The Investment Checklist

by Michael Shearn

  When you are reading historical articles about a business or archived conference calls, look for those examples where the management team walked away from certain acquisition targets due to price or other factors. This is a positive indicator that they are disciplined acquirers.

  Evaluating the Price Paid

  Write down how much management paid for an acquisition and note whether it used cash or issued stock or debt. What is the multiple paid for the business, such as the enterprise value to earnings before interest and taxes (EBIT), EBITDA, and free cash flow? If the business is paying a high multiple, such as more than 10 times EBITDA, then management expects the EBITDA to grow in the future. The lower the multiple paid for a business, the more room management has to make mistakes in its future projections of the acquired business. The following example illustrates how you would go about determining whether management paid a good price for a business.

  Over the last 10 years, Penn National Gaming acquired six casino businesses that generated a combined EBITDA of $454 million for a going-in multiple of 7.2 times EBITDA, which was lower than the average industry multiple competitors were paying of 8.6 times over the same time period. To determine if Penn paid a good price for all of these businesses, you’d need to understand if the EBITDA increased or decreased over the 10-year period. For 2010, the EBITDA of these six businesses is now slightly above $454 million, which means the multiple that Penn paid on the transactions is still 7.2 times excluding maintenance and development capital expenditures. This indicates that it not only paid a good price, but that Penn has been able to successfully manage these casinos. On the other hand, most of the casinos acquired by Penn’s competitors have seen EBITDA decrease by 10 percent to 40 percent over this same time period. Because most of these casinos were acquired at an 8.6 times going-in multiple, they effectively paid a higher multiple because EBITDA dropped, which means they are not successful acquirers. This speaks to Penn’s ability to identify, accurately price, and operate casinos more efficiently than their competitors.21

  When Western Union, a money-transfer business, acquired Custom House (May 2009), an international money-transfer company for businesses, it paid $370 million in cash. Custom House at the time was generating $100 million in revenues. Western Union paid a multiple of close to four times sales. This price makes it difficult for Custom House to yield a high cash-on-cash return on investment for Western Union. In order for Western Union to generate a 10 percent rate of return on this investment in the next five years, the intrinsic value of Custom House would need to increase to $600 million, which means Custom House would need to generate approximately $40 to $60 million in profits by the end of the fifth year. Considering that revenues in 2009 are currently at $100 million this would not be an easy task. At this price, Western Union is betting on the potential that it will be able to significantly increase Custom House’s cash flows.

  What is the enterprise value to book value paid for the business? If a business is paying a premium to book value for an acquisition, this is an expensive way to grow. It is easier for a business to earn a decent return on book value if it is not paying a high multiple of book at the start. For example, Target builds all of its stores denovo (i.e., from the ground up) and therefore builds stores at book value. If instead, Target were to purchase other retailers at a high multiple of book value—for example, if Target paid two times book value—then it would earn a lower return on its investment.

  To further illustrate this concept, consider this example: If a stock has a book value of $100 and a market value of $100 and it earns a 12 percent return on book, then you would get a 12 percent rate of return on your purchase. In contrast, if you bought a stock at 150 percent of book value and it earned 12 percent, then you would be receiving only an 8 percent rate of return. Based on valuation alone, which stock would you rather buy?

  How Is the Acquisition Financed?

  You need to determine how the acquisition is financed, which will give you an insight into the risk tolerance of the management team. In general, there are four ways an acquisition is financed: A business can issue debt, it can use the cash on its balance sheet, it can issue equity, or some combination of all three. Let’s look at each of these financing methods in more detail.

  Using Cash to Finance Acquisitions

  If an acquisition is financed using cash on the balance sheet, then management is highly conservative. Most of the acquisitions that Warren Buffett, CEO of Berkshire Hathaway, has made are in cash. These conservative acquisitions have contributed to the excess returns that Berkshire Hathaway has delivered to its shareholders.

  Using Debt to Finance Acquisitions

  In contrast, if a management team uses debt to finance an acquisition, be cautious that it does not take on too much debt. Closely monitor debt coverage ratios and model various scenarios of how the debt might constrict the free-cash flows of the business. For example, create a scenario modeling what would happen if revenues at the combined firm dropped by 10 percent to 40 percent. Determine at what level of free-cash flows it would be difficult for the business to make debt repayments.

  For example, for many years, CEMEX, a cement manufacturer based in Mexico, used its strong free-cash flows to issue debt to acquire other cement businesses around the world. CEMEX then slashed expenses and improved the operations of the acquired cement business, which generated even more free-cash flows. CEMEX then used these increased free-cash flows to issue additional debt to make more acquisitions. Each time CEMEX acquired a business, Wall Street analysts questioned whether CEMEX had taken on too much debt. However, CEMEX continually proved these skeptics wrong and continued to increase the free-cash flows of the acquired business and pay down the debt.

