1 00:00:04,110 --> 00:00:06,389 Sean Aylmer: Welcome to the Fear and Greed daily interview. I'm Sean 2 00:00:06,390 --> 00:00:09,749 Sean Aylmer: Aylmer. We love talking about M& A activity here on 3 00:00:09,750 --> 00:00:12,539 Sean Aylmer: Fear and Greed. A good acquisition is exciting for those 4 00:00:12,539 --> 00:00:15,719 Sean Aylmer: watching the markets and for investors, it should represent an 5 00:00:15,719 --> 00:00:19,410 Sean Aylmer: opportunity for a company to grow and deliver returns to shareholders. 6 00:00:19,920 --> 00:00:23,190 Sean Aylmer: But what does a company look for when considering a 7 00:00:23,190 --> 00:00:27,809 Sean Aylmer: takeover, and what happens when they pay too much? Most 8 00:00:27,809 --> 00:00:32,009 Sean Aylmer: importantly, what's that mean for shareholders? Remember, this is general 9 00:00:32,009 --> 00:00:35,279 Sean Aylmer: information only and you should get professional advice before making 10 00:00:35,279 --> 00:00:38,700 Sean Aylmer: any investment decisions. Roger Montgomery is the Founder and Chief 11 00:00:38,700 --> 00:00:43,019 Sean Aylmer: Investment Officer of Montgomery Investment Management. Roger, after the Christmas 12 00:00:43,019 --> 00:00:44,490 Sean Aylmer: break, welcome back to Fear and Greed. 13 00:00:44,700 --> 00:00:46,290 Roger Montgomery: It's great to be on the show again, guys, and 14 00:00:46,290 --> 00:00:47,129 Roger Montgomery: I hope you're all well. 15 00:00:47,610 --> 00:00:48,900 Sean Aylmer: Did you have a good break, Roger? 16 00:00:49,139 --> 00:00:51,959 Roger Montgomery: Yes, I did. I have a son who lives in 17 00:00:51,960 --> 00:00:56,040 Roger Montgomery: Tokyo, and so the family went to visit him and yeah, 18 00:00:56,310 --> 00:00:59,190 Roger Montgomery: it was wonderful seeing him again and it was nice to have that family 19 00:00:59,310 --> 00:00:59,940 Roger Montgomery: all together. 20 00:01:00,300 --> 00:01:01,770 Sean Aylmer: I've got to ask you, Roger, you have been in 21 00:01:01,770 --> 00:01:04,110 Sean Aylmer: the markets for many years and as a journalist you 22 00:01:04,110 --> 00:01:07,199 Sean Aylmer: have, in my journalism time, you've always been kind of 23 00:01:07,200 --> 00:01:09,059 Sean Aylmer: in markets. How do you relax? 24 00:01:09,450 --> 00:01:10,530 Roger Montgomery: By not thinking about it. 25 00:01:11,010 --> 00:01:13,350 Sean Aylmer: Right. And you can do that? 26 00:01:13,530 --> 00:01:18,150 Roger Montgomery: Well, no. I found myself checking on markets and stocks 27 00:01:18,360 --> 00:01:20,880 Roger Montgomery: pretty much every day, but I do that in the 28 00:01:20,880 --> 00:01:23,309 Roger Montgomery: very early hours of the morning when everyone's still asleep 29 00:01:23,309 --> 00:01:26,850 Roger Montgomery: and then we get on with enjoying our holiday. 30 00:01:27,150 --> 00:01:28,859 Sean Aylmer: I'm digressing here a little bit, but I remember when 31 00:01:28,859 --> 00:01:31,560 Sean Aylmer: I used to manage journalists and journalists are probably a 32 00:01:31,560 --> 00:01:34,560 Sean Aylmer: little bit like people in the market. They are obsessed. 33 00:01:34,950 --> 00:01:38,130 Sean Aylmer: I was always pushing them to stop thinking about work 34 00:01:38,130 --> 00:01:42,328 Sean Aylmer: because you become a broader person just by experiencing other 35 00:01:42,330 --> 00:01:44,099 Sean Aylmer: stuff that helps you in your job. 36 00:01:44,099 --> 00:01:47,939 Roger Montgomery: Yeah, indeed. Indeed. For what it's worth, my observation of 37 00:01:47,940 --> 00:01:50,430 Roger Montgomery: Japan from being over there and you can't help thinking 38 00:01:50,430 --> 00:01:53,220 Roger Montgomery: about the economy and thinking about the structure of businesses 39 00:01:53,220 --> 00:01:56,430 Roger Montgomery: and how things are going, is that it really is 40 00:01:56,520 --> 00:02:00,630 Roger Montgomery: