'Serial acquirers' are fighting a losing battle against slowing growth, using diluted shares to snap up existing businesses. Organic growth is better. Here's how to spot it.
By Harry Domash
Serial acquirers can be hazardous to your investing health. Whats worse, you may have one in your portfolio and not even know it.
Whats a serial acquirer?
I first heard the expression from Dennis Kozlowski, the former Tyco International (TYC, news, msgs) CEO, whose recent trial for alleged misdeeds in that role was all over the news.
Kozlowski coined the term serial acquirer to describe his growth strategy in the 1998-2001 go-go days, when Tyco was growing sales and earnings at a rapid clip -- almost exclusively by acquisition.
Tycos story ended badly in early 2002, when the company stumbled and its stock lost more than 80% of its value. Tyco is only one of many serial acquirers to suffer that fate. But despite its dismal results, growth by acquisition is still a popular strategy. Heres why.
Slowing growth is not an option
Most new companies start life with a new product or service and grow as their products gain traction in the marketplace. But as sure as night follows day, eventually they saturate their market and the company faces the prospect of slowing growth.
However, the stock market usually assumes that a companys early growth rate will continue at the same pace indefinitely, and any hint of slowing growth would likely sink its share price.
For the companys top execs, however, that is not an option.
One way or another, via stock options or bonuses, top managements wealth is linked to the share price. So key executives have great incentive to keep the stock price, and hence the growth rate, moving up.
In the best case, management maintains growth by developing new products and expanding into additional markets. But thats not always feasible, causing some companies to turn to an acquisition strategy to spur growth.
Delaying the inevitable
On the surface, growth by acquisition is an appealing strategy. Why spend the time and effort to learn the ins and outs of a new market, and then develop products from the ground up? Its easier and faster to acquire an established company already serving the market. Its cheaper, too! Most serial acquirers dont use real money. Instead, they pay with newly issued shares. That dilutes existing shareholders equity, but no cash changes hands.
The acquisition strategy works great in the beginning, allowing the company to maintain its growth rate and keep its share price moving up, which is important since its stock is the currency used to keep the acquisitions going.
The downfall of an acquisition strategy is that the numbers keep getting bigger. For instance, a company with $100 million in sales can grow sales 25% by acquiring a company with $25 million in sales. But when it achieves $200 million in sales, it must acquire a company with sales of $50 million to maintain the same growth rate. Compounding the problem, as the numbers get bigger, worthwhile acquisition candidates become harder to find.
Nevertheless, many serial acquirers carry on for years. General Electric (GE, news, msgs), for instance, had a great run under former CEO Jack Welch.
But eventually the numbers get too big and the strategy fails. In the best case, growth simply slows because the serial acquirer runs out of qualified candidates and stops. That was more or less, what happened to General Electric, which, although its stock is down from its peak, floated to a relatively soft landing.
But all too often, the serial acquirer stumbles badly.
The meltdown typically starts when a large acquisition doesnt go well, dragging the acquirers sales and earnings below expectations. The disappointing earnings report sinks the share price, making future acquisitions difficult. Without continuing acquisitions, growth slows further, and its game over. That fate befell Tyco, Cendant (CD, news, msgs), Waste Management (WMI, news, msgs), WorldCom and many others.
How to spot habitual acquirers
Fortunately, thanks to a relatively arcane accounting rule, its easy to pinpoint habitual acquirers. All it takes is a simple calculation using numbers readily found on MSNs Balance Sheet report. Heres how it works.
In the sometimes fairy tale land of accounting, a companys shareholder equity, or book value, defines its value. But in the real world, book value, at best, reflects the depreciated value of land, plants and equipment. It has little to do with the companys worth as a going business. So, when one company buys another, the acquiring company typically pays much more than the accounting book value.
Accounting rules require the acquiring company to record the difference between the actual purchase price and the book value on its balance sheet. Depending on the nature of the assets, the figure is recorded on either a line labeled goodwill or a line labeled intangibles. The definition of each isnt important for our purposes. Even better, MSN makes life easier by combining both into a single intangibles entry on its Balance Sheet report.
A company that has never acquired another for more than its book value would show either zero, or a relatively small number for intangibles on its balance sheet. By contrast, a serial acquirer would show a big number on that line.
Of course, what constitutes big and small depends on the size of the company youre analyzing. Heres where youll need your calculator. Ive found that the ratio of intangibles to total assets, also found on the balance sheet, works well to identify habitual acquirers. The higher the ratio, the more acquisitive the company.
How it works
Ill show you how it works by comparing adult school operators Apollo Group (APOL, news, msgs) and Corinthian Colleges (COCO, news, msgs).
Starting with Apollo, enter its symbol in the quote box and get a quote. Then select Financial Results from the left side of the page, click on Statements and then select Balance Sheet from the dropdown menu. Finally, select the Quarterly View to see the latest figures.
When I looked, Apollo's most recent figures were from February 2004. Dividing intangibles ($37.1 million) by total assets (1,622 million) gives a ratio of 0.02, or 2%, for Apollo. Doing the same math for Corinthian yielded a much higher 0.51 ratio, or 51%.
The figures show that Corinthian is growing primarily by acquisition while Apollo is growing mostly by building new schools or by expanding existing units. You can verify those conclusions using MSNs Key Developments report (in the left menu after youve gotten a quote). Among other items, the report chronicles acquisition announcements going back five years or so.
There are no hard and fast rules, but as a rule of thumb, consider companies with ratios below 10% as organic growers and those with ratios above 15% as potential serial acquirers.
There are probably thousands of companies with less than 5% ratios. Here are a few examples:
| Organic growers | | Company | Ratio | Company | Ratio | | Avon Products (AVP, news, msgs) | 0% | Intel (INTC, news, msgs) | 8% | | Bed Bath & Beyond (BBBY, news, msgs) | 5% | Lennar (LEN, news, msgs) | 0% | | Costco Wholesale (COST, news, msgs) | 0% | Motorola (MOT, news, msgs) | 0% | | CSX (CSX, news, msgs) | 0% | Occidental Petroleum (OXY, news, msgs) | 0% | | Dell Computer (DELL, news, msgs) | 0% | Southwest Airlines (LUV, news, msgs) | 0% | | Fluor (FLR, news, msgs) | 2% | Target (TGT, news, msgs) | 0% |
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By contrast, here is a sampling of companies suspected of growing primarily by acquisition:
| Potential serial acquirers | | Company | Ratio | Company | Ratio | | Alberto-Culver (ACV, news, msgs) | 27% | Henry Schein (HSIC, news, msgs) | 66% | | Amdocs (DOX, news, msgs) | 30% | Masco (MAS, news, msgs) | 40% | | Black Box (BBOX, news, msgs) | 65% | SCP Pool (POOL, news, msgs) | 28% | | Broadcom (BRCM, news, msgs) | 41% | Symantec (SYMC, news, msgs) | 27% | | Hain Celestial Group (HAIN, news, msgs) | 58% | Warnaco Group (WRNC, news, msgs) | 29% |
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The intangibles-to-total assets ratio is a good starting point, but it isnt infallible. Accounting rules demand that a company write off the value of goodwill over time (so that a brand name bought generations ago isn't still on the books as worth a fortune). A single large acquisition years ago that's still being depreciated could make a company appear to be a serial acquirer, unless you investigate further.
Theres nothing wrong with riding an acquirers growth as long as you get out in time. But its tricky business figuring out when a serial acquirer is running out of viable acquisition targets.
Harry Domash does not own, control or have a short position in any of the stocks mentioned in this column.
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