This is quite an elementary topic. Actually, it’s very elementary. But, in this economic climate and with the profligacy of some managers, it’s important to keep front of mind. I’ll introduce the topic with a few quick calculations. Consider a business with sales of $100m, gross margin of 60% and EBITDA of $20m. If sales drop 20% down to $80m, you’re also losing gross profit of $12m. Usually at a minimum, this will fall directly to the EBITDA line.
So, in this example, EBITDA will now be $8m. This is quite a serious problem for investees, but made much worse by the continued profligacy of managers and inflation in fixed expenses.
So what’s the implication of this? For starters, you’ve conceivably just dropped 60% of EBITDA and therefore 60% of value (that is, if the new EBITDA is deemed the new maintainable EBITDA). That’s a BIG problem. The obvious reaction is to reduce fixed costs so EBITDA doesn’t drop by the full GP loss, but that carries risks too. It obviously creates tension if you have to let people go, but it also limits your ability to return to previous sales levels if you have to sell off important equipment.
What are the other options? I’d say one of the better options is to delay cuts to people and major equipment and put as much effort as possible into taking market share and boosting sales. Also, make sure that costs don’t blow out as a result of the sales drive. It’s just as much about sales as it is financial discipline.
Now you can see this is a privat equity 101 issue: decreasing sales can drastically affect value of an investee.