Buying either parts of or even entire other companies is a common way for businesses to grow. This inorganic route though is often used for empire building (higher salaries and bonuses), sometimes even to hide own problems inside the core business (presenting an external growth story) and more often than not destroying shareholder value by overpaying for the targets. Today, I’m discussing a company that is losing through diversification.
Summary and key takeaways from today’s Weekly
– Clearly, I don’t like companies that acquire others, especially no big M&A and / or diversification attempts.
– Diversification for me is often associated with Peter Lynch’s “di-worse-ification”.
– Today, I discuss a company that “diversifies” from its leading niche-position into an area where it is almost irrelevant and still loss-making after almost a decade.
When the management of a company intends to diversify or bring in external or inorganic growth, shareholders should be cautious. An acquisition is not automatically an attempt to diversify, though. There is a difference between small, so called “bolt-on” acquisitions that complement an existing portfolio on one side and big one-time attempts. The latter clearly is more risky.
Even more so in the case of adding non-complimentary operations, i.e. diversifying.
Peter Lynch called this “di-worse-ification” – and he nailed it. Some investors like it, others (like me) hate diversification. There are good reasons for both.
While the former preference tends to be observed rather with inexperienced and / or more anxious investors who maybe either do not feel confident enough to do own research or who simply don’t have the time for a comprehensive analysis (absolutely legitimate), the latter is clearly preferred by professional investors, especially those who want to generate alpha, i.e. to beat the market.
This is also what I intend to do with my stock ideas for my members.
As I wrote in my articles about ETFs (see here and here) which is clearly a form of diversification, though on a higher level, too much diversification caps the potential performance while the downside remains when whole markets tank. It serves well against individual company risks in a portfolio.
Diversification works only to a certain point – one can have a vivid discussion whether up to to ten or 20 individual positions. But everything above this range certainly has more a “capping the gains” than “spreading the bets” effect.
Though be aware, a portfolio full of garbage is not a well executed diversification.
I’m mentioning this because I often observe people from the dividend crowd relying on legacy businesses with a great history as the main argument, though weak finances. This strives the topic of the “Lindy effect” – newer readers of my blog can have a look here.
That’s why we as professionals see diversification not as a positive.
Neither on a portfolio level, nor on a business level where companies at some point don’t know anymore what they’re doing (or they’re constantly reorganizing). Risk management is done through proper research and valuations as well as buying stocks at a discount to (subjective) fair value – the famous margin of safety.
Going a level lower into the business area, diversification is often seen as another leg that holds the chair or table, meaning buying more safety and stability.
What is often not discussed is the execution risk which comes with diversification attempts. Also, sometimes just growth for growth’s sake is the motivation. This can be observed more at bigger, older and less growing companies and executed by management teams with only little skin in the game, often without founders involved.
Also, takeovers tend to be done on a pro-cyclical basis, i.e. when cash flows, but also prices of the targets are rather high – the famous “at the top”. Paying too much means destroying shareholder value.
Just think of Time Warner and AOL for an example “at the top” or just of Daimler (today Mercedes-Benz Group, ISIN: DE0007100000, Ticker MBG) and Chrysler or Bayer (ISIN: DE000BAY0017, Ticker: BAYN) and Monsanto for really bad growth attempts where size and scale were great motives.
And guess where their all-time highs are? Right, before those mergers.
Today, I want to discuss a company that is not so well known, but which is executing rather poorly on its diversification front. It’s far from having destroyed much shareholder value, yet, but it is clearly losing its focus which is worrisome.
The average total return of my best stock ideas is +14.9%, beating the S&P500 and the iShares MSCI World ETF.
as per 24 January 2024 market close – since August 2022
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My thoughts on diversification + a stock discussion
I can make it short at this point as I am against too much diversification.
Regarding portfolios, I start to feel uncomfortable with more than 15–20 individual positions to manage. When you are spending a big chunk of the week with researching, reading and monitoring, you will clearly have preferences. Only a few stocks of your entire investment universe are really great ideas. That’s what I want to focus on. You cannot have 50 “best ideas”, so why care about what comes after position 15 or 20?
Is it different with companies? Speaking about focus, this is what often gets lost when companies try to diversify, however, already way quicker.
It does not have to come this way, but usually it does.
For me, focussing on too much is focussing on nothing.
On a business level, I want to see organic growth stories and positive developments without the need to buy external growth, not to mention any diversification attempts, because I primarily see the execution risks, not the great stories and proclaimed chances.
If a business is strong and thriving, you don’t need to diversify.
Depending on the case, I can be fine with a complimentary acquisition that strengthens the core business. But where my alarm bell rings is when diversification is the magic keyword.
With this, let’s discuss the case of Teradyne (ISIN: US8807701029, Ticker: TER).
Teradyne is not so well known, but it is an important company from the semiconductor sector. In brief, Teradyne primarily designs, develops, produces and sells automatic test systems that are used to ensure the functionality of semiconductor chips, wireless products, data storage and other electronic systems. Tests are done with wafers at an early value-add stage as well as with final products (see here).
Customers are producing companies like TSMC (ISIN: US8740391003, Ticker: TSM) or Samsung Electronics (ISIN: KR7005930003, Ticker: A005930). Interestingly, this niche of testing is somewhat special. And it is practically a duopoly between mentioned Teradyne and its Japanese competitor Advantest (ISIN: JP3122400009, Ticker: 6857).
