The four variables: important measures to understand your account base
By Victor Harding
Recently, I tuned in to one of the best webcasts I have ever heard, given by Michael Barnes of Barnes Associates, a U.S. based security industry advisory firm.
The webcast, hosted by a U.S. magazine, addressed the four key variables by which owners, buyers, lenders and investors should value an account base. I have talked about these four variables over the years but have never completely understood the numerical underpinnings of each. Barnes may not have originated these variables, but he has articulated them in a very compelling way. If a buyer was being completely rational, how these four variables calculate would explain an account base’s value. However, most of the smaller deals in Canada today are being done without these four variables being calculated. Throughout this article I will be referring to Michael Barnes’ webcast “Minding Your Metrics: Insights into tracking value in an RMR-based business.” I recommend you view the webcast yourself if possible.
1. The Cost to Create a new customer or new RMR (Recurring Monthly Revenue)
The Cost to Create (CTC) is generally expressed as a multiple of the RMR that has been created. So, for example, over all in the U.S. last year, Barnes estimated the overall CTC to be about 29X RMR. If you consider that the average RMR on accounts being created these days is much higher than 10 years ago ($35/month versus $25/month) then each new monitoring customer in the U.S. alarm industry costs more than $1,000 to create. This CTC number that Barnes quotes is driven by three high cost scenarios: a) authorized dealer created accounts, b) telco created accounts and c) summer door-knocking accounts. Generally, commercial accounts cost far less to create (15-18X), which explains why people value them higher today. The lower the replacement cost for a lost account, the more attractive the account base is. Generally this high CTC for residential accounts today (26 to 32X RMR) is the reason why most independent alarm dealers don’t focus on the residential market.
2. The margin on the monitoring RMR and service revenue created
As Barnes talks about it, this variable combines both monitoring and service revenue and their corresponding costs together to get at one combined gross margin. Typical margin numbers here vary between 50 per cent for smaller companies who might pay higher per unit monitoring costs and don’t make as much on service to 65-70 per cent for larger companies whose volume drives down their monitoring costs per account and who might charge higher rates for service. The example Barnes used in his webcast showed us a sample company whose margin on service and monitoring was 54 per cent.
I have always written that alarm accounts with higher rates are generally worth more than accounts with low rates. This rule of thumb is backed up by what Barnes says about this second variable. Run some numbers yourself and see how much more money drops to the bottom line on $30/accounts versus $20/accounts. You will never sell a $20 account again. Today, average RMR rates are climbing with the increasing use of cell services and interactive accounts, but the costs for these services are also a factor, so often the overall margin is lower. Including the margin on service in the overall calculation helps explain why buyers may not like accounts with lifetime warranty attached. It lowers the service margin.
Here is something that most of us don’t take into account — to do a proper calculation of this variable, Barnes says you should allocate some overhead from your operation and add these costs to the monitoring and service costs to get a true margin. Barnes actually took 50 per cent of the total overhead of the sample company and added it to this calculation. This confirms what I have been saying for some time, which is that it does cost to manage an account base.
3. The attrition percentage on the base, or how long the RMR lasts
Most of us have been told for years that attrition is an important number to consider when valuing an account base. But few of us know how to go about calculating gross or net attrition or give attrition enough consideration when assessing an account base. The important issue is to know how long an account base will last and how much it will cost to replace the attrition. An important concept that Barnes introduces here is what larger U.S. buyers and investors are using more and more now, which is the concept of Steady State Net Operating Cash Flow (SSNOCF) or the cash flow that is generated in the business after it has replaced its attrition. Today, on these larger deals, the price is often expressed as a multiple of SSNOCF rather than a multiple of RMR. So, for example, a multiple of 38X RMR might equate to 10X SSNOCF. It is also important to note that lowering the monitoring, service or overhead cost factors in an account base after it has integrated into the buyer’s base can lower the multiple of SSNOCF it has to pay for an account base.
4. The RMR growth factor
This variable is often neglected in valuing an RMR base. The growth factor, if there is one, nets the total lost accounts or RMR against the total new RMR to hopefully come up with a positive number. In Canada, I don’t run into many dealers whose account base is actually growing. It stands to reason that companies that purposely push to grow their account base or RMR should be worth more but, Barnes makes the good point that this will only be the case if the investment in new accounts produces enough incremental cash flow to be worth it.
I suggest you check out Michael Barnes’ webcast and start to think about these four variables every time you are assessing an account base.
Victor Harding is the principal of Harding Security Services (email@example.com).
This story appeared in the June/July 2019 edition of SP&T News Magazine.