The Investment Checklist

by Michael Shearn

  1. The finance area manages the flow of money through accounting, treasury, tax, and regulatory departments.

  2. The operations area controls the sales, distribution systems, call center, ordering systems, manufacturing facilities, legal, communications, policy and planning, administration, project management, and health and safety. For example, if a retail store is having difficulty obtaining inventory, it will contact people within the operations area.

  3. Human resources handles recruiting, payroll, and benefits for employees.

  4. Technology handles all of the information technology for the business, such as networking and computing systems.

  In 1987, airline company USAir bought Pacific Southwest Air for $385 million in order to expand its routes to the West coast. Shortly thereafter, USAir bought Piedmont for $1.6 billion, which tripled the size of USAir. After acquiring both businesses, USAir learned that its information systems could not handle the increased traffic that came from acquiring Piedmont. Computers broke down regularly, customer service suffered, and even flight crews were scheduled on the wrong days. USAir had clearly outgrown its corporate infrastructure. This caused profitability at USAir to drop from 6 to 7 percentage points higher than the industry average before the merger to 2.6 points below the industry average after the merger.22 So if you were considering investing in an airline in the 1980s, you should probably have passed on USAir because it was growing beyond its infrastructure.

  Is the Business Finding the Right Locations?

  The best management teams in the retail industry expand their store base opportunistically rather than setting a specific goal to open a certain number of stores within a certain amount of time. When the management team follows an opportunistic strategy, management waits for the right location, such as a corner on a busy intersection, instead of instructing its real estate department to find a certain number of locations in a city.

  In contrast, when a management team sets a specific goal of finding a certain number of locations, the real estate department will look for locations that are available instead of looking for ideal locations. By following this strategy, the management team is creating problems because a few years down the road, the company may have to devote time and significant expenses to closing unproductive locations. This is equivalent to taking two steps forward and one step backward.

  Tilman Fertitta, Chairman and founder of restaurant chain Landry’s, confirms this idea:

  “You need to grow, but you can’t grow at such a pace that you start having secondary locations. And that is what everybody seems to do.” Landry’s once opened 40 locations for restaurant chain Joe’s Crab Shack in a single year, and later sold the chain. Fertitta admits, “If you look at the performance of those 40 stores, [they represented] . . . the worst year of any openings.”23

  Organic grocer Whole Foods Market also follows a disciplined store-opening strategy by not opening a store until it finds an ideal location. For example, it took Whole Foods Market 10 years to find a suitable site for its first store in San Francisco, California. As a result of its careful expansion strategy, Whole Foods Market has not closed any stores that it has opened since it was founded. Jim Sud, Vice President of Store Development at Whole Foods Market, summed up the company’s strategy during a fourth quarter 2010 conference call:

  We’re not going to just sign stores to hit some kind of growth number or some kind of percentage or some kind of target. We’re going to sign stores if we find good locations that we think are going to deliver good returns on capital for us. And we’re not going to do it artificially just to hit some kind of expectation. Now it’s a question of really finding locations that meet our very strict criteria. We’re still very proud of the fact that in our 30-plus year history, we’ve never had a store that we opened ourselves ever fail. So we’re really determined to keep that track record alive.

  Key Points to Keep in Mind

  The main advantage of investing in a growing business is that you can receive the benefits of tax-deferred compounding.

  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.

  Businesses that use their own cash to grow have more sustainable growth compared to those that finance growth by issuing debt or equity.

  Businesses that grow organically carry less risk than those that depend on acquisitions in order to grow.

  Be concerned when management is under pressure to grow. Signs of pressure include launching new initiatives and buying businesses outside of the company’s area of expertise.

  Growth is more sustainable if it is supported by innovations or secular industry trends. To help you identify secular growth, think about the industry’s job-growth potential. Ask yourself if the industry is one where your children or grandchildren will work.

  You need to be careful when forming your future growth expectations from the past success of the business. Remember, you do not profit from yesterday’s growth.

  Avoid paying a high multiple for a growing business, because if expected earnings growth slows, the stock price will drop.