lacking innovation. It's really lacking massive investment. That's a function 41 00:02:00,630 --> 00:02:04,289 Roger Montgomery: of the fact their average age is 49 and their 42 00:02:04,289 --> 00:02:08,340 Roger Montgomery: working age population is declining. I saw many instances where there 43 00:02:08,520 --> 00:02:11,340 Roger Montgomery: were three or four people doing the job of one 44 00:02:11,340 --> 00:02:14,668 Roger Montgomery: person in Australia that in the checkout, in the supermarket, 45 00:02:14,669 --> 00:02:18,329 Roger Montgomery: there'd be two or three people helping you get through 46 00:02:18,330 --> 00:02:23,069 Roger Montgomery: the checkout when really you only needed one. Because the 47 00:02:23,070 --> 00:02:25,918 Roger Montgomery: population's declining, there's no incentive to invest. 48 00:02:27,180 --> 00:02:29,310 Sean Aylmer: Yeah. Fascinating. Anyway, back to M& A. 49 00:02:29,310 --> 00:02:29,430 Roger Montgomery: Okay. 50 00:02:29,430 --> 00:02:33,599 Sean Aylmer: So let's look at the basics first, Roger. What does 51 00:02:33,599 --> 00:02:37,679 Sean Aylmer: a company look at when acquiring a business? What is 52 00:02:37,679 --> 00:02:38,520 Sean Aylmer: it thinking about? 53 00:02:38,910 --> 00:02:41,639 Roger Montgomery: Well, what it should be looking at is returns to 54 00:02:41,639 --> 00:02:46,139 Roger Montgomery: shareholders. Can this acquisition, can spending this money on this 55 00:02:46,139 --> 00:02:50,580 Roger Montgomery: particular target enhance returns to shareholders? And when you think 56 00:02:50,580 --> 00:02:53,070 Roger Montgomery: about returns to shareholders, there's a number of ways of 57 00:02:53,070 --> 00:02:56,309 Roger Montgomery: measuring that. I tend to look at, and what I 58 00:02:56,309 --> 00:02:59,400 Roger Montgomery: think managers should look at when they're allocating capital is 59 00:02:59,400 --> 00:03:03,540 Roger Montgomery: return on equity, how profitable that acquisition is going to 60 00:03:03,540 --> 00:03:07,798 Roger Montgomery: be and will it enhance profitability, existing profitability for shareholders. 61 00:03:07,800 --> 00:03:11,309 Roger Montgomery: But unfortunately, often what managers will look at when they're 62 00:03:11,309 --> 00:03:15,240 Roger Montgomery: making an acquisition is, can this grow our footprint? Can 63 00:03:15,240 --> 00:03:18,930 Roger Montgomery: this expand our earnings? Can it expand earnings per share? 64 00:03:18,930 --> 00:03:22,290 Roger Montgomery: Will our revenue go up? And so that can lead 65 00:03:22,290 --> 00:03:25,139 Roger Montgomery: to a misallocation of resources if you're looking at the 66 00:03:25,139 --> 00:03:30,599 Roger Montgomery: wrong measures of return when thinking about acquisitions. And there's 67 00:03:30,599 --> 00:03:33,900 Roger Montgomery: a lot of hubris as well. And so managers need 68 00:03:33,900 --> 00:03:36,750 Roger Montgomery: to be careful, CEOs need to be careful that they're 69 00:03:36,750 --> 00:03:42,600 Roger Montgomery: not simply growing for growth's sake. And sometimes there's an 70 00:03:42,600 --> 00:03:46,110 Roger Montgomery: incentive to grow because by being bigger, you'll become a 71 00:03:46,110 --> 00:03:49,770 Roger Montgomery: more attractive target, and that can be the wrong incentive. 72 00:03:50,219 --> 00:03:52,109 Roger Montgomery: I think it was Warren Buffet or Charlie Munger who said, " 73 00:03:52,109 --> 00:03:54,119 Roger Montgomery: Show me the incentives and I'll show you the behavior." 74 00:03:54,869 --> 00:03:58,170 Roger Montgomery: So there really needs to be a focus on return 75 00:03:58,170 --> 00:04:01,619 Roger Montgomery: on capital or return on invested capital and return on equity. 