The Bubble Misnomer

It’s been said that beer distributorships are experiencing a value bubble. Well, I heartily disagree. I disagree not because I think there are no significant downside price risks, or because I subscribe to the belief that value bubbles don’t really exist (some economists argue historical price collapses are better explained by supply/price imbalances versus mass manias). I disagree because I think the term “value bubble” is an atrocious misnomer.

In the classical sense, “bubbles” are short-lived phenomena and their collapse is inevitable. They must burst under the weight of fictions, fantasies, and/or frauds. That’s not where beer-distributorship values are.

Mention the word “bubble” and I immediately jump to the classic, Extraordinary Popular Delusions and the Madness of Crowds (it’s nearly free for Kindle download). That’s where you’ll find frames of reference in Charles Mackay’s tales of Tulipmania, The Mississippi Scheme, and perhaps the mania that inspired the phrase “bubble,” The South-Sea Bubble.

Regarding the South Sea Bubble, Mackay writes,

“In the mean time, innumerable joint-stock companies started up everywhere. They soon received the name of Bubbles, the most appropriate that imagination could devise. The populace are often most happy in the nicknames they employ. None could be more apt than that of Bubbles. Some of them lasted a week, or a fortnight and were no more heard of, while others could not even live out that short span of existence. Every evening produced new schemes, and every morning new projects.”

Oh, if you could simply conjure up a beer distributor transaction. What a wonderful duopolistic world it would be. But, sadly, you can’t. Like birth, it’s a struggle. You generally have to persuade a financially secure individual to hand over a family-owned business that has provided cash-flow for years—or, more likely, for generations. On top of that, you could be asking them to give up a totally awesome occupation and watch as friends (akin to family) are forced to seek new employment.

Mackay continues,

“Some of these schemes were plausible enough, and, had they been undertaken at a time when the public mind was unexcited, might have been pursued with advantage to all concerned. But they were established merely with the view of raising the shares in the market. The projectors took the first opportunity of a rise to sell out, and the next morning the scheme was at an end.”

Sellers aren’t traders looking to bolt at the first sign of a profitable exit. They’re grabbling with the notion of cashing out at premium price under current tax rates now versus keeping recession-tested cash flows in a world that presently offers few comparably compelling investments. Their state of mind isn’t effervescent, it’s reluctant.

Sitting across from these sellers are buyers who don’t plan to flip their acquisitions or who have dreams of ever-blossoming earnings streams. Consolidators are looking at a near-term earnings pop from synergies followed by a tough slog keeping earnings growth ahead of inflation. Acquirers don’t sign notes at closing feeling certain their investment will pan out. Nope, even in a liability-free asset purchase the acquirer takes possession of all future worries. Consolidators are stepping up to an investment proposition. They know the industry and its history. They are up to speed on the state of the industry. They know about the risks and are concerned by them but, in the end, they like the odds.

Buyers aren’t gorging themselves at some kind of bacchanalian feast; they’re feeding on the limited number of acquisitions available. Acquirers aren’t overindulging, they’re gathering sustenance. They intend to keep their acquisitions and cash flow their debt away over time. They want to promptly replace debt with equity and reposition themselves to capture the next opportunity that presents itself. There is no “greater fool” or “hot-potato” game afoot.

I concede, however, there is a sort of a mania at work. There is a kind of feeding frenzy going on. Industry waters are swirling. Anyone paying attention can see it is eat or be eaten. It is not that every morning there is a new consolidation project; instead, every month there is perhaps one less potential consolidation project.

Self-preservation can be quite the motivator. It can cause someone to extend themselves to their absolute limits. It can make a would-be consolidator walk right up to financial suicide and look it straight in the eye. But, in the end, nobody in this industry chooses financial suicide or is allowed to choose financial suicide; not with a major suppliers brands in their grasp. What happens is that a fish big enough and strong enough to capture the acquisition gets stronger after it “feeds”—and the fish that don’t eat start looking more and more like bait. It’s worth noting that some huge predators are just now entering the waters. Billionaires like Buffet and Trott are now trolling through the sea of alcohol distribution chumming up the waters with their cheap and deep capital.

No doubt one could compile historical beer-distributor transaction data and show that values have risen dramatically, but that is not evidence of a value bubble. It also is possible the value of certain beer distributorships or beer distributors in general could fall dramatically; but it won’t be because some delusional mass mania comes to an abrupt and foreseeable end. The truth is that in an examination of recent beer distributor transactions, it’s difficult to see any of the classic features of a so-called value bubble.

There is a valid, readily demonstrable, and compelling economic reason for higher prices—consolidation. Consolidation has been tested extensively and repeatedly, and the results are in. Increases in profitability and the benefits of scale are not dreams, fantasies, or even dangerously overoptimistic assumptions. Synergistic fit is essential; but, if you put two highly complementary distributorships together, the savings are real and substantial.

We’re not talking about some future yet-to-be-developed revenue stream. We’re talking about readily identifiable expense savings that can be implemented and turned into debt service almost immediately. It’s not like the situation where you have the founder of FedEx point to his fleet of planes, trucks, cars, and real earnings and openly mock the ridiculousness of Webvan’s market cap and flawed business model.

The prices and premiums being paid aren’t based on irrational notions of growth and earnings. Buyers might be giving up an atypical proportion of synergies, but they are not obtaining supplier approval and financing with fanciful and unobtainable dreams. When a buyer bites into an acquisition, he tastes cash flow, not smoke and mirrors. Those who have most savored consolidation’s delights are those who have most quickly leveraged their acquisitions into increased effectiveness and profitability.

