CENAK Consulting - News and Views

Black Friday and Cyber Monday - How to Really Save Money

The marketing departments of the retail industry have to be considered the masters of how to (mis-)use language to put a positive spin on what is really a negative event.  Consider this typical message that you see everywhere these days in some form or fashion:   

"LCD TV for only USD1,999.  Pay USD1,899 and save an additional USD100 if you buy this TV today".

What's wrong with this message, it looks awfully positive, you think?  Let's take a closer look.

Let's assume you buy this item today.  What really happens? 

First and foremost, you spend 1,899 bucks of your hard earned money!  But is that the message they want you to remember?  No.  The message they want you to remember is that you "saved" 100 bucks, not that you spend 1,899.

But, do you really "save"?  Only, if you actually go ahead and put what you "save" into savings!  That can be an interest-bearing savings account, your retirement account (which I hope you have), invest it in mutual funds or stock, etc.  Now, who really does that?  If my unscientific observations are any indication, pretty much no one. 

The next time you hear someone tell you that you save by buying an item, turn around and tell them that first and foremost you are spending a significant amount of money and not technically saving anything, unless you take that discount amount and stash it away somewhere where it earns you interest or capital gains.

It's the retail industry's positive spin that you save money, when in reality you are spending money.  Think a little bit about that before you hand the credit card over or press the "buy" button this Christmas season. 

Business Valuation Using Comparable Company Analysis - Part 1

One method to value a business (target) is the comparable company analysis (Compco) or multiple analysis.  We at CENAK use this method as one data point for company valuations in addition to cash flow models and other valuation approaches.  The Compco is typically not used as a stand alone valuation method.  Due to its relatively easy mechanics it is often used as a starting point or "back-of-the-envelope" method to get a general idea of a valuation range.  In this series we will describe this method over the next few days and weeks.

The quality of the results of a Compco depends highly on the quality of the input data.  In fact, the majority of the preparation time goes into making sure that the data used is consistent and applicable. The data needed for a Compco is:

• Target company's historic and projected financials (2 years forward)
• Comparable companies' historic and projected financials (2 years) as well as stock price and capital structure

The first and most important step in preparing a Compco is to identify publicly traded companies whose business model is similar to the company to be valued.  For example, if the target company is a producer of PCs, then companies such as Dell, Acer, Lenovo and HP could serve as comparable companies.  However, it can already be seen that there are differences even in this universe of comparable companies.  For example, Dell markets its products almost exclusively through its website while others market their products through other distribution channels as well such as retail stores.   HP produces other, higher margin products in addition to PCs such as printers.  Lenovo is traded on the Hong Kong stock exchange and Acer in Taiwan.  It is in the discretion of the analyst to adjust the analysis for these differences by taking into account different accounting treatments and general valuation differences between countries (country adjustment).  Further, certain companies may trade at a premium because they are considered "best in class", while others may trade at a discount to the average.  Some companies may have to be taken off the list because their valuation is based mainly on other product lines.  In our example, HP's data would only be of limited use because HP's core business is computer periphery such as printers.  HP's multiples should reflect this and be a blend of multiples of the different business segments.  IF HP were to spin off its PC business tomorrow, it would trade at a different (probably lower) multiple than the combined business today.  All of these factors will ultimately have to be considered in analyzing the final results.

Some industries may not lend themselves to the Compco due to the lack of comparable companies.  The more comparable companies can be identified the better, however as a bare minimum a basket of at least five companies should be evaluated.  If there are less than five or no comparable companies available at all, a close look should be taken at the underlying business model.  For example, if the target company is in the commodity business but there is no other public company in the exact same space, then it might be worth looking at other commodity businesses as a proxy for the target company, even though the underlying commodities between the target company and the comparable companies might be different. 

Compcos are of limited use if the target company is a start-up with no income or even revenues.  Compcos compare certain financial multiples of companies that are applied to revenues and certain earnings measures (more about that in part 2).  If there are no revenues yet it does not make sense to apply any multiples.  The same holds true for companies with negative earnings (losses).  As an example, Internet start-ups in the late 1990s often went public without having ever produced positive margins.  These companies were sometimes valued using revenue multiples only.  In the biotechnology arena, companies went public without having ever sold anything, making the preparation of a Compco meaningless.

Compcos can be prepared for parts of target companies if data is available for the division to be valued.  This is routinely done for companies that consider spinning off a division.  Conversely, divisions of comparable companies cannot be used for the analysis even if broken down financial information is available, because the stock price relates to the entire entity and reflects a blended value over all of the the company's divisions.

Despite these few limitations the Compco can be a very valuable tool for business valuations.  Most  businesses and industries today can be valued using this methodology.    

 

Once a basket of comparable companies has been identified, the next step is to collect financial data about these companies.   In part 2 of our series we will describe in more detail where the data can be found and how it needs to be adjusted for a meaningful analysis.

