P/E MULTIPLE OF TURKISH COMPANIES HIT THE 9 YEAR LOW IN 4Q 2018 AS A RESULT OF INCREASED POLITICAL AND MACROECONOMIC RISKS IN TURKEY AND WIDER IN THE MIDDLE EAST. M&A ACTIVITY HALVED ALREADY IN 2016-2017 , MAINLY AS A RESULT OF BIG, INFORMED PLAYERS’ ABSENCE. MANY ARE QUESTIONING THEMSELVES “IS IT NOW THE TIME TO BUY A TURKISH COMPANY OR WE ARE WITNESSING A TEMPERED BOMB?”

Good conditions for corporate acquisitions in Europe

Relative power of companies in the developed world increased in the period after the financial crisis. Economic conditions in 2016, 2017, 2018 were/are prosperous, while the access to money is relatively easy and cheap. M&A activity in the developed world is on the other side reaching historical heights. Many companies gathered free cash resources and are thus facing questions such as which company to buy, when, at what price and how to properly address the risks.

Impact of macro on corporate valuations in Turkey

Valuations of Turkish companies are for some time already at the spotlight of the foreign financial analysts and companies with the inorganic grow (M&A) ambitions.  Turkish BIST 100 P/E multiple dropped in first 8M period of 2018 from 9x to 7x and hit the lowest levels in last 9 years. Its maximum was in 2013, when the multiple reached 12x.

A fast look into the multiples may indicate a good entry point. However well-informed big M&A players pressed a brake. Main fears are gathered around the potential impact of future macroeconomic & political risks on business operations. Let’s point out few key developments:

• Turkish Lira is continuously loosing its value against the EUR or USD for last 15+ years. The Aug 2017 – Aug 2018 decrease is significant and amounts to 40+%. Futures (CME) in Aug 2018 forecast a significant further drop also for the following years, while the costs of hedging are increasing steadily.
• Inflation rate in July 2018 reached 15,85% p.a. From Mar 2018 it is up for 5+% points and is increasing exponentially. Current inflation levels are the highest from Jan 2004 and are significantly above the long-term target inflation rate.
• Turkish companies are in average well-exposed to FX risks. They hold significant amounts of loans in EUR and USD.
• Significant credit risk eruption seriously threatens Turkish companies. Excess of serious liquidity problems may occur due to the maturity gaps between investments and loan financing.
• Country risks grow rapidly. 5Y credit default swap for Turkey increased for 350 basic points compared to the BOY 2018 and reached 500 basic points in Aug 2018.
• Average cost of debt for companies is high. Average interest rate for company loans reported by Turkish Central Bank reached 21,75% p.a. in Jul 2018.
• Payment discipline problems as well as payment terms are on the rise. Liquidity ratios of Turkish companies are worsening. Average trade receivables outstanding (TRO) in 1H 2018 amounted to 121 days, nevertheless 46% of business partners demand a significant increase.

No matter the environmental and industry analysis, the final conclusions related to the feasibility of the M&A activity is determined based on the individual case and in line with the corporate value-maximization principles. Besides the underlying case findings, the decision whether to involve in the M&A activity and at what price heavily depends among others also on motives, strategy and alternatives. One should be well aware of risk-benefit profile and accept the decision based on the well-informed decision making process.

Let’s look at the case study of a B2B multinational industrial company and how they addressed the question of increased risks linked to the operations in Turkey.

The background of the corporate acquisition:

Acquirer holds a dominant niche position in Europe and wider. It is considered as a reliable, high-quality supplier with a wide portfolio of own products. The company is active in the CapEX intensive industry. It reached its leading market position due to the fact that they were able to internationalize its business operations faster and thus reach the economies of scale and scope, which nowadays represent hard-to-beat market entry barrier. Part of the success can also be attributed to banks, which were for a long period exposed to above-average indebted company.

Turkish target is a direct competitor of the acquirer and was founded as a result of the acquirers’ clients activity, to decrease their dependency and regain the negotiation power. Once the target started to threaten the performance of the acquirer more seriously, the company adjusted the regional pricing policy and thus strengthen its competitive pressures. Due to the limited financial power and negative macro development, the competitor offered the acquirer the option to acquire the company.

Corporate market value estimate of the target in the context of recent macro developments & risk perception:

Comment: Target’s market value estimate is attractive, especially if considered in the context of historical pricing. Only from the BOY 2018 the company lost more than a quarter of its value. P/E multiple of the target is also cheaper than the reference industry / market multiple, reflecting the acquirer’s competitive pressures. Market value estimate is approximately on the net asset value, which is used as a post-acquisition strategy base. The commercial side of the deal is stimulative for the acquirer.

