Westfield, Oracle, Cleanaway and the cost of acquisition
Our favouring of businesses seeking to create business value through organic investment in plant and equipment, labour and R&D at book value over acquisition based expansion will remain. Much of the materials sector along with some industrials remains in this category and also remains very sensibly valued. As prices move ever higher, the likelihood of creating enduring value through an acquisition based strategy will move ever lower.
The year did not end with a whimper. In one corner, Frank Lowy and Rupert Murdoch chose to sell businesses they’d spent decades building, suggesting they believe selling prices are attractive. In the other, Aconex was the subject of a takeover bid from Oracle, AWE from Mineral Resources and Tox Free from Cleanaway, indicating the buyers believe purchase prices well above prevailing market prices make sense. In the longer term, it is unlikely the fight will prove even. Someone will hold the title and the other end up punch drunk. History, based on an analysis of the facts, suggests the acquirers usually spend a couple of rounds (years) dancing round the ring looking good (often through accounting trickery), but by round 5 or so they’ve taken a few jabs to the solar plexus and shareholders have a couple of black eyes. By round 9 they’re on the canvas and shareholders are nursing goodwill write-downs listening to a new CEO run through a new and upgraded strategy. Just as the bookies use the numbers and track record to set the odds on the fight, in determining whether we have a chance over the long term, the numbers give us the best guide. Mirroring an equity market in which valuations vary wildly, the numbers on these acquisitions are similarly divergent. Oracle are paying $1.6bn for Aconex, a businesses which reported $161m of revenue, $15m of EBITDA and made no cash. EBITDA bears no resemblance to real earnings for almost all companies, however, we will refer to it in these examples as anything resembling cash flow is buried deeply in the presentation appendices and in a font size rendering it illegible to those of advancing years. At 10x revenue and 100x EBITDA, the entire purchase price is a bet on the future. A 10% return on capital will require sustainable earnings that are around the current revenue base of the company. Given the accumulated software investment is a tiny fraction of the purchase price, and Oracle presumably have some software engineers able to develop similar software and sales staff able to garner revenues, the differential in purchase price versus build cost is attributable to the laziness/ineptitude in creating a competing product, or a desire to stifle competition. Alternatively, it is perhaps just a response to the perverted incentives of free money and stratospheric valuations. Suffice to say, it riles us a little when commentators suggest fund managers are not adequately embracing, or are undervaluing technology. We feel our value proposition should involve fostering a measured and rational approach to allocating capital over an extended period, not ‘embracing’ themes. We do not debate the great benefit which technology has and will continue to provide to the global economy. Whether $1.6bn is best spent paying many times the cost of a technology already developed or paying the salaries of many people to develop more, is another matter altogether.
Whilst the AWE and Tox Free acquisitions are on less egregious acquisition metrics, our assessment of the prospects is tinged with similar scepticism. Tox Free is itself a collection of acquisitions and entails significant goodwill. We are positively disposed to the prospects for difficult to replicate assets such as recycling facilities and landfills, however, a relatively small proportion of the $831m purchase price is connected to such asset value, hence a disproportionate goodwill component. It does however, have around $500m of revenue and $83m of ‘underlying’ EBITDA. ‘Underlying EBITDA’ is a further embellished variant which tends to exclude a large range of entirely relevant and actual costs for the purposes of making a business seem cheaper than in reality. Whilst we are extremely complimentary of the efforts of Cleanaway CEO Vik Bansal to date, as his focus on productivity gain and cost efficiency has been admirable, the objective facts on acquisition metrics give us cause for longer term concern.
We place great store in trying to make decisions which are based, to the extent possible, on facts and data. Data collection/science is making great strides in facilitating the analysis of ever larger amounts of data rapidly and accurately. Almost certainly more important, and a more intractable problem, is the relevance and quality of the data. Much effort is currently being expended collecting and torturing data with questionable veracity and utility. Net promoter scores, return on capital, gross domestic product and a thousand other measures are yardsticks developed in an effort to measure progress and aid future decisions. The source of the intractability, however, is that different variables and pieces of data have wildly varying degrees of materiality and utility. In turn, our decisions may be sound in the context of available information, yet the interdependence of these decisions on the decisions and behaviours of others can render them erroneous. Almost everyone buying property, bonds or equities in recent decades feels they have made a good decision. Prices have gone up. A significant element in this outcome, however, is the decision by central banks the world over to take the price of money (interest rates) down. Had a divergent path been taken on interest rates, these same decisions would likely have had a vastly different outcome. Frank Lowy has created enormous value for Westfield shareholders over many years, however, the Unibail-Rodamco transaction values the income from Westfield shopping centres at a cap rate of around 4.7% or more than 20x cashflow. In the hedonistic times immediately prior to the GFC, this was around 6.5%. On property income of some US$800m, the difference in value is the best part of US$5bn or around 40%. Combined with a healthy amount of debt on the balance sheet and the resultant favourable impact of financial leverage, gains to Westfield equity holders are far higher. A thank you card to Mario Draghi and Janet Yellen may be in order. Years of hard work managed to grow the property income to $800m, decisions on interest rates based on data sets with more holes than a Sydney CBD road (GDP and inflation) and theories with almost no empirical support, dwarfed them.
Part of the infatuation with acquisition driven growth stems from the difficulty in finding growth organically. Earnings downgrades for retailers such as Myer and Retail Food Group, aged care providers such as Japara and childcare operator G8 Education, suggest making more money than last year isn’t coming easily to everyone. The success of businesses such as Afterpay are partially reflective of the desperate need for retailers to try and bring forward even more of tomorrow’s demand to today in order to avoid the collapse in operating leverage which accompanies deteriorating same store sales. This interdependence of so many sectors of the Australian economy with a banking and financial sector which has lent too much for too long continues to exercise our minds as we seek investments which can perform well in an environment of more constrained credit. Investments in businesses such as Elders, Bingo, Monadelphous and a relatively diverse range of materials businesses such as Alumina, Independence Group, Western Areas and Iluka, give us confidence that opportunities will remain.
Concerns over the ‘butterfly effect’, where apparently small changes can give rise to large eventual impacts, continue to occupy our minds greatly. Genuine diversification is becoming increasingly important and increasingly difficult to find. We feared higher interest rates in the US and winding back quantitative easing would prove challenging for already effervescent equity market levels. This has not transpired as yet. Whether accelerated quantitative easing by the Japanese and Europeans, efforts by the Swiss to depress the currency or numerous other potential factors offset actions by US policymakers is a moot point. We attempt to monitor these factors in an effort to remain vigilant to exogenous factors which have the potential to overwhelm other data in our decision making process. The scale of wealth transfers, the extent to which speculation has been favoured over legitimate investment and income generation and the suppression of capitalism in favour of a manipulated global economy remain of concern. This is tempered by an acknowledgement that efforts to quash volatility and artificially suppress the cost of money are not likely to be abandoned. Wishing for an alternative investment environment to the one offered is likely to remain unproductive.
Our favouring of businesses seeking to create business value through organic investment in plant and equipment, labour and R&D at book value over acquisition based expansion will remain. Much of the materials sector along with some industrials remains in this category and also remains very sensibly valued. As prices move ever higher, the likelihood of creating enduring value through an acquisition based strategy will move ever lower. Extraordinary gains through ‘investment’ in crypto currencies and tech start-ups provide ample sign that investment has given way to speculation in many instances. As always, however, as money chases short term gain, opportunities will be left behind.
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