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Analyzing a company's allocation of capital; acquisitions, dividends, share repurchases, excessive capital expenditures.

December 18, 2004

Acquisitions: This is one of the most serious threats to a company's shareholder value. An extreme example of this is Mattel's acquisition of The Learning Company.

In 1999, the Mattel purchased The Learning Company for about $3.5 billion in stock. 126 million shares were issued for the acquisition, causing Mattel's shares outstanding to increase from 286 million in March of 1999 to 425 million in March of 2000. The Learning Company began losing money as soon as it was acquired by Mattel, and ended up costing the company hundreds of millions of dollars. Eventually, Mattel essentially gave the company away for free, after finding someone generous enough to take the money losing company off their hands.

A person who owned one share of the company owned 1/286 million, or .00000035%, of the company before the acquisition, but only owned 1/422 million, or .00000023% of the company after it. So investors owned about 30% less of the company than before, and received no benefit for this loss. The dilution cost shareholders roughly 30% in intrinsic value, and the failed acquisition caused several hundred million dollars of additional losses. Needless to say, the CEO (Jill Barad) was forced to resign. But she got a multi-million dollar severance package that included payments of $106,745 per month, for 10 years, forgiveness of a 3 million dollar loan for a home, and forgiveness of another 4.2 million dollar loan. The monthly payments were part of her original employment agreement, but the loans were a reward for her catastrophic failure.

It's also useful to look at smaller acquisitions. Certain companies frequently acquire small businesses. Often, the new acquiree fails to perform, and the acquirer disposes of the acquired company. When you're analyzing a company's 10-K document, look to see if it takes large, "non-recurring" charges for the disposal of businesses.

If a company makes a large acquisition that I feel uneasy about, or if it has a bad track record with small acquisitions, I will avoid the company. If I own it, I will usually sell. Poor acquisitions can do serious damage to even the best companies. They are one of the biggest threats to shareholder value.

Dividend policy: at the end of Microsoft's most recent fiscal year, it had $60 billion in cash and short-term investments. Recently, they announced that they will be paying a large, special dividend. But I think this dividend should have come sooner. This $60 billion was just sitting around, earning low interest rates. It would've been better off in the hands of its shareholders.

Share repurchases: Companies often repurchase stock when it is high and stop repurchases when it is low. For instance, when Bristol Myers Squibb stock took a large haircut awhile back, management decided to suspend the stock buyback program. The reason: since the stock is lower, less people will exercise stock options, so there will be less dilution to offset. This, of course, not what they should be doing. It's better to buy back stock when it is undervalued and to stop repurchases when it is overvalued.

Excessive capital expenditures: Often, a company will invest excessively in its business. To get a handle on this, look at its cash flow statement, which will be in its annual report. If the company's free cash flow is zero, for example, it had better be growing at an average, annual rate of 10% or more. If not, then the company is earning less than 10% on what it is investing in the business. You don't want to own a company that is producing no cash per year and is only growing at 5%, because the stock would be expected to produce long term returns of only 5%.