Jeremy Chia, Author at The Good Investors : Page 4 of 20

What Makes Some Serial Acquirers So Successful

What makes serial acquirers such as Berkshire Hathaway so successful?

Serial acquirers are companies that acquire smaller companies to grow and they can make for excellent investments. They use the cash flow produced by each acquisition to buy even more companies, repeating the process and compounding shareholder value.

There are many serial acquirers that have been hugely successful. The best-known of them is Warren Buffett’s Berkshire Hathaway. But there are others who have been tremendous successes in their own right.

Markel Corp, for example, is like a mini Berkshire. It is an insurance company at its core, but has used its profit and insurance float to acquire numerous companies and build a large public stock portfolio. Over the last 18 years, Markel’s share price has risen by 286%, or 7.8% compounded.

In the software space, Constellation Software has made a name for itself by acquiring vertical market software (VMS) companies. Its targets are usually small but have fairly predictable and recurring streams of cash flow. Constellation Software’s stock price has compounded at 33% over the last 16 years. The total return for shareholders is even higher, as Constellation Software started paying a quarterly dividend a decade ago and has given out three bumper special dividends.

Another great example of a niche serial acquirer is Brown & Brown Inc. Founded way back in 1939, Brown & Brown is an insurance brokerage company that packages and sells insurance products. The industry is highly fragmented but Brown & Brown has grown to become a company that generates billions in revenue each year. The company has done it by acquiring smaller insurance brokerage firms across the USA to build a large presence in the country. In the last 18 years, Brown & Brown’s stock price has grown by 439%, or 9.8% per year. In addition, Brown & Brown’s shareholders have also been receiving a growing dividend each year.

After reading through the success stories, here are some things I noticed that many of these successful serial acquirers have in common.

Buying companies at good valuations

Good returns on capital can be achieved if acquisitions are made at a reasonable valuation. Constellation Software is a great example of a company that makes acquisitions at really reasonable valuations.

The companies acquired by Constellation Software are often not fast-growing. This can be seen in Constellation Software’s single-digit organic growth in revenue; the low organic growth shows that Constellation Software does not really buy fast-growing businesses. But Constellation Software has still managed to generate high returns for its shareholders as it has historically been paying very low valuations for its acquisitions, which makes the returns on investment very attractive. It helps too that the companies acquired by Constellation Software tend to have businesses that are predictable and consistent.

Focusing on a niche

Constellation Software and Brown & Brown are two serial acquiries I mentioned above that focus on acquisitions within a particular field.

Judges Scientific is another company with a similarly focused acquisition strategy – it plays in the scientific instrument space. Specifically, Judges Scientific acquires companies that manufacture and sell specialised scientific instruments.

Since its IPO in 2004, Judges Scientific has acquired 20 companies and its share price has compounded at 27.9% per year. Its free cash flow has also grown from £0.3 million in 2005 to £14.7 million in 2021.

Serial acquirers that focus on a special niche have a key advantage over other acquirers as they could become the buyer of choice for sellers. This means they have a higher chance of successfully negotiating for good acquisition terms.

Letting acquired companies run autonomously

Berkshire Hathaway is probably the best known serial acquirer for letting its acquired companies run independently. The trust that Buffett places in the management teams of the companies he buys creates a mutually beneficial relationship.

This reputation as a good acquirer also means Berkshire is one of the companies that sellers want to sell to. Often times sellers will approach Berkshire themselves to see if a deal is possible.

Other than Berkshire, companies such as Constellation Software and Judges Scientific also have a reputation for allowing companies to run independently. Judges Scientific’s top leaders, for instance, may only have two meetings a year with the management teams of its acquired companies and they let them run almost completely autonomously.

Returning excess capital to shareholders

One of the common traits among all successful companies – be it a serial acquirer or not – is that their management teams emphasise shareholder value creation. This means effective use of capital.

When successful serial acquirers are unable to find suitable uses for capital, they are happy to return excess cash to shareholders. They do not let cash sit idly in the company’s bank accounts. Companies like Brown & Brown, Judges Scientific, and Constellation Software all pay dividends and rarely let excess capital build up unnecessarily on their balance sheets.

Final thoughts

Serial acquirers can be great investments. Those that are successful are usually great stalwarts of capital. While no single acquisition is the same, the thought process behind the acquisitions is repeatable. With a structured approach to acquisitions, these serial acquirers are able to repeatedly make good acquisitions to grow shareholder value. And when there are insufficient acquisition targets available, successful companies are not afraid to put their hands up and return excess capital to shareholders.

When you invest in a serial acquirer, you are not merely investing in a great business but in great managers and great processes that can keep compounding capital at extremely high rates of return for years to come.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Markel Corp. Holdings are subject to change at any time.

3 Best In Class Practices That All Companies Can Learn From Constellation Software

Constellation Software’ stock price has climed by more than 100x since 2006. Here are some of the reasons for its success.

Constellation Software (TSE: CSU) is a Canada-based software company that grows by acquiring vertical market software (VMS) companies. Since its founding in 1996, it has grown to become one of the largest diversified software companies in the world. In 2021 alone, it generated US$5.1 billion in revenue and US$1.2 billion in free cash flow.

Shareholders of Constellation have been healthily rewarded over the years. Since its IPO in 2006, the company’s stock price has skyrocketed by around 114 times in value, which equates to a compounded growth rate of 32% per year. In addition, for the past decade, Constellation shareholders have been collecting a dividend each quarter and have enjoyed three special dividends.

Why has Constellation been such a success? One of the main reasons is that management has been excellent stalwarts of its capital. The company uses most of its cash flow generated from operations to acquire and buy smaller software companies at a relatively low price. These software companies tend to be already free cash flow positive, which means they can generate more cash flow for Constellation once they become part of the family. The process is repeated with the cash flow generated from these new acquisitions.

But other than making excellent acquisitions, Constellation’s management also has best-in-class practices that serve shareholders extremely well. Here are three big ones that all other companies can learn from.

