Sunday, June 03, 2007

Projecting Growth - Not as easy as it seems

True be told, I didn't really know how to title this post, so I just left is as "not as easy as it seems" ! The main crux of this post is to explain how growth works for a company and how many people may over or under-estimate the growth of a company's revenues (top-line) and earnings (profits or bottom-line).

First, the basics. Growth of a company is what drives its top and bottom line to better performance every quarter/half-yearly, and this in turn drives up its share price as share prices are correlated to the valuation of a company (based either on DCF, PER or Sum of parts analysis). When we say "growth", it's not just growth based on recycling cash or capital, but also to grow owner's earnings based on actual increases in sales or through yield-accretive acquisitions. This is where it gets murky....some companies claim superlative growth over a period of 2-3 years but sometimes this is at the expense of shareholders. Some companies over-leverage and cause their debt to mushroom using growth as an excuse, while others do endless placements and/or rights to increase their equity base and further dilute existing shareholders. Thus, there is "growth" but this does not add to shareholder's value.

Strictly speaking, growth consists of 2 types: organic and through acquisitions. Organic growth works for most companies, in which they expand their customer base, get more sales and make more money ! While it may sound deceptively simple, growth does not come easily as most of the time, expanding customers and entering new territories incurs higher costs and there may be significant barriers to entry. From a marketing perspective, entering new markets or expanding existing product lines always carries a certain risk: that of lower sales and higher costs. Thus, be very careful of companies which claim to increase their production capacity, because this may not always mean higher sales and higher profits. In fact, increase of production should come with increased demand and the manufacturer should have a certain level of pricing power. Otherwise, as the market for the product matures, more entrants come in and drive down prices through competition. The result is that the capacity increase will come at a high cost: that of declining margins. Frequently, I have seen companies in "commodity" industries such as chips and PCB boards suffer from declining profits even as their sales grew. This is due to the margin erosion effect which cannot be effectively eliminated through economies of scale.

The other option is for a company to grow through acquisitions. One immediate example is Olam International Limited, an SGX listed company which deals with the SCM business of distributing foodstuffs ike peanuts and coffee beans. They are vertically integrated and cover the entire supply chain of production, distribution and selling. Recently, Olam was involved in a tussle with Louis Dreyfuss to buy over Queensland Cotton, with the bids getting increasingly higher at A$5.80 per share. The outcome is as yet unknown but one must ask: what price does Olam have to offer to make the deal unattractive ? The problem with growing through acquisitions is that a "fit" needs to be obtained. Frequently, acquisitions or mergers involve staff from different companies with different cultures, which may result in problems. Take the example of Daimler-Chrysler in which the Chysler unit was never profitable after the merger (it was eventually sold off just recently). Other notable Singaporean examples include Osim's acquisition of Brookstone which has dragged down the company due to the high debt financing the company had to undertake, coupled with losses incurred in the USA-based unit. Growth through acquisitions is therefore fraught with risks and uncertainties and I do not understand why shareholders get so amazingly excited when an acquisition is announced, as the merits of the acquisition have to be reviewed objectively before one can conclude if it is indeed "great news" for the existing shareholders.

Growth which is too swift also tends to fizzle out after a while. A lot of companies can report superb earnings growth for 1 year, maybe 2; but how many can consistently grow their earnings over a period of say 5-10 years ? The volatile nature of business these days means that shareholders are stepping on a minefield when it comes to expecting growth every quarter. Take UTAC for example, after 14 consecutive quarters of growth, it suffered its first quarterly decline in revenue of 2.4%. This is due in part to the uncertainty and cyclical nature of the industry. A shareholder thus has to sit back and think about the business: will it be able to sustain a consistent growth track record over a long period of time ? If not, then value investing dictates that this may not be a good long-term investment. The ability of a company to weather the storms depends on the nature of its business, its Management as well as the competitive advantage it commands.

For myself, I go for companies with consistent growth rather than superlative short-term growth. Examples I can think of are Pacific Andes and Boustead. Pacific Andes has steadily increased their revenues and profits through a series of acquisitions, as well as organic growth (though at the expense of higher gearing). Boustead has a 5-year track record of increased revenues and earnings ever since CEO F.F.Wong turned the company around in FY 2002 by selling off unprofitable units and steering and focusing on the company core competencies. His strategic vision has also, in part, contributed to the strong and steady growth of the company. These are companies which I feel comfortable investing in for 3-5 years, and which are more likely to survive a recession should one come along.

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