John Chew over at csinvesting, a fun blog focused on Intensive investing education through case studies, posted a link to The New York Times You’re the Boss blog that makes for an interesting valuation case study. The blog post, Would You Pay $6.2 Million for This Business?, presents information on a small HVAC company in the southeastern United States with $4.67 million in revenues and $1.69 million in free cash flow in 2011. My interest was immediately peaked. There is a reason why I titled my blog Enterprising Investor. While I like being a desk jockey, I have always had a slight entrepreneurial streak and have admiration for small business owners, especially the ones that find financial success.
The owner is asking $6.25 million for the business and real estate. It is interesting that the asking price is 3.2x free cash flow which is about a third higher than most companies in the industry ask. This business is making a cash flow yield that is hard to believe.
Is It Possible?
The first concern is whether or not the numbers presented are possible. We are starting with limited information in the blog post but with a little research, we can find some interesting information. The broker for the business is Jim Dunmie at Murphy Business and Financial Corporation in Clearwater, Florida. The listing for the business can be found on their website with more detail regarding the business:
This is a High Tech Residential Retail HVAC Sales and Service business. They have 7,800 Extended Warranties, 37,400 Annual Tune-Ups and 1,008 Service Agreements for their 40,000 customer base. Techs carry laptops and printers in their service vehicles (powered by inverters). The techs have the ability to print a system replacement quote from the truck and usually offer same day installation. Technicians are highly trained. They replaced 800 full systems in 2011. They also sell, service, and install pool heat pumps, generators, and insulation. Stable employees with most on board 8 years plus. Very efficient POS dispatching software. Exceptionally clean books and records with no pending litigation. Revenue through September 2012 is up 3.8% and net income is up 7.9%.
The location is disclosed as east central Florida in the business listing and we know that with a list of 40,000 customers and 37,400 annual tune-ups, the business is likely to be in a large metropolitian area. The central Florida region has population of 3.3 million and incompasses a large area of Florida. However, I think I may have identified a business that fits the profile. There is an HVAC business in a suburb of Orlando that fits the profile. A bedroom community of Orlando with above median income levels would be great demographics for a service oriented HVAC company.
Depending on the actual location, the company may have a market share that indicates some competitive advantage. Actually only being located in a small geographical region lends to the company achieving economies of scale that make it difficult for competitors to encroach. The fact that the service area is within a 20 minute drive decreases the cost of transportation and more importantly the opportunity cost of travel time. With less driving time, the company can have higher transaction turnover, something that is very valuable in a low markup industry but exceptionally valuable in a high markup industry like construction. Operational effectiveness alone doesn’t create a durable competitive advantage but certainly helps to garner market share on the way to achieving economies of scale. This company utilizes point-of-sale technology in the service trucks used by their technicians. A point-of-sale system connected to a robust cost estimating system at the home office leverages technology in a way I have seldom seen in the construction business.
It Looks Possible
While the numbers are rough, we can get an idea of what the revenue and cost structure for this company might look like.
The extended warranties and service agreements revenue estimates are particularly rough around the edges as we don’t have enough information for an accurate estimate for accrual accounting since we would need to know the timing of when services were provided before booking the warranties and service agreements to revenues. This would be critical in analyzing the free cash flow numbers presented by the business broker since much of the warranty and service agreement cash payments would flow through the cash flow statement prior to hitting the income statement. There is no sense in halting the analysis at this stage due to a lack of data because I’m having too much fun. Let’s soldier one.
To estimate the extended warranties and service agreements revenues, I assumed that 20% of the warranties and service agreements in force would have $100 on average in revenues booked in 2011. First, I assumed that 65% of the revenues were labor costs for the extended warranties, annual tune-ups and service agreements business and 40% for the full system replacements. If we mark-up the lower cost items that would likely be used in warranty work, annual tune-ups and service agreements at 100% and the higher cost items like air conditioning condensers and furnaces at 50% we can arrive at an reasonable estimate of the costs associated with the 2011 revenue break down. I think the labor costs are in-line on average. I’m sure some details are missing but the data is not available to us. I don’t think that 100% mark-up on the lower cost items is unreasonable for this company assuming my thesis that this company is leveraging IT for the cost estimating and marketing systems. If the operational effectiveness is robust, this company is properly marking up each item whether it’s freon, a small switch, copper piping or any of another hundred or more items used in their business.
From this, we can get an idea of what the income statement of the company could look like. To estimate the labor cost associated with cost of revenues, I assumed 20 of the 26 employees average salaries 10% higher than the average $42,530 for HVAC technicians as reported by the Bureau of Labor Statistics. Employer costs were also included in the estimate.
It is very difficult to determine how much is spent on advertising but a high-quality HVAC service company is going to take advertising and marketing seriously so I estimated $100,000. Office labor and owner salary was estimated by assuming the six other employees averaged $40,000 per year in salary and the owner took home $100,000 per year. Employer costs were included in the estimate. Depreciation was estimated by taking a 29-1/2 years straight-line depreciation for $850,000 in real estate. While that is the market value claimed by the broker and not the cost, it’s the only data we have to work on. There are surely lease or depreciation expenses for the fleet of trucks the company is going to be operating that we have no data on.
We arrive at net income of $981,632 for the company. While this is 42% lower than the $1.69 million in free cash flow advertised, it appears to me that there is some possibility that this HVAC company is throwing off some serious cash. It would be a blast to crack open their books and have a conversation with management to verify the results and see what they are doing to achieve them.
We can even construct a skeleton balance sheet of the company. This begs even more questions like what is the working capital position of the company? What is the cash position, are there any receivables and what are the terms for accounts payable with their vendors? On the little information we have, book value of the company is approximately $1.1 million.
The owner is asking 3.2x free cash flow, 6.4x my estimate of earnings and 5.9x book value. Using a discounted cash flow method and assuming that the free cash flow numbers presented are correct results in an impressive valuation $9.6 million for the company.
Even with zero growth and a 25% discount rate, the valuation seems excessive, especially since the owner is asking $6.25 million! Surely the owner knows what the business is worth.
Clearly, you would want a margin of safety if you are purchasing a small business. That is why I would only buy this business at a discount to the intrinsic value. In this case, I’d probably be starting at a 50% discount which arrives at a $4.8 million bid. In negotiating a business purchase, it’s probably not a good idea to go in saying I think it’s worth $9.6 million in theory but I’m willing to buy it if you put it on sale with a 50% discount. A proud business owner is unlikely to want to run a blue light special.
I come up with a more reasonable valuation of $5.2 million if I use my net income estimate as a proxy for cash flow.
Based on the information I have and if a due diligence proved it to be accurate, I wouldn’t bid any higher than $5.2 million for this quality HVAC service business.