How to Write Business Strengths/Weaknesses in Investment Memos

Preface

One of the most challenging aspects of any buyside case study is determining a business's strengths and weaknesses, especially if you're unfamiliar with its sector. However, there is a simple way to quickly churn out relevant points to include in your memos - leveraging investment characteristics that are applicable to nearly every business. The details below provide an overview on the 15 characteristics you can pick and choose from while composing your investment memos. Although the below characteristics cover a wide breadth of potential strengths and weaknesses, you should try creating your own as practice. For example, additional characteristics could include Barriers to Entry, Geography and Distribution, to name a few.

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Investment Characteristics & Examples

The 15 characteristics below are "boiler-plate" in nature, which means they'll be applicable to almost any individual company or industry that appears in a case. When completing a case study, you should analyze the company information you receive against the characteristics below and formulate two to three bullet points for your Investment Strengths and Investment Weaknesses sections of your memo.

Note that each of the below characteristics can either be an investment strength or weakness, depending on how the company performs against that characteristic. For example, if a company is consistently generating cash flow, that would be a strength. On the other hand, if a company has a spotty cash flow generation record or has been cash flow negative, that would be a weakness. The 15 examples below feature the investment characteristic positioned as a strength in the first bullet point and as a weakness in the second bullet point for a hypothetical company ("Company A").

1. Cash Flow Profile

• Sustained Cash Flow Generation – Company A's core business continues to benefit from increasing demand in its healthcare services segment and minimal maintenance capital expenditures. Consequently, the business has generated ample cash flow over the past few years and is projected to sustain this cash generation over the projected period. Taking this into account, Company A could likely service a higher-leverage profile than its peers and potentially support a cash distribution

• Deteriorating Cash Flow Generation – Given decreasing demand for its products across a variety of end-markets, Company A's cash flow generation has begun to deteriorate over the past year. This pressure has been further exacerbated by inflation in the cost of critical inputs, such as steel and freight. Absent a turnaround in Company A's cash flow generation, it likely could not support more than 1x leverage without incurring significant further cash burn

2. Revenue Dynamics

• Reoccurring Revenue – Although Company A's customer relationships are not locked in via a contract, the business enjoys reoccurring revenues due to a complimentary service that addresses a continuous customer need. Additionally, Company A's corporate clients usually purchase its products on a bi-annual cycle to ensure they continuously have the highest quality equipment. As such, lenders will likely be comfortable with our leverage assumptions

• Lack of Sustained Repeat Revenue – Company A's product portfolio is limited in scope and functionality, which has stymied its ability to generate meaningful revenue from a customer post their initial purchase of the product. As such, Company A's marketing expenses account for a meaningful amount of revenue (~65%) as it needs to constantly source new customers. In a scenario were Company A is unable to cover its marketing expenses, leverage could materially increase and debt service payments might be missed

3. Management Team

• Highly Experienced Management Team – Although our firm lacks experience with public to private transactions, Company A's management team is highly experienced in navigating the complexities of these transactions while still managing the business under a leveraged capital structure

• Departure of Key Executives – While Company A is in the midst of executing a turnaround strategy, the success of this endeavor has been continuously interrupted by departures from key executives. Specifically, the Head of Engineering and Head of Sales have left due to alleged tensions with the new CEO. Absent strong candidates filling these vacancies, either through internal promotions or external hires, Company A will likely struggle to meet the financial forecasts used to secure its debt package, potentially paving the way for a restructuring scenario

4. Market Position

• Established Market Leadership Position – While the market for Company A's products is fragmented, it holds a clear leadership position, with ~8% of the market. This leadership position has been the result of carefully planned expansion projects and opportunistic M&A. Company A has been able to leverage its position to negotiate favorable long-term contracts with both suppliers and customers

• Competition Eroding Market Position – Over the previous decade, Company A was the dominant player within its segment due to its customizable product offering that could be tailored to a given customer's needs. However, Company A's competitive dominance has been eroded by competition over the past three years, with most of its product lines losing market share quickly. This was the result of a series of business decisions that were designed to increase margins at the expense of product and service quality

