Death of the Telecom VAR in 2013
How an entire sub-industry will be wiped out in the next 24 months 11/17/2011
Overview and Origins
Traditional telecom VARs or value-added reseller businesses- those that derive the majority of their revenue from the sale of on-premise PBX equipment to business customers- have ridden one of the longest product life cycle waves in recent technological history and combined with an emerging threat from hosted phone providers and a professional background that leaves most ill-prepared to run a business larger than a few employees is threatening to wipe-out or dramatically alter an entire sub-industry in the next 24 months.
When you think of technology and technological businesses, you usually think of the break-neck speed of change, innovation and an ever evolving business model which consistently weeds out the old, poorer performing businesses in favor of new, more nimble competitors. Business and consumers have come to expect that technology does more and costs less as each year passes. To survive in this type of competitive marketplace takes a business with laser focused objectives around innovation, talent management, procurement as well as a routine, disciplined approach to financial analysis and capital expenditure/R&D investment back into the business. Yet, as a whole, an entire industry has evolved and sustained an existence for decades despite sub-par performance on each of the fore-mentioned competencies. What are the key factors driving the extinction of this breed of business and what if anything can be done to change its trajectory?
There are a few background details to cover before beginning. Nationally, Telecom VARs range in size from several hundred thousand dollars in annual revenue to well over $100M in topline annual revenue but for the purpose of this paper I am specifically focused on those businesses that fall between $1M and $20M in total annual revenue. These are typically businesses that have grown past the “two men and a truck” or “trunk-slammer” moniker and have developed a diverse client list, professional management team, and honed a few core competencies. I also want to be very specific about the kind of business I’m defining as a Telecom VAR. These are businesses that recognize well over 50% of their revenue from the sale of phone system hardware and related services to other business clients. It does not include cell phone companies, computer hardware business, ILEC/CLECs or any of the other various types of businesses that compete in the broad technology space. As of 2011, I estimate there are around 1000 businesses that fit this classification as a telecom VAR with revenue between $1M and $20M.
Origins of the Business
To understand the industry and the dynamics deeply embedded within it, it is important to first understand its evolution and how we got to where we are today. For most, the story begins with the divestiture of AT&T in 1984. Until that point in time, the old AT&T-The Bell System- as it was known, operated as a regulated monopoly and had been largely insulated from market pressures for much of its history. On January 1, 1984 all that would change and a framework would be laid to allow for the birth of new businesses and competition. It was now possible for nearly anyone to go into business for themselves and compete head to head with what was thought to be a nearly impossible telecommunications competitor.
Businesses began to form in mass and what resembled a large land grab ensued. Initially, the break-up lead to a surge in competition for long distance transmission as large profits could be made by connecting these calls but soon after, there was all out war for every piece of the business once dominated by AT&T. Nearly all telecom VARs still in business today selling phone systems got their start during the five year period between break-up of AT&T in 1984 and 1989. Some were start-ups, hatching from the most humbling of beginnings while others where new divisions inside of large, already well established businesses selling things like dictation machines, office products, or offering analog business security to business clients.
As telecom VARs or dealers, as they would also come to be known, began sprouting up all over the county, a new industry was born. The boom of these dealers was primarily driven by the mass adoption and need for on-site telephony by many small and medium size businesses. During this period businesses found that by installing telephony hardware on-site at their business locations the cost for interoffice voice calls could be eliminated and a PBX system also provided a much more feature rich platform that increased worker productivity and drove down personnel costs. As more and more manufacturers began producing key systems that met this increase demand, innovation increased and prices began to fall making it now more affordable than ever for a business to own its telephony hardware. This spurred even greater adoption rates and, by the early 1990s, VARs began to see record profitability that would continue through the decade.
