The Capital Allocation Playbook (Part 13)

Learnings – 3

Org Structure: As a company grows, it becomes harder to manage in the same way. Netcore at $100 million is twice the size of what it was three years ago. The management structure we created then is perhaps not what will take us to $300-400 million in the coming years. We may need to look at a more decentralised structure with operating units because we have different businesses even though all are aligned to the core objectives of customer communications, engagement and experience. Our platform business operates at very high gross margin while our messaging business (SMS primarily) is at much lower GM. Our platform and messaging revenues come largely from India and emerging markets, while Unbxd’s revenues come from the developed markets. Companies like Berkshire Hathaway and Transdigm have created a lean HQ with decentralised decision making in the operating units. We may also need to consider such a structure in the near future. This will mean bringing in business leaders who think like owners and have P&L responsibility. Profits generated can either be deployed in the same business (provided they meet the hurdle rate for return on investment) or sent back to HQ for allocation.

Management: Every growing company needs to build depth in top-level leaders. As we grow, we need leaders who can think like entrepreneurs and owners to take up new opportunities – organic or inorganic – and build them. What got us here (to $100 million) will not take us ahead (to $300-400 million). This is where every one of the top leaders needs to evolve, and think strategy and capital allocation. Many leaders rise through the ranks and capital allocation is not something which they learn. At HQ, the two most important decisions are therefore those related to people and capital.

Kaizen: Continuous improvement has to become an integral part of the culture. Going back to compounding, becoming 1% better daily means than one can see a 37X improvement in a year. Complacency is one of the biggest reasons for the decline of once-good companies. Fatigue and hubris are both company killers. In spaces which are fast evolving – and most spaces are – there is no room for mental lethargy. Inefficiencies need to be constantly rooted out. Each day must feel like “Day Zero” with the energy and hunger of a startup to succeed.

**

Capital allocation is first and foremost about capital – the generation of surplus cash which can be deployed for new growth opportunities. As we have seen, the most successful companies are also among the best at capital allocation. My hope is that we can make Netcore into such a company, combining good strategy and flawless execution with the best techniques of capital allocation to deliver high multi-decadal growth to make the magic of compounding work. Like a batsman taking a fresh guard on reaching a century, we at Netcore need to do the same to prepare for the next phase of growth from our current $100 million revenue.

The Capital Allocation Playbook (Part 12)

Learnings – 2

Free Cash Flow: The most important element in capital allocation is the generation of capital. The best way is by being profitable. Netcore has been profitable for the past 15 years. The free cash generated is what we have used for our business growth, investments and acquisitions. To generate free cash predictably for long periods of time, a business needs some combination of monopoly and moat. In Netcore, this comes via our email and SMS business. The cash generated has helped us invest in building the martech stack and expanding to new geographies, our acquisitions of Boxx, Hansel and Unbxd, and our investments in Profitwheel, EasyRewardz and Comsense.

New Growth Engines: To keep increasing free cash flow, new growth engines need to get created. Competition is never far away. Innovation is necessary to keep creating additional value for customers. Ideas like Email 2.0 and Loyalty 2.0 offer the potential to create new growth engines for Netcore. Email has not seen much innovation in the past decade or so. With ideas like AMP and Atomic Rewards, we should be able to make inroads into global customers and also switch spending from adtech (new customer acquisition) to martech (existing customer retention and growth).

Acquisitions: We will never be able to build everything that customers want internally. Hence, acquisitions will be an important mechanism for future growth. Getting acquisitions right is very important as companies like Danaher have shown, else they can be destroyers of capital. In future, we will need to think of Netcore as a “House of SaaS” – by building a large customer base, we will be able to continuously add new products (built internally or bought) and reduce sales and marketing costs by selling to the same buying centre in a company. Research has shown that two out of three acquisitions do not deliver the value that is anticipated. This is what we need to guard against. Every acquisition is a risk, but done in the right way and at the right price, it can be a powerful mechanism of growth and a new source of free cash in the future.

Going Public: Netcore is a private company. We also don’t have external investors. As such, it becomes hard to place a value on the stock. Becoming a public company will give us greater flexibility in capital allocation decisions. We can then use stock as a currency for acquisitions rather than just cash. This will help us think bigger in terms of scale.

