Residual Value Separates the Builders from the Scavengers

Posted: 09/1998

Residual Value Separates the Builders from the Scavengers

By Casey Freymuth

The single-most important aspect in any business model is a factor whose elusiveness
often causes it to be virtually ignored in operational planning and investment. Yet,
without it, earnings are as stable as today’s outstanding receivable and tomorrow’s close
rate. Its name is Residual Value. Also known as terminal value, without it, business is
not built, it is scavenged.

Image: The Relationship Between Funds Allocation & Customer Base Size

Easier Said Than Done

Defining residual value is easier than estimating it. In simple terms, residual value
can be defined as the market value of an enterprise. If XYZ Telecom is a publicly held
company, the measurement is somewhat simple–define the market cap and you have defined
residual value. For a private entity the definition is less clear, requiring the answer to
the questions: "If XYZ is a private entity, and sold today, what would another
competitive provider pay for it? What will it be worth in three years? Five years?"
These questions are particularly important in the telecom sector, which is undergoing
massive consolidation. Put simply, entrepreneurs likely will sell their businesses over
the next three to five years, so positioning their companies for maximum buyout prices is
mission-critical.

Most business development and financial professionals will tell you that estimating
residual value is as much art as it is science. In discounted cash-flow analyses, which
are designed to measure profitable returns, a residual value estimate is required at the
end of the forecast period. This is where things get sticky. If small long distance
companies are selling for multiples of six times to 12 times monthly revenues, for
example, what rate would be used in the estimate? This all depends on the buyer of course,
and all the issues surrounding its own residual value. A small company might estimate
retained value at the low end to be conservative. A large company, on the other hand,
might use the high end because large companies tend to sell at multiples of 12 times
monthly revenues and higher. In either case, of course, the buyer is making risky
assumptions on the future. In reality, neither company really knows what the company will
be worth in three or five years and recognizes such estimates as guesswork.

Because of this, many private companies invest in raw revenue growth, hoping it will
all come out in the wash. Regardless of the measurement used to estimate residual value,
there are compelling reasons to invest in it heavily.

Image: The Effect of Churn on $1

Attrition and Residual Value

While there may be great debate and subjectivity with regard to measuring residual
value in terms of revenue or earnings multiples, the single greatest factor influencing
residual value for most competitive players is customer attrition.

In most cases, companies that acquire other companies have their own sales engines in
place. This means that, in most cases, buyers essentially are acquiring a customer base
that is eroding. The rate of that erosion is the key determinant of future earnings from
the acquired base, and thus, the key determinant in how much a buyer could pay for that
base. According to Bob Ott, a principal with Kane, Reece and Associates Inc., an Edison,
N.J., firm that performs independent appraisals of telecom firms, banks are starting to
proactively request attrition analyses in valuation projects.

"Banks have caught on to the reality that projected earnings don’t apply to
customer base acquisitions," he explains, "and they want to make sure that we
know it, too."

The irony of this development, of course, is that despite more than a decade of
widespread acknowledgement of the impact of attrition on future earnings, studies show
that the 90:10 ratio of investment in sales vs. retention remains the norm. Joe Sperry, a
principal with Schaefer, Sherman, Sperry and Swadling, an Iowa-based management consulting
firm, told telecom executives at a 1995 Telecommuni-cations Resellers Association (TRA)
meeting that his firm had come to the conclusion that getting corporate executives to
invest in customer retention was nearly impossible. The primary reason for the
unwillingness of most executives to invest in retention is that traditional cost
accounting makes the results of such investments difficult to measure.

Group IV Inc. developed tables that discount the value of current revenues based on
attrition rates in a manner that is similar to discounting investment dollars (determining
net present value) for discounted cash-flow models. The table (at left) was created for
the purpose of simplifying earnings analyses in acquisition-related transactions. Its real
value, however, may be in the message it delivers to business managers: the impact of
churn on the value of the company. It puts the idea of where to invest business
development dollars in an entirely different light.

Furthermore, retention is the single greatest factor in growth. Figure 1 on page 62
applies this lesson via several models that are differentiated through variances in
customer acquisition/customer retention investment ratios over a five-year period. In one
example, new sales are reduced by 20 percent in exchange for a 50 percent improvement in
customer retention, resulting in an 81 percent larger customer base despite the reduction
in new customer acquisition. In reality, this model is conservative because it assumes a
fixed sales/retention budget. Presumably, the increase in revenues and related
profitability would provide funds for greater investment, thus boosting the increase in
customer base with triple-digit growth.

The Double Play

Image: The Relationship Between Customer Attrition and Buyout Multiples

Growth is important, but if residual value is key to the amount a buyer can pay to
acquire another provider, how does retention translate to buyout multiples? Figure 2 (on
page 63) applies basic industry figures in a buyout model to various customer-attrition
rates. Development and valuation experts will recognize the ranges in this model to be
eerily close to those in the marketplace, indicating that churn is being considered
heavily in real-world valuations of telecom companies.

The reality is that investing in customer retention is a residual value double play.
Profitability issues aside, it provides for a larger customer (and revenue) base at the
time of acquisition, as well as a larger multiple on that base. When exit strategies are
factored into a business case, there is no greater investment area than retention.

It seems no matter how hard a company tries, the impact of customer retention cannot be
overcome. From profitability to revenue growth to valuations at the time of exit, this
issue is at the heart of everything that is built. If a company can’t avoid it, it had
better figure out how to put it in its favor. And the first step is simple. Clearly,
there’s no better place for a company’s investment dollars than its existing customer
base.

Casey Freymuth is president of Group IV Inc., a Phoenix-based consulting firm
specializing in strategic and operational issues affecting global telecommunications and
utilities industries. He can be reached via e-mail at [email protected].