Salesman or Technician
To fully understand the telecom VAR business, it’s important to not only examine its lineage but to also understand the owners that lead them. A deeper look inside the professional background of the business owners reveals some interesting insights. First, nearly all owners had a career as either a top salesperson or top technician in the industry before starting their own business. This right place, right time background provided an easy transition into the business as they already had a good working knowledge of the industry and in many cases took a small pool of clients with them to help get the business off the ground. As a start-up company under a few million dollars in revenue, the owner’s background in sales or as a technician was extremely advantageous. With little in the way of overhead or administrative staff, this revenue paid the bills and allowed the business to continue to grow. As the business grew and started to become more complex over time, the core role of the owner needed to move from revenue production to one of more broad leadership and oversight in key areas such as strategy, operations and finance. Unfortunately, with little formal training and a career path that kept them inside of their own businesses, many owners failed to master these skill sets and either promoted or hired others who were not qualified to perform their function within the context of a larger business. It is very common to see the bookkeeper promoted to controller and then on to the CFO position as the business continued to grow with no real demonstrated changed in performance capacity, education, training or proficiency.
The Roaring 1990s
The 1990s were a great time to be in the business of putting in phone systems. Although some telecom VARs would fail to make it, most flourished and were met with an ever increasing demand for on-site PBX systems by the businesses clients they served. The general economy was also booming as the Dow Jones Industrial Average grew from approximately 2800 in January of 1990, to close out the decade at 11500, an astounding growth rate of 3100%. This general climate of economic exuberance led to a tide that tended to raise all boats, irrespective of quality.
Until the beginning of the 1990s, the expense of full-fledged PBX on-site phone system had kept it out of the reach of all but the largest business customers. Soon, many smaller, less expensive PBX systems began to emerge on the market which appealed directly to that of small and medium sized businesses and opened up an abundance of new sales opportunities for telecom VARs. This new technology not only allowed businesses the opportunity to save money on their internally switched calls, but also offered services and features unavailable in the external operator network such as call forwarding, extension dialing and hunt groups.
As mid-decade approached, dealers continued to see profitability growth driven not by optimizations in their businesses but by the ever increasing capability of the PBX box and a cost of ownership that continued to drop for their clients. As the PBX feature list grew, and prices tumbled, unit volume surged. Even as prices dropped, dealers saw margins actually increase driven by a shift in revenue mix with a greater portion now coming from service/install work and add-on warranty sales, often called managed service contracts. There were also opportunities to generate revenue and profits in ancillary businesses. The world was now moving more data and doing it in different ways. Low-voltage cabling and infrastructure work exploded as commercial construction revved up and the dot com boom fueled the need for more fiber, cable and end-points in every new business. Payphones, cell phones, and data gear were all in vogue and offered additional revenue opportunities. Telecom VAR revenue exploded and it was not uncommon to see annual net profit exceed 10% year after year during that time.
While telecom VARs were celebrating their record profitability during the mid-1990s, several trends started to emerge that threatened the entire telecom VAR businesses model. The first major business trend was the massive growth in data that began to be transmitted and the need for businesses to develop a packet switched infrastructure capable of moving an ever growing stream of information. As these networks grew, the temptation to use the internet as a global delivery system was even more attractive and the development of the first Voice over Internet Protocol, or VoIP, PBX system began. VoIP based PBX systems would eventually allow businesses as well as residential clients to use the internet, rather than traditional circuits, to transmit telephone calls and create an opportunity for businesses to outsource their entire voice network while still retaining all the features and functionality of an onsite PBX system. Doing so would eliminate the need to purchase expensive hardware and avoid the high cost of servicing the system should something break. This breakthrough in technology gave birth to the first hosted phone providers.
As a new decade began, the telecom industry- specifically the telecom VARs- continued on their record growth and profitability pace. Manufacturers, which produced the equipment that telecom dealers sold, were also seeing outstanding financial results. In 2000, Lucent, which itself was spinoff of AT&T, spun off its high growth customer premise equipment (CPE) division naming it Avaya. And Nortel, with a market capitalization of over $300B, was named the 10th largest company in the world according to Forbes. However, even with such strong growth momentum and profitability, the dealer network remained fragmented and failed to produce any one business that could effectively challenge the manufacturers, shape distribution standardization or drive a common industry language in any meaningful way.
