The Right and Wrong with Strategic Acquisition

By Tom Gibbs - May 25, 2012 | Tickers: GM, HNZ, NWL, TYC, DIS | 0 Comments

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For a firm that largely grows inorganically through business acquisition, future returns are no doubt related to the price paid for those acquisitions.  The hypothesis is easily understood: a simple increase in sales is hardly a good metric on which to analyze a firm’s growth strategy.

First, sales figures can be manipulated through aggressive revenue recognition.  Similarly, the level of sales that end up flowing to the bottom of a firm’s income statement is directly influenced by the firm’s efficiency.  Sales of course is a key driver to profitability gains, but is only one cog in the machine:

• Driving Gross: A firm must have the ability to bargain with suppliers to control input costs, maintain efficient inventory management systems to avoid product obsolescence/spoilage/etc., and have the ability to generate meaningful demand for the products and sell goods at increasing percentages above their balance sheet costs. 
• Controlling Wages & Salaries as a Percent of Sales: A firm must have effective systems for tying wages and salaries to key performance metrics (i.e. piecemeal pay vs. hourly wages for line workers).  Likewise, having the ability to determine when marginal pay increases are not generating marginal sales is key.
• Controlling Operating Margins: Along with the controlling of pay plans’ efficiency, a firm must also generate captive marketing/advertising platforms on which to drive meaningful demand increases (relatively low SGA as percent of sales).
• Avoiding Write-Downs & Restructuring Charges: Even if non-cash in nature, such impairments highlight the overall inefficiency of a given firm.  Many corporations that grow largely through acquisition are known to write down excess amounts paid for a business through goodwill impairment charges.  Paying an optimal price (ideally less than market value) and for firms with complimentary products and services to the purchasing firm’s own offerings is characteristic of the most effective inorganic growers.

Driving residual earnings is extremely difficult because it does not just require an increase in sales – which any corporation can do – but it requires the strategic control of each profitability driver.  This difficulty grows exponentially over the long run, as it becomes increasingly difficult to generate the same returns as net asset bases (common shareholders’ equity) grow.  Only the most special firms, protected with significant economic moats, have the ability to grow excess earnings over time. 

An example expounds upon the point. HJ Heinz (NYSE: HNZ) and Newell-Rubbermaid (NYSE: NWL) are both firms that have largely relied on strategic acquisitions to grow their operations throughout their histories. Their past ten year operating histories are showcased below, with sales and residual operating incomes highlighted.  Heinz’s growth in overall profitability was, of course, do to a certain extent to its generally increasing sales levels.  However, although sales only grew at a rather average 3.8% CAGR over the given time period, residual operating income (excess earnings above and beyond the firm’s cost of capital requirements) grew at a 25.0% CAGR. As described with the residual earnings drivers above, there is much more at play than increasing sales through acquiring new businesses. 

Figures in Thousands

 Figures in Thousands

Heinz has followed a very slow, yet strategic growth pattern over the past ten years.  Gross and operating margins have remained relatively flat, and have essentially followed one another with a very close correlation.  This is, of course, due to effective cost management (10 year SGA/Sales average and 5 year SGA/Sales average are 21.5% and 21.2%, respectively), and minimal asset write-downs and goodwill impairment.

 Sales in Thousands

In fact, the corporation has only experienced $200 million in impairment charges over the past ten years, which represented 0.23% of the revenues generated over the illustrated time period.  Rubbermaid, on the other hand, experienced meaningful intangible impairment and restructuring charges -- $1.57 billion since 2002 – which represented 2.6% of sales generated over the same time period.  As a measure of relative profitability, Rubbermaid has written off more than 11x the amount of acquired assets (as a percentage of sales) than Heinz.