5. Equity Growth Narrative

• Strong Equity Growth Narrative – Company A has a compelling equity growth narrative driven by the successful launch of its newly launched product and geographical expansion. In spite of Company A's rapid revenue growth, only ~10% of the market has been penetrated in the U.S. (doesn't include international opportunity), which leaves significant white space available to capture

• Indefensible Equity Growth Narrative – Although Company A has grown its top-line by a CAGR of ~30% over the past five years and maintained EBIT margins of over 25%, competitive pressures have begun to increase in its niche that could threaten its future growth trajectory. While management has tried to dissuade investors from placing too much weight on the matter, Company A could be susceptible to a deceleration in revenue growth that could result in a lower exit multiple in the next three to five years

6. M&A & Integration

• Track Record of Successful Inorganic Growth – Company A has an impressive track record when it comes to executing and integrating bolt-on acquisitions, which has allowed it to increase its revenue and solidify its position within the market. Over the projected period, Company A anticipates that it will execute two to three acquisitions per year using minimal debt, allowing it to further grow its market presence

• M&A Integration Risk – While Company A has executed five bolt-on acquisitions in the past decade, its anticipated merger with Company B could prove to be more strenuous as the transaction is essentially a merger of equals. For example, Company A has no international presence or corresponding knowledge of how to operate efficiently in these markets, however, Company B has multiple manufacturing facilities in China and Mexico that may be difficult to properly manage. Additionally, Company B also utilizes different technology systems to run its business, and it will likely take a significant amount of resources to properly sync these with Company A's system

7. Entry & Exit Multiple

• Complex Situation Warrants Lower Entry Multiple – A large international conglomerate is seeking to sell its North American portfolio, which holds significant market share in a niche manufacturing segment. However, the complexities around the divestiture has spooked potential bidders that lack experience with corporate carveouts. As such, in spite of Company A being an otherwise pristine asset it could likely trade at a lower multiple (<8x Adj. EBITDA) due to lack of investor competition

• Dwindling Growth Could Catalyze Multiple Contraction – Over the past year it has become apparent that Company A is running out of growth opportunities, as revenue growth has decelerated from ~25% annually to ~10% over the prior year. In spite of this, investors are still placing bids at an elevated entry multiple (+15x Adj. EBITDA), which is concerning given that over the 5-7 year hold period Company A's revenue growth might drift down to ~5% per year, creating a very real possibility of multiple contraction

8. End Market Dynamics

• Aerospace & Defense Exposure Provides Stability – Company A serves as a supplier to original equipment manufacturers in the aerospace & defense sector, which has allowed its revenue to be unaffected by downturns in the broader economy. Additionally, many of its clients are growing their manufacturing programs due to strong demand from the government, as a result Company A's revenue has seen steady growth over the past five years and an uplift in margins

• Hobbyist End Market Concerning – The products produced by Company A are primarily sold to arts and crafts retailers, such as Michaels, Party City and JOANN Fabrics. This is concerning for two reasons: (1) hobbyists tend to exhibit sporadic shopping behavior that makes them unreliable as customers and (2) many of the retailers that specialize in arts and crafts have displayed signs of financial stress/distress, such as credit downgrades or Party City's Chapter 11 filing. These factors make Company A a less attractive business for lenders and lower the amount of leverage that can be placed on the business

9. Customer Contracts

• Typical Contract Term of 3+ Years – Company A's revenue is locked in via customer contracts, with the typical term being over three years in length. The stability of the business's revenue base has made lenders comfortable with extending leverage, making it a particularly compelling buyout candidate

• Lack of Contracted Revenue – Company A's customers are not locked in by contracts and frequently negotiate lower prices by threatening to leave for a competitor. This dynamic has crimped Company A's ability to meaningfully grow, with revenues increasing by less than 5% over the past two years

10. Technology Dynamics

• R&D Investments Paying Off – Over the past three years, Company A has diligently planned an executed a capital intensive R&D project that has meaningfully enhanced the quality of its product portfolio. Consequently, it has won a series of multi-year contracts that pave a path for meaningful revenue growth over the next two years