Supply Chain Economics
In most industries, the supply chain offers clues to where the true power resides. Large retailers like Wal-Mart, Costco, Home Depot and Target have revenues in excess of all but the very top manufacturers and vendors that sell products on their shelves. With few other options, manufacturers have to cut their margins if want to use these retailer’s distribution network to put their products on shelves that see massive foot traffic every day. With scale and size on their side, retailers are able to dictate terms, drive standardization, and significantly drive down unit prices in which they can choose to pass along to the consumer or keep to boost their own margins. Other industries have seen much vertical integration which, in many cases, leads to the same result.
Operating in this fragmented network, dealers are at the mercy of their suppliers and distribution partners which are many times larger than any single VAR. With size and scale on their side, manufacturers have the ability to dictate terms and priorities to their network throughout the country which often times are not completely in alignment with the dealers' objectives. One example is the dealer saturation seen in key strategic markets. This began as the industry approached the academic definition of maturity. Around the mid-2000s growth began to sputter and manufacturers, still trying to prop up their financial results, began taking a zero-sum approach and began the saturation process of their dealer base, taking on more and more dealers in an effort to boost sales. Dealers, realizing the tactic by their manufacturing partners but lacking a strategy to adjust their business model, were left with little option but to drop prices in order to be competitive and win larger projects. This, along with a plateau in unit growth, began to negatively impact their overall financial results and the business outlook.
Manufacturer Financial Performance
Along with individual dealers, PBX manufacturer financial results could only be artificially inflated for so long. Manufacturers soon started to report declines in growth rates and profitability to their shareholders on quarterly conference calls, and by 2006 most major manufacturers were producing, at best, break-even net profit financial results for their businesses. As the country entered one of its worst recessions in recent history, PBX manufacturers like Avaya, Mitel and ShoreTel saw their business results slide faster and further than the general economy.
|10k reports filed with the SEC in years 2009 and 2010|
As a whole, this group of manufacturers lost money every single year from 2006-2010. Cumulatively, these losses totaled over $3B during the period and began to accelerate as the decade came to a close.
Although net profit trends tend to provide an accurate assessment as to the general health of a business, sometimes just looking at this one metric by itself fails to tell the whole story. Net profit is calculated after one-time gains or losses on asset sales, any mark-down of goodwill, taxes and debt service, which fails to offer insight as to how the business is capitalized. For a better look at how a company’s core business is performing and how much cash flow it is generating, it is helpful to look at the Earnings from Operations it generates.
|10k reports filed with the SEC in years 2009 and 2010|
Unfortunately, this too tells the same story. Over that past three years, only Mitel was able to generate profits, however negligible, from its core operations in a single year. Unable to generate cash flow from operations, these companies have had to use other sources to fund expenditures and growth.
Another important metric that doesn’t immediately become noticeable is how much each company is spending on Research and Development costs. R&D spend gives a good indication of how management feels about the future potential of the business and shows how many of today’s dollars they are willing to invest back into the company to help drive further growth and innovation and Below is a chart showing R&D spend for the three manufacturers:
|10k reports filed with the SEC in years 2009 and 2010|
The chart gives a diverging view on how management sees the potential for their businesses and how much, as a percent of revenue, they are willing to invest for potential future revenue growth. ShoreTel averaged just over 22% percent of revenue during the three year period on R&D spend while Avaya and Mitel averaged 7.7% and 8.4% respectively. If ShoreTel’s Operating Earnings were adjusted to match the average of Mitel and Avaya’s at approximately 8% of revenue, it would have produced positive earnings in each year from 2008-2010. The opposite would be true for Mitel. If it hadn’t scaled back R&D investment in 2010, it would have produced negative Operating Earnings.
Normally, R&D spend in technology businesses are necessary to innovate and drive the product pipeline and future revenue growth. However, in some cases, management has no choice in dropping R&D expense as other structural issues with the business, such as large amounts of debt and the associated interest payments, artificially force their decision.
