What You Should Look for in a Serial Acquirer


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Written by

Jae Jun

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I used to subscribe to The Motley Fool.

It was in Q3 of 2007 and I had finally gotten the courage to invest with real money. I was ready to take the jump, buy my first stock and finally mingle with the crowd at work talking about investments and not look stupid.

Everything happened except the mingling and not looking stupid part.

I realized too late that value investing was not accepted. It was nerdy and boring. In my co-workers point of view, I still looked stupid.

But life went on and I continued reading my Fool newsletter.

Multiple Dating Opportunities with Middleby (MIDD)

Over the 2-3 months that I had my subscription, there was a company that the Fool kept recommending. I didn’t accept the date though.

5820% since 2000

5820% return since 2000

MIDD was her name and she’s in the business of selling commercial and residential food service and processing equipment.

If you love to cook or have a special person that does, you should know how many equipment and gadgets there are in this industry.

It’s extremely fragmented and there are hundreds of brands in the marketplace.

The potential for market growth is there.

Fast food is growing, old restaurant chains are upgrading to more efficient and quicker equipment while traditional restaurants continue to open. Anything hospitality related, there is a kitchen and when you consider that the emerging markets are continuing to blossom and those countries start to adhere to food safety guides, the market potential is great.

Not to  mention that MIDD is also in the residential equipment space so with new homes going up or people renovating their kitchen to put it on the market, it’s another avenue of revenue.

I’m glad that MIDD grew up in a boring industry because that’s what I like. But although the guys over at the Fool egged me on to take her out on numerous occasions, I never did.

Because She’s a Shopaholic

The biggest turnoff for me was that she’s a shopaholic and I couldn’t manage that.

YearAcquisitions ($M)
2000 0
200195.1
20020
200319.1
20042.0
200539.6
20066.4
200768.4
2008205.8
2009133.3
201025.7
2011181.1
201261.9

MIDD paid $380m in an all cash deal to purchase the Viking brand this year and in the past 10 years from 2003 to 2012,  the total sum of the acquisitions add up to $743m.

Include the Viking deal and that’s $1 billion in 10 years.

Compare the $743m spent to the FCF generated over the same period; $705m.

When you compare the money spent with the FCF, has there really been organic growth? I don’t see it and it’s easy to play money shuffling games when so many purchases take place.

She’s Looking Fine

With the latest shopping spree, debt has increased but surprisingly MIDD is still in consistent shape.

She isn’t the best looker, but she has been able to maintain her figure going on more than 10 years.

YearCurrent RatioDebt/Equity
20031.050.91
20041.1517.51
20051.082.51
20061.110.82
20071.540.53
20081.481.03
20091.480.8
20101.430.5
20110.670.62
20121.700.4
TTM1.690.95

But I was Young and Wet Behind the Ears

I read a quote somewhere about companies that grew through acquisitions. I was told that they were just bad ideas so it was best to stay away. She would eat me alive.

I’m a bit wiser now and know that I should dig deeper to understand companies like MIDD. The one thing I failed to do was take things into context and take an all round look.

I still have that train of thought to this day, but at least I try to check whether it is impacting the business negatively such as what I’ll go through below.

Checking Revenue, Accounts Receivables and Inventory

For any serial acquirer, one of the first things you can do is to verify the relationship between:

  • revenue
  • accounts receivables
  • and inventory

Check the images below to see how these three items relate to each other throughout the years of shopping.

The first table is the annual changes. The second image shows the quarter over quarter changes and the third and last image is a comparison of Q1 results.

Annual Trends of Rev, AR and Inventory

Annual Trends of Rev, AR and Inventory – click to enlarge

When you look at the above image for the annual changes, the only cause of concern is the growth of accounts receivables from 2010 to 2011. The increase in accounts receivables both exceeded the growth in revenue.

Quarter over Quarter Rev, AR and Inventory

Quarter over Quarter Rev, AR and Inventory – click to enlarge

But when you look closer at the quarter over quarter numbers, the accounts receivables growth issue isn’t evident. I don’t see much to worry about from this picture.