If you have any questions regarding the multiple analysis please contact us at any time.

The State of the US Air Traffic System

We are approaching the holiday season and with that increased air travel and congestion.  I think we all agree that there is a problem in the air traffic system in the US and it will need to be fixed soon.  Short term patches such as the suggested opening of military airspace can only be temporary and don't really solve the problem.  How can the problem be solved?

Before I try to give some answers let me point out that I used to be an Air Defense Controller in the German Air Force and know a thing or two about what's going on in air traffic.  But I also travel a lot for  business domestically as well as internationally, and I am as frustrated as everybody else out there.  Let me also say at this point that I believe in free capital markets with a minimum of government intervention.

Having said that, I do believe that the US air traffic needs government intervention.  It can clearly been seen that the airline industry is digging itself a hole in this unregulated market that is getting deeper and deeper.   Airlines have to make money and the the American consumer wants the cheapest fares.  The result is cut-throat competition, airlines in chapter 11 and a system that is stretched to the limits as personnel gets reduced while passenger numbers increase.  And don't get me started on service. 

The ultimate reason why the system is near collapsing is the consumer who wants cheap flights.  This has pushed the airlines into the position they are in today and not only has effects on service but also on the other parts of the system, meaning air traffic control and airports, and ultimately safety.  More and more flights get cramped into the rush hours of air traffic, especially in the afternoon, stretching the air traffic control system to the limits.  The last day when JFK does not show some sort of delays because of volume?  There might have been one in early 2006.  Maybe. 

The airline industry needs regulation, I am afraid.  What is going to happen without regulation is not pretty. We are going to eventually see accidents happen because of the broken air traffic system.   For starters, if 80 movements in one hour are the limit for an airport in best weather conditions, then don't schedule 100.  Secondly, significant money needs to be spend to modernize the ATC system.  Further, there needs to be oversight over the airline industry to a certain extend.  That includes how many standby planes need to be available, the number of personnel servicing passengers, etc.  I am afraid that in the case of air traffic the government needs to save the American customer from him or herself in the quest for the cheapest flights out there.

The interesting thing is that this problem is somewhat confined to the US carriers.  I don't use this word lightly, but I hate flying domestically in the US.  When I travel internationally, there is a noticeable improvement in service and friendliness, especially when I fly international carriers.  Again, the consumer gets what the consumer wants.  A quite curious thing in a country that otherwise is a case study in service.

Safety concerns in air travel demand that the government gets involved.  Hopefully, that will happen soon.  I am tired of oversold flights, chewing gum chewing gate agents, disgustingly unclean planes and sitting on the tarmac for three hours with no information whatsoever.  But most importantly, I am afraid that we wait until accidents happen before change will take place.

Opportunities in the Sulphur Industry

One of our valued clients is Omni Sulphur, located in Nipomo, California.  Omni Sulphur was formed to take advantage of the exciting opportunities in the global sulphur industry.  We at CENAK Consulting actively assist Omni Sulphur in developing its business plan and realizing its growth potential.  We prepared the company's budget model and are currently working with the company to develop and refine its long term business plan.  It is anticipated that a first round of equity capital will be raised in the first half of 2008.  CENAK Consulting is preparing the financial models and information memorandum as well as actively advising Omni Sulphur in its project development efforts around the globe.

Sulphur is a commodity product produced mostly during the refining of crude oil and natural gas.  It is stripped out of oil and gas as a by-product.  Given that most new oil and gas production is from fields that are of lower quality with a high sulphur content, it is widely expected that there will be a glut of sulphur inventory starting in late 2008, when a number of new refineries are expected to come online.  The price for sulphur is therefore expected to decline and even be negative in certain areas of the globe.

On the demand side, sulphur is used mostly to ultimately produce phosphate fertilizers.  Other applications are in the mining industry and some other industries to a small extend.  One niche product is to use sulphur in conjunction with clay and micronutrients as a fertilizer. 

Omni Sulphur is best positioned to take advantage of the expected overproduction of sulphur by offering solutions to refiners as well as users of sulphur.

Sulphur produced at refineries is typically in a molton form.  Unless there are applications for the sulphur nearby these plants, the molton sulphur needs to be formed into a product that can easily be shipped.  This process is called forming of sulphur.  There are several different technology providers who manufacture machines that can be used for this purpose.  Omni Sulphur has significant experience with building and operating these plants, and continues to develop opportunities globally for the forming of sulphur, as refiners are looking for ways to manage the ever increasing amount of sulphur.   