Both together are dominating this c. 8–9 bn. USD market.
I read something of 90% together, but using revenues of both from 2022 and calculated in USD, they achieved 6.5 bn. USD. In relation to 8.5 bn. USD, this is 76%, i.e. still dominant.
Teradyne itself breaks down just SoC (system on a chip) and memory (RAM) markets to be together around 4 bn. USD for 2023 and close to 5 bn. USD in the two years prior before the industry-wide downswing set in.
Teradyne had 2 bn. USD in sales in 2022 in its semiconductor segment and Avantest more than 3 bn. USD in total. Here or there, I maybe will have not used all the correct numbers, but I think the main message remains the same, though.
Two dominant companies in this niche.
Although being cyclical due to depending on what the producers do and order, this is a more defensive business area, because all those electronic components have to be tested, e.g. no matter who the designer or developers is.
From the charts below, you can see that both are cyclical and have strong margins.
As a first rough impression, over the last years, Advantest surpassed Teradyne in terms of operating, but also free cash flow margins. Also, Advantest showed a growing trend, while at Teradyne this was not the case.
Also, Teradyne clearly seems to have lost market share to Advantest.
As a rule of thumb, on can assume that the testing market must keep pace with the developments in the semiconductor and other electronics sector, because all those products have to be tested.
However, in 2022 where the market grew by 3.3%, Teradyne suffered losses (negative growth) in these areas, especially in its most important semiconductor segment.
The same applies over the first nine months of 2023, where revenue losses were clearly in the double digits while the market is expected to have lost less than that with “only” sightly less than 10%.
At the same time, Advantest grew sales in JPY throughout the whole year 2022 and Q1 2023 with more than 20% in each quarter and only recently suffered sales declines.
Certainly, the weaker Japanese Yen was and is supportive in this regard, but I do not think that this is the sole reason.
While this is not a perfectly precise measurement, I think that the charts of both are rather confirming, even though I am not a chartist, as I said many times. I don’t believe in any technicals, etc.
But long-term trends tend to tell stories.
Even in USD, Advantest made more than 1,000% over the last ten years, alas more than double of what Teradyne’s stock appreciated.
Their business models are not 100% the same.
While Advantest is more a pure-play, Teradyne unfortunately is investing in a non-complimentary business in the robotics space – you guessed it, to diversify, respectively to acquire growth.
It started with the acquisition of Universal Robots in early 2015 (see here). Teradyne clearly wanted to hop onto a growth sector as they paid a 7.5x sales (not earnings) multiple. Shortly thereafter, they also bought the British engineering firm Energid in 2018 (see here), then Danish MiR (Mobile Industrial Robots, see here) just a month later and AutoGuide Mobile Robots in 2019 (see here).
Though not just one big M&A deal and not having spent a fortune (some deals were undisclosed, all in all somewhere up to a bn. USD or about two average yearly FCFs) it leaves the impression that the goal was to gobble up everything that has something to do with robotics.
Of course, I am a bit exaggerating here.
To be more precise, they created a segment offering collaborative robotic arms and autonomous mobile robots. They are used in manufacturing or logistics to overcome labor shortages, but also clearly to increase efficiencies and productivity.
But where I am not exaggerating is that this is an already crowded space with experts like Kuka, Fanuc, ABB, Siemens, Yaskawa Electric and others.
Why the heck do they want to play where they had no prior experience?
However, this move is far from being successful. Though Teradyne increased sales of its robotics segment from 42 mn. USD (3% of sales, see here p. 26) in FY 2015 to 469 mn. USD (15% of sales) per FY 2022, this is still a loss-making adventure.
Until 2026, Teradyne wants robotics to even have a revenue share of almost 20% of the whole company. Any wonder, the stock is lagging its peer? The market does not buy this story as it seems. Who shifts from a market leader in a duopoly with high barriers to entry into a segment where they are almost irrelevant?
For me, this looks somewhat like sleepwalking and seeking orientation.
What I cannot answer is whether Teradyne made this move because it knew it was losing steam in its core business or has it lost ground in its core business due to having shifted the focus somewhere else (robotics), neglecting its strong position in testing?
The current CEO came to power just early in 2023 and he was the robotics boss, so you likely know where the focus will lie. The prior CEO (left without a given reason) started in 2014, shortly before the new adventure was started, first under the name of “industrial automation group”, later switched to “robotics”.
It remains to be seen. But as is, Teradyne’s stock is not interesting for me.
What I look for instead for my members
I want clear-cut cases and preferably organic growth stories.
What I don’t like are companies with a rich acquisition history and in the worst case lots of goodwill in the books which can be written down like was the case just recently with BAT’s (ISIN: GB0002875804, Ticker: BATS) announcement to write-off a gigantic amount of 25 bn. GBP in assets, i.e. goodwill from overpaying for Reynolds (see here).
Besides, instead of buying acquirers, why not prefer takeover targets? This at least gives us the optionality for a significant premium. While one cannot know for sure whether a company will be acquired, buying smaller, but fundamentally strong companies, is a great basis.
Some of my ideas for my members check this box. However, this is never the main thesis, but just a bonus on top of an otherwise sound case.
Clearly, I don’t like companies that acquire others, especially no big M&A and / or diversification attempts.
Diversification for me is often associated with Peter Lynch’s “di-worse-ification”.
Today, I discuss a company that “diversifies” from its leading niche-position into an area where it is almost irrelevant and still loss-making after almost a decade.
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