Due to consolidation accounting (or “Group accounting”) rules, when one company controls another one (from 50% + 1 vote up to full-control of 100%, depending on circumstances), that first company (or the “parent” company) gets to accounting for both the financial performance of itself and the financial performance of all the companies that it controls (or its “subsidiaries”).
This process is logical and I agree with it (unlike some accounting rules out there). If you think about it, the Parent Company controls the underlying resources of all subsidiary companies via its shareholding in them. Thus, in order to best understand what the Parent Company actually looks like, you should take into account what the sum total of all subsidiaries also look like.
I hope that makes sense? If it doesn’t, then here is a little more practical reading on the subject for you.
Anyway, you need to understand this concept of “consolidation” in order to understand exactly what acquisitive growth is.
As most listed companies are in fact groups of companies (in the legal and accounting senses of the word), the key financial results that they release bi-annually are “consolidated group” financials.
Since a subsidiary company’s results will only be consolidated into the parent company’s results from the date that control was obtained (i.e. normally from the date of the acquisition), the parent company’s profits can appear to grow during this period when in fact it is purely the uplift of accounting for a larger group that has happened.
What do I mean?
Well, let’s say that Company P earns annual profits of R1000 (this profit never changes nor grows; i.e. static). Company P then borrows R100 at a 10% interest rate and buys Company S. Company S earnings annual profits of R20. Let’s also say that Company P makes this acquisition half way through its FY 16.
Thus, in FY 16, Company P’s earnings will impacted by the following (ignoring taxation for all purposes):
- Add: Original profits of R1000 pa
- Less: R100 x 10% interest for 6 months = -R5 in FY 16
- Add: R20 Company S earnings that are consolidated from the date of acquisition (i.e. for 6 months or half of FY 16) = R20 / 12 months x 6 months = R10.
Thus, Company P’s (group) profits for FY 16 appear to have grown to R1,005 (= R1000 – R5 + R10), yet nothing actually changed. This is acquisitive growth of R5.
Likewise in FY 17 when the following happens:
- Add: Original profits of R1000 pa
- Less: R100 loan x 10% interest for a full year = -R10
- Add: R20 Company S earnings for the full FY 17 year (as it was controlled for the full FY 17 period) = R20
Thus, Company P’s (group) profits for FY 17 appear to have grown to R1,010 (= R1000 – R10 + R20), yet nothing has actually changed.
Once again, this is acquisitive growth of R5 in FY 17.
I hope you followed that example (if you did not, then I suggest you read it again), as it demonstrates how a company’s profits can appear to grow across multiple financial years from a single smart acquisition, yet the core business is potentially flat. This is what they refer to as “buying growth”.
In the above example, Company P is using debt. In order for Company P to ensure that this acquisition increases (i.e. is “accretive to”) its earnings from the moment it is consolidated, Company P must ensure that it is paying less interest on its loan than it is earning in profits from Company S. This is easier said that done, as interest is fixed and may rise with interest rates while a business’s profits will likely be volatile.
Still, you get the idea about how to structure an acquisition such that when it is consolidated that the Group’s profits grow acquisitively.
Likewise, if Company P was paying for Company S with shares (issuing share and not borrowing from the bank). While I am not going to go into the intricacies of the calculation, take my word for it that if Company P pays a lower Price Earnings (PE) for Company S than Company P’s shares are trading at, then the acquisition is probably going to be accretive.
Hence, companies like EOH Holdings (EOH), Ascendis Health (ASC), Consolidated Infrastructure Group (CIL), Bidvest (BVT) and a lot of the listed property REIT can structure such impressive growth rates over many years.
Not all of these are bad companies, for example, I really like CIL – see here. That said, I also have serious doubts about EOH’s sustainable valuation (see here) as the core business is only pretty much growing at a market-related growth rate (per my calculations).
All I am saying here is that acquisitive growth is neither good nor bad. It is what it is. Rather understand it thoroughly, and then analyse each company and potential share investment on its own merits, taking this knowledge into account. Thus, hopefully, you will not get caught out with listed companies that buy growth while they are quietly failing in the background and you can find and invest in those businesses with excellent capital allocation and integration teams that are exponentially rising up the ladder.