Harry Domash's Winning Investing


How to Spot Serial Acquirers

Acquisition-fueled growth is like a Ponzi scheme. It works until something goes wrong.

When the market recovers, most investors will want to hop on growth stocks to get in on the action.

Growth investors look for stocks that have already racked up strong sales and earnings growth, and are expected to continue their winning ways. That makes sense since share prices usually track earnings. But beware. Some firms resort to a "Ponzi like" acquisition strategy to spur growth. 

Such strategies usually end badly. I'll describe how to spot those rascals in a minute, but first some background.

Must Have Growth
In the beginning, most firms grow organically, that is, their growth comes from selling more products, or by opening new stores. Alas, eventually supply catches up with demand or new competition appears, and growth slows.

But top executive’s wealth is usually tied to the company’s stock price one way or another, and word of slowing growth has a nasty way of driving a firm’s share price into the ground. With that as an incentive, management tries to find new ways to keep the company growing.  

Most firms develop new products or enter additional markets, but others turn to an acquisition strategy to maintain growth. I call such firms “serial acquirers,” 

The Dark Side
Growth by acquisition is an appealing strategy. Purchasing an established company saves the acquirer the time and expense of learning the business and developing products from scratch. The process is relatively inexpensive because the acquiring firm usually uses its own shares to pay for the deal. 

The acquisition strategy is often successful early on, allowing the serial acquirer to maintain its strong growth rate, keeping the market happy and its share price up. The latter is important because the firm’s stock is the currency enabling the acquisitions.

Eventually, however, the numbers get too big. Consider the math. A company with $100 million in annual sales can achieve a 25% growth by acquiring a company selling $25 million a year. However once it gets to the $200 million level, it must acquire firms with $50 million in annual sales to maintain the same growth rate. Compounding the problem, the bigger it gets, the fewer the number of acquisition candidates.

Something Goes Wrong
Sooner or later, something goes wrong. Perhaps the firm overpays for an acquisition, or the expected cost cutting synergies fail to materialize. Maybe a clash between corporate cultures drives key employees in the acquired company out the door. Possibly, the acquired firm’s products don’t sell as well as expected.

Whatever the cause, the serial acquirer fails to meet earnings growth forecasts, torpedoing its stock price. The lower stock price takes away its acquisition currency, further slowing growth and thereby putting more pressure on its share price. It’s game over!

Easy To Spot
Spotting serial acquirers in easy. You’ll need to dust off your calculator, but it’s a simple calculation. Here’re the details. .

When an acquisition happens, the acquirer almost always pays more than the target firm’s accounting book value. When it does, the acquirer adds the difference to either the goodwill or intangibles lines on its balance sheet. In fact, acquisitions are the only way that numbers get added to those categories. Both would be zero if a company has never made any acquisitions.

Thus, you can gauge a firm’s acquisition history from the value of goodwill and/or intangibles on its balance sheet. But, even firms that aren’t using acquisitions to fuel growth have probably made a few strategic buys over the years. So those numbers don’t mean much by themselves. You have to compare them to something that reflects company size. I’ve found that ‘total assets’ does the job. It’s listed close to goodwill and intangibles, so you can do your analysis quickly.

The process involves comparing the total of goodwill plus intangibles to the total assets. I call the result the “acquisitions ratio.” The higher the ratio, the more acquisitive the firm.

Doing The Math
You can find the needed information on many financial sites. I’ll describe the process using Yahoo Finance (finance.yahoo.com).

Using drug store chain Walgreens (WAG) as an example. First get a quote and then select Balance Sheet in the Financials section. Finally, select Quarterly Data so that you’re using the most recent information. Yahoo lists goodwill and intangibles (intangible assets) in the long-term assets section, and total assets at the bottom of that section. Always use the most recent information, which was the November 30, 2008 report for Walgreens. Yahoo listed $1,400 million for goodwill, zero for intangibles, and  $24,513 million for total assets. Thus, the acquisition ratio for Walgreens is 6% ($1,400 divided by $24,513).

Next, do the same thing for Walgreen’s competitor, CVS Caremark (CVS). Looking at the December 2008 figures, Yahoo listed $25,494 million for goodwill, $10,446 million for intangibles, and $60,960 for total assets. Doing the math, CVS Caremark’s acquisition ratio was 50%.

Both Walgreen’s and CVS Caremark are relatively fast-growing firms. However, the numbers tell us that Walgreen’s is mostly growing by opening more stores (organically) while CVS Caremark is relying mostly on acquisitions to fuel growth.

Here are the acquisition ratios for a sampling of familiar firms.

•  Abercrombie & Fitch, 0%

•  Apple, 1%

•  Bed Bath & Beyond, 0%

•  CACI International, 62%

•  Carnival, 14%

•  Caterpillar, 4%

•  eBay, 50%

•  Fortune Brands, 56%

•  Google, 32%

•  H&R Block, 17%

•  Harley Davidson, 2%

•  J M Smucker, 52%

•  Kohl’s, 2%

•  L-3 Communications, 58%

•  McDonald’s, 8%

•  Nike, 8%

•  Peet’s Coffee, 0%

•  PetSmart, 2%

•  Proctor & Gamble, 65%

•  WD-40, 53%

•  Weight Watchers, 75%

•  Zimmer Holdings, 50%

As a rule of thumb, organic growers usually show ratios below 5%, and ratios of 15% or more identify firms growing at least partly by acquisition.

published 3/29/09

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