Valeant (VRX) Chess and The Investment Game
I like to play chess. I am not particularly good at it, but I enjoy it. After my not infrequent losses, the app I play sends me offers to go from Beginner to Chess Master in 5 years. I have no idea what a Chess Master is, but I was impressed to see an offer for something that might take 5 years. In contrast, every weight loss magazine at the grocery store promises me I can lose 15 lbs in 2 weeks. Why can’t I be a Chess Master in 2 weeks?
In the investment world, I consider highly acquisitive companies on the same playing field as grocery shelf magazines. They are peddling something for sure, I just don’t think I want to buy it.
As noted in the following article, 2015 will be the largest year for total acquisitions ever:
A series of 112 deals announced that day involving little-known companies like China’s Zhejiang IDC Fluid Control Co. and Shanghai STO Express Co., which agreed to combine, added up to $8.5 billion and pushed global M&A volume to $4.304 trillion, data provider Dealogic said Thursday. That pushed 2015 to date ahead of 2007’s total, when the previous record of $4.296 trillion of mergers was struck.
In all, buyers this year have agreed to nine transactions valued at $50 billion or more and 58 valued at $10 billion or more, which both would be records.
Given the record pace of M&A in 2015, it might be a good time to discuss some potential pitfalls or areas of concern for highly acquisitive companies using a few examples from 2015. In theory, there is nothing wrong with highly acquisitive companies. It has occasionally worked. However, I would much prefer to see a company grow organically over a multi-year period than “roll-up” the industry in a very short time. There are a few things that typically go wrong with highly acquisitive companies.
- Acquisitive companies are often dependent on the capital markets for equity (using their high stock price as currency) or debt to pay for their acquisitive targets.
- Multiple acquisitions in short time frame present a murky year over year comparison in a company’s financials in a way that often allows a company to paper over problems within its core operating units. Worse, it present management with the chance to massage the earnings to show a consistent organic growth story (i.e. excluding routine operating expenses as one-off merger-related expenses) when instead new acquisitions may be offsetting the declines in the core business.
- If executives in a specific industry begin an aggressive roll-up strategy, the prices being paid for the targets become more expensive. This typically happens when the pool of potential acquisitions targets begins to get smaller as the acquirer grows. The fewer targets available means that most target companies catch on that if X company wants to grow in this industry, then our company is one of only a handful of acquisition targets and therefore we are going to demand a higher price.
None of these points are particularly ground-breaking. Most sophisticated investors buying into a “roll-up” understand that these are the risks, but are seduced by the growth in revenues, which typically mirrors a similar growth in the stock price. I presume they believe they can get off the train before it stops (or goes off a cliff) or believe that “this time/company is different.”
So far, this year (2015), we have seen the following acquisitions stories unravel:
Valeant (VRX) is perhaps the poster child for all three problems, having created the perfect storm in 2015.
Valeant’s growth has been almost entirely fueled by debt (roughly $40B in new debt over past 5 years) with stock issuance as a helpful contributor (share count has risen 76% since 2011 from 196m shares to the current 346m shares). On October 30 of this year, VRX’s ability to access to the capital markets was effectively suspended when S&P downgraded Valeant’s debt.
Leading us to point numbers 2 and 3. Valeant’s entire model has been built on acquisitions leading many to question whether merger-related expenses are being used as a smokescreen for ongoing operating expenses. Furthermore, in the same category as accounting shenanigans, there is a question mark on whether the acquisitions contain durable assets that continue to grow organically post-acquisition or whether revenues from new acquisition hide the decline in the revenues from past acquisitions. John Hempton, Jim Chanos, James Grant and AZ Value have all made similar arguments.
Throw in an “undisclosed” Valeant operating unit (Philidor) with a suspect purchase option agreement, and you have all the makings of a huge stock decline, over 70% in less than 4 months.
XPO Logistics: Bradley Jacobs roll-up of the logistics brokerage segment became muddled this past year when his asset-lite company made headlines with the purchase of lots of assets (Con-Way). XPO suffered from a few problems listed above. Shares outstanding increased from 8 million shares in 2011 to 82 million at the end of 2015. Additionally, long-term debt went from zero to $592m over that same time period. But, what really shocked the market in 2015, causing the stock to decline over 50%, was Jacobs purchase of Con-way, which is a traditional asset-heavy logistics business (Con-way owns their trucks). I suspect that Jacobs was unable to find suitable (financially) acquisition targets in the asset-lite space, however, this is almost certainly the result of him bidding up the assets. So, instead he turned to an asset heavy company whose valuation appeared better, however, that changed his vision for the company in a way that he didn’t adequately express in advance. I am not sure better story-telling would have solved the problem because once a few people believe the train has stopped, the exit becomes very crowded. The stock nose-dived over 50% following the deal, and it is probably safe to say that XPO is temporarily out of the acquisition game until Jacobs can restore confidence in his vision.
Kinder Morgan and Sun Edison may appear wildly different, but they are both the same version of a simple “yieldco” scheme that has been successful until it was not. A typical ponzi scheme will take in cash and pay out earlier investors a “return” on their investment with the new money. No assets are typically bought. Continually finding new investors is a prerequisite to this scheme and when the new “suckers” stop, so does the entire scheme. A slightly more legal version is a yieldco structure in which a company is able to sell its stock for inflated values and buy assets at prices/valuations below the price it is able to sell its stock. It is able to do this because it has convinced a certain group of investors (mainly retail and retirees) that the dividend it pays out is similar to a bond or a CD and should be valued accordingly. However, as soon as the valuation of its stock makes it impossible to sell more stock (and therefore make it impossible for the companies to buy new assets), the scheme unravels. The difference between a ponzi scheme and a yieldco structure is that Kinder and Sun Edison did buy real assets, but those assets were never worth the value of the stock they were selling to the public. Kinder’s stock has fallen over 65% and Sun’s is down over 90%, thus making it impossible for them to keep up the game.
The main lesson I take away from the 2015 “platform” story (Bill Ackman’s euphemism for “roll-up”) is that companies that have good returns will deliver value over a long period of time. Roll-ups that try to pull that time-period forward typically fail for a variety of reasons, some of which I outlined above. Just like weight-loss or learning to play chess, building a great company takes time. People often group Berkshire into this discussion of “acquisitive” companies, but the main difference is Buffett never set out to be X size in Y amount of years. He let the value build slowly, allowed the opportunities to come to him, instead of aggressively bidding up assets values to the point where returns could only be generated through aggressive financial engineering.
This is a good chart of Buffett’s net worth. It took him over 50 years to get to his first $1 billion in net worth (inflated adjusted), but from age 56 to roughly 85, that number moved to $72B. Wealth, value, and many other things take time. An apt quote from Buffett summarizes this principle well: “You can’t produce a baby in one month by getting 9 women pregnant.”
*Note: Two companies that fit the bill above, but haven’t fully stumbled are ACHC and EXAM.
Chess and The Investment Game by Matt Brice, The SOVA Group