Welcome back to the small-cap X-files. In last week's episode, I showed you how an astute investor would have sold shares of Plantronics (NYSE: PLT) based on three classic warning signs. Today, I'd like to share another small cap (mis)adventure with you.
The year was 1999. The company was Koala Corporation (Nasdaq: KARE). Koala Corporation makes those cute Koala Bear Kare baby changing tables that you see in restrooms at restaurants, malls, and other public areas.
While it never made the Foolish 8 list, Koala certainly had all the attributes of a small-cap growth stock. The company had a big year in 1997, with sales growth of 52% and gross profit margins just shy of 60%. It also had no debt, and cash from operations exceeded net income by a large amount for the full year 1997.
Koala was founded in 1987 with a better idea for a diaper changing station, and business took off. By the early '90s, the company had added new products such as child protector seats and high chairs. In an effort to diversify the revenue stream and generate some new growth, it eventually added children's activity products --acquiring Activities Unlimited in 1996 -- designed for use in commercial waiting areas, as well as modular indoor play equipment for fast-food restaurants and shopping malls. Still, at the end of 1997, the baby changing stations accounted for the majority of the company's revenue. Koala obviously needed to do something radical.
Management decided on an acquisition strategy: It would grow by buying businesses that fit its "family-friendly" theme. In 1997-98, Koala acquired two modular play equipment makers: Delta Play and Park Structures. By the end of 1998, the baby changing station represented less than half of Koala's sales and the 10-K articulated that the company had established a "formal acquisition program... as a means of adding complementary businesses and product lines."
The company still had a tiny market capitalization of about $50 million when I purchased shares at $19 each -- or about 15 times 1998 earnings -- in January of 1999. Here was a company growing sales at 52% and earnings at 28% per year -- how could I go wrong paying only 15 times earnings?
In hindsight, it's clear that the company's changing table business, simple though it was, had some fantastic economic characteristics. Profits were high and cash flow was excellent. In contrast, the modular play equipment business had much lower profits and was much more capital intensive. Even before the impact of the Park Structures acquisition, Koala was tying up almost twice as many assets in the modular play business as in the convenience and activity products business -- for less than one third the profits.
Koala's convenience/activity products business was generating 30% operating margins and a return on assets of around 25%. The modular play business, on the other hand, generated operating margins of 14%, and the assets showed returns of less than 5%. In addition, as the baby changing stations gradually became a smaller part of the business, Koala's profit margins dropped from 64% in 1996 to 54.8% in 1999.
In 1999, Koala acquired two more businesses: Superior Foam & Polymers, a maker of children's foam activity products for amusement and water parks, and Smart Products, a manufacturer of child safety and parental convenience offerings. By the end of 1999, sales of the baby changing station accounted for less than one quarter of the company's total sales.
By 1999, all those acquisitions were really juicing sales. Revenues jumped 94%, to $37.1 million, and net income grew 64.1% from the previous year. In October, the company did a 2-1 stock split. Forbes magazine included Koala in its annual 200 best small companies list for the fifth consecutive year. The shares soared. Unfortunately, diluted EPS grew only 30%, and cash flow had begun to underperform net income. More importantly, the company's cash balance was only $173,000 at the end of 1999, and a short-term credit line was tapped for a $13.9 million loan.
I sold in April of 2000 after noticing that cash had dropped to almost nothing, and short-term debt had increased to $31 million. Despite impressive revenue growth of 57.3% and net income growth of 33%, diluted EPS increased only 26.6%. There was a happy ending of sorts for me, as I was rewarded for a poor investing decision with a 33% gain in about a year. The market cap was then around $85 million.
Things went rapidly downhill from there. Koala made two more acquisitions in 2000 and sales continued to grow rapidly, coming in at $59.7 million in 2000, up 60% from the year before. But earnings per share actually declined by 25% and the company -- with virtually no cash -- had amassed almost $40 million in debt.
As of yesterday's close, Koala shares had lost 72% of their value in the last year, and had entered penny-stock country. The market cap is down to $27 million. I'm sure that there are still many Koala investors simply shaking their heads and wondering what happened.
In a nutshell, what happened was the natural result of Koala's management continuously giving away portions of a good business (the changing stations and related businesses) in return for businesses of vastly inferior quality. Warren Buffett, in writing about acquisitions, always cautions that in a trade, what you give is just as important as what you get.
Let's run through Koala's acquisition scorecard and see what it forfeited and what it gained:
- In June 1997, Koala paid $5.3 million (about 13.9% of its value) in cash and stock for Delta Play.
- In December 1998, Koala paid a total of $19 million in cash and stock for Park Structures, a company with $10.6 million in 1998 sales and income of $2.8 million. Koala's business was then valued at $48.5 million, so it gave away value equal to 39% of the company to acquire Park Structures. In part to raise money for the acquisition, Koala did a secondary offering that resulted in share dilution of about 15%.
- The March 1999 Superior Foam acquisition cost about $6.2 million in cash and stock -- 10.7% of Koala's value.
- In September 1999, Koala bought Smart Products for $1.3 million in cash, or about 1.5% of Koala's valuation.
- In March 2000, Koala acquired SCS Interactive for about $23.6 million in cash and stock, or 26.8% of Koala's market cap.
- In August 2000, Koala acquired Fibar for a total cost of about $6.4 million, or 7.2% of Koala's total valuation.
In total, Koala gave away value of somewhere near $68.8 million. In return, it received a bunch of businesses that, in aggregate, produced about $37 million in sales and $3.5 million in operating income in 2000. The pre-tax return on assets of those businesses was likely in the area of 6%.
Koala investors had a lot of time to see this coming. If they had been carefully watching the business, they would have seen the warning signs of shrinking profit margins, sales growing much faster than earnings, and debt mounting rapidly on the balance sheet.
Despite the company's problems, Zeke Ashton still has a soft spot in his heart for that cute little Koala Bear Kare logo. Zeke does not own shares of Koala, but he does hold stakes in Berkshire Hathaway. The Fool is investors writing for investors.