ALQ – The Acquisition Machine
Back in the day I used to get all excited about earnings growth. A company would announce they are going to grow earnings by 10% a year for the next x years. Cool, jam the bid.
The market loves this stuff. But now I think about more about how they are getting these earnings. Or more importantly how much capital are they investing to generate these additional returns.
A truly great business is one that can scale quickly without the need for additional capital we know them as businesses that have economies of scale.
Utility companies or bricks and mortar retail do not have major economies of scale. Sure they have some sharing of corporate overheads and purchasing power the bigger they get, but if you want to really lift earnings you have to invest capital in a new power plant or a new retail store.
IT software is obviously scalable. The marginal cost of adding a new user to Xero is negligible the work has already been done.
Anyway that brings us back to earnings and optimistic management guidance.
I had a small position in ALS Limited (ALQ). They announced their FY2017 report and on balance there were some pluses in the commodity business coupled with some negatives in the Life Science business. Sometimes diversification works.
Anyway what caught my eye and I’m sure the market was the aspirational targets they set for the next 5 years.
ALQ is targeting $2.2bln in revenue by 2022 with EBITDA of $500m at an EBITDA margin of 22.7%. The calculator comes out and you punch in an EV/EBITDA multiple of 15x, multiple this out by EBITDA of $500m and you get an EV of $7,500m, take away $1bln in debt and you get an equity value of $6.5bln. Divide this by shares outstanding of around 500m and you get a share price of around $13. Happy days when compared to the current of $6.50!
But let’s dig a bit deeper. I remember reading a quote from an investor, who I can’t recall the name, said something like small businesses do not stay small because they want to. They stay small because they cannot grow. So why now has management seen the opportunity to increase size and compound revenue at 11.5% till 2022 when their revenue has fallen in the boom times from $1,420bln in 2012 to today?
ALQ has a long history of acquiring growth and has been incredibly good at acquiring businesses at cheap multiples using its comparatively expensive equity. It has played this share price arbitrage brilliantly between 2004 and 2012. Since then it has been a lot tougher to grow earnings without this share price arbitrage.
How is ALQ going to add over $900m in revenue in the next 5 years?
Revenue for FY2017 was $1,365bln ($1,272bln if we exclude the Oil & Gas business which is up for sale). EBITDA core was $253.1m on a margin of 19.8%. As at FY2017 current invested capital including goodwill is $1.7bln.
So let’s say to increase revenue by 72% from FY2017 levels of $1.272bln (ex oil and gas) then they can do it organically utilising their existing business, by acquisition or a combination of both.
What has historically been the percentage of revenue to its capital base?
From the table above we can see that up until 2013 the revenue to capital base was a fairly constant ratio of 1. They were efficiently extracting revenue from their invested capital.
When the mining downturn hit in 2014 revenue fell away but ALQ was stuck with the inflated capital base from previous acquisitions. The revenue to capital base ratio peaked at 146% in 2014. Note that the improvement in the ratio in 2016 was assisted by impairment charges rather than an increase in utilisation of the capital base.
So let’s say that ALQ achieves revenue of $2.2bln by 2022 and it does this through a combination of organic growth and acquisition and the capital base expands to $2.2bln giving a ratio of Invested Capital to Revenue of 100%. With current invested capital at the end of FY2017 of $1.7bln this would mean that business would need to add around $500m in additional capital by 2022.
The invested capital revenue ratio is 125% for FY2017 indicating there is around $340m in potential revenue if it can bring its utilisation back to pre FY2014 of 100%.
So what does the return on this expanded capital base look like?
For FY2017 depreciation charges were $68m. We will assume around $100m in Capex and depreciation by the year 2022 to reflect the increased capital base. Capex should increase in line with depreciation otherwise the business is winding down and reducing the capital base. After all ALQ is not being run by Private Equity being shopped out for sale.
So that leaves us with an EBITA of around $400m by 2022. NOPAT assuming a tax rate of 29% would give $284m by 2022.
Dividing this NOPAT by the capital base gives a ROIC of 13.2% by 2022 on a $2.2bln capital base. The following table shows profitability metrics for compounding revenue at 11.5% for the next 5 years.
If ALQ can achieve its stated target then it represents great value at current prices. It will be able to compound the additional capital at 31.5% as well extracting revenue from its past acquisitions.
What if revenue compounds for the next 5 years at 5% and ALQ can maintain an EBITDA margin of 20%? The following table shows what the valuation looks like.
This does not look so rosy. At these levels of acquisitions the company is struggling to justify its capital base and will not be making its WACC. We can agree that the company will not increase its capital base under this scenario.
Following table is CAGR revenue at 8% for the next 5 years with EBITDA margin of 20%.
This looks better but again the company is struggling to match its WACC.
From what I can see ALQ needs to improve its existing return on capital on its current capital base before it should pursue acquisitions and increase revenue. The focus should be on extracting revenue from the existing businesses not adding revenue from acquisitions.
In its FY2017 announcement the company should be focusing on improving its return on capital of its existing capital base before planning to grow revenue. Revenue and earnings growth will look good but it will not increase the intrinsic value of the company if the capital base keeps expanding.