Preface: According to Urban Dictionary the phrase “make it rain” refers to: “When you’re in da club with a stack, and you throw the money up in the air at the strippers. The effect is that it seems to be raining money.”
My background is in buying companies, 100% of them. I believe this experience has helped me with buying stocks. It allows me to value the entire company as if I were buying it myself. If the market is selling a share of the company for less than I believe it’s worth as a whole, I’m a buyer.
One big difference between actually buying 100% of a company and buying shares in a company is control of the cash. If you buy 100% of the company you control the cash. If you buy shares, you don’t. This can be important if your approach, like mine, uses cash as a reduction in the purchase price.
Let’s look at Apple as an example. In this week’s earning announcement Apple showed $97 billion of cash and marketable securities on their balance sheet. They have no debt and as of yesterday’s market close their market capitalization was $416 billion. If you were to buy the whole company last night for $416 billion you would get that $97 billion of cash which would effectively reduce your purchase price to $319 billion.
The problem that I’ve run into several times with this approach is that I’m not actually buying 100% of the company so that cash may, and often is, spent on acquisitions that do not create dollar-for-dollar value. This means that the cash on a balance sheet is far from risk-free for most investors, including myself.
Here is a perfect example of this risk. There is a small publicly-traded company in Minnesota called Rimage (RIMG) that makes equipment for creating CDs. Their equipment can be found at your local drug store, the ones that burn your photos onto a CD. This is not a growth business by any stretch of the imagination. In fact, it is probably more of a cigar butt with a few puffs left since the storage of photos is quickly moving online.
If you were analyzing Rimage on October 9th you would have pulled up their latest 10-Q and seen $119 million of cash and marketable securities with no debt. The company made $1.2 million of after-tax net income that quarter and $6.8 million for the previous twelve months. Shares outstanding were 9.3 million and the stock closed at $12.83 resulting in a market capitalization of $119 million. That meant the enterprise value, the market capitalization less the cash, was $0. It was a free company using this approach. If you bought 100% of the company that evening for $119 million you could (theoretically) withdraw $119 million in cash from the bank accounts the next morning. You would have all of your cash back and still own the cigar butt of a company that made $6.8 million in net income.
If instead of buying 100% of the company on October 9th you invested your life savings in Rimage stock you would have had a rude awakening on October 10th. When you woke up on the 10th and glanced over the financial news you saw a press release reading “Rimage Signs Definitive Agreement for Acquisition of Qumu.” Your heart starting beating a little faster as you read the headline but you tell yourself it must be a small acquisition that would not require too much of the company’s cash. As a value investor who knows the track record of corporate acquisitions, your heart starts pounding like a drum when you read the first paragraph of the release:
“Minneapolis, MN - October 10, 2011 – Rimage Corporation (Nasdaq: RIMG), the industry-leading provider of on-demand CD/DVD/Blu-ray Disc™ publishing systems, today announced that it has signed a definitive agreement for the acquisition of Qumu, Inc., the leader in enterprise video communications. The acquisition provides Rimage with a strong presence in the rapidly growing video communications market with an established partner, serving 100 Global 1000 customers and generating strong revenue growth. The purchase price totals $52 million, consisting of $39 million in cash and one million shares of Rimage common stock. The transaction is not subject to any regulatory conditions or shareholder approvals and is anticipated to close within 24 hours.“
You keep reading…
“Qumu’s revenue has increased more than 45% per year over the past three years. In 2010, it generated $10.3 million in revenue and it is on track to achieve approximately $15 million in 2011. Based on current opportunities and expectations, Qumu is expected to generate approximately $21 million in revenue in 2012……… ”For 2012, the Company expects Qumu annual revenue growth to continue at greater than 40%. It also anticipates that Qumu will contribute slightly to cash flow in 2012.”
$39 million of your cash and 1 million new shares of your company were just used to buy a company that generates negligible cash flow today. To throw salt in the wound, management decided spending almost half of the market capitalization on an unprofitable company generating $10-15 million a year in revenue does not warrant a vote by the shareholders. By the way, the acquisition will close within 24 hours so there is not much of anything you can do to stop it.
Yesterday you owned a company with $119 million of cash generating almost $7 million of after-tax earnings and today you own a company with $80 million in cash that is still generating $7 million of earnings. On top of that you own 10% less of the company since management issued 1 million new shares to the seller. That “free” company is no longer free since you can no longer withdraw $119 million. Since you can only withdraw $80 million the cigar butt now costs you $39 million to acquire. If you count the newly issued shares it’s closer to $60 million. You are now paying almost 10 times earnings for a cigar butt that you thought was free just because your management team “made it rain” on an acquisition. They threw your money at the
I don’t know how this acquisition is going to turn out. It might be a great deal for Rimage. The travesty here is that management spent $39 million of your cash without asking. They should be fired for this move in my opinion but they won’t. Most shareholders don’t view this cash as theirs so when management uses it without asking it’s not an issue.
This example illustrates the dangers of treating cash as your own. In general, don’t do it unless management also treats the cash like it’s yours, not theirs. It also illustrates how little of a voice shareholders have with some of today’s management teams. Management knows that they can get away with this and they do. Shareholders need to rise up together to stop management from looting your companies. If management does not like that approach, they can take their value-destructing behaviors elsewhere.
Here are three ways to protect you from getting burned by treating cash as a reduction in purchase price.
- Invest in companies where management has real skin in the game in the form of shares, not options. If part of that cash really does partly belong to management it will be handled with care.
- Discount cash if you don’t completely trust management with it. For example, instead of using $119 million of cash you could apply a 35% discount and count only $77 million in your valuation of the company. This provides a margin of safety against bad management.
- Consider the implications of repatriating the cash back to the company’s home country before it pays a dividend. International companies will hold the cash they’ve made overseas to minimize their tax burden. This “trapped cash” can only be used overseas to fund those operations. If it is brought back to the home country it will be taxed which will reduce the amount available for dividends. Apple’s $97 billion of cash would be less if they brought it all into the U.S. today. Your purchase price adjustment should reflect this. In general, companies do a poor job of disclosing this trapped cash and the implications of repatriating it.
Disclosure: I have no ownership in the companies mentioned in this post. (Thankfully, I have never owned Rimage. I never will with this management team.)