  You can identify a business whose growth is slowing by learning if the business is targeting a new customer base, changing its business model, or paying out a larger percentage of its earnings in the form of a dividend.

  Growing businesses have higher short-term expenses: Adjust earnings accordingly to get a true picture of underlying earnings.

  1. Standard and Poor’s Capital IQ.

  2. Ibid.

  3. Ibid.

  4. Strayer Education Annual Report 2009, Robert Silberman.

  5. Norfolk Southern 2009 Annual Report.

  6. Toossi, Mitra. “A Century of Change: the U.S. Labor Force, 1950–2050.” Monthly Labor Review, May 2002. Accessed May 11, 2011. http://www.bls.gov/opub/mlr/.

  7. “Tea.” Who’s Buying Groceries, 5th ed., Ithaca, NY; New Strategist Publications, Inc. 2007.

  8. Copeland, Michael, with Seth Weintraub, “Google’s Next Act.” Fortune, August 16, 2010.

  9. Standard & Poor’s Capital IQ; IDEXX 10-K reports, 2006 to 2009.

  10. Mangelsdorf, Martha E. Interview with Clayton M. Christensen in “Good Days for Disruptors.” MIT Sloan Management Review 50 (2009): 67–70.

  11. Graco 2009 10-K.

  12. Standard & Poor’s Capital IQ.

  13. Medtronic 10-K reports, 1992 to 2010.

  14. MoneyGram International 2007 Analyst Day Transcript-Final, Fair Disclosure Wire, March 7, 2007; Ersek, Hikmet (Western Union CEO), Credit Suisse Group Technology Conference Transcript, Fair Disclosure Wire, December 1, 2010.

  15. Q4 2006 Apollo Earnings Conference Call, October 18, 2006; Standard & Poor’s Capital IQ.

  16. March 29, 2010 Apollo Group Conference Call, Fair Disclosure Wire.

  17. Standard & Poor’s Capital IQ.

  18. Ibid.

  19. Standard & Poor’s Capital IQ; Giverny Capital’s Francois Rochon; Bed Bath & Beyond 10-K reports, 1995 to 2001.

  20. Stieghorst, Tom. “Cheap fares, Short Staff Mean Long Delays for Spirit Airlines.” South Florida Sun-Sentinal, September 30, 2007.

  21. Strayer Annual Reports, from 2001 to 2009.

  22. Carroll, Paul B., and Chunka Mui. “7 Ways to Fail Big: Lessons from the Most Inexcusable Business Failures of the Past 25 Years.” Harvard Business Review, September 2008.

  23. Ruggless, Ron. “Having Words with Tilman Fertitta, Chairman and Founder, Landry’s Inc.” Nation’s Restaurant News, October 25, 2010, p. 42.

  CHAPTER 11

  Evaluating Mergers & Acquisitions

  In the quest for greater growth and profits, many management teams see mergers and acquisitions (M&A) as a surefire way to expand their business empires. And they are often willing to pay any price to secure a short-term victory. M&A activity can represent serious risks to a business because poorly executed or undisciplined M&A has proven to be one of the fastest ways a business can destroy va
lue. As an investor, how do you evaluate whether a company’s M&A activities are creating or destroying value?

  One way of evaluating M&A activity is to understand the motivation of management: Why is senior management merging with or acquiring another company? Another is to evaluate whether past acquisitions were successful by using a list of seven questions (discussed in this chapter) to gain insight into management’s rationale for making acquisitions. This way you can forecast whether future M&A decisions will add value to the business—and therefore, whether that business is a worthwhile investment for you.

  58. How does management make M&A decisions?

  It is critical to understand how management makes merger and acquisition decisions. Todd Green, senior managing director of investment management firm First Manhattan, suggests it is frequently as important to understand how acquisition decisions are made as it is to understand why they are made. Green says understanding how management thinks about acquisitions is one of the few concrete ways for investors to reduce uncertainty in assessing a company’s chances of success.

