valuation of customer assets

Valuation Research Corporation

Ed Hamilton, CFA

Vice President

[email protected]

Direct: 609.243.7018

Mobile: 609.221.8174

Alternative Approaches to Valuing Customer-Related Intangible Assets

PJ Patel, CFA, ASA

Managing Director

[email protected]

Direct: 609.243.7030

Mobile: 609.240.1337

• Qualitative Considerations

• Customers in Certain Situations

• Alternative Valuation Techniques

• With-and-Without Approach

• Distributor Method

• Cost Approach

Agenda

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Customer lists

Transactional purchase

order based

Transactional customer

relationships

Recurring customer

relationships with

Customers with long

term Take or pay contracts

Continuum of Customer Assets

Customer lists order based

customersrelationships with MSAs

relationships with

switching costs

term contracts

Take or pay contracts

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Customer Value – Two Scenarios

Company Customer Relationship

Margin Comments

DefenseContractor – IT Related

• Contractual• Multi-year• Renewals and/or extensions often occur

9% • Customers are a key acquisition rationale• Customers often the primary intangibleintangible

Consumer Branded – Food

• Purchase order based• Non-contractual• Based on strength of brands, consumer demand

25% • Customers of limited importance• Customers help company reach consumer but brand is key

3

MPEEM – Two Scenarios

IT Defense Branded

Contractor Product

Revenue $100,000 $100,000

EBITA 9,000 25,000

9.0% 25.0%

Pre-Tax Returns on Supporting Assets

Charge for Use of the Trademark 0 (5,000)

Adjusted Income Before Taxes 9,000 20,000

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Less: Income Taxes 3,600 8,000

Debt Free Net Income 5,400 12,000

5.4% 12.0%

Returns on Supporting Assets

Working Capital (1,200) (900)

Property, Plant & Equipment (180) (2,700)

Workforce (2,500) (500)

Return on Supporting Assets (3,880) (4,100)

-3.9% -4.1%

Net After Tax Cash Flow to Cust. Relationships 1,520 7,900

Implied Royalty Rate 1.5% 7.9%

MPEEM – Alternative Calculation

Branded Branded

Product Product

Revenue $100,000 $100,000

EBITA 25,000 25,000

25.0% 25.0%

Pre-Tax Returns on Supporting Assets

Charge for Use of the Trademark (5,000) (15,000)

Adjusted Income Before Taxes 20,000 10,000

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12.0% 6.0%

Returns on Supporting Assets

Working Capital (900) (900)

Property, Plant & Equipment (2,700) (2,700)

Workforce (500) (500)


-4.1% -4.1%

Net After Tax Cash Flow to Cust. Relationships 7,900 1,900


MPEEM – Key Limitation

• When the customer relationship asset is the unique asset, use of a traditional MPEEM may be appropriate.

• When another asset is the unique asset, use of the MPEEM may overstate customer value.

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• Valuation of Customer assets is heavily dependant on qualitative issues

• Prior to choosing a valuation method, it is important to understand the qualitative characteristics of the customer asset and its relationship to the business

• Are the customers a primary asset of the business?

• What is the relative importance of the customer relationships vs. other assets of the business?

Qualitative Issues

• Where does balance of power lay between a company and its customers?

• Are there significant barriers to entry?

• Are there significant switching costs?

• What is the relative class spend (i.e. customers vs. technology)?

• Where are the company’s products in their life cycle?

• Are there any contractual rights (e.g., trademark registration, patents, customer contracts, etc.)?

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Customer Type Market Proxy Margins earned by Market Proxy

Transactional purchase order based customers

Appears similar to the type of relationships maintained by distributers

Typically 3-6% - may be greater or lower depending on customer/manufacturer leverage

Transactional customer relationships with MSAs

Appears similar to the type of relationships maintained by distributers, although slightly

Expect margins to be at the high end of distributors but below those of customers with long term contracts

Match Qualitative Info to Market Data

stronger

Recurring customer relationships with switching costs

Appears similar to the types of relationships maintained by companies with long term contracts although not as strong

Expect margins to be higher than distributors but lower than customers with long term contracts. Although in some unique cases margins may be much higher.

Customers with long term contracts

Appears similar to the types of relationships maintained by contract manufacturers, defense contractors etc

Varies, however margins for certain long term service providers range from 5-10%

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• Value is based on the present value of expected future cash flows attributable to the asset being valued

• Three primary factors

• What are the earnings or cash-flows relating to the asset being valued?

