Growth by acquisition is a popular model followed by some ASX companies, but it may not be as successful as the companies want you to believe.
They are collectively referred to as 'roll-ups' or aggregators, but essentially their business is to buy similar businesses to their core business, integrate them and then reap the benefits of economies of scale.
That might range from more negotiating power when it comes to rent and lease agreement discussions with landlords – "If you don't give us a cheaper rate, we may consider moving elsewhere" – to achieving lower prices with suppliers for greater purchase quantities. It could also be the ability to lower unit costs such as requiring less staff to manage certain assets such as IT equipment.
Many rollups issue debt or new shares to fund the purchase of complementary assets, including stocks listed on the ASX such as G8 Education Ltd (ASX: GEM), Affinity Education Group Ltd (ASX: AFJ), Greencross Limited (ASX: GXL), Capitol Health Ltd (ASX: CAJ), Slater & Gordon Ltd (ASX: SGH) and internet service providers TPG Telecom Ltd (ASX: TPM) and iiNet Limited (ASX: IIN).
Those are just a few examples, and there are certainly others.
But a key concern for many investors is whether these companies are actually adding value or not. It's fine for companies to report growing revenues and net profit, but unless the acquisitions are adding value, eventually earnings per share will fall and the market will catch on, ala the most infamous roll-up of them all ABC Learning.
And by adding value, I mean growing earnings per share (EPS). Sure, net profit may increase, but if the company has to raise more equity to produce the profit, there will be more shares on issue and an investor may have seen their share of company profits diluted.
A classic example is G8 Education.
| 2010 | 2014 | Change | |
| Revenues ($m) | 66.6 | 479.2 | 620% |
| Adjusted net profit ($m) | 4.5 | 60.5 | 1,244% |
| Earnings per share (cents) | 4.2 | 18.5 | 340% |
Source: Company reports
As you can see, revenues and net profit growth looks fantastic, but when you take into account the more-than-doubling of the shares on issue, earnings per share have grown at a quarter of profit. Still, 340% growth in EPS over 4 years is wonderful (annualised it comes to 44.9%), but future growth should be considered in this light.
Slater & Gordon has similar statistics (although these numbers may need to be revised following recent news).
| 2010 | 2014 | Change | |
| Revenues ($m) | 124.7 | 418.5 | 236% |
| Adjusted net profit ($m) | 19.8 | 61.1 | 209% |
| Earnings per share (cents) | 15.7 | 30.3 | 93% |
Source: Company reports
Interestingly, while revenues have grown by $294 million in the four years, contributed equity i.e. funds raised from shareholders has jumped 188% as well, from $81 million in 2010 to $234 million, or roughly half the increase in revenues.
But what is also interesting is that while revenues have grown, profit margins have dropped from 15.9% to 14.6% suggesting management have made the company less profitable. Is that due to acquiring businesses with poorer margins, or have management dropped the ball when it comes to controlling expenses?
Foolish takeaway
Aggregators can get away with rolling up businesses for many years with very few investors noticing that the quality of the company is steadily deteriorating and their earnings aren't growing as fast as it may appear.
Given the companies regularly state the benefits of acquisitions include factors such as cost-benefit synergies through reduced headcount and overheads, increased purchasing power, reduced competition, and potential cross-selling opportunities, then, in theory, net profit and earnings per share should grow at a higher rate than revenues over the long term. As you can see in the examples above, both G8 and Slater & Gordon have been unable to translate growing revenues into faster-growing earnings for shareholders.
Something to watch for.
