Networking Industry A New Way to Listen to the Music: ROIC by Paul Silverstein, Paul Johnson, CFA & Ara Mizrakjian – Robertson, Stephens & Company
- Over an intermediate to long-term investment horizon, an investor’s primary focus should be value creation—how much economic value has been and will be created from the funds invested in and deployed by a company.
- Return On Invested Capital (ROIC) is a superior quantitative touchstone with which to assess value creation. We believe ROIC to be an important guide to a company’s future prospects for value creation and to be significantly more informative than traditional investment heuristics—EPS, EBITDA and ROE—which can be misleading indicators of value-creating industries and companies, in our opinion.
- Confirming our belief that the networking industry is in the early stages of what we believe to be a relatively long investment cycle, the industry continued to generate an exceptional ROIC throughout the past 11 calendar quarters.
- 3 of the 12 companies we follow in the networking industry achieved an ROIC in excess of 100% over the four-quarter period ending in the third quarter of calendar 1996; 5 of the 12 companies exceeded 60%; 9 exceeded 35%; and 10 exceeded 25%. These 12 companies collectively achieved an aggregate ROIC of 62% during this same period.
- Benefiting from both industry consolidation and high barriers to entry, the industry’s leading vendors are well positioned to reap the lion’s share of the billions of dollars to be invested in building advanced networks, and should be able to maintain their extraordinary levels of profitability, over the next decade, in our opinion.
- Largely by avoiding competition with Cisco and the other leading networking vendors, a number of smaller, younger networking companies—Ascend, PairGain and VideoServer in particular-have achieved impressive levels of ROIC by successfully gaining “first mover advantage” in their specific market segments of the networking industry.
Value Creation Is King
Traditionally, guided by security analysts and the financial press, investors have focused on reported earnings as the single most important investment criteria in evaluating a corporation’s operating performance and investment merit. In recent years, an increasing number of academic scholars, analysts and investment managers have turned to free cash flow as a more accurate analytical tool to assess operating performance and to project future stock prices. We believe, however, that both of these measures have serious shortcomings as effective investment guides.
We instead propose that over an intermediate to long-term horizon an investor’s principal investment criteria should be value creation—more specifically, how much economic value is being and will be created from the funds currently and prospectively invested in and deployed by a company. We believe that the key driver of intermediate to long-term value creation is Return On Invested Capital (ROIC).
ROIC measures the amount of cash generated by each dollar of capital invested in a company’s operations. Alternatively stated, ROIC measures how effectively a company has deployed the capital invested in its business in generating cash flow. A company whose ROIC exceeds its cost of capital generates positive net cash flow, thereby creating value; a company whose ROIC is less than its cost of capital generates negative net cash flow from an economic perspective, thereby destroying value; and a company whose ROIC equals its cost of capital neither creates nor destroys value.
A company can create value by any one of the following four means:
- Reallocating or otherwise improving the use of its existing capital to increase the spread between its ROIC and its cost of capital.
- Deploying more invested capital in its current business, provided the returns generated by such capital exceed its cost.
- Investing additional capital in new projects (lying outside of the traditional scope of its business) yielding a marginal ROIC in excess of the cost of such additional capital.
- Lowering its cost of capital.
One common theme runs through each of the above value-creating strategies: in order to generate more cash flow than is consumed by its business, a company must earn a higher ROIC than its cost of capital. The ultimate size of this net cash flow to investors is driven by the following three factors:
- The size of the spread between a company’s ROIC and its cost of capital.
- The length of time such spread persists.
- The amount of capital that can be invested at such spread.
The ideal value-creating company is one that has an ROIC that far exceeds its cost of capital and that has an unlimited number of investment opportunities each of which will yield an ROIC greater than the cost of the capital required for such investment. The larger the positive spread, the longer it can be sustained by the company, and the more capital that can be invested in the company’s business, the greater will be the net positive cash flow generated by the company.
While the positive spread between each investment’s ROIC and corresponding cost of capital ideally should be equal to or greater than the spread between the company’s current ROIC and cost of capital, each investment will create value as long as its spread is positive, regardless of the size of the spread. If a company’s cost of capital exceeds its ROIC from current and prospective investment projects, however, any growth will transfer value from the company’s investors to its customers, suppliers, management and/or employees.
Early Warning System: Identifying Changes on the Margin
By analyzing ROIC and its constituent components, cash flow and invested capital, we believe that we can more accurately assess how effectively, how much and how long capital can be invested by a company in its business. In short, we believe that ROIC analysis provides us with insight as to the exploitability, size and time span of a competitive advantage.
Of equal importance as a guidepost to investors, ROIC analysis facilitates the early and accurate identification of fundamental changes in operating performance by quantifying the magnitude and direction of change in operating profitability. In contrast, the reported earnings metrics of EPS, EBITDA and ROE often fail, are slow to reflect or, even worse, mask changes on the margin in a company’s business.
More specifically, analysis of the level of marginal or incremental ROIC relative to historical ROIC—and concomitantly the change in the level of sequential ROIC quarter-over-quarter and year-over-year—for both individual companies within an industry and the industry as a whole can provide an early warning system regarding fundamental shifts and emerging trends in their competitive dynamics, profitability and investment attractiveness.
Industrywide marginal ROIC that exceeds historical ROIC (i.e., increasing sequential ROIC) and extraordinary levels of ROIC are the hallmarks of an industry that is young, strong and growing. Companies that compete in such an industry typically foster high investor expectations and are rewarded with high P/E valuations. In contrast, a sequential decline in ROIC or marginal ROIC below historical ROIC (other than due to seasonal factors) may indicate that the long-term investment opportunities in the industry are dissipating, which is a sign of a maturing industry. While this shift may be due to increased competition within the industry, saturation of demand or a number of other factors, the more substantial the decrease and the longer the trend continues, the more likely it is that this change is indicative of a fundamental shift in the economics of the industry.
