KEN KIRSCHENBAUM, ESQ
ALARM - SECURITY INDUSTRY LEGAL EMAIL NEWSLETTER / THE ALARM EXCHANGE
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Comment on inflation and why RMR sells for a multiple
June 27, 2022
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Comment on inflation and why RMR sells for a multiple
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Ken,
Great take on inflation in your articles from May 20th and June 17th, 2022. I just want to add a bit more on the effects of inflation on account valuation. As you know my firm specializes in this industry and we perform 20 – 30 complex valuations each year for divorces, partner disputes, buy outs, and other purposes. Our work has to stand up in Court but it also has to be so simple that a juror can understand it. Anyone who has been in the industry for a while knows that alarm companies most times trade on a multiple of RMR. There are cases in which they don’t, but, for the most part, the highest and best value of an alarm company will be based upon a multiple of RMR.
In both of your articles you gave a great assessment of today’s turbulent economic conditions and their effects on business profitability. You discussed multiples of RMR, their range, the factors causing them to differ for a given piece of RMR and the fundamental requirements (marketable agreements, type of system, focus of company, etc…) of a successful alarm account sale.
Let me take this discussion a step further and discuss why RMR sells for a multiple at all. The Fair market value of a business or its assets is defined as the price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, both being adequately informed of the relevant facts and neither being under any compulsion to buy or to sell. Each year there are thousands of sales of RMR between companies. Mike Barnes, of Barnes and Associates compiles a report each year called the Alarm Industry Overview. His Overview summarizes actual transactions by size of account base, type of company, and other factors, to give Buyers and Sellers a well-researched study of industry trends.
Now that we understand that RMR multiples are what they are because “someone paid the amount” we can answer the next question, which is “why would someone pay a certain amount?” While you are spot on about the factors that add to, or subtract from, purchase multiples, I am going to bring some math and science into the equation to provide an understanding of where multiples come from in the first place.
Businesses buy assets to produce cash flow. For example, the best installer can’t do much if they are sitting around the office so it is a good idea to get them a truck to drive. If you can lease the truck for $800 per month, and the installer can bill customers $10,000 per month, leasing the truck is a fairly easy decision. The same applies to the purchase of RMR. If I can buy an account that produces $30 per month, for 35x, then I break even after a certain amount of months, and make a profit thereafter until the customer cancels.
So how does a buyer determine the expected net cash flow from that account? Forgive me for oversimplifying but many of you never signed on to be bean counters. Let’s take a scenario of a typical security company with 750 customers paying $30 per month each. This would represent $22,500 of RMR or, theoretically, $270,000 of annual cash paid by customers. Let’s say that the company monitors the accounts at a third-party central station that charges $3 per account per month, and they spend $1.50 per account for billing costs. This means that each monitoring account generates $25.50 of cash flow ($30-$3-$1.50) or $19,125 per month total. We can’t simply multiply the net monthly by 12 to determine the annual net cash flow for a number of reasons, the first of which is attrition. Let’s say that the company experiences 10% annualized attrition. Attrition happens consistently throughout the year so we would expect the annual net cash flow to be slightly greater than 90%, say, $207,356. In a world without inflation, we could expect the accounts to burn off at a 10% rate, year over year, and, over the next 12 years, our $22,500 of RMR would produce $1,519,909 of net cash flow, or approximately 68X RMR. Unfortunately, we don’t live in a world without inflation, and as Ken so correctly puts it If you are ending up with the same dollars as 2020 or even 2021 you won't be able to buy as much. In fact, figure you are losing 7 to 8 percent, so your dollar is worth only 92 cents. What’s more important is that if we apply the 8% inflation rate over 12 years, our dollar is now worth only 36 cents. Inflation has ranged from a low of 0.7% in 2015 to a high of 2.3% in 2019, so we haven’t been tremendously affected by it as of late. If we apply the 2019 inflation rate to our cash flow our Net Present Value falls from $1,519,909 to $1,350,198, or 68X to 60X. If Inflation hits 8% our Net Present Value is $1,040,657, or 46X, and our value has fallen by 30%.
You may think that 46X is still a great multiple for a group of accounts. The problem with this thinking is that a buyer of RMR is actually investing in the accounts. If the Buyer pays 35X for accounts that have a net present value of 46X it would seem to be a great investment, but investments contain risk and uncertainty. Investors pay less than they believe that an investment is worth in the hopes of making a profit on the investment. Investors calculate what is referred to as a Rate of Return on a given investment. This compensates them for the cost of money (i.e. if they purchase the $22,500 of RMR for 35X = $787,500, they have to either borrow the money from a bank or raise it from other investors) to make the purchase, and for the dividends that they have to pay out. When we compute the Rate of Return we typically use 15%, which compensates for inflation, interest, and/or dividends paid. When we apply a 15% Rate of Return our $22,500 of RMR is now worth $797,181 or 35.43X, and this is where the multiples originate. True, most RMR transactions are simply the result of a Buyer paying the “going multiple,” but the calculation above is how the multiples come to be in the first place. Ken is correct that we start with a multiple (in this case 35.43X) and modify it for characteristics such as contract quality, but the adjustments are just that, adjustments to the value of the future cash flows.
One thing to keep in mind as you digest this lengthy explanation is that inflation is socioeconomic, not just a financial phenomenon. As consumers suffer though inflationary pressures (and most certainly recession of depression) they may consider alarms a luxury that they can do without. This may cause attrition to spike and lower the values even more. In summary, inflation is a bad thing. Us bean counters can create mathematical formulas to quantify it, but the real impact could be much worse.
Mitch Reitman
Reitman Consulting Group
Fort Worth, TX
817-698-9999
http://www.reitman.us
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Ken Kirschenbaum,Esq
Kirschenbaum & Kirschenbaum PC
Attorneys at Law
200 Garden City Plaza
Garden City, NY 11530
516 747 6700 x 301
ken@kirschenbaumesq.com
www.KirschenbaumEsq.com
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