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Author: atta9508 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 27420  
Subject: Valuation Question - Growth / Acquisition Date: 10/18/2012 4:49 PM
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Hello - I am looking at a company that has had some lumpy CapEx primarily due to acquiring other companies. I am currently trying to reconcile my caclulated growth rate (Investment Rate X ROC) = Growth, where investment rate is a function of CapEx. Since this company has historically made a number of acquisitions in the last 5 years my implied growth rate is fairly high. Much higher than I would expect and higher than what I think they are capable of doing organically.

I don't really understand how acquisitions affect growth, but I can appreciate the fact that if you are acquiring a company with X% of the market, their revenue now becomes your revenue and I guess that added revenue is growth. Is this a good way to grow? Seems that this is what you do if you don't know how to grow your own business.

I feel that it might be risky to assume large growth in EBIT due to acquisition. I suppose in the end, the cashflow in my model will take a hit due to the heavy spend on acquiring other companies. Maybe it works out in the end. My valuation shows that the stock should be trading twice what it currently is. I suspect this is due to this high growth rate assumption and this makes me nervous. I could manually put in a lower growth rate to see how sensitive the numbers are to the acquisition assumption.

I would appreciate any thoughts on growth through acquisition.

Thanks,

Jared
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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 26226 of 27420
Subject: Re: Valuation Question - Growth / Acquisition Date: 10/18/2012 11:57 PM
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Acquisitions and the outcome have very much to do with buying them at the right price.

Most buyers have definite plans for how to pay down debt, and reduce costs, making the combined businesses more profitable--provided the price was right.

Paying down debt usually means selling some of the acquired company's assets. Reducing costs depends largely on the synergies involved. Most companies have overhead in various functions such as purchasing, accounting, legal, IT, etc. Often headcount can be reduced or junior people can be hired to assist sr personnel.

Where excess capacity shows up, sometimes facilities can be closed or sold, and profitable product lines moved.

An acquiring company that does it well can grow by series of acquisitions provided they can continue to find undervalued companies to acquire.

High growth businesses tend to be expensive. That means often you buy a mediocre company and rejuvenate it. Sometimes you find good business opportunities within the mix that were overlooked or underfunded. They may blossom with attention. More often a diamond in the rough must be acquired and polished.

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Author: JustMee01 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 26227 of 27420
Subject: Re: Valuation Question - Growth / Acquisition Date: 10/19/2012 9:00 AM
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Jared,

It's hard to say whether or not an acquisition will pan out, and different companies will make acquisitions for different reasons. A medical device maker or technology company might make an acquisition for nothing more than a piece of intellectual property. A consumer staple might buy in a competing or foreign brand to fill out their product suite (KO and PEP do it all the time). You need to look at why and how much they paid. Look at the acquired company, value it and ask if the acquirER paid a good price for the acquirEE. Digging into the company they bought may answer your question with regard to whether or not that growth expectation is reasonable.

I don't really understand how acquisitions affect growth, but I can appreciate the fact that if you are acquiring a company with X% of the market, their revenue now becomes your revenue and I guess that added revenue is growth.

This is exactly the case. If you buy a company all its future revenue is yours. And that added revenue is growth. Synergies can also exist to exploit. When PepsiCo went into Russia and bought WimBillDan, a big part of the rationale was cooler space. Buying the largest dairy in Russia not only brought in a new Dairy/Juice line, it also gave them an entrance for all their products, without the cost of assembling a distribution network and marketing group de novo. It automatically gave Pepsi a new toehold in Russia.

Is this a good way to grow? Seems that this is what you do if you don't know how to grow your own business.

Yes it can be a good way to grow, and yes, it is a way to grow a business that can't grow. Many do spurn that "non-organic" growth model. In part that's because it's not as predictable as organic growth. Yet, some companies that are serial acquirers do it quite well for very long periods of time. The mega-brand compaies like KO and PEP come to mind. Illinois Tool Works (ITW) buy small industrials and string them together in a strategic network, bringing managerial expertise to improve their efficiency.

Another example is GE and its look-alikes: EMR, HON, etc. Conglomerates can live off acquistions for growth for a long time. Techs as well. CSCO and MSFT are serial acquirers, buying to round out their product suites. Perhaps the prime example would be Berkshire-Hathaway. Buffett has mounds of cash. Buying new businesses at good prices is how that Empire was built, and continues to be built. It's what he does and he does it well. Is there a limit? Perhaps, but he's succeeded in making it work for an entire lifetime. It just needs to be done well to work well, like anything else.

Peter

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Author: atta9508 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 26228 of 27420
Subject: Re: Valuation Question - Growth / Acquisition Date: 10/19/2012 12:59 PM
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Thanks for both responses. Helpful.

I haven't gone though the previous annual reports to hunt for goodwill charges, but the 2011 annual report indicated that their acquisitions didn't indicate impairment and were valued over what they paid. I guess this means that on some level they are acquiring and managing the acquisition process well????

The issue I haven't discussed is that this company is dependent on medicare/medicade reimbursements. So some risk their, but I think the risk is that revenue may go up and down with policy. I think the next 10 years are safe. On the flip side of the negative, they can probably buy up companies on the cheap if they are not positioned well or have the balance sheet to handle the ups and downs. Thoughts?

Also, I would think that you could slowly change your business model such that you are not as dependent on government reimbursements.

Thanks, agian

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Author: JustMee01 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 26229 of 27420
Subject: Re: Valuation Question - Growth / Acquisition Date: 10/19/2012 6:29 PM
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Jared,

I haven't gone though the previous annual reports to hunt for goodwill charges, but the 2011 annual report indicated that their acquisitions didn't indicate impairment and were valued over what they paid. I guess this means that on some level they are acquiring and managing the acquisition process well????

Don't confuse goodwill with over or underpaying. Goodwill is just a balance sheet issue. When they cram the two companies' balance sheets together, any money paid above the book value of the company has to go to go on as something. So, they put it on as goodwill.

A company can sell for much, much more than its book value and still be a great purchase. Some companies are asset light and have a lot of intangible value. A software company might be an example. Much of their IP won't show up on the sheets. Another example might be a cash producer that's asset light. It's cash flow might justify a much bigger number than its book value. So, don't look at goodwill as a bad thing, necessarilly. For some companies and some acquisitions, book value is pretty unimportant. You're right though, that later impairments of goodwill are a bad indicator.

The focus on good or bad is more complex. You really need to step back and take a look at the bigger picture: why they bought the acquisition, what they anticipated it would provide, and if that outcome came through as expected. Some companies are very good at repeatedly scoring good buys and driving growth that way.

On the flip side of the negative, they can probably buy up companies on the cheap if they are not positioned well or have the balance sheet to handle the ups and downs. Thoughts?

Exactly. That's what Berkshire does. They pair their high cash flow insurance businesses with old economy businesses that are very profitable when protected by Berkie's balance sheet. A company with large capital needs can get buried by debt, since their cost of capital is becomes too high. Berkshire's cost of capital is low, so they can funnel cash to those subsidiaries and make them more profitable than they would be on their own. And of course, with that strong balance sheet they can bail out weaker companies or buy them outright when the economy is down.

Peter

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