76 00:04:02,250 --> 00:04:06,389 Sean Aylmer: Okay. So let's say that is the focus and they've 77 00:04:06,389 --> 00:04:10,740 Sean Aylmer: decided to make an acquisition. What is it that makes a good 78 00:04:10,740 --> 00:04:13,500 Sean Aylmer: acquisition? It's not even necessarily whether it's a quality or 79 00:04:13,500 --> 00:04:16,800 Sean Aylmer: a non- quality company in a way, because if you can, the example that you've just 80 00:04:16,800 --> 00:04:19,980 Sean Aylmer: given about a Japan supermarket, potentially that may not be 81 00:04:19,980 --> 00:04:22,830 Sean Aylmer: quality, but someone can take that over and take costs 82 00:04:22,830 --> 00:04:24,300 Sean Aylmer: out and become much more efficient. 83 00:04:24,360 --> 00:04:24,510 Roger Montgomery: Indeed. 84 00:04:25,259 --> 00:04:27,870 Sean Aylmer: I'm just wondering, is it management? Is that what really 85 00:04:27,870 --> 00:04:30,599 Sean Aylmer: matters most? Is it how capital is employed? What are 86 00:04:30,600 --> 00:04:31,320 Sean Aylmer: you thinking about? 87 00:04:31,500 --> 00:04:34,200 Roger Montgomery: Yeah, so CEOs have to have two skills. They've got 88 00:04:34,200 --> 00:04:36,029 Roger Montgomery: to be able to run the business, but they also 89 00:04:36,029 --> 00:04:38,610 Roger Montgomery: need to know how to allocate capital. And they're two 90 00:04:38,610 --> 00:04:42,600 Roger Montgomery: distinct skills. The best CEOs are able to do both 91 00:04:42,870 --> 00:04:46,258 Roger Montgomery: very, very well. But in answer to your question, we 92 00:04:46,260 --> 00:04:49,650 Roger Montgomery: hear a lot about synergies. You'll hear about costs being 93 00:04:49,650 --> 00:04:52,770 Roger Montgomery: taken out of businesses, we can get rid of duplication 94 00:04:52,770 --> 00:04:55,230 Roger Montgomery: if we acquire this business, we don't need two accounting 95 00:04:55,230 --> 00:04:58,169 Roger Montgomery: departments, we don't need two HR departments, we can cut 96 00:04:58,170 --> 00:05:01,950 Roger Montgomery: costs, that will be synergistic. And that should be a 97 00:05:01,950 --> 00:05:06,178 Roger Montgomery: minimum expectation, particularly if you're paying too much for an 98 00:05:06,180 --> 00:05:09,870 Roger Montgomery: acquisition. So often there's an overpayment for control. So there's 99 00:05:09,870 --> 00:05:13,799 Roger Montgomery: an expectation in markets that if I'm relinquishing control of a 100 00:05:13,860 --> 00:05:18,150 Roger Montgomery: company to a company that's acquiring me, I should demand 101 00:05:18,150 --> 00:05:21,299 Roger Montgomery: a premium because they're going to have control. The consequence 102 00:05:21,299 --> 00:05:24,209 Roger Montgomery: of paying that premium is that you need synergies. You 103 00:05:24,209 --> 00:05:27,839 Roger Montgomery: need cost cutting, you need to have earnings accrete. You 104 00:05:27,839 --> 00:05:31,110 Roger Montgomery: need higher earnings to justify that higher price that you've 105 00:05:31,110 --> 00:05:33,389 Roger Montgomery: paid. One of the things that I hear a lot 106 00:05:33,389 --> 00:05:37,259 Roger Montgomery: is earnings accretion, talking about this acquisition will be earnings 107 00:05:37,259 --> 00:05:40,409 Roger Montgomery: accretive in year one or year two. Well, that, again, 108 00:05:40,410 --> 00:05:44,100 Roger Montgomery: that's a minimum requirement if you're overpaying. And remember, you 109 00:05:44,100 --> 00:05:45,510 Roger Montgomery: can put money in the bank and that's going to 110 00:05:45,510 --> 00:05:49,680 Roger Montgomery: be earnings accretive. So there's nothing really exciting about earnings 111 00:05:49,680 --> 00:05:52,738 Roger Montgomery: accretion. What you really should be thinking about is what 112 00:05:52,740 --> 00:05:56,340 Roger Montgomery: is the impact on the return on equity of the 113 00:05:56,700 --> 00:06:01,139 Roger Montgomery: acquirer as a consequence of making that acquisition and where 114 00:06:01,170 --> 00:06:04,890 Roger Montgomery: return