• What is the expected life?

• What is the appropriate discount rate?

• Approach takes several forms:

• With-and-Without Model

Income Approach

• With-and-Without Model

• Multi-Period Excess Earnings Model

• Distributor Method

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• Value is estimated by quantifying cash flows under a scenario in which the customer-related assets must be replaced but assuming all other assets are present.

• Base case cash flows are projected in a manner consistent with company/asset group projections

• Without scenario incorporates the costs and lost profits over the time period expected to rebuild customer asset

• The value is based on present value of the differential cash flows

With-and-Without Model - Overview

• The value is based on present value of the differential cash flows

• Useful in valuing non-primary assets

• Theoretically intuitive

• Costs incurred, profits lost and time period to recreate asset are highly subjective and difficult to quantify

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With-and-Without Method – Key Assumptions

• Impact on revenue

• Impact on cost of goods sold

• Direct costs to establish and recreate the customer-related assets

• Other costs such as direct and indirect SG&A

• Other required assets or expenditure, e.g. working capital and capital expendituresexpenditures

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With-and-Without Method – Recreating the Customer Rel.

• Expected time to recreate

• Historical time to build to current levels

• Typical sales cycle

• Time to establish a new relationship

• Lag between sales proposal and an order

• Level of competition in industry• Level of competition in industry

• Minimum sales guarantees once an initial product is sold.

• Switching costs and whether this will increase the difficulty of attracting new customers.

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• Company A acquires Company B, a manufacturer of branded consumer electronics. Company A acquired Company B primarily for its brand and all other assets were thought to be easily replaceable. The purchase price was $168 million.

• After consideration of additional SG&A costs to replace the customers and other cash flow impacts, new cash flows are projected to be reduced by $12 million, $6 million and $3 million for years one, two, and three, respectively.

With-and-Without Model - Example

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Year 1 Year 2 Year 3

Cash Flows - With 100.0 110.0 120.0

Cash Flows - Without 88.0 104.0 117.0

Incremental Cash Flows 12.0 6.0 3.0

With-and-Without Method - Calculation


Debt-Free Net Cash Flows (with Cust. Rels.) 100.0 110.0 120.0

Debt-Free Net Cash Flows (w/o Cust. Rels.) 88.0 104.0 117.0

Incremental Cash Flows 12.0 6.0 3.0

Midpoint 0.5 1.5 2.5

Present Value Factor 0.9428 0.8381 0.7449

Present Value of Incremental Cash Flows 11.3 5.0 2.2

Sum of PV of Incremental Cash Flows 18.6

TAB 4.3

Fair Value 22.9

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Tax Benefit=L/(L-(Fa*T))

Tax Life 15 Years

Tax Rate 40.0%

Discount Rate 12.5%

Amortization Factor 7.0352

Tax Benefit 23.1%

With-and-Without Method – VRC Comments

The group also discussed calculating the With-and-Without Method by estimating the value of each scenario independently. In the end, this approach was not recommended/included due to difficulties and drawbacks in implementing.

Comments/Considerations

• The group had significant discussion around which cash flows to discount and at what discount rate.

• Is the discount rate consistent with the total loss of customers?

• If different discount rates are used for the two scenarios, and the without scenario is more risky, a higher discount rate leads to lower value for the without scenario and thus a higher value for the customer-related asset. This is counterintuitive.

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Distributor Method – Theory & Usage

• A business is composed of various functional components (e.g. trademarks, technology, manufacturing, marketing, sales & distribution.)

• For certain functions, market-based data may assist in isolating the margin associated with a functional component.

• Distributor data may be appropriate when the customer relationships have characteristics that are similar to those of a distributor

• Useful because it allows for use of the MPEEM to value another asset, e.g. technology or brands.

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• Value is based on the present value of expected future cash flows attributed to the asset being valued

• Cash flows are projected based on market participant inputs for certain key inputs with adjustments for growth and customer attrition similar to the MPEEM

• DM is useful in valuing non-primary assets and reduces reliance on CACs

• DM requires selection of appropriate comparable companies who can provide a reasonable market based proxy (i.e. they serve a similar function) and profit margin for the customer asset being valued

• DM requires many inputs:

Distributor Method

• Projected revenue

• Expected margin

• Long term growth rates

• Attrition rates

• CACs for certain limited contributory assets

• CACs are not required for manufacturing related working capital, PP&E, workforce, product trademarks and technology as these items are captured in the distributor’s COGS

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• Company A acquires Company B – a manufacturer of branded consumer products. Company B generates $100 million in revenue per year. Company B sells its products to retailers. The brands are the primary asset of the business and contributory assets include working capital, PP&E and workforce related to the sales/distribution function.

