Stock research and analysis: How to spot serial acquirers

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How to Spot Serial Acquirers

What do Daimler Benz, McKesson, Cendant, WorldCom, Waste Management, Rite Aid and Tyco International have in common? They are all former stock market stars that stumbled while following a growth by acquisition strategy. It’s easy to spot firms exploiting this risky strategy, but first a little background.

In the beginning, most firms grow organically, that is, their growth comes from selling more products, or by opening new stores. Eventually growth slows as supply catches up with demand or new competition appears. Then, management must find new ways to sustain the growth rate; otherwise the slowing growth will sink the firm’s stock price.

At that point, most firms develop new products or enter additional markets; but others turn to an acquisition strategy to maintain growth.

Pyramid Scheme
Growth by acquisition is an appealing strategy. Purchasing an established company already serving a market saves the acquirer the time and expense of learning the business and developing products from scratch. The process is relatively inexpensive because the acquirer often uses its own newly issued shares to pay for the acquisition.

The strategy is often successful early on and the acquiring firm is able to maintain a strong growth rate, keeping the market happy and its share price up. The latter is an important factor since the firm’s stock is the currency enabling the acquisitions.

Many firms pull it off for years, but acquisition-fueled growth is somewhat like a pyramid scheme. Consider the math. A company with $100 million in annual sales can achieve a 25 percent sales increase by acquiring a company selling $25 million annually. However once it achieves the $200 million level, it must acquire a company with $50 million in annual sales to maintain the same growth rate. Compounding the problem, the bigger it gets, the fewer the number of acquisition candidates.

Something Goes Wrong
Eventually something goes wrong. Perhaps the acquirer overpays. Maybe the acquired company doesn’t perform to expectations, or expected cost cutting synergies fail to materialize. Perhaps a clash between corporate cultures disenchants key employees in the acquired company and they leave.

Whatever the cause, the serial acquirer fails to meet earnings growth forecasts, torpedoing its stock price. The lower stock price takes away its acquisition currency, further slowing growth, thereby putting more pressure on its share price. In essence, it’s game over!

Spot Serial Acquirers
Given that scenario, determining if your candidate is a serial acquirer should be a factor when you’re researching a stock. How do you find out? Reading the last few annual reports is one way, because firms detail recent acquisitions in the reports. But there’s an easier way.

Theoretically, a company’s shareholder’s equity, or book value, defines the firm’s value. However book value primarily reflects hard assets such as plants and equipment, but not the firm’s worth as a going business. Consequently, buyers typically pay much more than book value when they purchase a firm. The difference between the actual purchase price and the book value is termed “goodwill.”

Goodwill Tells All
According to accounting rules, the buyer must record the goodwill amount on a line labeled “goodwill” or “intangibles” in the long-term assets section of its balance sheet. A company that never acquired another firm for more than its book value would show no goodwill or intangibles on its balance sheet.

Thus, you can gauge a firm’s acquisition history by comparing its goodwill and other intangibles to its total assets. For brevity, call the result of dividing goodwill plus intangibles by total assets the GI/A ratio. The higher the ratio, the more acquisitive the firm.

Drugstore chains Walgreen and CVS afford a good example. Both are relatively fast growing firms. Walgreen relies entirely on internal growth, while CVS using a combination of internal growth and acquisitions to increase its sales. According to their most recent annual report balance sheets, Walgreen’s GI/A ratio was a flat zero, compared to 10 percent for CVS.

Here are GI/A ratios for companies that have employed acquisitions for much of their recent growth.

Allied Waste Industries 60%, Black Box 57%, Cisco Systems 12%, Clear Channel Communications 85%, Tyco International 34%, VeriSign 75%, Waste Management 26%, and WD-40 Company 52%.

For comparison, here are the ratios for firms that have grown mostly organically:

Bed Bath & Beyond 0%, Chico’s FAS, 0%, Columbia Sportswear 3%, Dell Computer 0%, Harley-Davidson 2%, Home Depot 1%, Microsoft 3%, and Outback Steakhouse 0%.

As you see, there is a wide divide between the ratios of serial acquirers and organic growers. As a rule of thumb, ratios of 10 percent or more identify companies growing at least partly by acquisition.

Here’s How
You won’t find the GI/A ratio computed on any Website, but it’s easy to calculate. Both MSN MoneyCentral (moneycentral.msn.com) and Multex Investor (www.multexinvestor.com) display the needed balance sheet information, but MoneyCentral combines goodwill and intangibles into a single number (Intangibles), saving you the step of adding them manually. Here’s how to do it using MoneyCentral.

Get a quote on MoneyCentral’s homepage, select Financial Results, click on Statements, and then select Balance Sheet from the dropdown menu.

Using homebuilder Standard Pacific (ticker symbol SPF) as an example, MoneyCentral listed $14.5 million in intangibles compared to $1,336.3 million of total assets, as of its December 2001 balance sheet. Dividing the two (14.5/1,336.3) yields a 1 percent GI/A ratio, so Standard Pacific is not a serial acquirer.

Not all acquisition-oriented firms disappoint their shareholders, and some firm’s intangible figures include other factors unrelated to acquisitions. But given the long list of busted serial acquirers, it pays to take that risk factor into account when researching investment candidates.
published 4/7/02