Corporate acquisition related risks and post-acquisition strategy 

In order to limit the effect of high risks on future business operations and value generation, operational restructuring is planned.

• After the corporate acquisition part of the capacities double. The plan is to move them to other continents, where the acquirer already supplies some (other) products from its portfolio to certain clients. Local production will open new business development opportunities and good base to increase the value generated / revenue synergies.
• After the corporate acquisition products for existing Turkish and Middle East clients are to be produced on more efficient production lines of the acquirer within the EU. To guarantee sufficient flexibility the supply will be coordinated through the local warehouse.

Corporate acquisition enables also realization of selected new business opportunities. Projects relate to Turkish and Middle east clients and are only available to local producers with sufficiently advanced know-how. These projects are planned in line with the value creation principles. In other words, due to high operational risks only execution of projects with returns above the weighted average cost of capital take place.

Base scenario (symbolic graphics; imaginary numbers are used):

Comment: The corporate acquisition results in synergies as presented above. Additionally created value supports the decision to acquire a company.

Worst-case scenario (symbolic graphics; imaginary numbers are used):

Comment: New business opportunities are due to the environmental challenges limited. Operational restructuring works as a shield to protect against eruption of risks after the corporate acquisition. The core value is thus significantly less exposed to Turkish risks.

Market entry (corporate acquisition) is attractively priced and is from the perspective of the acquirer a good business decision, while post-acquisition strategy limits the effect of further negative risk development. Additionally, the acquirer also plans to:

• minimize the exposure to Turkish Lira (change most of the existing commercial agreements to EUR; hedge the TRY-EUR FX rate risks)
• minimize the exposure to risks related to Turkey (continuous excess cash pay-outs / reinvestment, optimization of net working capital and financing mix)

The recent developments of risks in Turkey, enabled the acquirer to 1) execute the business acquisition (acquire the competitor), 2) consolidate the business operations and improve the operational efficiency, 3) speed up the the Middle East market entry and develop the regional presence. In the given case the transaction size matches the net asset value, which the acquirer used to relocate certain duplicated capacities (fixed assets) to other continents. The focus of the post-acquisition strategy addresses high risks and provides the answer how to restructure the operations to maximize the value. Despite the fact that the majority of companies decided to put their M&A activity in Turkey on hold, the given macro situation offered the acquirer an attractive business opportunity.

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Addressing the pain: EU tax optimization schemes

In the first step, Consilue gained detailed understanding of the business, gathered some preliminary data (incl. owner’s personal tax residency, expectations, limitations) and performed an analysis of the current tax-related expenses.

Then tax consultants analyzed the existing tax optimization strategy. The approach involved tax havens and offshore companies and truly lacked transparency. It also had several significant flaws and drawbacks. The strategy was classified as risky and inappropriate by Consilue. Since the client was risk-averse by nature, tax consultant advise the client not to proceed with its implementation and rather seek for safer EU alternatives.

The work continued with further in-depth analysis. The goal was to find the approach which would on one side result in maximum tax savings and on the other side be as simple and transparent as possible. Together with the client, tax consultants came up with optimal solution to minimize overall tax expenses.

Tax consultants realized that corporate income taxes could be further optimized already within the existing tax environment of one of the companies in the group (Slovenia, EU). In order to do so, the case company would have to acquire a proper growth strategy, which is in fact more business-related measure. Why so? Existing tax environment promotes companies’ investments in selected tangible assets in the form of tax reliefs. Since the client’s business is investment intensive, this is in fact a superb base for the client to optimize taxes. Currently the company sales were stagnating. Investments were on the level of depreciation & amortization (D&A). However, reaching for higher growth rates of sales would result in the need for additional investments and as such further decrease taxes paid. Consilue realized that only with some business restructuring activities within the group of companies in the neighbor countries the client could be in fact paying effectively 0% CIT. It is literally the undeclared tax haven in the heart of EU for corporate income tax optimization when it comes to fast growing investment intensive businesses. The client realized that from the perspective of value generation and value-based-management on the group level, it would also be more rational to move the headquarters and base his future business developments in the given tax environment. Despite the fact that the client liked the idea of CIT optimization for the case company, Consilue proceed with the analysis of best practice of comparable businesses Europe-wide and the effect on value generation. One should be aware that taxes are to be understood in the wider context (corporate income taxes or CIT, dividend taxes or DIV, capital gains or CG, witholding taxes or WHT etc.) and analyzed in line with the group presence and future development.

Tax consultants’ efforts were focused also on the optimization of owner’s personal taxation – dividend taxes and capital gain taxes. The owner expressed willingness to sell the company in the future and was well aware of the importance of personal tax optimization as well. Consilue found the approach aligning with his personal interests, limitations and expectations. The tax rates drop and consequently the total tax savings are to be significant, especially due to the fact that the transaction value expected is significant.