Not giving stock-based compensation to employees

Stock-based compensation (SBC) is a great way to incentivise employees to think like shareholders. But the dilution from SBC can be a real problem.

Constellation’s solution is to not give SBC at all. The idea is that SBC in the form of options or restricted stock units (RSUs) that can be sold immediately upon vesting can sometimes encourage employees to drive up a company’s stock price over the short term. Constellation wants its employees to focus on the long term.

Instead, Constellation buys its own shares in the open market and then pays these shares to employees as a bonus. Employees are restricted from selling these shares for an average of four years. The difference between Constellation’s practice and more common forms of SBC is that no new shares are created – they are bought from the open market – resulting in no dilution. The multi-year restriction on selling shares also ensures that Constellation’s employees are not too focused on the near-term stock price of the company.

Not letting cash sit idle

Constellation first started to generate more than a billion US dollars in free cash flow in 2021. Instead of letting all this cash sit idle on Constellation’s balance sheet, management is consistently looking for ways to redeploy that capital. Management typically looks for companies to acquire. But when suitable candidates are insufficient for Constellation to deploy all its excess cash, the company returns capital to shareholders.

This, to me, is the fiscally responsible thing to do as shareholders are able to put that cash to work through other investments or even subscribe to Constellation’s dividend reinvestment plan. This enables shareholders to own a larger percentage of the company over time.

This practice is unlike many companies – such as many that are found in Singapore – which have hurt shareholders by letting their excess cash sit idle in low-yielding accounts in the bank. This cash could have been put to better use by returning them to shareholders.

Mark Leonard, Constellation’s founder and president, explained his reasons for paying a special dividend in 2019. He said:

“Capital allocation is a perennial topic for our board discussions. This quarter I got the sense that the board hit a tipping point. There were a number of factors. We had excess cash. We are deploying more capital in the vertical market software sector, but don’t see dramatic growth this year unless competition slackens. One of the directors mentioned that they were disappointed with my efforts to find new avenues for investment (outside of vertical market software), and that we should apply more effort. I don’t disagree, but that is unlikely to reduce our cash meaningfully in the short term. Those factors seemed to combine to make this the right time to pay a special dividend. Perhaps dividends are perceived as a failure… but to my mind, they are less of a failure than sitting on excess cash.”

Not buying back shares mindlessly

Share buybacks that are conducted at low prices can be a better use of capital than dividends if the dividends are subjected to tax. But if the buybacks are done at high prices, it could lead to lower returns for shareholders.

Some companies mindlessly buy back their shares even when their share prices are high. This is detrimental to their shareholders who would be better off just getting the cash in dividends. Unlike such companies, Constellation’s management is cognisant of the benefits and drawbacks of share buybacks.

In 2018, Leonard flashed out his thoughts on buybacks:

“History is replete with examples of directors and officers using insider information to abuse shareholders. Regulators eventually twigged to the problem and market-making by insiders is now illegal except in highly prescribed circumstances. Despite these regulatory efforts, the scholarly research is clear that buybacks commonly increase short-term share prices and are more frequently associated with insider selling than insider buying. My sense from the research is that most buybacks help short-term sellers rather than long-term owners. I’d prefer that our employees be aligned with Constellation’s long-term owners. Alignment with long-term owners may not work in PE-backed or venture-backed companies or when the majority of your investors are transient. In those instances, catering to the objectives of short-term sellers is more rational.

There are a minority of cases where a company designs a buyback to benefit long-term owners by acquiring shares at less than intrinsic value. If you consider only long-term owners, the “success” of this kind of buyback is dependent upon the company acquiring as many of its shares as far below intrinsic value as possible. In that case, the directors and officers could maximise “success” by 1) convincing the market not to buy the company’s shares, and 2) convincing some existing company shareholders to sell their shares below intrinsic value. This is one of those instances where the moral compass and the apparently common-sense definition of “success”, point in opposite directions. When there are reasonable alternatives, I try to avoid such dilemmas.

If the problem is determining how to return capital to shareholders when its shares are trading for less than intrinsic value, why expend energy on the inherent conflict of a buyback, when dividends are a good alternative? In those circumstances I can think of only a couple of examples where I might prefer a buyback to a dividend… i.e. if most of our shareholders were taxable entities, or if I’d had a sincere conversation about the company’s prospects with a sophisticated large block shareholder who still wished to sell.

If the problem is that company shares are trading at a value significantly below or above intrinsic value, and the directors and officers have exhausted all other methods of broadly communicating that fact, then a buyback or share sale may be warranted. “

I think the main benefit of buybacks for long-term shareholders is that it is a more tax-efficient than receiving dividends which are, in some circumstances, taxed. However, in Constellation Software’s case, this argument may not hold as Canadian residents are not taxed on dividends received from Canadian companies. As such, Constellation Software has no reason to prefer buybacks over dividends. (Non-residents of Canada who are shareholders of Constellation Software may benefit from buybacks but this group of shareholders is likely the minority.)

Closing thoughts

It is no coincidence that Constellation’s shareholders have been healthily rewarded for many years. Management is prudent with the company’s capital, and is extremely thoughtful when it comes to the major financial decisions that impact shareholders.

I believe that as long as Constellation continues to uphold such high standards, shareholders will continue to be well-rewarded for years to come.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any companies mentioned. Holdings are subject to change at any time.

When Should Companies Buy Back Their Shares?

The scenarios in which share buybacks make sense.

Stocks have taken a beating this year, to say the least. The S&P 500 is down around 19% year-to-date while the NASDAQ has slumped by around 30%. Many high-growth stocks have fallen even harder than that and it is not uncommon to find stocks that are down more than 80% this year.

While these declines are painful, a downturn in stock prices does provide a potential upside: The opportunity to conduct cheap buybacks. Low stock prices mean that companies can buy back their shares at relatively cheaper levels. When done at the right prices, share buybacks can be highly value-accretive for a company’s shareholders.

