Don’t underestimate importance of adding high-quality customers

May 1, 2009 By    

If you buy and set a new propane tank, are you always increasing the value of your business?

We will examine the mathematics of this proposition using examples and provide an answer that might surprise you.

First, we should agree that the main mission of our business is to increase its value, and therefore all activities should be evaluated on their contribution to this overarching cause. Of all the activities we perform – delivering gallons, completing service calls and collecting receivables, to name just a few – the addition of new customers should always add value.

Second, we should accept as fact that the buyers in the market establish value, and that the bulk of the buyers of retail propane companies determine value based on a multiple of the seller’s cash flow.

It remains an industry myth that retail propane companies are valued on the number of customers, assets or gallons they sell.

Let’s explore two realistic examples of the economics of customer tank sets in order to find our answer and demonstrate our point.

In the chart we show the results of making a $1,000 investment in two different applications. Investment A could be a residential customer who annually uses 750 gallons. The economics produce $.50 per gallon of incremental cash flow or EBITDA (earnings before interest, income taxes, depreciation and amortization). Investment B could be an agricultural or commercial application that produces $.10 per gallon of cash flow on 1,200 gallons of usage.

Note that both A and B are profitable, defined by total gross margin exceeding incremental operating expenses. Investment A generates $375 of cash flow per year compared to $120 for Investment B.

Valuation on cash flow basis
Using a modest purchase multiple of four times, Investment A is valued at $1,500, while Investment B is valued at $480. Therefore, Investment A creates $500 in value above the original $1,000 investment. Conversely, Investment B is valued under its original investment of $1,000 by $520.

This is the answer to the original question: Not all investments that flow off positive cash will increase the value of a business. A buyer for this business would pay less for this particular asset than if the investment had not been made.

Looking at it another way, assume that a company is composed solely of 1,000 type A investments. This theoretical company generates $375,000 of cash flow (by multiplying the math in the chart by 1,000) and represents an example of when the whole (valuation at $1.5 million) is greater (by $500,000) than the sum of its parts (the $1 million investment).

Conversely, a company composed solely of 1,000 type B investments generates only $120,000 of cash flow and is an example of when the whole (value of $480,000) is less (by $520,000) than the sum of its parts (the $1,000 investment).

The first key lesson is about understanding the positive impact of adding high-quality customers and the negative impact of adding low-quality customers.

The second lesson is about understanding the urgency in moving all assets that fall into the type B category into investments in the type A category.

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