In the last week, I noticed three stories that at first
sight seem to be unrelated but I think share a common theme:
- The first was on Google, with the focus being on how much Google is spending to impressive growth numbers.
- The second and continuing story is on Groupon and it’s imminent or not so imminent IPO, with the emphasis being on the accounting shenanigans and market whiplash.
- The third story is on Green Mountain Coffee, an incredible success story over the last five years, and the skepticism that some investors are showing about whether it can sustain its growth.
While the stories are on different issues, the questions
they raise all revolve around the sustainability of growth at these companies,
the price paid to generate the growth and the relationship between growth and
value.
The feasibility of growth: With growth companies, the debate about how high growth rates can be and how long growth can be sustained falls along predictable lines. The optimists argue for high growth and the pessimists argue that this growth is not feasible and investors are caught in the middle, wondering which side to believe. Ultimately, though, a company’s growth is constrained by the size of the market in which it operates. Green Mountain Coffee, for instance, had revenues of $1.36 billion in 2010, a sizable market share of the processed coffee market. To provide a measure of what is feasible, the overall revenues from coffee sales at supermarkets, drugstores and retailers in the US in 2010 amounted to little more than $ 5 billion; Folger's is the largest of the grocery store coffee producers has revenues of about $ 2 billion. While this total revenue does not count revenues from products like Keurig, it leads me to believe that Green Mountain Coffee is not a "small" company in this market. It is always possible that Green Mountain could expand its product line but what are its choices? Green Mountain maple syrup comes to mind, but that is a tiny market; Green Mountain chocolates may work, but the premium chocolate brands carry Swiss or Belgian imprimaturs. It is also possible that Green Mountain could increase the overall size of the market by convincing tea and soda drinkers to switch to gourmet coffees... but I think that is unlikely to happen.
Scaling Growth: As companies get larger, their growth rates will decline. That is indisputable, though great growth companies may be able to slow the decline and extend it over longer periods. Google, for instance, has been more successful than most growth companies in the last decade in sustaining high growth for an extended period, but even it has found that it is far more difficult to post high growth rates in revenues as its gets bigger. In the figure below, I graph out the percentage change in revenues and the dollar change in revenues each year at Google from 2001-2010. While the $ change in revenues has increased over time, the percentage change in revenues has decreased every year (except 2009). And consider this: Google is one of the most successful growth companies of the last decade.
Growth and Value: While many analysts view higher growth as good for value, it is clearly not that simple. After all, going for higher growth requires companies to make a trade off. On the one side, there is the good stuff: higher growth boosts revenues and earnings. On the other side, there is the bad stuff: growth is not free. Companies have to invest to generate sustainable growth: those investments can be in long term assets (factories if you are a manufacturing firm, R&D if you are a technology or a pharmaceutical firm, recruiting & training if you are a consulting firm), short term assets (inventory or accounts receivable) or acquisitions of other companies. All of these investments reduce cash flows. The net effect can therefore be positive or negative and is captured by looking at whether the firm generates a return on its investments (return on invested capital or return on equity) that exceeds its cost of funding (cost of capital or cost of equity). In the case of Google, the price of growth has risen over time, as the company seems to be caught in a cycle of making acquisitions that get larger each year, to post the same growth rates. With Groupon, this debate has morphed into an accounting question. Even if we accept the company’s argument that customer acquisition costs should be capitalized (see my earlier post on the issue), the question that follows is a simple one. How much value is added by a new customer? (To answer this question, the company will have to provide more information on customer behavior.) More critically, is it becoming less positive over time as the company gets bigger and goes after more elusive customers, in the face of increased competition from Amazon and LivingSocial? Unfortunately, the firm is providing little information on these key questions.
Growth and Credibility: My favorite framework for thinking about businesses is a financial balance sheet.
Within this framework, here is the key difference between mature and growth companies. The former derive most of their value from assets in place, whereas the latter get the bulk of their value from growth assets. Since the value of growth assets rests entirely on perceptions and expectations about the future, it also rides on the credibility of management. In other words, you need to believe managers when they tell you their plans for the future and you expect them to be disciplined in following through. If managers are not credible and disciplined, the value of growth assets can very quickly melt away. That is the lesson that Groupon and its investment bankers do not seem to get. As a potential investor in Groupon, I am not valuing it based on how much money it made or lost last year but on my expectations about its future. All the accounting moves made by Groupon over the last year seem to be centered around making their numbers (revenues, earnings etc.) from last year look better. Even if they succeed in this endeavor, all they will do with these actions is change the value of their existing assets marginally. In the process, though, they have damaged the trust that investors have in them and put the value of their growth assets at risk. When 90% or more of your value comes from growth assets, that is just dumb.
