Case 087Portfolio operations and exitsWarm up

Procurement takes 2% off a Rs 600 crore COGS base. What is the EBITDA gain and the value at a 10x exit, and how does it compare with a 2% price rise on Rs 1,000 crore of revenue?

The situation

Rasdhara Beverages, a sponsor-owned maker of packaged juices, has revenue of Rs 1,000 crore, cost of goods sold of Rs 600 crore and EBITDA of Rs 150 crore. The operations team has renegotiated sugar, packaging and freight contracts and expects to cut COGS by 2%. Separately, the sales head proposes a 2% list price increase across the range.

The fund expects to exit at 10x EBITDA in three years.

Your task

Work the EBITDA and exit value effect of each lever, say which is worth more, and say which you would bank first and why.

Quick check

Both levers are 2%. Is the price rise worth more than the procurement saving?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Procurement adds Rs 12 crore of EBITDA, worth Rs 120 crore at 10x; the price rise adds Rs 20 crore, worth Rs 200 crore, if volume holds. The price lever is larger because revenue is a larger base than COGS, but it depends on customers, and a volume loss of about 4.8% wipes it out. Bank the saving first: it is certain, it needs no customer to agree, and every rupee of it is worth ten at exit.

Step 1Why is a cost saving worth ten times itself?

Because a buyer pays a multiple of EBITDA, and a saving that recurs is EBITDA. A household that cuts its electricity bill by Rs 1,000 a month has not saved Rs 1,000; it has saved Rs 12,000 a year for as long as the habit lasts. Two per cent off Rs 600 crore of COGS is Rs 12 crore a year, and at a 10x exit the buyer pays Rs 120 crore for it. That is why the operations team arrives in month one: a saving made in year 1 is in the EBITDA the exit is priced on, and the same saving made in year 3 may not have shown up in the accounts the buyer trusts.

Every rupee of EBITDA is worth ten at exit, which is why sponsors hunt savings in year one, Rs croreProcurement: 2% off COGS of 600in the sponsor's handsEBITDA +12Value +120 at 10xPrice: 2% on revenue of 1,000only if volume holds;a 4.8% volume loss cancels itEBITDA +20Value +200 at 10xA 1.2% price rise would match the saving; the saving needs no customer to agree.Lime: the value a sponsor can bank. Paper: the value that depends on the market.
The procurement saving adds Rs 12 crore of EBITDA and Rs 120 crore of exit value in the sponsor's own hands; the price rise adds Rs 20 crore and Rs 200 crore on paper, but only if customers keep buying, and a 4.8% volume loss cancels it.
Step 2Why does the price rise look bigger, and why is that misleading?

The base is bigger: revenue is Rs 1,000 crore and COGS Rs 600 crore, so 2% of each is Rs 20 crore against Rs 12 crore. But a price rise is a bet on volume elasticityHow much the quantity sold changes when the price changes. A 2% price rise that loses 2% of volume has gained nothing on revenue and lost on contribution.; with a contribution margin of 40%, losing more than about 4.8% of volume turns the Rs 20 crore to zero. Juice is a category where a 2% list price rise can push a retailer to a rival brand, so the Rs 200 crore is a hope, while the Rs 120 crore is a contract.

Rs croreProcurement 2%Price 2%
Base it acts onCOGS 600Revenue 1,000
EBITDA gain1220
Exit value at 10x120200
Depends onsigned contractscustomers accepting it
Volume loss that cancels itnoneabout 4.8%
The price lever is worth Rs 200 crore against Rs 120 crore for procurement, but the first rests on customers accepting it and the second on contracts already signed, and a price rise of only 1.2% would match the procurement saving.
Step 3What would you tell the board to do first?

Bank the saving and test the price. Lock the procurement contracts now, so the Rs 12 crore is in this year's accounts, then trial the 2% price rise in one region and one channel and read the volume before rolling it out. A price rise of only 1.2% would match the procurement saving, so even a partial increase is worth having if volume holds. The limit of the arithmetic is the multiple: a buyer pays 10x for EBITDA it believes will recur, and will haircut a saving that looks like a one-off supplier concession or a price rise that the next quarter's volume has not yet confirmed.

Where candidates lose it

The usual loss is comparing 2% with 2% and calling them equal, without noticing that one acts on Rs 600 crore and the other on Rs 1,000 crore. The bases differ, and so do the risks.

The second is crediting the full Rs 200 crore to the price rise without asking what volume does. A price lever is only worth its EBITDA if customers keep buying, and the breakeven volume loss here is under 5%.

What the interviewer asks next

  • The procurement saving comes with a two-year supplier contract and a 1% rebate clawback if volumes fall. How does that change the value?
  • Variable costs are 60% of revenue. If the price rise loses 3% of volume, what is the net EBITDA effect?
  • Why do buyers often refuse to pay full multiple for savings made in the last year before exit?

Company names and figures are illustrative.