company growing rapidly, a trailing, unadjusted 12-month multiple may lead to the impression of an unreasonably high price; whereas a trailing, adjusted multiple is less susceptible to distortion. Chart C (page 42) summarizes selected recent transactions and estimated multiples paid, based on audited trailing earnings.

Any owner-related adjustments factored into a buyers' valuation are not typically disclosed in publicly available financial statements. Accordingly, the "true" multiple of trailing EBITDA may differ significantly from the multiple that may be derived from publicly available information.

Additionally, other acquirers will evaluate a target's operating earnings over the course of an economic cycle (three to five years), particularly in a cyclical industry such as equipment rental. Any analysis that relies too heavily on simple multiples of trailing financial performance are subject to substantial distortion resulting in misleading information. Chart D (page 42) summarizes multiple ranges that we have found to be a reasonable guide to mid-sized rental equipment companies.

Notwithstanding the limitations of relying on after-tax earnings, many acquirers will evaluate acquisitions based partially on multiples of net income adjusted for any non-recurring owner-related items or accelerated depreciation on the fleet. A modified approach to the net income multiple analysis is to calculate "pro forma" adjusted after-tax earnings, taking into consideration the pro forma target debt levels and income tax rates. By subtracting estimated interest expense and taxes from adjusted EBIT, an acquirer can calculate the residual equity value assuming a range of P/E multiples.

This calculation is helpful because it adjusts operating income, or EBIT, by interest being paid on debt that is presumably being used to purchase additional fleet equipment and earnings growth. Moreover, public acquirers, sensitive to earnings dilution, are unlikely to consider paying a higher multiple of earnings than the market assigns to its own shares. Earnings dilution is a primary concern of publicly traded companies issuing new shares to make acquisitions.

With competition to acquire both RER 100 firms as well as smaller rental centers increasing, multiple ranges have trended upwards. Among the largest completed deals, Atlas Copco's $1.2 billion acquisition of Prime last July was about 11 times trailing EBITDA, and eight times analysts' expected 1997 EBITDA. It's hard to know all the synergies and other benefits that may have been factored into this valuation, but based on publicly available information, the price paid significantly exceeds our simplified pricing matrix.

A final shorthand valuation method that some acquirers use in developing preliminary bids is based on applying multiple ranges to rental and sales revenues. In cases where there is limited (if any) information on profitability, acquirers may estimate enterprise value as up to three times rental revenues and up to one times new equipment sales revenues. While subject to important refinement, the method reflects the higher margins and recurring revenue associated with rental revenue streams.

Adjusted net worth The adjusted net worth calculation uses the net assets of the company, as reflected in its most recent balance sheet, adjusted for variances between the book value of the assets and "fair market value." However, valuations analyzing the underlying assets do not consider future earnings potential and, therefore, are not appropriate for valuing a "going concern." Instead, an underlying asset valuation is more appropriate in a liquidation scenario.

A related valuation method is to use the fair market value of the fleet and subtract funded debt, then add any cash and marketable securities that will remain with the company. The method also fails to consider the future earnings potential and is rarely used to determine the purchase price of a company.

While adjusted net worth is not a good indicator of going-concern value, the liquidation value does provide an owner with a "floor" valuation.

PQs: A recent Wall Street survey indicates that two out of three owners of companies with revenues in excess of $2 million received unsolicited offers to buy their companies.

Atlas Copco's $1.2 billion acquisition of Prime last July was about 11 times trailing EBITDA, and eight times analysts' expected 1997 EBITDA.

Valuations are currently approaching levels well beyond values likely to be achieved under existing ownership.

The below charts have already been trxed to Mo. Additionally, they still need to be updated so they are included here for reference only. We will need to thoroughly edit them in lasers, however.

PQ: Tax issues are one of the most important factors that affect valuation.

Mo: Charts for reference only. Do not layout.

Why sell? Clearly, valuing a business is not a simple matter. Still, several methods - some more complex than others - help an owner understand how acquirers think about valuation.

While the DCF valuation is the most analytically defensible approach, it is subject to important limitations. Foremost, the DCF is predicated on an acquirer being able to evaluate a thoughtfully prepared five-year financial projection. To the extent that such projections are not available, or are not well-prepared, this analysis will be of limited value.

Similarly, if the only projections available are this year's expected earnings outlook, then an acquirer may be limited to using the multiple approach. Whether or not an acquirer will be at the low end of a multiple range or the high end is primarily a function of the issues that impact business valuation referred to in Chart A.

In the present environment of unprecedented, rapid corporate consolidation, it is useful to reflect on these measures of valuation. But, perhaps the most significant factor currently driving valuations is that demand for successful, well-managed rental equipment firms has not abated while acquirers continue to access public capital to fund growth through acquisitions.

With a number of aggressive corporate and financial acquirers targeting many of the same business owners, valuations are currently approaching levels well beyond values likely to be achieved under existing ownership. This suggests it may be a good time for certain owners to reflect on what their business is worth to them.