How Companies Allocate Capital Decides Their Fate

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1. How Companies Allocate Capital Determines Their Fate

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How Companies Allocate Capital Determines Their Fate

Mergers and acquisitions often become more and more popular during financial turmoil

Public companies have earnings targets set by Wall St 

The stock performs well, the stock price goes up making the company more valuable and management and shareholders are happy

If the company isn't growing the way management wants, they made need to engage in some strategic capital allocation in order to hit those earnings targets, like M&A

But there is another way that management can use their excess cash to help boost up their earnings per share

Share repurchases or share buybacks

Share repurchases, also known as stock buybacks, are a financial strategy used by companies to repurchase their own shares from the open market or from existing shareholders

The management of a company may choose to do share repurchases for various reasons, including:

Return of Capital to Shareholders: Share repurchases can be used as a means to return excess cash or capital to shareholders. By reducing the number of outstanding shares, the company can increase the ownership stake of existing shareholders, potentially leading to an increase in the stock price and enhancing shareholder value.

Capital Allocation: Share repurchases can be part of a company's capital allocation strategy, along with other uses of cash, such as dividend payments, debt reduction, or reinvestment in growth opportunities. Management may choose to repurchase shares if they believe the stock is undervalued, and that doing so would be a more attractive use of capital compared to other investment options.

Earnings Per Share (EPS) Boosting: Share repurchases can also impact a company's earnings per share (EPS), which is a common financial metric used to assess a company's profitability and for management/executives to get their bonuses. When a company repurchases its own shares, the total number of outstanding shares decreases, which can result in an increase in EPS, assuming the company's earnings remain constant or increase. This is because the same amount of earnings is distributed among a smaller number of shares, resulting in a higher EPS.

Simple example: The company generated $100 in GAAP (generally accepted accounting principles) earnings and has 20 shares outstanding

Their GAAP earnings per share is $5 per share ($100/20)

If management repurchases 10 of those shares with their access capital, now the GAAP earnings per share is $10 per share ($100/10)

There was no increase in efficiency or effectiveness of the business operations, just management using their cash on the balance sheet to reduce the number of shares outstanding

Share Price Support: Share repurchases can also be used to support the company's stock price. By repurchasing shares, a company can create demand for its own stock, potentially helping to stabilize or increase the stock price. This can be particularly relevant when a company's stock price has been under pressure or when management believes the stock is undervalued.

Another way management can allocate excess capital is paying down debt, paying shareholders a dividend, or engaging in M&A

Companies engage in mergers and acquisitions for various reasons, including:

Strategic Expansion: M&A allows companies to expand their business operations, customer base, geographical presence, and product/service offerings. It provides an opportunity to enter new markets, gain access to new technologies or intellectual property, and achieve economies of scale, which can enhance their competitive advantage.

Synergy Creation: M&A can create synergies, where the combined entity can achieve cost savings, revenue enhancements, and operational efficiencies that may not have been possible as separate entities. Synergies can result from consolidation of redundant operations, elimination of duplicate expenses, cross-selling opportunities, and leveraging complementary strengths of the merging companies

Diversification: M&A can be used as a strategic tool to diversify a company's business operations, reducing risk by expanding into different industries, markets, or geographies. This can help companies mitigate risks associated with relying too heavily on a single market or product/service, and create a more balanced and diversified portfolio.

Access to Resources: M&A can provide access to critical resources such as talent, technology, patents, distribution networks, manufacturing capabilities, and financial capital, which can accelerate growth and innovation. Companies may pursue M&A to gain access to unique capabilities or assets that can be leveraged for long-term growth.

Enhancing Shareholder Value: M&A is often pursued as a means to enhance shareholder value. By combining forces, companies aim to increase revenue, improve profitability, and boost shareholder returns through increased stock prices, dividends, or other financial metrics.

Competitive Pressures: M&A can be driven by competitive pressures, such as the need to respond to changes in the market, competitive threats, or disruptive technologies. Companies may engage in M&A to stay ahead of the competition, strengthen their market position, or defend against potential threats.

Financial Considerations: M&A can be a financially motivated decision, where companies seek to achieve financial gains through activities such as leveraging tax benefits, improving financial ratios, utilizing excess cash, or diversifying investments.

Exit Strategy: M&A can provide an exit strategy for founders, owners, or investors who are looking to monetize their investments or exit the business. M&A can provide liquidity, unlock value, and offer an opportunity for stakeholders to realize returns on their investments.

A lot of the FAANG stocks you know of today have been successful engaging in M&A

It's not always the case, there are plenty of really terrible acquisitions like Lululemon's $500m acquisition of MIRROR fitness equipment ended up not being very successful and Lululemon in just a few years has written off almost the entire value of MIRROR

Here is a list of some of the better acquisitions by well known companies:

Facebook's acquisition of Instagram: In 2012, Facebook acquired Instagram, a popular photo-sharing app, for $1 billion. Since then, Instagram has grown exponentially and has become one of the most widely used social media platforms with over a billion active users, providing significant value to Facebook and diversifying its offerings.

Google's acquisition of YouTube: In 2006, Google acquired YouTube, a video-sharing platform, for $1.65 billion. YouTube has since become the dominant platform for user-generated video content, and its acquisition has greatly expanded Google's reach in the online video market, creating substantial value through advertising revenue and user engagement.

Microsoft's acquisition of LinkedIn: In 2016, Microsoft acquired LinkedIn, a professional networking platform, for $26.2 billion. This acquisition has helped Microsoft expand its presence in the enterprise and professional networking space, providing synergies with its existing products and services and opening up new opportunities for growth.

Disney's acquisition of Pixar, Marvel, and Lucasfilm: Disney has made several successful acquisitions over the years, including Pixar Animation Studios in 2006 for $7.4 billion, Marvel Entertainment in 2009 for $4.24 billion, and Lucasfilm in 2012 for $4.06 billion. These acquisitions have allowed Disney to expand its portfolio of beloved intellectual properties and characters, leading to successful movies, merchandise, and theme park attractions, generating substantial revenue and enhancing shareholder value.

Amazon's acquisition of Whole Foods Market: In 2017, Amazon acquired Whole Foods Market, a grocery store chain, for $13.7 billion. This acquisition has helped Amazon enter the brick-and-mortar grocery retail market and leverage Whole Foods' physical store presence, customer base, and supply chain capabilities to further expand its online grocery business.

It's worth noting that successful acquisitions are not solely determined by the price paid, but also by the integration strategy, execution, and ability to achieve synergies and create value

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.