Debt service and the use of debt to fund telecom manufactures is also a major concern. The following chart shows total debt of the businesses from 2008 to 2010:
|10k reports filed with the SEC in years 2009 and 2010|
Although ShoreTel has managed to steer clear of any long term debt, both Mitel and Avaya have piled on debt over the years through ill-timed acquisitions, poor financial management, and increased operational expenses relative to revenue. One of the major concerns of having high levels of debt is it the amount of cash flow needed to service it can handcuff the business from investing in new technology, making acquisitions, or investing back into their core business through capital expenditures or R&D as previously discussed. In 2010 Mitel convinced outside investors to give it $147.4M through an initial public stock offering which it promptly used to pay down some of its burgeoning debt load which still stands at over $300M.
Though it doesn’t take an advanced business degree to see that the financial condition of the manufactures are rapidly deteriorating, often times the leadership teams at telecom VARs fail to recognize or comprehend these trends. Telecom VARs have come to depend on the annual dealer conference to get their communication straight from upper management on the vision and direction of the business. These conferences tend to operate more like pep-rallies, filled with propaganda and positive spin. Few owners read the 10K report companies file each year with the SEC. Fewer still choose to attend the quarterly investor conference call where analysts have the opportunity to ask tough questions of the management team regarding their results and future projections for the business and companies have to be frank about the challenges facing them in the current environment and how they are responding. A large Avaya dealer in Colorado underscored this point when asked in June 2011 about the financial health of Avaya. He commented with confidence that he “wasn’t worried at all about Avaya, and in fact...,” he added, “...they’ve been profitable in their last nine quarters.” Factually, that is obviously false but his answer hints at a deeper, more fundamental problem.
As you map the financial stress plaguing manufacturers, it quickly becomes apparent that this is an industry in serious trouble. But there are even more reasons to be concerned and these have nothing to do with the manufacturers but reside inside of the dealers themselves.
Specific Telecom VAR Challenges
Individual dealers, regardless of which manufacturer(s) they associate with, are facing challenges to their business model unlike anything they have seen in their history. While some telecom VARs face challenges specific to their own business, there are three threats facing almost the entire industry.
Technology and the Product Life-Cycle
The first threat comes from the core technology dealers provide, the PBX system and business telephone. All products are born from, and eventually die from, innovation. Innovation of products, services and technology increases productivity and improves our standard of living. A clear lifecycle exists for all products and services as they are adopted by a few at the beginning, move to mass adoption until maturity and finally decline as a new and better technology takes their place. Even a core piece of communications technology like a PBX system has a lifecycle. Its lifecycle is subject to innovation and the marketplace typically dictates the pace that drives this evolution over time.
Each life-cycle has unique characteristics and traits. Some are very short- and have a quick peak and bust while others are longer and can span decades or centuries. Pagers are a good example of the former.
Pagers first started seeing use around 1980 mainly for on-premise communications but by 1990 and the advent of wide-area paging, the number of pagers in use rose to 22 million. By 1994 users had peaked at over 61 million. However, by 1995 2G cell networks were in place and cell phones started to become the choice of communications for both individuals and businesses. The number of pagers in use began to fall dramatically and by 2004, were largely an obsolete tool of communicating with only 750,000 in service. Today, with the exception of doctors and drug dealers, the pager has been completely replaced by cell phones and other, more sophisticated ways of communicating.
Other popular products that have recently moved through their life cycles and are in decline or death include the VHS which was launched in 1976 by JVC and for all practical purposes died in 2005 and the feature, or “dumb”, cell phones which were first commercially launched with a cell tower network in Japan in 1979 and started to gain adoption in the US during the early 1980s. These cell phones are in steep declines with total 2011 shipments of “smart” phones expected to for the first time surpass those of feature phones.
Disruptive technology, or lack thereof, is one of the primary determinates of life-cycle lengths and, like pagers and feature phones, the on-premise PBX also has a life cycle that is clearly in a decline stage. With the exception of its physical size getting much smaller, the on-premise PBX has largely seen very little in the disruptive breakthroughs or innovation in the last 5 years and the phone on the desk has seen even less.