Measuring the impact of share buybacks

Buybacks reduce the number of shares outstanding. A company’s future cash flows are, hence, divided between fewer shares, leading to more cash flow per share in the future. But it comes at a cost. The cash that’s used to buy back stock could have been used to pay a dividend to shareholders instead. So how do share buybacks impact the long-term shareholder?

To better appreciate what happens when a company buys back its own stock, let’s examine a simple example. Let’s assume that Company A generates $100 in free cash flow per year for 10 years before it stops operating. The company has 100 shares outstanding, so it essentially generates $1 per share in free cash flow for 10 years. Let’s imagine two different scenarios.

In Scenario 1, Company A decides to pay all its free cash flow to shareholders each year. Hence, shareholders will receive $1 per share in dividends each year for 10 years. In Scenario 2, Company A decides that it wants to buy back its shares after the first year. Let’s say its stock price is $5. Therefore, Company A can use its $100 in free cash flow in year 1 to buy back and retire 20 shares, leaving just 80 shares outstanding. From year 2 onwards, Company A decides that it will start returning its cash flow to shareholders through dividends. The table below shows the dividends received by shareholders in the two different scenarios.

In scenario 1, shareholders were paid $1 per share every year starting from the end of the first year. In scenario 2, shareholders were not paid a dividend at the end of the first year, but were paid more for each subsequent year.

We can measure the present value of the two streams of dividends using a discounted cash flow analysis. Using a 10% discount rate, the dividends in Scenarios 1 and 2 have a net present value of $6.14 and $6.54, per share, respectively. In Scenario 2, shareholders were rewarded with better value over the 10 year period even though they had to wait longer before they could receive dividends.

When buybacks destroy value

In the earlier example, Company A created value for shareholders by buying back shares at $5 a share.

But let’s now imagine a third scenario. In Scenario 3, Company A’s stock price is $7.50 and it decided to conduct a share buyback using all its cash flow generated after the first year. Company A, therefore, spent its first $100 in free cash flow to buy back 13 shares, leaving the company with 87 shares outstanding. The table below shows the dividends received in all three scenarios.

In Scenario 3, because shares were bought back at a higher price, fewer shares were retired than in Scenario 2 (13 versus 20). As such, Company A’s dividend per share in subsequent years only increased to $1.15. The net present value of Scenario 3’s dividends, using the same 10% discount rate, is only $6.04. This is actually lower than in Scenario 1 when no buybacks were done.

This demonstrates that buybacks are only value-enhancing when done at the right price. If the required rate of return is 10%, buybacks in the example above should only be done below the net present value per share of $6.14 if no buybacks were done.

Applying this to a real-world example

We can use this framework to assess if companies are making the right decision to buy back their shares. Let’s use the video conferencing app provider Zoom as a case study. Zoom started buying back its shares this year even as its stock price tanked.

In the first three quarters of its fiscal year ending 31 January 2023 (FY2023), Zoom repurchased 11 million shares for US$991 million. This works out to an average share price of approximately US$90 per share.

The table below presents my estimate of Zoom’s future free cash flow per share. I made the following assumptions:

Revenue grows at 10% for the first few years before growth tapers off slowly to 0% after 15 years.
The free cash flow margin improves from 27% currently to 45% over time.
Dilution from stock-based compensation is 3% a year
Zoom stops operating after 50 years
Its revenue starts to decline in the last seven years of its life

The table above shows the free cash flow per share generated by Zoom in each year under the assumptions I’ve made. Using a 10% discount rate and including current cash on hand (that can be used for buybacks or returned as dividends) of around US$18 per share, Zoom’s net present value per share works out to around US$112.

Recall that Zoom was buying back its shares at an average price of US$90 a piece. Under my assumptions, Zoom’s buybacks are value-accretive to shareholders.

Time to shine

Buybacks can be tricky to analyse. Although buybacks delay the distribution of dividends, they can result in value accretion to shareholders if done at the right price. With the stock prices of many companies falling significantly this year, buybacks have become a potential source of value enhancement for shareholders.

But remember that not all buybacks are good. We need to assess if management is buying back shares because the shares are cheap or if they are doing it for the wrong reasons. With stock prices down and the capital markets tight, I believe that this is a time when good capital allocation is essential. A management team that is able to allocate capital efficiently will not only cause its company to survive the downturn but potentially create tons of value for shareholders.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Zoom. Holdings are subject to change at any time.

The Drawbacks of Stock-based Compensation

Stock-based compensation conversation gets pushed to the back when stock prices are rising but problems start to creep up when stock prices tank.

Stock-based compensation (SBC), where a company pays its employees partly with shares, is table stakes when attracting talent for growing companies. And for good reason too.

Employees value SBC as it allows them to profit from a potential rise in a company’s stock price. From a shareholder perspective, SBC is also useful as it aligns employees’ interests with theirs. This is critical for high-level management who make executive decisions in a company; the idea is that executives who earn SBC will make decisions that drive shareholder value.

In addition, using shares instead of cash for compensation also improves a company’s cash flow. For cash-strapped businesses, SBC can be a good way to attract talent without breaking the bank.

But SBC is not without its drawbacks. This is becoming more apparent in recent times as stock prices of many fast-growing companies fall.

How does SBC work?

Before discussing some of the drawbacks of SBC, I’ll first quickly go through how SBC works. There are a few types of SBC. The most common forms of SBC that I’ve seen so far are restricted stock units (RSUs) and options.

RSUs are shares that are given to employees over a period of time. They are typically granted when an employee initially signs for a company or renews an employment contract. These RSUs vests over a few years. For example, an employee may start his employment at a company and be granted 100 RSUs that vest over four years. Essentially, the employee will get 25 shares of the company every year for four years.

The other common form of SBC is options. Options give the employee the right to buy shares of the company at a pre-determined price. Employees are also typically given options that vest over a number of years. For example, an employee may be given 100 options, with an exercise price of $100 per option, that vests over four years. This means that in each year, the employee will collect 25 options and he or she can decide whether to exercise the option and convert it into shares. The employee will need to pay the company $100 in exchange for the shares. If the share price is more than $100 in the open market, the employee can sell the shares and pocket the difference.