on equity drops substantially as a result of making 115 00:06:04,890 --> 00:06:08,969 Roger Montgomery: an overpriced acquisition that typically is negative for share price 116 00:06:08,970 --> 00:06:10,980 Roger Montgomery: performance subsequently for a period of time. 117 00:06:11,849 --> 00:06:15,238 Sean Aylmer: And as you alluded to then, management don't just have 118 00:06:15,240 --> 00:06:17,640 Sean Aylmer: one choice to take over or not to take over. 119 00:06:17,850 --> 00:06:20,070 Sean Aylmer: They can actually use that capital in other ways, and 120 00:06:20,070 --> 00:06:22,678 Sean Aylmer: they've got to be measuring the return on equity or 121 00:06:22,680 --> 00:06:26,279 Sean Aylmer: the return on that investment vis-à-vis the other options. 122 00:06:26,428 --> 00:06:28,349 Roger Montgomery: Well, yeah. And one of those other options is buying 123 00:06:28,349 --> 00:06:31,830 Roger Montgomery: back your own shares. If the share price is low, 124 00:06:31,830 --> 00:06:34,350 Roger Montgomery: if you believe it's time to make acquisitions because there 125 00:06:34,350 --> 00:06:37,890 Roger Montgomery: are bargains abounding, well, maybe your shares are a bargain. 126 00:06:37,890 --> 00:06:40,890 Roger Montgomery: So should you be acquiring your shares at a low 127 00:06:40,890 --> 00:06:44,190 Roger Montgomery: price? That could enhance return on equity, particularly if you're 128 00:06:44,190 --> 00:06:46,710 Roger Montgomery: buying at or near the equity per share level. 129 00:06:47,370 --> 00:06:49,439 Sean Aylmer: Stay with me, Roger. We'll be back in a minute. 130 00:06:55,890 --> 00:06:58,200 Sean Aylmer: My guest this morning is Roger Montgomery, Founder and Chief 131 00:06:58,200 --> 00:07:03,089 Sean Aylmer: Investment Officer of Montgomery Investment Management. Okay, with that in 132 00:07:03,089 --> 00:07:04,799 Sean Aylmer: mind, I want to talk about a couple of examples. 133 00:07:04,800 --> 00:07:06,359 Sean Aylmer: One was quite a while ago and a very big 134 00:07:06,360 --> 00:07:10,440 Sean Aylmer: one, the other more recent. So Coles, the acquisition of 135 00:07:10,440 --> 00:07:14,730 Sean Aylmer: Coles by Wesfarmers back in 2007, what happened there? You've 136 00:07:14,730 --> 00:07:15,480 Sean Aylmer: written quite a bit about this. 137 00:07:16,200 --> 00:07:18,810 Roger Montgomery: Yeah, so at the time the acquisition was made, I 138 00:07:18,810 --> 00:07:22,679 Roger Montgomery: actually wrote several articles saying that they'd overpaid for that 139 00:07:22,679 --> 00:07:25,049 Roger Montgomery: acquisition. And in fact, I gave a presentation for the 140 00:07:25,049 --> 00:07:28,590 Roger Montgomery: Australian Stock Exchange on a Saturday in Perth at the 141 00:07:28,590 --> 00:07:33,000 Roger Montgomery: time, and I said that Wesfarmers has overpaid and Wesfarmer's share price is 142 00:07:33,150 --> 00:07:35,610 Roger Montgomery: going to go down. And well, you can imagine the 143 00:07:35,610 --> 00:07:42,450 Roger Montgomery: response sometimes parochial WA investors. Turned out to be correct. 144 00:07:42,780 --> 00:07:46,859 Roger Montgomery: And the reason why is quite simple. Coles at the 145 00:07:46,859 --> 00:07:50,460 Roger Montgomery: time, this is back in 2007, Coles at the time 146 00:07:50,460 --> 00:07:55,710 Roger Montgomery: was generating a profit of $ 747 million, and they were 147 00:07:55,710 --> 00:07:59,999 Roger Montgomery: doing that on balance sheet equity of about, well had 3. 148 00:08:00,240 --> 00:08:01,920 Roger Montgomery: 6 billion at the start of the year and 3. 149 00:08:02,190 --> 00:08:05,369 Roger Montgomery: 9 billion at the end of the year. So it was average equity for 150 00:08:05,369 --> 00:08:09,360 Roger Montgomery: that year of about $ 3. 75 billion, which meant that 151 00:08:09,360 --> 00:08:13,680 Roger Montgomery: the return on equity that they were generating was 20%. 