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What constitutes impressive growth?



March 11, 2014 – Comments (2) | RELATED TICKERS: HAIN

It is very often that investors, media, bloggers, and newspapers completely ignore operating performance and focus on revenue, net income, and cash flow growth.  For this group of people, the fuel required to achieve this growth barely matters.

I think this is a mistake.

In the 1979 annual letter to shareholders, Warren Buffett made this statement about operating performance vs earnings growth:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. 

Understanding how a company is achieving earnings growth is much different that simply noting earnings growth.  With that in mind, let's take a look at the fast-growing food products company, Hain Celestial (HAIN).

What HAIN has done over the past decade would be classified by most as incredibly impressive.  Since 2001, HAIN has compounded Net Income 14% per year, driven by revenues that have compounded 12%.  Per The Motley Fool, over the past 3 years EPS have grown 38% per year and revenues have grown 20% per year.  Still looking impressive.  Looking at the latest quarter, revenue increased 33% per year and net income rose 32% per year.

So why am I bringing up HAIN, then?  Because I want to talk about how they are achieving these impressive growth rates.

In order to drive growth in revenue and earnings, HAIN is adding assets.  Lots of assets.  Just over the past 4 years, assets have doubled from $1.2B to $2.4B.  Over the past 13 years, assets have compounded 14% per year.  

Now this wouldn't necessarily be a bad thing, if the company had the financial capability to pick up these assets using cash generated from operating activities.  But they don't.

Over the past 15 or so year, HAIN's ROA has averaged 3.5%.  That's not a typo.  Investing in more and more assets has lead to more and more paltry gains with respect to operating efficiency.  And despite the fact that the company has leveraged up quite a bit over the past several years, the ROE currently sits at 11%.  And that 11% is an all-time high.

Because of the poor returns on shareholder capital, HAIN has needed some extra capital to make all of these asset investments.  It's come at the expense of shareholders.  Since 2001, HAIN has diluted shareholders to the tune of about 2.5% per year.  In 2001, there were 34.5 million diluted shares.  Today there are nearly 50 million diluted shares.  On top of the increase in outstanding shares, debt more than doubled just over the past 2 years.

What does that mean for shareholders?  Well, when people speak about net income growth, they are looking at the enterprise level.  But enterprise level numbers don't mean a whole lot for the individual shareholder - per share values are much more useful, especially when the number of shares is changing on a regular basis.

As I highlighted above, net income has grown by 14% per year over the past decade.  EPS, however has only grown at 11% per year.  That's a huge difference to shareholders.  And even though operating metrics have inched up slightly over the past few years, more dilution (and debt) is likely to come as long as the company continues its "growth regardless of the cost" mentality.

So, what's an investor to do?  I'm not recommending doing anything with this post.  It is just meant to be informative.  But, I would keep a close watch on operating metrics (hoping for continued improvements) and diluted average shares outstanding (hoping that the dilution slows a bit).  The trend has been positive over the past few years, which is good.  However, investors may have already caught on and baked this into the stock price - the stock's P/E of 34 is a 10-year high.


Good luck.

2 Comments – Post Your Own

#1) On March 11, 2014 at 11:50 AM, constructive (99.98) wrote:

ElCid, I agree completely.

That comment and similar ones in Buffett's letters were revelatory for me and substantially improved my investing process.

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#2) On March 11, 2014 at 12:14 PM, ElCid16 (92.81) wrote:

That comment and similar ones in Buffett's letters were revelatory for me

Me too.  

I actually own some HAIN - I purchased it a little over a year ago.  Since then, my process and criteria for investing has changed quite a bit.  (I can't remember a year going by when my process didn't change.)

This has actually been a very challenging (and frustrating) aspect of investing for me.  Each year I learn more and more about investing; circumstantially, each year I look back in regret regarding at least a couple of my historic purchases.  This makes me want to unload old positions and add new positions, but that creates high turnover, which makes me nothing more than a longer-timeframe trader.  My goal going into 2014 was to substantially reduce my portfolio turnover.  This leaves me reluctant to sell positions - not exactly a fun position to be in.

I think I may have lucked out with HAIN, likely because we've seen this acceleration in EPS growth due to a slight increase in ROE & ROA.  But any slippage in ROE back to historic levels could send this stock plunging back to a P/E closer to 20 or so. 

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