When does it make sense to pursue a business with relatively low margins?
September 16, 2024
by a searcher from University of Virginia-Darden - Darden School of Business in Washington, DC, USA
I've reviewed a number of LMM deals in the past few months where the business seems fundamentally strong: long history, outstanding customer reviews / reputation, well-known brand in the community. However, SDE margin leaves little room for error for an independent searcher, even leaving in generous add-backs (pre-LOI).
In the spirit of NOT chasing the proverbial unicorn, when does it make sense to pursue this type of deal. Here are some of the items on my list:
- Seller has taken their foot off the gas (low working hrs).
- Obvious efficiencies: founder-led business without any professionalization.
- Seller managing the business to minimize taxes (potential positive in dd?).
- Extensive direct experience in the sector.
- Partner with someone who can visualize realistic improvements.
- Strong preference to operate in that sector or business.
In any case, it seems like a bit of a turnaround scenario, which is not the generally recommended ETA model. But in a world where there are no absolutes or unicorns, I'm trying to keep an open mind.
from Harvard University in San Francisco, CA, USA
There's a simple shorthand for assessing the quality of a business - ask yourself, "what would happen if it were to raise prices?" (i.e. "does the business have pricing power"). Typically, lower margins (say gross margin < 20%, or ebitda < 10%) indicate a lack of pricing power and therefore relatively low business quality - low barriers to entry, low value-add, price-sensitive customers, etc. Tough way to live. A high margin is evidence of pricing power and therefore high business quality. But a low margin isn't NECESSARILY evidence that it doesn't exist, merely that management isn't EXERCISING it (out of fear, habit, etc.). When you see a low margin business, this is what you should be looking for - "hidden" pricing power.
Of course - you can buy a "not good" business and it can be an amazing investment - but you have to accept the additional challenges (price competition, mercinary customers, constant cost pressure) and price the investment accordingly.
from Stanford University in Austin, TX, USA
That said, when you say "low margins", what exactly are you referring to? Gross margins? Net margins? EBITDA margins? For example, there are some asset-heavy businesses that have net margins thrown off by high depreciation expense (non-cash). While on paper it doesn't look great, they can be great from a cash-flow perspective. For this reason, it's probably worth considering this through the lens of EBITDA margins to assess the actual business. I would then ask why margins are so low? High labor? High marketing expenses? High cost of goods sold? High rent? If you have a play to address any of those margin killers, then you can create some upside value.
You might also consider that some lower-margin businesses are presumably lower risk and offer some level of recession resistance. If you are betting on a recession, a low-risk, low-margin business could definitely make sense.
But none of it makes sense unless you get the price you need upfront.