Within an industry, a company that consistently earns an ROIC in excess of the industry average and that is able to maintain or increase the level of its ROIC typically deserves and is rewarded with a higher market valuation than its peers. Similarly, ROIC consistently below the industry average and that is declining on a sequential basis typically indicates an ailing or weak competitor that merits and receives a discounted valuation relative to its peers.
ROIC Analysis Applied to Mergers and Acquisitions
On a micro level, marginal ROIC analysis can be used to assess the profitability and thus the potential for long-term value creation of a particular merger or acquisition by comparing the change in cash flow to the increase in invested capital resulting from the transaction.
In general, we view mergers and acquisitions with what we believe to be a healthy degree of skepticism as to their potential for creating value for the surviving or acquiring company and its investors. We believe that diversification alone is never a sufficient justification for an acquisition since a company’s investors are perfectly capable of independently investing their capital in the target company if they so desire.
In order to create value, a merger or acquisition must result in the surviving entity’s generating greater positive net cash flow per dollar of invested capital in its operations than the net cash flow per dollar of invested capital generated by the merging entities or the acquiror prior to the transaction. This increase can be realized in one of two basic ways: by generating additional cash flow or by reducing the amount of invested capital required to produce the same level of cash flow. For example, the recent spate of mergers and acquisitions in the banking industry have been driven largely by the latter as banks have recognized that they can achieve large cost savings without adversely impacting revenues by eliminating redundant branches, administrative personnel and cost centers.
In the networking industry, merger and acquisition transactions have been driven predominantly by the leveraging of complementary products and R&D to generate greater net cash flow from the same base of invested capital than could be individually generated by either of the independent companies. These networking merger and acquisition transactions have typically been of two varieties: a merger of two large established organizations—or alternatively, an acquisition of the smaller by the larger—each of which has existing commercial products, customers and salesforces and/or distribution channels. Such mergers and acquisitions include the merger of Synoptics and Wellfleet to form Bay Networks in September 1994, the acquisition of Chipcom by 3Com in October 1995, and the recently completed acquisition of Stratacom by Cisco.
The other principal merger and acquisition paradigm that has emerged in the networking industry involves the acquisition by a mature company with an established sales force and/or distribution channels of a relatively young company having impressive R&D, technology and/or products but lacking sufficient marketing, sales and financial resources to commercialize its technology or to effectively capture the market opportunity on its own. Shareholders of the acquired company typically receive a significant premium for their shares. The acquiror in turn gains desired technology and products to complement and/or expand its current product line and perhaps to penetrate a rapidly expanding market niche when such technology and products would have been more costly and taken longer to design, develop and commercialize on its own. The acquiror typically can easily integrate the acquired technology into its own products and/or add the acquired products to its line-up. In many instances, the two companies already have in place a supply, joint marketing or joint venture agreement.
We believe that ROIC analysis provides a means of quantifying the value generated or destroyed by such transactions by taking into account both the additional capital invested in the acquiror/surviving company’s business and the additional marginal cash flow generated therefrom.
Moats and Walls
In the long run, in order to sustain extraordinary (i.e., above average) ROIC, a company must create or compete in an industry that has high barriers to entry. In the absence of entry barriers, a high level of ROIC within an industry will lead existing competitors to increase the amount of capital invested in their operations in an effort to grow their businesses and reap additional correspondingly high returns. In addition, high ROIC will attract into the industry new entrants seeking to capture a portion of these extraordinary returns.
In the absence of barriers to entry, the amount of capital attracted to an industry will be roughly proportional to the level of ROIC generated by the industry—the higher the industrywide ROIC, the more capital will be attracted to the industry. Inevitably, once the pace of investment overtakes the industry-demand growth rate, ROIC for the industry will begin to decline as the rate of increase in net additional investment overtakes the rate of increase in net cash flow generated by such additional investment.
In the networking and other technology related industries, barriers can exist in a variety of forms including, most prominently, the following:
- Intellectual property which is protected by patents or copyrights or which is difficult and time consuming to reproduce.
- “First mover advantage” which is a phrase used to express the inherent advantages that come to the first company to exploit a new technology market. The following five economies of scale derive from first mover advantage in the networking and other technology related industries: customer feedback, volume leverage from the cumulative production of integrated circuits, economies of scale from software-based products, crucial early customer wins and distribution.
What About Cash Flow?
The father of the dividend discount model, John Burr Williams was one of the first investment analysts to equate investment values with cash flows. Williams first set forth this equation in his seminal work, The Theory of Investment Value, published in 1938, as follows:
The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.
Applying John Burr Williams’s formula, in order to analyze the process of value creation, we must first identify the primary source of cash flow. After studying several different approaches, we believe that the best economic model is based on the definition of cash flow proposed by the consulting firm Stern Stewart & Co. and used in its EVA analysis1. Stern Stewart argues that the “best” definition of cash flow is net operating profit after paying cash taxes, commonly referred to as NOPAT. Essentially, NOPAT is cash earnings from a company’s operations less cash taxes that would have been paid on such earnings in the absence of tax effects relating to short- and long-term financing considerations.
Cash flow as defined as NOPAT is a function of revenues minus operating expenses (including depreciation, which we discuss in the following section of this note) minus cash taxes. Revenues are the product of units times average selling prices. Future revenues are thus a function of the following two drivers:
- Unit growth (traditional demand analysis) which is a direct reflection of demand for the company’s product(s). Demand for technology products tends to fall along traditional product lifecycles.
- Pricing trends (traditional supply analysis) which are a function of competition. Barriers to entry, product substitution and rivalry among competitors are the primary determinants of pricing competition.
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