Each of these issues deserves a full post and I will make a series of posts in the next few days on each one. In the meantime, these companies will continue to entertain us for the next few months. Let's face it! Growth companies are a lot more fun to assess than mature companies.
Blog post series on growth
Growth and Value: Thoughts on Google, Groupon and Green Mountain
Growth (Part 1): The Limits of Growth
Growth (Part 2): Scaling up Growth
Growth (Part 3): The Value of Growth
Growth (Part 4): Growth and Management Credibility
The feasibility of growth: With growth companies, the debate about how high growth rates can be and how long growth can be sustained falls along predictable lines. The optimists argue for high growth and the pessimists argue that this growth is not feasible and investors are caught in the middle, wondering which side to believe. Ultimately, though, a company’s growth is constrained by the size of the market in which it operates. Green Mountain Coffee, for instance, had revenues of $1.36 billion in 2010, a sizable market share of the processed coffee market. To provide a measure of what is feasible, the overall revenues from coffee sales at supermarkets, drugstores and retailers in the US in 2010 amounted to little more than $ 5 billion; Folger's is the largest of the grocery store coffee producers has revenues of about $ 2 billion. While this total revenue does not count revenues from products like Keurig, it leads me to believe that Green Mountain Coffee is not a "small" company in this market. It is always possible that Green Mountain could expand its product line but what are its choices? Green Mountain maple syrup comes to mind, but that is a tiny market; Green Mountain chocolates may work, but the premium chocolate brands carry Swiss or Belgian imprimaturs. It is also possible that Green Mountain could increase the overall size of the market by convincing tea and soda drinkers to switch to gourmet coffees... but I think that is unlikely to happen.
Scaling Growth: As companies get larger, their growth rates will decline. That is indisputable, though great growth companies may be able to slow the decline and extend it over longer periods. Google, for instance, has been more successful than most growth companies in the last decade in sustaining high growth for an extended period, but even it has found that it is far more difficult to post high growth rates in revenues as its gets bigger. In the figure below, I graph out the percentage change in revenues and the dollar change in revenues each year at Google from 2001-2010. While the $ change in revenues has increased over time, the percentage change in revenues has decreased every year (except 2009). And consider this: Google is one of the most successful growth companies of the last decade.
Growth and Value: While many analysts view higher growth as good for value, it is clearly not that simple. After all, going for higher growth requires companies to make a trade off. On the one side, there is the good stuff: higher growth boosts revenues and earnings. On the other side, there is the bad stuff: growth is not free. Companies have to invest to generate sustainable growth: those investments can be in long term assets (factories if you are a manufacturing firm, R&D if you are a technology or a pharmaceutical firm, recruiting & training if you are a consulting firm), short term assets (inventory or accounts receivable) or acquisitions of other companies. All of these investments reduce cash flows. The net effect can therefore be positive or negative and is captured by looking at whether the firm generates a return on its investments (return on invested capital or return on equity) that exceeds its cost of funding (cost of capital or cost of equity). In the case of Google, the price of growth has risen over time, as the company seems to be caught in a cycle of making acquisitions that get larger each year, to post the same growth rates. With Groupon, this debate has morphed into an accounting question. Even if we accept the company’s argument that customer acquisition costs should be capitalized (see my earlier post on the issue), the question that follows is a simple one. How much value is added by a new customer? (To answer this question, the company will have to provide more information on customer behavior.) More critically, is it becoming less positive over time as the company gets bigger and goes after more elusive customers, in the face of increased competition from Amazon and LivingSocial? Unfortunately, the firm is providing little information on these key questions.
Growth and Credibility: My favorite framework for thinking about businesses is a financial balance sheet.
