A Closer Look At Our Serial Acquirers
Do today's multiples offer long-term upside?
One-pagers are very useful in breaking down the basic ingredients that are essential to create great long-term compounders. We’ve already touched upon the makings of a serial acquirer in the below one-pager.
Now, what should we pay for such compounding machine at maximum? There’s no clear answer to that question. It depends on multiple factors, one of which is uncertainty: we cannot adequately predict the future cash streams of a business. And even if we had perfect foresight, the outcome in terms of your final investment return could still be disappointing. Nevertheless, time is the friend of an excellent company as long as you’re able to hold onto it through thick and thin.
Here some of our general observations:
There are several methods to value a company. Some will compare the current earnings multiple to the longer-term average, which we deem as tricky. Businesses and ROIC constantly evolve, the law of large numbers may be looming around the corner, investor perception and much more. Others will run a Discounted Cash Flow (DCF) model, which is subject to your return hurdle rate and comfort level of fully understanding the business that caught your attention.
We’d rather utilize multiples to contextualize valuation distortions between peers. We tend to pick three valuation metrics.
EV/NOPAT: present or terminal steady-state multiple? It can be both, whereas the Market Cap/FCF is a short-term and more volatile metric.
Free Cash Flow is a company’s current cash flow available for M&A, dividends and share repurchases. A significant internal CAPEX program will initially depress the short-term free cash flows (maybe 1 to 2 years) only to then reap the long-term benefits of it.
Adjusted net income is normalized net income + acquisition-related amortizations. It’s a good proxy for underlying free cash flow prior to any organic growth investments. Adjusted net income is favored by Mark Leonard, the CEO and founder of Constellation Software.
So, let’s figure out why serial acquirers can trade at – sometimes widely – different multiples. Most of the time, organic growth yields higher returns than M&A. For instance, Diploma Plc has enjoyed strong organic growth over the past years, capitalizing on its excellent Return On Capital. Growth from M&A tends to be somewhat smaller, as evidenced by the relatively high dividend payout ratio indicating leftover cash is better to be distributed back to shareholders than to be invested in (riskier and/or unattractively priced) acquisitions.
Overall, serial acquirers achieve a ROIC on M&A of close to 10%-11% in year 1 (un-levered and based on cash flows instead of paper profits). Maximizing ROIC on M&A and organic growth is the core principle to compounding the shareholders’ capital durably.
Putting strong organic growth, high reinvestment rates (or low distribution yields) and high ROIC on M&A together is likely to result in a premium valuation. In short: it’s all about maximizing NOPAT/share growth in conjunction with small, and above all, smart use of leverage to juice up the returns.
Thanks to the higher NPV (Net Present Value) of future cash streams, negative capital employed serial acquirers with good organic growth have the highest return potential amongst all others. Simply stated, high or low organic growth: it won’t matter that much to overall working capital and CAPEX movements. Organic growth expenses show up in their P&L and are being compensated for by revenue growth. Unsurprisingly, we feel comfortable putting most of our allocation to serial acquirers in the CSI family basket.
When a serial acquirer runs out of growth opportunities, organic growth and/or sees its ROIC deteriorate, investors should reset their expectations. For some of the Swedish serial acquirers, total EBITA (and NOPAT) growth has been pretty astounding as of late. Investors have been paying up for their future growth outlook but they'd better be cognizant of the main driver behind that growth: margin expansion. The current multiples reflect the tailwind of efficiency enhancements we've witnessed over the past 5 years. Rather than upgrading their revenue growth forecasts, investors are counting on that very same profit tailwind to justify their future fair values. So, beware.
Let’s now take a look at the serial acquirers we currently have in the portfolio, and see whether we can identify divergences between what a realistic outlook could look like and what investor expectations actually imply/reflect.