CHAPTER THREE

CHAPTER THREE

Digital transformation has been in the technical press for years; geeking out on everything from the merits of low-level network protocol design to high-level platform architecture. That’s all good for a nerd like me, but now that the technology of digital transformation has matured, it’s time to discuss it from a financial perspective—in particular, from the financial perspective of the leveraged buyout firm. Why? Because it’s a perfect fit for GP portfolio companies, and it’s now ready to be put to work by the digital operating partner as their primary value creation tool.

Digital transformation supports innovation and invention that, in turn, supports a steeper growth profile—a growth trend that is sustainable because going digital is a structural change, not a short-term blip in cash flow.

There are as many definitions of digital transformation as there are different interests in it, but from our perspective, the perspective of maximizing enterprise value, digital transformation is the transformation of a traditional company into a digital-traditional company through one or more digital initiatives. Digital enables us to operationally transform most types of portfolio companies into the type of companies that have the highest valuations: tech companies. For example, there are traditional companies like taxicab companies that operate in the physical world and digital companies like Uber that operate in both the virtual and physical worlds. Both roughly do the same thing, but the one that is more valuable is obvious.

Most operational improvements in private equity deal in percentages. Percentage of costs, percentage of working capital and percentage of price, which yield fractional improvements. Digital transformation can hit harder with whole-number improvements in EBITDA and the valuation multiple. Next, we’ll break down enterprise value to see how fund managers can create alpha by using this new operational value creation tool. Time to geek out financially.

ENTERPRISE VALUE

ENTERPRISE VALUE = EBITDA x VALUATION MULTIPLE

As a value driver, digital transformation has it all. Not only does it employ digital initiatives to turn down COGS and OPEX, but it can also turn up the two biggest knobs of enterprise value: revenue growth and the valuation multiple. Data-driven operational improvements increase cash flow and provide different options to ratchet up the valuation multiple during the holding period. Enterprise value is our North Star. We always go back to EBITDA and valuation multiple when choosing which digital initiatives to implement when designing a portfolio company’s digital transformation.

EBITDA

EBITDA = net income + interest + taxes + depreciation + amortization

Let’s focus on cash first. Examining EBITDA is a great way to isolate the portfolio company’s profitability from its core operations before considering the impact of capital structure, leverage and other non–cash flow items. To do this we will look at net income’s revenue and then margin.

Net income = revenue – COGS – OPEX +/- other profit/(loss) line items

REVENUE

When considering operational improvements as measured by EBITDA gains, the X factor is revenue growth. Revenue solves all problems. Whether from inorganic growth or price rationalization, it’s all good, but the most coveted growth comes from increasing market share and market size—both being the sweet spots of digital transformation because they’re both the sweet spots of digital companies. (See Figure 3.1.)

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Figure 3.1 Change in Revenue

When we think about the most successful companies as measured by valuation/enterprise value, digital companies such as Microsoft, Apple and Alphabet come to mind. In fact, tech companies, including these, are the most valuable companies in history. Digital transformation enables traditional portfolio companies to have the “superpowers” of tech companies, and the common denominator of the most valuable tech companies is that they are all data driven. So the source of these superpowers is data—data to help you understand how customers use your products (usability), what they use your products for (utility) and how they make money with your products (monetizability). Networking tech and software give digital companies a direct connection to their customers through their smart products. This primary customer data drives successful organizations to make better products (innovation) and make new products (invention), but it’s not limited there: it also enables these data-driven companies to innovate their business models and even invent new ones.

This is the “why” of digital transformation. To transform traditional portfolio companies into digital-traditional portfolio companies is to make them more data driven, because traditional companies that are data driven (digital-traditional companies) can use the same playbooks as the ones that made Microsoft, Apple, Alphabet and other tech companies so valuable.

MARKET SHARE

All things being equal, market share goes to the company with the most competitive product. For successful digital companies this alpha comes from interpreting customer data to improve usability and utility. In the same way Apple observed its iTunes software users to improve its interface, functionality and performance and then produced iTunes’ successor Apple Music, smart tractors from John Deere have been similarly improved through usability and utility. John Deere’s smart products are the most innovative in the company’s industry and as a result enjoy the greatest market share.

