Acquisitive companies are generally mistrusted by investors. There are good reasons for this, as many acquisitions make shareholders worse off rather than better off. Distribution company Bunzl (BNZL) has proved to be an exception to this general rule and has done a good job in making acquisitions work for its investors.
The main reason why investors are wary of acquisitive companies is because many acquisitions destroy value rather than create it. Here, I am defining value creation as when a company makes a return on capital employed (ROCE) greater than what it costs to fund it (its cost of capital).
How much does a company need to make to keep investors happy?
The cost of capital is one of the most heavily debated and frankly boring discussions in academic finance, but it is an important one. It is the weighted average of the returns companies have to pay lenders and shareholders to fund their business.
The cost of borrowing is easy to identify – it is the interest rate on borrowings – but how much shareholders want in returns is much harder to gauge. Shareholders will want more than lenders because they get paid last (this is known as the equity risk premium) and therefore bear more risk.
The higher the risk, the higher the returns that a shareholder will demand to invest in a business. Risk is determined by the nature of the business a company operates in. Small companies in competitive industries where profits are highly sensitive to the ups and downs of the economic cycle are more risky than large companies with a strong competitive position selling things that customers buy regardless of the economic climate.
Companies with big debts and pension fund liabilities are also more risky for shareholders. This is because more of the company’s profits and cash flows have to be paid to service them before shareholders get paid anything. A downturn in trading profits can see no money left to pay them.
Low interest rates have reduced the cost of financing for businesses and this is one of the big reasons why share prices have gone up so much over the past decade or so. Investment projects with lower returns that might not have gone ahead are now seen as worthwhile and increase the value of a business.
So what is a company’s cost of capital?
You should not stress too much over this and keep things as simple as possible. For most medium to large companies in developed economies a ROCE of 10 per cent or more is probably going to be in the right ballpark.
Not all acquisitions are bad
In most cases, it is usually more profitable for a company to build something than to buy/acquire something from another company. A business built from scratch will tend to earn a higher ROCE than buying another business.
This is because buying another business usually involves paying more than the build cost of it. This premium is known as goodwill and is related to things such as a company’s brands, customer base and competitive position.
The problem with buying businesses often occurs when the amount of goodwill – which is often substantial – gets too big and the company cannot then make an acceptable ROCE on the price paid. Instead of making shareholders better off, the acquisition destroys value within the business.
Other problems come when a company makes an acquisition that significantly increases the size of it. This can make it difficult to manage and lead to a deterioration in business performance. If the acquisition has been funded with large amounts of debt then the company’s actual existence can be threatened by a bad buy as it struggles to pay a higher interest bill with lower profits.
Acquisitions can also be used to mask problems in a company’s existing business, such as declining sales and profits. Buying a company in a similar line of business often gives a company scope to cut costs by cutting out duplicated costs. These cost savings can boost profits for a couple of years and give the impression that a company is doing well until they run out. This is what happened with support services company Carillion, which needed to make bigger and bigger acquisitions to keep its profits going up until it found out it couldn’t.
Yet not all acquisitions are bad. They can take a company into new product markets, new countries and give it access to new customers. The increase in company size can allow the company to buy things cheaper from suppliers, which can allow it to charge more competitive prices.
Providing a company does not overpay, acquisitions when combined with healthy existing businesses can create significant wealth for shareholders. Companies such as Halma, Diploma and Ashtead have been very good at this.
Weighing up Bunzl’s buying strategy
Bunzl is one of the most acquisitive companies listed on the London market relative to its size. Acquisitions are a key part of its business strategy and it has spent more than £3.5bn on them since 2004. It has a current market capitalisation of £8.1bn.
Bunzl is a distributor. It buys and supplies products that are used everyday by its customers in six key sectors and has current annual revenues of £9.6bn.
It sells anything from disposable tableware and catering equipment to hotels and restaurants; food packaging to supermarkets and retailers; personal protection equipment (PPE), such as gloves, masks and hats, to healthcare and construction companies; cleaning and hygiene products; and medical supplies to hospitals and care homes.
The business is very diverse and consists of selling small consumable items that are used all the time. This gives Bunzl’s business predictable and defensive characteristics.
Bunzl is selling itself as a problem-solver to its customers. By investing in warehouses, delivery trucks and IT while using its global sourcing power it can give its customers a better and cheaper purchasing solution than if they did it themselves. They do not have to sink money into warehousing and trucks or worry about things such as stock control. Bunzl makes sure that the right quantities of products are delivered to the businesses when they need them.
Bunzl is a global business operating in more than 30 countries. Nearly 90 per cent of its revenues come from outside the UK, with the bulk of its profits coming from North America and Europe.
