ROIC + Organic New Revenue Growth

[randallchsu]

From Constellation Software Inc. shareholder letter:

 

"Obviously, when you divide Adjusted Net Income by Invested Capital, you get a measure of the return on our shareholders’ investment (i.e. ROIC). If you add Organic Net Revenue Growth to ROIC, you get what we believe is a proxy for the annual increase in Shareholders’ value. In a capital intensive business you couldn’t just add Organic Net Revenue Growth to ROIC, because growing revenues would require incremental Invested Capital. In our businesses we can nearly always grow revenues organically without incremental capital."

 

Why adding organic net revenue growth to ROIC in an asset light business made sense? Also, how do you determine organic net revenue without management telling you the number?

[netnet]

• Three things
   
  
  • Generally, this question should be asked in the Constellation thread.
     
    
  • This has been partially answered in the thread (and is answered in Constellations' AR)
    
  • Some curmudgeons, on this board have chastised me for answering questions like this, i.e. they think posters should look it up first
    

 

Now that said, if you invert the question would you add organic net revenue growth to a capital heavy business, no you would not. The question is answered right there for you!  Every incremental dollar of revenue is going to require a lot of capital, with CSU this is not the case.  The capital in ROIC is invested in acquisitions. (ALERT editorial opinion on a divisive subject)  In this case without the Valeant funny business accounting.

 

For other companies without CSU's characteristics, this would be a bad number to use, if you acquisitions were not material and/or most of your growth came from organic growth, you may even be double counting.

 

I was first put off by this and it seems like apples and oranges (or apples and hand grenades), but for this company it works. Apparently they manage to this number.  They seem to have strict capital allocation and most importantly revenue growth is extremely high margin. If the company did not have both strict capital allocation and high margins then you would not use that number. But since this is not the case, % increase in organic revenues tells you the % of organic growth. etc.

 

Ultimately, the CEO has given you his targets and tells you how to judge him.  Very honorable indeed.

[randallchsu]

Thank you for your reply. This question is not targeted for CSU, but is asking if this metric is a good way to apply to other asset light businesses. Accepting this approach seems like higher valuation can be justified, making the two birds in the bush that much more attractive than the one in hand.

 

So from what you are suggesting, this would be a pretty unique way to look at CSU and less so with other businesses?

[KCLarkin]

if this metric is a good way to apply to other asset light businesses

 

Asset Light is not a sufficient condition. You also need negative working capital. If you have an asset light business (say a distributor), you will still need incremental capital for receivables and inventory to fund organic growth.

[ZenaidaMacroura]

Sorry to bring this back from the dead -if the company was capital light and instead of acquisitons it paid out most of it's adjusted net income (buy backs/dividends) -could you use ROIC + Organic rev growth? 

 

And I guess at some point the ROIC would become meaningless if enough buybacks/dividends shrank the "Invested Capital" figure?

[Graham Osborn]

Sorry to bring this back from the dead -if the company was capital light and instead of acquisitons it paid out most of it's adjusted net income (buy backs/dividends) -could you use ROIC + Organic rev growth? 

 

And I guess at some point the ROIC would become meaningless if enough buybacks/dividends shrank the "Invested Capital" figure?

 

This "adjusted ROIC" doesn't make much sense to me.  For one thing, it doesn't make much sense to add a revenue figure to a net income figure.  For another, organic vs inorganic revenue growth is almost impossible to determine in the cases where it would make a substantial difference.  Just look at the debate over how much of Valeant/ Allergan's revenue growth was organic - it generally wasn't/ isn't disclosed in a useful manner.

 

Off the cuff, it seems like a metric created for the same reason as most adjusted metrics - to flatter.

[KCLarkin]

Sorry to bring this back from the dead -if the company was capital light and instead of acquisitons it paid out most of it's adjusted net income (buy backs/dividends) -could you use ROIC + Organic rev growth? 

 

And I guess at some point the ROIC would become meaningless if enough buybacks/dividends shrank the "Invested Capital" figure?

 

No. This is briefly addressed in the CSU 2016 letter. This only works as a proxy for intrinsic value creation in very specific edge cases. If you paid out 100% of ROIC and Organic Rev doesn't require any incremental capital, your expected TSR would be organic growth + dividend yield. CSU is valuable because they can reinvest in very high ROIC acquisitions.

 

This "adjusted ROIC" doesn't make much sense to me.  For one thing, it doesn't make much sense to add a revenue figure to a net income figure.  For another, organic vs inorganic revenue growth is almost impossible to determine in the cases where it would make a substantial difference.  Just look at the debate over how much of Valeant/ Allergan's revenue growth was organic - it generally wasn't/ isn't disclosed in a useful manner.

 

Off the cuff, it seems like a metric created for the same reason as most adjusted metrics - to flatter.

 

This is only a rough proxy for Intrinsic Value creation and it only applies in very specific circumstances. (100% of IC is for acquisitions, incremental margins = 100%, organic growth requires zero IC, organic growth is disclosed in a useful manner). These happen to be roughly true for CSU. But likely won't be true in the future.

 

But frankly, you are focusing on the calculation and missing the insight. The insight is that organic revenue growth is "free" since it requires zero capital. In fact, organic growth can generate "float" to fund acquisitions.

 

If you haven't read the 2016 CSU letter, you should.

[Graham Osborn]

This is only a rough proxy for Intrinsic Value creation and it only applies in very specific circumstances. (100% of IC is for acquisitions, incremental margins = 100%, organic growth requires zero IC, organic growth is disclosed in a useful manner). These happen to be roughly true for CSU. But likely won't be true in the future.

 

But frankly, you are focusing on the calculation and missing the insight. The insight is that organic revenue growth is "free" since it requires zero capital. In fact, organic growth can generate "float" to fund acquisitions.

 

If you haven't read the 2016 CSU letter, you should.

 

I'll have a look, but it seems like the larger point is how useful a metric might be if the metric only applies uniquely to that company.  If the metric improves or worsens, that will tell you whether the company is doing "better" or "worse" according to its own definition.  But this information won't give you a sense of opportunity cost - whether it might be better to sell the position or invest in a competitor eg.

 

I am generally a bit leery of adjusted metrics even if they are industry standard.  If they aren't industry standard that sets off more alarm bells.

[Liberty]

I'll have a look, but it seems like the larger point is how useful a metric might be if the metric only applies uniquely to that company.  If the metric improves or worsens, that will tell you whether the company is doing "better" or "worse" according to its own definition.  But this information won't give you a sense of opportunity cost - whether it might be better to sell the position or invest in a competitor eg.

 

I am generally a bit leery of adjusted metrics even if they are industry standard.  If they aren't industry standard that sets off more alarm bells.

 

That's probably usually wise. But on the other hand, there are dozens of different business models/structures, so it's expected that GAAP numbers can't work with them all at the same time; they'll be close to real economics with some businesses, and distort things with others. The question always is: Do you understand what's going on enough to trust the adjustments, or trust that GAAP actually is reflecting reality?

 

Sins of omissions are real. If you pass on a great business that you would otherwise understand because the GAAP numbers are ugly, it's just as as real as if you buy something because of the adjusted numbers and they don't turn out to be accurately representing economic reality.

 

An example of this might be cable companies. They've created a lot of value over the past few decades, but usually had pretty ugly GAAP numbers. It's only by looking at non-GAAP numbers that you could understand what was going on underneath.