In 2016, Wesfarmers (ASX:WES) raised the eyebrows of many investors when it expanded into the UK and Ireland hardware business. Two years later and $1.7 billion down on its investment, WES has decided to pull out. It shows yet again why growth through acquisition can be a risky strategy.
As expected, Wesfarmers has announced its decision to exit its ill-fated expansion into UK and Ireland hardware retail. Wesfarmers entered the market through its 2016 acquisition of Homebase for £340 million (A$665 million). From the time of the initial capital outlay for acquisition in February 2016 and over the following 22 months to the end of calendar 2017, the company recorded pre-tax losses in its income statement totalling A$1.184 billon. On an after-tax basis, Homebase generated cumulative losses of around A$1.2 billion including the asset write down taken in the first half result. On top of this, sell side analysts expect WES to record another A$80-100 million of operating losses in the second half of the 2018 financial year, on top of the company’s estimated £200-230 million loss (A$355-405 million) on sale of the business to Hilco on 30 June 2018.
This brings the total amount of shareholder capital lost from Wesfarmers misadventure to around A$1.7 billion or A$1.50 per share over 28 months.
Following this announcement, there are likely to be numerous press articles deriding management for this investment and calling for accountability. While an understanding of how this occurred is important, it’s also important that recriminations do not lead to a dramatic increase in conservatism in capital investment. Equities are risk assets, but with that risk comes higher returns.
At Montgomery, our investment philosophy focuses on identifying shares in high quality businesses that can be bought at attractive prices. One of the key attributes of a high quality business is that it is able to redeploy capital at high rates of return in order to drive earnings growth in future periods.
While a growing earnings stream is valuable, not all growth is equal. The value of growth is determined by the amount of capital the company needs to invest to fuel that growth. The lower the amount of capital a company needs to reinvest to generate that growth, the more valuable the growth is to shareholders. Or in other words, the higher the marginal rate of return a company can generate on reinvested capital, the more valuable the resulting earnings growth will be.
This is because if a lower amount of capital can be reinvested to generate a given rate of future earnings growth, it leaves more capital to be returned to shareholders in the form of dividends. Alternatively, it provides additional capital for reinvestment into other growth options.
The issues faced by Wesfarmers in the UK highlight that the value and risk associated with reinvestment for growth is not equal. Some reinvestment generates higher value at lower risk than others. While a broad generalisation, reinvestment for organic growth is more attractive than acquisition driven growth.
Organic growth refers to reinvestment in a company’s existing operations. For example, increasing production capacity or investing in the internal development of new products. Reinvestment can also be undertaken through operating expenses, reducing earnings growth in the short term to generate a longer term benefit. An example of this would be a company increasing the size of its sales team or employing people with new or enhanced skills.
Acquisition based growth tends to be more lumpy and larger scale, although it can also be represented by smaller scale acquisitions in what is known as a bolt-on acquisition strategy. Capital invested in acquisitions tends to generate a lower rate of return than investment in organic growth. This is because the acquirer generally needs to pay the seller of the business a price that exceeds the investment they have made in the assets of the business themselves. The amount paid in excess of the amount invested into the business by the previous owner is referred to as the intangible portion of the acquisition price.
Clearly, if one company is generating growth by investing in its own assets, it is likely to have a marginal return on capital that is greater than a company that is acquiring its growth by buying other businesses. This is because acquisitions not only pay for the investment in hard assets like property, production plants and working capital, but also include a premium in the form of intangible asset value. To offset the higher investment per dollar of acquired earnings, companies will generally rely on synergies between its existing and the acquired businesses to boost the net return generated.
Not only does acquisition driven growth tend to generate lower returns, but it also comes with added risks. Two such risks are cultural and disclosure based. While the synergy opportunities might appear logical on an investment banking white board, the respective cultures of the two companies that are merging are a critical factor in determining whether these benefits will be realised. Customer response to the merger is also important.
The UK example for Wesfarmers highlights the risk in paying large amounts for goodwill when the acquirers value add to the business is limited. It also highlights the risk in deploying capital through acquisitions into new markets. Wesfarmers is just the latest in a large number of Australian companies that have had to learn the hard way that their success in Australia is not necessarily due to their capabilities, but more because they are a big fish in a small pond. Incumbency is a powerful position to hold over smaller competitors. But when the model is taken to a new market where the company doesn’t have this market position, it exposes the true determinant of its strong performance in the domestic market. Such has been the case for Bunnings in the UK.
When valuing the prospects of a company, it is not only important to assess the size of its earnings growth opportunity, it is equally important to assess the quality of its growth. A good place to start is differentiating between the value of organic versus acquisition driven earnings growth strategies.
The Montgomery Funds own shares in Wesfarmers.
Stuart is the Portfolio Manager of The Montgomery [Private] Fund – a concentrated, All-cap Australian equity fund that aims to achieve absolute returns from a portfolio of long only Australian shares and cash. Capital preservation is paramount.
Excellent article Stuart