What’s the real cost?

Although SBC does not result in any cash expense for a company, it does have a cost – shareholder dilution.

This is because by giving away new shares to employees, the total number of the company’s outstanding shares increases. The higher number of shares outstanding means existing shareholders now own a smaller cut of the pie.

For instance, as of 30 September 2022, Palantir had around 2.08 billion shares outstanding. However, it also had around 331 million unvested or unexercised options and 131 million unvested RSUs. When vested (and if exercised), the outstanding share count will increase by 22%. Ultimately, what this means is that Palantir’s economics will have to be split among 22% more shares and each share will be entitled to lesser economics.

When stock prices fall, employees are unhappy

SBC is designed to reward employees when stock prices rise. It also encourages employees to stay with the company in order to collect the RSUs and options that vest over time. But when stock prices fall, these RSUs are worth less and there is less incentive to stay.

For example, in March of 2021, Okta’s president of field operations, Susan St Ledger, was given 43,130 RSUs that vest over four years. At the time, Okta’s stock price was around $228; today, it’s around $67. St Ledger has around 26,956 RSUs that have yet to vest. At the time of the grant, these unvested RSUs were worth $6.1 million. Today, her remaining unvested RSUs are worth just $1.8 million.

Okta announced recently that St Ledger is retiring. Although there are many possible reasons for her retirement, the decline in value of her unvested RSUs may have played a role in her decision.

Making up for shortfalls

As shown above, falling stock prices can have a big impact on the actual dollar value of unvested RSUs. To retain existing employees, some companies may opt to increase the number of RSUs that employees receive in order to make up for the decline in the dollar value of the unvested RSUs.

Zoom is one company I know of that has done just that. In its latest annual report, Zoom said, “In October 2021, we added a feature to new and existing stock awards that provide employees with additional awards based on certain stock price criteria.” The key word here is “existing“.

In typical employee contracts, the company is not required to increase the number of RSUs if the stock price falls. This is supposed to be the risk to employees for agreeing to SBC, and employees are meant to be impacted by lower SBC, which should drive them to work harder to increase the company’s stock price. But Zoom decided to step in to make up for the loss in RSU value by increasing the number of shares paid to employees over and above what was previously agreed.

Zoom has a reputation for emphasising employee welfare and pay packages are undoubtedly part of that equation. But retroactively increasing RSU grants is at the expense of shareholders who are getting more dilution in the process.

Offering more stock to new hires

Besides increasing the number of RSUs initially agreed upon for existing employees, companies need to offer higher number of shares to attract new talent and as “stock refreshers” to retain employees.

Let’s say a potential new hire wants a pay package that includes $100,000 worth of RSUs per year. If the stock price is $100 per share, the company would need to offer the employee 1000 RSUs per year. But if the stock is only trading at $50, the company will need to offer the employee 2,000 RSUs per year. This will lead to two times more dilution.

Unfortunately for shareholders, this is exactly what is happening to many companies in the stock market today. Take Facebook’s parent company, Meta, for instance. The total value of RSUs granted in the first nine months of 2022 and 2021 were around US$20 billion and US$16 billion, respectively, at each grant date. This only a 22% increase in dollar value.

But the true cost is the number of RSUs granted. In the first 9 months of 2022, Meta granted close to 100 million RSUs, while in the same period in 2021, Meta awarded 53 million RSUs. This is an 86% increase.

The discrepancy between the increase in value versus the increase in the number of RSUs is because the weighted average grant price in the first nine months of 2022 was US$201 compared to US$305 in the first nine months of 2021. The lower stock price meant that Meta needed to promise more RSUs to provide the same dollar-value compensation to employees.

As you are familiar with by now, more RSUs granted means more dilution down the road. And it may get worse. Meta’s stock price has fallen to around US$123 as of the time of writing, which will result in even more RSUs needing to be offered to match the dollar value of compensation.

And it’s not just Meta that is facing this issue. Companies like Zscaler, Snowflake, Netflix, Okta, Docusign, Amazon, Shopify, and many more have all granted multiples more RSUs and/or options so far this year compared to a year ago.

Final thoughts

SBC is a difficult topic to fully understand. Although it’s not a cash expense, it does have a very real impact on shareholders as it ultimately results in shareholders’ split of profits being diluted down.

When stock prices are high, dilution from SBC is low and it’s not too concerning. But when stock prices are low like today, dilution from SBC can become a real problem.

This issue should not be lost on investors. We need to monitor how our companies handle this issue and whether they are doing the fiscally responsible thing for shareholders.

In my view, SBC should be reserved for executive management who make important decisions for the company and its shareholders. Other employees should be paid less in SBC and predominantly or exclusively in cash, especially when the company has sufficient cash. Employees who want stock can use cash compensation to buy stock on the open market. This reduces dilution to shareholders. This is particularly important when stock prices are low and somewhat undervalued. Companies should be trying to buy back shares at these prices rather than issuing new shares.

Although the increase in SBC is leading to more dilution, it is not totally out of control yet. For example, Meta’s dilution (the number of grants awarded against the number of outstanding shares) this year is still only in the low single-digit percentage range.

But companies need to start being more prudent with their SBC before dilution gets out of hand. I believe that businesses that are able to find the right balance in times such as these will likely be the big winners once this downturn is over.

The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Meta, Docusign, Amazon, Okta, Zoom, Shopify and Netflix. Holdings are subject to change at any time.

What Is A Fair PE Ratio To Pay For A Stock?

Valuing a stock can be tricky. A high PE ratio may not mean poor returns and vice versa. Here’s a simple framework of what is the right ratio to pay.

One of the trickiest elements of investing is finding out how much to pay for a stock.

To make things simple, investors often divide the current stock price of a company by its earnings-per-share to gauge how expensive or how cheap the company’s shares are. This is known as the price-to-earnings, or PE, ratio.