152 00:08:14,910 --> 00:08:19,049 Roger Montgomery: Okay. So Coles is generating 20% on the money that 153 00:08:19,049 --> 00:08:23,129 Roger Montgomery: Coles shareholders had invested in the business, so capital they'd 154 00:08:23,129 --> 00:08:26,310 Roger Montgomery: contributed and capital that they'd left in the business. So 155 00:08:26,520 --> 00:08:31,590 Roger Montgomery: retained profits. So the combination of shareholders capital and retained 156 00:08:31,590 --> 00:08:37,079 Roger Montgomery: profits amounted to $ 3. 75 billion on which the company 157 00:08:37,080 --> 00:08:41,279 Roger Montgomery: was generating 20%. So that's step one. Okay. So then 158 00:08:41,549 --> 00:08:43,470 Roger Montgomery: you ask yourself the question, well, if I'm going to 159 00:08:43,500 --> 00:08:47,130 Roger Montgomery: buy Coles and I want to get a 20% return 160 00:08:47,130 --> 00:08:50,578 Roger Montgomery: on my money, I can't pay a dollar more than 161 00:08:50,580 --> 00:08:52,199 Roger Montgomery: the equity in the business. So the equity in the 162 00:08:52,200 --> 00:08:56,759 Roger Montgomery: business was, average equity 3. 75 billion. I can't pay more 163 00:08:56,759 --> 00:08:58,920 Roger Montgomery: than that. And if I don't pay more than that, 164 00:08:58,980 --> 00:09:01,500 Roger Montgomery: I will be earning 20% a year, which is great. 165 00:09:01,530 --> 00:09:05,010 Roger Montgomery: Now, if I think I'm a brilliant retailer and I 166 00:09:05,010 --> 00:09:07,710 Roger Montgomery: think I can do a better job than existing management, 167 00:09:08,070 --> 00:09:10,679 Roger Montgomery: then I could potentially pay a bit more because I 168 00:09:10,679 --> 00:09:13,108 Roger Montgomery: know that the profit that I'm going to generate is 169 00:09:13,110 --> 00:09:14,728 Roger Montgomery: going to be higher. I'm going to get some synergies, 170 00:09:14,730 --> 00:09:17,009 Roger Montgomery: I'm going to extract costs, I'm going to get rid 171 00:09:17,010 --> 00:09:20,040 Roger Montgomery: of some duplication, blah, blah, blah, and I can pay more 172 00:09:20,040 --> 00:09:22,800 Roger Montgomery: than that. So what would you pay if you thought, 173 00:09:22,800 --> 00:09:26,280 Roger Montgomery: for example, that you could increase the profits, you might 174 00:09:26,280 --> 00:09:28,589 Roger Montgomery: pay a bit more. If you were happy with a 175 00:09:28,590 --> 00:09:31,620 Roger Montgomery: lower return than 20%, you could pay a bit more. 176 00:09:31,620 --> 00:09:34,350 Roger Montgomery: So if you wanted a 10% return on your money, 177 00:09:34,770 --> 00:09:37,530 Roger Montgomery: you could pay double the equity of the business. So 178 00:09:37,530 --> 00:09:41,220 Roger Montgomery: you'd pay 7. 2 or thereabouts billion dollars, and that 179 00:09:41,220 --> 00:09:43,350 Roger Montgomery: would give you a 10% return on your money. If you are 180 00:09:43,530 --> 00:09:46,050 Roger Montgomery: happy with a quarter of 20%, so if you're happy 181 00:09:46,050 --> 00:09:49,828 Roger Montgomery: with 5% return, you could pay four times the equity or 182 00:09:49,830 --> 00:09:52,409 Roger Montgomery: 14 and a half billion dollars. But if you pay 183 00:09:52,410 --> 00:09:56,250 Roger Montgomery: any more than that, you're really starting to get to 184 00:09:56,250 --> 00:09:59,280 Roger Montgomery: a point where you have to ask yourself, why am 185 00:09:59,280 --> 00:10:03,059 Roger Montgomery: I taking this additional risk? Why am I taking on 186 00:10:03,059 --> 00:10:05,849 Roger Montgomery: the risk of owning a business for a return that's 187 00:10:05,849 --> 00:10:07,650 Roger Montgomery: really not much more than I could get in a 188 00:10:07,650 --> 00:10:11,730 Roger Montgomery: term deposit. That doesn't make sense. So paying anything more 189 00:10:11,730 --> 00:10:14,130 Roger Montgomery: than 14 and a half billion dollars would be crazy. 