Investing Flashcards
What company would you invest in and why?
I recently bought some Telstra stocks. It was driven by a few factors: firstly, given the current macro conditions and rising inflation, I thought it would be wise to invest in a company operating in a non-cyclical market. You might forgo a new handbag to cut costs, but not your Internet or phone connection. Looking further into the future, the industry stands to gain from the Government’s ambition for Australia to be a leading digital economy by 2030.
Telstra specifically is a strong brand, a market leader that has obviously benefitted from Optus’ recent troubles around privacy and data security.
It’s performing well in terms of customer satisfaction, as well as things like network coverage and speed, and its most recent financial results seem to show it’s on the right track with first its T22 strategy – and now T25 strategy – to become a simpler, more efficient company (e.g., monetising existing infrastructure and facilities via contracts with NBN; divestments like real estate assets, potentially InfraCo).
So it has a clear roadmap for growth, with sound management that know the industry well. The P/E ratio was sitting at around 21, so I might have bought it at a bit of a high given the telco industry range, but I’m optimistic.
Given the considerable CapEx requirements of the business though, it’s certainly a long-term hold.
What makes an asset attractive in PE?
A good LBO candidate typically has the following characteristics:
- Strong market position and sustainable competitive advantages: Strong LBO candidates are market leaders with sustainable business models. This can be characterized by high barriers to entry, high switching costs, and strong customer relationships.
- Multiple avenues of growth: You want a balanced and diverse growth strategy, so that a company’s success is not completely reliant on one driver. This could include growth through the introduction of new products, increasing in the number of locations, new customers, increasing the penetration of current customers (upselling products), exploring adjacent industries, and expanding into new geographies, among other possibilities.
- Stable, recurring cash flows: Due to the reliance on high leverage, PE firms must find companies with stable and recurring cash flows in order to have sufficient cash flow to service all of its debt requirements. This requires a company to have relatively low exposure to seasonal fluctuations in cash flows, as well as low sensitivity to cyclical fluctuations (i.e., relatively immune to economic downturns and/or commodity prices).
- Low capital expenditure requirements: Companies with low maintenance capital expenditure requirements provide management more flexibility in terms of how it can allocate the company’s capital and run its operations: investing in growth capital expenditures, making bolt-on acquisitions, growth in its core operations, or give back capital to its shareholders in the form of a dividend. Capital-intensive businesses will typically generate lower valuations from private equity firms since there is less available capital (after interest expense), and there is increased financial risk in the deal.
- Favourable industry trends: You want companies that are well-positioned to benefit from attractive industry trends, since it results in above market growth and provides stronger equity return potential as well as stronger downside protection for the investment. Examples include increasing automation, changing customer habits, adoption of a disruptive technology, digitalization, changing demographics, increasing regulation, etc.
- Strong management team: A strong management team is crucial to success as PE firms will provide strategic guidance but will almost exclusively rely on management to execute their operating strategy. If a company does not have a strong management team, the private equity firm must have a replacement ready before even seriously contemplating the investment.
- Multiple areas to create value: In addition to the characteristics above, a good LBO target candidate will also have multiple areas where the PE firm can create additional value. Examples include selling underperforming assets, increasing the efficiency of operations, pricing optimization, organizational structure, and diversifying the customer base.
Note also: the difference between a good business and a good investment is price. You could have a great business, but if you have to pay a huge amount for it, it might not be a great business. Conversely, you could have a so-so business, but if you can get it for a good price, it might make a great investment.
What industries do you think are currently attractive?
You’d want to look at industries that are mature, growing at a moderate rate, and non-cyclical. The companies found in these types of industries are more likely to generate predictable revenue with fewer disruption risks from technological advancements or new entrants due to having high barriers to entry.
The ideal industry should exhibit stable growth in the upcoming years and have positive tailwinds that present growth opportunities. You’d want to avoid industries expected to contract or prone to disruption.
If you’re looking at roll-up acquisitions – you’d look for fragmented industries where the consolidation strategy (i.e. “buy-and-build”) would be more viable since there are more potential add-on targets in the market.
What would the ideal type of products/services being sold be for a potential LBO target?
- Mission critical product/service, that is essential to the end market being served – i.e., discontinuance would be detrimental to the customers’ business continuity, result in severe monetary consequences, or damage their reputation
o e.g., a decision for a data centre to terminate its contract with its security solutions provider (video surveillance, access control) could impair the data centre’s relationships with its existing customers in the case of a security breach and loss of confidential customer data. - High switching costs that make customers reluctant to move to a competitor
o e.g., Apple / iOS system - Recurring revenue component: Products/services that require maintenance and have a recurring revenue component are more valuable, given the greater predictability in revenue (customers prefer to receive maintenance and other types of related services from the original provider they purchased the product from)
What are some of the red flags you would look out for when assessing a potential investment opportunity?
- Industry cyclicality: Ideal LBO candidate should generate predictable cash flows. Therefore, highly cyclical revenue and demand fluctuations based on the prevailing economic conditions (or other external factors) make an investment less attractive from a risk POV
- Customer concentration: As a general rule of thumb, no single customer should account for more than ~5-10% of total revenue given the resulting risk of losing that key customer
- Customer / employee churn: High rates of customer and employee churn can be perceived as a negative sign, since high customer churn creates the need for constant new customer acquisitions while low employee retention signals issues in the organisational structure of the target
Tell me about a recent deal.
I thought Quadrant’s recent acquisition of the three cybersecurity businesses in New Zealand (Quantum Security Services, ZX Security and Helix Security Services) was quite interesting – and well-timed given the attention the industry is receiving lately, thanks to the likes of Optus and Latitude.
I read the combined revenue of these companies had grown by 35%+ over the past three years; they also have an established and steady base of customers comprising a mix of corporates and government departments.
Cybersecurity is obviously a need that isn’t going to subside any time soon, and I think Quadrant has identified opportunities to realise synergies and combine each company’s strengths to create a single specialist group, likely with an expanded service offering, capable of helping more customers uplift their cybersecurity maturity.
And the nature of the business is such that it’s a relatively niche business with high margins – the industry isn’t really dominated by a major player like you have CBA in home loans, or Woolworths and Cole’s in groceries – plus you wouldn’t expect huge CapEx costs.
Given two companies (A and B), how would you determine which one to invest in?
An investment decision will require a comprehensive analysis of both quantitative and qualitative factors:
* Business model: How does the company generate money, how does it work?
* Market share / size of the market: How defensible is it, opportunities for growth
* Margins and cost structure: Fixed vs. variable costs, operating leverage, and future opportunities
* Operating efficiency: Analysing ratios such as inventory turnover, working capital management, etc.
* Capital requirements: Sustaining vs. growth
* CapEx: Additional funding required
* Risk: assessing the riskiness of the business across as many variables as possible
* Customer satisfaction: How do customers regard the business?
* Management team: How good is the team at leading people, managing the business, etc.?
* Culture: How healthy is the culture and how conducive it is to success?
All of the above criteria need to be assessed in three ways: how they are in (1) the past, (2) the near-term future, and (3) the long-term future. This will be the basis of a DCF model (which will have multiple operating scenarios), and the risk-adjusted NPV for each business can be compared against the price the business might be purchased at.
