Similarly, when the Internet industry first evolved, it also grew extremely rapidly, yet most of the businesses were not profitable. It was extremely difficult to predict which businesses would come out winners.
To evaluate whether historical growth has been profitable, compare gross and operating income margins to unit growth over a three- to five-year period. As the number of units sold increases, do the gross and operating profit margins remain the same, or do they increase or decrease?
For example, as the number of transactions increased at money transfer business Western Union, the gross profit margin decreased from 46.9 percent in 2005 to 43.4 percent in 2009. In addition, the operating income margin decreased from 31.8 percent in 2005 to 25.2 percent in 2009.3
Then, compare operating income growth to unit growth, again over a three- to five-year period. The operating profit per transaction at Western Union decreased from $9.44 per transaction in 2003 to $6.51 per transaction in 2008. For Western Union, you can conclude that the growth in transactions over the last five years has been less profitable, and you need to determine whether this is a trend that will continue.
56. What are the future growth prospects for the business?
Begin by reading the business description section and the Management, Discussion and Analysis (MD&A) section found in the 10-K, where management often discusses the growth opportunities for the business.
For example, let’s look at the 2010 MD&A section of the 10-K for Intuitive Surgical, which manufactures the da Vinci™ Surgical Systems, which provide minimally invasive alternatives to complex surgical procedures. In the 10-K, Intuitive Surgical’s management discloses that the installed base of da Vinci Surgical Systems has grown from 795 systems as of the end of 2007 to 1,395 systems as of the end of 2009. Clearly, the business is growing quickly and could represent a great investment opportunity. If, instead, you saw the installed base growing from 795 systems to 800 systems, then this may indicate that the business lacks future growth prospects, and you should pay a lower price for the stock.
As Strayer’s CEO Robert Silberman says, “What makes a business attractive is not the rate it can grow in any single year, but the number of years it can grow at any rate.”4 The destiny of any fast-growing business is to experience a growth rate that slows down at some point. Therefore, you need to determine how long growth can be sustained. To start, you must ask if the business model can be replicated broadly, or if it can be replicated in only certain geographic locations.
For example, hotel franchisor Choice Hotels can license its Comfort Inn hotel brand throughout the entire United States or beyond. A clothing manufacturer, such as Polo Ralph Lauren, has similar potential.
Be careful when forming your future growth expectations from the past successes of the business. Remember, you do not profit from yesterday’s growth. For example, if you learn that doughnut maker Krispy Kreme is successful selling doughnuts in display cases found in Exxon gas stations, do not assume that strategy will work in all Exxon gas stations. The danger lies in taking one instance of success and projecting it. Things may change: For example, more competition may enter the market, or Krispy Kreme may begin to cannibalize its own sales as it begins to open new locations near Exxon gas stations.
Sometimes, it is easy to determine the future growth prospects of a business. For example, let’s take a look at Build-A-Bear, the niche mall-based retailer that lets kids build their own stuffed animal. From 2004 to 2009, the management team stated in the company’s 10-K that it believed it could open stores in 350 locations, primarily malls, in North America. At the end of 2009, Build-A-Bear had already opened 291 stores, so its growth prospects were limited. Future growth would have to come from increases in sales at existing stores or growth through its franchise business. Build-A-Bear was near its saturation point in terms of possible locations that met its requirements, indicating growth from new stores would be marginal at best.
In other cases, it is more difficult to discern the future growth prospects of a business. In the case of homebuilders, for example, it is not easy to forecast future demand, interest rates, and supply cost increases. You would need to have a handle on all those elements before you could forecast growth for a business in this industry.
To understand the source of earnings growth, compare it to another relevant metric at the business. For example, the earnings of a railroad business may be increasing, but if revenue ton-miles (basically a calculation of total cargo weight times number of miles shipped) is not increasing, this would imply there are other sources of earnings growth. Place earnings growth next to the specific metric of a business, as shown in Table 10.1, for railroad company Norfolk Southern.5
Table 10.1 Comparison of Operating Metric to EPS
In this case, we are comparing revenue ton-miles to earnings per share (EPS). You can generally see from Table 10.1 that as revenue ton-miles drop, so does EPS. If instead, EPS increased when revenue ton-miles decreased, then this might indicate that the business is resorting to other things such as cost cutting to increase EPS. These are less sustainable sources of earnings growth.
To forecast potential growth, you must understand if there are secular trends that will help a business prosper by fueling demand. You must also know if the business invests in innovation to develop new products or services. A growing business is one that expands its customer base or sells more to existing customers.
Is the Business Growing Because of Secular Trends?
Secular growth trends are sustained trends driven by demographic or social changes. These demographic or social changes can create an extended period of demand for products or services. For example, think of the growth in the number of women entering the workforce: From 1948 to 2000, women grew from 29 percent of the workforce in 1948 to about 50 percent by 2000.6 This was a social change, and it drove the secular trends of women purchasing more workplace clothing, the growth in popularity of frozen foods (because there was limited time to cook a meal), and other social changes caused by women having less available time.
