Book Reviews, Value Investing

Rollups By Their Very Nature – Billion Dollar Lessons

The rollups chapter from Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years by Paul B. Carroll & Chunka Mui

By their very nature, rollups are financial high-wire acts. If companies are purchased with cash, debt piles up. If companies are purchased with stock, the price needs to be kept high to keep the string of acquisitions going. Yet strategists often underestimate what relatively small changes in the business environment can do to rollups’ borrowing costs or stock price.

“Research says more than two-thirds of rollups fail to create any value for investors”

Who is that “Research” guys that appears so often?

Rollups Billion Dollar Lessons

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years by Paul B. Carroll & Chunka Mui

”This book is your chance to learn from others’ mistakes.”– Entrepreneur

In the 1960s, IBM CEO Tom Watson called an executive into his office after his venture lost $10 million. The man assumed he was being fired. Watson told him, “Fired? Hell, I spent $10 million educating you. I just want to be sure you learned the right lessons.”

There are thousands of books about successful companies but virtually none about the lessons to be learned from those that crash and burn. Now Paul Carroll and Chunka Mui draw on research into more than 750 flameouts to reveal the seven biggest reasons for business failure.

Size not always leads to purchasing power

Other dynamics can also be at work that make it impossible to assume that size equals power. Compaq Computer Corporation, though not a rollup, provides a stark example.

In the early 19905, no-name Personal-Computer Sta rt-ups were undercutting the prices of the giants, among them Compaq Computer. Compaq’s chairman, legendary venture capitalist Ben Rosen, wondered how that could be, given that Compaq negotiated so ha rd to get the best prices from component suppliers and should have far more purchasing power than the start~ups. He challenged the CEO, Rod Canion, who had been a seasoned computer-industry executive before cofounding Compaq in 1982 and who had done the seemingly impossible by taking leadership of the PC industry away from the once-untouchable IBM in less than a decade. Canion, a disciplined executive, had done his homework. He showed Rosen how Compaq’s component prices compared with those of IBM and other industry leaders and assured Rosen that Compaq was getting the best prices available. But Rosen, who financed Lotus Development Corporation, Compaq, and many other successful PC-industry start-ups, was suspicious.

Working without the knowledge of his friend Canion, Rosen put together a team that would pretend to be a PC start-up and would see what prices they could get. Meeting with suppliers in hotel rooms during the mammoth Comdex computer trade show in Las Vegas in November 1990: the team found it could handily beat the prices Compaq was getting.

Why? Because of the peculiar economics of the computer industry. Let31001: at Intel Corporation. To launch a faster generation of central Processor. Intel had to build a more advanced manufacturing facility. to allow for ever tinier electronics on the chips, produced in ever more sterile“ rooms. In those days, a new plant cost in the hundreds of millions of dolIars. (These days, the plants Cost billions of dollars each.)


Intel negotiated contracts with its major customers, such as Compaq, Intel included the cost of the plant in its calculations. Now, fast-forward a few months into the production of the new generation of chips. Intel has recovered all its fixed costs. It also has become far more efficient at manufacturing the new chips. Initially, almost all production is waste, but a few months later almost every one of these little masterpieces of electronics works perfectly when it comes off the line. Intel, which had negotiated a price of, say, $100 per processor, could now produce each chip for a few dollars. Intel was by now so efficient that it was making many more processors than its major customers had ordered. What to do? It could offer the excess chips at bargain prices to the major customers-but then it would have to cut prices on all the chips, and why do that? Or, Intel could sell the chips in hotel rooms in Las Vegas to start-ups at bargain prices-and still get a markup of five or six times the cost of production-without lowering the prices to big customers. The choice was obvious. The result was at odds with common sense: The companies with the least scale were getting the best prices. And this was true for all PC components: disk drives, memory chips, everything.

When Rosen showed the board that Compaq wasn’t close to getting the lowest prices for its components, Canion resigned.

These economics, by the way, can’t be dismissed as applying just to computers. They apply to some extent to all electronics products, as well as products with a significant electronic component. In addition, many other industries face versions of this when dealing with excess inventory and with the marginal costs of production. Whatever the particular situation, the point is: Claims of increased purchasing power are open to challenge.

You gotta dance

Once a company gets going on a rollup, it’s hard to stop. After you’ve promised Wall Street that you’re going to triple in size every year for the next five years, you can’t just say, “Oops, never mind.” Even if you have a good reason-you need time for integration and for due diligence on the next round of purchases, or the prices of acquisition candidates have become impossible-the drop in growth will hammer your stock, and your rollup will fall apart.

The problem is exemplified by a conversation relayed to us by George Churchill, a partner at our former firm, Diamond. The conversation was with the head of strategy at a rollup he was advising. The rollup had just reported a surprisingly strong first quarter in 2007, mostly because the benefits from a major deal kicked in sooner than expected, but the head of strategy looked glum. The conversation went like this:

CHURCHILL: “What’s bugging you?”

ROLLUP: “We need to raise expectations for Q2.”

CHURCHILL: “Why? I don’t see much more coming from [the major

deal]. Where are you going to find the growth?”

ROLLUP: “I have no idea.” A“,

CHURCHILL: “Then why raise expectations with the Street? Tell them you executed well, and maintain the same targets for Q2 and Q3 so you can continue on the original plan.”

ROLLUP: “We can’t tell them we no longer believe in the business!

The rollup did raise expectations and got a nice bump in the stock price. Six months later, the rollup acknowledged that it couldn’t meet those expectations. The stock fell below where it had been in the first place

We found that many rollups end in fraud

Thus executives may have incentives to take risks that investors should shun. The reason investors can get sucked in is that rollups often look great early on. The concept makes sense, growth is unbelievable, and problems haven’t surfaced yet. Those putting the rollups together may cash out before failure looms, so they make bundles while any investors who hold on too long lose their shirts. For instance, Jonathan Ledecky started numerous rollups that have an abysmal record, yet he has come away with what he estimates to be hundreds of millions of dollars and owns a big chunk of the Washington Capitals hockey team. (He has said the problems at the rollups came after he left an operational role or occurred at businesses where he was merely a passive investor. Responding to a class action by shareholders, he denied using any accounting trickery to boost a stock price and let him cash out before problems became apparent.)

Second, with rollups, investors shouldn’t always believe what they’re told. A certain amount of skepticism is, of course, called for when investing, but that’s especially the case with rollups, because-much to our surprise-we found that many rollups end in fraud. In addition to the fraud cases we’ve already mentioned, MCI, Philip Services Corporation, Westar Energy Incorporated, Tyco, FPA Medical Management Incorporated, IWP Incorporated, and many other rollups wound up involved with fraud charges.

Rollups have to keep growing by leaps and bounds, or investors disappear, and the financing for the rollup goes with them. Any sort of setback can derail the whole strategy, especially if acquisitions are made with stock; you can’t keep buying if the currency that you’re using, your stock, takes the kind of hit that high-growth companies take when they miss their goals. So, executives will sometimes go to any length-even fraud- to prevent reporting a setback.

We decided as a rule to avoid writing about situations where fraud 7 brou8ht a company down. There just isn’t much to say about fraud other than “Don’t do it.” But the link between fraud and rollups is strong enough that investors should be extra careful.

h/t Plan Maestro,

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years

Get our newsletter and our in-depth investor case studies all for free!