Emergence of Hosted VoIP as The Cloud Comes Full Circle
Initially, the reason that businesses elected to outfit their buildings and data rooms with a PBX system and move away from central switchboards “in the cloud” was because of cost savings and the additional features having an onsite switch provided. This began the market need for a local telephone shop to sell, install and maintain the equipment. We are now in the midst of a reversal of this exact thinking as businesses are beginning to move their IT infrastructure from their data room back to “the cloud”. This, unfortunately for the telecom VARs, means the PBX and other related telephony equipment as well. It must be noted, this is not a fad or soon to be forgotten trend. This is happening for the exact same reason businesses decided to own the hardware and keep the technology on-site starting in the late 80s; namely cost saving and additional features/functionality. Companies that do business as hosted VoIP providers are seeing record revenue growth and client additions as many businesses elect not to replace their outdated phone systems with expensive new hardware and instead switch over to a hosted platform in which all equipment, upgrades and maintenance are remotely stored and serviced. As shown below, since 2008 the adoption of the hosted telephony platform has sky-rocketed and is projected to grow at a rapid pace as providers continue to refine the core technology and software and user costs per line continue to drop.
|Infonics Market Research 2010|
Another factor contributing to the decline of the business telephone is the emergence of Generation Y and their preference of how to use technology to communicate. These technology savvy twenty-something young professionals entering the workforce prefer texting to phone calls and a mobile device or softphone to a desk phone. As Gen Y continues to make its way into the work force, mobility for businesses will continue to surge and use of traditional office phones will continue to decline. Even Mitel’s founder and large shareholder, Terry Matthews is hedging his future bets with a large investment into a company called CounterPath which develops and sells desktop softphones and mobile applications for business clients.
Finally, the emergence of free voice over internet calls provided by companies like Skype and Google Voice threaten to provide further disruptions in the future. Although these VoIP networks are mainly designed for peer-to-peer calls and lack the robust features that most enterprise users demand, they could pose a significant threat to current businesses communications if they, and their deep-pocketed owners, decided to invest to build out their features and functionality further. Companies like Microsoft, which now owns Skype, could potentially begin offering free voice and calling technology to further its value proposition and anchor points with business clients. These companies, electing to monetize their core business of software and search could give away peripheral features such as voice as a way to exert a more dominate position in the industry.
Dealer Financial Performance
A look at the financial performance of the individual telecom VARs also provides also some interesting insights. Much of the insights tend to match closely with what large manufacturers are already reporting on their quarterly conference calls with their investors which are; key performance indicators such as sales and gross margin are flat to down when compared to previous years , customer acquisition costs are rising and there is plenty of debt that needs to be refinanced. Dealers are facing similar financial challenges and many of these can be traced to four major factors affecting their businesses.
The first major factor is the decline in Revenue per Employee telecom VARs have seen in the past few years. Revenue per Employee is one of the Key Performance Indicators (KPIs) that has the strongest correlation to employee productivity and business profitability. For many dealers in 2010, Revenue per Employee was well below its mid-decade peak and has steadily declined since 2007. These businesses have seen less productivity from their outside sales team and have continued to hold onto administrative and overhead employees even as revenue has declined, hoping sales will turn around with the economy. Overstaffed telecom VARs are facing a major headwind to profitability that will continue until the org chart is properly readjusted to match the new revenue trend of the business.
The second major factor lies in the fact that unit hardware and equipment sales are declining in the aggregate across the industry. The fact is, more and more business, especially smaller businesses are moving away from owning their telephony equipment and those that do continue to own are electing to repair rather than replace with expensive new hardware when they have a problem. The latter trend of maintaining older systems has been a slight positive for dealers as it drives service revenue which tends to be higher margin overall than other revenue streams. However, this trend has masked the bigger problem of demand for business phone systems and has given a false sense of security to dealers based on the results they see on their monthly financial statements.
