Thinking about growth

Jae Jun of Old School Value wrote a post valuing K-Tron International, Inc. (KTII). His analysis got me interested in K-Tron, but I was worried when I read "I don't see why it can't grow at 23%." Perhaps I'm just more conservative (or paranoid!) when it comes to forecasting growth. K-Tron's growth for the past few years has very impressive, but is it prudent to forecast similar growth rates into the future?

Growing with the industry
Is K-Tron growing at the industry average or GDP growth rate? Is the company operating in an expanding industry? I don't know the average growth rate, but I suspect K-Tron is growing at an above average rate. If growth exceeds the industry or GDP growth rate, we need to beware of reversion to mean.

Companies have been using materials handling and processing equipments for quite a while to automate their manufacturing plants. If K-Tron is involved in a new and growing industry, a high growth rate may be sustainable (at least while the industry is growing). But I think K-Tron is involved in an existing and stable industry, so the growth in demand for their machines should be dependent on their customer's need for expanding production capacity. A global recession may prompt their customers to cut back on capital spending and expansion. As such, I won't count on a high industry growth rate, so K-Tron's prospects of growing with the industry for the near future is uncertain. So what contributed to K-Tron's growth in the past few years?

Growing by stealing market share
If K-Tron is operating in a stable industry, it's likely that the company is taking market shares from others or making acquisitions.

If the company is taking market share from others, how can it keep doing so? What gives the company the competitive advantage? Does K-Tron have products offering significant advantages over its competitions? Do they have above average marketing and sales? How much market share can K-Tron capture before other companies neutralize its competitive advantages? I do not understand K-Tron or this industry enough to answer these questions... in fact, I don't even know who are K-Tron's direct competitors, not to mention indirect/potential competitors.

Growing by buying
K-Tron seems to grow primarily by acquisitions, but acquisitions don't necessarily create value. Integrating two companies is difficult and the projected synergies may not be realized. If K-Tron acquires business producing similar products (e.g. both companies making pharmaceutical feeders), K-Tron and the acquired company's current customers may not see a need to buy a new product when the old one works just as well. If K-Tron acquires businesses producing adjacent products (e.g. a company making electronics feeders), their current customers may not need those products. If K-Tron acquires business producing upstream or downstream products, there might be more potential for vertical integration, cross-selling, and synergy. No matter what type of acquisition a company makes, brilliant management is usually required to make the most out of it.

I think there are too much uncertainty to forecast growth by acquisition:

1. There may not be appropriate acquisition targets in the future.
2. They may not be available at attractive prices.
3. Expected synergies and value may never be realized.
   

A word on market cap
The "law of large numbers" implies companies with large market cap, high revenues and earnings will grow at an average rate. A small market cap, however, does not imply a high growth rate. It's just that more growth is possible before the "law of large numbers" sets in. The growth rate that can be achieved, however, is dependent on the economics of the business, the industry and the competition.

Forecasting growth
I believe forecasting past growth into the future on a linear basis is "dangerous", especially when past growth rate has been high. High growth rate is not impossible or unsustainable, but I wouldn't forecast an above average growth rate for an extended period of time until I have a good understanding of the business, the competition, and the economics of the industry. I do not have sufficient understanding of the economics of K-Tron's businesses, so I don't dare to forecast 23% growth as JJun does.

P.S. This post was featured in the 92nd Edition of the Festival of Stocks at Fat Pitch Financials.

Discloure: No position in KTII.