Michael Mauboussin on capital allocation and value creation

The elements of capital allocation

The objective of capital allocation is to build long term value per share. It is an important topic, both to investors and managers. Companies that allocate capital carefully have opportunities to create significant value. Doing this well requires managers to have an analytical framework and independence of mind, particularly when markets face undue pessimism or optimism. Michael Mauboussin, Dan Callahan and Darius Majd wrote one of our preferred guides to this topic, aptly named Capital Allocation – Evidence, Analytical Methods and Assessment Guide. The paper provides a helpful foundation to understanding a company’s choices when it comes to capital allocation, and how such choices might create or destroy value.

In this post, we will review some of the key lessons that we took from their work, omitting the empirical evidence for brevity. The topics covered here are relatively elementary. If you are quite familar with topics on capital allocation, you may prefer to skip this post altogether. For those that are new to this topic, we also highly recommend that you read the Mauboussin’s actual paper in full when you have the time.

Capital sources and choices

Before thinking about effective capital allocation, it is important to understand common sources of capital and the capital allocation choices. Common sources of capital include the cash that the business generate, access to capital from debtors and shareholders, and proceeds from the sale of assets. The company can then invest capital in the business through capital expenditures, increases in working capital, research and development, and/or mergers and acquisitions. Alternatively, the company can return cash to debt and/or equity holders. Companies can also return cash to shareholders through additional divestitures

In the following sections, we will look at the features of such choices. This post will start with mergers and acquisitions, before looking into capital expenditures, research & development, working capital and the returning of capital to debt and equity holders.

The opportunism and follies of M&A

According to Mauboussin et al, mergers and acquisitions (M&A) are the most common and costly method for businesses to pursue their strategic goals. Aggregate M&A levels tend to follow the stock market closely. Activity is generally strongest when the economy and stock markets are performing well, and when access to capital and credit is easy. This is because companies are tempted to make to deals when they can rather than when they should. First movers in M&A market tend to benefit more from cheaper valuations and a larger acquisition pool than companies that enter late in the business cycle. The latter often enter due to strong bandwagon effects.

The M&A formula

A deal creates value for the acquirer when synergies from the deal exceeds the premium paid to control the target. Empirical studies would suggest that the cost synergies (e.g. reduction in duplication) are usually more realisable than revenue synergies (e.g. anticipated increases in sales).

NPV of M&A deal = PV of synergies – Premium paid

Mergers and acquuisitions often require upfront payments and are difficult to reverse. They can be value destroying if the premium paid is too large. Acquirers tend to overestimate the potential savings and revenue from M&A. They also tend to underestimate the time, cost and complexity of M&A. Additionally, the benefits and synergies from M&A might also be unsustainable if competitors can replicate the benefits through their own deals and integration processes.

Different deals tend to create different value

According to Mauboussin et al, empirical studies have found certain deal types are more likely to create value than others. They are listed as follows:

85+%: Opportunistic purchases of dying competitors or competitors in exit have shown high probability of success. Common success risks include obsolescence or incompatibility of assets and technologies.
65-85%: Operational purchases of bolt-ons or line extensions that help firms to address gaps, improve differentiation or introduce next generation products. Common risks include integration and scalability challenges.
37-60%: Transitional purchases of large competitors in contraction (or emerging players) to grow market share via scale, synergies or picking ‘winners’. Common risks include overestimating and overpaying for expected benefits.
30-45%: Operational purchases of single or multi-core enterprises as complements to existing offerings. Again, common risks include overestimating and overpaying for expected benefits.
15-25%: Transformational purchases that represent major change to the company’s entire operations. Success is highly dependent on acquisition and execution skills.

Rapid asset growth and lacklustre returns

Empirical research suggests that rapid asset growth is typically associated with poor risk-adjusted total shareholder return. By contrast, companies that contract their assets on average tend to generate relatively greater per share value. Ultimately, all of this depends on the asset’s intrinsic value and the price paid for it. Since growth is not always good, context becomes very important.

Divestitures can create great value

Companies can engage in divestitures through division sales, spin-offs and equity carve-outs to create value. A company should divest when another potential owner values the operation more highly. Divestitures are also valuable if it can provide more focus to the parent company. Mauboussin notes that value creation tends to come from a relatively small percentage of a company’s assets. Many ‘Tail-end’ assets do not earn their cost of capital and might be more valuable to other owners. Since buyers tend to lose value in M&A deals, sellers must tend to gain value (the ‘winner’s curse’).

