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The Cost of Growth

April 27th, 2012 | Posted by Torin in Energold

Growth is expensive, and not just for investors who must pay a premium for companies on the upswing. It is expensive for companies, too. Keeping pace with increasing demand from customers is costly. You have to lease twice as much office space as you need, knowing it will be full a year from now. You hire marginally qualified people and send them into the field too soon, knowing there is no better alternative. Your unproductive employees stay on the payroll because a cold body is better than no body at all. You overpay to poach high-performing employees from your competitors. You pay consultants to research new regions and markets where you don’t yet make any money. You never have the time to dive into your expenses and see where you can trim your budget.

The list goes on. For companies growing at a breakneck pace, everything is more expensive than it would be under normal circumstances.

Energold, a large position in Monte Sol accounts, is one of those companies. It grew 130% in 2010, 145% in 2011, and it should grow at least 50% in 2012. In North America there are about 5,000 public companies that are Energold’s size or larger, but only about 30—or less than 1 in 150—are growing as quickly as Energold.

Energold’s competitors are growing more slowly, and not coincidentally their overhead is much smaller relative to their sales. This is a point that has been discussed elsewhere, but I want to go at the analysis in a slightly different manner.

The chart below compares Energold and its competitors with respect to their growth rates and overhead costs. As you can see, there is a clear correlation between a company’s growth rate and how efficiently it utilizes its overhead (I define overhead as selling, general, and administrative costs, or “SG&A”—exclusive of depreciation and amortization). Energold is growing faster than every other driller, and it is proportionately less efficient for doing so—it spends about 12% of its sales on overhead whereas its competitors spend between 7.5% and 8.5%.

Energold won’t grow at its current rate forever, so the excess overhead that it bears right now is not permanent. Most analysts, myself included, think Energold will earn about $0.60 per share in 2012. But what if its SG&A were more in line with everyone else’s, say 8.5% of sales rather than the 12%+ that prevails as long as Energold grows so quickly? In that scenario, instead of earning $0.60 per share, Energold would earn about $0.73—more than a 20% increase.

Does the Energold share price reflect this? I don’t think so. If one values Energold based on the adjusted earnings, rather than on current earnings, the stock goes from being one of the most expensive in the industry to the least expensive. I think it should be the most expensive, given its superior growth prospects, management, and financial condition.

In a few years, when Energold starts to mature, I actually think it may end up spending less of its revenue on overhead than its competitors do, thanks to the premium drill rates it earns for the environmental friendliness of its drills. But that is a discussion for another post. In the meantime, investors evaluating Energold should not confuse current earnings, which are being weighed down by the cost of growth, with what Energold will earn when it is a bigger and more efficient company.

 

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