190 00:10:14,610 --> 00:10:17,730 Roger Montgomery: And then I remember doing the calculations, and if I 191 00:10:17,730 --> 00:10:19,980 Roger Montgomery: took out costs, if I was a great retailer, if 192 00:10:19,980 --> 00:10:21,389 Roger Montgomery: I thought I was a good merchant and I could 193 00:10:21,389 --> 00:10:24,179 Roger Montgomery: do a better job, the maximum I would be willing 194 00:10:24,179 --> 00:10:27,870 Roger Montgomery: to pay at the time for Coles would've been about $ 11. 195 00:10:27,870 --> 00:10:31,140 Roger Montgomery: 7 billion. And I wrote about this, subsequently wrote about 196 00:10:31,140 --> 00:10:35,850 Roger Montgomery: this in my book, Value. able. Wesfarmers didn't pay $ 3. 197 00:10:35,850 --> 00:10:40,919 Roger Montgomery: 75 billion. They didn't pay $ 7.2 billion. They didn't pay $ 198 00:10:40,920 --> 00:10:46,858 Roger Montgomery: 11.7 billion. They paid $ 22 billion for it. So they 199 00:10:46,859 --> 00:10:48,900 Roger Montgomery: were earning a return on equity of just three and 200 00:10:48,900 --> 00:10:49,590 Roger Montgomery: a half percent. 201 00:10:49,679 --> 00:10:53,070 Sean Aylmer: Didn't Wesfarmers back then have, I'm trying to remember, but 202 00:10:53,070 --> 00:10:55,410 Sean Aylmer: they had these bunch of rules where they had to 203 00:10:55,410 --> 00:10:57,510 Sean Aylmer: have return and equity in double digits or something. 204 00:10:57,570 --> 00:11:02,010 Roger Montgomery: Well, that broke that rule because the consequence was that 205 00:11:02,370 --> 00:11:04,979 Roger Montgomery: the return on equity they were getting for the acquisition 206 00:11:04,980 --> 00:11:07,380 Roger Montgomery: was just three and a half percent. And because that 207 00:11:07,380 --> 00:11:09,990 Roger Montgomery: was going to be consolidated into the accounts of Wesfarmers, 208 00:11:10,230 --> 00:11:14,280 Roger Montgomery: it would ultimately dilute Wesfarmer's return on equity as well. 209 00:11:14,670 --> 00:11:19,049 Roger Montgomery: And so they clearly overpaid, and that was reflected in 210 00:11:19,049 --> 00:11:23,008 Roger Montgomery: two subsequent events. So number one, the shares did fall. 211 00:11:23,010 --> 00:11:26,730 Roger Montgomery: They fell from 41 or $42. I think they ultimately got down 212 00:11:26,730 --> 00:11:31,020 Roger Montgomery: to about $ 12 during the GFC. So they fell considerably 213 00:11:31,020 --> 00:11:33,838 Roger Montgomery: more than many others. So people would say, " Oh, that's 214 00:11:33,840 --> 00:11:36,150 Roger Montgomery: due to the GFC." Well, no, they fell a lot 215 00:11:36,150 --> 00:11:40,410 Roger Montgomery: more in relative terms than many other companies during the 216 00:11:40,410 --> 00:11:46,020 Roger Montgomery: GFC, particularly big established businesses on the ASX. So they 217 00:11:46,020 --> 00:11:48,600 Roger Montgomery: fell a lot harder. And then as we know in 218 00:11:48,600 --> 00:11:53,910 Roger Montgomery: 2018, they ended up selling or spinning off Coles to 219 00:11:53,910 --> 00:11:56,549 Roger Montgomery: shareholders. They couldn't sell it, so they just gave it 220 00:11:56,549 --> 00:11:59,340 Roger Montgomery: back to shareholders. And when they sold it, it was 221 00:11:59,340 --> 00:12:04,530 Roger Montgomery: capped at $ 16. 6 billion. So they paid 22 in 222 00:12:04,530 --> 00:12:09,030 Roger Montgomery: 2007, and then 11 years later, they effectively got 16. 6 billion 223 00:12:09,030 --> 00:12:13,410 Roger Montgomery: for it. So they clearly overpaid. And I think that's 224 00:12:13,650 --> 00:12:18,030 Roger Montgomery: a great example of not only how to assess an 225 00:12:18,120 --> 00:12:22,800 Roger Montgomery: acquisition, but also a great testament to how important return 226 00:12:22,800 --> 00:12:25,860 Roger Montgomery: on equity is for judging whether or not a company 227 00:12:25,860 --> 00:12:26,760 Roger Montgomery: has overpaid. 