The third major factor is the fact that hardware equipment margins are under severe pressure. The prices dealers can charge clients for hardware have not increased in nearly three years, yet the price they pay for materials continues to go up every year from manufacturers and suppliers. This is a fundamental problem with the economic moat surrounding the VAR business. Businesses with wide economic moats have very little trouble passing their input costs along to their customers and clients. Telecom VARs face a host of economic obstacles when trying to raise prices including almost unlimited competition and the ease of substitution from one brand to another. In order to compete in this environment, these businesses would be forced to take a hard look at their operational expenses and surgically cut out any expense that doesn’t contribute, including admin staff and employees. This, unfortunately, is easier said than done and many times, with the owner inexperienced in financial analysis or managing operational efficiencies, doesn’t get done.
The fourth major factor relates to structural issues that have taken place with the balance sheet over time. In good times, many of these businesses grew and expanded organically with cash from operations funding the business. VARs typically needed very little outside debt with the exception of large acquisitions or major Capex investments and many dealers put credit lines in place for the “just-in-case” rainy day but used them conservatively. Over the last three years, many of these businesses have started to tap these credit lines, not for capital equipment or an acquisition expenses, but to fund operations and make payroll. This is a big problem as many are now finding themselves near their credit limit and unable to meet covenants or other loan requirements. In addition, a large percentage of cash flow is now being used for debt service and any remaining equity in the business is being quickly siphoned away.
Unable to adapt to a new model of selling
As discussed, the way many small and medium sized businesses are purchasing voice and data infrastructure has begun to change due to the advance of cloud-based technologies and storage costs that continue to plummet. Outsourcing much of their technology infrastructure has essentially allowed businesses to move much of their IT spend from a capital to an operating expenditure and thus has given them more flexibility with the cash they hold on their balance sheet. This model of procurement can be a huge advantage to a telecom VARs or other businesses if it is positioned correctly to take advantage of it. Successful VARs have adapted to this way of purchasing and created strong recurring revenue streams from it. Under this model, sales are not based on winning large, one-time contracts to install new equipment but rather on longer-term agreements where VARs get paid very little up-front and recognize the revenue through the life of a one to five year contract. Hosted voice, network and carrier services and managed IT services are all examples of telecom solutions successfully being sold and purchased through this model. Clients enjoy the benefit of not having to put out large amounts of money up front to own expensive hardware and telecom VARs develop recurring revenue streams for years to come.
It seems like a win-win for the client and telecom dealer yet many telecom VARs are having a extremely hard time moving to this new model of selling. Why? Two main reasons exist. The first can be found by looking at the balance sheet. As sales and profitability started to dry up, many tapped existing credit facilities to support operations. Servicing this new debt, in addition to any legacy obligations has left many in a razor thin cash flow position and unable to adapt to a model where they receive little up front in the sale. The second has to do with the compensation plans that drive the sales team. In many cases these have not been updated in years and still incent the sales team to look for opportunities that produce large payouts on the front side (ie. new hardware sales) and ignore recurring revenue opportunities that promote longer-term business health but would pay very little today under the current compensation structure.
The Next 24 Months: M&A, Turnarounds, or Closures
As a whole, the next two years will be characterized by the changing landscape of Telecom VARs as we know them today driven by the declining economic model, changing technology and the need for the owner to transition for retirement or other reasons. Most dealers will follow one of three paths in the next 24 months in regards to their business. The first, will lead them down the path of M&A and a sale of their business to a buyer. The second will see the owner pursue a turnaround strategy, making major changes to their business and the way it operates. The third option will be to close the business down, take whatever cash is left, and retire or pursue other professional opportunities.
Some VAR owners may find the prospect of selling their business and retiring or, staying on to help run it, an exciting and attractive way to divest of their business and cash in on a potential big payday. As some owners begin to ponder the question of whether or not to sell their businesses, there are a few key questions that need to be answered. The questions that need to be answered first are; does a qualified buyer exist for the business as it operates today and, if so, what is the business worth? While there are a multitude of factors that will determine market interest and valuation of the business, there are a few important guideposts that owners should use to determine if their business is a good candidate for M&A on favorable terms.
