The Cancer Surgery Strategy
Pattern matching one of the most useful tools in an investor's toolbox. The idea is to figure out what's worked in the past and identify similar set-ups in the present. History may not repeat, but it does rhyme. One of the most profitable patterns is what Warren Buffett and Charlie Munger call the Cancer Surgery Strategy. I’ve also referred to it as “shrink to grow.”
The set-up involves a company with multiple lines of business. One is the crown jewel — growing, capital-light, and free-cash-flow generative. The other is troubled or mediocre. The lousy business obscures the good, soaking up its free cash flow and weighing down the parent company's valuation multiple. The strategy is to buy these companies and surgically remove the lousy business.
Buffett introduced the idea in his 1980 letter to shareholders:
"GEICO's problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true "turnaround" situation in which the managers expect - and need - to pull off a corporate Pygmalion."
Munger discussed it in his 1994 speech A Lesson on Elementary Worldly Wisdom:
"GEICO is a very interesting model. It's another one of the 100 or so models you ought to have in your head. I've had many friends in the sick business fix-up game over a long lifetime. And they practically all use the following formula—I call it the cancer surgery formula:
They look at this mess. And they figure out if there's anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work.
And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.
All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again.
And, in GEICO's case, think about all the money we passively made… It was a wonderful business combined with a bunch of foolishness that could easily be cut out. And people were coming in who were temperamentally and intellectually designed, so they were going to cut it out. That is a model you want to look for."
Coca-Cola
Coca-Cola is a particularly stunning example of this pattern. In the late-seventies, Coca-Cola's core beverage business generated a prodigious amount of free cash flow and was growing 3-4% per year. Things were going so well, Coke's managers only had one problem: what to do with all the cash flow? Buffett cautions that "A fat wallet is the enemy of high investment returns," and Coca-Cola explains why.
Boards usually compensate management for growth. But they rarely charge managers for the capital used to grow. Coca-Cola's managers wanted big bonuses, and 3-4% per year wasn't going to cut it. They needed to grow the business faster but couldn't figure out how to accelerate the core beverage business. So, they looked elsewhere. By the early eighties, Coca-Cola had bought a shrimp farm, a pasta maker, and a plastic-cutlery company. This diversification was diworsification.
Roberto Goizueta became Coke's CEO in 1981. Initially, he continued the acquisition and diversification strategy. He even bought Columbia Pictures in 1982. You can thank him for gems like Ghostbusters, Stripes, and The Karate Kid. Fortunately for shareholders, Goizueta quickly realized that less was more.
He noticed that if he stripped away everything — from the shrimp farm to Coke's bottling plants — he'd be left with an asset-light syrup business that could sustainably grow earnings per share at a high-teens rate. The stripped-down business would have less revenue but higher margins. It'd be a smaller company on an absolute basis but more valuable on a per-share basis.
Goizueta spent the rest of his 16-year tenure surgically excising Coke's cancer. The strategy worked. Coke's stock multiplied 65 fold those 16 years, producing a 30% compound annual return. Buffett saw what was happening and bought shares in 1988. Berkshire still holds those shares today.
General Dynamics
A few years later, in 1992, Buffett saw the pattern again. This time it was at General Dynamics. William Thorndike tells the story in Chapter 3 of The Outsiders.
A year earlier, Bill Anders had become CEO. He didn't have the typical CEO background. Anders started as a Navy test pilot (you can read about him in The Right Stuff) and became an astronaut. He was part of the first crew to orbit the moon on Apollo 8 and personally took the famous Earthrise photo.
Anders's unusual background freed him from sunk costs. He logically and impartially surveyed the situation and concluded that General Dynamics should shrink, not grow. The Cold War had just ended, and the US defense budget was bound to shrink. Inspired by GE's Jack Welsh, Anders vowed to exit every business General Dynamics wasn't already number one or number 2.
Thorndike writes:
"In less than three years, Anders had dramatically streamlined operations, sold off over half of his company, generated $5 billion in proceeds, and, rather than redeploying the cash into R&D or new acquisitions, returned most of it to shareholders, using innovative, tax-efficient techniques. Each of these moves was unprecedented in the defense industry and created enormous value for shareholders. It is very, very rare to see a public company systematically shrink itself; as Anders summarized it to me, "Most CEOs grade themselves on size and growth . . . very few really focus on shareholder returns."
