Strategic Evaluations
Aviation business operators meet to learn principles for evaluating their companies
BY John F. Infanger, editorial director
September 1999
EVANSTON, IL — The National Air Transportation Association had hosted management conferences for airport-based businesses before. Northwestern University's Transportation Center has had a growing presence with sessions related to other aviation segments. The intent for the first Strategic Management for Fixed Base Operators workshop held here in August was to bring about a defined economic model for an airport-based business — a model built on NATA's understanding of FBOs and Northwestern's knowledge of management and training. It was a good start.
Noticeable by its absence was a real-life FBO model from which to build — not necessarily mandatory for the exercise.
The three-day conference was attended by some 30 owners and executives of FBOs from around the U.S., and was led by Kellogg Graduate School of Management and Transportation Center officials, with an outline of the FBO business today by Dean Harton, president of Piedmont-Hawthorne Aviation, based in Charleston.
It touched most specifically on methods for evaluating the health and worth of a business, opportunities for increasing profits, and the technique of becoming an effective negotiator. These were particularly poignant topics, considering today's buy/sell environment among FBOs. Other topics discussed: marketing; employee stock ownership plans; estate planning; managing change; and, the future FBO business.
Some principles which stood out: Forget multiples (almost); cash flow is king; cutting costs may be easier than increasing revenues, thus boosting profits; and, value is not merely a numbers game.
Here are selected highlights from the conference.
Some Core Concepts
From Harton comes the following definition of an FBO:
A person operating under a written agreement for the use of land, buildings,
or facilities at the airport for the purpose of providing to the public
services required under written agreement including, without limitation
... the sale of aviation fuel, ground handling services, aircraft rental
and sales, (etc.).
Pilots and technicians once represented the core business leaders for the aviation service business, but today business management personnel and large investment companies play key ownership and management roles. FBOs have moved from being companies that fly to ones that serve those that fly. Sub-leases and subcontractors play an integrated role in services provided at a particular location; traditionally, the FBO offered a nine-course dinner variety of services. Such companies tend to be better when specialized, says Harton.
He offers three basic examples, using arbitrary numbers, to demonstrate the financial models of a "core service" FBO and one with maintenance operations (charts at right, below). (Harton also offered ones with charter and airline services and a full-service FBO.)
Harton, whose own
company is aggressively seeking FBO acquisitions, talked of factors that
add value to the company:
• EBITDA (earnings before interest, taxes, depreciation, and amortization)
and potential EBITDA
• Addition of incremental revenue opportunity already negotiated (prior
to sale of the company) • New airline in town
• Evidence of excessive spending
• Fuel cost savings/insurance savings
• Strategic planning.
Regarding the last point, Harton says strategic planning sets the tone of the company, allowing management to put in place the mechanisms over time that fit into a 5-10 year plan. It adds value.
Excessive spending, he says, is "one of the things we look at as a buyer because it means expenses can be cut." It becomes part of a process he calls recasting: A seller's recast is offered by the owner to put the company in one light; a buyer does the same; and, the negotiated value is somewhere in the middle. (An example is a general manager's salary that may be inflated beyond industry norm because the GM is also the owner.)
Some risk factors,
from a buyer's point of view, says Harton, include:
• How departments offset each other
• Environmental issues
• Insurance
• A business downturn
• Competition
• Self-produced risk (e.g., misfueling) • Service attitude/reputation.
A company that maintains a discipline of planning and cost control, says Harton, is one that can make an attractive profit. Toward that end, he says all companies should regularly perform a High-Low Case Analysis (graph, below left). In essence, it's a prediction of projected revenues.
Adds Harton, "From a valuation standpoint, you really always look at the EBITDA."
Analyzing The Business
Similarly, Prof. Bala V. Balachandran, director of Kellogg's Accounting
Research Center, emphasizes that cash flow is king among economic indicators
for a business. "I really like cash flow," he says. "Cash
flow you cannot manipulate."
Balachandran quickly impresses as a man of intelligence with an inherent sense of humor ("Good bean counter is an oxymoron."). He carries with him a long list of credentials, including serving as consultant to the U.S. Air Force and FAA.
To illustrate the vitality of cash flow, Bala points to the internet book distributor amazon.com, which is infamous for not making a dollar of profit on its core business. But it is making money by investing its cash flow generated by the stock market, says Bala. Once a purely electronic company, amazon.com is now constructing infrastructure such as warehouses that will change its business long-term.
When analyzing the health of the business, the accepted practice in the U.S. is to follow generally accepted accounting principles (GAAP) that are dictated by the Financial Standards Accounting Board, which he says is dominated by CPAs. Balachandran refers to them as Controlled and Required Accounting Principles, or CRAP. Yet, they are the standard.
The key to successfully monitoring and planning the business, says Balachandran, requires getting and maintaining a handle on costs and incorporating activity-based management, a tool for evaluating the customer base and costs associated with serving that base.
"Costs are Profits Lost"
The quote represents Balachandran's philosophy that good business management
focuses heavily on cost control. Cutting costs, he says, doesn't necessarily
mean across the board cuts; some costs may need to increase. However,
a company's costs are controllable by the business, not by its competitors.
In particular, he
says, target fixed costs first. While textbooks generally put fixed costs
as a flat variable over time, he says, a company that tracks them will
find that fixed costs actually represent a "super variable"
cost center. "All costs are ultimately variable," he says, offering
the following formula:
PROFIT = (Sales Revenue — Variable Costs) — Fixed Costs
Sales revenue and variable costs are calculated as a unit because they are driven by the volume of business; fixed costs are what it takes to run the business. The means of management for each is different, says Balachandran. His Rule #1, then, is to use "costs down" as a predominant strategy. "You want to focus on revenues when variable costs are less than 50 percent of sales revenue," he explains.
