Platform Value, Value Creation & Capital Allocation
Our friend over at the Punch Card Investing blog has a great post up discussing what Bill Ackman has called “platform value”. In two presentations (here and here) over the last couple of years, Ackman has talked about platform value as an intangible value that some companies possess due to their ability to make value-enhancing acquisitions.
Ackman’s fund had its worst year on record (down over 20%) in 2015 and his shareholder letter says one major mistake was in overestimating the platform value of some of his holdings. The Punchcard critique does not dismiss the legitimacy of platform value, but mocks Ackman for taking credit for “discovering” this “ephemeral form of value”.
Ackman’s presentations on platform value point to the excellent book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William Thorndike for highlighting the incredible success of a small handful of companies who have successfully executed a platform strategy. The Outsiders may well be the most influential book in recent years to impact the investing of top value (and especially activist) investors, with the fact that Warren Buffett endorsed the book in his 2012 annual letter catalyzing the book’s popularity.
So while Ackman thinks he overestimated platform value and Punch Card warns of how a platform company may just be a “roll-up” that investors should best avoid, we think that this whole debate can be simplified by recognizing that no matter what you call it some companies can create shareholder value by deploying capital into smart acquisitions. This value creation opportunity is neither ephemeral nor a sure thing, but as The Outsiders highlighted, it can be a powerful driver of investment returns (the companies described in the book generated stock returns of over 20% a year over multiple decades).
All companies exist to generate a return on capital (with employees, on the other hand, seeking a return on labor). With any given dollar of capital, a company can return it to investors (dividends to return capital to equity holders and debt reduction to return capital to debt holders) or seek to generate a return on that capital in one of three ways:
Investing in the business: By purchasing new capital (ie. opening stores, buying equipment, etc) a company can attempt to expand its business. Capital can also be invested in the business via the income statement such as by spending money on sales and marketing.
Buying the business: Instead of seeking to expand the business, capital can be used to buy back a company’s own shares. If the share price is less than the intrinsic value of the business, the company can generate a return on their capital that is superior to simply returning the capital to shareholders. Buybacks can also be viewed as a form of returning capital to equity shareholders, but since the ultimate use of the capital is directed by the company, we include it in this section and believe management should be held accountable for the returns generated by this use of capital.
Buying other businesses: Capital can also be used to acquire other businesses. Since this is exactly what investors do (buying the shares of various companies), there’s no reason that companies cannot successfully deploy capital the same way. Businesses can potentially enhance their returns by acquiring a controlling interest in other businesses and combining it with their own in an attempt to reduce total costs or enhance total revenue.
Interestingly, public companies have an only mediocre track record with all three uses of capital. Historically, public companies generate returns on capital they reinvest into their business at rates that only marginal exceed their cost of capital. They buy back their own stock at levels that have not outperformed the market. They engage in mergers and acquisitions in ways that actually destroy shareholder value more often than it enhances it.
This doesn’t mean public companies are dumb, it just means that capitalism is brutally competitive and while most companies deploy capital in ways that generate positive returns, they don’t often create excess value above and beyond required rates. This analysis is not dissimilar from noting that while most investors generate positive returns, few outperform the market. Again, not because investors are dumb, just because the stock market is brutally competitive.
However, Ackman’s concept of platform value does not suggest that all merger and acquisition (M&A) activity is good. The Outsiders did not suggest this either, instead highlighting a small set of CEOs who used M&A to greatly enhance shareholder value. Both suggest that some companies, under some conditions, can create significant shareholder value using M&A and that investors would be wise to take note of this potential value creation opportunity.
At Ensemble Capital, we generally assume that the M&A done by companies in our portfolio will result in market-like returns on capital. This assumption implies that M&A is no more (but no less) valuable an activity than paying dividends. We certainly hope that our portfolio companies do better with their deals, but in valuing our holdings, we usually ascribe no value to M&A potential. Or in the vocabulary of Bill Ackman, we ascribe no platform value when analyzing our holdings. But that being said, we only invest in companies where we trust management to be smart allocators of capital and holdings such as Broadridge Financial (BR), Sensata Technologies (ST), and Advisory Board Company (ABCO) appear to have generated shareholder value through their M&A activity over time.
However, on occasion, we do identify companies that we believe have sustainable opportunities to deploy capital via M&A. One such holding for us is TransDigm Group (TDG), which happens to be a company mentioned in passing in The Outsiders and which Ackman cites as an example of a company with platform value. TransDigm is a supplier of parts to the airlines. They are the sole provider for 75% of their products. Due to FAA regulations, airlines are required to replace many of the parts TransDigm sells on a set schedule and so after winning a slot on an airplane design, TransDigm gets to sell replacement parts over and over again during the approximately 40-year lifespan of an airplane. Their business model has generated fantastic results. Since 1993, revenue (with M&A) has grown at over 20% per year, while EBITDA as grown at over 24% per year driving enterprise value growth of 31% per year (Source: TransDigm presentation).
The industry of supplying parts to airlines is highly fragmented. 85% of all parts suppliers do under $100 million a year in revenue and collectively these small companies make up about 60% of the industry. Due to this fragmentation, TransDigm is able to acquire target companies at low valuations and then use their sole source provider position to raise prices while cutting costs to generate significant margin expansion at the acquired companies.
There is nothing “ephemeral” about this value creation opportunity. TransDigm has been executing on it consistently for over 20 years. However, measuring the scope of the opportunity is difficult. But then again, so is measuring the scope of opportunity for various companies to reinvest in their own business. Forecasting the future is hard whether you are forecasting M&A opportunities or the opportunity to use capital expenditures to grow a business.
Despite TransDigm management’s explicitly stated strategy and outstanding history of utilizing M&A, Wall Street analysts generally forecast TransDigm’s future results and value the company while assuming there will be no future acquisitions. While forecasting future deals is hard, assuming no deals assigns no platform value to a company that has consistently created value through M&A for over two decades. This lack of willingness to assign value due to difficulties in forecasting size and timing leads to what we believe is a systematic undervaluation of TransDigm shares, despite the fact that the shares trade at what appear to be a high multiple of current earnings.
The contribution that The Outsiders made was articulating the common attributes of a group of highly successful practitioners of M&A. Top among these was a focus on running a decentralized organization with the CEO controlling capital allocation while allowing acquired companies to be controlled by the people on the ground. Since this is exactly the strategy deployed by Warren Buffett and Charlie Munger at Berkshire Hathaway (and they are one of the “outsider” companies described in the book), it is impossible for value investors to dismiss the opportunity in this approach despite the fact that most value investors avoid companies that engage in high levels of M&A.
We don’t know if the companies in Ackman’s portfolio offer significant platform value or the degree to which he might have overestimated this value. But we do know that platform value is real. Far from being ephemeral, platform value just seeks to describe the value of a smart capital allocation opportunity that happens to involve M&A.
At the end of the day, there’s nothing new here. Company value is driven by the level of returns on capital a company can achieve and the scope of opportunity a company has to deploy capital into these opportunities. Whether these opportunities involve M&A or investing in expanding the business, there are pitfalls and opportunities involved and most companies will achieve only mediocre results. We spend our time seeking out companies that we think have unique competitive advantages that will allow them to generate above average returns on the capital they deploy, whether into their business or via M&A, and which will choose to return capital to shareholders when opportunities to deploy capital at high returns are scarce.
Ensemble Capital’s clients own shares of TransDigm Group (TDG), Broadridge Financial (BR), Sensata Technologies (ST) and Advisory Board Company (ABCO).
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