Acquisitions Strategy: A Case Study
The current strategic issues facing CNS Inc., the maker of Breathe Right nasal strips, are a fascinating case study. After losing money every quarter from Q1 '99 through Q2 '01, the company has righted its ship and the future looks bright. Perhaps, however, rather than expanding its current product line, the company would best serve shareholders by sticking to its core business and seeking an acquirer.
By Whitney Tilson
November 13, 2001
In last week's column, I warned investors to be wary of companies that engage in acquisitions, given the risks and high failure rate. Today, I'd like to discuss a company, CNS Inc. (Nasdaq: CNXS), that I considered investing in -- but did not -- because I'm not convinced that management shares my belief that the company should be acquired rather then trying to grow on its own, in part via acquisitions. It's a fascinating case study on a number of dimensions.
The product
Breathe Right nasal strips account for the great majority of CNS's sales. The strips stick to the nose like a Band Aid, but are spring-loaded such that they pull open the nasal passages and allow easier breathing. The product really works -- I tried one last week and, while my wife thought I looked really goofy, I could feel the difference. You may have seen football players wearing them, but the vast majority of sales are to people who wear one every night to eliminate snoring and other breathing problems. The company is rolling out versions for children and cold sufferers (with strips impregnated with Vicks Vap-o-rub), and is expanding rapidly overseas.
Competitive position
Breathe Right nasal strips have a strong brand name and use patent-protected technology, so there are real barriers to entry. Schering-Plough (NYSE: SGP) aggressively launched a competing product about three years ago, which hurt CNS in the short term, but it achieved little penetration and Schering-Plough has effectively exited the market, leaving CNS with 92% market share.
History
When certain high-profile athletes like football player Jerry Rice started using Breathe Right nasal strips in the mid-1990s, sales took off (and CNS's stock followed). But it proved to be a fad, sales plunged, and the stock did, too (yet one more reason to avoid small-cap growth stocks; just be patient and most will eventually become value stocks).
The current CEO, Marti Morfitt, joined the company three and half years ago to engineer a turnaround. She has cut costs, focused the company around its core Breathe Right franchise, and significantly improved the cost effectiveness of the company's marketing and advertising, which is by far the largest cost area.
After fending off the Schering-Plough challenge, the results are finally appearing. Consumer Breathe Right sales have grown year-over-year in every month for more than two years, at a rate that has recently been about 10%. More importantly, after losing money every quarter from Q1 '99 through Q2 '01, the company recently reported a healthy profit in the third quarter and projects consistent profitability going forward.
Economics and valuation
Breathe Right should become a very profitable product line. Due to its strong competitive position and loyal users, CNS is able to charge a high price (each strip sells for roughly $0.50), resulting in healthy 67% gross margins. Overhead is minimal since CNS subcontracts the manufacturing, so the entire company has only 60 employees. The company believes it can achieve 15-20% operating margins, up from the 10-15% it expects to report in 2002.
CNS has a market capitalization of $77 million and has $22 million in cash and no debt, so the enterprise value is $55 million. The company has projected $9-$12 million of operating income next year, on sales of $90-$100 million. While the company won't pay taxes for a year or two due to losses in previous years, I always like to use tax-adjusted numbers, so NOPAT (net operating profit after tax) would be $5.7-$7.6 million (assuming a 37% tax rate). Thus, the stock is trading at a modest EV/NOPAT multiple of 7.2-9.6x.
Value to an acquirer
There are good reasons to believe that the company would be worth quite a bit more to an acquirer than its current value. First, the most logical acquirer would be a large company already selling similar products to similar customers through similar distribution channels. A company like this could vastly reduce CNS's overhead associated with being an independent company, and could likely negotiate savings in manufacturing, distribution and marketing/advertising. In other words, an acquirer could pay a hefty premium and still get a bargain.
Second, many companies and products are bought and sold in the consumer products space, so comparable valuations can be made. According to someone who posted CNS as an investment idea on the ValueInvestorsClub website, such transactions have typically been done at 1.5-2.5x sales. Even at the low end of this range, that would be $135 million (based on $90 million in sales next year), or 2.5 times today's enterprise value.
Given everything I have written so far, you may be wondering why I haven't purchased the stock. There are two primary reasons.
Capital allocation
It is regrettably all too common for companies, large and small, to take the profits from a great businesses and fritter them away investing in (or, worse yet, making acquisitions of) less-great businesses. While I don't have the detailed financial information to make a definitive judgment, it appears that CNS fell into this trap by developing and launching FiberChoice chewable fiber tablets, a product in a highly competitive field unrelated to CNS's core business, and by continuing to develop nasal strips for horses (I'm not kidding), which is related but doesn't sound like a big market.
You can imagine my skepticism, therefore, when the CEO said that her strategy is to expand beyond nasal strips to develop other "better breathing" products, partly via in-house development and, of greater concern, acquisitions. I would instead argue that CNS could grow at a healthy rate, very profitably, by focusing entirely on its current efforts to expand the Breathe Right nasal strip franchise.
Sure, CNS might be able to develop other profitable products, but I think the highest and best use of scarce financial and management resources is to expand the company's highly profitable, patent-protected business until it's clear that such investment is unproductive.
End-game strategy
The second major reason I haven't bought the stock is that I'm not convinced that management shares my view of the best end-game strategy. It is clear to me that CNS is worth more as part of a larger company, so my recommended strategy would be to first continue the current course, such that a year from now CNS is consistently profitable, as management has projected.
In the meantime, the company should use all but, say, $5 million, of CNS's $22 million of cash (plus profits as they roll in) to buy back CNS's undervalued shares. This would result in the retirement of 20-30% of the outstanding shares over the next year. Finally, sometime in the middle of next year (depending on market conditions, how the company is performing, etc.), CNS should be well positioned to initiate discussions with potential acquirers. I have little doubt that if the company hits its projections between now and then, there will be many interested parties willing to pay a significantly higher multiple than the market will award the company as an independent entity.
While CNS's CEO has not ruled out selling the company, this is clearly not her preference. I'm not surprised -- how many CEOs do you know who seek to put themselves out of a job in short order?
Conclusion
Among the most critical things that investors must do when evaluating a company is to analyze the strategy the company is pursuing, including the accompanying capital allocation decisions. If management gets this wrong, an otherwise great investment situation can turn sour.
In the case of CNS, I think there is room for reasonable people to disagree. It's entirely possible that the strategy management is pursuing will generate more shareholder value than the one I've outlined -- but obviously I'm not convinced.
-- Whitney Tilson
Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. |
