For example, Immucor, a blood testing-instrument maker, estimated in its 10-K report (dated May 31, 2010) that the worldwide blood banking reagent and instrument market generates $1.2 billion in sales each year. Immucor’s sales at that time were $329 million, indicating that Immucor had 27 percent share of the market. This indicates that Immucor has plenty of opportunities to grow and increase its earnings in future years, which potentially makes it a good investment opportunity.
However, you also need to be cautious about accepting at face value the market share estimates that are provided by the management team or industry associations. It is always best to assume that businesses have an incentive to report a market size that is larger than it really is. Instead, figure out how market share figures are calculated. Read how competitors estimate the size of the market and whether they are using the same yardstick and the same market definition.
In the case of mature markets, there are several things to be aware of. First, make sure the market size hasn’t magically expanded. Read at least 5 to 10 years of 10-Ks to understand if a business has changed the way it calculates its market share or defines its market. For example, one business-services company that had effectively saturated the universe of large business customers began to include mid-sized businesses as part of its potential market size, even though these smaller businesses had less incentive to buy and use this company’s product.
In another example, I noticed that a medical waste business that I followed reported less market share one year, even as it had grown to be the dominant U.S. medical waste disposal company. As the company had expanded into international markets, it began to report a smaller number that reflected its global market share, and by doing so, they showed significantly more opportunity for growth. New markets, however, are different markets, and must be evaluated separately in terms of potential to grow revenues and in terms of potential profits.
You also want to watch out for shrinking effective markets, which may increase the market share of incumbents. For example, Darling International is the largest U.S. rendering company, which collects and processes animal by-products to create the ingredients for things like soap, chemicals, and rubber. When my firm calculated Darling’s market share, we noted that it increased every year. What we found was the effective market size was shrinking. There was just as much rendering going on, but as smaller ranches and slaughterhouses were bought by larger companies (which do their own rendering in-house), there were simply fewer small operations left to choose between Darling International and its competitors. Darling International was increasing its market share, but it did so within a shrinking market with fewer total customers.
You also need to watch out for overlapping segments, distribution, and geography. For example, when my firm was analyzing the market share size of Western Union, there were several confounding factors in play. After finding several different estimates and measures of how much money actually crosses international borders, my firm looked in depth at the sources of the estimates: We compared information from national banks, U.S. government agencies, the International Monetary Fund, the World Bank, think tanks, and scholarly studies. We discovered that underreporting in this industry is a predictable norm, making it difficult to estimate the true size of the market. In one case, what first appeared to be an increase in overall market size turned out to be a change in the way Western Union’s own data was incorporated into the national estimate. In other words, nothing had changed, but because the new market size estimates were bigger, it appeared Western Union’s market share had shrunk—which might have led investors to avoid Western Union. Yet the main complicating factor is the large black market for money transfer, or the informal segment. We now think of the informal segment as another competitor, and note that Western Union’s growth often comes from taking market share from this segment.
Watch for Signs That Growth Is Slowing
There are many signs that a business’s growth may be slowing, including these:
Targeting a new customer base.
Attempting to change its business model.
Paying out a larger percentage of its earnings in the form of a dividend.
Let’s look at each of these signs in more detail.
When a business targets a new customer base
When a business begins to target a new customer base, this is often a tell-tale sign that its core business is starting to slow. For example, Apollo Group, a for-profit university, piloted a new program in 2004 to target a new customer when the growth of its core business, the University of Phoenix, began to slow. It created a national online community college named Axia College to target students seeking associates degrees. Instead of serving its core customer of working adults in their late 20s to early 30s who seek bachelor degrees, Axia targeted students who were 18 to 23 years old.15 By the end of 2010, Axia college students represented nearly 50 percent of the total student population at Apollo Group.
However, even though Axia has been a fast-growing division of Apollo Group, Axia generates less profits for Apollo Group than the University of Phoenix because the students at Axia represent half the credit hours compared to bachelor-degree students. Furthermore, Apollo had lower receivables collection rates from Axia students. The increase in receivables from associate-level students constituted the majority of the bad-debt expense at Apollo. This is because Axia students tend to drop out at a higher rate than the traditional bachelor students.16 From August 2005 to August 2010, the operating margin dropped from 31 percent to 27.9 percent.17 Therefore, even though Apollo Group has been able to offset some of its slowing growth with growth from a new customer base, this new customer base contributes substantially less to profits than its traditional core customer.
When a business changes its core business model
Another way to recognize if growth is slowing is when a business begins to change its core business model. For example, computer manufacturer Dell has been changing its business model from manufacturing computers to providing computer services. Dell has made several acquisitions in this area, such as its $3.9 billion purchase of Perot Systems. This new business strategy indicates that Dell’s core business of selling computer hardware is declining.