Results: Reaching tax savings in a safer way

The tax optimization strategy resulted in significant savings in taxes paid. What is most important, the strategy was tailored to the client and its needs. It is safe, transparent and simple to understand. It also has no negative image on the corporate brand, since no tax havens and other countries on the so called tax authority black list were involved. The client is comfortable with it and that is the most important.

Taxes paid as competitive advantage

I have to admit. Firstly, I was a bit skeptical about Consilue. Tax experts normally have two or three solutions developed and they stick to this. I was looking for a transparent and safe way to optimize taxes. A business partner recommended me Consilue and I am really glad. Consilue definitely delivered it! The approach was tailored to my business and personal needs. In fact, we transformed tax environment into our competitive advantage. The growth strategy is in my case definitely the right way to go. Tax credit logic and the approach to optimize personal taxes are straight forward and I feel 100% comfortable with the solution. The funny thing is that the approach is scalable and it is actually generating more savings on taxes paid as those risky strategies initially considered with companies in tax havens – offshore company system.

Advisor’s thought: Be comfortable with taxes

Despite the fact that nowadays majority of the world capital runs through tax havens, there are many underlying risks related to it. In case of SME, the cost-value-risk ratio plays important role. Things like complex operation schemes, high costs of legal, accounting and other services, risks of changing the regulation and other critical topics normally cause the clients to prefer straight-forward and transparent tailor-made tax optimization strategies over the offshore company and tax haven alternatives.

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The case company is a privately-owned SME, distributor of highly regulated chemicals. Past company financials initially indicated a very good position, a stable business and above-market profitability.

Advisor approached the company with the goal to optimize tax-related expenses and propose the client how to manage the excess cash more efficiently. Surprisingly, the consultant realized that the company is in fact in a very delicate situation and should be focusing on a completely different area – i.e. risk management. The discussion with the owner revealed extremely high concentration of buyers and significant dependency-related risks.

The main buyer of a case company represents approx. half of company sales. His performance is poor, but relatively stable. Nevertheless, the company analysts did not do their job properly – the analysis of the buyer that Consilue did in another case revealed a very serious financial problems on the consolidated group level, which could quickly result in fatal consequences for the case company.

Addressing the pain: Corporate risk management measures

Immediately after Consilue realized the seriousness of the situation, the client was pushed to urge. The consultant arranged with the client a dedicated meeting to discuss current situation with the client and present potential consequences of poor risk management. In the next phase, the proposed steps were systematically presented, with one single goal – to minimize the underlying corporate risks and strategically overcome the client dependency issue.

The approach the consultant proposed to the company:

• Firstly, the company and the consultant need to minimize outstanding problematic receivables through renegotiation of the days receivables outstanding (DRO). Furthermore, also a cost-effective solution for the securitization of receivables should be found. Additional insurance costs should than be charged to the buyer.
• Based on the financial projections prepared, the consultant has to determine the optimal financing structure. In other words, the target amount of equity needs to be kept as minimal as possible, however still at the reasonably acceptable levels for the creditors. Afterwards, the financing has to be agreed with banks and suppliers and the predetermined amount of equity paid out to the shareholders.
• With the above stated measures the company is only buying time. The company needs to impact the source of the problem – lack of sales diversification. Since the organic way of market penetration would last too long in this case and is due to that fact in given situation not appropriate, one of the possible solutions pointed out to the client is to lean in the direction of M&As, i.e. gain the network through acquisition of a target with relatively diversified sales. These activities, however, should take place independently from the base company in order not to poison the equity of the overtaken company with the company’s underlying risks as well.

Despite warnings to speed up the decision-making process, the company was hesitating with the active engagement and implementation of preventive measures. The company managers and owners did not see the real added value in the proposed changes at the moment of writing of this case study.

Results: No risk management solution for now – bad sign

The importance of risks is often underestimated, also due to the fact that the financial impact lags. The case company prolongs to be heavily exposed to risks, since the management decided to make changes gradually.

Due to the fast pace of changes on the buyer side, the company crisis management and other last-minute measures might result in additional unnecessary costs.

Client’s testimonial: Risk assessment procedure in action

We are now aware of the financial problems in which the buyer ended up and we are tracking the developments more carefully. We are getting assurances from their side that the situation will not be impacting the strong partnership we have established through the years of good cooperation. The agreed 20 days increase in due date in trade receivables is probably of one-time nature. We checked with our insurance company and it seems they are not ready to securitize the outstanding receivables. For the moment we continue to work further as we did so far and we will see what time brings.