The Capital Allocation Playbook (Part 11)

Learnings – 1

Compounding: One of the greatest secrets in the world is the power of compounding. A 10% annual growth over 10 years means that $100 dollars becomes $260 – 2.6X. A 20% annual growth for the same period results in $620 – 6.2X. Over 20 years, the difference is stark; $670 vs $3700, over five times greater. In Netcore, we have grown per share value at 26% compounded over the past 10.5 years which has meant that $100 has become $1000 – 10X. If we can do this for another decade, that would mean 100X. So 10% over 20 years is 6.7X, 20% is 37X and 26% is 100X. Understanding the power of compounding is a must for entrepreneurs. As Morgan Hansel writes in his book “The Psychology of Money”: “If something compounds—if a little growth serves as the fuel for future growth—a small starting base can lead to results so extraordinary they seem to defy logic. It can be so logic-defying that you underestimate what’s possible, where growth comes from, and what it can lead to.”

Longevity: High growth can be done for a few years. The challenge is to sustain it over long periods of time. As a friend wrote to me recently, “The compounding formula is (1+r%)^n. People forget the “n” of compounding actually matters more than the “r”. Too many people focused on “r”, too few on “n”.” Compounding growth over long periods of time is what creates value. For that, a process and discipline is required not just in strategy and execution, but also in capital allocation. A few mistakes can wipe out years of growth. In Netcore, we have made our fair share of mistakes – which have hurt us. We could have done much better than our 10 years, 26% CAGR in per share value had we got martech automation right early on, and used the SaaS mindset to expand globally much before we did.

Luck: While one has to be smart to succeed, luck also plays an important role. Timing for decisions matters. In 1999, when I sold IndiaWorld for Rs 499 crore ($115 million), the timing was just right. Had I wanted a few months, I do not know what the value of the business would have been because the dotcom bubble burst. In fact, had I sold a few months earlier, I would have probably realised only a fraction of the value. The right timing meant that my initial investment of Rs 20 lakhs in IndiaWorld grew almost 2500X in five-and-a-half years, a CAGR of almost 300%.

The Capital Allocation Playbook (Part 10)

Constellation Software – 2

Auri Hughes in May 2022: “This was started by a gentleman named Mark Leonard in ’95 and he was a venture capitalist 11 years and he acquired small software plays. Then he continuously did this for long periods of time and the business has just grown tremendously. Over years, it compounded something like, I think in the high 20 or 30 percent for over 10 years. He’s done this with a M&A strategy. I think this is profound because a lot of companies essentially destroy value with M&A and they’re not great capital allocators or they overpay or they promise synergies and things that don’t materialize and we see that later. But he has this wonderful strategy. One of the things that I think is unique is in CapIQ the share count when they went public was 21 million shares and today it’s still 21 million shares. They’ve earned a return on equity in the high 30s for a consistently long period of time. I think this is one of the best companies in the world a lot of people don’t know about. They are very disciplined and they have this process as well. I think the other unique thing to mention is as you get larger, you have to do more acquisitions to generate the same amount of earnings and return on equity because your capital base is growing. They’ve consistently been able to do this for a long period of time so I think Mark Leonard is just a master capital allocation.”

Bill Mann (continuing the same conversation): “If you ever get a chance to go to the Constellation Software front page of their website, they are first and foremost interested in getting introductions to vertical management software companies that are interested in selling. This company is built for capital allocation. Because if you think about it, there’s no such thing as let’s go upload the Constellation Software suite. It doesn’t exist. They’re a series of small companies and they use the returns from those companies as force multipliers for other companies that they are interested in buying. They do them by the dozens each year at this point.”

Simon Handrahan in October 2021 aggregated wisdom from the shareholder letters written by Mark Leonard. A sample:

“We have an objective of generating average annual revenue growth per share and average annual EBITDA growth per share of at least 20% for the five year period… I recently ran a screen of public companies… that met these criteria for the last 5 year period. I discovered that less than 1% of companies qualified.”

“We’ve handled our geometric growth to date by largely abdicating management to the general managers of each of our vertical businesses. CSI. We count on the fact that with each new acquisition will come general managers who are steeped in their verticals…”

“… our senior managers consistently generate rates of return in excess of 25% on the capital that they deploy. As investors you’ll know that this is wildly difficult to achieve. How do we keep these multi-talented managers? Hopefully we provide an environment that is fulfilling, colleagues that are both challenging and entertaining, and work that is meaningful. We also pay them well.”