• To properly allocate cash flow and value between the brands and customer relationships, the distributor method is used to value the customer relationships and the MPEEM using PFI is used to value the brands.

Distributor Method - Example

• Key inputs are as follows:

• Expected revenue growth – 3%

• Expected customer attrition – 10%

• Appropriate distributor margin – 4.1%

• CACs are needed for working capital, PP&E, trademark and workforce based on distributor levels rather than manufacturer levels

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Revenue Adjusted for Growth $100,000 $103,000 $106,090

Remaining After Attrition 95.0% 85.5% 77.0%

Revenue After Attrition 95,000 88,065 81,636

EBITA (4.1%) 3,895 3,611 3,347

Less: Income Taxes 1,558 1,444 1,339

Debt Free Net Income 2,337 2,166 2,008

Distributor Method - Example

Debt Free Net Income 2,337 2,166 2,008

Contributory Asset Charges

Normal Working Capital (684) (634) (588)

Property, Plant & Equipment (238) (220) (204)

Workforce (95) (88) (82)

Return on Supporting Assets (1,017) (942) (874)

Net After Tax Cash Flows 1,321 1,224 1,135

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Distributor Method MPEEM

Revenue Adjusted for Growth $100,000 $100,000

Remaining After Attrition 95.0% 95.0%

Revenue After Attrition 95,000 95,000

EBITA 3,895 19,000

4.1% 20.0%

Adjustments

Less: Royalty Charge for use of TM 0 (9,500) 10.0%

Adjusted EBITA 3,895 9,500

Distributor Method vs. MPEEM




Debt Free Net Income Margin 2.5% 6.0%


Normal Working Capital (684) (1,425)


Workforce (95) (1,045)


-1.1% -4.6%

Net After Tax Cash Flows 1,321 1,330

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EBITA 3,895 28,500

4.1% 30.0%

Adjustments













-1.1% -4.6%



21





EBITA 3,895 28,500

4.1% 30.0%

Adjustments












-1.1% -4.6%


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• Key attributes

• When using the distributor method, inputs used in the MPEEM should reflect distributor inputs, such as:

• Working capital to revenue ratios

• PP&E to revenue ratios

• Other assets that may be present such as trademarks, workforce, etc.

• Development of an appropriate discount rate

• There are drawbacks to this approach:

Distributor Method – Final Comments

• There are drawbacks to this approach:

• It should not be used when customer relationships are the primary asset

• For many relationships a market proxy may not be available

• Cash flows relating to customer relationships may be overstated. However, MPEEM using PFI appears to further overstate cash flows to customer relationships, especially if applied mechanically without thought to qualitative attributes

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Cost Approach - Overview

• Premise is that a prudent investor would pay no more for an asset than the amount for which the utility of the asset could be replaced.

• May be appropriate when the customer related asset isn’t the primary asset and can be recreated in a short period of time.

• Time to recreate is critical – if time is significant may point to a value greater than an accumulation of costs.greater than an accumulation of costs.

• May be used for early-stage companies that are unable to forecast revenue with reasonable certainty or when other approaches are difficult or not possible.

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Cost Approach – Costs

• Direct – Costs incurred to develop customer related asset - direct advertising, marketing, selling, etc. Should reflect current costs but historical may be a reasonable proxy.

• Indirect – G&A and other related costs.

• Developer’s Profit – Reflects the expected return on the investment. Should be a reasonable profit margin based on market inputs.Should be a reasonable profit margin based on market inputs.

• Opportunity Costs – Profits lost while the asset is being created. Based on a reasonable rate of return on the expenditures while asset is being created. Applicable if asset cannot be used while being created.

• Taxes – Not tax affected. It is believed market participants view expenses on a pre-tax basis.

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Cost Approach - Example

• Company A acquires Company B a manufacturer of branded consumer electronics. Purchase price was $500 million.

