Someone who reads my blog asked me this question:
“How do you get comfort that when a company is spending for growth it will yield results? This may be spending on an existing geographic or product market or on a new geographic or product market.”
That’s a great question. It’s answered better in the Chris Zook books (one of them is titled “Repeatability” I think) than I can answer it in this article. You can go off and read those books if you want the few hundred-thousand-word answer. I’ll stick to the couple-thousand-word answer here.
Repeatability. Has the company done this before? Let’s take Howden Joinery (LSE:HWDN, Financial) as an example. Howden is a U.K. company. It sells only to local builders. It provides them with the stuff they need – granite countertops, private label appliances, etc. – to do a kitchen. It sells the stuff on credit. But it doesn’t sell to the public. There are – as I write this – probably something like 600 of these centers in the U.K. They aren’t all the same size. They aren’t identical or anything. But they’re pretty independent. There’s a manager to handle each one. Customers go to their local center. They don’t have national accounts the way a company like Grainger (GWW, Financial) does.
Each Howden location is just the repetition of a theme. It’s repeatable. It’s predictable. You just look for signs of oversaturation. That can happen. When Howden first talked about how many of these centers it could have, I’m not sure it said 800 or more. It says that now though. Maybe it is right. Maybe there isn’t cannibalization by going from 600 to 800 of these in the U.K. But that’s not the only kind of growth in which Howden is investing. The other kind is on the continent. Howden now has a few centers in places like France and Belgium.
I’m not saying it can’t have success in these countries. Another U.K. company I wrote a report about – HomeServe (LSE:HSV, Financial) – has had success in places like France and the U.S. It was very dependent on the U.K. market at first. But a lot of its business proved repeatable. It could market its services through water companies in the U.S. and France. And now those businesses are worth a lot. They are potentially at least as good as – maybe better than – long-term markets than the U.K.
That was part of the reason we wrote the report. HomeServe’s renewal rates in the U.K. had dropped, and new sign-ups were running at basically nil. The company’s marketing had been too aggressive. It ran afoul of regulators. Paid a fine. And – for a time – basically shut down its outbound marketing operation. Naturally, this meant it wasn’t signing up new customers. The negative headlines probably increased cancellation rates in the U.K. for a year or two. And the dis-economies of scale that kicked in were obviously bad. But it already had these markets in France and the U.S.
We were especially interested in the U.S. business. The U.S. is huge compared to the U.K. – about six times bigger by population and richer, too – and has a much more fragmented utility industry. There was the hope if HomeServe could have success in one U.S. state by signing up the local water utility to co-brand its insurance products in Florida or New Hampshire or wherever, it could do the same thing in Colorado and Nevada and each of the 50 states. There was no reason why it couldn’t. One U.S. state is pretty much like every other U.S. state.
So is Canada. In retail, restaurants, etc., what works in Virginia will work in California and what works in California will work in British Columbia and Ontario, too. That’s the kind of growth in which you want a company to invest. I think of this as sort of “Peter Lynch” growth. It’s the kind of company he’d buy. You find a great restaurant concept in your local area, and you know it can roll out across all 50 states. That’s the best kind of growth you can ever find. What’s the worst?
Spreading out into other countries is tougher. I didn’t write that report on HomeServe until the business was already better than break even in both the U.S. and France. The company tried entering markets like Belgium – and failed. We didn’t get our hopes up about any market where the company hadn’t yet achieved critical mass.
The same was true when we wrote our report on Grainger. Grainger is a U.S. company. It has a big stake in a Japanese company. It’s basically a subsidiary that is publicly traded in Japan instead of being consolidated. You can buy the stock over there. Don’t. It always trades at a very, very high price. It’s a super-fast growth stock. But Grainger took the same model that a Japanese MRO distributor uses, and it applied that approach to its low-end U.S. market. This is the small customer business. Basically, it’s the part that competes with Amazon (AMZN, Financial). These are not the national accounts. And it’s just the repetition of the same model that worked in Japan applied to the U.S. I’d bet on that. I’d bet on repeating the same approach in one country in another country when those two countries are as similar as the U.S. and Japan.
You know where Grainger didn’t have success? China. China has a totally different MRO business. There’s a good reason for this. Labor is cheap in China. It’s expensive in the U.S. It’s expensive in Japan. But it’s really cheap in China. When you run out of some random thing – light bulb, mop, generator, batteries, you name it – you send someone out as a go-fer to a big open-air market and search for that item.
You don’t do that at a U.S. company because then you’d screw up the logistics of your company. You don’t want any employees hanging around doing nothing specific with their time and then being reassigned to totally different tasks like that. But you can do it in China. Grainger has only had success in high GDP per hour worked type countries. That’s the limit of its market opportunity. If you compare the U.S. and China – you can see that, yes, the U.S. is much, much richer on a per capita basis.
That understates the situation for a Grainger customer because the number of people working relative to the total population is lower in the U.S. And the number of hours those people are working is lower, too. Each hour of work by an employee in the U.S. is really expensive. You need to treat that as a precious resource in the U.S. In China, you don’t. They don’t need to ration a worker’s time. They have more workers supplying more of their time than they know what to do with. A Chinese company can afford to allocate some of its workers’ time to very, very low productivity tasks like hunting down miscellaneous items.
