Companies That Underpromise and Overdeliver
Disciplined growth is better than pushing the envelope.
by Pat Dorsey, CFA | 02-24-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints
I love managers who don't push growth to the limit.
Why? Because the goal of a company is not growing earnings at top speed--it's generating the highest possible return on its capital base. While superfast earnings growth might increase the share price in the short run, growth that's not profitable or sustainable will inevitably result in an ugly blowup that leaves long-term shareholders holding the bag. This is a game that creative financial engineers can sometimes stretch out for many years, but once the earnings-per-share stone is squeezed dry ... well, let's just hope you're outside the fallout zone.
But high earnings per share growth is so richly rewarded by Wall Street that it takes a very strong and disciplined management team to not push the EPS pedal to the metal. So, when I run across a company that's deliberately growing at a slower pace in order to maximize long-term value creation, I get very interested very fast.
Diamonds Are an Investor's Best Friend
Consider online diamond retailer Blue Nile NILE, which has been very clear on this issue. When asked last fall on a conference call why the firm didn't spend more on advertising, the CEO responded, "As far as why we don't spend more, I think we like being a profitable business and when we look at it, what we're really trying to do is optimize operating profit and optimize the long-term operating profit of the business. ... We spend 4% [of sales] on marketing. We could ramp that up to 10%, but I think if we did that ... the economics wouldn't work. You wouldn't see a commensurate increase in revenues." This is a management team that is clearly thinking about long-term value creation, not short-term earnings growth.
Recently, Blue Nile announced that sales growth would slow for a while because the firm plans to ratchet down spending on paid keyword search, which management felt had become much too expensive to generate a reasonable return on investment. This was another tough, but intelligent, decision--instead of pursuing growth at any cost, the firm is meticulously focusing on the bang it's getting for each advertising buck.
The market reacted predictably to this announcement (the stock tanked), but that's good news for anyone looking to invest in this very shareholder-friendly growth stock at a good price. We think Blue Nile shares are worth $42, substantially above the current quote.
Prudence and Profitability
Perhaps more than any other industry, insurance is an area in which the growth versus profitability tradeoff really separates the class-act companies from the also-rans. Generating premium growth is easy--if you price a policy low enough, you can sell quite a few of them. The problem comes later, when those policyholders make claims and you discover that the premiums you received weren't high enough to pay off the claims profitably. So, watch out if you ever hear an insurance company crowing about high premium volume without mentioning its underwriting profitability.
Progressive PGR is a great example of this kind of discipline. Even though the firm has a fantastic product--evidenced by very high customer-retention rates--and could grow much faster, it only increased premium volume by 4% in 2005. Why? Well, the company saw loss rates ticking up a little, and competitors were driving policy prices down, so it didn't take a genius to figure out that profitability might suffer. Again, this is exactly the kind of decision that separates great managers from the rest of corporate America.
Progressive, unfortunately, is pretty pricey right now. Staying with financial-services, though, there's BankAtlantic Bancorp BBX, which is quite cheap and has also been deliberately slowing down growth recently. The Florida-based bank has essentially stopped making new home loans and expects very little loan activity in 2006 because it feels that the risk-reward tradeoff is poor, given the runup in Florida home prices coupled with low interest rates. Given how successful the firm has been at gathering deposits, it certainly has the capacity to grow much faster, but it's chosen to forgo the quarterly earnings game in favor of long-run profitability. And at 1.6 times book, we think the shares are quite cheap--our fair value estimate is $20.
Staying on Pace
Finally, I'd be remiss if I didn't mention Whole Foods Market WFMI. It may seem odd to put a company that has compounded earnings at 20% annually in the "measured growth" category, but there's no question that the firm could be expanding square footage much faster than its current 14% pace. After all, with comparable store sales increasing at an unbelievable double-digit pace, there's clearly plenty of demand from consumers.
However, the company has deliberately chosen a solid and sustainable pace rather than a breakneck one. CEO John Mackey addressed this issue specifically in Whole Foods' recently issued annual report, so I'll let him explain:
"We are frequently asked that given the large opportunity before us, why aren't we opening more stores per year. Clearly, as evidenced by our record store development pipeline and cash balance, the growth opportunity is there and we have sufficient capital; however, the constraint we face is human capital. We believe that averaging 14% square footage growth is a manageable growth rate for us in that it allows us to maintain our unique corporate culture which we believe is one of our most important competitive advantages. We are fortunate that we are an employer of choice and in hiring for our new stores see a healthy ratio of applicants to job openings; however, as we open larger stores with more restaurant quality food venues, finding high quality, experienced Team Members will be an ongoing challenge."
I would guess that another constraint for Whole Foods is finding high-quality locations--grocery stores aren't small--but no matter. The point is that the firm has chosen to not push the limits of customer demand and capital availability, but rather to grow at a pace that it sees as sustainable over the long haul. We don't currently think Whole Foods shares are cheap enough to merit a table-pounding buy, but we do think the shares are worth $74, and they'd be worth a long, hard look in the mid-50s.
Discipline Matters
As a side note, another high-quality firm that I've mentioned in previous columns-- Strayer Education STRA--has alluded to a similar human-capital constraint to its growth. Demand for adult education is very high, and Strayer spits out gobs of cash, but management is limited by the supply of qualified campus directors and deans. As with the firms above, I view this positively, because it means that the company is unwilling to trade educational quality for faster short-term growth, and maintaining a great educational experience is crucial to Strayer's long-run success.
The bottom line is that when you hear a management team explicitly talk about why it's not pushing the growth envelope, you have very likely found a winner. Growing EPS at a high rate for a few quarters--or even a few years--is easy. Generating high returns on capital and increasing cash flow over a long time frame is much harder but ultimately much more rewarding for shareholders.
