When performing an appraisal, the appraiser may request a company profile and promotional material on the company they are appraising to gain a better understanding of that company. The best source for this type of material would be the most recent 10K, offering memoranda, databases such as those found on the Internet, and even old lender borrowing base certificates. The company's promotional brochure frequently offers detailed product descriptions, which can be helpful in compiling the Identification section of the appraisal report. Knowing the company’s major competitors is also a critical factor in developing the final correlation and absorption analysis. This is because a company’s competitors are frequently one of the best avenues for resale. Consequently, a determination must be made whether this group would have interest in purchasing the inventory. However, an inventory that consists of proprietary manufactured products may eliminate the competitor base as a viable means of sale due to the unique nature of each company’s design. On the other hand, even with proprietary inventories, the raw materials, say for example a 48" stainless steel coil, may be of significant value to a competitor.
The customer base may also be a viable avenue for disposal of inventory, though it can also be an extremely complicated base of potential buyers. Consider the following example:
1. The subject is a manufacturer of turbine fans for a major OEM engine manufacturer. In addition, they are subcontractors to the U.S. Navy for impellers. Fifty percent of its turbine production is for turbines and 40% is for General Electric.
2. The remaining 10% is for 30 very small, dispersed customers who require them to keep a certain stockpile of their proprietary parts.
On the surface, this set of facts appears to present a simple liquidation, given the size and financial capacity of the OEM, and the strength of a government contract. However, upon investigation, it is discovered that the General Electric contract could be cancelled at any time, and that General Electric has over a dozen subcontractors making the identical part as the subject. Furthermore, the market analysis shows, from a good source, that GE will not buy parts when there is even a hint of quality-control problems of the type commonly associated with a liquidation. Therefore, for this OEM's part, which is completely proprietary, and has already been fully machined, there is no market for the finished good, and its value is no more than scrap.
Research further shows that the engine manufacturer’s part is completely different. Meaning that the subject inventory is that manufacturer’s sole-source for this part, and the company owns the tooling. It would take more than eight weeks to reproduce this tooling, and another two weeks for another shop to fully tool-up and begin production. In essence, the engine manufacturer would be compelled to buy not only all the production parts they could acquire, but also the tooling. Otherwise, they would have to suspend operations at their engine plant indefinitely. The appraiser’s investigation also shows that the government, in effect, has an irrecoverable and insuperable lien on both its parts and tooling, and can collect this material without immediate compensation.
Except for distribution inventories, vendors are not necessarily the best targets for bulk sale. This is because some vendors offer repurchase agreements that, in most cases, are not enforceable by third parties, and cannot be relied upon, especially under forced sale conditions. However, there are exceptions to this such as market conditions in which a commodity is in short supply, and the company acquired this commodity before an inflationary spiral. Certainly, this determination would require the appraiser to analyze market conditions, but his analysis should avoid projections or predictions of where a market appears to be headed, unless sourced to a reliable industry reference. This is because future conditions are purely speculative, and no value conclusion should be drawn based on what may happen. When conducting this analysis, the appraiser should segregate the major markets served into regional, national, and international markets, and indicate what impact, if any, they may have.
The type of customer the company serves is also important, i.e., retail customers, regional wholesale distributors, national wholesale distributors, international wholesale distributors, OEM’s, end users, brokers, re-builders, and government, and can be of invaluable assistance in developing a cohesive, supportable exit strategy. The area of client concentration should be addressed insofar as there is an adequate diffusion of clients to insure a competitive bidding environment. As a rule, a company whose sales are dominated by one or two customers can be problematic in a resale under forced sale conditions. Frequently, the failure of such a company is often attributable to the loss of a dominate client, which leaves that segment of the inventory open to the broker market.
When valuing inventory under any removal concept, there are specific areas considered ineligible by the appraiser. Something such as a license agreement would be classified as ineligible if an investigation revealed this restriction. This is because license agreements are not typically subject to transfer. However, such agreements vary in content just as lease agreements, and an appraiser is not a lawyer; therefore, they may classify this type of inventory as ineligible due to such an issue being beyond the realm of their expertise. An appraiser would classify other areas of inventory as ineligible due to their proprietary nature, lack of compatibility, and/or alternative use, and factors related to all forms of depreciation, i.e., physical deterioration, functional and economic obsolescence. The starting point of consideration between the appraiser and the lender is equal. However, if the lender advances against each of the ineligible areas defined by the appraiser, the exposure between that advance and the appraiser's opinion of value becomes extreme.
The important thing for an appraiser or any third party to recognize is that there are valid reasons for classifying areas of inventory such as packaging, work-in-process, slow-moving, and obsolete as ineligible or exempt. Conversely, there are instances within each of these areas where value consideration can be given. Large quantities of items purchased due to price incentives that could not be sold by the company within one year are not automatically ineligible. However, a situation such as this would bring up issues such as absorption rates (supply and demand), which could lead to a lower value assignment. This is because a liquidator would assume the sale of the whole for one price. In other words, as the items are the same, quantities that could be sold by the company within one year would not bring a different price than could not be disposed of in that time frame.
A liquidator would also consider many other factors when analyzing the most proper method of disposal. These considerations, to name a few, would include timing, market reaction (acceptance), presentation, potential buyers, absorption rates (supply and demand), seasonal recovery, where, when, and how. However, there are also factors to consider that would alter the method of disposal such as the nature of inventory, i.e., manufacturer, wholesaler, distributor, or retailer. Other issues a liquidator would address may include:
1. Should the work-in-process be completed to achieve a higher net recovery?
2. Is the inventory in balance?
3. Is the mix of inventory conducive to a successful auction sale, or would it be better disposed of under orderly conditions?
4. Is the inventory specialized and/or specific enough to require seasonal recovery?
An example of the nature of inventory having an impact on recovery could be a chain of shoe stores. If a company were to liquidate an inventory of shoe stores with multiple locations, there would be two methods of disposal to consider. The first and less desirable method of consideration would be to relocate all inventory contained within each store to one location for disposal. When looking at this method of disposal, an experienced liquidator would recognize the negative impact on value recovery that would occur. The second, and most desirable method of disposal, would be to liquidate the inventory at each store, on a retail basis, at a reduced price. In this instance, the most likely result would be a recovery greater than historical cost to the owner. This example brings to light the fact that, as stated earlier, value recovery of inventory is not always less than cost.
An example of disposing of an inventory during a specific season having a negative impact on value would be an inventory related to a seasonal activity such as golf. For instance, disposing of an inventory of golf supplies during an off-season, in the northeast, would most likely result in a lower recovery than could be achieved during the seasonal months. Additionally, this would be another example of an inventory that would best be disposed of in a retail situation, at a reduced price, when considering absorption rates (supply and demand) and the time required for disposal. This is because flooding the market of any one item distinctly drives down the price of recovery.
The issue is recovery, and though it may have been standard practice in the past, advancing a set percentage against inventory is no longer feasible for a lender, without an analysis of that inventory by those who have the background and experience to do so. That analysis is typically done by an appraiser who is schooled in value assignment and marketing methods that are necessary to achieve that stated value. Such an expertise is what separates an appraiser from an auditor or accountant. This is not to say that each does not have a position, it merely points out that each professional's purpose is different.