“When we acquire an underperforming company Growth suffers. …we generally grow our acquired businesses, frequently providing additional products for them to sell into their installed base, and bringing our increased scale and best practices to bear upon their business…. the reduction of an acquired business to a profitable Core will leave us with a smaller, but usually more profitable business.”

There is a lot to learn from the likes of Berkshire Hathaway, TransDigm, Teledyne, Constellation Software and businesses like them. As a latecomer to the world of capital allocation, I will summarise my learnings and how these could be applied to Netcore to deliver exceptional returns in the years to come.

The Capital Allocation Playbook (Part 9)

Constellation Software – 1

In software, one of the companies regularly mentioned in capital allocation conversations is Constellation Software. In its own words: “Constellation Software is a leading provider of software and services to a select group of public and private sector markets. We acquire, manage and build industry specific software businesses which provide specialized, mission-critical software solutions that address the particular needs of our customers. Our businesses continuously develop innovative solutions that enable our customers to achieve their objectives. With over 125,000 customers in over 100 countries and a proven track record of solid growth, we’re establishing a broad portfolio of software businesses to provide our customers and shareholders with exceptional returns.” The CEO is Mark Leonard, and the company is headquartered in Toronto, Canada.

Its stock performance through the years (from Google Finance):

From a recent commentary in Rational Thinking: “Under [Constellation Software’s CEO Mark Leonard’s] reign, the company has compounded at about 40% for almost two decades! … Constellation’s business model is to acquire small software companies under one umbrella while giving them autonomy without fiddling from HQ.”

25iq in 2018: “With an initial $25-million investment from OMERS and his old associates at Ventures West Capital in 1995, Mark Leonard has built Constellation into a world-leading consolidator of vertical market software (VMS) companies—firms that create products to help run businesses in specific industries. Over the years, Constellation has made scores of acquisitions and, through its six operating groups, now provides software to over 60 industries, from health care to law to public transit…. Typically, Constellation’s acquisitions are small—in the $2-million to $4-million range—but add them all up, slip in a dose of Constellation’s financial and operational discipline, and you have [a company with a market cap of $18 billion….In this age of zero privacy, Mark Leonard has managed to maintain a practically unthinkable level of anonymity for just about any individual—let alone an IT executive who runs one of Canada’s most dynamic, fastest-growing and most acquisitive software companies, and who has been compared favourably with Warren Buffett and Prem Watsa.”

Eagle Point Capital in 2021: “Mark Leonard and the small headquarters team are the foundation for capital allocation at Constellation, but most of the work is carried out in the subsidiaries. Leonard is clearly a very skilled capital allocator and investor. He thinks like Buffett and has a repeatable framework when thinking about acquisition candidates, purchase prices, risk, and forward rates of return. Constellation’s stated goal is to be a “great perpetual owners of VMS (vertical market software) businesses”. They look for what they deem both “exceptional” and “good” VMS businesses. Exceptional businesses feature an outstanding manager, consistent profitability, and above average growth. Leonard classifies good businesses as first or second-ranked players in their verticals that may still be working to establish a solid track record of growth and profitability. Constellation has carved out a sweet spot by acquiring lower organic growth (GDP-like growers) albeit very high-quality software companies. They’ve been able to maintain valuation discipline by staying away from high-growth software businesses where valuation multiples are far higher.”

The Capital Allocation Playbook (Part 8)

The Outsiders

In his book, William Thorndike discusses 7 other case studies besides Teledyne and compares them with Jack Welch’s performance at GE (who is not among “The Outsiders”). The table below from Strategy for Executives summarises the performance of the Super 8 capital allocators:

CEO Company Period as CEO Stock’s Compound Annual Growth Rate (CAGR) Factor by which the stock outperformed the S&P 500
Jack Welch GE 1981-2001 20.9% 3.3 Times
Tom Murphy Capital Cities 1966-1996 19.9% 16.7 Times
Henry Singleton Teledyne 1960-1989 20.4% 12 Times
Bill Anders General Dynamics 1991-1993 23.3% 6.7 Times
John Malone TCI 1973-1998 30.3% 40 Times
Katharine Graham The Washington Post 1971-1993 22.3% 18 Times
William Stiritz Ralston Purina 1981-2001 24% 4 Times
Dick Smith General Cinema 1962-2005 16.1% 16 Times
Warren Buffet Berkshire Hathaway Since 1965 20.7% Over 100 Times

