Roll-Up Roll Up – Circus Tricks by Investment Master Class
A roll-up is effectively an arbitrage play. An acquisitive listed company buys another company [usually unlisted, but not necessarily] on a lower multiple which ordinarily is accretive to the acquirers earnings. The market/analyst community rewards the acquisitive company with high future earnings forecasts and a higher multiple to reflect this higher growth.
The acquisitive company is often consolidating a fragmented industry and the stock market puts a premium multiple on the company which allows the acquisitive company to raise equity or debt to continue to buy other assets [ie roll-up the industry] and drive earnings. It becomes a circular function. It all works well in theory until it doesn’t.
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Over the years I’ve seen a lot of roll-ups blow up and usually there are a number of common factors involved.
David Einhorn described the process in his book ‘Fooling Some of the People All of the Time‘ when discussing his short position in ‘Century Business Services (CBIZ), a ‘roll-up’ of accounting service firms with lousy accounting itself’ …
“In a roll-up, a consolidator typically buys small, private companies at a lower multiple than the consolidator receives in public markets. Every acquisition is accretive to earnings, which drives the stock price higher and enables the consolidator to use its currency to do more acquisitions of private companies in a never ending virtuous circle”
The discussion on roll-ups is well explained by George Soros’s REFLEXIVITY theory in his book the Alchemy of Finance [see The Case for Mortgage Trusts – pg61]. In discussing the roll-up trend in mortgage trusts Soros notes..
“The conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price investors may be willing to pay for those earnings. This method is inappropriate to the analysis of mortgage trusts because the price investors are willing to pay for shares is an important factor in determining the future course of earnings”
The key difference between a roll-up and a normal corporate is that the roll-up requires an ongoing premium market multiple to continue to drive growth and maintain that premium multiple. Plenty of analysts overlook this FACT.
Most companies earnings are not reliant on the whim of the stock market [financials/highly geared companies can be an exception]. Seth Klarman explains this with reference to George Soros’s REFLEXIVITY theory in his book Margin of Safety..
"Stock price[s] can at times significantly influence the value of a businesses. Investors must not lose sight of this possibility. Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability and bankruptcy"
Poor acquisitions - M&A is not easy and most transactions fail. In the case of selling businesses, the vendors are in a position of power. They know the business better than the buyer.
"We have all the difficulties in perceiving the future that other acquisition minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking 'just fine'" Warren Buffett
Lack of Organic Growth - the roll-ups typically need acquisitions to fuel growth as pedestrian underlying growth alone will not justify the high multiple placed on the company. When management is largely focussed on acquisitions often their existing business are mis-managed and promised acquisition synergies may not materialise.
Accounting Issues - There can be questionable practices in regards to accounting of the acquired companies to boost EPS growth. While accounting earnings may look good often cash flow does not.
Law of Large Numbers - In the early days, a roll-ups acquisitions tend to represent a larger percentage of the underlying asset base so can be highly accretive. Over time, larger and larger acquisitions are required to move the dial on EPS growth as the asset base expands. As the industry consolidates, often imitators enter the market increasing competition and the prices to be paid for further business acquisitions. Larger acquisitions tend to increase the risk profile of the company and may require bridging finance.
Debt - Roll-ups often utilise debt as an interim measure to fund acquisitions prior to equity raising. As debt levels rise risk also rises. When combined with accounting issues [ie earnings higher than cash flow] this can be a deadly combination.
Marathon Asset Management remind us..
"When debt propels growth rates and equity returns higher, enthusiastic investors may too easily forget the dangers inherent in financial leverage"
"When conditions change, very quickly (and more often than not, very unexpectedly) debt, hitherto unnoticed takes centre stage. Those who comfortably applauded the results of leverage in the good times then find themselves caught in a negative spiral as the process reverses"
Fraud/Over Promotion - when management need to keep promising growth via acquisitions there can be a temptation to try and paper over underlying business issues to meet market expectations.
Overconfidence/Groupthink - when a management team has made a string of successful acquisitions they can become overconfident. Without a thorough unbiased review of the business, a board may overlook risks involved in the acquisition process.
"Of one thing, however be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairytales are emperors told they are naked" Warren Buffett
The end result is ordinarily an equity market de-rating of the stock. When expectations of strong growth slow the stock price can get decimated as analysts cut their earnings forecast and investors no longer are willing to pay such a high premium. A double whammy - earnings and PE de-rate. When equity prices sink below the price of previous capital raising investors often lose support for the stock. Stocks can enter a death spiral.
Both Warren Buffett and George Soros have discussed the conglomerate roll-ups in the 1960's. In the Alchemy of Finance, Soros noted ..
"The key to the conglomerate boom was a prevailing misconceptions among investors. Investors had come to value growth in per-share earnings and failed to discriminate about the way earnings growth was accomplished"
Warren Buffett's 2014 Annual Letter also touched on the subject.
“In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his “bold, imaginative accounting.” Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be.
Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice. Once again, it became evident that business models based on the serial issuances of overpriced shares – just like chain-letter models – most assuredly redistribute wealth, but in no way create it. Both phenomena, nevertheless, periodically blossom in our country – they are every promoter’s dream – though often they appear in a carefully-crafted disguise. The ending is always the same: Money flows from the gullible to the fraudster. And with stocks, unlike chain letters, the sums hijacked can be staggering.