It is similarly rare (outside of the CEOs in this book) to see a company systematically return proceeds to shareholders in the form of special dividends or share repurchases. The combination of the two was virtually unheard of, particularly in the tradition-bound defense industry."
Berkshire's investment multiplied several times over. Buffett sold the entire position the day Anders retired.
Modern Examples
These situations aren't a relic of the past.
In 2014 Carl Icahn agitated for eBay to spin off PayPal. He thought PayPal was a crown jewel being obscured by eBay's marketplace business. He was right. Today PayPal is nine times more valuable than eBay.
Two years later, a similar situation played out at Fiat-Chrysler. CEO Sergio Marchionne noticed that Fiat's valuation gave the company no credit for owning Ferrari. Ferrari is more like Hermes and Prada than Jeep and Chrysler. Marchionne spun out Ferrari in 2016 to highlight how cheap it was. Today Ferrari is almost twice as valuable as Fiat-Chrysler.
Common Threads
What do these situations have in common?
First, they all had new CEOs, often from outside the company. This fresh perspective is crucial. As outsiders, they have no sunk costs, loyalties, or infatuations with a line of business. They're willing to sell anything at the right price. Surgeons must be contrarian, opportunistic, and hyper rational.
Second, these situations take time. Managing a multi-billion dollar corporation is a bit like steering an aircraft carrier. They don't turn on a dime. Goizueta spent the better part of a decade stripping Coca-Cola down. GE looks to be undergoing cancer surgery now. CEO Lawrence Culp is an outsider with a background at Danaher, a company famous for its capital allocation and lean operations. But, it's too early to tell if there is a crown jewel buried in GE's guts. We are watching closely but patiently.
Third, Buffett only invested after the cash was in the bank. He got wind of the situation at General Dynamics after Anders tendered for 30% of outstanding shares. The sales were already complete. He wasn't divining the future or relying on projections. Similarly, Buffett didn't buy Coca-Cola until 1988, when the company's transformation was mostly complete. The market doesn’t process major strategic pivots instantaneously. Often there’s a year or more lag — plenty of time for enterprising investors to get on board. It is safer to wait for the cash to arrive than to seek brilliance by anticipating it.
NortonLifeLock
Last year we noticed this pattern at Symantec. I wrote about the situation in November 2019, so I won't rehash every detail.
Starboard Value, an activist hedge fund, realized that Symantec's profitable consumer business was subsidizing losses at its enterprise division. They took a 5.8% in Symantec, gained board seats, and installed a "surgeon" named Rick Hill as CEO.
Hill didn't waste any time. That summer, Symantec sold its enterprise division to Broadcom and cleared $8 billion, net of tax. Hill had traded 10% of Symantec's operating income for 50% of its market cap in cash.
Like Anders, Hill returned every penny to shareholders via a special tax-advantaged dividend. He also announced a buyback equal to 20% of the ex-dividend market cap, a plan to reduce stranded costs by $1.3 billion, and a plan to raise $900 million through real estate sales.
Today NortonLifeLock (the company's new name) is free of its cancer and thriving. This week they announced that they've removed all stranded costs and expect real estate sales to net $600 million more than forecast. Norton now enjoys 50% operating margins, produces $900 million of free cash flow, and is growing at a mid-single-digit pace. They've recently repurchased over $1 billion of stock and have $600 million more authorized.
Today the stock looks cheap at $20 per share and a $12 billion market cap. That's only 13x free cash flow, which seems low for a growing, capital-light software company with reoccurring revenue. These types of businesses trade for at least 20x these days.
The issue seems to be a lag between what's happened and what the financials show. Norton's historical financials still include the stranded costs. They're messy, and the algorithms haven't figured out what's going on yet. Next quarter will be Norton's first "clean" quarter. I expect that the market will wake up to what's happened after a year of "clean" results make it undeniable.
McAfee is Norton's closest comp and trades for 16x free cash flow. McAfee looks a lot like Symantec used to. An unprofitable enterprise division is obscuring its profitable consumer business. Maybe Starboard Value will send Rick Hill to McAfee next…
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