Last year, the Corporate Executive Board Company (NYSE:CEB) made an acquisition, which it was very enthusiastic with. So far, all signs show that the acquisition isn't really adding anything to the company except for adding a badly managed business with ultra low margins to its holdings.
First, some background information: Corporate Executive Board is a consulting company that provides a variety of services to corporations and its clients include many Fortune 500 companies. The company has been growing at a pretty decent rate until recently and the investors have a lot of faith in the company, evidenced by its P/E ratio of 71. When companies reach maturity and their earnings nearly peak, they are expected to trade for a P/E ratio of 10, so the investors expect this company to increase its earnings by 7-fold eventually. Last year, the company generated $622 million in revenues, which gives it a price to sales ratio of 4. Keep in mind that the company's share price has appreciated by 40% year to date and 105% in the last 2 years, which is another indicator that investors have very high expectations of it.
Last year, Corporate Executive Board acquired the SHL, which provides pre-employment assessment solutions to corporations. SHL is based in the UK but it has a strong presence in the US as well. The management of CEB believes that SHL has a lot of potential for growth and its wide range of clients offer CEB more room for penetration. Basically, the main motivation of the acquisition was this: "Hey SHL, I see that you have some Fortune 500 clients, and I have some Fortune 500 clients. Why don't we merge so that CEB can sell its products and services to existing SHL clients and SHL can sell its services and products to CEB's existing clients, effectively doubling the penetration rate of both companies?" This is something the management has emphasized many times as well.
We also see this on SHL's website where it talks about the merger:
"The acquisition will significantly expand the addressable market of both companies through an increased global presence and in key emerging markets, enhancing CEB's ability to efficiently scale its existing platform with technology-driven solutions across all critical corporate functions. The combined company also will offer compelling career opportunities for its talented base of more than 3,000 employees as part of a larger, stronger global organization committed to advancing the science and practice of talent management."
Unfortunately, in the first year of the merger, things didn't go as planned. It turns out that just because a company uses CEB's services doesn't mean it will use SHL's services and just because a company uses SHL's services doesn't mean it will use CEB's services.
Now, let's look at some numbers. SHL was acquired by CEB for $660 million in cash for which the company had to take a loan. Prior to this, the company was owned by a set of venture capitalists. Prior to the acquisition, CEB had zero debt on its balance sheet and this acquisition introduced debt to the company's balance sheet for the first time in a long time, if ever. At the time of the acquisition, SHL was generating $209 million in revenues and $7.8 million in net income. Basically, the company was bought for 3 times its sales and 84 times its earnings. The company also had $25 million in cash and $253 million in debt. The company was actually paying $9.6 million per year to service its debt.
In the first quarter after the acquisition, SHL generated $25.6 million in revenues and $2.7 million of loss. In the next quarter, the company generated $38.06 million in revenues and $6.34 million in net loss. In the first 2 quarters of this fiscal year, SHL was able to generate $89.9 million in revenues and $4.46 million in net loss. Basically, SHL generated $153.56 million in revenues and a $13.5 million of net loss in earnings in the first 4 quarters following the acquisition. This compares pretty badly against the $209 million in revenues and $7.8 million in net earnings in the last 4 years prior to the acquisition. SHL's bad performance wasn't the only constraint on CEB either. The company had to spend $45.39 million in the first 6 months of the year in order to service the debt it had to take in order to acquire SHL. Without this spending, the company would have generated $54 million in free cash flow; instead it ended up generating only $8 million and some change in cash flow. Since acquiring SHL, CEB's gross margin fell from 65% to 62% and the company's operating margin fell from 19% to 14%. Obviously, acquiring SHL was not such a great idea after all.
Of course, one could say that looking at the first year's performance in an acquired company might not be fair. After all, some acquisitions are long-term investments and they pay themselves off over time. I don't think SHL is one of those investments though. If we look at the company's past history, we see that all the growth in its history came from acquisitions and mergers while very little organic growth actually ever occurred. For example, in 2011, SHL bought PreVisor a Minnesota based company. PreVisor also owes a lot of its growth to past acquisitions such as Brainbench in 2006, CraftSystems in 2007 and ASE in 2008. A look at the company's Glassdoor page also reveals this as several employees complain about lack of organic growth in the company. Some of the feedback regarding the company includes comments such as:
"The company hasn't seen any organic growth in years."
"All the growth comes from mergers and acquisitions."
"Too much office politics and drama."
"Highly inefficient, functions like a government institution."
"The company hasn't innovated in years. Competition is catching up."
Another person's feedback includes even stronger words:
"Culture is weak, people don't have much passion for the company, high turnover rate, very high workload and no work-life balance. Most employees are unhappy and wanting to leave. Since we merged with CEB, it's been all about selling more products. It's all about increasing revenues at all costs. No matter how hard we work, we keep losing market share to competition."
It's interesting how this employee is bothered with the fact that the company has to focus on "selling more products" since the merger. I guess, the company's employees aren't used to being pushed for growth since it was never a public company until recently. Another employee reviewing the company at Glassdoor also confirms this with his/her comment: "Innovation was not very much accepted. [It is] very hard [for the company] to change and adapt to market needs."
CEB keeps talking about how pre-employment testing is a hot market that grows at a 15-20% rate annually. Recently, IBM acquired Kenexa and Oracle acquired Taleo in order to take advantage of this trend. While SHL is in a fast-growing industry, the company isn't showing much of a growth, as I've demonstrated above. Being in a fast-growing industry doesn't mean much unless you can keep up with the industry's growth, ask Nokia and BlackBerry between 2007 and 2011, as they couldn't take advantage of a rapidly growing market at the time. Keep in mind that much of SHL's business is focused in Western and Northern Europe where the economy is near maturation and the companies are cutting costs such as consulting costs.
I would have been more optimistic about CEB if it didn't fall into the trap of acquiring a company like SHL without researching it thoroughly. Since the acquisition, at every presentation and conference, the company's management has been trying feverishly to sell the acquisition to the shareholders but they have to show results first. In the last year and a half, I don't remember any conference where CEB's management didn't spend at least 5-10 minutes trying to convince its shareholders why it did a good thing by acquiring SHL. Since the company is trying too hard to prove a point, the management must be realizing that its decision to buy SHL wasn't a smart one after all.
At the moment, CEB's acquisition of SHL might be hindering rather than helping the company's growth. For the time being, I would sell CEB given its high valuation and bad acquisition decision. In the future, if the share price falls significantly, I might reconsider my conclusion regarding the company.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.