You want to be skeptical of growth into markets that are different. Don’t assume a company in a developed country can enter a developing country – or vice versa. People make very different uses of their time in these places. On the other hand, there are societal trends that do translate well from one country to the next.
Let’s take a fast food or another restaurant concept in the U.S. Can it travel to the rest of the world? Maybe. All countries are going to follow the same trend of increasing the percentage of household income allocated to food away from home. In other words, every country – except the top countries in this category, like the U.S. – is going to have restaurant growth above the rate of nominal GDP growth. How do we know if a concept will catch on in this other country? KFC is huge in China, but it’s not huge everywhere. Starbucks (SBUX, Financial) is in a lot of countries, but it’s not in every country.
The easy answer is to wait for critical mass in a certain country. Is the business break even? Does it look like it has financial metrics like what we saw in the home country at the start? Think of HomeServe. Does the business in France and the U.S. look a lot like the business in the U.K. looked at the start of its development? Answer: Yes. I think it’s OK when a company like that says it is going to invest more in those geographies.
What about Howden? Howden’s trickier. If you look at how those centers in France have done compared to the U.K. – so far, the answer is not so good. Now, I don’t know enough about the relative rate of growth in kitchen remodeling, etc., in the U.K. versus France. I know the U.K. economy has often outperformed the French economy during the period when Howden was in both countries. But I also know looking at the comparable sales figures that Howden’s U.K. centers have grown same-store sales faster than the French depots (in constant currency terms) despite the average French depot being younger than the average U.K. depot. I’d say Howden’s plans to grow outside the U.K. are “unproven,” not necessarily disproven. But I wouldn’t assign any value to the business outside the U.K. Not yet.
On the other hand, I would – and I’ll admit this is speculative, but it’s honestly what I’d do – assign value to the 200 centers in the U.K. Howden thinks it can add. When I look at Howden Joinery, I don’t look at it as it exists today. I look at it as it will exist when it has 800 fully mature centers in the U.K. The company will invest some of that money in other countries, but I won’t count on that growth. I’ll assume – for my purposes – that Howden will just grow to 800 mature stores in the U.K. It’ll never grow beyond that.
Here we come up against a capital allocation question. It’s one thing to be conservative by not assuming any international growth. That’s fine. It’s good. It’s a proper value investing technique. But think about it. Is it conservative enough? We know that Howden will try to grow in other countries. If it’s going to fail, that’s not just going to be value neutral for the stock. It’s going to destroy value, right?
This is why I always included a section called “Capital Allocation” in the reports I wrote. You need to look at how the company thinks about capital allocation. How is management compensated? Does it talk in terms of sales growth, EPS growth, return on capital? Does it own shares in the company? Does it have options? On what is its performance reward (bonus) based?
If given the choice to buy stock in AT&T (T, Financial), Verizon (VZ, Financial) and ATN International (ATNI, Financial) – I’d pick ATN. Why? Because of capital allocation. I don’t trust the people allocating capital at AT&T and Verizon to do a good job. I do trust the Prior family at ATN to do a good job. Why? Because I’ve seen what it did in the past. I saw how it shut some things down. I saw the mergers it did, and I’ve read the annual reports.
It seems to me to be focused on allocating capital toward those areas with low enough competition. It  doesn’t run toward the sexy growth opportunities a lot of companies do – it runs away from them. Now, yes, it has entered some risky businesses. It started out as a monopoly in Guyana. To this day, that business has huge political risk. And when it entered the solar business it went into India. Doing solar in the U.S. would have had less risk. I’m not sure the returns would have been good enough.
Also, it has had a big cash balance – like Berkshire (BRK.A, Financial)(BRK.B) – at times, and it hasn’t blown that money too quickly. If you look at companies like AT&T and Verizon – they’re often eager to do big, transformative deals even when they don’t have enough cash to buy the target outright. I’d always pay the higher multiple for ATN than for AT&T or Verizon. That’s capital allocation.
Capital allocation is especially important in capital intensive industries like railroads, cruise lines and telecom because those growth investments – both the good ones and the bad ones – will generate positive cash flow. It’s easy to know when you should shut a restaurant down. When it’s bleeding cash, you shut it down. How about a cruise ship? It’s not going to burn cash. The capital allocation mistake is never going to manifest itself that way. Instead, here’s what’s going to happen. You are going to spend $1 billion on a new cruise ship. That ship will generate $40 million a year of free cash flow. That’s a 4% return on your investment. You obviously made a mistake. But you can’t undo it. The ship is making you money. You are going to keep it in service.
You must be careful when the management in a capital-intensive industry talks to you about growth. It can make mistakes like this. Industries that aren’t capital intensive – ad agencies, software, media, restaurants, etc. – are different. Management will realize its mistake early on. You can often be conservative just by using the approach I suggest you apply to Howden. The U.K. business model is proven. Assume Howden can reach saturation in the U.K. Assume it can have 800 mature centers in the U.K. But don’t assume it will ever have a moneymaking business outside the U.K. For capital intensive industries, you just have to avoid absolutely every stock where you think management is too aggressive in its growth seeking behavior. If ATN were controlled by someone else, I wouldn’t be interested in it. The only reason the stock is interesting to me is because of who controls the company.
Disclosure: No positions.
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