When I first got into investing I didn’t care whether a company was acquisitive or not, but the longer I invest the less I like acquisitions. Any roll-up strategy is an instant pass for me. Two things have slowly changed my views over the years.
First, there’s a lot of evidence that acquisitions (especially large acquisitions) are a poor way to grow a company. According to a McKinsey study, the average acquisition has historically increased the value of the combined entities by 5.8%. The problem is, more often than not, all of this increased value is transferred to the shareholders of the acquired company via the premium paid (i.e. goodwill). The average public company acquisition is made at a 30% premium to its previous day close. Increasing an acquired company’s value by 30% just to break even on the price paid is a hard enough task as it is, let alone earning an adequate return on top of that. Another interesting note is that M&A activity peaked in 1999 and again in 2007. It seems managers are all too prone to make acquisitions when times are good and valuations are high.
The below chart shows how returns on capital have changed from 1963 to 2013. Excluding goodwill, returns on capital have been on a steady climb thanks to more technology companies that boast higher returns on capital. Including goodwill, returns on capital have gone nowhere and are more than 10% lower than returns on capital without goodwill. This suggests acquisitions as a whole haven’t added any value to their acquiring companies.
[Side note: I think I’ve mentioned them on this blog before, but the two McKinsey books Valuation and Creative Cash Flow Reporting are fantastic. Not the easiest reads, but they are two of the most valuable investing books I’ve read.]
The below chart is another one I really like. It basically summarizes Valuation’s chapter on growth, which really drove into my head a lot of the concepts on why one way of growing a company is better than another. The best type of growth either doesn’t affect competitors or benefits them (one example is bringing new customers into the market). These are the best ways to grow because competitors are unlikely to retaliate (which often means price wars). The worst types of growth are ones where competitors can easily retaliate and/or where you have to commit a significant amount of capital upfront with an unknown future (e.g. large acquisitions).
I think it’s important to always look at concepts from a high level and make sure it makes sense there first. In my opinion, the high level viewpoint is how hard it must be to merge two completely separate companies into one. Every company has a different culture, rules, management styles, dress code, vacation days, maternity leave, and just general way of doing things. Buying competitors for 8x EBITDA, centralizing operations, and profiting from the synergies sounds great, but it also completely leaves out the human element of trying to combine hundreds or thousands of people that are used to doing things differently. From a high level, mergers and acquisitions don’t seem easy to me and this leads into the second thing that really had an effect on my attitude towards acquisitions: talking to actual business owners who have merged companies into their own. I don’t mean public company CEOs, just friends and associates who are (relatively) small entrepreneurs.
It’s nearly unanimous the entrepreneurs I’ve talked to who have said merging another company into their own was significantly harder than they expected. And this is coming from small entrepreneurs. Those complexities are multiplied when there are hundreds or thousands of employees to integrate and retrain. In addition, the couple friends I’ve had who worked for a company that got acquired have very few good things to say about the process (and not because they were fired, they were all kept on board).
From an investment analysis point of view, the big negative is how acquisitions can muddy the financials. It’s really hard to accurately measure a company’s true growth rate when they’re buying companies on a regular basis. And when acquisitions make the financials confusing, it’s easier for management to hide stuff they don’t want investors to know. This is something I struggle with on Where Food Comes From, especially because their acquired companies cross-sell with each other—management probably couldn’t give an organic growth rate number even if they wanted to. And when does an acquired company get included in the organic growth rate anyway? A company might break out organic (or legacy) growth rate for a year or two after an acquisition, but eventually it gets thrown in with everything else. That’s fine, it’s how it should be, but it makes accurate analysis harder (if not impossible).
One specific example of acquisition financials that’s easy to miss is adjusting for working capital. When an acquisition is made, that cost is recorded as an investing use of cash. But part of that acquisition is most likely working capital, and when that acquired working capital gets liquidated it becomes a source of operating cash flow. So companies acquire working capital which hurts investing cash flow, but then when that working capital is liquidated it increases operating cash flow. Roll-ups can basically acquire operating cash flow and keep it going for years. To adjust for this, acquired inventory needs to be included in operating cash flow and acquired assets (PP&E) need to be counted as capital expenditures. I tend to normalize entire acquisition costs and count them against the company. If a company has made one acquisition in the past fifteen years, it’s probably safe to ignore it. But if a company has made three or four in the past decade, I average those acquisition costs over ten years and count that as an annual expense going forward.
I mentioned them above, but by far the most acquisitive company I own is Where Food Comes From. The nine companies I own right now have made ten acquisitions in the past five years and six of those were by Where Food Comes From. One of these Where Food Comes From acquisitions added roughly 25% to sales, another around 10%, and the rest were smaller. So one sizable acquisition, one moderate, and the rest more bolt-ons. Even though I think their acquisitions makes analyzing the company more difficult, I do like their acquisition strategy a lot more than most companies. Three of the acquisitions were done where they buy 60% upfront with a right of first refusal on the other 40%. John Saunders, the CEO, likes this structure and from talking to him it sounds like this will be the preferred way of acquiring companies going forward.
The main reason John prefers this 60/40 structure is it gives the owners of the acquired business a liquidity event, but it also keeps them engaged for at least a couple years. This obviously helps create a smooth transition. The price of the last 40% is also based on growing that company’s profitability so the owners do remain incentivized. Only purchasing 60% upfront also lowers Where Food Comes From’s risk. If the acquired company doesn’t perform as planned they can forgo buying the other 40%.
Of their six acquisitions to date, two were fold-ins while the other four have been kept as separate silos. Each division is run independently (even though they cross-sell and work together) and all excess cash flow gets funneled up to the corporate level where John decides where best to allocate it (similar to Berkshire’s structure). All acquisitions have been manageable in terms of size—no transformational takeovers that require loads of debt.
In addition, there are very clear reasons why their acquisitions should be worth more as a Where Food Comes From subsidiary than as a standalone company. All of their subsidiaries (or acquisitions that were folded in) have similar customers so the cross-selling opportunities are substantial. John is well aware that acquisitions are historically a poor way to grow a business, so he’s structured them in a way that decreases at least some of the risk: mostly small bolt-ons, don’t pay everything upfront, previous owners kept in place, and very clear reasons for why 1+1 should equal 3 (similar customers and cross-selling opportunities, not just *synergies*).