One important factor is the size of the business. Most national and strategic buyers want to see top-line revenue at or above $10M. While revenue of less than $10M doesn’t eliminate the business from being a good candidate for a sale, it certainly decreases the pool of interested buyers. National buyers know that nearly the same about of work and integration is necessary whether they purchase a business producing $3M in revenue or $30M in revenue and will more likely opt for the larger transaction. This leaves a smaller group of local or regional buyers to consider a business under $10M in revenue. Basic economic theory states that if supply is fixed and demand becomes lower, price will drop. In the case of a smaller VAR, this usually results in multiples being driven way down relative to that of an identical, larger business.
Revenue quantity aside, buyers will also want to closely examine the quality of revenue generated from business operations. Buyers will want to see that the business has made an effort to migrate out of the PBX installs and is starting to develop or already has developed strong recurring revenue streams driven by the sale of software, IT, virtualization, and other managed services with no concentration of client accounts or a single large customer. Regular and disciplined capital reinvestment back into the business by the owners is also important. A buyer will want to see that sellers were consistent with their Capex spend and ensure the business has up to date software systems and other infrastructure. The buyer will also want to see that there is reporting in place that helps management assess the business' performance and produces accurate financial statements that can be drilled down to a department level.
The reality is, many of the telecom VARs today operate with outdated or obsolete fixed assets through years of electing to use the excess cash flow as a dividend for personal expenditures rather than reinvesting it back into their business. Buying one of these businesses is like buying an old rental property that has renters but needs much in the way of rehabilitation. If a savvy buyer, modeling out forward Capex expense sees that a large percent of future cash flow will need to be invested back into the business to bring it up to date, they will either move on and pursue a more modernized business or adjust the offer price accordingly to ensure they still earn a good return on their investment.
Finally, the percent of recurring revenue a business recognizes each year in relation to its total revenue will have an effect on the purchase price a buyer is willing to pay. The sale of on-site PBX systems produces little to no recurring revenue for a VAR by itself. Some VARs, in quest to drive profitability and recurring revenue will successfully sell add-ons that include carrier services, cloud based services such as server monitoring or email hosting and extended service agreements. These can all be profitable but unfortunately don’t contribute much to the total amount of recurring revenue when compared to total business revenue. Most VARs today have less than 5% of their sales under recurring, contracted revenue agreements. Without a strong base of contractual revenue, projecting and valuing the future revenue potential of the business becomes difficult and forces buyers to be conservative in their future projections of business performance. This continues to drive the price down.
Of the three options, pursuing a turnaround strategy is by far the toughest and most challenging to execute successfully. Successful turnarounds encompass a true transformation of the business in all aspects. They can push even a seasoned management team and a seemly strong employee culture to the brink of collapse. Companies that emerge from a successful turnaround are leaner, more profitable and better equipped to compete vigorously in their marketplace. Often times the company that emerges from a true turnaround resembles very little of the old business that began the process. For a turnaround to be successful it will need a well-defined strategy, a focused but realistic timeline and an execution team committed to seeing the plan through. The turnaround option should not be considered until though analysis produces clear objectives to be accomplished and there is a management team in place committed to seeing it though.
Although each plan will need to be specifically tailored to fit the individual VAR, the majority of the turnarounds underway right now follow a similar playbook:
Resizing the Business
One of the very first things that has to take place is the resizing of the business to its current and forward revenue projections. Many small businesses inherently lack the sophistication to employ forward looking metrics that help model out their pipeline and pair forward revenue with forward operational expense. This can be a double edged sword. In a situation where revenue is growing rapidly, the businesses, failing to forecast the size of the growth, has to react quickly to meet the sales demand. This typically results in a situation where the VAR is understaffed for the demand and employee productivity inherently increases, acting as pure leverage to the bottom line. The reverse is also true. When sales fall, these same VARs tend to be overstaffed and wait for the economy to turn around before they begin layoffs. This acts as a strong headwind to net profit as employee productivity decreases, which is the situation many VARs find themselves in today.
VARs should use the revenue per employee metric to help manage to the right number of staff needed to run the business. As a general rule, dealers with less than $135k per employee are rarely profitable. Although a good long term number should be closer to $250k/employee, the six month turnaround goal should have the business closer to the $180k/employee range.