  This strategy worked for 20 years, until CEMEX acquired Rinker, an Australian cement company, in 2007. When the real estate industry collapsed in 2008, that collapse compressed CEMEX’s free-cash flows, and CEMEX found it difficult to pay back the debt that was coming due from the Rinker acquisition. As a result, in less than 18 months—from June 11, 2007 to November 17, 2008—CEMEX’s stock price dropped from $39.25 to only $4 per share.22 In other words, the stock price was almost one-tenth its price a year earlier, because investors feared that CEMEX would not be able refinance the debt.

  Eventually, CEMEX was able to refinance a large portion of the debt coming due, but it was forced to accept a higher interest rate and more onerous terms. This has impaired the free-cash flows of CEMEX. Even though CEMEX will probably survive and even prosper, a lot of shareholder value was destroyed by a debt-fueled acquisition strategy.

  Using Stock to Finance Acquisitions

  Finally, if a business uses its stock to make acquisitions, make sure the stock is not undervalued, as the acquisition would then dilute the ownership interest of the acquiring business’s owners. When a business pays too much, it effectively redistributes wealth from itself to the shareholders of the acquired business. Therefore, you must determine what percentage of the business is being given up to make the acquisition.

  For example, when Warren Buffett was on the board of the Coca-Cola Company, he did not let Coca-Cola’s management buy Quaker Oats (owner of Gatorade) because “Giving up 10.5 percent of the Coca-Cola Company for Quaker Oats was just too much for what we would get.” Buffett estimated that Gatorade would have increased Coke’s worldwide case sales less than 2 percent, while saddling Coke with Quakers Oat’s slow-growth food business.23

  If the business can use its overvalued stock to make acquisitions, it favors the acquiring shareholders. For example, many banks have been able to create value by using their high stock prices, such as two times book value, to buy banks priced at substantial discounts to book value, such as 0.5 times book value.

  Key Points to Keep in Mind

  Understanding how and why management makes acquisitions is one of the few concrete ways for investors to reduce uncertainty in assessing a company’s chances of success.

  As promising as it soun
ds, 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.

  Acquisitions are most likely to fail when the two merged businesses serve different customers or are in unrelated areas.

  A management team is likely to overpay for an acquisition or buy a business that is not a good operational fit under the following circumstances: The business uses its own undervalued stock to make the acquisition,

  The target business is sold in an auction-like situation,

  Management uses debt to finance the acquisition, or

  Management pays a premium EBITDA multiple, such as 10 times or more, or a premium to book value (two times or more).

  Management is likely to make a successful acquisition if: Management has a history of making successful acquisitions and has shown discipline by walking away from deals in the past,

  The acquisition fits into the core competency of the business,

  Management intimately understands the business they are acquiring,

  The customers and employees remain at the acquired business,

  The business acquired is bought at a distressed price, and

  Management uses overvalued stock or cash to finance the acquisition.

  1. Author’s interview with Todd Green, May 28, 2010.

  2. Caterpillar press release, November 15, 2010.

  3. MacFadyen, Ken. “A Synergy Runup?” Mergers and Acquisitions Report, May 10, 2010, p. 37.

  4. Carroll and Mui, “7 Ways to Fail Big.”

  5. Carroll and Mui, “7 Ways to Fail Big.”

  6. With permission from John Mackey.

  7. Danaher Conference Call, Fair Disclosure Wire, December 11, 2003.

  8. Hindo, Brian. “A Dynamo Called Danaher.” BusinessWeek, February 19, 2007.

  9. “Mergers—The Cisco System, Secrets of US Computer Giant’s Success.” Strategic Direction, Vol. 20 No. 7, 2004, pp. 25–27.

  10. Ibid.

  11. Ewers, Justin. “Cisco’s Connections.” U.S. News & World Report, June 26, 2006, pp. 49–53.

  12. Ibid.

  13. Ibid.

  14. Benedict, Jeff. How to Build a Business Warren Buffett Would Buy: The R.C. Willey Story. Salt Lake City, UT: Shadow Mountain, 2009.

  15. Mattel at Banc of America Securities 33rd Annual Investment Conference, (Robert Eckert, CEO of Mattel), September 17, 2003, Fair Disclosure Wire, September 17, 2003.

  16. Case, Stephen. “Thinking Ahead.” Executive Excellence, June 2001, p. 8.

  17. “America Online and Time Warner Complete Merger to Create AOL Time Warner.” BusinessWire, January 11, 2001.

  18. Standard & Poor’s Capital IQ.

  19. Stoessel, Eric. “Hotel Sales are Hopping.” National Real Estate Investor. November-December 2010, p. 15.

  20. Marr, Garry. “Brookfield Said Set to Re-open O&Y Bid: ‘Pennies’ Reported to be Standing in Way of a Deal.” Financial Post, August 25, 2005.

  21. Kontomerkos, Mario (Corporate Vice President of Finance at Penn National Gaming) in discussion with the author, February 2011.

  22. Standard & Poor’s Capital IQ.

  23. Eig, Jonathan. “Behind the Coke Board’s Refusal to Let CEO Daft Buy Quaker Oats.” Wall Street Journal, November 30, 2000.