228 00:12:27,059 --> 00:12:28,649 Sean Aylmer: Okay, we're running out of time, but I just do 229 00:12:28,650 --> 00:12:32,850 Sean Aylmer: want to ask you quickly about online Car Marketplace carsales. com. 230 00:12:33,390 --> 00:12:37,170 Sean Aylmer: au and its recent purchase of Trader Interactive. You are 231 00:12:37,170 --> 00:12:37,800 Sean Aylmer: not a fan. 232 00:12:38,100 --> 00:12:42,240 Roger Montgomery: Well, using the same framework as we've just discussed for 233 00:12:42,420 --> 00:12:45,840 Roger Montgomery: Wesfarmers and Coles, the executive summary is you reach the 234 00:12:45,840 --> 00:12:51,420 Roger Montgomery: same conclusion with Carsales acquisition of Trader Interactive. So they 235 00:12:51,509 --> 00:13:01,078 Roger Montgomery: basically paid $ 797 million for the first 49% back in 2001, and then they paid $1.1 billion, almost $ 1. 236 00:13:01,290 --> 00:13:06,300 Roger Montgomery: 2 billion for the other 51% in June last year. So 237 00:13:06,300 --> 00:13:09,899 Roger Montgomery: the total acquisition price was just less than $ 2 billion. 238 00:13:10,708 --> 00:13:13,708 Roger Montgomery: And at the time they said the acquisition expected to 239 00:13:13,710 --> 00:13:18,030 Roger Montgomery: generate attractive financial returns for shareholders with low double digit 240 00:13:18,390 --> 00:13:21,328 Roger Montgomery: EPS accretion in year one quote, unquote. Now, as I 241 00:13:21,330 --> 00:13:24,750 Roger Montgomery: said, we love an earnings accretive acquisition and we love 242 00:13:24,750 --> 00:13:27,629 Roger Montgomery: synergies, and they're on track for doing, in fact, they're 243 00:13:27,630 --> 00:13:33,030 Roger Montgomery: ahead of their timeline for extracting synergies from that business. 244 00:13:33,330 --> 00:13:37,020 Roger Montgomery: But at a bare minimum, you've done nothing exceptional if 245 00:13:37,020 --> 00:13:41,850 Roger Montgomery: you've overpaid. And the question is, have they overpaid? Carsales 246 00:13:42,059 --> 00:13:45,690 Roger Montgomery: was generating for its shareholders in FY '20, this is 247 00:13:45,690 --> 00:13:49,110 Roger Montgomery: before they made the first half acquisition, they were generating 248 00:13:49,110 --> 00:13:54,088 Roger Montgomery: a near 30% return on shareholders capital. So if shareholders 249 00:13:54,090 --> 00:13:59,670 Roger Montgomery: demand the same 30% from any acquisition that Carsales make, so 250 00:13:59,670 --> 00:14:02,220 Roger Montgomery: as not to dilute the return that they're already getting, 251 00:14:02,610 --> 00:14:07,260 Roger Montgomery: then Trader Interactive needs to generate an after tax profit 252 00:14:07,320 --> 00:14:12,030 Roger Montgomery: of almost $ 600 million. If shareholders are happy with a 10% 253 00:14:12,030 --> 00:14:15,150 Roger Montgomery: return on equity, then Trader Interactive needs to generate an 254 00:14:15,150 --> 00:14:20,549 Roger Montgomery: after tax profit of $ 200 million. Problem is annualized EBITDA, 255 00:14:20,549 --> 00:14:24,209 Roger Montgomery: not after tax profit, but annualized EBITDA from last year 256 00:14:24,209 --> 00:14:28,560 Roger Montgomery: was only $ 91 million. So it's nowhere near the 200 257 00:14:28,560 --> 00:14:31,530 Roger Montgomery: million to get 10%, and it's a long, long way 258 00:14:31,530 --> 00:14:34,769 Roger Montgomery: from the 600 million needed to get 30%, which is 259 00:14:34,770 --> 00:14:38,460 Roger Montgomery: what Carsales was generating before making the acquisition. So what 260 00:14:38,460 --> 00:14:41,489 Roger Montgomery: is going to happen now is the return on equity 261 00:14:41,490 --> 00:14:46,350 Roger Montgomery: is going to drop substantially for Carsales. From 29%, it's 262 00:14:46,350 --> 00:14:50,309 