Lessons in value creation

Introduction

Value creation is hard won by a corporate, and easily lost. Invariably, when we ask Boards and management what the purpose of their company is, the answer is “to create value for shareholders”. It’s when we ask how that value is created, and measured, and assessed as being structural or cyclical, let alone whether value creation is a purpose or an outcome, that the conversation starts to go awry and take many different forms. Many refer to market capitalisation, which we think a poor proxy for true value creation, but nonetheless increasingly popular in a listed equity environment where flows are increasingly being directed to index funds with no other anchor of fundamental worth.

In this context, it was refreshing for us to recently host Brendan Harris, the CFO at South32, to discuss how they view value creation. Brendan highlighted that through the past decade, as the commodity price index rallied until 2011, operating returns on capital for the industry were collapsing because of undue levels of pro cyclical investment (compounded by M&A). South32’s parent, BHP, was of course a prime contributor to this poor sectoral outcome. Learning from this, South32 has a well-considered and clear capital allocation framework; value is created through optimising return on invested capital, by allocating excess capital to the highest returning option among share buybacks, special dividends or acquisitions, once the pre-conditions of an investment grade credit rating and a dividend payout ratio of at least 40% are met. To that end, South32 have just announced a US$500m capital return program.

Other companies are less successful in defining value and understanding how hard it is to create and how easy it is to destroy, especially through ill-considered investment.  Downer EDI Limited, for example, has had a share price between $3 and $7 per share for all but a few months through the past decade. This remarkable volatility is despite a more robust earnings before interest and tax (“EBIT”) line, which has been between $260m and $300m for much of that time, and towards the upper end of that band consistently for the past five years. Its operating divisions are unchanged through this period, and nothing of size had been disposed  and only Tenex, a $300m purchase in 2014, acquired. Given a net asset base of $2bn, and negligible debt levels, EBIT of approximately $200m, representing a 10% return, is required for Downer to meet its cost of capital, and any increment in EBIT above that required return creates shareholder value. If, for example, EBIT of $280m was sustainable, as we assume, then every year that number is reported (and realised in cash), then Downer creates $80m of value for shareholders. Downer has 19,000 employees and the general consensus is after a mixed period, in recent years, it has been well managed. The market had rewarded this performance through the past 18 months as the Downer share price re-rated, hitting $7.20 in early March, a market capitalisation (and enterprise valuation) of $3.1b, or 12 times sustainable EBIT.

If that is the scale and acumen required to work well and generate $80m of value per annum, then the Spotless bid is a classic case study in how to blow almost a decade’s worth of hard work with one bid. Unlike Downer, Spotless remains heavily geared, the last remaining gift that keeps on giving from the private equity vendors when Spotless was relisted on the ASX in 2014. Not three years later, Chairman gone, management gone, vendors gone, shareholdings realised, and almost $500m in write downs later, the Spotless share price was trading shy of half of its listing price of $1.60 per share, with net debt of $850m well in excess of the market capitalisation, and with almost all net debt due to be refinanced within the next two years. Spotless has been listed on the ASX for more than 30 years apart from the several year interruption when owned by Financial Sponsors (private equity). It has rarely made more than $100m in cash EBIT through this time, especially if “bolt on acquisitions” are characterised as stay in business capex, although through the time of private sponsorship ownership it apparently made more, and when it was floated it was claimed that this improved performance was sustainable. Alas, as is commonly the case with such issues, that has not transpired. We cannot see a credible case for Spotless to make more than $120m of sustainable EBIT, and remain wary of contingent liabilities that may yet be accounted for. If our assumed EBIT is correct, then using the Downer multiple of 12 times EBIT (arguably too generous) and Spotless’ debt of $850m, the Spotless equity is worth $600m, and the enterprise value is $1.45b. Downer bid $2.1b for Spotless. That is, on our calculations, the bid, if completed on the proposed terms, destroys $650m of value for Downer shareholders. Given Downer lost $630m in market capitalisation after announcing the bid, it appears the market does not disagree with our view of value destruction. Now, 19,000 people, well managed, work hard for another eight years, without interruption, to reclaim the value lost with one dumb deal, which featured “Increased market relevance; combined revenues of c.$10.5 billion, c. 55,000 employees and pro forma market capitalisation of over $4billion” as one of the five stated “Transaction highlights” in the pitch book. South32 started with return on invested capital as a driver for value creation; Downer ended with revenues, employee numbers and pro forma financial witchcraft. We know which we feel a better long run North Star for shareholders.

Whilst the South32 and Downer contrast is graphic, and contemporary, of course shades of grey dominate for most stocks in the investment universe. For example, we are no longer overweight AGL, which is currently undertaking a buyback after outperforming by more than 30% through the past year, after the CEO recently noted that it did not matter what price they repurchased shares at. Whilst King Coal is back, helping AGL’s business mix for so long as it remains the case, indifference to the price shares are repurchased at – and in turn the investment hurdle rate – seems more akin to the Downer playbook than the South32 one. Brambles is another classic case in point, albeit whilst AGL has been an outsized outperformer, in underperforming by 20% through the past year Brambles is on the other side of the ledger. Separating the cyclical/ephemeral – deflation in whitewood pallet prices, retailer destocking, new CEO and CFO resetting baselines - from the structural – the Amazon/online shopping impact upon pallet movements, and increased competitor activity through Peco  – impacts in the recent downgrades are critical in determining what Brambles is now worth. It is a business with much intuitive appeal, with a broad base of customers, suppliers, and much smaller competitors in a business where scale should give economies, and yet its last US$1b of sales growth hasn’t seen any growth in EBIT. Clearly the Brambles valuation is now hyper sensitive to the assumed return on investment for both the existing balance sheet and any further investment.

Ultimately, the rules of value creation, and dissipation, transcends industries. All of the principles discussed in relation to South32, Downer, Spotless, and Brambles relate just as much to Fairfax, Westfield and Aconex. That’s the way we value them and assess their governance.  Even if commodity prices fall from here, as we forecast they will, as a shareholder we are confident South32 will be spending their capital wisely; the Downer discussion is, unfortunately, now more nuanced.

Outlook

In the past year, resources have outperformed, following commodity prices as spot returns on capital are seen as rising. Through the past quarter, the reverse has been the case as many prices have dropped from multi year highs. In our view, extrapolating spot returns as a process in a cyclical market like the ASX200 is a nonsense, and the only sensible approach is to determine a mid-cycle anchor for returns and value a business, and hence the equity of that business, accordingly. That valuation, as South32 highlights, cannot escape from the returns generated by the invested capital of the business, as much as in the eye of the storm, whether that be for boom or bust, it is always hard to admit that human emotion governs short term returns as much as the most precise spreadsheets.