For instance, a company that is earning $1 a share and trades at $20 a share has a PE ratio of 20. Another company that is earning $1 a share and trades at $10 a share has a PE ratio of 10.

On the surface, the latter company seems cheaper. But that’s not always the case. Other factors such as growth rates, reliability of earnings, and durability of growth come into play.

With many variables influencing stock valuation, here’s a simple framework that helps me gauge what is the right PE ratio to pay for a stock.

The DCF method

Before going further, we need to understand the discounted cash flow (DCF) valuation method. A DCF is the backbone behind valuing any stock.

The idea behind the DCF is that the value of a stock is the sum of all its future cash flows discounted back to today.

Let’s start with a simple example. Company A earns and pays out $1 a share in one year’s time before it closes down. If you are an investor, you will not want to pay $1 for a share of Company A today. You will want to pay less than $1 so that in one year’s time you will be able to reap a profit. Let’s say your required rate of return is 10% per year. In this case, you will only be willing to pay $0.909 ($1 discounted by 10%) a share. In a year’s time, you would be given back $1, which is 110% of your initial capital.

This is the thinking behind the DCF method of valuation. If a company will survive for more than a year, we can add more cash flows to the equation and solve for the net present value in order to ensure that we earn our required return.

Setting the stage

The DCF is the core concept that drives stock valuation. The PE ratio that we discussed earlier is a shorthand that gives us a quick sense of how much we are paying for a company.

Using the DCF method, and making some assumptions, we can find out what is a fair PE ratio to pay. To make things simple, I will make a few assumptions and parameters for this exercise. They are:

First, in the following examples, I use a 10% required rate of return.
Second, I assume that the companies’ earnings are the same as free cash flow to the shareholder.
Third, I assume that these earnings are distributed to shareholders who can invest the cash at a similar required rate of return (10% in this case).
Fourth, the companies’ earnings grow or shrink at the stated CAGR (compounded annual growth rate) evely.
Fifth, investors hold these stocks forever or until the business closes down.

A no-growth company

Using the assumptions above, let’s start with how much we should pay for a no-growth company.

Let’s say Company B will earn $1 a share a year for eternity. As mentioned above, our required rate of return is 10%. The DCF formula to find the net present value of this company is:

(E*(1+G))/(R-G), where E is next year’s earnings, G is growth and R is the required rate of return.

Plug Company B’s numbers into the equation and you get a value of $10 a share.

In this case, an investor will need to pay $10 a share to earn 10% per year. This makes perfect sense as the earnings yield needs to meet our expected rate of return because the company is not growing. In this scenario, the fair PE ratio is 10 (we need to pay $10 a share for Company B that is earning $1 per share).

A growing company

Let’s take another example.

Company C will earn $1 a share next year but will grow its earnings at 2% a year for eternity. Using the same formula, we find that we can make a 10% return if we pay $12.75 for the company. This means we should be willing to pay a PE ratio of 12.75.

What happens if there’s a company that can grow even faster? Let’s say Company D, with $1 a share of earnings next year, can grow at 8% per year for eternity.

Plug those numbers into the formula and you will find that you can now pay $54 for the company. This translates to a PE ratio of 54.

As you can see, the higher the growth rates, the higher the multiple that you can pay.

A shrinking company

The same formula works for a shrinking company too. For example, Company E will earn $1 a share next year, but from then on, its earnings will shrink by 5% a year.

Plug those numbers into the equation and you will find that in order to earn a 10% return on investment, you will have to pay $6.33 a share. That’s a PE ratio of 6.3. The table below is a compilation of the PE ratios that an investor should be willing to pay for companies with different growth profiles.

Growth plateaus

In practice, however, companies don’t grow to perpetuity. They tend to grow fast during the early stages of their life cycle before growth plateaus or goes to zero.

For example, a company may grow 5% for ten years before its growth zeroes and its earnings will thus remain flat forever. In this scenario, a fair PE ratio would be around 14.8 to achieve a 10% rate of return. The table below shows the fair PE ratios to pay for companies growing for 10 years at different rates before growth reaches zero.

As you can see, even if a company’s growth goes to zero after 10 years, an investor would still be able to pay a PE ratio of 132 for a company that is going to grow its earnings per share by a compounded annual rate of 35% for the first 10 years.

Limited life companies

In all of the above scenarios, I’ve assumed that the companies would last forever. However, in real-world scenarios, companies die out eventually.

As such, I have also modelled a scenario where a company grows for 10 years, before growth is zero for the next 30 years. From year 40 to 50, the company’s earnings then steadily falls to 0.

In this scenario, if the initial growth rate is 5%, a fair PE ratio to pay for the company is 14.8. The table below shows the fair PE ratios to pay for companies in the above scenario but with different initial growth rates.

But what if a company’s initial growth is more durable and lasts for 20 years instead of 10? Here are the reasonable PE ratios to pay for a company that will experience 20 years of growth before its growth is zero for 30 years and its earnings per share then slowly declines to zero from year 50 to year 60.

Using this information…

A company’s CAGR and the duration of that growth rate can have a large impact on what is the right multiple to pay for a company.

Some investors may be more demanding and require a higher rate of return than 10%. Personally, I target a 12% rate of return on my investments which means I will be willing to pay a lower PE ratio than those who demand just a 10% rate of return.

While this exercise gives us a feel of what sort of PE ratios to pay for a stock, there are some limitations to this method. For instance, inaccurate projections and wide variations in outcome-probability can impact valuations. In addition, holding a company’s shares to perpetuity or till the company shutters may not be feasible for most investors.

In the former case, the exit multiple of the stock and the market’s required rate of return at the point of exit is an important consideration. This will be influenced by factors such as the prevailing interest rate environment at the time of exit.

So while this is not a foolproof method, this framework at least gives us a sense of whether a stock is cheap or expensive based on our own required rate of returns.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Singapore Airlines Is Redeeming The First Tranche of MCBs – Is That Good For Shareholders?