It seems pretty clear buyers aren’t blundering down a path to inevitable disaster lead on by financial delusions. It is true dreams of empires have inspired eager consolidators to sacrifice synergies and endure more risk and leverage, but the dearth of notorious failures suggests financial reason has not been compromised. Certainly, some impressive empires have been built. Somewhere there is a large and still-healthy dolphin wondering what growth hormone turned his pod-mate into a killer whale.

The term “bubble” does not accurately depict current beer distributorship pricing. And, a statement “profits are good” combined with an absence of financial pain does not support the notion of a bubble.

I don’t contend distributorship prices are currently in a state of perfect price equilibrium. I wouldn’t dispute the current splitting of synergies appears atypical, or that there is a significant gap between buyers and sellers. Nor am I trying to suggest paying premium prices for an acquisition carries no risk. I just think using the term “bubble” is an inaccurate and unconstructive way to describe current pricing and industry risks.

Beer distributorships have proven to be incredibly resilient. In fact, there’s part of me that finds the idea of a beer distributorship bubble slightly comical. The country goes through the worst recession since the Great Depression. Banks fail, Wall Street gets rocked, the auto industry goes up in flames, and the real estate market collapses. Michael Lewis refers to it as “the greatest financial crisis in the history of the world.” Shrapnel is everywhere, but a beer distributorship value bubble persists through it all—due to improved profits, no less.

Don’t get me wrong, the industry hardly is free of risks. There are plenty of downside price scenarios. Industry wide, values could come down; however, it is not inevitable that values will come down. Prices are not destined to collapse under the weight of financial reality. Moreover, if values do drop, they won’t pop like a bubble.

It is highly conceivable values could be eroded slowly over time. It is reasonable to expect the middle-tier’s profits increasingly will look like essential nourishment to first-tier suppliers. It also is conceivable values could take a significant and substantial hit in a short period. In this instance, however, the collapse of values would look more like a catastrophic system failure than a burst bubble.

Beer distributorship price risk does not have the characteristics of a bubble. The price risk looks more like that of a crystal or a gem. Diamonds have emotional value, certainly; but they also have a long history of enduring value and real utility. Each is unique, all are precious, and they are rare. Diamonds are resilient and can withstand tremendous forces. With great thought, vision, and skill diamonds can be refined. Unfortunately, diamonds also can be shockingly fragile. Striking in the wrong place can ruin a diamond’s value instantly. Beer distributorship values clearly are exposed to this kind of catastrophe. It is a frightening scenario but, thankfully, not a high-probability event.

Describing current pricing as a bubble suggests irrational pricing and inevitable correction. As a consequence, those concerned about price risks are pointed in the wrong direction. It doesn’t say the three-tier system has sustained this fracture and now is poised for collapse. It doesn’t say supplier X is going to piranha Y cents per case of your profits over the next five years, and lower your value by Z%.

What using the term bubble does is facilitate a misunderstanding of the ever-present and perhaps expanding gap between buyers and sellers. It almost seems to be intended to be a reason for buyers to offer less. Especially when it is comingled with an observation sellers are looking backward and buyers are looking forward.

Of course, every seller wants a price based on their best years, but a truly willing seller must accept a price influenced by more recent and less positive performance. Sellers absolutely try to point to the best of years when in negotiations but, deep in their hearts and minds, they are more focused on the future years of business they and their children won’t see. Their time horizon is decidedly not quarter to quarter—it’s generational. Sure, sellers sometimes take a painful while to go from lofty to realistic. But that process and the so-called value gap isn’t evidence of a bubble because the value gap isn’t where transactions happen. The value gap is where transactions don’t happen.

It’s not that sellers are looking backward and buyers are looking forward. It’s that buyers and sellers see the exchange from two opposing positions. The seller is often giving up his stable, unlevered, cash-flowing business. The buyer is levering up the business and assuming the risk of uncertain future earnings. The sellers are cashing in their equity; the buyers are putting theirs at risk. That same dairy cow looks extraordinarily different from opposite sides.

Perhaps using the term “bubble” could serve some useful purpose. It could jolt a beer distributor into examining future prospects. That distributor might see the values being paid for the limited number of strategic combinations imply substantial premiums. That distributor might look around and see it didn’t eat earlier when it should have. All the other fish in their waters have grown too large. There’s nothing left for them. They aren’t going to grow anymore. Their future is confined to staying alive and healthy. At that point, perhaps they can see current prices more appropriately, as a window of opportunity.

Prices aren’t irrationally high, but for many wholesalers—especially smaller distributors without realistic acquisition opportunities—there seems to be more downside than upside. As such, sellers should not be deluded by notions of grandeur. The rumor mill passes tales of exceptions most easily. Odds are you’re not as good as—or better than—the best there ever was. A seller that carries unrealistic expectations can get unjustly crushed by time and circumstances if a sale becomes necessary.

I do have some concerns about taking this position. The economy seems to be treading water. High unemployment is expected to continue for years. Our country’s fiscal policies look like a train wreck in the making. I’m troubled by negative volume trends and inter-tier tensions. And, stumbling across John Gerzema’s The Brand Bubble while writing essay this stopped me in my tracks - momentarily.

Nonetheless, I call the beer distributorship value bubble a misnomer. I see risks, not inevitable decline. I see risks that need to be acknowledged, managed, and if possible eliminated. I see industry concerns and brand risks. I don’t see folly destined to end in tragedy.

Tossing out the term “bubble” provides drama, which can be fun, but it also detracts from bona fide insights regarding an industry suffering from an insufficiently competitive state of mind, the trading of long-term brand health for short-term profits, and the courage individuals show when they address threats and issues that others are reluctant to acknowledge.