John Huber has recently published a few outstanding articles on the concept of ROIC. The ratings speak for the quality of the articles themselves. I have nothing to add on the discussion on the ROIC itself but I feel obligated to point out although ROIC is extremely important, there is one thing every investor should watch out even with a high ROIC business.
This one thing is what they do with the capital generated a.k.a, the capital allocation decision. I’ve seen great businesses suffer from poor capital allocation decision over and over again, dragging the return on the common stock.
Assuming a business generates really high ROIC, we have to further evaluate what management has done with the capital. There are not that many options.
1. They can plow the capital back in the business and generate organic growth.
2. They can acquire other companies.
3. They can pay dividends.
4. They can repurchase shares.
5. They can leave the cash in the bank or short term investments.
6. They can invest the cash in equities or other types of investments.
7. They can pay down debt. (I didn't think of this option, the credit goes to BreakingParInvesting).
Ideally, with a high ROIC business, you want them to deploy option number 1 above and keep the business growing. Inevitably though, it becomes harder as the base becomes much larger. This is where high ROIC businesses pose challenges to investors. Management can do stupid things that destroy more capital than the business generated, especially through acquisition and shares repurchase.
Let me give you two examples. The first example is Weight Watchers International , a stock I discussed a few days ago. The ROIC on this business is unbelievable. The business model is extremely asset light and it has very high margin and generates tons of free cash flow. Looking at the historical balance sheet, you may ask where the hell did the majority of the cash go? Well, they really flunked it when they raised an enormous amount of debt to repurchased shares at a level that is detrimental to shareholders. The Company commenced a “modified Dutch auction” tender offer and simultaneously entered into an agreement with Artal Holdings to purchase its common stocks at $82 per share for a total of approximately $1.5 billion financed by debt offering. The purchase price is almost 20 times earnings per share, which was declining and more than 18 times free cash flows per share which was also declining. Both multiples are very high on a forward basis. This is an extremely poor capital allocation decision and boy has WTW and its shareholders suffered from it while the business itself is deteriorating.
The second example is the CME Group. It is a great business with very high margins and had a very high ROIC. They can cut the net margins in half and still fare better with an average American business. It’s a shame what management had done to this exceptional business. In this case, CME’s acquisitions of CBOT and NYMEX have pushed the ROIC to a very low level since 2007. When CME merged with CBOT, CBOT had revenue of just over $600 million and net income of about $170 million. CME paid $11.2 billion for CBOT, 18.2 times sales and 65 times earnings. Similarly, when it acquired NYMEX for $9.4 billion, they paid 14 times sales and about 42 times earnings. These two acquisitions were made at incredibly stupid prices and the drag on ROIC and shareholder’s value has been nothing but terrible.
Therefore, my point is, while ROIC is enormously important, it is only a starting point. Unless you track an index of high ROIC companies such as the Magic Formula companies, what’s more important is to evaluate the capital allocation decisions by management. Getting the ROIC number is easy so we are subject to the powerful availability bias. Evaluating the capital allocation decision by management is quite complicated and takes much longer than simply getting a ROIC number. We must work against the will of our brain to take the extra step. However, the reward is well worth the time.