Among the first questions that a tire dealer asks when approached by a strategic or financial acquirer is, “Why do you want my business?” There are many good standard reasons why, and then there’s what I consider the underlying reason. First, some standard reasons.
Geographical expansion. Say you are in Chicago with pretty good market share and decent store coverage. Any larger dealers in nearby states not already in Chicago and looking to expand are some of your potential acquirers, as they are nearby and familiar with the operating environment of your market.
Speed. Greenfields take time and zoning boards are at times misguided. You’d think zoning boards would welcome tax-paying tire and service retailers, but unfortunately, many municipalities don’t. It’s faster to buy than build in many markets.
Acquire people and talent. It’s a full employment economy, and it’s hard to find qualified technicians, experienced salespeople and managers who know how to run a quality, profitable operation. Buy the talent in an acquisition.
Acquire new skill sets. A recent client had an innovative call center that the buyer was looking to duplicate for its other stores. Another who employed a more disciplined service delivery process, knew how to enhance customer loyalty, and was social media-savvy was attractive for those reasons.
Competitive strategy and response. Why did Monro Inc. finally enter California with the Certified Tire & Service Centers Inc. acquisition? Well, California is the fifth largest economy in the world with lots of people and lot of cars. But if Monro took its time going from state to contiguous state as it had been doing, by the time they had reached New Mexico all of the attractive opportunities in California would have been gobbled up by competitors.
Financial opportunity. Sometimes an acquirer looks at a business and knows he or she can do better. If a business is at 6% EBITDA (earnings before interest, taxes, depreciation and amortization) and an acquirer thinks he can buy it fairly and take it up to 12% or higher, that’s an incentive. Those are all valid and good reasons why mergers and acquisitions happen. Now, here’s the underlying reason deals are done.
It’s a form of arbitrage. Broadly speaking, arbitrage is when someone takes advantage of the differences in price of an asset and pockets a “risk-free return.” Let me explain how this works with a hypothetical example.
Joe’s Tire has three stores in Greensboro, N.C., doing collectively $6 million in revenue annually, and dropping 10% adjusted EBITDA or $600,000 annually. Joe’s life is pretty good, but he’s pushing 67 and wants to spend more time fishing at his cabin near Asheville. Joe figures it’s time to exit.
Sue’s Tire is a friendly, respected competitor that Joe has known for a long time. Sue has 10 stores around the Charlotte area, and she’s made an offer to buy Joe’s business — not the real estate that Joe owns — for $1.8 million or three times adjusted EBITDA. And Sue will lease the locations from Joe at fair market rents for the next five to 10 years. Joe finds that to be reasonable and fair, and he sells the business to Sue.
Sue pays attention to the acquisitions making news in Modern Tire Dealer, and based on what she learned in her 20 Group, she thinks her 10 stores doing about $17 million in revenue and $2 million in annual adjusted EBITDA is worth at least a 6 multiple or around $12 million. She’s known Joe for 10 years, knows that he runs a good business. She understands his market, his tire/service mix, his employees and his types of customers. For Sue, it’s a no-brainer to buy Joe’s business to expand her footprint with a quality operation.
Now, let’s see what happens to the value of Sue’s Tire after she buys Joe’s Tire:
So, Sue’s Tire buys Joe’s Tire for $1.8 million cash or a 3× multiple to EBITDA, and after the deal closes, because she’s larger, more profitable and more diversified in the state, her 13 stores doing $23 million is deserving of a slight bump in value to perhaps 6.25 × EBITDA. Her business value jumps $4.25 million from $12 million to $16.25 million ($2.6 million EBITDA × 6.25) and it only cost her $1.8 million to buy Joe’s Tire.
Another way to say this is that Joe’s $600,000 in profit is worth $1.8 million to him in a fair transaction, but the market says that for her it’s worth an additional $4.25 million on top of her original $12 million in value. That difference of $4.25 million (really $2.45 million net after paying Joe $1.8 million) is as close to arbitrage as one can get in this game. Now, it’s never, ever a risk-free return for the buyer because buyers really don’t know everything about what they’re buying (think environmental issues, hidden liabilities, pending employee lawsuits etc.), but because Sue knows Joe’s business and knows how to keep it running smoothly and perhaps better, it’s as close to risk free as she might get.
The financial markets reward bigger and more profitable businesses. They provide liquidity to these larger businesses in the form of debt and equity to keep them growing. That’s why the game is played. Now, there are certain things that Joe might have done to get a higher valuation than he did. I’ll save those revelations for another day. ■