Will They Seek Out More Profitable Lines?

June 18, 2008 by Joe Ponzio

Businesses generally expand in three ways – increased sales of existing products, sales (and increased sales) of new products, and acquisitions to expand product lines. We looked at “increased sales of existing products” in Can They Increase Sales For Several Years? Fisher then went on to talk about “sales (and increased sales) of new products”:

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

There are two schools of thought on this subject – the rational, business-like approach and the “other” approach.

The “Other” Approach

There is an old saying in business: Throw enough sh*t at the wall, and something’s gotta stick. In practice, many business owners (i) struggling to get by on their primary business, or (ii) poor at allocating excess capital, will expand into other areas. The thought process is simple (yet quite absurd): Business A can only go so far, so I’ll start Business B, C, and D and make a small living from each.

You see it all the time in publicly traded companies. Management has no idea what to do with their present business or excess cash, so they try to expand into other areas – most likely because they want to impress investors. (Think “Institutional Imperative”) Need an example? Check out Citigroup’s list of subsidiary companies as of their 2007 annual report. Let me break it down a bit.

Citigroup has 2,259 subsidiaries on that list. With 2007 revenues of $81.7 billion, that means that its average business generates about $36.1 million a year in revenue. Furthermore, it averaged about $15 billion in net income from 2003 through 2007, or about $7 million from each business.

Those Numbers are Skewed

You bet! We know that Citigroup has some very major, very core businesses – CitiFinancial and Smith Barney come to mind. It’s fair to assume that these core, massive businesses contribute the lion’s share of the revenue. So why does it own Southern Graphics Systems – a graphic design and packaging company – and how much do businesses like this contribute to the owners / stockholders?

No wonder Citigroup shareholders are up in arms, screaming that the company needs to dump some of its less-profitable businesses.

The Institutional Imperative

Citigroup is a classic case of the Institutional Imperative that Buffett speaks of. You have this wonderful investment business, and you go and do something stupid – like buy or start 2,200 more businesses.

Citigroup vs. The Rational, Business Approach

Warren Buffett is the embodiment of “rational, business approach” to growth. Berkshire has 50% more revenue, 2,200 less subsidiaries, and twice the market capitalization of Citigroup. Why? Buffett and Munger read Fisher.

Without any real products to sell, Berkshire’s “product” is capital allocation. To paraphrase (and slightly twist) Fisher, Buffett, Munger, and company have the determination to continue to allocate capital (via acquisitions) that will increase total sales potentials (read: cash flow for more capital allocation) when the growth potentials of current product lines (subsidiaries) have largely been exploited.

Berkshire owns Forest River – a trailer and RV company. Buffett and Munger know it doesn’t have the potential to be as big as Coca-Cola; still, it is an investment that will serve the company’s ultimate goal – to provide the two with more capital to allocate.

What Will Your Managers Do?

It’s not a question of whether or not the company has a lot of subsidiaries. It comes down to focus – does your management have it or not? To expand into new product lines or to make intelligent acquisitions, your management needs to be focused. The deals need to make sense.

When Coca-Cola owned shrimp farms in the late 1970s and early 1980s, it didn’t make sense. On the one hand, food and drink go together. Still, shrimp and Coca-Cola / wine / juice? It didn’t make sense. There could be very little resource sharing; Coca-Cola couldn’t minimize expenses because it had to run two very different businesses.

Look at Pfizer. 441 subsidiaries (yes, I know some of them are joint venture or other LLC/partnership-type arrangements). But they are pretty much all drug, research, or healthcare related (except Site Realty, which still has me scratching my head). Pfizer has been beaten down some 60% over the past eight years. Wall Street is worried that the November 2011 expiration of the Lipitor patent will effectively wipe out all $12 billion of Lipitor’s revenues, and destroy the company entirely. Granted, Lipitor generates about 25% of the company’s revenues; still, odds are, neither Lipitor nor Pfizer are not going to disappear entirely.

So, What is Pfizer To Do?

Right now, Pfizer is plowing $8 billion a year into research and development. The ultimate goal: “to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines [Lipitor] have largely been exploited.”

Pfizer is generating about $10 billion a year in owner earnings, with only about $2 billion in annual capital expenditures. With the Lipitor patent gone in three years, owner earnings are likely to decrease. What is Pfizer doing to prepare for that? Research and Development (here’s their “in the pipeline” report) and acquisitions of related businesses. Will it pay off? There is no way to know for certain; still, Pfizer management seems to be focused on the right process, and that’s all a shareholder can ask for.

If we start seeing products or acquisitions in unrelated businesses, or if it appears like Pfizer is giving up hope and content to do little more than battle the generics for Lipitor market share, get out of the way. Otherwise, Pfizer seems to fit Fisher’s Point 2 very nicely. It’s not enough to go on, but it’s a start.

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