By DAVID MOON, Moon Capital
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
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.
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).