Be certain to distinguish between this kind of long-term growth and shorter-term cyclical changes. These short-term changes are also called business cycle changes: these are the ups and downs that are associated with growth and contraction in the wider economy. The earnings of a cyclical business, such as a steel manufacturer, are especially sensitive to business cycles, and change with swings in the economy. (Non-cyclical businesses don’t tend to go up and down with the economy.)
If a business benefits from a secular growth trend, its growth is longer lasting than a single business cycle. Secular growth continues through a business cycle. In fact, earnings-per-share of businesses riding secular growth trends tend to peak at each succeeding major business cycle.
Also, be careful to distinguish rising commodity prices from secular growth trends. For example, an oil and gas firm may show revenue growth due to the rise in the price of oil rather than an increase in the amount of products sold. Study the price of the underlying commodity for the industry over at least three to five years in order to determine the percentage of revenue increases or decreases that are coming from changes in commodity prices versus changes in unit growth.
To better understand investing in growing businesses, I studied the investors who have been most successful at identifying important trends early on. Ron Baron, founder of Baron Funds, has been very successful at recognizing and profiting from the early identification of secular trends. Baron has been an early investor in many successful businesses, including nursing home operator Manor Care; casino Wynn Resorts; for-profit education providers DeVry and Strayer Education; staffing company Robert Half; and online diamond retailer Blue Nile. What is particularly impressive is that he not only invested in these businesses in their infancy, but he continued to hold these stocks over long periods of time—in fact, for decades, in several instances. He discovered most of these businesses long before they began their extended growth phase. He was able
to identify most of these businesses because they were run by entrepreneurs who had a clear vision for the opportunities of their businesses, whereas skeptics did not see opportunity. As Baron often says, “We invest in people not just buildings.”
For example, Baron invested early on with Mark Vadon, founder of Blue Nile. Vadon believed that not only would wholesale diamond distributors place their inventory on his online retail site, but also that consumers would purchase these high-end products online. Other investors were skeptical, but as Vadon bypassed traditional retail channels and decreased the price consumers paid, Blue Nile became part of the first wave of successful Internet retailers.
To identify secular growth trends, Baron asks whether an industry is one where your children or grandchildren will work, or if it is one where your parents and grandparents worked. His firm looks for those industries that are positioned to have strong job growth over the next 5, 10, or 20 years, and then his firm searches for the best companies in those industries. Today, his firm is investing in innovative businesses that are addressing the biggest challenges on the horizon, such as battery-powered transportation and alternative energy.
Other examples of secular growth trends include:
The shift in advertising dollars from traditional media (such as cable TV) to online channels has helped fuel the growth of Internet search business Google.
An increasing number of young professionals are deferring having children and instead purchasing pets, which benefits businesses that sell products for animals, such as pet store retailers PetSmart and PETCO.
More than ever, people need a college degree to get good jobs. This has benefited for-profit education providers, such as Strayer Education and Apollo Group.
You need to identify and measure the secular growth trends that potentially support the growth of the business in which you are considering investing. Begin by researching the underlying trends supporting secular growth. Try to draw specific insights rather than focusing on broad themes such as “an aging baby boomer population will fuel the demand for nursing homes.” For example, if a business sells to 20- to 25-year-old males, then you would research this group to understand how they think and shop. There are various sources you can turn to, such as the research products from:
Market research firms Euromonitor or Mintel
Polling firms Harris and Maritz
Websites such as trendwatching.com
Regional demographic sources such as ESRI Business Information Solutions
Magazines such as Advertising Age
You can view Market Research World’s website to locate substantial summaries of these kinds of reports and other studies conducted by leading market research firms. For example, in Who’s Buying Groceries from the Who’s Buying series, you will find such information as the fact that household spending on tea rose 28 percent between 2000 and 2005. You can also get a breakdown of the buying patterns of each different age group: people 25–34 years old spent $16.44 on tea in 2005, while people 35 to 44 years old spent $28.08.7 Most of these sources extrapolate information from government data: For instance, the tea calculations are based on data from the Bureau of Labor Statistics Consumer Expenditure Survey.
Any business school’s library will give you current links to market research and demographics content sites.
Innovation
A growth business must always look for new ways to supplement its growth. For example, eight years after its DOS operating system came out, Microsoft supplemented that growth by introducing Windows Office, which in 2009 accounted for 40 percent of its earnings.8
Is Innovation a Management Priority?
Monitor management’s commitment to Research and Development (R&D) by observing R&D expenses over time. Calculate the percentage of sales spent on R&D expenses.
