Should investors avoid acquisitive companies?

Last week, I wrote about how you can spot signs of trouble brewing at a company before its share price falls heavily. One of the warning signs is related to companies that make acquisitions. Not all acquisitions cause trouble, but unfortunately many of them do. Sometimes the problems come from one big acquisition. In other cases, it can be from a series of acquisitions.

The problems encountered by companies making acquisitions range from profit warnings to bankruptcy and have led to them getting a bad name among investors. Yet not all acquisitions are bad. There are a selection of UK-quoted companies that have become very good at buying companies, integrating them into their existing businesses and making them work well for their shareholders. We shall see some examples of them later on.

Why do companies make acquisitions?

There are many reasons why companies make acquisitions. The most common ones are:

• To enter new markets with new products. It is sometimes easier and faster to buy something than to make it yourself.
• To acquire scale in an existing market and/or to take market share from competitors. By adding a similar business to one a company already owns it is possible to benefit from economies of scale. These benefits range from better buying power with suppliers to more efficient production and selling. This can often boost profit margins.
• Its existing business is mature and has weak growth prospects. Businesses go through life cycles and eventually growth rates slow down or even decline. By buying another business it may be possible to get company profits growing again.
• To make use of a strong balance sheet. Good companies can often accumulate significant piles of cash and may decide to use it to make acquisitions rather than paying it out to shareholders.

The economics of acquisitions – building versus buying

Let’s take a look at how the economics of making acquisitions can stack up. I will do this by looking at the return on investment or capital employed that are earned depending on whether a company builds or buys a business.

Returns from building and buying the same business

Source: Investors Chronicle

The best way to look at the financial performance of a business is to compare the profits made by it with the money that has been invested in it – its capital employed. This is done by using the return on capital employed ratio (ROCE), which compares a company’s operating or trading profits with its capital employed or money invested. We can use this ratio to weigh up whether an acquisition make sense for a company – does it deliver a good return on the money spent?

When a company builds a business from scratch it does not have to pay a premium to buy the assets that generate the revenues and profits. If the management has built a very good business it can be highly profitable and make high profit margins and ROCE.

It is a simple rule of business economics that businesses with high returns are worth more than the money invested in them. In other words, the high levels of profitability have added value to the assets or money invested.

As a rough rule of thumb, a company has to make a minimum ROCE for its assets or capital employed to be worth the money spent on them. This minimum return is known in financial jargon as a company’s cost of capital. It is a very complicated subject that causes no end of argument and debate among investors and academics as to what the number should be. In the spirit of keeping things simple, if you assume a company has to make a minimum ROCE of around 10 per cent to justify the cost of its investment then you are not going to be too wide of the mark for most companies.

In our example here, the business is making a ROCE of 20 per cent. As it is double the 10 per cent minimum an argument can be made to suggest that the economic value of the business is at least twice the amount of money invested in it, depending on its future growth prospects.

The important point to take on here is that the buyer of a business tends to have to pay an estimate of its economic value rather than the value of its assets or capital employed. This premium over asset value is known as goodwill.

In our case, the buyer pays an additional £100m over asset value for the business or £200m in total. The underlying business is still making 20 per cent returns, but the buyer has to pay its economic value and it gets a lower return on investment of 10 per cent.

If possible, it is better to build rather than buy a business as buying often depresses a company’s ROCE – sometimes by a significant amount.

Why acquisitions go wrong

Some acquisitions work out well for the buyer, but many do not and the implications for shareholders can be disastrous. The main reasons are:

• The buyer paid too much. Overpaying is a common problem. This means that the starting rate of return on investment is low and the combination of future growth and any cost savings can’t drive profits high enough to make an acceptable return.
• Overpaying with debt. If a company has overpaid with borrowed money and has been unable to make an acceptable return this can put severe pressure on a company’s finances and make it difficult to pay the interest bill on the debt used. In the worst-case scenario a company can go bankrupt.
• The acquired business goes wrong. It is not uncommon for a seller to sell out at the top when the business’s potential for growth has been all but exhausted. Private equity sellers are good at doing this and often leave nothing on the table for the buyer, having maximised their return on investment by selling for an inflated price.
• Accounting shenanigans are exposed. Acquisitions give directors considerable scope for accounting jiggery-pokery. One of the things to watch out for with acquisitions is something called 'fair value adjustments'. This is when the value of assets and liabilities acquired may be changed in order to boost future profits. These adjustments are often hidden away in the cost of the acquisition and can get ignored by investors, but they can have a nasty habit of exposing a flawed acquisition later on.
• Cost savings run out. Some acquisitions only make sense if the buyer can wring out significant cost savings from the purchase. The problem with this is that the cost savings eventually run out and if the underlying  business isn’t growing or is stagnating the company itself can run out of growth and resort to making another acquisition to try to get growth going again. This can end badly for shareholders.

Case studies: Good acquisitions and bad acquisitions

Carillion (Bad)

If you wanted to write a book about warning signs then construction and support services company Carillion would provide you with plenty of copy. It is also a good case study of a company that became very reliant on acquisitions to grow its profits. This was not only achieved by buying businesses with revenues and profits, but by getting cost savings from integrating them into its existing business as well.

Between 2006 and 2011, Carillion spent over £1.2bn on three major acquisitions that promised to boost annual profits by £90m from cost savings alone.

Carillion acquisitions

Source: Annual report

At first, this strategy looked to be really successful. When Carillion bought Mowlem in 2006 it was a modestly profitable business with a ROCE of just 6.6 per cent and producing annual free cash flow of £30m. Five years later, profits had surged, ROCE had almost doubled and free cash flow (FCF) was £130m.