• Business Burdened by Technological Debt – Under the current private equity owner, Company A has increased its operating margins by over 500bps. However, after conducting further diligence, it appears that this was the result of significant underinvestment in research and development. This is particularly concerning given the market's preference diverting from Company A's current product offering, and will likely result in significant the need for material R&D investments over the next few years

11. Regulatory Environment

• Deregulations Contributing to Growth – A favorable regulatory environment has enabled Company A to execute on its international growth aspirations and double its revenue over the past year. According to the regulatory body, deregulations are likely to continue as the country seeks to enhance its attractiveness to international investors

• Burdensome Compliance Regulations – Despite Company A's unblemished compliance record, industry wide scrutiny has impacted its ability to scale as quickly as it would have liked. Accordingly, the company has had to pair back its growth ambitions and write-down the value of its recently acquired logistics division. Since the incremental costs associated with the new industry wide regulations were not taken into account in the latest financial forecast, we will need to revise our projections

12. Cost Structure

• Variable Cost Structure Provides Flexibility – Although Company A operates in an industry that typically requires significant fixed costs, like manufacturing equipment, the company has taken deliberate steps to keep its costs variable. Specifically, Company A has outsourced a significant amount of the manufacturing to upstream suppliers. If demand were to decrease, the company has the ability to temporarily furlough workers, which would allow it to alleviate cash flow pressures during these periods

• Fixed Cost Structure Problematic – While Company A previously benefitted from its fixed cost structure, declining demand for its core products could cause near-term cash flow pressures. Over the past few years, Company A entered into long-term fixed contracts with the majority of suppliers that were designed to enhance its margin profile. Although this worked favorably for a while, now that sales have declined ~40%, it is unlikely that the business will be able to generate any cash flow over the next year. This is particularly concerning given its ongoing capital expenditure needs and upcoming maturity

13. Customer Concentration

• Diverse and Growing Customer Base – Company A's core B2B product has wide appeal, with the number of potential customers estimated at over 50,000 businesses in the United States alone. The business has done well attracting attention and currently serves over 1,000 customers, with the top 10 customers accounting for less than 7% of revenue. Company A believes that it could raise prices by 5-10% a year and see minimum churn from existing customers

• Three Customers Accounts for >50% of Revenue – Over the past few years three customers have continuously placed larger and more frequent orders with Company A. Although this is a testament to the businesses excellent service, it is slightly concerning given the leverage they have against Company A. If any of the customers were to lower their purchase volume it would have a material impact on the business and hinder Company A's ability to service debt payments

14. Supplier Concentration

• Entry of New Suppliers Has Kept Costs Down – Company A's universe of potential suppliers has expanded over the past two years as new participants have entered the space. Many of these new entrants have flooded the market with discounts to entice potential customers, which has resulted in Company A's manufacturing costs actually decreasing over the past year. Although this favorable pricing dynamic is unlikely to last forever, it does signal a change in negotiating leverage that could persist for many years

• Overly Reliant on Key Suppliers – In the past Company A utilized a variety of suppliers to produce its products, however, after consolidation of its upstream suppliers, the business now relies on three key companies. These suppliers have already begun to leverage their position, as in the last round of annual contract negotiations they were able to increase pricing by 15%, a steep increase from the typical 3% uplift that has historically occurred. Consequently, Company A revised its financial forecasts and now anticipates generating negative cash flow for the fiscal year

15. Maturity Profile & Liquidity Position

• Ample Liquidity & No Near-Term Maturities – Company A has over $200 million of liquidity, comprised of $100 million of cash and $100 million of availability on its revolving credit facility. This is more than enough to cover its ongoing maintenance capital expenditures (~$25 million per year) and leaves the door open for M&A opportunities. Additionally, Company A recently refinanced its term loan at a more attractive rate while pushing its maturity back four years

• Near-Term Maturity Profile Concerning – Although Company A has attempted to bolster its liquidity profile over the past six months via asset sales and capital raises, the amount raised is likely inadequate to fully address its looming maturity wall. This is particularly concerning given the state of credit markets, and could potentially put Company A at risk of a default