Within this framework, here is the key difference between mature and growth companies. The former derive most of their value from assets in place, whereas the latter get the bulk of their value from growth assets. Since the value of growth assets rests entirely on perceptions and expectations about the future, it also rides on the credibility of management. In other words, you need to believe managers when they tell you their plans for the future and you expect them to be disciplined in following through. If managers are not credible and disciplined, the value of growth assets can very quickly melt away. That is the lesson that Groupon and its investment bankers do not seem to get. As a potential investor in Groupon, I am not valuing it based on how much money it made or lost last year but on my expectations about its future. All the accounting moves made by Groupon over the last year seem to be centered around making their numbers (revenues, earnings etc.) from last year look better. Even if they succeed in this endeavor, all they will do with these actions is change the value of their existing assets marginally. In the process, though, they have damaged the trust that investors have in them and put the value of their growth assets at risk. When 90% or more of your value comes from growth assets, that is just dumb.
Each of these issues deserves a full post and I will make a series of posts in the next few days on each one. In the meantime, these companies will continue to entertain us for the next few months. Let's face it! Growth companies are a lot more fun to assess than mature companies.
Blog post series on growth
Growth and Value: Thoughts on Google, Groupon and Green Mountain
Growth (Part 1): The Limits of Growth
Growth (Part 2): Scaling up Growth
Growth (Part 3): The Value of Growth
Growth (Part 4): Growth and Management Credibility
10 comments:
Prof. I'm your student and with all due respect, as these companies grow larger I do agree the growth with slow down, but lower growth on a bigger pie would result in exponentially larger profits year on year.
Ashu Shukla
Disclaimer: I sold put spreads on google a week earler, and bought put spreads on GMCR
Are we talking about dollar profits (where I don't disagree with you) or about percentage growth in profits (where I do)?
Off-topic:
Prof. Can you please share your recommended reading list, in addition to your own writings, and online resources that you follow and find the most interesting?
Aswath,
2 Comments:
1. The statement I heard the other day is that hitting the expected growth is a lot better, market-wise, than what the actual growth number is.
2. The topic of scaling growth always reminds me of restaurant stocks. The growth prospects are great for a while, and all the analyts are hot for those companies. During different periods it was either "Shoneys, Shoney's, Shoneys", then "Krispy Kreme, Krispy Kreme, Krispy Kreme", then "PF Changs, PF Changs, PF Changs". The critical time occurs when the market realizes the scaling event has occurred. Once they are on every street corner, there is not much more growth to be had.
This leads to my question: a stock with 20% exepected growth will be priced a lot differently than 10% growth. What is the best way to manage the market's expectation to that change without tanking the shares?
It is true that the stock price reaction to an earnings report is all about whether the earnings meet expectations. But that feeds into my point. When you buy a company for a high PE, you are building in high expectations of growth. Much tougher to meet those expectations...
As for managing growth expectations, I am assuming that you are asking from the perspective of the management of these companies. There is no easy way to let down investors whose expectations have been set too high. That is why I also think that the key is to step in before the expectations get out of hand and dampen them...
Are "innovative" companies bound in size by a knowable market size? Basically, is there a way of estimating a market size for a new market?
Dave has a good point. Some companies (mostly tech) will be able to create a market for their products and take the benefit of being number 1 player in that market for a while. You wouldn't be able to say the same thing about a company like Green Mountain (or, at least, there is less chances for that).
Hitting the 'expected numbers' is important because the share price of a company should already incorporate the expected growth (if you believe in market efficiency anyway).
I think an interesting topic would be investing in value vs growth companies.
Dave and Florin,
You are far more optimistic about "innovation" at companies that I am in. First, no company has a monopoly on innovation. Second, even if innovative, they cannot carry innovation across product lines. 3M may be innovative when it comes to office products but it won't carry over into appliances. Can a company pull this off? Sure! Is it likely? No. You never want to value for the exception.
Deewali Greetings Sir!
Is there any possibility to pen your thoughts on Flipkart.com, another ecommerce company emerging in India. On valuation side, heard that it is $ 1 Billion now by some publications. Would be great if you could share your insights on this..
I have always found turning the argument on it's head very useful and that is to make the implicit assumptions explicit by finding out "what is in the price" ie what are the goal seek combo of growth rates assumed, terminal growth ,breakup of price for past vs price for future in the current price. The putting thoughts on the assumptions playing out makes it much much easier.
Post a Comment