The big, the fat and the ugly

By DAVID MOON, Moon Capital Management
September 5, 2004

For Tennessee football fans, today is a big day. As a big guy, I love big things. Tennessee football is big. The players are big. The stadium, the crowd, the budget ' they're all big. The stadium doesn't have a replay screen or even a big screen. It has a Jumbo tron, where we see big players make big plays. Or big mistakes. In the 1960s, my uncle was a 200-pound offensive lineman at Alabama. Twenty years later, I played the same position at Tennessee, at a svelte 300 (or so) pounds. Twenty years after me, a Mississippi State lineman weighed more than 400 pounds.

But jumbo players aren't necessarily better. Ask William 'the Refrigerator' Perry. Or Krispy Kreme and Starbucks.

Both Krispy Kreme and Starbucks, purveyors of addictive specialty morning products, recently disappointed Wall Street. One of the problems facing each business is managing extraordinary growth, particularly in new store locations. There may still be room for another 20 million or so coffee and doughnut shops in the US, but that is an expensive way to generate growth. You have to buy or lease real estate, construct new buildings and hire a bunch more teenagers to run the new restaurants. Adding new stores requires additional capital: both the financial and human types.

A company that constantly adds new store locations may be able to continue growing its earnings. But the key metric to notice is return on capital. Is a company generating higher earnings at the expense of exponentially greater capital needs? Are returns on capital declining?

Retail businesses generally report two components of earnings changes: growth generated by existing locations ('same store sales') and the growth resulting from new stores. This is significant. A company with increasing earnings but consistently flat or declining same store sales is on a disaster course. When new stores are driving the growth of a company, investors will flock to those attractive quarterly earnings. The stock price skyrockets, as does the P/E ratio. When a company is selling at 80 times earnings, the market is expecting annual earnings growth of at least 25 to 50 percent. A risk in this scenario is that the market's expectations won't be met, and a stock selling at 40 or 80 times earnings is vulnerable.

If a company with 100 locations opens 40 new stores, it's pretty easy to see how it could generate 40 percent earnings growth. After ten years of opening 40 stores a year, the business would have 500 locations. With that many locations, an additional 40 stores is only an eight percent increase. A larger business is harder to grow with new locations. Eventually, a business must generate internal growth. Bigger isn't always better.

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Last week, I wrote a tongue-in-cheek piece about a possible Knox County 'will tax.' There is no such proposal. The county mayor actually proposed an increase in the cost to register an automobile, otherwise known as a wheel (not will) tax. So much for satire.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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