Category: Entrepreneurship

Teledyne’s Singleton – 2

For an internal presentation to my Netcore colleagues, a friend had prepared a few slides on Teledyne which tell the story:

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.

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.

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

Jacob Levy writes in “The Rebel Allocator”:

At the most basic level, [capital allocation is] how you decide to spend money.  But it’s even deeper than that.  Successful capital allocation means converting inputs like money, materials, energy, ideas, human effort, into more valuable outputs.  It’s that transformation process.

… Capital [can be viewed] as goods, both tangible and intangible, that were previously produced that aren’t directly satisfying a human need yet.  Capital is whatever bits, atoms, or energy that are available to eventually produce something that delights a customer.

… Businesses that make great capital allocation decisions deliver higher returns for their shareholders.  They earn higher returns on capital and they don’t squander the money once they earn it.  In fact, it’s hard to imagine a higher-leverage effort for an investor than improving management’s capital allocation skills.

… When leaders choose projects, employees come naturally attached.  When management makes the wrong decision and is forced to change course, the collateral damage rains down on the helpless employees.  Writedowns, restructurings, and layoffs represent failures of past decisions, of bad capital allocation.

… Good capital allocation means doing more with less to create happier customers.  The pressure to continually deliver value is one of the wonders of the free market.

… Imagine that inside you are all of these different locks.  Each lock represents one of your wants or desires … Now imagine that each capital allocation project creates one key.  Ideally, the entrepreneur knows the lock their key will fit beforehand.  A restaurant provides you food, a hotel gives you shelter, shoes protect your feet.  The role of business is to use the least amount of resources to create the key that fits a certain lock.  Doing a proper job spares resources to create more keys for other locks.  In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so.  When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.  That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.

He quotes Warren Buffett from his 1987 letter to Berkshire shareholders: “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes, institutional politics. Once they have become CEOs, they now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead, to be named Chairman of the Federal Reserve.”

Capital Allocation

William Thorndike writes in his book, “The Outsiders”:

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important.

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Essentially, capital allocation is investment, and as a result all CEOs are both capital allocators and investors. In fact, this role just might be the most important responsibility any CEO has, and yet despite its importance, there are no courses on capital allocation at the top business schools.

Investopedia adds: “Greater-than-expected profits and positive cash flows, however desirable, often present a quandary for a CEO, as there may be a great many investment options to weigh. Some options for allocating capital could include returning cash to shareholders via dividends, repurchasing shares of stock, issuing a special dividend, or increasing a research and development (R&D) budget. Alternatively, the company may opt to invest in growth initiatives, which could include acquisitions and organic growth expenditures. In whatever ways a CEO chooses to allocate the capital, the overarching goal is to maximize shareholders’ equity (SE), and the challenge always lies in determining which allocations will yield the most significant benefits.”

This graphic from Strategy for Executives captures the key ideas:

In Netcore, I had not given much thought to capital allocation until recently. Yes, we were profitable and therefore had a lot of cash on our books. What next? Cash sitting in banks and mutual funds earns just a few percent interest each year. It needs to be deployed into opportunities to accelerate business growth. That is where we started the process for looking at acquisitions of reasonable scale – resulting in the Unbxd deal. While that was a one-off, what I realized is that successful companies made capital allocation core to their business. This is what I had to understand. Luckily, there are many teachers for curious students.

Exceptional Returns

I recently came across 50xpodcast.com, alerted via the Colossus newsletter. The 50X podcast is hosted by William Thorndike, who had earlier written one of the best business books I have read, “The Outsiders.” The podcast’s brief: “We track the often circuitous route to exceptional long-term returns, exploring the foundations of value creation and how that rarest of investment commodities—conviction—is created, maintained, threatened, and sometimes lost… From the seat of the professional investor and occasionally the CEO, we explore its origins, evolution, and eventual outcome, studying key themes around long-term value creation ranging from operations, capital allocation, and culture to pivotal buy and sell decisions.”

I have written about the book’s big idea in my Proficorn series #49: “The book answers a simple question: “What makes a successful CEO?” Thorndike’s answer: “it is the returns for the shareholders of that company over the long term… What I like about Thorndike’s idea is that it distills success down to a single, measurable number – with a focus around capital allocation.” The one metric to measure CEO performance: increase in a company’s per share value. Besides the obvious track of winning via product, sales and marketing strategies and execution, what the book discusses is about capital allocation. In a way, long-term success hinges on combining ideas from authors like Jim Collins (Good to Great, Built to Last, and other books) and Thorndike.

Back to the podcast. The first company discussed was Transdigm: “Since inception in 1993, TransDigm has returned over 1,750X its primary equity and a remarkably evenly distributed 36% IRR.” I had not heard of Transdigm before. It is in the aerospace industry. As I listened to the conversation with Nick Hawley, the founder and executive chairman, I realised that there was a lot to learn on company building and delivering superior performance. When I reflected on the conversation between Thorndike and Hawley, I determined that I should also apply the ideas to Netcore going forward.

Netcore is a private company. We have never raised external capital. However, I can estimate our returns through our 25-year journey. I will skip the first 10 years because we did not grow much. In 2012, we had an acquisition offer with a clear valuation. Compared to that offer and factoring in my estimate of Netcore’s current valuation, in the past 10.5 years Netcore has delivered an 11X per share increase for a CAGR of 26%. If we can sustain this for the next decade, the returns would exceed 100X. (In comparison: my first successful company, IndiaWorld, had delivered 2500X return in 5 years.)

At $100 million annual revenues, Netcore is still relatively small. I have written earlier about our past journey and future expectations. Consistent compounding, capital allocation, multi-decadal growth are not ideas I had thought much about. But as we start thinking about our future as a public company with external investors, I decided to probe more into what creates great companies (and capital allocators) like Transdigm, Teledyne, Berkshire Hathaway, Constellation Software, and others: companies that have delivered exceptional returns to investors over long periods of time.

I spoke with Harichandan Arakali, Tech Editor of Forbes at the Start Up Fridays Podcast. We discussed Netcore’s past, present and future, and also my early IndiaWorld journey. Core theme: my life as an entrepreneur.

I spoke to hosts Sean Ellis and Ethan Garr on Netcore’s bootstrapped growth and more. Available on YouTube, Spotify and Apple.

 

Here. Alex and I spoke about Netcore’s journey to a $100M ARR proficorn, my  take on the current market and advice for sustainable growth, and learnings from the $100M M&A process with Unbxd.