  Green believes that, with so many variables in trying to predict where a company is going to be five years from now (such as where the economy is going to be, where future interest rates will be, and what input costs will be) the one tangible factor where you can decrease the uncertainty in the process is in understanding how a management team thinks about acquisitions. In other words, what were they thinking: What did they see as potential benefits?

  Green learned this valuable lesson at one of the first meetings he attended after joining First Manhattan in 1981 out of Columbia Business School. The meeting was with the chief executive officer (CEO) and chief financial officer (CFO) of a newspaper publishing and TV broadcasting business. There were 15 people gathered around a conference table, ready to ask questions. Green had done his homework on the company and was eager to learn more. Art Zankel, senior partner at First Manhattan, proceeded to question management about an earlier acquisition that was relatively small. Zankel spent an hour and a half asking management about the merits, prospects, costs, and the risks of the acquisition. Green was surprised that Zankel did not spend any time talking about the publishing business, which represented the bulk of the value of the company.

  After the meeting, Green asked Zankel why he would spend an hour and a half asking about such a small acquisition. Zankel said, “If you can understand the rationale behind a $30 million acquisition today, you’ll probably be in a better position to predict or understand the rationale behind a $300 million acquisition they make next year or a $3 billion acquisition that they make five years from now.” This taught Green that one of the most important parts of the research process is to put oneself in the shoes of the people making the acquisition or capital-allocation decisions. By understanding their thinking in the past, he could evaluate how they might act in the future.

  Green used this lesson to evaluate a new CEO of one of his core holdings. As Green got to know the new CEO, he was able to understand how the CEO thought about acquisitions. The CEO had a history of extensive M&A activity and Green understood that the company he was now invested in was going to be a lot bigger in five years, mainly as a result of new acquisitions. Because he understood the CEO’s thinking and rationale regarding the prospects, costs, and risks associated with acquiring new companies, Green believed these acquisitions had a high probability of failure, so he sold that company’s stock.1

  What Is the Motivation Behind an Acquisition?

  By understanding the motivation behind an acquisition, you can often identify problems in management’s process or thinking. There are two common motives or reasons behind an acquisition.

  The first is simply to increase the size of the business. Often, you will find management teams with big egos who want to be in charge of a larger business. As they consider growing, CEOs and CFOs often become enamored with the acquisition process itself. These CEOs and CFOs may be bored or out of touch with the day-to-day details involved in running their business. They may be insulated, spending most of their time in corporate offices. These CEOs and CFOs often hire investment bankers to find acquisition targets and will then drift into making acquisitions in unrelated business lines. Once begun, the process of buying a business is difficult for them to stop as they become caught up in the excitement of something new. For example, as surprising as it may sound, the Coca-Cola Company once went so far afield as to buy a shrimp farm. Gillette once bought an oil business. These types of acquisitions generally destroy shareholder value because they tend to distract management from the core business. Later on, management often divests these same businesses for less than they bought them for.

  Sometimes, of course, it makes sense to grow the business through acquisitions. It is often easier and a more effective use of the company’s time to gain a large set of customers by acquiring an entire business rather than acquiring customers one at a time. There is usually less risk in this strategy if the management team is acquiring a customer base that is similar to its existing one.

  The second reason management claims to make acquisitions is when they believe they can improve the operations of the acquired business. Management often believes that it can improve the operations of the acquired business through synergies, which are supposed to work by making both companies more efficient together. There are typically two main types of synergies:

  Revenue synergies include cross selling to the combined firm’s customers, potential access to new markets, or increased pricing power due to reduced competition.

  Cost synergies include improvements in margins by making the acquired firm more efficient; reduction of duplicate costs such as corporate overhead; reduction in procurement costs due to increased buying power; and tax benefits. Cost synergies are usually easier to realize when compared to revenue synergies.