This chart from the book (via Kyle Eschenroeder) shows what the 8 Outsider CEOs had in common:

Towards the end of the book, Thorndike has a capital allocator’s checklist. Here’s a summary:

  1. The allocation process should be CEO led, not delegated to finance or business development personnel.
  2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).
  3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk
  4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.
  5. Focus on after-tax returns, and run all transactions by tax counsel.
  6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.
  7. Consider a decentralized organizational model.
  8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.
  9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
  10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.

The Capital Allocation Playbook (Part 6)

Teledyne’s Singleton – 1

I had not heard of Teledyne till it was discussed in “The Outsiders.” The best place to learn about Teledyne is this case study:

Dr. Henry Singleton was more than just a great capital allocator, he was a visionary, entrepreneur, and excellent business person who believed that the key to his success was people—talented people who were creative, good managers and doers. Once he had those managers in place, he gave them complete autonomy to meet agreed upon goals and targets.

He and his co-founder and initial investor, George Kozmetsky, bootstrapped their investment of $450,000 into a company with annual sales of over $450 million, an annual profit of some $20 million, and a stock market value of about $1.15 billion.An investor who put money into Teledyne stock in 1966 achieved an annual return of 17.9 percent over 25 years, or a 53x return on invested capital vs. 6.7x for the S&P 500, 9.0x for GE and 7.1x for other comparable conglomerates.

Teledyne’s investors were rewarded with a triple whammy of increasing earnings with a shrinking capital structure along with an expanding P/E ratio. As the single largest investor in Teledyne, Dr. Singleton chose to make money alongside his fellow investors not from them.

More from William Thorndike:

Henry Singleton had a unique background for a CEO. He was trained as an engineer and scientist. He got his undergraduate degree, masters, and a PhD from MIT in electrical engineering and for his doctoral thesis, he programmed the first computer at MIT. He subsequently went on to develop a degaussing technology that allowed naval ships to avoid radar detection during the Second World War. He ended up working for one of the pioneering conglomerates in the 1950s, Litton Industries. While he was there, he developed an inertial guidance system that’s still in use in military and commercial aircraft.

He was a super talented engineer. When he was an undergraduate, he won something called the Putnam Medal which is awarded to the top mathematician in the country. Later in his career, at the age of 43, he founded his own company, Teledyne, which grew to be one of the most successful of the sixties-era conglomerates and in running that business over almost 30 years, he generated exceptional returns … 20% compounded over 28 years.

It roughly doubled the rate of return for his conglomerate peers. In doing that, he developed a whole range of varied, unusual, [and] idiosyncratic practices, including pioneering stock buybacks, never selling his stock, and doing a whole range of things that were unheard of at the time.

… He is still relatively unknown. Part of that stemmed from his personality type. He disdained the limelight and was very reticent to spend time with the business press and with Wall Street analysts. In his day he gave no earnings guidance. He never appeared in Wall Street sell-side conferences and that sort of thing. He preferred to stay apart and focus on building value in his company over time.

The Capital Allocation Playbook (Part 5)

Berkshire Hathaway

Adam Mead’s book “The Complete Financial History of Berkshire Hathaway: A Chronological Analysis of Warren Buffett and Charlie Munger’s Conglomerate Masterpiece” offers a fascinating view into the capital allocation decisions made through its history. He writes: “Berkshire Hathaway [is] among the greatest of human achievements. Berkshire’s financial outcomes were a result of business mastery, the perfection of a system that cultivated human potential. The capitalist system put in place by America’s Founding Fathers and the incredible tailwinds of the mid-twentieth century provided the rich soil to allow the genius of Warren Buffett and Charlie Munger to flourish. The full story of Berkshire Hathaway is worth understanding for what it can teach us about continuing timeless methods of excellence in business and in life.”

In a section on capital allocation, Mead writes:

Berkshire’s philosophy: Treat subsidiaries as investments, providing for operational independence. Use the cash flow from them, along with capital gains from investments, for organic expansion.

Early conglomerates: Acquire diverse businesses to achieve synergies or take a hands-on approach to managing them post-acquisition.