• Customer related assets were created ratably over the past three years at a cost of $21 million ($15 million past three years at a cost of $21 million ($15 million direct, $6 million indirect)

• Developer’s profit based on market observations.

• Opportunity costs based on a 12% return and an average 3 month lead time between initial contact and first purchase.

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Cost Approach - Example

Direct & Indirect Costs % of Total Value

Direct Costs 15.0 55.8%

Indirect Cost 6.0 22.3%

Total Costs 21.0

Developer's Profit

Developer's Profit Margin (1) 20%

Developer's Profit 5.25 19.5%

Opportunity Cost

# of Customers 1,000

Average Lead Time (Months) 3

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Average Lead Time (Months) 3

Required Return 12%

Investment per Customer (2) 0.021

Opportunity Cost per Customer (3) 0.00063

Total Opportunity Costs (4) 0.630 2.3%

Total Cost 26.880 100.0%

Calculations

1 - (Cost / (1 - Margin) * Margin) such that the margin earned is 20%.

Profit / (Revenue) = 5.25 / (21.0 + 5.25) = 20% margin.

2 - Total Costs / # of Customers

3 - Lead Time in Years * Required Return * Investment per Customer

4 - Opportunity Cost per Customer * # of Customers

Valuation Techniques

Pros Cons Best Used when

Multi-Period Excess Earnings Model

- Consistent with PFI- Assumptions / inputs available

- Sig. number of assumptions needed, i.e. LTGR, attrition rate, etc

- Customers are the primary asset of the business

Distributor Model - Inputs are available- Reduces reliance on CACs- Some portion of goodwill not included in value- Allows use of MPEEM to

- Market inputs can be subjective and require valuerjudgment- Requires availability of appropriate market inputs.

- Customers are a non-primary asset

Summary of Valuation Techniques

- Allows use of MPEEM to value primary asset

appropriate market inputs.

With-and-Without Model

- Underlying theory is intuitive - Key assumptions are subjective and difficult to support

- Customers are a non-primary asset

Cost Approach - Objective, if good data is available- Goodwill not included in value estimate

- Data difficult to find- May understate the value

- Customers are a non-primary asset and cost data is readily available

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Valuation Research Corporation

• Formed in 1975, VRC has eight U.S. offices and eight international affiliates.

• VRC provides M & A advisory services, fairness and solvency opinions in support of corporate transactions, and valuations of intellectual property and tangible assets for financial reporting and tax purposes.

• VRC maintains relationships with corporations, lenders, accountants, investment banks, private equity firms, and law firms.

• VRC was instrumental in forming the Appraisal Issues Task Force (AITF), a valuation industry group that meets quarterly with representatives from the FASB, the SEC, and the PCAOB to discuss valuation issues surrounding financial reporting.

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P.J. Patel, CFA, ASA

• Mr. Patel is a Managing Director with VRC and specializes in the valuation of businesses, assets and liabilities for financial reporting purposes.

• Mr. Patel is an active member of the Appraisal Industry Task Force (AITF).

• He is a member of the Appraisal Foundations Working Group preparing an industry Practice Aid for valuing customer related assets.

• Mr. Patel is a frequent presenter on valuation issues for financial reporting

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• Mr. Patel is a frequent presenter on valuation issues for financial reporting purposes and has recently presented on valuation issues relating to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other emerging issues. In addition, Mr. Patel was on the Fair Value Panel at the 2008 AICPA SEC Conference. He has been quoted numerous times in the press regarding valuation issues.

Contact Information:

[email protected]

Direct: 609.243.7030

Mobile: 609.240.1337

Ed Hamilton, CFA

• Mr. Hamilton is a Vice President with VRC and specializes in the valuation of businesses, assets and liabilities for financial reporting purposes.

• Mr. Hamilton is an active member of the AITF and is currently involved with the Appraisal Foundation Working Group preparing a Practice Aid for the valuation of customer relationships.

• Mr. Hamilton is a frequent presenter on valuation issues for financial reporting • Mr. Hamilton is a frequent presenter on valuation issues for financial reporting purposes and has recently presented on valuation issues relating to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other emerging issues.

Contact Information:

[email protected]

Direct: 609.243.7018

Mobile: 609.221.8174

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valuation of customer assets

Documents

customer value

customer contracts

customer relationship

customer relationships

customerrelated assets

unique asset

primary asset

income approach value