There are two basic ways to minimize fixed costs, he says. Short-term: Can a company do more business with the same fixed costs? This is yield management, used by the airlines. Long-term: Can a company do more profitable business with less fixed costs? This is activity-based management.
Prioritizing
Getting a handle on the business takes time; Balachandran's Rule #2 is
to prioritize. Example: Attack the customer base first in which costs
of sales account for the highest variable costs. Example #2: Employ people
in appropriate areas, serving the appropriate customers. Approaches such
as these raise the possibility that perhaps some customers are worth losing
(or sending to the competition) because they cost too much to service,
he suggests.
When prioritizing,
consider "Bala's 4Ms":
• Measure both revenues and costs correctly.
• Monitor the measurements of both revenues and costs periodically — at
least every three months. Apply the 50 percent rule (above) for benchmarking.
• Manage to the action plan.
• Maximize profitability.
Fixed Asset Management
"In my opinion," says Balachandran, "the service industry
sells capacity." His Rule #3, when excess capacity may be an issue,
is to minimize idle capacity by A) the margin game; B) the leverage game;
and C) the payback game.
A) The Margin Game. Here, a company sells existing products but increases volume via new customers or larger orders. The product is the same and volume is increased with the same fixed costs.
The associated risk: Established customers become upset (loss of service, different prices, etc.) and leave.
B) The Leverage Game. This involves developing creative byproducts that generate additional revenue. For example: Wendy's cooks its hamburgers fresh; McDonald's burgers are 80 percent cooked to the retailer. To compete on time, Wendy's must anticipate demand more than McDonald's. In doing so, it can find itself with cooked, unsold burgers. However, those go into a byproduct: chili.
Risk: What happens if demand for the byproduct should exceed demand for the main product? "It's still a better problem than the original one of excess capacity," says Balanchandran.
C) The Payback Game. Develop customer loyalty and improve retention of those customers that are most profitable in the long-term. Consider an insurance agent: If an average policy charges a $200 premium and the agency cost is $300 the first year and $100 each subsequent year, customer loyalty for two years is necessary for the agency to break even. Each subsequent year is then profitable. And, increasing this customer's business activity increases profits.
Risk: What happens if the customer dies, leaves, etc.?
Activity-Based Management
Explains Balachandran: If you want to manage anything, you have to measure
it. That requires defining and understanding the activity. Wrong measurements
can lead to improper decisionmaking. This is where activity-based management
comes in: It's the process of analyzing the customer base and what it
takes to serve them to determine which customers create what profit margins,
and which customers actually cost the company money.
Analyzing specific activities is a way of breaking down indirect costs into direct processes — a way of finding hidden costs. It's a way of defining activities to account for each. Balachandran cautions that when analyzing company activities, limit the analysis to ten so as not to get bogged down. (In fact, he recommends that whenever a company hires an outside business consultant, limit the number of activities the consultant analyzes to ten and allow a maximum of three months for the independent study to be finished.)
Why are activities
so important for analysis? Balachandran offers the following:
• They are actionable — "you understand what you do and what it takes."
• They consume resources.
• They can be easily understood by diverse groups of people and their
cost can be tracked and measured.
• They link planning and control, and integrate financial and non-financial
performance measures.
• They highlight cross-departmental interdependencies.
• They facilitate an understanding of cost drivers. Some of the benefits
of activity analysis include: ... managers better understand the workload
profile in their area;
... it helps to clarify the customer/supplier relationship;
... it causes a review of existing organizational procedures and responsibilities
and clarifies the causes and effects of activities;
... it fosters improvement;
... it establishes a basis for tracing costs and implementing activity
accounting.
Valuing ... and Multiples
The session on business valuation — or determining economic worth — was
conducted by John F. Thomas, vice president of LEK Consulting LLC, of
Boston and Sydney, Australia. He has conducted business analysis services
for a variety of industries, including airlines and aerospace.
Core questions to ask related to worth are: Why would someone buy your business? How could you get them to pay a higher price? And, what would you do to make it a good deal for them? (See sidebar below.)
Of particular interest with this audience and with FBOs in general in today's marketplace is the question of multiples. (For a more detailed look at multiples, see pages 22-23.) Thomas says that "people throw around multiples at will, and cautions that a multiple represents what the value of the acquisition is to the buying company. It does not necessarily represent a standard multiple that can be used across the board in a particular industry segment.
"What are you buying?," asks Thomas. "You're buying a future stream of revenue. That's why multiples just don't get it.
"I'm saying multiples are flawed. It's shorthand for investment bankers. The problem is investment bankers treat it as gospel.
Thomas says the appropriate way for valuing a company is by using discounted cash flow. Other factors are weighed to subjectively adjust a potential multiple. For example: Comparing one company's market share with another's that may be a significantly larger player in the particular business. "While investment banking houses talk multiples, they actually use discounted cash flow," says Thomas. "I know, because we train them." Discounted cash flow is defined as "cash flows forecasted under the current (business) strategy discounted at the weighted average cost of capital."
Value created in an
acquisition is the difference between the target's value to the buyer
and the paid price. In other words ...
... price is what you pay for something;
... value is what it is worth to you.
"Investment bankers don't see the difference between the two,"
says Thomas, though it can be significant. A buyer must assess where the
highest value lies: in breaking up the acquisition; maintain the status
quo by following the current business strategy; or, via synergies that
might be created with existing or other businesses.
The best way to project the potential of a business, he adds, is to evaluate the market and the type of business, not necessarily the historical line of business. And, there are other variables: "Do you value goodwill? You actually do."
