where to from here, page-55

There are few financial metrics that are more misused and abused than ROE.

I see a lot of people bandy about the term under the guise of sounding financially literate.

Sure, in a pure arithmetic sense, ROE is easy to derive, but understanding its meaning in an investing sense is far from straight forward and requires all sorts of caveats and qualifications.

For starters, in the classical definition of ROE (After Tax Profit divided by Net Equity) both the numerator and the denominator in “ROE” are constructs of the accounting profession.

As I have travailed before at length, most accounting constructs need to be sanitised and scrubbed because they often incorporate all manner of strange twists and turns, from the idiosyncratic quirks of accounting standards, to mild audit process liberties, to creative alchemy, to aggressive financial engineering, and to even downright fraudulent misrepresentation of the financial performance of a company.

[There are several ways a small investors can unearth some of these accounting quirks without being a qualified forensic accountant. Most diagnostics involve some or other reconciliation with, or reference to, that one financial parameter that is beyond reproach, namely CASH FLOW.]

For this reason, when a company proudly reports “Net Profit After Tax of X hundred million dollars”, my starting position is always that it is little more than an approximation of the profitability of the company, and it needs to be subject to quality adjustment.


And if I have a level of mistrust for the numerator (“NPAT”) in the ROE calculation, I have an even greater distrust for the meaning of the denominator, namely “Total Equity”.

For if certain accounting oddities are indeed occurring over time, then the effect of those will be compounded in the balance sheet.

Put another way, some elements of the balance sheet, especially those of a Non-Current nature, are riddled with legacy issues, some of which are relevant to the present and the future of the company, and some not.



Take WES as a topical case in point.

In WES’s case, we have an “E” of some $25bn, of which $16bn is represented by goodwill, where it has been since the acquisition of Coles.

[Before the Coles acquisition the goodwill carrying value balance was $2.5bn, so the goodwill bloat on the balance sheet due arising from the Coles acquisition can be estimated to be around $13.5bn.]

So, almost half of “E” is comprised of goodwill related to one major corporate transaction.

The result today is ROE of some 8.8%. ($22.bn on NPAT on $25bn of Equity)

So does this mean that shareholders in WES today REALLY own an 8.8% ROE business?

Is the company’s management really investing all the company’s capital today at an average rate of return of just 8.8%?

If so, how does this “accounting metric” reconcile with the CASH FLOWS being generated by the business which are way in excess of the ongoing requirements of the business, as we have proven?

[Recall from an earlier post that WES’s capital cycle over the past 10 years performed as follows:

- cumulative OCF of $19.3bn generated,
- $4bn of this spent on maintaining the company assets,
- a further $7bn spent on organic expansion initiatives,
- acquisitions totalling $4.1bn made (basically just Coles...other than Coles the company has been a net seller of assets over the decade),
- $9.3bn in dividends paid to shareholders.

Despite this aggressive distribution of capital, solvency metrics have still improved significantly since the acquisition of Coles]


How can a business at the same time be low in accounting ROE, yet high in surplus capital generation?

For the two concepts are mutually inclusive in their meaning and implication.

Low ROE businesses CONSUME capital perpetually, leaving little left over for shareholders, not the other way around which is the situation with WES where shareholders are getting a fulsome dividend from the company, and yet there is ample surplus capital left over to maintain the company’s assets, invest heavily in organic growth as well as acquisitions, and the same time dramatically IMPROVE the solvency of the company.

One of the approaches is given off a faulty signal, and I know which one it is.

It isn’t the CASH FLOW one.
I know that for sure.
Because CASH FLOW I can touch ‘n taste ‘n see.

It is not predicated on a subjective quantity like “Net Profit After Tax” or “Equity”.

Here’s an explanation for the discrepancy:

Let’s start off by not mincing words:
WES overpaid for Coles.
Unequivocally.

The transaction destroyed value for the shareholders at the time, not only by overpaying for the business, but in the equity dilution that followed as part of the financing of the deal at a time when equity capital was very expensive.

To wit: in the middle of the GFC.
Really dumb.

However, that value destruction has already occurred. It occurred at the time of the over-payment and at the time of the heavily-discounted, quasi-distressed equity raising.

The value-destruction from that event is not ongoing to perppetuity.

It is a sunk event.

The trouble with ROE measure for WES is that is reflects this value destruction, not just as a historical event, but as an ongoing phenomenon for the company, when that is highly unlikely to be the case.

In others words, by saying “WES’s ROE is 8.8%” suggests that ALL invested capital – historical, present and in the future – will generate a return of 8.8% for shareholders.

And yet that 8.8% figure is dominated by the impact of one transaction.

Dominated to what extent, you ask?

Well, to put into accounting effect the view that WES overpaid for Coles would require the board to write down part of the Coles-related goodwill.

It’s a strictly non-cash accounting entry, requiring little more than the board to say, “Mea culpa, folk. We overpaid. We made a mistake and we’ll now acknowledge that by writing off the goodwill.”

For argument’s sake let’s say they write off half of the Coles-related goodwill, i.e., around $7bn.

Now ROE magically becomes 12% (NPAT of $2.2bn divided by Equity of $25bn less $7bn), certainly in excess of WES’s cost of capital.