Roger Montgomery: going to go somewhere like 10%. And unfortunately that's going 263 00:14:50,309 --> 00:14:53,790 Roger Montgomery: to have an influence on share price performance over the 264 00:14:53,790 --> 00:14:56,640 Roger Montgomery: next couple of years. Now, it might be that management 265 00:14:57,030 --> 00:15:01,290 Roger Montgomery: grow revenue and grow profit astronomically, and we really quickly 266 00:15:01,290 --> 00:15:05,640 Roger Montgomery: recover to 30% return on equity. That has to happen 267 00:15:05,940 --> 00:15:08,580 Roger Montgomery: for the share price to do well. In the absence 268 00:15:08,580 --> 00:15:12,029 Roger Montgomery: of that, if it just plods along and doesn't grow 269 00:15:12,030 --> 00:15:15,420 Roger Montgomery: substantially the after tax profits, then return on equity will 270 00:15:15,420 --> 00:15:18,209 Roger Montgomery: be diluted for Carsales, and it'll be a while before 271 00:15:18,240 --> 00:15:22,830 Roger Montgomery: shareholders see sustained terrific share price performance from Carsales shares. 272 00:15:23,130 --> 00:15:28,380 Sean Aylmer: Roger, that is a great journey through finance within an M& 273 00:15:28,380 --> 00:15:30,450 Sean Aylmer: A deal. So thank you for your time this morning. 274 00:15:30,540 --> 00:15:32,070 Roger Montgomery: Well, it's an absolute pleasure. And I think you guys 275 00:15:32,070 --> 00:15:34,409 Roger Montgomery: are really brave allowing me to talk about that on 276 00:15:34,410 --> 00:15:38,040 Roger Montgomery: a podcast because most people will be, I think they'll be 277 00:15:38,040 --> 00:15:40,470 Roger Montgomery: replaying it over and over again to say, " Now what 278 00:15:40,470 --> 00:15:41,070 Roger Montgomery: does that mean?" 279 00:15:41,280 --> 00:15:44,460 Sean Aylmer: Well, what we might do, just do a separate podcast 280 00:15:44,760 --> 00:15:48,150 Sean Aylmer: on this because it is a really, really important thing. Bottom line in 281 00:15:48,150 --> 00:15:50,549 Sean Aylmer: this is it's the shareholders, might be my super fund, 282 00:15:50,549 --> 00:15:54,329 Sean Aylmer: it could be my personal account. I'm losing value. And 283 00:15:54,330 --> 00:15:55,410 Sean Aylmer: so it's really critical. 284 00:15:55,980 --> 00:15:59,580 Roger Montgomery: Correct. And if the shares weren't listed, you are definitely 285 00:15:59,580 --> 00:16:01,229 Roger Montgomery: going to be seeing... So imagine for a moment the 286 00:16:01,230 --> 00:16:03,570 Roger Montgomery: company wasn't listed on the stock market and everyone's hoping 287 00:16:03,570 --> 00:16:06,509 Roger Montgomery: the shares go up. If it wasn't listed, you'd be 288 00:16:06,509 --> 00:16:08,790 Roger Montgomery: spitting chips that they paid so much for this acquisition 289 00:16:08,790 --> 00:16:10,350 Roger Montgomery: because it's going to dilute your return. 290 00:16:10,619 --> 00:16:13,110 Sean Aylmer: Yeah, absolutely. Thank you very much for joining us this 291 00:16:13,110 --> 00:16:13,740 Sean Aylmer: morning, Roger. 292 00:16:13,740 --> 00:16:14,400 Roger Montgomery: My pleasure. 293 00:16:14,820 --> 00:16:17,790 Sean Aylmer: That was Roger Montgomery, Founder and Chief Investment Officer of 294 00:16:17,790 --> 00:16:21,120 Sean Aylmer: Montgomery Investment Management. This is the Fear and Greed daily 295 00:16:21,120 --> 00:16:24,179 Sean Aylmer: interview. Remember, this is general information only and doesn't take 296 00:16:24,179 --> 00:16:27,330 Sean Aylmer: into account your personal circumstances. You should seek professional advice 297 00:16:27,330 --> 00:16:30,450 Sean Aylmer: before making any investment decisions. Join us every morning for 298 00:16:30,450 --> 00:16:32,880 Sean Aylmer: the full episode of Fear and Greed, Australia's most popular 299 00:16:32,880 --> 00:16:35,640 Sean Aylmer: business podcast. I'm Sean Aylmer, enjoy your day.