Carillion profits, ROCE and FCF

Source: Annual report

But danger signs were already flashing. Every time the cost savings of an acquisition ran out, Carillion seemed to make another acquisition. It seemed that acquisitions and cost savings were masking an underlying business that was stagnating or going backwards.

After 2011, operating profits stagnated and free cash flows went backwards for a couple of years. Then in 2014 Carillion tried to merge with its bigger rival Balfour Beatty with the aim of delivering £175m of annual cost savings. Balfour Beatty rejected the offer and, within two years, Carillion was in deep financial trouble. But the stagnating profits and the need to grow via acquisitions were red flags long before the company’s share price collapse.

FirstGroup/Laidlaw (Bad)

FirstGroup entered the US school bus and transit market in 1999 with a big acquisition. In 2007 it splashed out on buying Laidlaw. There was nothing initially wrong with the quality of assets it was buying^, the problem with this acquisition came from two issues. First, the company arguably paid too much. It paid $3.5bn for a business with annual operating profits of $290m – a return on investment of 8.2 per cent.

Secondly, it loaded its balance sheet with huge amounts of debt relative to its profits and cash flows. Its net debt to Ebitda ratio soared on the acquisition and has struggled to come down since. When the US business started to struggle it couldn’t cope with the debt load. FirstGroup had to resort to a big rights issue and scrapping its dividend.

Often it is difficult for investors to keep track of how well an acquisition is performing. This is because its financial performance can get hidden away in the results of another business. That said, it is possible to get a feel for what has been going on in some cases.

Using the segmental business notes in the annual report, we can see how FirstGroup’s North American business has fared over the years since the Laidlaw acquisition.

Here, I’ve looked at the operating profits as a percentage of total assets. We can see that profits peaked in 2009 and bottomed in 2014, before picking up and falling back again. Running a fleet of buses is an asset-intensive business, which does not lend itself to making high returns on investment. That said, these numbers suggest that despite spending lots of money FirstGroup has struggled to generate decent returns for its shareholders from its North American bus business based on its return on total assets (ROTA).

FirstGroup North America

Source: Annual reports/Investors Chronicle

Making regular acquisitions pay off – Diploma and Halma

As a rough rule of thumb, the bigger the size of the acquisition relative to the size of the buying company, the more risk there is for shareholders. Finance the acquisition with lots of debt and the risks are magnified.

But not all acquisitions are bad. Successful businesses can use regular acquisitions to complement their existing businesses to boost growth and returns to shareholders. A great example of this has been Diploma, the medical devices, special seals and controls business. It tends to make acquisitions every year, but has not staked the company’s future on them.

Diploma financial performance with acquisitions

Source: SharePad

It has bought companies without stretching its balance sheet and has very little debt. In doing so, it has been able to grow its profits and free cash flow while maintaining high profit margins and a very impressive ROCE. Stripping out goodwill, and looking at ROCE, we can see that Diploma’s business portfolio remains highly profitable.

Shareholders have done very well from this strategy. Over the past 10 years. Dividend payments have soared and the shares have delivered a total shareholder return of 1,180 per cent.

Another company that has used acquisitions as an effective strategy has been Halma, a business that specialises in protection and solving problems across many different sectors.

Halma financial performance with acquisitions

Source: SharePad

Just like Diploma, Halma has been able to buy companies every year for the past decade without taking on dangerous levels of debt. High profit margins, free cash flow margins and ROCE have been maintained with the underlying business (as evidenced by looking at ROCE ex goodwill) remaining very profitable. Dividends per share have doubled over the past decade, with the shares delivering a total shareholder return of 794 per cent.

Acquisitions to keep an eye on

Tesco/Booker

In many ways, Booker is a better business than Tesco. Its higher profit margins have helped Tesco achieve its profit margin target, but does the acquisition really stack up?

Tesco: financial returns on Booker acquisition

Source: Tesco/Investors Chronicle

Tesco paid nearly £4bn for Booker, which delivered £196m of operating profits for Tesco in the 51 weeks to February 2019. This looks like an expensive acquisition with a return on investment of just 4.9 per cent.

But Tesco reckons that by spending another £75m it can achieve £200m of extra profits for Tesco and Booker combined. If it achieves this, the return on investment will go up to 9.7 per cent, which is nothing special and probably only marginally better than the return on buying back its own shares.

Restaurant Group/Wagamama

Restaurant Group’s acquisition of Wagamama contains lots of red flags for investors. The company bought the business from private equity sellers for a very high price and took on lots of debt to do so.

Restaurant Group has tried to sell this deal to investors by saying that it can still grow Wagamama’s sales and profits and will deliver considerable cost savings and synergies by combining it with its existing business.

Return on investment: Restaurant Group /Wagamama

Sources: Restaurant Group/Wagamama/Investors Chronicle

Restaurant Group paid £559m for a business that was making £32m of profit in 2017. Adding £22m of synergies would get this up to £54m, but would still only give a return on investment of 9.2 per cent.

Looking at the latest results presentation from Wagamama in November this year, I calculate that annual operating profits are running at just £34.9m (I have deducted opening costs and share-based payments as genuine costs in arriving at this figure), giving a return on the acquisition cost of 6.2 per cent.

The real worry is the sharp slowdown in like-for-like sales growth from over 12 per cent in the first quarter of 2019 to just over 6 per cent in the second quarter. This is still an impressive number in a difficult sector, but if it continues to slow rapidly – as it did with Restaurant Group’s existing business a few years ago – then the business’s high operational and financial gearing could see this acquisition added to a list of very bad ones for shareholders.