Acquiring growth

Acquiring growth

Ansell (ASX: ANN) is a company that has grown its earnings by 7 per cent a year for the past 6 years. But rather than doing it organically, it has primarily done this by purchasing other companies.

An acquisitive-centric growth strategy can provide long-term value, but it is important for investors to understand the risks and upside involved. As Ansell has just announced another large acquisition, let’s take a look at some of these in a bit more detail.

Funding risk
Acquisitions are predominantly funded via debt, equity or cash. Ansell has mainly used operating cash flows to fund acquisitions, which is typical of many mature organisations that have large market shares but are achieving minimal organic growth.

Prior to 2013, Ansell was generating in excess of $100 million a year in operating cash flows. A business is free to pursue a number of activities once it has ensured that its current house is in order, pay dividends and buy back shares for example.

ANN however decided that rather than paying higher and higher dividends to investors, a good use of its free cash flow would be spending it on value-driving acquisitions. It was not uncommon for ANN to spend $50m a year on buying complimentary businesses.

2013 was something of an anomaly for the company. It spent $206.3 million on the purchase of four businesses, which exceeded its operating cash flows of $130 million, leaving a shortfall of internally generated funds that was ultimately filled with debt. Gearing subsequently rose from 7.2 per cent to 23.3 per cent.

While this gearing level is still low and not really of concern, investors should be aware that the excessive use of debt or equity for funding has the potential to detract value. Too much debt may burden a company and lead to other investors discounting future cash flows at higher and higher rates, which would lower the business’ overall valuation.

Management has indicated that the company has $165m of available debt facilities at its disposal, which is likely to support further acquisitions. So in ANN’s case, such an event seems very unlikely at this stage.

Another risk to consider is that equity raisings may dilute shareholder wealth if budgeted earnings are not achieved post-integration. While NPAT may rise, EPS may in fact fall – and in the end, it is the bottom line that investors care about.

Integration risk
Companies tend to pay premiums for acquisitions because management expect the combined entity to generate synergies (through increasing sales or lowering costs or a combination of both) that could not be achieved alone.

But there is always a risk that the company will be unable to achieve these benefits. If a company does not conduct effective, forensic level due diligence, or if resources are stretched too thin, the acquisition will not generate the desired outcome.

For the most part, Ansell appears to be generating synergies that are in line with expectations. The company is releasing seven times more products than it did in 2010, and there is a big focus on reducing costs through supply chain improvements.

All of this is a big plus for shareholders and a large reason for the recent share price rise.

Future growth drivers
It is important that companies do not become reliant on acquisitions for growth. If they do, then in order to maintain a constant growth rate, they will be forced to continually make larger and larger acquisitions.

This is perhaps a concern given Ansell has been very focused on growth via acquisition. In 2013, it grew sales by 9 per cent, of which only 1 per cent was organic. But growth by acquisition could also be viewed as an opportunity for a market leader with meaningful free cash flow to consolidate smaller players.

It may be difficult for Ansell to consistently achieve a high level of organic growth because it operates in mature markets that are sensitive to macroeconomic events. By assembling a network of businesses across the medical, industrial and specialty sectors, management has the ability to cross-sell and pollinate ideas, which should extract further value between divisions.

Final thought
Growth via acquisition can be a viable long-term investment strategy, but investors must understand management’s rational before investing in a company. Is the company acquiring for the sake of increasing earnings, or is it making a purchase with scale, innovation and added market penetration in mind?

With regards to Ansell, the company has achieved all of these – and the result has been a compound annual growth rate in the high single digits for the past six years. While Ansell’s latest acquisition reflects management’s priority to target inorganic growth in coming years, we anticipate that this strategy will position the business for sustainable growth in the long run.