Food & Beverage to the structure of the agribusiness industry, usually farmers are price takers. Their ability to pass along higher production costs to their customers via higher prices is limited. Food commodity suppliers and processors have little control over the macro forces that govern supply and demand. However, companies can increase profitability by entering into long-term contracts that give them an advantage over the spot market in certain situations.

For instance, farmers with contractual agreements to sell their crops or livestock at favorable prices when the markets are falling, or who have entered into purchasing agreements when production costs are rising, are better positioned to maintain their margins than suppliers who lack such contracts. Farmers also might be able to hedge some of their price volatility by using derivatives. Food processors also can take advantage of contracts to maintain selling prices and minimize production costs. They have more flexibility than producers do to negotiate prices and pass along some of their rising costs.

Food processors sell products to food retailers that can rapidly pass price increases to consumers. How quickly and to what degree companies can transmit rising commodity prices to their customers, how well they can hold the line on falling prices, and the agreements in place to lock in primary production costs have a sizable effect on a company’s operating margin. Because M&A deals usually are priced based on a multiple of normalized Ebitda, changes in commodity prices over time need to be segregated from COGS to quantify their impact on earnings. Quantifying the Impact Normalized Ebitda represents the base of the future earnings capacity of a company. Arriving at a normalized Ebitda begins with analyzing the company’s past revenues, COGS, and sales mix.

The analysis typically looks back three to four years. At a minimum, the buyer and seller should evaluate the following: • Revenues What was the company’s revenue growth in past years? How does the company’s revenue growth compare to that of its competitors and industry benchmarks? • Sales Mix What was the company’s mix of product sales in past years? What percentage of changes in earnings can be attributed to changes in the product mix? • COGS What are the significant components of the company’s COGS, and how has the cost of the components of COGS changed over the past few years? How does the company’s COGS compare to that of its competitors and industry benchmarks? What percentage of earnings increases or decreases can be attributed to changes in commodity prices? Earnings are then normalized by removing nonrecurring revenue and expenses and making other adjustments. In particular, buyers want to be sure that a seller’s earnings expectations remove extraordinary income and retain recurring costs.

Once the impact of commodity price volatility on earnings is quantified and earnings are normalized, buyers are able to establish an Ebitda multiple for a deal. Companies with significant earnings uncertainty usually fetch lower acquisition multiples than businesses with more predictable profitability do. Naturally, both sides of a potential M&A deal want to protect their interests. To do so, buyers and sellers should quantify the impact of price volatility for commodities to arrive at a normalized Ebitda valuation multiple that will serve as a realistic basis for negotiating a deal. Jesse Evans is a senior manager, and Marc Shaffer is a partner at Crowe Horwath Advisory Services. (#87927) Reprinted with permission.

© 2015 SourceMedia Inc. and Mergers & Acquisitions. All rights reserved.

SourceMedia, One State Street Plaza, New York, N.Y. 10004. For more information about reprints from Mergers & Acquisitions, visit PARS International Corp. at www.SourceMediaReprints.com. PRINTED COPY FOR PERSONAL READING ONLY. NOT FOR DISTRIBUTION. .