MARKET SIZE

Alpha from increasing market size is achieved by entering new markets. Data-driven companies minimize the risk of entering new markets by using customer data to invent new products or innovate existing products to serve their new markets.

Microsoft used 15 years of customer data gathered from Windows to inform the design and function of its then new Xbox game console, launching the company into a growing $35 billion market. Fast-forward 20 years, and game revenue represents almost 10 percent ($11.4 billion) of its total revenue. The Xbox console differentiated itself by being not only smart but also connected (networked like a PC), allowing customers to play each other, not just play against the game software. From game hardware Microsoft grew into producing game software and now uses the microtransactions business model for in-game purchases.

In the physical world, Continental Tire used its smart tires to invent new information products for the fleet management market. Today Continental sells a new information product into a new market to monitor safety and logistics costs, and in the process, the tire company has increased the size of its total addressable market.

PROFIT MARGIN

In general, margin expansion with digital transformation is about using data science to reduce costs and expenses through operational efficiency. Analytics and AI/ML is used to interpret data from the portfolio company’s operations sensors to improve one or more of asset utilization, human capital utilization, production yield, availability, capacity, performance and quality.

While digital can support traditional expense reduction efforts such as salesforce efficiencies, inventory management, group buying power, and supply chain and distribution efficiency, its main focus is to measure and optimize the operations of creating a product or providing a service. Operations are quantified and then efficiency/performance models are developed, improved and interrogated to provide useful information to improve profit margin. (See Figure 3.2.)

Figure 3.2 Change in Margin

COGS

Robots and other automation devices have been reducing the cost of goods sold for decades. Digital transformation goes one step further by creating a layer above this equipment and other assets to orchestrate them. This is the purpose of the industrial internet of things (IIoT) and Industrie 4.0 (I40): to digitize and stitch together devices and a plethora of high technology to deliver digital initiatives such as predictive maintenance, asset monitoring, asset tracking and fleet management. To support these initiatives, capital is redirected to high technology to create a digital twin of the portfolio company’s manufacturing or production processes.

This is digital transformation as it pertains to the production of products, but the customer data collected can also reduce operating expenses by improving the efficiency of other functional departments within the organization.

OPEX

Understanding how your customers use your product/service, why they use your product and how they make money using your product produces data that can be used to improve virtually every department in the digital-traditional company. For example, product usability data can be used to optimize SG&A spending by knowing or predicting when there are opportunities to sell more products or product consumables. Similarly, product utility data can be used to create marketing communications customized for each customer.

There are as many definitions of digital transformation as there are different interests in it, but from our perspective, the perspective of maximizing enterprise value, digital transformation is the transformation of a traditional company into a digital-traditional company through one or more digital initiatives.

VALUATION MULTIPLE

In addition to taking advantage of arbitrage, negotiation skills and market inefficiencies, the job of the buyout firm at exit is to convince the buyer that the asset for sale is well positioned for future growth and profitability—to substantiate its premium valuation multiple.

The structural changes from being digital can be a strong company-specific component of the narrative used to communicate an increase in the growth profile and a decrease in the risk profile of future cash flows. Digital helps accomplish this in two ways: the support of nondigital investment thesis strategies and the digital rerate.

INVESTMENT THESIS SUPPORT

Part of the digital investment thesis is to support and amplify the strategies in the overall investment thesis to increase the asset’s growth profile (Figure 3.3). Inorganic strategies such as buy and build, and TAM expansion (horizontal or vertical or geographic integration) are supported by extending digital capabilities into the add-ons to integrate them with the platform. This is not the plumbing integration of IT but the integration of the data within the overall data science strategy focused on improving the platform company’s KPIs. Another step is to digitally integrate the platform and add-on companies’ products.

Figure 3.3 Investment Thesis Support

DIGITAL RERATE

The digital rerate takes three forms: valuation migration, premium goodwill and potential disruption.