Metrics and Accountability
Good business leaders know that you can’t manage what you don’t measure. Once telecom VARs have successfully resized the business and have the right people on the team, it’s now time to institute business accountability by setting targets, giving people the tools and resources to go out and execute, measuring the results and having a process in place for recognition and feedback. It is critical at this point that leadership teams begin both regular reporting on operational and financial results and sharing those with the leadership team and staff. Some of the best KPIs to measure the health of the turnaround are: forward revenue/employee, recurring revenue %, tech utilization %, backlog (measured in weeks) and days sales outstanding. There are many others but each of these will need to be on management’s dashboard and reviewed weekly.
VAR’s don’t want to find themselves twelve months into a eighteen month turnaround and have the bank pull the revolving credit line or other form of short-term financing and effectively kill the entire effort. Putting in longer-term financing arrangements before beginning a turnaround or making sure the business has cash on hand to see the entire process though is critical. Some VARs have plenty of cash to complete a turnaround without having to seek outside funding. Others will need to try and seek outside funding that carries a longer-term maturity and can be counted on for at least 36 months. Turnarounds don’t happen overnight and businesses that begin them and have short-term revolving credit lines can quickly find themselves tripping covenants or other restrictions which can result in their financing floor pulled out from under them. If possible, make sure the business if fully funded for at least three years or longer before beginning the turnaround.
Many owners will try one or both of the above options in an effort to sell or save their business. Some will be successful and see their business move on to resemble something closer to an IT service provider, hosted voice provider or network services provider. Other business will emerge and look more like a technology consulting company or find an underserved niche in their market such as a high-end provider of enterprise A/V equipment. The possibilities are endless for those that are willing to look forward and accept the need to change. Many however, will explore these options only to find they are left with little choice but the final option which is to wrap up operations and close the business. Unsuccessful turnarounds or lengthy M&A transactions that don’t result in a sale waste valuable time and resources. When owners are left with closure as the last and only option, it’s best to try and identify this as quickly as possible, which will allow for maximum cash preservation.
Today, most telecom VAR owners fall between 50 to 65 years of age. For many, the simple reality is no market exists to buy their business and they don’t have the physical and mental stamina to complete a true turnaround. Some believe that the economic cycle and macro factors, rather than an advance in technology is driving the demise of their business results. They are comforted in the thought that they’ve seen this before and everything will be alright. They would be wise to study the history books and look to what the capital system does to businesses that fail to evolve over time. This same capitalistic system that gave birth to their business will unapologetically usher in its last breath.
Summary and Conclusions
Lower demand for PBX systems is not driven from a macroeconomic business cycle or some other temporary event. Telecom VARs are experiencing a much more microeconomic shift in technology that could better be classified as permanent, structural impairment to forward demand. The majority of Telecom VARs will cease to exist in their present form 24 months from now. The technological life cycle of the on-site PBX is quickly coming to an end and being replaced by a better technology platform, one which allows businesses more flexibility and better management of its IT spend and at a lower cost. Owners of these businesses are facing an onslaught of issues that must be dealt with immediately that come from both inside and outside their businesses. Owners that are skillful in navigating through, or avoiding all together, these issues will be successful and continue building and growing their business or have the option to sell, on good terms, to a buyer. Those businesses that failed to make tough changes along the way and continued doing things the way they always have will be forced to either a) undergo an immediate turnaround and make the necessary changes to their business model or b) wind down operations and close.
The capital system is one of the greatest inventions of all time. It incentivizes those that pursue a mission of continual improvement and constant reinvention. It rewards businesses and individuals that innovate and help increase standard of living through their products and services. The unfortunate fact is sometimes great businesses fall behind and can't keep up with market demands. Telecom VARs have reached an important inflection point in their business life. Their future hangs in the balance and for some it will take everything they have to survive the coming few years. For the best, those that continue to innovate and find ways to drive costs down for their clients and business partners, the future looks bright and they will continue to prosper in their reincarnated form. Those that can’t change and adapt to the new marketplace will disappear for good.