SIA shareholders were treated to the news that the company was in a position to redeem the first tranche of MCBs. Here’s what that means for shareholders.

Singapore Airlines (SGX: C6L), or SIA, will be redeeming its first tranche of mandatory convertible bonds (MCBs).

These bonds were issued by the airline merely 2.5 years ago in 2020, near the peak of COVID-19 lockdowns. Back then, SIA had to pause most of its operations as passenger air travel was severely restricted due to the pandemic. Cash was short for SIA and it desperately needed to raise money. But things have improved significantly for the company this year as it reported a record profit in the first half of FY23 and free cash flow was also comfortably positive.

With its finances moving in the right direction, SIA’s management has decided that redeeming the airline’s first tranche of MCBs would benefit its shareholders. In this article, I explore whether the airline is making the right decision.

First, is redeeming the MCBs a good use of capital?

In my view, the short answer is yes. The MCBs are a costly source of capital for SIA and redeeming them early will save the company significant money.

The MCBs are zero-coupon bonds but have a set annual yield that starts at 4% before rising to 5%, and then 6% (head here for more detail on the MCBs). What this means is that the longer the MCBs are left unredeemed, the more expensive it becomes for SIA to redeem them in the future.

Moreover, if left unredeemed for 10 years, these MCBs will automatically convert to shares. The conversion price of the shares is S$4.84 at the end of the 10-year mark, which is lower than SIA’s current share price. (A low conversion price is bad for shareholders as it means more shares are issued leading to more heavy dilution.) Bear in mind, the conversion price is not based on the principle paid. It is based on the principle plus the accumulated yield.

If converted to shares, the MCBs will heavily dilute SIA’s current shareholders, leaving them with a smaller stake in the entire company.

All of these lead me to conclude that redeeming the MCBs now seems like an efficient use of capital by SIA on behalf of its shareholders.

But should SIA conserve cash instead?

SIA has a history of producing irregular free cash flow.

I looked at 15 years’ worth of financial data for SIA (starting from 2007) to calculate the total free cash flow generated by the company. In that period, SIA generated a total free cash flow of a negative S$3 billion. Yes, you read that right – negative free cash flow.

In 15 years of operation, instead of generating positive cash flow that can be returned to shareholders, SIA actually expended cash.

This is mostly due to the high capital expense of maintaining its aircraft fleet. Capital expenditure for the expansion of SIA’s business was only S$5.6 billion, meaning the value of its fleet only increased by S$5.6 billion.

I say “only” because even if I exclude the expansion capital expenditure, SIA only generated S$2.6 billion in total free cash flow over 15 years. This is an average free cash flow of just S$174 million per year. Keep in mind that this free cash flow was generated off of a sizeable net PPE (plant, property, and equipment) base of around S$14 billion in 2007. The free cash flow generated is a pretty meagre return on assets.

What this shows is that SIA is a business that struggles to generate cash even if it is not actively expanding its fleet. This said, SIA does have a significant amount of cash on hand now.

With the cash raised over the past two years and the strong rebound in operations, SIA exited the September quarter this year with S$17.5 billion in cash. Redeeming its first tranche of MCBs will cost SIA around S$3.8 billion, around a fifth of its current cash balance.

The airline also has a relatively young fleet of planes now, which means its net capital expenditure requirement for maintenance is going to be relatively low in the near future, which should lead to higher free cash flows in the next few years.

And with the global recovery in air travel as countries around the world get a better handle on COVID-19, SIA’s operating cash flow is also likely to remain positive this year.

As such, I think it is fair to say that SIA does have the resources to retire the first tranche of its MCBs pretty comfortably despite its business’s poor historical ability to generate cash.

Can it retire the 2021 tranche of MCBs?

This brings us to the next question: Can SIA retire the second tranche of its MCBs which were issued in 2021? To recap, besides the S$3.5 billion raised in 2020 via the issuance of MCBs, SIA raised a further S$6.5 billion through this second tranche of MCBs in 2021.

Including interest, the total outlay to redeem the second tranche of MCBs will be slightly more than $6.5 billion (depending on when exactly SIA redeems the MCBs).

After redeeming the first tranche of its MCBs, SIA will be left with S$13.7 billion in cash. But the airline also has S$15.8 billion in debt (including long-term liabilities), which means it will have net debt (more debt than cash) of around $2.1 billion.

Bear in mind that the MCBs are not considered debt according to SIA’s books. Instead, they are considered equity as they have a feature where they are “mandatorily converted” in 10 years. So the debt on SIA’s balance sheet are additional borrowings which will eventually need to be repaid or refinanced. Given the small net cash position, I don’t think SIA should stretch its balance sheet to pay back the second tranche of MCBs yet.

SIA executives should also have wisened up to the fact that the company should keep some cash in its coffers to avoid another situation where they have to raise capital through the issuance of stock at heavily discounted prices (which happened during COVID-19) or through borrowing at usurious terms. A secondary offering or expensive debt in troubled times will be much more costly to shareholders than the MCBs.

The bottom line

All things considered, I think it is a good move by SIA’s management to redeem the first trance of the airline’s MCBs. The MCBs are an expensive source of capital and retiring them early will benefit SIA’s shareholders. The airline is also in a comfortable financial position to do so.

But the second tranche of MCBs is a different story altogether. After redeeming the first trance, and given SIA’s history of lumpy and meagre cash flow generation, I don’t think management will be willing to stretch its balance sheet to redeem the second tranche of MCBs just yet.

It is worth mentioning that SIA also decided to start paying a dividend again. I would have thought that management would prefer to retire the airline’s second tranche of MCBs before dishing out excess cash to shareholders.

One needs to remember that despite its poor cash flow generation in the past 15 years, SIA still paid dividends nearly every year. In hindsight, this was a mistake by management as the distributed cash would have been better off accumulated on the airline’s balance sheet to tide it through tough times such as during the COVID pandemic.

Ultimately, SIA paid dividends in the past 15 years, only to claw back all of the money (and more) from shareholders by issuing shares in 2020. This was certainly a case of one step forward, two steps back, for shareholders. Let’s hope for the sake of shareholders that history doesn’t repeat itself.

