Safe Harbor or Stormy Seas?
How well your alarm business will hold its value in today’s economy is determined by how ‘centered’ it is â€” and size does indeed matter.
With the stock market and housing prices showing record declines, most alarm company owners are wondering if the equity value in their business will hold. Fortunately, the market for most is likely to be relatively stable, albeit down. Unfortunately, the farther you are from the “center” the more likely you are to have a significant drop in value.
The center describes a mode of operating that is broadly defined as having the following three characteristics:
- Geographically focused operations with a good sense for what and how the local economy is doing;
- Offering traditional intrusion and fire alarm systems, possibly with some capability in access control and video surveillance, to a broad swath of both the residential and commercial middle markets; and
- A conservative capital structure (low reliance upon debt).
Most alarm companies operate with these characteristics, and are best suited to quickly read and efficiently adapt to changing economies, and have the most amount of flexibility in how to adjust. Additionally, they tend to exhibit the highest levels of overall operating stability.
MOVING AWAY FROM CENTERThe market will generally favor that with which it is familiar, and that which has low operating risk. Given the uncertainty of the times, the last thing most acquirers will want to do is take on something that is too far outside the box. For example, a company focused exclusively on offering a newly developed high-end system designed uniquely for sub-prime mortgage brokerages is not going to be attractive.
Even companies with a good operational profile can and will experience significant changes in equity values if they have a large part of their capital structure in the form of debt. It is not called leverage for nothing. Many homeowners are learning this the hard way. A home that declines in value by 10 percent results in a 50 percent decline in the equity value if 80 percent of the value is in the form of debt. Luckily, most alarm companies don’t have those levels of debt in their capital structure, but any level of debt magnifies the effect of market changes on equity values.
THE NUMBERSBroadly, valuations correlate with size. Most alarm companies have less than $50,000 of recurring monthly revenue (RMR), and not surprisingly this is the size category where most transactions occur. For any given seller, there are a number of potential buyers, and as a result the market tends to be orderly and efficient.
Average values in this size category over the last 10 to 15 years have ranged between a low of 31 times RMR and a high of 36 times RMR. Within those averages, individual transactions have been up at or near 40 times RMR and down in the 20s, but these are the exceptions. With more than 8,000 companies occupying this size category â€” and the potential buyer group ranging from another local buyer, the large regional companies, and all the way up to ADT â€” there tends always to be a market.
Companies with RMR of $50,000 to $100,000 are scarcer, and generally perform better than those with less than $50,000. From a transaction size perspective, it still fits well within the capacity of many buyers. As a result, the demand forces push up average values, with the high end of the range being 40 times RMR and the low end 33 times RMR, and the highest and lowest individual transactions trading in a closer proximity to the average.
BUBBLE, BUBBLE, TOIL & TROUBLEThe market changes above $100,000 of RMR. There are only 200 or so companies in this size range in the United States, which limits the supply. Generally these companies tend to be some of the best performers in the industry, which pushes values even higher. The number of existing industry buyers, however, progressively decreases the farther one moves up the size range, and these buyers are generally more subject to broader capital market forces. So the demand for any given transaction can swing substantially depending upon a number of variables. This is further complicated by these companies typically representing the pool from which new entrants to the industry seek to acquire an operating platform.
The diagram below indicates most every transaction involving between $100,000 and $10 million of RMR, since the beginning of 2000. Each “bubble” is scaled to the amount of RMR and positioned by the date of the transaction and the value of the selling company as a multiple of RMR. Red bubbles indicate that the buyer was new to the industry, and blue bubbles indicate that the buyer was an existing industry player.
A number of informative data points can be gleaned through viewing transactions in this format. First, the market has clearly been on an upswing since its bottom in 2003. With a broader timeline, one would see that the prior market peak had been in 1997, and before that in the mid- to late-1980s. Each time, the market had been pushed up by the presence of multiple buyers aggressively seeking growth through acquisition, and supported by euphoric capital markets.
Second, the wide spread of transaction values in this size segment is apparent. Literally, within the past two years we have had a deal at 62 times RMR and one at 20 times RMR. The high was HSM’s sale to Stanley Works and the low was a company well outside of the center. This large range is indicative of the market’s growing maturity, and an expression of the differences in benefits that buyers can derive from any given acquisition.
Third, the market is not as high as often speculated. Since the rebound beginning in 2004, there have only been five transactions at or above 50 times RMR. There have been an equal number of transactions during this time frame below 30 times RMR, yet these are often not mentioned when discussing trends. The higher-valued deals all were relatively large and they therefore move the averages up more than the smaller, lower-valued deals. The mainstream segment of the market has consistently been in the upper 30s to mid-40s. This is the range that we refer to as the “fair market value” zone, because it defines a range that is bracketed at the lower end by the present value of a good performer’s future results, and at the upper end by the present value of the same results adjusted for well-established consolidation savings.
Lastly, there is a clear floor to the market at, or just below, 30 times RMR. This is the point where the economics for buyers generally become too compelling, and where sellers simply cease to engage.
SUPPLY & DEMANDUltimately, the market will change only to the extent the supply and demand inputs change. Supply-side pressures have historically been increased by one or more of the following three factors:
- Market values move high enough that the offer is just too good (into the upper levels of the fair market value zone, or beyond), with a resulting rush to sell;
- An increased pessimism regarding what the future holds; and/or
- The access to capital is restricted.
Clearly, the last two factors are likely to influence the market today. The looming prospect of recession is clear, and while the debt markets have generally continued to be supportive of the industry, there will be some restriction of capital and the pricing will be higher. The combination of slower future growth and higher-priced capital affects the present value calculation of future benefits for both prospective buyers and sellers. In other words, it moves the fair market value zone down.
Offsetting to a large degree the sell-side pressure, market demand appears surprisingly stable, albeit inevitably softening. Most of today’s transactions are being done by existing players in the industry, who are generally well capitalized and pursuing longer-term results. This is in contrast to prior periods where the market has been driven to a larger degree by speculators and/or strategic players entering from other industries. While the crisis in the capital markets is and will continue to affect demand, it currently doesn’t appear as if it will have the material impact that has been felt in many other industries.
PREDICTIONSPredictions are tough, but here goes: Over the next year a general decline in average values of 10 percent. This puts the average, under $50,000 of RMR company back down in the range of 32 or 33 times; and the average $50,000 to $100,000 RMR company at around 35 or 36.
These declines should occur in an orderly way, and not the result of a brief market free-fall. This orderliness will, in large part, result from a probable increase in activity in this segment, as many buyers redirect their efforts away from the more expensive and less predictable market for large companies. This increased focus, combined with the natural heightened resistance to risk, will lead to a greater spread between the high and low values realized in each size range.
The over-$100,000-of-RMR market is likely to be best characterized by two words: volatility and friction. On one hand, there will be a couple of deals that will defy the odds and realize very high valuations, either because of the scarcity factor, and/or because of stellar performance results. On the other hand, the market is likely to be par-ticularly punishing of companies that are forced to sell, that operate well outside the center and/or are poorly documented. There also will be much emotionalism and dysfunction as buyers and sellers work to reconcile the bid and the ask. This friction will result in many broken transactions, and at times the market will experience vapor lock, as the spread can’t get resolved. This will not be a market for the timid, or thin-skinned. On balance, however, the center will hold, but probably with an average decline of closer to 15 percent.