When a business begins paying out higher dividends
Another signal a business has limited growth prospects is a high dividend-payout ratio, such as when a business pays out more than 30 percent of its earnings in the form of a dividend. You can calculate a dividend-payout ratio by taking the dividends paid by a business and dividing that number by the earnings of the business.
For example, chocolate maker Hershey Company paid out 50 percent of its earnings in dividends in 2010, which is a typical payout ratio for businesses in the consumer staples industry. Reynolds American, a cigarette manufacturer, paid out more than 75 percent of its earnings in 2010 and increased its payout to more than 80 percent of earnings in 2011. Clearly, the growth prospects of both of these businesses are not as high as they were in the past, and both companies’ management teams believe they do not need to reinvest the earnings back into the business.
Beware of Paying Too High a Price for Growth
A growth company usually has a premium price-to-earnings ratio (P/E) attached to it. The reason is that when investors expect growth in earnings, they are willing to pay more, which increases the P/E. For example, you might buy a business that trades at a P/E ratio of 20 times that earns $1 per share. If it is able to double its earnings in the next year, then you are effectively only paying 10 times next year’s earnings.
Avoid paying a high multiple for a business, because if expected earnings growth slows, the stock price will drop. For example, the stock price of Internet search business Google was flat from October 2007 to October 2010, even though earnings per share (EPS) grew from $13.50 per share to $25 per share during those three years. The main reason the stock price stayed flat was that investors were concerned that growth was slowing, and they were unwilling to p
ay a higher price for slowed growth. In Google’s case, the P/E multiple dropped from 45 times to 21 times during this period.18 Now that Google trades at a lower P/E multiple it may be a good investment opportunity, especially if you believe that Google can continue to grow its EPS at historical rates. If you believe that Google’s EPS will not grow in the next several years, then you need to pay a lower P/E multiple.
On the other hand, if you pay a high price, and the business continues to grow its earnings at a rapid rate, then the growth will eventually bail you out. When my firm first began buying grocer Whole Foods Market, we paid 20 times adjusted EPS for our initial purchases, at $40 per share. We believed that the high growth rate of Whole Foods Market would increase the earnings of the business and we were effectively paying a lower multiple for the business. For the next two years, the earnings growth slowed down as we entered the recession in 2007 and the stock price decreased to as low as $8 per share. The earnings then resumed their historical growth rate and the stock price rose to more than $50 per share by the end of 2010. Even though it was delayed, the earnings growth made up for the high price we paid for our initial purchases.
Is the Management Team That Was Responsible for Historical Growth Still Leading the Business?
If a business has grown for many years, it is important to make sure that the management team that was responsible for that growth is still intact. When forecasting growth, some investors make the mistake of assuming that the business is generating the growth regardless of the management team. If the management team changes in a material way, then there is a risk in extrapolating from past growth. For example, in the case of Apple, investors are clearly interested in exactly who is running the company, and concern about Steve Job’s health directly affects the price of the stock.
57. Is the management team growing the business too quickly or at a steady pace?
Investors often mistake fast-growing businesses for good investments. In fact, businesses growing too quickly are among the riskiest investments, because the growth is not controlled. Furthermore, a business or industry that has steep rather than gradual growth characteristics attracts more competition, which can also drive down profitability.
You need to determine if the management team is following a disciplined or undisciplined growth strategy. A high rate of growth does not guarantee profitability, especially if the management team follows an undisciplined growth strategy. If the company is growing in a disciplined way, then the management team will be able to control the growth, creating more value. The following sections describe indicators you can use to determine whether a business is growing in a disciplined manner or if it is growing too quickly.
Is the Business Growing within Its Means?
Businesses that use their own cash to grow have more sustainable growth compared to those that finance growth by issuing debt or equity. First, internally generated cash flow is a cheaper source of capital compared to debt and equity. Second, a business is not exposed to the vagaries of the capital markets, such as when the debt markets froze up in 2008. You can estimate how quickly a business can grow using internal funds by calculating the length of time a business’s cash is tied up in working capital.
To do this, calculate the cash-conversion cycle (CCC) for the business. The CCC measures the length of time money is tied up in a business before that money is finally returned when customers pay for the products. It is calculated by adding and subtracting the following:
The number of days that inventory is outstanding (DIO)
Plus the number of days that sales are outstanding (DSO)
Minus the number of days that payables are outstanding (DPO)
The lower the number of days in the CCC, the faster a business can redeploy its internal free cash flows into growth because less capital is tied up in inventory or capital equipment.
For example, homebuilders have to continually borrow money because they typically do not have cash on hand to grow their business because their CCC cycles range from 200 to 400 days. On the other hand, a software business typically has a CCC of 10 days, which allows it to collect and fund a large part of its growth with internal free-cash flow. As a result, a software business has lower risk because it can finance its growth internally and is not dependent on outside sources of capital to grow its business.