At both BPL and Berkshire, we have never invested in companies that are hell-bent on issuing shares. That behaviour is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.”
Valeant Corporation is a more recent example of a roll-up that has been decimated.
Omega's Leon Cooperman described the issues on CNBC recently ..
“I’ve seen this movie before. The company grew as a result of a roll-up strategy. They took a high priced stock, bought a lot of businesses, used a lot of debt. They lost their multiple which meant their equity was not a currency for acquisition and they’ve exercised their debt option so they couldn’t put more debt on the balance sheet and do acquisitions. So the market is striving to figure out what the internal level of recurring earnings is and this companies faux pas is statements or restatement that don’t engender any confidence.”
Wally Weitz of Weitz Investment Management stated on Wealthtrack that when he asked the Valeant CEO how he managed a far-flung business the CEO responded "we tell managers 'make your numbers or we will get someone who will'". Mr Weitz noted "When there is pressure from the top to make numbers, sometimes people succumb to that and bad things happen. Management is so important" … “The Philidor deal made us wonder what other arrangements they might have."
As Warren Buffett has reminded us ..
“Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers”
And Marathon Asset Management note..
“An obsession with growth, combined with over-promotion, is likely to end in tears”
And it's not a new phenomena. Phil Fisher recognised the risks of an acquisition focussed company in 1960 ..
"There may be quite a high degree of investment risk in a company that as a matter of basic investment policy is constantly and aggressively trying to grow by acquisition.. it is my own belief that this investment risk is significantly still further increased when one of two conditions exist in a company's organisational make-up. One is when the top executive officer regularly spends a sizeable amount of his time on mergers and acquisitions. The other is when a company assigns one of its top officer group to making such matters one of his principal duties. In either event powerful figures within a company usually soon acquire a sort of psychological vested interest in completing enough mergers or acquisitions to justify the time they are spending." Phil Fisher
In a recent interview with the FT famed short seller Jim Chanos talked how he liked to find short positions in roll-ups and what he saw at Valeant ..
"We're just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they're actually growth companies by virtue of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between announcement of the deal and the closing of the deal so they look better once you fold them in. And so we love those kinds of stories, the roll-ups, or as they been deemed, the 'platform companies'".
"Valeant is a good example. The first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said : "this looks like Tyco." In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell bent on buying companies and making them fit no matter what."
"and again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sort of things before. And having a person running a company to please Wall Street can be really problematic, and even on the first pass though you would see that with a company like Valeant, and that's why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to.. for a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great roll-ups of the late 90s and early 2000s. So I think that was helpful for us."
"So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and WorldCom. You're probably on the right track if you're a short seller if it reminds you of not only one of those, but three of those".
Chanos's first problem was it's way of doing business. Cutting R&D spend at the acquired companies and raising drug prices of the newly acquired drugs to boost earnings. Chanos believed earnings were overstated as there was no R&D spend to support future earnings as drugs don't last forever.
"So he [the Valent CEO] got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5."
Not everyone avoided losing money on Valeant including famed investors Bill Ackman and Sequoia Funds. Ackman made an exception for Valeant .. From the Interim 2015 Pershing Square Holdings Report...
"We select investments in companies that meet our extremely high standards for business quality. We primarily invest in businesses that are simple, predictable, and free-cash-flow-generative with substantial barriers to competition and strong pricing power due to brands, unique assets, long-term contracts, and/or dominant market position. We vastly prefer businesses that have limited exposure to macroeconomic factors by generally avoiding companies that are highly exposed to commodity prices, material changes in interest rates, and other extrinsic factors we cannot control. We focus on large capitalization, North-American-domiciled businesses that earn the substantial majority of their profits in North America. We often hedge large non-U.S. currency exposures in the portfolio. We seek investments that trade at a discount to intrinsic value as is, and an even wider spread as optimized.
The result of this approach is a portfolio comprised of the highest quality collection of businesses that we have ever owned, managed by the strongest management teams that we have worked with, all trading at substantial discounts to intrinsic values. These businesses are generally conservatively financed, often investment grade or soon to be, generate substantial amounts of recurring free cash flow, typically don’t need access to equity capital to survive or thrive, and often return capital to shareholders through buybacks or dividends. As a result of these characteristics, the intrinsic value of the businesses we own is not particularly correlated with equity or credit market volatility.
We may make occasional exceptions to the above principles if we believe the additional risks are compensated for by greater potential profitability. For example, we own a number of highly acquisitive businesses, namely – Valeant, Platform Specialty Products and Nomad – for whom access to capital is necessary to achieve accelerated growth. Even in these cases, however, if the capital markets were to shut, their growth would slow from their current extremely high levels, but their businesses would remain profitable and cash generative. In each case, the current valuations reflect no value for these companies’ ability to make economically attractive acquisitions."
Even the world's best investors make mistakes. So what are the lessons for investors. Some traders [eg Soros] have profited from identifying roll-ups in the early stages of their growth/industry consolidation phase given their growth prospects and reflexivity.
However, being on the wrong side of a roll-up can lead to the permanent loss of capital. If you are going to buy a company reliant on acquisitions for growth watch out for the pitfalls outlined above.