September 13, 2017
Been to the mall lately? There are big changes going on in the retail and consumer industry. Some big box department stores are giving way to retail outlets that function more like showrooms, restaurants are changing the way they do business through apps, ordering from traditional retailers is changing, etc.
More and more, companies reaching out to consumers realize that customers are relying more on mobile devices to find out what their friends like, which brands are trending on social media and how their favorite influencers weigh in. Stores, then, are evolving into places to check out the look and feel of the merchandise before ordering it online for home delivery. The supply chain for companies are also changing to adapt to this new customer preference of quick, and customized experiences.
As discussed in PwC’s Total Retail Survey 2017, changes like that has led many companies to shop for new channels and technologies that can serve those needs better than traditional stores. Want to try something out? Great. Want to return an online purchase that didn’t work out? No problem. Just getting the customer into the store creates opportunity in the age of online commerce.
However, as retail and consumer companies venture into new technology, they must also beware of how they judge what an early-stage company is actually worth. Overlooking this blind-spot could lead the buyer to over-pay for a fast-growing company or, perhaps even worse, miss an opportunity by undervaluing a technology that could help a legacy company leap-frog its competitors.
One key to accurately understanding the value drivers stems from assessing its ultimate worth based on the sources and viability of its competitive advantage. Once that is truly understood, the nature of that advantage can guide the investor to the right decision or framework.
A buy-vs-build framework may be the answer for some. If the competitive advantage is easy to replicate, that may suggest the value of the acquisition is tied to the cost of building it from scratch and the time associated with the project. However, even if a technology is easy to replicate, the time to market could mean the difference between winning and losing in the market. This element, typically referred to as the “opportunity cost” of not having the technology today is a major factor that drives deal values.
If the technology is harder to replicate, the long development cycle or delays in building it internally could support buying an early stage company and then integrating its advantage into the core business. In that case, the buyer must consider other questions before deciding on a fair price. Those might include the cost of integrating the acquired membership base into the existing customer base, how that will affect online sale returns and service, and what impact differing demographics will have on revenue and operating costs.
Value can many times be viewed as a function of anticipated future cash flow. If the acquirer is a mature company looking at a similarly mature target, it’s easier to predict. But in the world of early-stage tech companies, the range of outcomes for that can be extremely wide. Before buying a high-growth company, which is often the target in this scenario, an extensive scenario analysis is required to avoid significant deviations in investment alternatives.
Given the challenge of conducting cash-flow forecasting, buyers may turn to a market approach where value is viewed as a multiple of revenue, EBITDA or another metric. The multiples are outputs that emerge from observed market values driven by the same things that drive value, namely cash flows. To get an accurate result, it’s critical to understand the core value drivers of the peer companies and how those compare to the target. The market multiples of an established company could seriously underestimate the value of an early-stage company.
Overall, we can expect retailers to keep looking for acquisition targets as competition rises between legacy and emerging competitors, and technology companies look like a logical way for established players to add innovation and growth. But putting the right price on those targets will continue to be a challenge, partly because such companies operated very differently from the retail and consumer acquisitions of yesteryear.
Given those challenges, buyers would be prudent to invest time and effort in the right framework for investment decisions before they pour cash into the acquisition itself. In the end, that may help them avoid a serious case of buyer’s remorse. Read more in our recently released report, Cross sector valuation: What retail & consumer companies should consider when acquiring early-stage technology targets.