Not All Acquisition Strategies are Made Equal

Any mass acquisition strategy is inherently risky –

• Acquisitions can make a firm lose focus on its core competency:  Animator Disney (NYSE: DIS) acquired the Anaheim Ducks NHL hockey team before it regained focus and made its best acquisition in Pixar in 2006.  The corporation went through a several year long period without producing any extremely profitable animated blockbusters. 
• Acquisitions do not always streamline corporations: Tyco (NYSE: TYC) made billions of dollars worth of acquisitions throughout its high growth phase, claiming that each subsequent corporation had the ability to improve economies of scale, and provide “synergy” (a word that has a more magical sounding appeal than any actual meaning).  Tyco’s recent break-up of its individual businesses illustrates the all-too-common result.
• Acquisitions can expand businesses beyond the manageable level: As if the Tyco example was not enough, General Motors (NYSE: GM) provides further emphasis.  Over its century long operating history, GM rapidly expanded operations through external acquisition.  Companies including Oldsmobile, Pontiac, Elmore, Oakland, Hummer, Opel, and Delco (among many more) became way too difficult for the parent corporation to manage.  GM’s loss of focus, bankruptcy, and rightsizing of operations illustrates that a small base of profitable core operations is optimal.

Growing inorganically is one of the most effective ways for a firm to rapidly expand its international operations, yet there is a right and a wrong way to execute the growth strategy.   Heinz, for example, spent nearly 47% more on acquisitions since 2002 than Rubbermaid, yet, on average, paid relatively less for each acquisition.  Goodwill, the intangible asset that represents the price paid for an acquisition above and beyond its fair value, as a percentage of purchase price was around 30% compared to Rubbermaid’s 67% ratio. 

This has directly contributed to the minimal return Rubbermaid has generated over the past decade.  Although operating inefficiencies (perhaps the GM or Tyco effect?) led to significant restructuring charges, the ever increasing, yet non-cash generating goodwill balances acted to damped overall profitability.  Even if the corporation could maintain stable operations, it would become increasingly difficult to generate consistent returns due to the continuous increase of non-working assets.  The dilutive effect of its efforts is easily understood.

Heinz has historically based its acquisition strategy on very small, yet accretive acquisitions that are directly related to its core business.  The $211 million cash purchase for Benedicta, a French sauce business, the $58 million cash acquisition for Cottee’s and Rose’s premium blended jams business in Australia, and the $68 million cash purchase of Renee’s Gourmet Foods, a Canadian condiments producer, highlight Heinz’s strategy over the past several years. 

Although it is not increasing its annual revenues at an electrifying pace, it is growing in an inherently safe manner.  By not paying much more, on average, than fair value for acquisitions, the firm’s profitability is not being severely dampened by non-working intangible assets.  As a result, the firm has generated significant shareholder value over the long term by generating consistent returns on ever increasing net asset balances.  Small, yet profitable, incremental growth gains tend to have much more lasting power than attempting and eventually failing to achieve gargantuan leaps in the business world. 

Does This Apply to the Individual Investor?

The Heinz vs. Rubbermaid growth example is beneficial to investors in two ways.  First, and most obviously, is the lesson of understanding a firm’s growth strategy.  In what is the firm investing?  Does the acquisition make sense from a core product standpoint?  If not, is the firm attempting to overextend itself into new businesses to simply generate top line growth?  How much is the firm paying for the acquisition?  If the firm is paying significantly more than market value, what are the chances that the acquisition will generate returns above and beyond the cost of capital requirements? 

Systematically weeding out companies with little growth focus is the difference between generating 6.7% returns on Heinz stock per year over the past ten years and essentially breaking even on Rubbermaid stock over the same time period (neither includes dividends).  Such performance is a simple buy-and-hold technique, and does not give justice to what an active investor might be able to achieve.  Purchasing the historically well-run Heinz stock at the recessionary low at a per share price of around $30 would have yielded nearly 19% per year to date. 

Similarly, the growth-through-acquisition strategy also teaches a lesson that can be applied directly to an investor’s stock picking philosophy.  Buying firms at their fair market price – i.e. most of the firms that would fall into the large cap, well-known, closely followed, and efficiently priced categories – will, at best, generate average returns over the long run.  Purchasing firms when they trade less expensively than their peer groups or their own historical valuations will tend to have the opposite effect. 

Individuals can systematically gain competitive advantage through the active seeking out and purchasing of corporations that are small (less than 100 million market cap), misunderstood (unusual or hidden assets), obscure (a small semiconductor company in Canada, for instance), or tainted (poor operating history but with a catalyst to turn the business around).  Priced at less than their fair value, average stocks with less-than-optimistic market expectations only need to meet (or slightly beat) the market’s expectations to really take off.

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