Q1 Comparisons of Rev, AR and Inventory

Q1 Comparisons of Rev, AR and Inventory – click to enlarge

It’s further confirmed by the Q1 periods over the past 8 years. The growth of revenue, accounts receivables and inventory are consistent with each other.

Had I known this in 2007, I would have taken another look at her instead of walking away so often.

But here’s the thing, I still don’t trust her.

Although management claims that the company is growing organically, MIDD has to continually buy companies in order to grow.

You saw how much was spent on acquisitions and the FCF MIDD generated. There wasn’t any huge growth in those numbers.

Besides, there is no such thing as organic growth through acquisitions and here’s why.

Acquisitions and Cash Flow

When a company expands its business or creates new products, there are expenses involved from the very beginning. Products have to be designed, tested, manufactured, redesigned, retested, approved, manufactured, packaged, shipped and so on.

These are all operating expenses.

But what happens in an acquisition?

The buyer pays cash or stock for the acquisition which gets categorized as an investing expense in the cash flow statement.

What this means is that acquisitions do not affect cash flows.

The screenshots you see were taken with the OSV stock analyzer by the way.

MIDD positive cash flow from operations despite acquistiions

MIDD positive CFO – click to enlarge

See how the net cash from operations is still a positive value?

That’s because the cash acquisition of Viking is excluded from “operating activities”.

But on the flip side, now that the company has been acquired and merged with the parent company, any sale that comes from Viking is included in revenue. The new collections you make from Viking accounts receivables goes towards operating inflow.

See how a new cash flow stream is generated without any initial cash outflow?

That’s the beauty of acquisitions. It’s also a reason why getting involved with too many will lead to fuzzy accounting because you end up consolidating all the revenues and assets, but the expenses turn out to be very minimal.

This makes a mess of accruals as you can below.

MIDD accruals analysis

MIDD accruals analysis – click to enlarge

Read more about accruals from these links

 What is a Company like MIDD Worth?

As I don’t believe there is a whole lot of organic growth, it is going to be difficult to value this company on a forward looking basis.

Instead, let’s do a sanity check to see what the current price is yielding.

With any valuation method, you can always start with the current price and work backwards.

Reverse DCF: 9% discount rate with $120m FCF = 18% growth expected

Reverse Graham: analyst estimate EPS of $7.66, corporate bond rate of 4% = 13% growth expected

Reverse Absolute PE: the current PE is 24.64 which maps to a current growth rate of 25%.

At the current stock price, MIDD is expected to continue growing at 13-25%.

Another interesting point is to look at the EPV and the relationship between the book value, net reproduction value and EPV.

MIDD Earnings Power Value

MIDD Earnings Power Value

What the EPV is saying is that MIDD doesn’t have a moat and that value will be destroyed.

I’m not surprised about the no moat part since all MIDD does is buy out smaller competitors, throws away excess fat and merge it into their system.

But value destroyer?

The chart is also saying that if a competitor worth $80 per share came along, they could replicate MIDD.

Evidence of Value Destroying?

Too early to say but if CROIC is an indicator of management effectiveness and how well they allocate cash, the decline is not a good indicator.

CROIC in decline

CROIC in decline

From 2003 to 2007, CROIC averaged 21%. A big differnce to the low teens since 2009 and the 8.9% for the TTM.

Include the increasing cash conversion cycle into the conversation and there are areas of concern.

It has gone from 69.1 days in 2003 to 112.2 in the trailing twelve months. The total cash conversion cycle has gone up in 7 out of the last 10 years.

Walking Down Memory Lane with Miss MIDD

I would definitely have liked having MIDD by my side, but as I reminisce about what could have been, I realize things haven’t changed.

The shopping habit that left me scared hasn’t gone away. MIDD’s ability to quickly and efficiently sell inventory and convert the other assets into cash is slowing down as it seeks to continue it growth path and I just don’t know how long and where it will lead to.

All I can do is watch from the sideline. Watch as jockster Mr Market woo her and praise her.

Was I dumb to let her go?

You tell me.

References

Financial Shenanigans pg 227

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