‘Roll-ups’ take different path toward growth
If you’ve ever marveled at a company that’s acquiring many others, you may be looking at a “roll-up.” And if you’ve ever wondered whether it might be an attractive investment, read on.
Roll-ups are companies that grow not by ramping up operations and increasing sales internally, but by acquiring many smaller competitors, usually in a fragmented industry. This can be a risky business, as each acquisition has its own ways of doing things and each has to be integrated into the roll-up.
Some roll-up companies include Alderwoods Group (specializing in funeral homes), Quest Diagnostics (providing diagnostic services for the health care industry) and Mobile Mini (a company that leases and sells portable storage units). Even Home Depot has been rolling up lately, buying 30-plus wholesale distributors.
Whereas many diversified firms begin as small companies and grow organically, gradually buying other companies, a classic roll-up has a more unusual modus operandi. The company may not even exist until its founder/promoter finds about five to 15 companies willing to join forces with him in exchange for cash and stock. This cash and stock may not materialize until the company goes public (which it quickly does), enticing investors with its rosy projections and plans. In a sense, the roll-up acquires companies on credit!
This process likely continues, with the company issuing more stock as it acquires more companies. Let’s say that an acquiree’s stock price is valued by the market at about 10 times earnings. If it generates $5 million in annual earnings, the roll-up might buy it for about $50 million in cash and stock. Meanwhile, the roll-up itself might be enjoying a valuation on the stock market of about 20 or 30 times earnings. In this way, the roll-up is immediately recognizing a higher value for its purchase than it paid.
Unfortunately, roll-ups are frequently run by people more adept at sales and promotion than at running large and growing businesses. Integrating the businesses can be extremely difficult.
Not all roll-ups are to be avoided. But study them closely before jumping in.
Ask the Fool
Q: What’s a company’s “payout ratio”? — H.L., Sheboygan, Wis.
A: It’s the percentage of earnings (net income) paid out to shareholders as a dividend. For example, Pfizer (NYSE: PFE) is expected to earn approximately $2 per share this year, and its annual dividend amount is currently 96 cents. Divide 0.96 by $2 and you’ll get 0.48, or a payout ratio of 48 percent.
High payout ratios leave little money to reinvest in the company. That can be OK, if a firm is big and established and doesn’t need that cash. Sometimes reinvested earnings would return less than shareholders could get investing the payout on their own.
Steep payout ratios can be red flags. If a company’s ratio is 125 percent, for example, it will have to dig into reserves to pay its dividend, something it can’t keep up forever. It may have to reduce its dividend.
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My dumbest investment
After I retired, we found a nice, rolling 100-acre place in the Midwest, built our home, and I tried to decide how to spend the rest of my life. My neighbor had cattle. So I thought, why not buy some calves and use them to generate a nice retirement income? It seemed sound. Buy a couple-hundred-pound calf, let it eat my grass (which I wouldn’t have to mow), and several months later, sell a much larger cow for a lot more money. Unfortunately, I picked the absolutely most expensive time to buy calves and the absolutely cheapest time to sell cows. I then bought heifers, had them bred, and lost two during calving.
The bright side of stock market investing vs. cattle stock investing is that if a company’s stock goes down, at least we don’t have to clean out the barn. I’m heading back to the stock market. — R.W., Baldwin, Kan.
The Fool Responds: That sounds like a good mooove.