Valuations & Acquisitions: Why Deal Due Diligence Is Worth a Try

In my last Catalog Success column, “What Acquisition Due Diligence Reviews Can Teach You” (February 2007, pg. 37), I explained why catalogers can benefit from embracing and using the analytical models employed by acquirers and financing sources in this industry as they decide which catalog/Web marketing businesses to pursue. Now, onto the use of due diligence methodologies in catalog deal-making.

These are some of the key analyses you should use in most of your seasonal circ plans and your annual strategic plan. Furthermore, and of no small importance, these are the same metrics and analyses your local banker should be using when deciding on whether to expand your working capital line or loan you money for an acquisition.

To operate a catalog/Web multichannel marketing business with what is considered “good” profitability — 8 percent to 10 percent EBITDA (earnings before interest, taxes, depreciation and amortization) — you have to understand the economics of your prospecting and how those economics compare for new customers sourced by a catalog mailing vs. those labeled as “pure” Web-sourced.

I’ll also look at one of the easy-to-understand models used in due diligence. Later installments of this column will go into more detailed approaches used by direct marketing consultants who often are retained by investors to assist with the investigation.

These models help you plan growth, improve profits, prospect breakeven, and analyze lifetime value.

If you’re determined to improve your catalog and Web business, invest some time and make sure your head of marketing analyzes and models your prospecting databases. This will allow you to more accurately set and achieve your growth goals — especially pretax profits — through the preparation of key marketing profitability metric models. These models can calculate for each season and primary type of prospecting the following:
3 a sales per catalog break-even P&L for new customers;
3 the cost to get a new customer;
3 new customer 12-, 24- and 36-month P&L value;
3 old customer reactivation profitability, breakeven and contribution; and
3 individual P&Ls for total revenue from customers and prospects.

The first (and foundation model) is the prospecting Contribution to Fixed Expense P&L (see 2007 Catalog Prospecting Breakeven Model Example below).

Note the $1.147 gross demand per catalog mailed is the break-even point. At this $1.147 level, the mailing has covered variable expenses and will start contributing to fixed expenses. In this example, the $1 sales per book achieved was below breakeven. So the 20 orders/customers secured (at a total cost of $65) means the cost per new customer was $3.25 each.

Next, run this result through a 12- to 36-month lifetime value cash flow model and see if it makes economic sense to invest this much to secure a new customer. Then run the same analysis on each primary channel you use for prospecting.

These models (which your marketing people should run every year, by primary season) will help you:
3 set your annual sales and profit forecast;
3 set circulation levels for prospects and customers in each seasonal mail plan;
3 maximize profits in your yearly circ plan; and
3 when the timing is right, be positioned to raise capital, sell equity or exit.

Also, calculate the size of your “proven” prospect universe and the future sales growth forecast range it might have the potential to generate. This is at least a two-part model: one for catalog mailings and one for Web marketing. And, of course, if you want to find growth from alternative media, add one for that program also.

One other financial model used in the deal world for catalogers is especially useful in helping outside financing sources (i.e., non-catalog investors) understand the overall profit metrics of mailings to house customers vs. mailings to prospects. One easy-to-understand table can be prepared by your marketing and finance departments to show annual (or even primary season) P&L.

The result shows the “large” amount of money made through housefile mailings, and the typical loss (or breakeven) recorded by prospect mailings. This helps any investor understand where the money is made and why it might be necessary to spend (invest) in prospecting. Furthermore, this model portrays a generally positive view of cataloging: the ability to manage earnings over the short term through cut-backs in prospect circulation — in poor times (see House Customer vs. Prospect Mailings below).

The P&L formats used are based on historic formats, in which revenue from order shipping expenses (charged to customers) was shown as an offset to the cost to actually ship those orders to customers, the net of which typically was shown in the net shipping expense line of the P&L.

Accounting standards rulings now require shipping revenue to be recorded in the top line of the P&L. You can build the above models either way; the contribution to fixed expense breakeven will be the same.

Larry West is president of West Cos., a New York-based valuations and acquisitions consulting firm. You can reach him at dmgrowth@yahoo.com.