VALUATION MIGRATION

The first form of a digital rerate is the step-by-step migration of the valuation multiple from the purchase multiple up to a multiple closer to the valuation multiple of digital/tech companies (Figure 3.4). This is based on the perception that the traditional company has become more like a tech company—e.g., after a theoretical 100 percent digital transformation, the traditional portfolio company would be a digital company and therefore command a tech valuation multiple. Since no digital transformation is fully completed during a hold period, a partial digital transformation will garner a partial tech valuation. And being unfinished is not bad news. On the contrary, it is an opportunity for further value creation, so it represents a credible future growth narrative that can be sold as upside to the next buyer.

Figure 3.4 Valuation Migration

PREMIUM GOODWILL

The second form of digital rerate centers on digital goodwill (Figure 3.5): goodwill that a strategic buyer will pay for to justify the inflated valuation multiple. Digital transformation is hard, and it’s even harder to do in a corporate structure where there are multiple shareholders. It’s not that the technology is any harder; it’s not. It’s harder because of all the nontech reasons, the same reasons why multishareholder companies don’t generally perform as well as PE-owned companies: strategy and alignment. Because digital transformation is hard to get off the ground for strategics, they will highly value the architecture of a smart product/platform and the assembly of a digital team and use them both as the starting point or to augment their own digital transformation. Strategics will account for this intangible asset on their balance sheet as goodwill after the acquisition, and the number can be quite large.

Figure 3.5 The Digital Rerate

POTENTIAL DISRUPTION

The third form of digital rerate derives from deploying innovative business models and other novel strategies supported by digital. This is an elusive but common trait of the most successful digital companies. Of course, digital does not guarantee the disruption of competitors and industries, but it does represent the home run of value creation (Figure 3.5).

Examples of innovative business models in the digital space include Apple’s pay per song in iTunes and its all-you-can-eat subscription model in Apple Music, Microsoft’s microtransactions in its video games and Alphabet’s pay per click and pay per conversion in Google Ads. Disruption requires innovative and inventive products, but these awesome products are usually accompanied by awesome, or shall we say, innovative and inventive business models.

These strategies disrupted the music industry, the electronic games industry and the advertising industry. Data from the customer-product-company connection enabled each disruption, and as such, all three strategies can be deployed by legacy companies too.

Because digital transformation is hard to get off the ground for strategics, they will highly value the architecture of a smart product/platform and the assembly of a digital team and use them both as the starting point or to augment their own digital transformation. Strategics will account for this intangible asset on their balance sheet as goodwill after the acquisition, and the number can be quite large.

A digitally transformed company has this same type of data coming from its physical products. GE sells its jet engines by the hour because its physical products are digitized. John Deere sells outcomes from its tractors and only shares in profits because its physical products are digitized. Same thing for Tesla. Because its physical products are digitized, Tesla is expanding its TAM by starting to sell auto insurance. By knowing how its customers drive, Tesla can underwrite policies that will always be highly competitive and profitable. And coming up, Tesla will offer to buy unused vehicle capacity from its customers. Soon Tesla owners will be able to make money from their car when it’s not in use by opting into Tesla’s upcoming Robotaxi services. That’s disruptive and reproducible by other digital-traditional companies, but novel strategies like these don’t need to disrupt industries to drastically increase the slope of the digital-traditional company’s growth profile.

Digital transformation supports innovation and invention that, in turn, supports a steeper growth profile—a growth trend that is sustainable because going digital is a structural change, not a short-term blip in cash flow.

THE DIGITAL PAYOFF

Now that the high technology of digital transformation has matured out of venture, it can be used by buyout firms to help produce superior returns for its investors. As a value lever, it creates alpha EBITDA growth and an alpha uplift in the portfolio company’s valuation multiple (Figure 3.6).

Figure 3.6 Alpha Created with Digital

Digital transformation splices digital company genes into the DNA of traditional portfolio companies, and the resulting data-driven “superpowers” express themselves in value after the portfolio company crosses the digital divide.

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