Another core competency of Omni Sulphur is the production of sulphur fertilizers using beforementioned forming equipment.  Omni Sulphur has developed a proprietary technology that allows the company to  mix elemental sulphur with clay to form a 90% sulphur/10 clay product called GreenSun 90.  This product is widely used and accepted in North America, however the largest growth markets for this product are in Asia and Brazil, where soils are significantly sulphur deficient.  Omni Sulphur is currently constructing its first sulphur fertilizer plant in India and expected to commence development of a second facility in Dubai before the end of this year.  Omni Sulphur is one of few companies that can make the forming technology work for the production of sulphur-based fertilizers and expects significant growth in this arena.  Further, the sulphur fertilizer can be mixed with micronutrients for additional fertilizer applications.

CENAK Consulting is actively involved in the development of several of Omni Sulphur's global forming and fertilizer projects.  Omni Sulphur and ultimately its clients profit from our international experience and our project development experience.  Further, we continuously help Omni Sulphur refine its business plan and financial model.  At present, CENAK Consulting is developing an information memorandum and strategy to raise capital for the company's rapid expansion.  We are very excited to be a part of the company's growth and about the future of the sulphur market.

Rich Dad, Poor Dad

We get frequently asked which business books we enjoyed reading.  And I am not afraid to say that the book I enjoyed the most was "Rich Dad, Poor Dad" by Robert Kiyosaki.  Not because it has any earth shattering business ideas (it doesn't).  I enjoyed it because it is inspiring and it motivates you to look beyond your horizon and maybe start something new. 

I read the book shortly after Enron went under and both Carol and I were trying to figure out where to go from here.  One thing we knew for sure.  We didn't want a downtown job and continue to be part of the masses that drive there in the morning, hide in the 32nd-floor cubicle, and then drive back at night.  We wanted to do our own thing.  In that general mood, we both read Kiyosaki's book and it inspired us even more to do something on our own.  It is also well written and easy to read.  Unlike many other business books, I actually read this one to the last page.

Now, on the flip side, I don't fully grasp the popularity of "Who Moved My Cheese?" by Spencer Johnson.  It's short, but I still found it boring to read.  The message is to be flexible and keep your eyes open because your cheese (standing for money or job or whatever you want it to stand for) may be moved and you may have to move, too.  Frankly, in today's environment that's a matter of fact for every professional. 

Wall Street Bonuses

The WSJ reported the other day about bonuses on Wall Street this year, which will be significantly lower in certain areas than last year.  There is still no reason for bankers to complain as the average investment banker makes somewhat around USD2 million, according to the WSJ.  But that's exactly where the problem is.

In another piece, the WSJ wrote about the CDO and SIV mess a lot of the banks have gotten themselves into.  How could that happen?  A big part of this is how bankers are being compensated.  Banks make fees on setting these vehicles up and bankers get bonuses based on those fees.  The problem here is that compensation is based on closing the deal, not on how successful it is down the road.  The investment bankers that advised Time Warner to merge with AOL received huge fees and bonuses, however the merger turned out to be a complete failure. 

The same holds true for innovative new products such as CDOs and SIVs.  They became the "flavor of the month" and banks couldn't get involved in them quickly enough.  They generated fee income and the involved bankers where awarded huge bonuses, attracting even more people and companies to get involved.  Unfortunately, a lot of these banks did not appropriately assess the underlying risk.   Why?  Because people see the fees that can be made and the bonus that will get them based on selling these products, not on their long-term success.

This has always been a problem with investment banks and will remain to be a problem unless someone comes up with an idea how to force investment bankers to have more skin in the game.  Unless that happens, CDOs and SIV will repeat themselves in a few years, just under different names and with different people involved.

About Us

Just a few personal words about us today.  We are a two person team, Carol and Andreas Kraemer.  The nice thing about working in a team of two people with similar backgrounds is that if one person does not have the answer to a certain problem, the other usually does.  And in our household, that is usually Carol :-)

We are from very different backgrounds.  Carol was born and raised in Mexico while I grew up in Germany.  We met at Thunderbird, School of Global Management, where we both graduated with an MBA in Finance.  After many years with investment banks and global energy companies we decided to put out our own sign and go it alone.  That turned out to be a great decision.  We truly enjoy what we are doing and love working with different clients every day.  The best thing about it is that we learn something new every day.  In our view, once you stop having the desire for knowledge and learning, you might as well be dead.

We spent most of our time on the Central Coast of California and commute from time to time to Houston.  The consulting job can be travel intensive, but we made the experience that travel typically comes in waves.  There are times when we travel for weeks, but there are also times where we can enjoy long stretches of being at home. 

One very unique thing about us is our international background.  Besides English, we speak Spanish, German and some Portuguese.  With global M&A becoming more and more important, we have a significant edge over others as we can offer our services in many countries around the world.  The other, less tangible thing, is that we are able to include non-English speaking research into our work.  This also allows us to expand our horizon beyond the mainstream news from CNN and the US networks.  It is very interesting to see how differently the media in Europe and the US reports about certain events.

