It's getting brighter on the pro dealer's horizon. Many analysts (me included) are cautiously optimistic that, barring another global financial meltdown, U.S. residential construction has bounced off its cyclical bottom. However, it's safe to say there is more tough sledding ahead. And even when conditions get far better, you can bet this will not be our industry's last cyclical downturn.
But you can avoid in the future some of our business' financial troubles of the past five years if you reflect now on the corporate finance lessons of the housing industry's crash. Then remember these principles when you consider how to capitalize your business so it can prosper through future cycles.
Cash reigns king. No amount of historic profitability, goodwill, or success can eliminate a business' most urgent need: cash flow (or as financial folks call it, liquidity). Profitability (revenue less expenses) does not equal cash flow (cash in less cash out). Profitability keeps liquidity moving in the right direction, but it's only part of the story. Businesses require working capital and money for capital expenditures. Also, when businesses can't achieve profitability (as many can't during cyclical downturns), they must have enough cash to fund those losses until profitability can be achieved. And as sales recover, a rule of thumb is that you'll need 20 to 30 cents in extra working capital and capital expenditure funds for every dollar of increased sales.
When we need cash most, it will be least available to us. When our industry is most starved for cash, other industries will likely be, too. Capital providers, debt or equity, will be their most risk-averse selves. Our numbers will look their worst and our negotiating leverage will be at its weakest. Business owners should capitalize their businesses now by maintaining conservative balance sheets and building cash/availability war chests via internal cash flow or third-party capital. Do not play financial roulette by waiting until hard times are upon you.
Relationships can only get you so far when raising capital. Ultimately, capital must be raised based upon your business' fundamentals. Start with your closest capital relationships but do not expect the process to end there. These processes take months and require focus. Casting a wide net never hurts and can only help.
Old notions of the "cost of capital" are deceiving. Third-party capital has cost and risk that goes far beyond stated interest rates or returns paid to investors. Never again believe debt is the lowest-cost form of capital. When times get tough, leverage (the hidden cost of loan financing, be it senior or mezzanine) rears its head with fury. In my experience, debt levels were the No. 1 determinant for which operations survived the crash and which didn't. Leverage is not inherently bad and is prudent when used in moderation. But its true cost–including the risk of leverage–must be appreciated.
Cyclical industries necessitate conservative capital structures. Prudent debt levels are inversely related to the cyclicality of a company's income stream. Housing, and therefore building products, always has been–and you can bet always will be–highly cyclical. Never again believe this time, or the next time, is different. Our industry is cyclical and necessitates conservative capital structures. Reasonable benchmark ratios are <50% debt-to-equity, <3x debt-to-EBITDA, and >4x EBITDA to interest expense. Do not fall into the trap of overleveraging your business when times are good, as many did via employee stock ownership plans, leveraged recaps and leveraged buyouts. Our industry's corporate graveyard is littered with those who did. Fiscal conservatism pays off in the long run in a mature, cyclical, and highly competitive industry like ours.
Matt Ogden is managing principal of Building Industry Partners LLC, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: firstname.lastname@example.org. 214.550.0405