Bargain-Hunting Auto Investments:

Friday, June 19, 2020

#Cybersecurity    #Quality    #Management Consulting    #Automotive Agile

Where Landmines Are Hidden Among Acquisition Gems

Bankruptcies. Unjumbling “coronavirus” can spell words like carnivorous, voracious and rancorous. Chapter 11 announcements since the start of the pandemic seem to be a daily occurrence. Putting aside all of the fashion retailers, cruise line operators and airliner bankruptcies, there have been several automotive-related giants like Hertz and Spectra Premium to announce financial issues since the start of COVID-19. Given historic unemployment and correlated drops in auto sales, there will sadly be many more such announcements. Decreases in auto-manufacturing revenues acts like diminished waterfalls: they starve out downstream waterways where smaller companies’ cashflows are likely drying up.

For some, though, this reads as a billboard of opportunity: the big fish will look to swallow smaller fish during auspicious times. Even without the ‘Rona Recession, some of this has happened over the past few years with mid-to-larger fish (e.g. Samsung acquiring Harman, Intel INTC acquiring Mobileye). But even more bargain-hunting makes perfect sense given Wall Street’s want for tech companies to double in size every five years and the scale of the mobility sector. There are 1.2 billion vehicles in operation globally with 23 trillion miles driven every year. Intel claims connected vehicles will upload that 4 TB of data  per day, which McKinsey estimates at $750 billion of value annually by 2030. That makes recent acquisitions like Red Pine Software and Trilogy Automotive bargains in normal times, which predated the current coronavirus firesale.

However, valuations are very difficult. Every episode of “Shark Tank” includes at least one debate about the valuation of a fledgling company with inevitably the entrepreneur’s claim that hyperbolic opportunities are on the horizon. This is especially true for software and data companies where large upfront investments create customer loyalty, market differentiation and enormous barriers to entry for competitors. Marketers will debate whether to multiply EBITDA, revenue, or some other metric, which should be evaluated based upon the type of business being purchased.

The great unknown, though, are the landmines, which can quietly disrupt the value long after the sale because the explosive risks were not exposed during discovery. Below are three engineering-based landmines for detectives to investigate on behalf of soon-to-be purchasers along with a suggested strategy to avoid a misstep.

 #1 Landmine: Trade Secrets

Investigating the underlying value of a trade secret is undoubtedly the most difficult evaluation for a purchaser due to confidentiality. When Continental acquired the cybersecurity start-up Argus for $450M in 2017, there were assuredly discussions about proprietary algorithms for determining malicious attacks on automotive networks. Was there publicly available Intellectual Property? Yes, but likely a fraction of the valuable information was publicly exposed; in part due to estimates that $225B to $600B have been lost by patent infringement to China alone. Trade secrets have become more valuable. Were those secret algorithms shared during negotiations? Probably not directly since Uber UBER has demonstrated to the world how tech giants thrive on trade secrets after having settled with Waymo for approximately $244 million. Yet, paying 100-200 times EBITA is a difficult check to write without some understanding of the trade secrets beyond the intellectual property. Yes, Argus had thirty-eight (38) granted or pending patents at the time, but that doesn’t equate to technology strategy nor would it have demonstrated to Continental the practices to quickly adapt the calculations to varied vehicles with thousands of build combinations.

#2 Landmine: Technical Maturity of Assets

Is there a stable architecture? Is the platform easily malleable for a new vehicle or project? Are the interfaces extensible and allow for future growth? Are portions of the design only a PowerPoint idea or has production-intent code been run in production? If so, were those critical portions of the design per the trade secrets, on how many vehicles were they tested and for how many months? Are the product requirements limited in detail on only useful for Research and Development? Is the support documentation sufficient if acquisition causes [likely] turnover?

The previous paragraph could almost become a novel of pure questions, which are usually difficult for the purchasing company to answer since A) the Merger and Acquisitions team is typically not schooled in software qualification or system architectures, and B) they are likely looking to buy unfamiliar chocolate for their peanut butter and, therein, are woefully ignorant about critical details. Assuredly, the selling company will provide positive answers to nearly every question, but as Red told Andy Dufresne in “The Shawshank Redemption”, “Everyone in here is innocent.” The parties guilty of developmental sins will assuredly not confess on their own.

 #3 Landmine: Organizational Health

It might be that the product is temporarily stable and supported by fantastic trade secrets, but could fall apart tomorrow due to poor ways of working or unstable teams. For instance, has Quality Assurance been working directly with the team to inject quality into the foundations of the design? Has Risk Management been handled as to prevent Problem Management? Has a Threat Modeling or a Threat Assessment considered vulnerabilities to hackers? Maybe the biggest questions are around Functional Safety, e.g. has a sufficient Safety Case has been created or are hidden design flaws acting like cocooned caterpillars waiting to become evil, punitive-litigation butterflies.

Once again, this is a difficult, financial landmine for the purchaser to unearth since it requires a working-level knowledge of ideal processes, critical personnel for sustaining homeostasis or the intended business growth, and where shortfalls will cause a future surprise. The peanut butter team won’t know who and how different chocolate engineers must interact.

Recommended Strategy: Third-Party Capability Evaluation

Hiring a third-party professional for a capability evaluation is a fraction of the cost of the potential investment, and helps to make the potential risks more visible before a multi-million dollar outlay. Such evaluations should provide multiple benefits versus a DIY approach. Firstly and probably most critically, the Evaluator can create a barrier of confidentiality to protect the trade secrets. They need only report on the differentiation, the thoroughness and the relevancy for product growth, and the anonymized report creates an information barrier between the buyer and seller. Thereafter, the Evaluator may bring automotive knowledge about standard practices for ways of working and what constitutes near-perfection versus risky. A word of warning: there are Top 10 consultancies that can hire an army of recent graduates with their own version of Shawshank Redemption innocence, but finding a firm that provides the expertise needed to ferret out organizational tumors or immature offerings is crucial. Such detailed reports should not only help quantify the risk, but may be used during negotiations to bring down or justify that exorbitant valuation.

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