For example, IDEXX Laboratories (a leading provider of veterinary testing and diagnostic products) has spent more than 6 percent of its revenues on R&D since 1992, to improve its existing products and develop new ones. From 2007 to 2009, IDEXX invested close to $70 million in R&D—which is 12 times more than its nearest competitor and nearly seven times more than all of its competitors combined. This enables the business to continually improve the quality of its veterinary diagnostics and to continually widen its competitive advantage. In fact, IDEXX controls more than 65 percent of its market, and it’s now the largest global player in the reference lab market.9
Are R&D Efforts Successful?
Just because a business spends a large percentage of revenue on R&D does not mean that it will create successful products. Clayton Christensen, a professor at Harvard who has studied innovation extensively, reminds us of two rather subtle things about R&D spending. First, most innovation starts out in the wrong direction: Therefore, spending more money upfront can mean more wasted money. Second, breakthroughs tend to happen when resources are most scarce. Christensen estimates that 93 percent of ultimately successful innovations actually start out in the wrong direction:
The probability that you’ll get it right the first time out of the gate is very low. So, if you give people a lot of money, it gives them the privilege of pursuing the wrong strategy for a very long time.10
So, rather than just looking at how much is spent, you will need to evaluate how successful past R&D investments have been. The best way to do this is to calculate the percentage of sales that come from new innovations. For example, Graco, a pump manufacturer, spends 3 percent to 4 percent of its revenues annually on R&D expenses. It strives to generate 30 percent of its annual sales from products introduced in the previous three years, and comes very close to achieving those goals: In 2007, 2008, and 2009, Graco generated 21 percent, 26 percent, and 26 percent of its sales from new products.11
Medical device maker Medtronic has spent an average of 10 percent of its sales dollars on R&D programs since 1990,12 which is comparable to most of its competitors that spend between 8 percent and 12 percent of their sales dollars on R&D programs. However, the company’s success in creating new medical products differs markedly. For example, Medtronic has consistently controlled close to 50 percent of the cardiac pacemaker market by constantly investing in new technologies and being the first to market with new products. As a result, most of Medtronic’s competitors have not been able to take market share away. Medtronic has also spent a large portion of its historical R&D on emerging technologies in neuromodulation, diabetes, and spinal products. The investments made from the middle to late 1990s in these three areas have increased Medtronic’s revenue from these areas from 25 percent of total sales in FY 2000 to 40 percent in FY 2010, and has given Medtronic a dominant market position in these three areas. Medtronic’s bone-graft product, for example, dominates the spinal market. Clearly, Medtronic has a successful R&D pipeline that leads to new products.13 By examining the percentage of sales generated by new products and services, you can understand whether management has successfully invested in R&D.
Does the Business Grow By Developing Transformational Products and Services?
It is extremely difficult to project demand for new products. The main difficulty is that you have no existing pattern to extrapolate from. Even if you have very early sales data, it is common to under- or over-estimate it. As you do attempt to estimate demand for new products, keep in mind that most new product launches fail.
Innovators such as Apple or Google are the toughest businesses to forecast, because their products and services are transformative. These businesses came to dominate their industries very quickly. Because these businesses created entirely new markets, there was no precedent to use as a basis for a reasonable forecast.
For example, it was difficult for most investors to estimate what the future sales of the Apple iPhone would be. By the end of 2010, Apple had sold nearly 90 million iPhones according to both Apple and Gartner Research. Apple also sold more than three million iPad tablets in less than three months, which is the fastest consumer electronics product in history to reach the $1 bill
ion revenue mark. Most Wall Street forecasts were substantially lower.
To further illustrate the forecasting problem, even Nintendo failed to anticipate the success of its own gaming console Wii in November 2006, which created product shortages. So how can you evaluate whether these companies are worth investing in, when so little is known about the transformative products they’re coming out with?
First, you can survey target customers, by calling up friends who use the products or finding message boards where customers discuss the product to understand what they think about the new product or service. Be sure you survey them after they have tried out the product or service for at least three months or so. Had you talked with early iPhone or Wii purchasers, you would have heard extremely positive responses. When the Wii first came out, I spoke with 15 parents of teenage kids I knew throughout the country. I asked them if their kids were requesting the Wii and whether their kids’ friends were buying them too. I also interviewed salespeople at five different electronics stores located in Austin, Texas, where the products were sold to ask them if the products were selling well. The answers were consistent that the Wii was a hit product and would likely generate increased sales at Nintendo, making it a potentially good investment opportunity.
Using Market Share Figures to Extrapolate a Company’s Potential Growth
To evaluate a company’s growth prospects, many analysts and industry associations make some estimate of the total size of the market and then determine the target company’s percentage of it. They then determine if a business has substantial growth prospects based on its market share.
To do this, start by reading the section of the 10-K report titled Industry or Market Size. The management team will often disclose the size of the market and its share of the market in this section.
The Investment Checklist Page 35