QUALIPORT
Growth Shares Heading For Trouble

By Maynard Paton (TMFMayn)
October 21, 2002

If you use a company's financial history to help judge its future performance, then beware of the business that has a penchant for acquisitions. More often than not, a company's acquisition spree eventually results in shareholder trouble.

Rather than be blinded by just a superior earnings record, long-term investors ought to consider how those earnings were created. Generally speaking, the best businesses to own are those that have grown without recourse to merger and acquisition activity. The worst businesses to own are those that are constantly adding to (and disposing of) their operational interests.

There are four reasons why organic growth should be the central plank to your share's growth record.

1) Buying a bad business

The obvious risk to any acquisition hungry company is that it buys a business worse than its own. Diworsification is always bad news. Just like the ordinary investor buying shares, there is always the chance of your company buying a truly awful business. 

2) Lack of financial clarity

When acquisitions are brought into the picture, the odds of misinterpreting a company's financial performance are greatly enhanced. As well as clouding 'underlying' turnover and profit figures, other calculations, such as the return on equity, can become very distorted. There are also those all-too-familiar costs that relate to corporate restructuring. If the company has a hankering for acquisitions, are those costs truly exceptional?

3) Integration problems

Acquisitions (especially foreign ones) require integration and management can soon be burdened with costly logistical and cultural issues. And while their concentration is directed elsewhere, operational slip-ups can occur in the main business.

4) Uncreative management

Acquisitions are hardly a sign of the entrepreneurial spirit that drives most businesses to long-term success. Instead, they give an impression of a boardroom lacking in creativity. It's far easier (and perhaps more exciting) to buy your rivals rather than spend time enhancing your own products or services. Simply, the really good companies should have no need to buy their rivals -- they should be steamrollering them instead!

Small growth

Good examples of companies that have suffered from acquisitions are JJB Sports (LSE: JJB), SFI (LSE: SUF) and Photobition. Each has given shareholders a terrible time after their corporate activity finally unravelled.

Two examples of acquisitive companies that could be heading for trouble are RPS Group (LSE: RPS) and PHS Group (LSE: PHY). Both firms operate within 'growth' industries, have attractive financial records and have a real hunger for acquisitions. While the two companies have yet to show any sign of difficulties, shareholder danger can't be too far away.

RPS

Floated in 1995, RPS is an environmental consultancy and provides services such as town planning, transport planning, waste management and engineering design. At 114p per share, the company is valued at £216m. The five-year record shows earnings compounding at 25%-plus per annum:

Year to 31 Dec              1997    1998    1999    2000    2001

Sales (£m)                  20.5    26.3    32.4    57.4    74.8
Pre-tax profit (£m)          3.8     5.1     6.5     9.9    13.9

Earnings per share (p)       2.0     2.7     3.3     4.5     5.5
Dividend per share (p)       0.8     0.9     1.0     1.2     1.4

However, the following table puts the growth activity of RPS into perspective:

Year to 31 Dec              1998    1999    2000    2001    2002 (h1)

Pre-tax profit (£m)          5.1     6.5     9.9    13.9     8.5
Acquisitions (£m)            2.3     3.4    16.8    13.4    16.7

To fund the purchases, a placing in 2000 raised £16m and a rights issue launched during 2001 provided a further £41m. The businesses acquired have been diverse: the UK's largest town planning consultancy, Ireland's leading 'planning, infrastructure and environmental' consultancy, a nuclear waste and power station decommissioning consultancy, a Dutch asbestos 'management' firm, a specialist providing noise and air quality assessments and two firms that advise the water industry on leak reduction. Combined with the more traditional health and safety activities, plus 'risk management' and engineering design services, RPS has become a very mixed bag.

One particular danger associated with RPS is the human element of its business -- all the company's assets walk out the office every night. A real shareholder threat is the entrepreneurs running the acquired consultancies walking out for good.

PHS

Floated during 2000, PHS provides various workplace services, including cleaning washrooms, dust mat rentals, the provision of live and replica plants and supplying water dispensers. At 77.5p per share, the company is valued at £401m. Although large debts prior to listing hampered profitability, turnover has doubled over the past three years:

Year to 31 Mar              1999    2000    2001    2002

Sales (£m)                  56.8    77.9    97.1   114.7
Pre-tax profit (£m)          9.6    (3.1)   (3.8)   21.9

Earnings per share (p)       1.4    (0.6)   (0.7)    5.2
Dividend per share (p)         -       -       -     0.4

At the time of listing, PHS had earmarked £100m for acquisitions. The company's first full year on the stock market saw £30m spent of 25 bolt-on purchases, while another £26m has been spent (so far) in the current financial year. To put those figures into perspective, brokers expect pre-tax profits of £38m from PHS this year.

Businesses involved in the rental of removal crates, washroom consumable telesales, the collection and disposal of out-of-date prescription-only medicines, air freshener rental and the supply of point-of-use purified water dispensers have all been snapped up. Like RPS, PHS is also fast becoming a very diverse operation.

Non-disclosure

Somewhat worrying for shareholders, both RPS and PHS do not divulge the profits and sales generated by acquired businesses in the year of purchase.

As PHS state: "Continuing operations include the results of acquisitions made during the year. It is not practicable to determine the post-acquisition results to the end of the year of acquisition.  This is due to the trade and assets of the companies or business acquired being incorporated into the existing trade and assets of the Group and consequently, their results are not separately identifiable post-acquisition."

Suffice to say, determining whether the 'synergy' benefits are flowing through is very difficult. As such, there's plenty of scope to hide a deteriorating core business via more purchases. All in all, the acquisitive nature of RPS and PHS, especially with the opaque accounting, signals clear danger.

More: Danger: Acquisition In Progress

The author owns shares in JJB Sports.