The Real Value of the Plant You’re Buying
Companies buy and sell plants every day. There are many reasons why a firm might choose to buy or sell a plant. Buyers seek to extend their business into new markets or gain scale economies within a market they currently serve. Or, they are bullish about the future and leadership believes the firm possesses the core competencies to compete in the market effectively. Either way, you need to know the real value of the plant you’re buying.
Sellers, on the other hand, seek to raise capital to pay off debt or to invest elsewhere, or to divest from a business where leadership believes the market may soften in the future. Or, they identify an area where the firm lacks the core competencies to maintain a competitive position.
In any buy-sell transaction, the most difficult activity is valuation. This is certainly the case when buying or selling a plant. Any valuation exercise that fails to consider the plant’s long-term prospects for reliability as a part of the due diligence process places the buyer at risk of overpaying for the asset or, in some instances, paying to acquire a costly liability.
The challenge for valuation, of course, is that sellers are trying to maximize the present value of the transaction while buyers seek to minimize it. Typically, the truth lies somewhere in between those two extreme points. The challenge is finding a price-and-deal structure that suits both parties. In the case of valuing a plant, organizations commonly attempt to assess the value of the following tangible and intangible assets.
- The value of land, buildings and equipment
- The future value of projected profits from operations
- The value of brands and/or the firm’s reputation in the market
- The potential value of marketing and/or operation synergies between the suitor and the target
When a firm makes the decision to divest of a plant, management immediately begins to take actions to increase the perceived value of the asset. Just as an individual thoroughly cleans and details an automobile before putting it up for sale, plant owners want to make the plant look as good as possible to drive up the prospective buyer’s perceived value of the plant or to cover “warts” that suitors might view as liabilities – a practice commonly referred to as “window dressing.” Window dressing is intended to shore up the short-term financial performance of the firm, thus increasing valuation. Some of these window dressings can have an adverse impact on the reliability of the plant, thus reducing the plant’s true value, which, unfortunately, won’t be felt for months or years after you’ve bought the plant.
BUYER BEWARE!
In addition to the normal checklist of due diligence items, before you acquire a plant, develop a checklist of reliability-related due diligence items to help you ascertain the plant’s true value. What follows is information on some of the reliability-related risks that you should consider before signing your letter of intent to acquire the plant.
1. Compare the plant’s current production levels to its longer-term historical levels to uncover signs of overproduction prior to the sale. One easy way to increase profits is to push the production equipment beyond its limits. You can get away with this for a while before the machines show signs of damage. But, at some point, the damage will reveal itself. If production levels were increased, require management to justify the change by providing auditable evidence of appropriate equipment modifications and/or changes in market conditions.
2. Evaluate historical maintenance activities. Cutting maintenance is an easy target for window dressers. Every maintenance dollar that is cut goes directly to the bottom line, but as is the case with overproduction, the true value of the asset is compromised. In financial terms, arbitrarily cutting maintenance is analogous to moving value from the asset column of the balance sheet to the bottom line of the income statement. The seller is killing and eating the goose that lays the golden eggs. Maintenance costs can be safely decreased by re-engineering the equipment or by changing work management processes. Require the prospective seller’s management team to provide auditable evidence justifying their decisions to reduce the maintenance budget.
3. Reducing staffing levels is another easy target for window dressing. Often, management of the prospective sellers will cleverly disguise arbitrary staff reductions as lean manufacturing. Lean is about engineering and managing waste out of the production process, not about reducing headcount below the point that the plant can be safely and reliably operated and maintained. Require the selling firm’s management team to justify any staff reductions with auditable changes in business practice that actually reduce the amount of required work.
4. Closely scrutinize changes in capital investment at the plant. Plants and equipment require updates and upgrades that are often classified as capital projects. Any unusual reductions in capital investment might leave you with out-of-date equipment and software – and a big capital bill on your nickel after the transaction is completed. Likewise, your financial people should closely scrutinize any unusual increases in capital investment. By changing accounting practices, the firm’s income statement can be bolstered by capitalizing investments that might have previously been expensed. Require the selling firm’s management to justify any unusual changes in capital expenditure or accounting methods prior to the transaction.
5. Evaluate the plant’s maintainability and operability, particularly for newer assets. Operability is the ease and efficiency with which the equipment can be reliably started, stopped, retooled and operated. Maintainability is the ease and efficiency with which the plant’s reliability can be maintained and/or restored. Often, plants are designed to achieve functional performance at the lowest possible purchase prices. If the plant design team failed to consider maintainability and operability, you may see the maintenance budget start to spiral out of control, particularly for a newer asset. Get expert assistance in reviewing the plant’s operability and maintainability before signing a letter of intent.
6. The training and development budget is another easy target. Avoided T&D expenditures directly hit the bottom line. But what happens to the value of your team? Failure to invest in training and development produces atrophy among existing employees and compromises the successful induction of new team members. Require the selling firm’s leadership to justify any unusual reductions in this budget.
I hope I’ve given you a few things to think about. The current and future reliability of a plant will significantly affect the plant’s return on net assets (RONA). Before pulling the trigger on acquiring a plant, be sure to develop a checklist of reliability-related due diligence items to be sure the window-dressers don’t stick you with a lemon!
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