Part 2 of Valuation Basics – COGS

by vgundara | Sep 27, 2020

Why is a practice valuation important? Why should you know the market value of your hospital?

The obvious reason might be to put your practice on the market to sell. Another great reason is to help run your practice more effectively and efficiently. It may be for general financial or retirement planning. Of course, all of these are good reasons, but I believe the most important reason is for your Peace of Mind.

You should know where you stand and where you stand in the market.

The good news is that every single corporate consolidator will be more than happy to tell you what your hospital is worth. The bad news is that with this approach, you will realize none of the benefits, and you really won’t know the market value of your hospital.

Do not sell yourself short, know your own market value.

Let’s get started. Picture your hospital’s P&L. For most of you, after revenue, the next category will be Cost of Goods Sold (COGS). COGS is my favorite from a valuation perspective, as it is the most misunderstood and provides the owners with the most options.

First, relief or specialty veterinary costs are not COGS. I start from the presumption that the correct costs/expenses are mapped to COGS. Second, I will focus on COGS as a matter of percent of revenue, and not total dollars or individual categories like medical supplies, pharmacy, and/or lab costs. Lastly, although some elements are applicable to any hospital type, most of the focus will be on general practice (GP) companion animal hospitals.

If we are on the same page up to this point, here are my broad generalizations based on the countless hospitals I have encountered in the past 8 years.

A GP hospital with good COGS as a % of revenue should be between 22% and 25% of revenue. If your hospital has a significant boarding and grooming, your COGS will be less as COGS for boarding and grooming is minimal. Same goes for specialty and emergency services…your COGS will be less.
To establish a baseline…the larger corporate consolidators GP COGS will be about 19%-20% on average. I estimate the mid-size groups will average about 21%-22%.
What is your hospitals COGS % of revenue?

What are the contributing factors that determines your COGS % of revenue?

Vendor pricing (leveraging Boehringer Ingelheim, MWI, Henry Schein, etc.)
Hospital service pricing (annual price increases, market/geographic comps)
Inventory management (bulking ordering may not be the right answer)
How medicine is practiced at the hospital (efficacy with efficiency)
Waste (obviously)
Theft (the worst case scenario)

How will the consolidators treat your COGS? The answer is unfortunately…it depends. Some consolidators (A) will pass-on the benefit to the seller and adjust COGS to 22%-24%. Some consolidators (B) will take the position they are acquiring the hospital “as is” and maintain the existing hospital COGS. The last group (C), of course, will be open to making a COGS valuation adjustment only if it is necessary to get the deal done.

Now with the stage set, I will walk you through the practice valuation playbook, using the following 3 hypothetical examples.

Example #1: your current 8 months 2020 COGS is 31%, full year 2019 was 29%, and 2018 was 28%

This is bad. You are clearly outside the norm and trending in the wrong direction.
Even consolidator A will pause and perhaps only adjust to 25%-26% if you can make the case.
What would I do? First, recognize that there is a problem and commit to finding the answers, as your hospital is “losing” money and your practice valuation will be sub-optimal. Then, with some sort of explanation on hand, I would adjust your COGS to 28% across the board. With a possible COGS solution, I would create a valuation scenario with COGS between 27% and 25%. Then prepare to show change, latest 3 months compared to matching prior year 3 months, with COGS improvement.

Example #2: your current 8 months 2020 COGS is 26%, full year 2019 was 27%, and 2018 was 28%

Not bad, but not good. Unfortunately, most consolidators will discount your partial year or interim 8 months 2020 COGS of 26%. They are likely to stick to 27%, or even worse, a blended two year average of 27.5% for your valuation.
Consolidator A will give you the most favorable valuation and you will have to push and shove with the others.
I would adjust your COGS and create a valuation scenario with COGS between 25% and 22%

Example #3: your current 8 months 2020 COGS is 24%, full year 2019 was 24%, and 2018 was 24%

I would accept nothing less than 22% from any consolidator in their valuation.
If you have a very large hospital (in terms of revenue size), I would consider a 20%-21% valuation adjustment in COGS.

At first, I assumed practice valuations were black and white and that they followed a uniformed accounting standard (GAAP), but this is really not the case. It is subjective…it is personal…it is unique…and it is cliché but an art.

If you go to all 35 consolidators or +50 as some have suggested, I have no doubt you will get +50 different valuations of your practice. Sure, most will be tightly banded together, but these small deviations, when viewed through the lens of purchase price multiples, will mean significant dollars for the practice owners or would be owners.

Hope you were able to follow along. If you are a veterinarian, I would be happy to help with any questions.

Next article will be on the Salaries and Wages group.