  For example, here’s how Caterpillar disclosed its motivation behind acquiring Bucyrus, a mining-equipment company:

  The acquisition is based on Caterpillar’s key strategic imperative to expand its leadership in the mining equipment industry, and positions Caterpillar to capitalize on the robust long-term outlook for commodities driven by the trend of rapid growth in emerging markets which are improving infrastructure, rapidly developing urban areas, and industrializing their economies. A driving motivation for the transaction is Caterpillar’s estimate of more than $400 million in annual synergies beginning in 2015 derived from the combined financial strength and complementary product offerings of the combined mining-equipment businesses.2

  As promising as it sounds, when you hear managers utter the word synergy when they make an acquisition, you should be extremely skeptical that the cost savings or revenue increases they promise will materialize. There are many examples of synergies that have failed to materialize, such as when United Airlines acquired Hertz car rental and Westin Hotels in the 1980s. These acquisitions were based on the idea that United would cross-sell airlines, rental cars, and hotels to travel customers. The intended revenue synergies of cross-selling never materialized however, because most customers chose their hotel based on convenience, not because it was offered as part of a package.

  Synergy estimates typically grow during boom markets as the acquiring company forecasts higher revenues due to cross-selling or increased cost reductions. Many times, synergy is invoked when management wants to rationalize a higher price to win a deal. The problem is that it is far easier to put numbers on a spreadsheet than it is to actually realize these cost savings or revenue opportunities in the real world.

  For example, when amusement park business Cedar Fair acquired Paramount Parks in 2006 for $1.24 billion, it paid 10.6 times trailing 12 months’ earnings before interest, taxes, depreciation, and amortization (EBITDA), which seemed high. Cedar Fair justified this high multiple by citing that it had identified $20 to $30 million in synergies that would materialize from the deal. These synergies would decrease the multiple paid for Paramount Parks from 10.6 tim
es to 8.5 times EBITDA. By February 2009, during his Q4 earnings call, Cedar Fair’s CFO told investors that $16 million in impairment charges were entirely due to the acquisition of Paramount Parks. By February 2010, CEO Dick Kinzel was again telling investors during his Q4 earnings call that the performance of “certain acquired parks” would result in impairment charges. He said that though Paramount was cash-flow positive, the performance of Paramount and other acquired parks was “below expectation.” The synergies management thought it could achieve turned out to be much more difficult to realize in the real world.3

  Synergies are least likely to materialize when the two merged businesses serve different customers or are in unrelated areas. For example, in 1999, disability insurers Unum and Provident merged. Unum operated in the group insurance market, and Provident served individuals. Executives of both companies thought that each company’s salespeople would be able to sell the other’s products, thus creating synergies. Unfortunately, after the two companies merged, the salespeople from each organization did not want to collaborate on cross-selling. The merger also had the unintended consequence of increasing prices for both group and individual customers, which caused customers to move to competitors. Unum eventually undid the merger and exited the individual market in 2007. From the date of the merger (in 1999) to 2007, the stock price of the merged entities dropped by half.4

  Some businesses combine many small businesses in the same industry into a larger one, which is known as a roll-up. The reason management teams engage in roll-ups is they believe they can cut duplicate overhead costs, increase purchasing power with suppliers, lower debt interest costs, and combine advertising. However, most roll-ups in industries such as funeral homes, medical practices, auto dealerships, food-service companies, and waste-disposal businesses have failed to create value for investors, and many that used lots of debt went bankrupt.

  For example, Loewen Group is a Canadian funeral home company that consolidated many funeral homes during the 1970s and 1980s. During this time, the stock price of Loewen was bid up by investors, due to its constantly increasing earnings. By 1989, Loewen owned 131 funeral homes, and in 1990, it acquired an additional 130 funeral homes. As Loewen began to struggle with its earnings, investors began to realize that the synergies that Loewen had based its acquisition binge on were not being realized. For example, Loewen found that customers did not value the name of a national brand; instead, most customers chose a funeral home based on referrals and previous experience. As a result, Loewen kept the names of its local funeral homes. The only efficiencies realized were that Loewen could cut some costs from embalming and acquiring hearses, but apparently, this was not enough of a benefit: In 1999, Loewen filed for bankruptcy.5