FOOL ON THE HILL
Why I Like Organic Growth

Some of the biggest growth stories in the last decade were actually "growth through acquisition" stories. Bill Mann prefers that companies show proof that they are growing internally as well. Why? Because some acquisitions make companies seem like they are growing faster than they actually are.

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By Bill Mann (TMF Otter)
February 23, 2001

The title of this article should really be, "Why I Like Organic Growth, and Why I Prefer Acquisitions Be Done for Cash, All Things Being Equal."

But that doesn't exactly roll off the tongue, does it?

First of all, let's set some definitions. Although "organic growth" sounds like a nasty fungus upon which to sic some Desenex, it really means a company is growing by expanding its existing business rather than through mergers and acquisitions. A company that grows its business without constant acquisition is one I prefer to hold as an investment. 

If a company needs to continually use its stock, cash, or debt to bring in different components and spur growth, there arises a difficulty in determining how much money is being created by each investment dollar. I'm not opposed to acquisitions, but they require lots of additional work for me to understand the business; For the sake of my own laziness, I like companies with a history of growing their internal businesses.

Methods of merger love
For those companies that do acquire, however -- and I own a few of them -- I prefer that they do so with cash. My second-favorite means is stock, and my least-favorite is debt.

The latter strategy has absolutely murdered AT&T (NYSE: T), which currently has a debt load in excess of $60 billion due to its numerous takeovers of the 1990s. There are certainly benefits to using richly valued stock as currency for acquisitions, but it can badly skew a company's earnings growth rate -- particularly if the pooling of interest accounting method is used.

According to U.S. Generally Accepted Accounting Principles (GAAP), there are two methods of accounting for acquisitions: purchase and pooling. Richard McCaffery (TMF Gibson) recently did an excellent job describing them, so I'll crib from him here:

"Under the purchase method, any premium paid in excess of the acquired company's book value that can't be assigned to a category of intangible assets (such as patents) gets recorded as goodwill. Companies don't like this, since goodwill has to be amortized, which means its gets deducted from earnings. Under the pooling method, the balance sheets of the two companies are combined, no goodwill is created, and net income isn't reduced by periodic amortization expenses. Lots of companies use the pooling method when allowable, for obvious reasons -- they don't want to see net income reduced as the by-product of a big acquisition."

(I know accounting arcana does not make for inspiring reading, but for any investor who wants to have an even marginal chance of succeeding in stock picking, this stuff is important. This is the language of business. Learn it.)

There are a few other risks. Management that is innovative and daring as an acquirer isn't always as dynamic in an operating environment. Management may have been terrible all along, but the growth the company had enjoyed by buying others masked underlying weakness. I'll show a simplified model describing how, through perfectly legal means, a company can show enormous growth simply by acquiring others.

How 1+1 can equal more than 2
TMFTeeTime's Mature Golf Balls Inc.
(Ticker: SLICE) is one of many players in the growing used golf ball industry. It just so happens that the company earned $10 million in 1998, and was growing at a 12% annual clip. The market, being somewhat efficient, valued TeeTime at 15x earnings, which were, conveniently enough, $1 per share.

TeeTime's owner -- let's call him Todd Lebor -- recognized an opportunity for consolidation within the business. But before he hatched his fiendish plan, he began promoting his company to analysts and investment banks, letting it be known that he MAY be farming out some fee-generating business in the near future. So the analysts chat up TeeTime stock, and what do you know? All of the sudden, it is priced at 20x earnings.

At this time, TeeTime announces an acquisition of Broken Shaft Recovery Co. (Ticker: DIVOT), a competitor which also was growing at 12% per year, and earned $5 million, or $1 per share. TeeTime makes the acquisition with stock.

Before the deal, TeeTime's financial statement looked like this:

Earnings:                    $10,000,000
Shares outstanding:           10,000,000
EPS:                         $1
Price/Earnings Ratio:         20
Share Price:                 $20
Market Capitalization:       $200,000,000

And Broken Shaft's:

Earnings:                    $5,000,000
Shares outstanding:           5,000,000
EPS:                         $1
Price/Earnings Ratio:         12
Share Price:                 $12
Market Capitalization:       $60,000,000

Since TeeTime's share price is high, it pays for Broken Shaft with stock. And to sweeten the deal, TeeTime offers a 50% premium, or $18 per share, to Broken Shaft shareholders. This means that for every share of Broken Shaft, investors would get 18/20, or 0.9, shares of TeeTime. The deal gets done, and the combined company grows at the same 12% per year as both did before (were it ever so easy as this!).

Here are the earnings for the end of the year:

Earnings:      ($10m * 1.12) + ($5m * 1.12) = $16.8 million
Shares outstanding:           14.5 million
EPS:                         $1.158
Price/Earnings Ratio:         20
Share Price:                 $23.17
Market Capitalization:       $335,000,000 

How'd Lebor do that? He grew earnings per share by 15.8%, even though organic growth was only 12%! And because the investment bankers had continued to talk up the leadership of TeeTime in the used golf ball sector, the stock remained priced high, so Lebor was able to give his shareholders a price appreciation of 15%. Not bad.

Unfortunately, eventually real earnings must support a stock price. This acquisition was done with a bastardized version of pooling accounting, in which the "goodwill" -- or premium paid by TeeTime -- is ignored, as the balance sheets are simply combined and thus no earnings-reducing amortization charges need be recorded.

Some of the big acquirers of recent years are suffering mightily today. Bernie Ebbers, the head of WorldCom (Nasdaq: WCOM), used his company's stock to make scores of acquisitions, growing a tiny carrier from Mississippi into the monster that swallowed MCI whole in the span of two decades. Then, this past year, regulators blocked WorldCom's proposed takeover of Sprint (NYSE: FON).

The problem here is that WorldCom has always grown through acquisition; it would be next to impossible to even make a case for any organic growth having occurred under Ebbers' reign. But now there are no more companies WorldCom can buy that will make a difference, so it's  reached the logical end of its growth-through-acquisition strategy. And suddenly there are many doubters in Ebbers' ability to run an operating company at all.

Other companies are suffering similar fates. First Union (NYSE: FTU) was a dynamite acquirer of other banks but has had a bear of a time ingesting CoreStates, its biggest conquest. JDS Uniphase (Nasdaq: JDSU) has a fantastic product line, but it is nearly impossible to tell how fast it is really growing since it acquired more than 20 companies in the last year alone. We will soon find out, however, as the regulatory oversight of its recent SDL acquisition gives the impression that JDSU is also at the end of the road for sizable acquisitions. Finally, there's Revlon (NYSE: REV) Chairman Ronald Perelman, who has taken over several companies and has provided little in the way of return for these expenditures.

Albert Einstein once said, "Things should be made as simple as possible, but not any simpler." So it is with investing. A glance at earnings per share may not accurately depict a company's performance over any period. For those who own acquisitive companies, the process of evaluation holds a few added snares that should not be ignored.

Got a take?
Come share it on the Fool on the Hill discussion board. Have a great weekend!

Fiat Fool!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann eats shrimp heads. At the time of publishing, Bill had beneficial interest in First Union. His stock holdings can be viewed online, as can the Fool's disclosure policy.