A successful business of any kind is the result of rational capital allocation over time. Berkshire Hathaway grew out of the philosophy Warren Buffett internalized from Benjamin Graham early in his career. A bedrock principle was that stocks represented ownership in a business. This framework gave Buffett an important vantage point to survey the economic landscape. No business or industry would be out of reach if Buffett could understand the business and its economics. Berkshire could allocate capital to wholly-owned businesses or buy pieces of businesses in the stock market, depending on which was more attractive at the time.

Crucially, the ownership philosophy set the stage for decentralization. Buffett and Munger’s early years were spent buying stocks as part of a portfolio. Berkshire was constructed using what might be termed a portfolio approach. It became a collection of businesses and not one large business with operational oversight of multiple business activities. This is an important distinction. Berkshire’s capital allocators were accustomed to acting as owners, not managers. If a hands-off approach worked for passive investments in stocks, why should the approach change much upon gaining control? Berkshire could view ownership of a subsidiary as equivalent to a stock in a portfolio and let it operate independently. The only difference between the two approaches was that Berkshire had a much higher threshold for divesting an operating subsidiary.

… The conglomerate structure also provided an important relief valve to subsidiaries. Berkshire’s subsidiaries could grow to their optimal size and send surplus cash flow to headquarters. Buffett and Munger were in the best position to allocate capital to the highest use once it could not be used for expansion at the subsidiary level. This afforded Berkshire the opportunity to buy businesses with strong competitive positions but little growth potential.

Since 1965, Berkshire Hathaway has provided over 20% average returns since its inception, almost double the 10% of the S&P 500.

The Capital Allocation Playbook (Part 4)

David Giroux writes in “Capital Allocation: Principles, Strategies, and Processes for Creating Long-Term Shareholder Value”:

Capital allocation is defined as the process by which management teams and boards deploy their firm’s financial resources both internally and externally. Examples of capital allocation include:

  • Building a new plant
  • Expanding into a new market or geographic region
  • Increasing or decreasing the R&D budget
  • Making an acquisition
  • Paying a dividend
  • Repurchasing shares
  • Buying new enterprise software

All of these capital allocation examples involve an outlay of cash or shares (i.e., the investment) and should be expected to generate an attractive return for shareholders on the investment over a reasonable time.

… The compounding power of generating strong returns on excess capital and a strong FCF (free cash flow) conversion rate (FCF divided by net income) cannot be overstated. A company that grows its profits at 4% organically but is able to earn 10% returns on excess capital deployment by year five and convert 100% of its net income into high-quality FCF can grow EPS at an impressive 11.2% per year. Another company with a similar organic growth profile that is only able to generate 6% returns on excess capital deployment and converts its net income into FCF at a 60% conversion rate will only grow at 6.5% per year.

The book offers a suggestion to how to differentiate between businesses in a firm:

For a company with some businesses that have secular challenges and others that don’t, one of the best ways to maximize shareholder wealth is to create two publicly traded companies.

GrowthCo would hold the assets without secular risk. This company can support a higher level of debt and will likely focus its capital allocation on acquisitions, share repurchase, and moderate dividends.

ValueCo will hold the businesses undergoing secular challenges. Its focus should be on maximizing cash returns to shareholders through dividends and regular special dividends while continuing to invest in innovative products and services. ValueCo can also be used as a consolidation vehicle for similarly challenged businesses.

The book has a checklist of strategic actions:

  1. Compare Returns of All Alternatives Before Deploying Capital
  2. Focus on Return on Invested Capital (ROIC) Instead of Discounted Cash Flow (DCF) or Internal Rate of Return (IRR)
  3. Monitor the Returns from Capital Deployment
  4. Identify a List of Potential Acquisitions
  5. Create Appropriate Incentives for Management
  6. Develop a Long-Term Strategic Plan to Make Each Business Better
  7. Conduct an Annual Review of Strategic Alternatives
  8. Engage with Shareholders

It also has a list of “Critically Important Mindsets” for boards:

  1. Challenge Assumptions
  2. Be Willing to Say No
  3. Take Everything Investment Bankers Say with a Grain of Salt
  4. Practice Patience
  5. Make Capital Deployment Independent of What Is Happening in the Core Business
  6. Prioritize Shareholders over Executives