  APPENDIX A

  Building a Human Intelligence Network

  After you have reviewed all of the publicly available information from articles, SEC filings, and industry sources, you may still have unanswered questions. This is the time to go out and interview people who are involved with the business on a day-to-day basis. Doing so will help you fill in the gaps and give you an in-depth view of a business. For example, if the success of your investment is predicated on the business overcoming a specific obstacle, interview sources that have direct experience or have dealt with that particular business first hand. Cross check any assumptions you are making about the business with people who have industry knowledge. This will give you greater confidence in your assumptions and ultimately help you correctly value the business.

  A friend once heard an analyst present what appeared to be a well-thought-out case for investing in chip-maker Advanced Micro Devices (AMD), which the analyst believed was undervalued. The analyst told investors in the audience that AMD had just developed a new technology that was going to give it an immediate advantage over its main competitor, Intel. When questioned at the conference about which computer manufacturers would be including the new technology in their products, the analyst had only a blank stare—he didn’t know the answer. My friend, who knew the computer industry well, knew that it takes as long as 24 months for manufacturers to incorporate new chips into their products. From that point, my friend knew that the analyst really didn’t understand the business, and his investment recommendation was not credible.

  This is a perfect example of why it is important to speak with those who have first-hand industry knowledge whenever you make an investment, especially if you are making large assumptions about a business, as this analyst did. It is easy to sit down in front of a computer and dream up various scenarios for a business, but you need to develop an understanding of how a business works from those who have experience operating or dealing with a business. You must make it a priority to speak with people who are involved with the business on a day-to-day basis. This Appendix describes how to locate a variety of sources you might talk to for information, how best to approach them to ensure you’ll get the information you’re looking for, and how to properly take notes so you’ll have the information to go back to in the future.

  Evaluating Information Sources

  First, you must distinguish whether you are seeking information from a primary source or a secondary source. Primary sources are those who have first-hand knowledge about a business, such as management, employees, suppliers, or competitors. Secondary sources are those who interpret information from a variety of sources, such as stock analysts or journalists. The problem with relying on secondary sources is that you may not know what information they are using to form their insights. They may simply be voicing an opinion with no factual data to support it. There is nothing wrong with considering these opinions, in fact, secondary sources of information can often be a great source of contrary information to investigate further. The mistake usually lies in accepting and following other people’s opinions or advice without investigating the supporting evidence.

  How to Locate Human Sources

  There are many types of people who can provide valuable information and insight about the company in which you’re considering investing. Try to talk to the company’s customers, journalists who cover the industry, people at industry conferences, other industry insiders or associates, professors and deans of business schools located near the company you’re researching, and even headhunters. The following paragraphs elaborate.

  Talk to Customers

  Early in my career, one of the first businesses that I researched was Nielsen Media Research, the TV-ratings company. This was and continues to be a monopoly business. Nielsen had been recently spun-off from Dun & Bradstreet, and the stock price had dropped due to the threat of a new competing ratings business, SRI Research, whom Nielsen’s customers were funding.

  In order to better understand this threat and to understand the stability of Nielsen’s business, I interviewed more than 80 percent of Nielsen’s customers. I wanted to find out if SRI Research posed a serious risk. I contacted managers in charge of selling advertising time at these stations. Many of the 100 or so sources that I spoke with managed advertising for several stations in a regional market. Nielsen measured 54 cable and network channels (e.g., Fox, CBS, and NBC), located in 44 major markets (and each market had an average of five to six TV stations).

  The interview process took me over six months, as I spent about 30 minutes each day contacting these sources. Every time I interviewed a customer, I asked who the customer thought was a g
ood source for me to contact. They told me the same thing over and over: “call Norman Hecht.” Hecht ran a research firm that helped Nielsen’s customers get fairer ratings, and at one time, he ran Nielsen’s primary competitor, Arbitron. When I first contacted Hecht, he was more than happy to talk to me, and in a one-hour conversation, he summarized everything I had learned from interviewing 80 percent of Nielsen’s customers. Why had I spent so much time interviewing so many customers when Hecht summarized my research and conclusions in an hour? The only benefit derived from interviewing so many customers was that I knew that Hecht was a credible source.

  I now interview and talk to a variety of sources in order to identify who the best sources are in an industry. I am looking for the Norman Hecht of the industry or those who are well connected and know a lot of people in the industry. Ideally, your source’s livelihood depends on knowing what is happening at that company, and your source will have done business with the company over a long period of time. It is in the self-interest of those sources to stay abreast of valuable information.

  Talk to Journalists Who Cover the Industry

  Journalists have a vested interest in seeking good information. As you begin to read articles about a business, you may notice that many of these articles are written by the same journalists. You can research the background of the journalist to learn how long he or she has been reporting about the industry. Look for those journalists who have been reporting on a certain industry for several years. Contact these journalists and ask them who they believe are the best sources to talk to in an industry or, better yet, how they identify the good sources.

  Go to Industry Conferences

  An industry conference brings together an entire industry under one roof, and it is an excellent way to understand the competitive landscape within an industry. You’ll be able to watch presentations from a range of professional perspectives, from CEOs to industry journalists. Find industry conferences where the business is exhibiting. You can often find this information on the website of the business.