Baby Steps
Companies often overlooked moves that add up to huge strides in value
We have written often about earnings quality and focused on companies finding short-term methods to boost earnings growth. This includes a company touting how it grew margins by 2%, but 1.5% came from cutting marketing and another 1.0% from cutting R&D. A case could be made that those costs will need to rise again so margin gains are unlikely to last. In fact, if that spending needs to return, investors may find that margins may come in lower than before. Other examples would include a company seeing flat or even negative income growth, but EPS growth is 4-5% due to share repurchases. But, it is borrowing money to buy the stock, and now it has to pay interest expense which lowers income while its debt-to-EBITDA levels are now over 3x and rising. How much longer can this EPS driver continue?
However, every now and then we find companies investing in small parts of the business or speeding up investments more quickly than planned to produce much larger and longer-lasting results. Some of the investment is never quantified and would be difficult to fully isolate. This is where analysts need to focus more on the company’s operating model and less on trying to invent a new computer screen. Often a company will talk about an area of the business they’d like to change. Analysts need to take in the bigger picture try to answer questions like:
Does this help or hurt sales and customer totals?
Could this help profit margin and cash flow?
What should happen if this is successful?
We are not talking about a company announcing a large merger or planning to build a new multi-billion-dollar plant in Norway. There will be full presentations with great details in that type of situation. If you’ve ever seen the Bill Murray movie What About Bob? – we are talking about Baby Steps. Small changes in the total picture. In the movie, Richard Dreyfus tells Bob to focus on what has to happen to get to the office door and then focus on how to get to the elevator – don’t focus on every aspect needed for the full journey. Think about Baby Steps that get mentioned on earnings calls. This can be a valuable edge since others are likely overlooking it because it’s tough to quantify. Here’s an anecdotal example of this type of thinking.
There is a large grocery chain in Dallas called Central Market which is owned by the private company HEB. Central Market has about 60 varieties of apples and 200 varieties of cheese. The president of the firm was being interviewed for an article while he stood in the store with a knife slicing off pieces of Envy and Jazz apples for passing shoppers. He was asked, “Wow, how much do you spend giving away apples?” He shrugged and said “I have no idea, but it worked, didn’t it? Every person that tried an apple bought some.” That is the type of change or unique item you’re looking for. Something really simple to understand with common sense, but you would have a tough time modeling it. Someone could probably compute what it cost him to slice up some apples and hand them out, but why? He’s betting $6 that he can pick up $1,000 in new sales over time. Is it a failure if he only gets $850 in new sales? Probably not. The outcome can only be judged over some time and would be difficult to attribute it to the free apple slices. Life’s too short to try to count pennies in every situation. The goal here is the big picture. Put down the calculator and use your common sense whether a new plan can help at the margin of the company.
Many companies have very small parts to their business where very small changes can have a profound impact on results. We will look at a few examples below.