There are many ways a company can grow. It can do so organically, by expanding its products and services and hence its sales, or it can do so externally, by making acquisitions. There's a lot to be said for both methods, and companies many times try to do both.
The growth-by-acquisition strategy, though, is fraught with danger. A company can make an acquisition that doesn't fit; think AT&T (NYSE: T ) when it took over Excite.com, and you'll see what I mean. Peter Lynch called it "de-worse-ification." Or maybe it overpays for the acquisition. Or the acquisition doesn't perform up to snuff. Acquisitions also can add a lot of debt to a company's balance sheet. And since deals are often done as a mix of debt and equity -- doling out shares to the acquired company's management -- it can dilute the stake in ownership of current shareholders.
Zeke Ashton gave a stark illustration a few years ago of how a good company can ruin itself by failing to heed Lynch's warning. A company I own is a current illustration of the growth-by-acquisition philosophy. Sporting goods manufacturer K2 Inc. (NYSE: KTO ) has been on a tear in recent years, buying up competitors and reflecting CEO Richard Heckmann's philosophy of consolidating the sporting goods industry under one roof. He did it when he headed US Filter, chewing up some 260 companies throughout the 1990s before allowing the company itself to be swallowed by Vivendi (NYSE: V ) in 1999.
By acquiring these companies, Heckmann has collected an assortment of sporting goods brands that are well-known, established, and respected: snowboard maker RIDE, baseball equipment company Rawlings, outdoor apparel maker Ex Officio, and more. Over the last two years, he's gathered under the K2 banner more than a dozen companies. Yet he's also added to K2's debt load, up 25% last quarter from the previous year, while doling out millions upon millions of new shares. The company currently walks a fine line; it still has some $18 million in cash in the bank, and it has taken a breather from its spending spree that has allowed insiders to buy up shares on a recent price dip.
To tell whether your company is a serial acquirer, you could read through the financial statements as companies spell out recent acquisitions they've made. But an easier way is to simply look at the balance sheet for a line item labeled "goodwill" or "intangibles."
When a company buys another, it pays for all the acquired company's machinery, plants, and other various hard assets. But it also pays for things that are hard to put a price on, such as brand recognition. If Home Depot (NYSE: HD ) wanted to buy Coca-Cola (NYSE: KO ) , it would be able to put a price tag on all the machinery that went into making the bottle of soda, but it would also be paying a lot for having one of the most recognized brand names in the world. That's the "intangible" related to the sale, and it shows up on the balance sheet under "goodwill." Simply put, goodwill is the difference between the amount paid for a company and its book value.
I use a Goodwill to Assets ratio (G/A) to determine whether a company is a serial acquirer. To calculate the ratio, I go to Microsoft's (Nasdaq: MSFT ) MoneyCentral website, as they add together goodwill and intangibles into one line item on the balance sheet. Then it's simply a matter of dividing Goodwill (on MoneyCentral the line item is "Intangibles") by Total Assets to get the G/A ratio.
K2 has intangibles in the last quarter totaling $271.8 million and total assets of $887.6 million for a G/A ratio of 30.6%. Anything greater than 10% and the company is at least partly financing its growth through acquisitions. Not everything included in intangibles will be an acquisition, but there is enough of a precedent to make the analysis worthwhile.
Here is a list of companies that grow organically and a list of those growing through acquisitions:
||Growth by Acquisition
||Proctor & Gamble
Also be leery of a company that makes an acquisition that is quite large in terms of sales or market cap. If the acquisition, or a series of acquisitions, is at least 25% as large as the acquiring company's original size, take a hard look at your investment. Swallowing a company that large can only give you indigestion.
There can be good reasons to acquire a competitor. K2, I think, has thus far made a compelling case for the acquisitions it has made. Still, I'm keeping a close eye on the situation. Too often serial acquirers go awry and turn into serial murderers of investments. Use this simple test to keep them at bay from your portfolio.
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Fool contributor Rich Duprey is a serial drinker of Coors Light. He owns shares of K2 but does not own any of the other stocks mentioned in this article.