Warren Eisenberg and Leonard Feinstein, the founders of housewares retailer Bed Bath & Beyond, had a golden rule that they would never use debt to finance their expansion. They would only open a new store when they had the capital to do it. As a result, during the first decade, growth was slow: The company started with one store in 1971 and grew to 37 stores in 1992, when Bed Bath & Beyond went public. By the end of the ninth year after going public, the store count increased 10-fold without the use of debt, and the market value increased 20-fold.19
Is the Business Growing at the Expense of Short-Term Earnings?
When a business is growing, expenses typically grow at a faster rate than revenues, which negatively impacts short-term earnings. For example, when a cable business first enters a new market, it has to make large front-end investments to install the cable. Most of these expenditures are made before the cable company is able to sign up subscribers and generate revenue. As a result, in the first couple of years, depreciation and interest expenses represent a high percentage of revenues, and the business will operate at a loss. However, as the cable business adds subscribers, by the third or fifth year, the profit margins begin to increase, and cash flows turn positive. Therefore, when a business is growing, it may mask the true underlying free-cash flows of the business.
For example, Whole Foods Market invested the majority of its discretionary free-cash flow in new store openings. These expenditures in new stores masked the strong free-cash flows that Whole Foods Market’s core business was generating. As a result, it appeared that Whole Foods Market was trading at a high price-to-earnings multiple, when effectively, it was trading at a lower multiple. When new store openings slowed, the high free-cash flows were revealed. For example, in September 2008, cash flow from operations was $335 million; one year later, in September 2009, when new store openings slowed, cash flow from operations had increased to $587 million.
When evaluating the earnings of a growing business, you need to determine if the management team is investing for the long-term at the expense of short-term earnings. To do this, you must understand when profitability is reached with new investments. For example, at Strayer Education (the for-profit university for working adults), a new campus reaches profitability by the end of the second year. Therefore, investments in new campuses made in 2010 will not be profitable until 2013. By understanding how long it takes an investment to become profitable, you will know that the start-up losses from new campuses will negatively impact earnings for a two- to three-year period, and you can adjust the earnings. As the base of campuses that are profitable grows larger and larger, the start-up losses from new campuses have less effect on earnings. For example, in 2003, Strayer opened three new campuses on a base of 14, so these new campuses had a greater impact on the earnings of the business than when it opened 11 new campuses off a base of 60.
Therefore, when evaluating a business that is growing you need to adjust the earnings of the business to account for the impact of higher short-term expenses in order to calculate the true earnings of a business.
Is the Business Growing within the Limits of Its Human Capital?
How fast a business grows can be limited by how fast it can add employees. If revenues grow at a rate of 30 percent or more a year, and a business needs to grow the number of employees at the same rate, a business would have to double its employee count every 2.5 years. Not only would the business have to retain existing employees, but it would also need to hire and train new employees. This can create many risks. It is therefore critical for a business to grow at a rate where it does not outstrip its ability to hire qualified employees.
Spirit Airlines was known for o
ffering low fares in the Florida market, offering fares as low as $9 one-way. Spirit grew quickly, adding as many as 13 destinations in one year. Unfortunately, Spirit also grew beyond the capacity of its employee base, with customers complaining that Spirit lacked enough people to staff its ticket counters, reservations, and customer-service centers. At one point, Spirit had more complaints than any other airline. In this case, the customers were, of course, right. If you checked U.S. Department of Transportation data from 2006 and compared employee counts to numbers of aircraft, you would see that Spirit’s low-fare competitors had 77 employees per aircraft, whereas Spirit had only 61 employees per aircraft. Clearly, Spirit Airlines attempted to grow too quickly, without making sure it had the personnel to grow.20
It is critical for a business to have enough talented employees to execute its growth strategies. This provides a strong foundation for the growth and makes it more sustainable. At Strayer Education, the number of campuses that it opens is limited by the number of leadership teams it has internally that can staff them. Strayer does not rely on hiring outsiders to grow; instead, Strayer promotes from within. It looks at its internal staff and determines which people have the leadership skills to take on higher-level assignments. Once management figures out how many leaders it has, then it determines the number of campuses it should open in a given year.21 This strategy frustrates many investors who believe that Strayer can grow at a faster pace; nevertheless, this strategy ensures the sustainability of Strayer’s growth.
Does the Business Have the Proper Infrastructure to Grow?
You can think about a corporate infrastructure as all the things that are necessary to support the growth of adding new employees, increasing inventory, or building new sites. There are four broad types of corporate infrastructure that support growth:
The Investment Checklist Page 36