The company operates in very large sectors where the market for supplying them with consumables is very fragmented. Bunzl wants to consolidate these markets by buying up competitors, but it aims to do so by making sure that it creates rather than destroys value for its shareholders.
As an investor, there are some key things to look out when checking out a company that makes a lot of acquisitions:
- Organic revenue growth. Is the existing underlying business still growing or is the business only growing by buying companies?
- Return on operating capital employed versus return on total invested capital. The first number tells you about how profitable the actual assets of a business are while the second shows how profitable it is on total money invested, which will include goodwill on acquisitions.
- The incremental returns on capital. This tells you how much extra profit has come from additional money invested.
- The impact on cash generation. Is the business generating more free cash flow and are acquisitions being predominantly funded from cash or additional borrowing?
This is probably my biggest concern with Bunzl. Its track record in generating organic sales growth (excluding acquisitions, disposals and changes in exchange rates) is alright, but not stellar. There have been some strong years, such as 2017 and 2018, but 2019 was weak.
It shows that there is not much underlying growth in its business, but at least there is some. Without acquisitions, I think it’s fair to say that this is a business that probably would not be able to grow its profits much.
Return on operating and total capital employed
Here Bunzl scores well. The underlying assets remain exceptionally profitable, with returns on operating capital employed (ROOCE) of nearly 50 per cent. Total ROCE, which includes goodwill on acquisitions, was 14.6 per cent in 2019.
Bunzl’s acquisitions are dragging down its returns compared to the underlying assets, but its ROCE figure is still very respectable and shows that its investments are creating value for its shareholders.
You will see that its operating margins are not particularly high, but they have been very stable which is a good sign.
Incremental returns on capital
This is a very good way to see how a company’s profitability is changing over time. You take two dates and look at the changes in sales, profits and capital employed to see how profitable additional investment has been.
For Bunzl, I’ve done this by ignoring the impact of rented assets on its capital employed from 2019. The amortisation of customer relationships has been added back to profits and capital employed. My ROCE figures are slightly different to Bunzl’s as I do not net off cash balances when calculating capital employed.
Bunzl: Incremental returns on capital
Adj Cap Employed
Source: Annual reports/Investors Chronicle
By my reckoning, between the end of 2010 and June 2020, Bunzl has added nearly £3bn of capital employed and generated £360m of additional operating profits – an incremental return on capital of 12.1 per cent. Given that the bulk of this extra investment has come from acquisitions, then it again suggests that they have delivered increased value.
Cash flow and financing
Bunzl’s cash flow performance has been impressive. It has been very good at turning its profits into free cash flow (a good test that profits are real), while it has been able to fund most of its acquisition spend from cash flow. At the same time, its dividend has increased for 27 consecutive years and remains comfortably covered by free cash flow.
Bunzl: Cash flow performance
CF left over
FCF Div cover
Source: Annual reports/Investors Chronicle
These figures highlight just how well Bunzl’s strategy of buying companies has worked for its shareholders. Net debt to Ebitda of 1.6 times at the end of June 2020 shows that the company does not have too much debt.
Can the strategy keep on delivering?
I think it can, but there are a few short-term uncertainties. 2020 has seen strong growth from its PPE and hygiene products due to Covid-19. Many of these are also own-label products and come with higher profit margins. By contrast, its foodservice, grocery and retail sales – which have lower margins – have suffered.
A recovery in sales in these areas, while welcome, could see the beneficial profit mix of 2020 reverse and mute any short-term profit growth. The other important issue is the recent strengthening of sterling, which could lower overseas profits when they are translated back into pounds. Bad debts from customers are a concern, but have not got worse since a provision of around £30m was made earlier in the year to cover outstanding invoices from struggling customers.
The pipeline of potential acquisitions remains good and could see businesses that have struggled during the pandemic become more willing to sell to Bunzl. The company’s decentralised, and entrepreneurial management culture has been a key attraction for many sellers to stay with their business after it has been bought. This has worked well for all parties.
Bunzl may not be a great business, but it is a very solid one. It has a very strong competitive position underpinned by its global scale, purchasing power (it has its own Asian sourcing business), investments and longstanding relationships with customers and suppliers.
Its shares have been very volatile and have been stuck in a trading range for the past four years. It is not a high-growth business, but looks as though it is very capable of growing modestly with its strategy. On that basis, I think the shares at 16.2 times 2020 forecast EPS whilst offering a forecast free cash flow yield of 6.2 per cent are not expensive. You are unlikely to get rich owning this share, but if you are looking for something to tuck away in your portfolio to help you sleep relatively well at night then they may be worth considering.