We hope this gives you a first glance into our private lives.  We'll continue to write about that from time to time so that you can get to know us a little bit better.

Valuation Series - Introduction

With today's blog I'd like to start a series about valuation techniques we employ here are CENAK.  Over the next few weeks, I will try to explain in more detail which analysis tools we use and how they work.  I hope that this will make the valuation process more transparent and highlight the advantages of our approach.

Generally, there are two different valuation approaches.  The first approach is based on using historic financials to estimate what the value of a company is today.  This method is often employed by accountants or lawyers.  The second approach uses projected future financials to determine a company's value.  Here at CENAK, we strongly believe in the second approach as a better way of analyzing a company's financial performance.  Just as in the stock market, the value of a company is based on future earnings and cash flows, not historic.

Typically, we use the following forward-looking valuation methods:

• comparable quoted company analysis (Compco)
• comparable acquisition analysis (Compaq)
• discounted-cash-flow analysis (DCF)
• merger consequences analysis (Merger Model)

Over the next few weeks, I will comment on all of these methods to shed some light on them.   These methods are routinely used by investment banks and serve as a foundation for any value negotiation today.  We will highlight the strengths but also some of the limitations of these methods.  We hope you will enjoy our valuation series and look forward to receiving your feedback. 

What we do here at CENAK

It's time to talk a little bit about what it is we do at CENAK.  Our core expertise is financial analysis and valuation work.  We have over 17 years of financial modeling experience and have developed some of the most sophisticated valuation models.  Our analysis work is used frequently for transactions such as mergers & acquisitions, IPOs, private equity, venture capital, LBOs, and project finance for the development of large infrastructure projects such as power plants.

Besides providing our clients with analytical tools to evaluate the economic implications of a transaction or project, we also make our vast transaction experience available to our clients.  Projects we take on can therefore have many different forms.  In the simplest form, a client asks us to develop a cash flow model to value his or her business.  Most clients, however, take advantage of our vast transaction experience and ask us to be actively involved in the project process early on.  Besides analysis work, our day-to-day business includes:

• identification of takeover targets for M&A projects
• due diligence work in any shape or form
• coordination of project teams including legal advisors, technical consultants, tax advisors, etc.
• negotiation of transactions
• project development work
• development of formal business plans and information memos
• preparation of professional presentations
• drafting of term sheets and other project documents

In the following weeks and months we will write a little bit more about all of these tasks to give you a better understanding of what we do on a daily basis.  Please come back frequently and don't hesitate to contact us if you have any questions regarding our capabilities.

Write-downs and no end in sight

The positive unemployment numbers this morning surprised analysts, however the stock market was up only briefly until we heard further bad news from a Deutsche Bank analyst about potential write-downs by banks and brokerages to the tune of USD10 billion that are yet to come.

It is hard for me to understand why people would sign mortgages without understanding the full commercial consequences.  In my view, that is at the core of the problem.  Sure, there was probably predatory lending out there and some mortgage brokers may have based their advise on their own fees rather than the interest of their clients.  And yes, anybody who ever sat through a closing knows that the amount of documents you have to sign is ridiculous.  However, how can it be that people sign mortgages without taking the time to understand the full commercial consequences? 

I hope that we do not swing from one extreme to the other now, as it happens so often in this country.  We had little oversight over the mortgage lending business which at least partially contributed to this problem, I admit that much.  However, I am afraid that if politicians get involved the pendulum will swing far - too far - to the other side and put even further downward pressure on the already beaten up housing sector.  So let's please leave politicians out of this as much as possible and ask ourselves how this can be avoided in the future. 

People taking out mortgages that they full understand with all of the short-term and long-term consequences would be a good start.  As such, I would like to see a single sheet of paper at closing or even before that explains exactly the commercial terms of the loan.  If it is an adjustable rate loan, I want to see on that sheet of paper the payments if interest rates rise, fall or stay the same.   It should also outline what happens if the market value for the house drops by 10% or more.  How much equity is left and what is the worst-case scenario if interest rates go up and values go down?  All of these questions should be answered on a single, easy to understand sheet of paper.  Yes, it would add to the paperwork you'd have to sign, but understanding the commercial terms should be the most important factor when buying a house, and it appears many people didn't in the past. 

As to the crisis in the banking sector, that will work out itself.  In my time at investment banks I  experienced several similar cases where banks jumped on hip new products only to find out later that they didn't really fully understand the exposure they had with these products.  What does concern me is that we are still dealing with off-balance sheet exposures that investors do not get information on how to value.  In fact, even the banks don't know how to value them.  Still, in this case I do see a need for action from the governing bodies to make sure these vehicles are disclosed in the filings.  It is disturbing that even six years after the Enron experience we are still dealing with off-balance sheet items that investors do not know how to value.

Let's hope next week will bring better news.  We'll be back on Monday.  Have a good weekend everybody.