“Heavy depreciation leads to deals being too expensive due to sellers wanting to use multiples of EBITDA or Net Income”
Why don't we buy heavy CAPEX companies? This is a two-fold answer, and it does not have to do with the operation of the business. It has to do with the valuation and acquisition process.
When buying a business, I base my valuation on cash production. Not EBITDA. Not income. Cash. If a company has healthy receivables and inventory, I will consider net income to be close to cash produced. The more inventory they have, the more I need to adjust in my head for the possibility of low rotation or inventory obsoleteness. This will affect cash production and will factor into the price I am willing to pay for the business.
If a company also shows heavy depreciation, this adds a new variable to the mix. Here is an example:
A company is earning $2m EBITDA and the seller wants $10m (5x) for the business. Seems reasonable.
But if the business has $800,000 depreciation, of which I need to reinvest $400,000 every year just to keep the business as is, now those $2m are $1.6m. The multiple just jumped to 6.25 and is getting too expensive. If the seller was willing to lower his price to $8m, maintaining the 5x, maybe we continue talking. But that is rarely the case. Heavy depreciation leads to deals being too expensive due to sellers wanting to use multiples of EBITDA or Net Income.
Another issue is how certain I am in those $400,000 of maintenance CAPEX mentioned above. Could it be $500,000? $600,000? I am adding a variable to the transaction. All acquisitions have variables. My job is to limit them as much as possible and/or get compensated by a lower multiple paid the more variables I find. The heavier the depreciation the greater the variable. So now I want to pay a bit less than 5x for the $1.6m in projected cash production, bringing the price offered below $8m. This makes the deal even harder to close.
So, it is not simply a function of the CAPEX, but the seller's expectation being tied to an earnings number that is not cash and a large unknown related to cash production that leads us to stay away from these opportunities.
Side Note: I do believe these heavy CAPEX opportunities can be more attractive for industry specialists and roll-ups. They know what maintenance CAPEX should be for the business. They can decrease the variable and buy with more confidence.