Advisor’s thought: Risk management consulting

Nowadays the management needs to understand the priorities and companies need to develop the capability to act fast when this is required. The corporate culture should be developed hand in hand with the change management philosophy. The ability of fast responding and value-based management is one of the ultimate things to long-term survival. The attitude examples towards changes should come from the very top.

The consultant is confident that the proposed approach adds value to the client, however the client itself needs to realize this as well. It is of extreme importance that the consultant remains at client’s side and further strengthens the level of trust.

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The owners of a privately-held engineering company engaging in medium-size utility projects approached us in panic to organize the sales process and find a solution to provide the sufficient liquidity until the new owner steps in. The company was performing extremely poor recently and felt into serious liquidity problems. Revenues collapsed and levels of financial debt rose in three quarters of a year from sound indeptedness to 180% D/E and 10,3x Debt/EBITDA. Owners were 100% sure that the company is on the way to bankruptcy and were only expecting a small fee for it.

According to their opinion, potential buyers could be managers, currently leading the company.

Addressing the pain: Company worth in the context of value generation

Consilue approached the valuation in line with the top-down approach, which also included in-depth analysis of the industry. After careful examination, we figured out that the demand for projects is highly correlated with cofinancing activity of EU structural funds and the valuation date matched the transition between the two investment cycles. Furthermore, the size of the EU contribution for the next investment cycle was also significantly changed for the key markets the client used to serve in the past.

After understanding the reasons which pushed the client into liquidity issues, we performed the in-depth financial analysis. We broke-down business into individual projects and analyze and project the developments one by one. We figured out that the company is in fact expecting a good profitability in the following two years, they only need to re-focus their activity on more prosperous countries in the region. Furthermore, also a significant increase in the cash conversion cycle (mainly increase in accruals) already indicates better times and is in fact by its nature only temporary.

For decision-making purposes, we decided to simulate the generation of economic value by years with and without operational restructuring and improvement in profitability. The purpose was to show the shareholders the importance of the active involvement into the future business activities of the company.

Later on we performed also the corporate valuation based on going concern. Since we used market value as our base value, also successful operational restructuring was assumed.

Results: Company worth estimate done right

We have showed the shareholders that the market value on the date of valuation is in fact significantly above their expectations. They understood that they were played by managers to sell them the company for the cheapest possible price.

Despite the existing high levels of debts, we persuaded banks to support the company with the short-term liquidity injection and stand aside.

Client’s testimonial:

When estimating the value of the company we took the EBITDA and multiply it with a given multiple. That was so wrong and almost costed us millions. One truly needs to understand where the value comes from. In our case, it was generated from the change in net working capital (decreasing the accruals) in the first year and strong EBITDA in the first two years.

We are sincerely thankful to Consilue for showing us the right path. Now we are about to change the management and actively approach the operational restructuring.

Advisor’s thought:

Valuing a company requires a deep understanding of the business. Often the process reflects many interests and fast response – as in given case – which makes it challenging.

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The client is a small company, operating in the plastic industry, specializing in the next generation packaging solutions. The company works for prominent clients from cosmetic, chemical, food & beverage, pharma and medical industry worldwide. The company is about to expand its presence in the Latin America. As planned, strengthening the presence in the emerging markets would most likely result in the projected two digit growth rates and EBITDA margins.

The client has developed strategic partnership relationship with its indirect competition all over the globe. Intense cooperation resulted in cost synergies and sharing of a supplier-side know-how. The indirect competitor’s owner has experienced a serious financial problems and thus a decision to divest the business has been accepted.

Addressing the pain:

Firstly, the client has decided for a general overview of the indirect competitor’s past operations. Based on the preliminary findings, the client has decided to continue only with the acquisition process of the most valuable asset – the existing customer database.

Later on the advisor has prepared the client a revision of the competitor’s past projects and their profitability analysis. The findings served as a base for the determination of key variables and preparation of the financial projections, calculation of synergies and customer database valuation.

In order to be able to achieve the full potential as planned in the financial projections, the client has been advised to employ competitor’s key sales personnel.

Results:

The acquisition of the customer database and complementary activities are expected to result in significant revenue and cost synergies and geographic risk dispersion.

Client’s testimonial:

It is very important to be aware of the fact that valuing the customer database from the perspective of “as is” projections and from the perspective of our business (reflecting our business model) varies. It messages significant synergies. Furthermore, taking over customer database with key employees is “a must” – it is a good oportunity to gain new capabilities.

Advisor’s thought:

The client is about to gain short term and long term boost in its operations through new emerging market penetrations and risk diversification. Last but not least, fulfilling the sales capabilities gap will enhance the company’s position and its ability to compete with significantly larger global players.

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