Growth Isn’t Free

If there’s one fantasy I see repeated in both public and private equity markets, it’s the idea that companies can grow without reinvestment.

Pull up any company model from a sell-side analyst or PE shop, and you’ll see projected sales and EBITDA go up while capex and net working capital growth is flat, if not declining. I see it in almost every model. Somehow, these companies are expected to undergo a magical transition that will accelerate incremental returns on invested capital and negate the requirement for reinvestment to grow in line with sales.

It’s easy to make these assumptions. It’s an entirely different matter for a company to deliver them. They rarely do.

This doesn’t mean the company isn’t a worthwhile investment or won’t make money. But it does mean a few things.

First, investors rarely understand the business. They have a trader mentality, only worried about fast growth because fast growth sells well in the short run. The cost and investment need to fund that future growth, however, is usually neglected with the hope someone pays a nice premium before the lack of reinvestment becomes apparent.

Second, it’s a way to dress up the company and solve for the valuation that you want. Nothing drives cash flow higher than not reinvesting in the business, at least for a while. Higher cash flow means higher valuation. That is, of course, if those cash flows are sustainable, which they are not. If you underinvest today, you’ll have to make it up in the future. Most of the PE industry is built on others not realizing this fact.

If you want to tell if an analyst or investor really understands a business, ask about the future reinvestment needs based on the assumed sales and EBITDA growth. The quality and depth of the answer will tell you everything you need to know, because it demands that investors and owners are thinking about the future competitive environment that never stops trying to compete and destroy each other. Even entrenched companies aren’t immune from investing to defend and grow their business.  

But some readers might protest, what about asset-light companies like software firms? They don’t have capex needs like an asset heavy company! Well I can assure you they do have reinvestment needs. It just takes a different form than asset-heavy industries.

While an asset-light company like a software company certainly has lower tangible fixed investment compared to a heavy manufacturer, there’s still a need for reinvestment, it just doesn’t show up on the balance sheet as a tangible asset.

Most “investment” for an asset-light company is expensed through the income statement as salaries and benefits (for example, those highly paid AI and software engineers) or SG&A (for the marketing and sales effort to win and retain new business). As with underestimated capex needs on the tangible side, many investors commit the same error on the income statement side: that since all the heavy lifting is done, the company will be able to grow at an accelerated rate without adding new people, new marketing spend, or additional R&D. That’s true, for a short time. But guess what – competitors continually come out with new products and innovations. Now, the company must reinvest again to keep up. It’s a never-ending game. The free cash flow expansion is rarely realized.  

Asset-light companies have to compete just like the asset-heavy companies. And to compete, you have to spend. The accounting treatment isn’t the concern. Whether it gets capitalized on the balance sheet and then depreciated or gets entirely expensed in the current period, the cash is getting spent (or invested) either way. I’m not as worried as how it’s accounted for, then when CEO’s, bankers, and investors all of sudden assume those investments are no longer needed at the same rate.

The typical private equity or small cap public company is not Microsoft. It’s not VISA. It’s not Apple. It’s not Oracle. Quit claiming that your company is in the same economic position. Investors and bankers may hope their company joins those ranks someday, but that’s wishful thinking, not reality. In the meantime, your little HVAC roll-up company must compete and invest like everyone else. It’s not immune from future reinvestment.

It’s the same issue for M&A. Companies are given the benefit of sales and EBITDA growth from future M&A, but the cost of the M&A is never included in the assumptions or go-forward model. It gives the benefit without the cost. That’s a big problem. The organic growth of most commoditized companies is pretty low, if not zero. Acquisitions fill the gap. But even those accretive acquisitions cost money, and that needs to be accounted for and built in when thinking about future cash flows. For many companies, even assuming a 5% growth will imply meaningful acquisitions over the forecast period because the organic growth isn’t there to deliver.  

There’s an old investing adage that says, “Don’t confuse genius with a bull market.” I’d modify that saying to say, “Don’t confuse a good business model with a bull market.” Rising markets hide lots of flaws and make terrible businesses seem mediocre and mediocre businesses seem fantastic. It’s during a bull market that ordinary economic assumptions can be suspended in favor of magical thinking. One of those assumptions is that companies don’t need to reinvest because growth is occurring effortlessly. But while a bull market might delay the inevitable reinvestment, it won’t prevent it.

Here’s the thing. There are exceptional companies that built a business model so robust and defensible that they can reinvest proportionately less as sales grow. But it’s the exception, not the rule. There are companies that can improve capital efficiency and ROICs. But again, that’s usually a one-time improvement, not an ongoing one.

I’d argue that reinvestment as a percentage of sales will need to increase, not decrease, for most companies as CEO’s misstep, chase the wrong trend, and then need to reinvent themselves. But that admission never sells well.

Growth without reinvestment is just another story that’s easy to sell but hard to deliver.