Selling or spinning off poor performing businesses can lead to ‘addition by subtraction’. Spin-offs involve distribution of shares of a wholly-owned subsidiary to shareholders on a pro-rata and tax-free basis. This can create value for the spin-off and corporate parent. The benefits include sharpened focus, improved information and better tax treatment.

Value creation through capital expenditures

After M&A, capital expenditures (CAPEX) are the next most popular use of capital for companies. Maintenance CAPEX is the spending required to maintain or replace long-term assets. Depreciation expense is a common proxy for this. CAPEX beyond this level represents expenditure in pursuit of growth. Similarly, from an accounting standpoint, research and development (R&D) is a capital allocation activity that are expensed in the period incurred because its benefits are often uncertain and difficult to quantify. Recent growth in R&D as a percentage of sales reflect structural changes in the market, particularly with growth in information technology and healthcare businesses.

Spend the right amount at the right time

As with M&A deals, CAPEX levels tend to correlate with industry cyclical patterns. Companies suffer most when they add too much capacity at the peak of an industry’s growth cycle and too little at its trough. Mauboussin reminds readeres that value creating CAPEX must generate returns in excess of its cost of capital. For this reason, it is more important to assess whether company is spending the appropriate amount as opposed to spending more or less than its peers. Firms that engage in empire building behaviour tend to underperform. This is consistent with evidence that rapid asset growth often corresponds to relatively poorer total returns to shareholders.

Understand the productivity of R&D

Similarly, it is important to know whether a company’s R&D is productive. This is the difference between a new product’s value and the investment required for its development. It is helpful to consider the R&D efficiency (cost to launch) and R&D effectiveness (value per launch). This is difficult to estimate because of the lag and uncertainty between investment and outcome. However, Mauboussin suggests we can assess R&D productivity by capitalising and amortising it over a fair period of time to calculate its return on invested capital. This treatment tends to increase profit (i.e. amortization is usually less than total R&D) and invested capital (i.e. R&D is capitalised).

Empirically, the paper notes how acquirers of R&D intensive companies tend to underperform the stock market. Mauboussin suggests that if an acquirer is unable to enhance the R&D effectiveness of their purchase, the value of R&D spending will accrue to the seller and not the buyer.

Net working capital and the cash conversion cycle

Net working capital is the difference between current assets (e.g. inventory, accounts receivable, cash, etc.) and non-interest-bearing current liabilities (e.g. accounts payable). It is the capital a company holds to run day-to-day operations. Additionally, the cash conversion cycle (CCC) is a common measure of working capital efficiency. It calculates how long it takes a company to collect on the sale of inventory. It equals the days in sales outstanding plus days in inventory outstanding minus days in payables outstanding (CCC = DSO + DIO – DPO). The paper notes that there is a strong relationship between lower cash conversion cycles and higher returns on capital. However, the impact on shareholder returns is less clear. Mauboussin notes that it depends very much with how companies choose to use cash in hand.

Dividends and buybacks

The last remaining choice for capital allocation is returng cash to debt and equity holders. Dividends are cash payments to shareholders, paid usually from company profits. A company will need to generate cash flow beyond levels required for maintenance and/or growth to sustain a dividend payout. Mauboussin notes that dividends are often viewed as a signal of management’s commitment to cash distribution and their confidence on future business earnings. It is an important element of total shareholder return and overall capital accumulation rate.

Share buybacks are the second way that companies can return cash to shareholders. While they are more cyclical in usage than dividends, there are three common motivations for managers to engage in them:

Fair value: Management will buy back shares to provide shareholders with flexibility. Shareholders that hold during a buyback are increasing their effective percentage ownership in the company. Other shareholders can sell their stake as homemade dividend.
Intrinsic value: Management will buy back shares when they believe the stock is trading below intrinsic value. For this to be profitable, management must have asymmetric information and strong analytical capability. This is often not the case. Executives sometimes have natural biases to assume undervaluation of their stock. Companies that buy back shares when its stock is overvalued will transfer value from buyers to sellers. A company should repurchase its shares only when its stock is priced below its expected value and when no better investment opportunities are available.
Accounting value: Management might aim to boost short term accounting results such as earnings per share to offset dilution from other stock or option-based programs, or to reach executive incentive targets. Buybacks do not always align with value creation principles and should be considered net of equity issuance.