Mental Model For Assessing Acquisitions

Are you a shareholder of a company that is acquiring another company? Do you know if the deal is good for you? Here’s how to find out.

Acquisitions often pose an analytical challenge for investors.

Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.

The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.

Here is a short primer on the things to look out for in acquisitions.

Accounting for cash outlay

Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs.

Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.

I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.

If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.

Let’s take Adobe’s acquisition of Figma as an example.

Adobe announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.

As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.

But given that it is a one-off expense, does this mean anything? A resounding, yes.

When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.

Consider dilution when looking at stock-based financing, instead of the current dollar amount

Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.

Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.

Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.

In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.

In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%.

This is the real cost of stock-based financing.

Is the acquirer overstretching its finances?

Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.

Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.

Let’s take a look at the Adobe-Figma deal again.

Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion.

Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.

Analysing the target company

Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?

As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc.

Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.

Second, will the combined entity work well together?

In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.

Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.

Does the price match the value?

Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.

In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.

Final Thoughts

Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.

With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.

If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.

The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Adobe. Holdings are subject to change at any time.

Pocket Aces, Stocks, and Variance

Variance plays a big part in poker. Investing is just like poker in that sense. We may deviate from our long term expected rate of return.

Pocket Aces is the best starting hand in Texas Holdem Poker. Against any other starting-hand combination, Pocket Aces will win approximately 80% of the time.

When facing just one other player, that gives Pocket Aces an expected return of 60%. This expected rate of return includes the times when Pocket Aces loses.

In poker, a profitable bet arises in any situation where your expected return is above 0%. Stock-picking is similar to poker. As stock pickers, we make calculated bets based on the expected rate of return. If the expected rate of return meets our target or exceeds other opportunities, then investing in the stock makes good investment sense.

Expected return for stocks

Like poker, when calculating the expected rate of return for stocks, we should consider all the potential paths a stock can take. In poker there are only two possibilities – you either win or lose. But stock picking is a little more complicated than that. There are numerous potential outcomes that we need to consider when estimating a stock’s expected rate of return.

Stock returns can range widely from -100% (a total loss) to +X,000% (thousands of percent) or more. The expected return for stocks should include an aggregation of all these possible outcomes.

Difference between expected and potential return

The expected rate of return should not be confused with the potential rate of return. The potential rate of return is the upside of investing and does not take into account the other possibilities.

For instance, in poker, when playing Pocket Aces, the potential return is 100% over a single hand played. But the expected return over many hands is 60%.

On the flip side, if you are holding a random starting hand against Pocket Aces, your potential return is still 100% as you still have a 20% chance to win the hand. But the expected rate of return is negative 60%.

Investing in stocks is just like poker. Many stocks may have high potential returns if the company’s management executes perfectly but the actual expected returns may be much lower or even negative as the probability that management executes so perfectly is low.

When investing we are looking for stocks that are just like “Pocket Aces”. These are companies that have high expected returns and not just high potential returns.

Variance and diversification

Another element of poker that transfers well to stock picking is the concept of variance.

If we play just one hand of poker, we are expected to lose with Pocket Aces 20% of the time. In the unfortunate case that Pocket Aces loses over a single hand, our actual returns for that game would be substantially lower than our expected rate of return.

Over two hands, we will break even 32% of the time, lose twice 4% of the time and win twice 64% of the time. In this case, we would now be below our expected return 36% of the time. Poker professionals call this phenomenon variance, which is why small-sample results usually mean nothing for poker players.

However, if we make numerous such bets on Pocket Aces, our rate of return will eventually converge toward 60%.

This is the same when investing in stocks. While we may have put our money in a stock that has a high expected return, the actual outcome may deviate substantially from the expected return.

Final Thoughts

I’ve been fascinated by the game of poker for many years. It is a game of calculation, game theory and exploitation of opponents’ mistakes.

Many elements of poker can also be transferred to investing such as position sizing, return calculations and even portfolio management.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Lessons From The Ongoing Bear Market

Surviving long-term, the importance of cash, and good management teams are some of the key lessons from this bear market.

This year demonstrated the cruel realities of investing in stocks.

Year-to-date, the widely followed US stock market benchmark, the S&P 500, is down 14%. Meanwhile, the NASDAQ Composite, a tech-heavier benchmark for US stocks, has lost 22% of its value.

But that’s just the tip of the iceberg. Many fast-growing companies have had it worse. For instance, the ARK Innovation ETF, an exchange-traded fund that invests in high-growth tech companies, is down by more than 50%.

Multiple stocks that were big winners during the COVID-induced lockdowns have also since returned all their gains; some are even trading well below their pre-COVID prices.

In my nine years as an investor, I’ve never seen such sharp and steep drawdowns across such a wide array of companies. But this likely won’t be the last time either.

With this in mind, I’ve penned down a list of investing thoughts to prepare myself for future downturns.

Don’t celebrate when prices go up

Stock prices gyrate wildly. During the booming market of 2020, there were many investors who celebrated when prices went up. Today, many of the stocks that rose in 2020 have returned all those gains – and then some.

2022 has so far reinforced the fact that stock prices really don’t matter in the short run. If prices run up without fundamentals, they will come back down eventually. Similarly, if stock prices fall below intrinsic values, don’t panic. Prices will eventually return to their underlying values.

As a long-term investor, I have learned to ignore near-term price movements and focus on business fundamentals and valuations.

Cash matters!

When stock prices were rising, companies could raise capital easily by issuing new shares at inflated prices. This increased their cash balances with minimal dilution to existing shareholders.

But now that stock prices have fallen, this source of capital has evaporated. Debt has also become more expensive due to rising interest rates.

It is in times of crisis that companies with strong balance sheets survive, while those with weak financials struggle. Companies that are burning cash and have insufficient cash may end up in a liquidity crisis or end up having to raise more capital at depressed valuations, which could severely impact existing shareholders. If these companies are unable to raise money, their debt holders may end up taking over them, leaving equity holders with scraps.

