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Friday’s Exit Strategy: Are MSP Valuations Based on EBITDA Misleading?

When publicly held companies buy one another, they often describe the price paid or valuation in terms of an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) multiple.

For instance, INAP recently acquired SingleHop for 7X EBITDA and Office Depot in October 2017 acquired CompuCom for a pricy 10 times EBITDA — though once deal synergies arrive, the multiple is a more reasonable 7X EBITDA, Office Depot says.

So what’s an IT service provider worth? You’ll hear estimates that range anywhere from 5X to 7X annual EBITDA — with some larger service providers sporting intellectual property fetching as much as 10X EBITDA (though that’s very, very, very rare).

But Wait: Are EBITDA-based Valuations Misleading?

Rick Murphy

Still, all the EBITDA talk can be misleading, Cogent Growth Partners CEO Rick Murphy asserted during Kaseya’s MSP M&A Symposium yesterday in Florida.

Plenty of experts agree with Murphy. Among the potential concerns:  Companies can misuse EBITDA, Harvard Business Review (HBR) notes.

“In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom’s stock.

Because EBITDA can be manipulated like this, some analysts argue that a it doesn’t truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to insure that EBITDA does actually convert to cash as expected.”

So if an EBITDA figure is wrong, manipulated or somehow misleading in other ways, multiplying that figure (say, ‘7 times EBITDA’) to reach a valuation estimate can be erroneous as well.

Warren Buffett’s Warning; Exodus Communications’ Lesson

Ellen Hancock

Warren Buffett

When asked about EBITDA back in 2002, famed investor Warren Buffett allegedly said: “People who use EBITDA are either trying to con you or they’re conning themselves.”

I first learned that lesson while covering Exodus Communications, a data center provider during the dot-com boom. Whenever I asked Exodus about the company’s financial health in the 2000 timeframe, executives from the company pointed me towards top-line revenues and EBITDA, along with the company’s march toward positive EBITDA.

The con? Exodus wasn’t doing anything illegal. But they convinced themselves that positive EBITDA was enough to overcome a massive debt load. In April 200, Exodus CEO Ellen Hancock noted: “This period marked the first quarter that Exodus achieved EBITDA profitability. This important milestone indicates the strength of our business model and our ability to generate a return on our investments.”

Sounds great. Hancock was telling the truth about EBITDA profitability — her figures were correct.  And she’s considered an ethical business leader based on her years of work at IBM, Apple and Exodus. But Exodus still filed for Bankruptcy in 2001 because the company was carrying too much debt when the dot-com implosion arrived.

Focus on Cash Flow… And…

Again and again during yesterday’s M&A Symposium, Cogent’s Murphy told MSPs to focus on their cash flow. Continually improve that figure, and you’re building value in your business, he asserts.

Correction/Update, Feb. 13, 2017, 7:54 a.m. ET: Murphy was actually referring to Free Cash Flow.

Good advice. But I gotta concede, I’m not ready to give up on EBITDA. I’m not suggesting that EBITDA and associated valuation multiples should be treated as gospel. But in my mind, EBITDA at least provides a baseline metric for M&A discussions. Certainly, dozens of additional metrics weigh into a company’s valuation.

In Cogent’s case, the company works with buy-side IT service providers to help determine the value of sellers — both in terms of dollars and cents, and the strategic value that seller may bring to the table.

Cogent has managed roughly 89 M&A deals over the past eight years. Murphy certainly knows each deal’s metrics. Yes, I’ll keep asking him about EBITDA valuation multiples. And yes, he’ll likely call such metrics B.S. — based on many of the reasons the he, Harvard Business Review, Warren Buffett and other experts have raised.

Still, I rather enjoy hunting for EBITDA deal multiples. Surely, you can’t blame an aggressive reporter for trying.


Joe Panettieri (@JoePanettieri) is co-founder and executive VP of After Nines Inc. and its IT media platforms — ChannelE2E and MSSP Alert. His great grandfather arrived to the United States from Italy around 1917, charting the way for three generations of entrepreneurs.

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6 Comments

Comments

    Dustin Bolander:

    If you have to focus on cash flow you need to be focusing more on really doing managed services right? Paying up front each month and not letting clients go overdue, you should have very few cash flow issues. Or are they talking about people doing break/fix and moving lots of product still? What am I missing?

      Joe Panettieri:

      Hey Dustin: A portion of the MSP market still loses money. Data points shared at the Kaseya MSP M&A Symposium suggested that about 7 percent of MSPs lose money. I suspect the figure is far higher. Somewhere around 15 percent, I suspect just based on anecdotal meetings I’ve had across the industry.
      -jp

    Stuart Crawford:

    Joe, we have started living the “Profit First” mentality at Ulistic. It is a system based on a former MSP business owner in New Jersey. I believe Mike was co-owner of Olmec in NJ. His metrics are rock solid.

    Stuart Crawford
    IT Services Marketing Consultant
    ULISTIC LP

      Joe Panettieri:

      Stuart: Thanks for the background. Let me know how the profit KPIs work out for you. Our own media company is similar in approach to today’s top MSPs. Amy Katz (my biz partner) and I are pretty obsessed about IT automation for just about every IT media service we launch. I closely track the digital KPIs (traffic, readership, etc.) while Amy closely tracks our financial metrics.

      We were pretty focused on some of those various KPIs in our previous business (2008-2011; exit transition 2012-2014). But in the current business (late 2014-present) you could say we’re obsessed with the KPIs.
      -jp

    George Sierchio:

    Hi, Joe- Thanks for running this piece on Rick and Cogent. I’d like to clarify for Dustin and any other readers about what Rick was referring to with cash flow. Although Dustin has a good point about running your business off of cash flows and not strictly on your P&L for a solid business, Rick was referring to free cash flow (FCF) versus EBITDA, which is what Mr. Buffet is also referring to. (Your link in the article points to a regular cash flow page, not free cash flow.)

    In an MSP, it could be a negligible, small, or large difference between the two if the business in question runs operations from their balance sheet. As an example, if an MSP takes a loan or capital lease out on data center equipment it uses to host customer environments on, that is a cost of goods (COGS) that’s hiding on the balance sheet. In turn, it gets ignored through EBITDA, but not in FCF. It’s a business operations cost just the same as if they instead paid the data center to use the facility’s equipment and had that expense on the P&L.

    I hope that clears things up a bit.

    As for your zest as an aggressive reporter to use EBITDA multiples, have at it 🙂

    EBITDA multiple comparisons, when used to compare deals of LIKE companies (what they do, how they do it, profitability, SIZE, etc), is common place. When comparing like companies without actually looking under the hood, it may get you a reasonable back of the napkin proxy value pre-deal. However, it’s really about the go forward FCF for the particular buyer starting with the seller’s FCF and continued organic growth plus consolidation, synergies, and growth opportunities as well as the ultimate deal structure, to name a few points. The more money the buyer thinks they can make above what the seller makes over a set investment horizon, the more they can pay, depending also on how they need to pay for it. The resulting EBITDA multiple is after-the-fact math based on purchase price and seller’s numbers alone (and aggressive reporter analysis). – Love you Joe!

      Joe Panettieri:

      Hey George: Thanks for the correction. I’ve added a Free Cash Flow link to the article. And thanks for the continued education. I certainly appreciate it, as do our readers.

      Best,
      -jp

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