If all the Coles goodwill is written off, then ROE becomes a most desirable 19% (NPAT of $2.2bn divided by Equity of $25bn less $13.5bn)

[Astute readers would now be aware that we approaching the situation of Return on Net Tangible Assets, which is probably what Persistentone alluded to when he posted “ I suspect that Cameron probably prefers return on invested capital and avoids ROE since it can be warped by goodwill...” Exactement!]


Of course, everyone knows this return uplift has taken place synthetically, with little more than one or two audit committee meetings and a few strokes of a pen.

But if management have a track record of shareholder value astuteness, and acquisition discipline (which WES certainly did before – and, indeed, since – buying Coles) , then it could be argued strongly that that is a completely appropriate course of action.

If it can be argued that management and the board simply had a rush of blood to the head on an isolated occasion, then 8.8% ROE is an aberration.

In fact, by stating “This is an 8.8% ROE business”, Montgomery is implying that the company will, for certain, make another major acquisition blunder of the scale and magnitude of Coles.

Well, that’s a very heavy call to make, and the burden of proof should be on its maker to substantiate it.

In the absence of a qualifying argument to that end, quoting ROE in isolation is almost meaningless.

It becomes a case of “Garbage-In; Garbage-Out”

What fresh investors to the stock need to consider when it comes to acquisition discipline - and its outworking on ROE - is whether or not an acquisition such as Coles is:

1. certain to happen again,
2. a legacy issue, and will not happen again because hard lessons have been learnt, or
3. somewhere in between these two ends of the acquisition risk spectrum

In WES case I suspect most investors will be more than happy to adopt a position on the spectrum closer to the that of WES board and management being disciplined acquirers; for the simple reason that they have been exemplary allocators of capital both for a long time before the Coles blip, and also subsequent to it.

The next logical step – for me anyway - as part of a hypothetical exercise is to ignore ALL goodwill and intangible items (together amounting to $20.5bn) and to then calculate the resulting return.

More financially literate readers will recognise this result as Return on Net Tangible Equity (RONTE).

In WES’s case RONTE = NPAT of $2.2bn divided by (Equity of $25.5bn less Goodwill and Intangible Items of $20.5bn), which is 44%

So, while WES’s ROE is 8.8% its RONTE is 44%.

Clearly the ends of the spectrum are miles apart.

Such is the distorting effect of the Intangibles bloat on the balance sheet.

So, which is right?

Neither, in isolation.

The former unreasonably includes “uncharacteristic acquisition” goodwill, while the latter incorrectly assumes that the company is able to operate without ever investing in goodwill or other intangible assets.

Somewhere in between is correct.

But where?

As in most cases, I like to go to the purest financial statement for my answers: the STATEMENT OF CASH FLOWS.

Here, the proxy I use for Return on Equity is the ratio of Operating Cash Flow to Maintenance Capex.

Why?

Well, the greater proportion of capital that needs to be retained in a business, the less there is available to grow the company and/or return to shareholders.

It stands to reason that a company whose OCF covers Maintenance Capex by a factor of five times, will be a higher return generator than a company whose OCE-to-Maintenance Capex coverage is just two times.

It’s admittedly not an intuitive measure to financial academics such as Montgomery, but it is perfectly appropriate for shareholders who have a Business Owner mindset.

The more OCF there is left over after making sure the business can operate competitively, the more that can be invested in the stuff that creates value for shareholders, namely organic growth and increased dividends.

It’s not a perfect measure – nothing is – but it’s a darn sight better than simply doing a quick sum based on accounting constructs of questionable reliability and concluding:

“Gee, WES’s ROE is only 8.8%, compared to WOW’s 25%, therefore WOW is a far superior business.”

Fact is, WES’s OCF-to-Capex ratio has averaged 4.7x over the past decade (4.4x since the Coles acquisition), compared to WOW’s 3.5x.

Further fact is that for WES, the proportion of EBITDA that converts to Free Cash Flow is 65%, compared to WOW’s 57% (somewhat disconcerting for WOW shareholders, myself included, the conversion rate has averaged just 51% over the past four years, but that will probably improve now that the property portfolio has been hived off).

So the reason WES is paying out “more” of its earnings as dividends compared to WOW, is because it simply can afford to do so.

Of the two, WES is the less capital-intensive business.

[Note: before I get a whole swathe of WOW shareholders baying for my blood, it warrants stressing that for both of these companies, these are impressive Capital Output - to - Capital Input metrics. It’s just that WES is the more impressive of the two. ]

So Roger Montgomery is arithmetically right: WES’s 8.8% ROE is woeful.

But he is wrong to stop there.

He needs to argue definitively that WES management is sure to lapse again in terms of acquisition discipline, and therefore 8.8% will be the ROE to perpetuity.

If not, he makes the mistake that many accounting purists make in believing all the reported financial statements are sacrosanct.

Income Statements and Balance Sheets can – and they do – tell lies.

But the Cash Flow Statement cannot but tell the truth.

And in WES’s case the truth confessed by the Cash Flows is a real ROE much, much better than 8.8%.

Yes, our financial academic’s software glitch that hilariously infers “looted” from “diluted” is a prescient one.

But the looting took place almost 5 years ago; it hasn’t recurred every year since.

Quite the opposite: the business has more than repaid all the loot since then.

And unless management loses the capital allocation plot again, the intrinsic value of the business will continue to go up, like it has for many years.

So remember: the next time you hear some seemingly smart folk bandying about the term "ROE", ask them if they wouldn't mind quailifying it.


The End.
Definitely.


Cam.