Invest in strong managers!

With asset prices low, this is a time for companies with the financial muscle to double down on investing for their future. This is a time when prudent managers shine through.

If a company has a great capital allocator at the helm, the company can come out of this bear market stronger than before.

Berkshire, for instance, has started to become more aggressive with its investments in terms of both buybacks and acquiring stakes in other businesses. I believe Warren Buffett’s recent decisions will pay off handsomely for Berkshire shareholders in the future.

Diversify

When stock prices were going up, there was a lot of discussion about concentrating one’s portfolio into just a few stocks.

But this is a risky strategy. Every company has its own set of risks that could result in long-term underperformance of its stock. Companies that are still growing fast and burning cash bear even more risk.

When investing for the long run, we are placing a bet on a company performing well for many years. This doesn’t always pan out. In fact, most companies don’t do well over time and the strong performances of market indexes are driven by just a small handful of companies. When investing, we never deal with absolutes. We are always playing the probability game.

As a long-term investor, survival and long-term steady returns are more important to me than simply maximising earnings. While having a diversified portfolio might reduce my expected returns, it increases my odds of long-term survival and stable returns.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Tencent’s Results Weren’t As Bad As The Headlines Suggest

Tencent’s revenue for the second quarter of 2022 declined by 3%. This may seem bad at first glance, but a look underneath the hood says otherwise.

Tencent released its 2022 second-quarter results last week and the headlines sounded pretty dire.

“Tencent woes mount even after US$560b selloff” – The Business Times

“Tencent’s workforce shrinks for first time in nearly a decade” – Bloomberg

“Tencent, the $370 billion Chinese tech giant, posts first ever revenue decline” – CNBC

If you’re just reading these headlines in isolation, you might think that Tencent is in dire straits. But that’s really not the case. On closer inspection, I think there a number of positives to take away from Tencent’s latest results.

Revenue growth will probably return after China’s lockdowns ease

Tencent’s revenue was down 3% to US$20 billion in the second quarter of 2022. This was the first time Tencent reported a decline in revenue but this shouldn’t have been a surprise. Most of Tencent’s revenue is derived in China and in the bulk of the second quarter of 2022, parts of China were still in COVID lockdowns.

There’s a common misconception that as an internet services company, Tencent will not be impacted by lockdowns. But this is far from the truth.
One of Tencent’s biggest revenue and profit drivers is its payments ecosystem, otherwise known as its Fintech segment. This is highly dependent on commercial activity and also includes offline payments. During lockdowns and when China’s economy is weak, this segment of Tencent’s business suffers. Conversely, when the economy reopens, the growth of Tencent’s payment business should start to reaccelerate.

Tencent also has a huge advertising business. When the economy stalls, advertisers cut back on marketing spending. In the second quarter of 2022, Tencent’s advertising revenue declined by 17%. Again, this should reverse when China’s economy improves.

Margins will get better

Tencent’s operating profit declined 14% during the quarter to US$5.5 billion, excluding exceptional items. Although this may seem alarming on the surface, there are signs that Tencent’s margin will climb in the future.

The company has been actively cutting costs and improving efficiency. In the second quarter of 2022, Tencent’s sales and marketing expenses dropped by around US$300 million. There were other cost-cutting initiatives, such as right-sizing the number of employees, stopping loss-making businesses, outsourcing unprofitable projects, optimising server utilisation, and exercising more prudence with content production in Tencent’s long-form content segment.

All of these cost-saving initiatives should lead to better margins for Tencent from the next quarter onwards.

Management is also confident about its Gaming business

Tencent’s revenues from both the domestic and international games segments were flat. The domestic games business was hampered by regulatory restrictions. For international games, the challenge came from the reopening of economies worldwide.

On the domestic front, the regulatory environment is starting to improve as there has been a resumption of the issuance of licenses for new games. In June this year, it was reported that China had issued 60 licenses to new titles, which is positive news for game developers such as Tencent.

In addition, Tencent’s current gaming franchises still have highly-engaged audiences, with engagement numbers for both domestic and international games being relatively high.

Tencent’s capabilities in digital gaming gives management confidence that the company is well positioned for growth once the challenging environment laps.

Share buybacks good for shareholders

Besides a likely turnaround in its business, Tencent has been using its capital to buy back shares. I think this is a value-accretive initiative given the fact that Tencent’s shares are relatively cheap compared to the value of its business and the potential free cash flow it could generate.

For perspective, Tencent has a market cap of around US$370 billion now. Its investments in public and private companies are worth around US$150 billion. This means the rest of Tencent’s business has a value of around US$220 billion, which is merely 12 times that of Tencent’s annualised operating profit for the second quarter of 2022. With Tencent’s operating profit likely to improve from here, the stock looks undervalued.

But don’t just take my word for it. Tencent’s own management has said its shares are very undervalued. In the latest earnings conference call, Martin Lau, Tencent’s president, said:

“We are very focused on returning capital to shareholders given we believe our share price is very undervalued and also undervalued in the context of our investment portfolio. So if you look at what we’ve done year-to-date, we’ve returned around $17 billion, $18 billion to Tencent shareholders. And we’ve been largely neutral in terms of our investments, divestments in other companies, excluding the substantial JD divestiture. So our focus from a sort of investments perspective has been buying back and dividending to our own stock, and that will likely remain the case going forward for some period of time. “

Bottom line

Headlines don’t always paint the full picture. In Tencent’s case, while the headlines conveyed a story of a company in dire straits, Tencent’s business is actually in a strong position to return to growth. The operating climate is challenging but Tencent’s core businesses remain in a good position.

Its shares are also priced at a low valuation, giving management the perfect opportunity to buy back shares and reduce its share count. This should be a long-term benefit to patient shareholders.

Based on today’s valuation, I think patient shareholders who are willing to hold shares for the long-term will likely be well-rewarded in the future.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Tencent. Holdings are subject to change at any time.