roe - on its own, it can mislead badly

Some time back a debate raged on the Wesfarmers stock forum concerning Return on Equity (ROE) as a qualification of investment grade.


The spectrum of opinion in that debate ranged from:

"It is a sacrosanct metric and given its paltry level for WES it indicates that WES is grossly overvalued."

through to:

"It's a mere accounting construct that needs to be qualified in order to be universally meaningful."


Being a staunch advocate for the latter camp, I at the time made a mental note to present a case study to demonstrate the perils of taking ROE (or any other financial measure derived from inputs derived from application of accounting practices) at face value.

I have finally gotten round to it.


The example company in question presented the following financial "attributes" (some seasoned readers might be able to guess the company's name...it will be disclosed later in the piece):

REVENUE:
Year 1: $391m
Year 2: $452m
Year 3: $833m
Year 4: $1,293m
Year 5: $1,945m
[Compound Average Annual Growth Rate = 49%!!]


NET PROFIT AFTER TAX:
Year 1: $97m
Year 2: $251m
Year 3: $407m
Year 4: $643m
Year 5: >$750m [Management Guidance]
[Compound Average Annual Growth Rate = 66%!!]


EPS:
Year 1: 42.7cps
Year 2: 74.2cps
Year 3: 116.2cps
Year 4: 174.5cps
Year 5: >$200cps [Management Guidance]
[Compound Average Annual Growth Rate = 45%!!]


ROE:
Year 1: 22.5%
Year 2: 28.8%
Year 3: 31.0%
Year 4: 32.4%
Year 5: >30% [Management Expectation]


Clearly, this appears to be an exceptional business, one that is able to grow its per share earnings at a prolific rate, while at the same time increasing its ROE – and not from some low starting base either, but from an already sensational level.



And in its latest published financial results, the commentary from management was unequivocally upbeat about how well the business was travelling:


“...met or exceeded all key financial metrics for (the past year)...”

“...well diversified origination activity...”

“...well positioned balance sheet including $1.7bn development pipeline to be developed in (the current year)and beyond.”

“...$5bn in committed uninvested capital, Group is well positioned to take advantage of opportunities in (the next two years).”

“...further growth in Group Net Profit forecast for (the next year).”

“....we have positioned ourselves well to take advantage of opportunities that may arise as a result of global capital markets dislocation. Based on prevailing market conditions and taking into account transactions already announced or completed, and the current run rate in recurring revenue growth, we currently expect a group Net Profit of at least $750m, representing in excess of 15% growth on the (past year’s) record result.”


In terms of Outlook, the view was equally exuberant:

“...while the environment remains very challenging and significant uncertainty still exists around the availability of capital from the financial markets, we are confident that our high-margin, low-risk model and financial strength positions us well for further growth in (the coming year) for a range of reasons including:


• We continue to be well-supported by our relationship banks...we will generate cash and available reserves approaching $1.5bn by the middle of (the current year).

• Given current market conditions and our anticipated balance sheet capacity, (we) may well use this opportunity to acquire shares through an on-market buy-back...

• Banks have demonstrably continued to support the Group...since the beginning of (the current year) the Group has obtained credit approved debt facilities for in excess of $12bn...a substantial number of these facilities have been secured on terms not materially more adverse than previous facilities and in some instances more favourable.”

• Based on Asset Under Management growth to date in (the current year), recurring revenue is expected to increase significantly in 2008.

• Our development pipeline has continued to expand and is expected to drive asset recycling activity in (the coming year)....we believe our development pipeline currently has significant embedded value not recognised by the market.

• We have already completed, or contracted, asset sales and advisory mandates...which will provide significant impetus to earnings growth in (the coming year).

• The XYZ division is positioned to significantly contribute to (current year) earnings. This division s well capitalised...

• The Group has approximately $4.4bn in uninvested equity in our infrastructure vehicles and continues to attract strong institutional capital inflows. We believe institutional investors have a desire to have their funds managed by a highly credentialed manager with a long and successful track record in originating and managing specialist assets

• A number of wholesale fund initiatives that commenced in (the past year)

• ...our North American business is well placed to deliver earnings growth in (the current year)...

• We continue to emphasise that our company is fundamentally different to that of the US investment banks...we have no material exposure to leveraged financial products which have resulted in the significant write-downs suffered across the global financial sector.

• Our (the current year) Group Net Profit forecast of at least $750m assumes that the current environment does not materially improve...it also assumes that all businesses will continue strongly to Net Revenue growth

These factors, in particular the demonstrated ongoing support of the debt market for our company, make us confident that we will have significant opportunity to perform in (the coming year)”


Such a business – with high (and increasing ROE) as well as strong organic profit growth - must surely be highly investment-worthy, right?

If your financial advisor or your stockbroker called you one day and said, “There’s this great quality business [with the financial attributes described above], and I’ve just been to a presentation by the CEO, and the outlook for the business is exceptional. You should buy the stock for your super fund,” you would certainly be tempted to do so.

But let's follow the sequence of events that unfolded in the subsequent weeks and months:


DAY 10 (following the last financial result):
A little over a week (that’s right, a mere week) after the mouth-wateringly bullish prognosis was proffered by the company’s management, the company is forced to make a seemingly innocuous announcement responding to “market rumours” about the levels of debt in some of its managed entities.

The official line from the CEO in this instance goes along the lines of: “These funds are, in the main, high yielding securities with strong, stable cash flows and enjoy the full support of their banking syndicates. We are comfortable with our (debt) positions...”


DAY 13:
Then, extraordinarily, despite the very recent “comfort with the debt positions” a mere three days later, the company announces that it had cleared all the loans held against marketable securities in the funds it managed.

This announcement concludes with the usual ebullience: “We confirm our (current year) Group Net Profit guidance of $750m, which represents 15% growth on the previous year.

We are well advanced in with our revenue generating activities and our normal asset recycling program and re-confirm that we are on track to generate cash and available reserves of $1.5bn by the middle of the current year. We believe this will place us in a strong position to take advantage of opportunities that may arise in the current market environment.”

In other words: everything is peachy.
30% ROE here we come again.


DAY 28:
However, a mere two weeks later, the company raises $220m in fresh equity capital (it has a $5.5bn market cap at this stage...but at its peak share price twelve months prior to that its market cap was around $15bn) and extends its debt facilities from $2.3bn to $2.8bn, and its banking syndicate from 20 to 25 banks.

Again, management remains extravagantly positive: “We are focused on ensuring that the company is well positioned with maximum flexibility to take advantage of opportunities that may arise in the current year and the following one.”

And again: “The underlying business continues to perform well and the Group remains on track to report a Net Profit of at least $750m.”


DAY 65: AGM Speeches
The share price, having fallen some 70% from their peak levels around 12 months earlier, and by 30% since the release just weeks earlier of the company’s most recent “exceptional” financial results warrants special comment from the chairman. “All of us at the company are very much aware that loyal shareholders have suffered material financial hardship as a result of this decline in the share price.” And this: “...it is as disappointing as can be that, despite sound underlying performances, the share price have come down in recent months as significantly as they have.”

However, shareholders need fear not, because “we remain absolutely confident in our basic business model, which is supported by strong global dynamics and prospects in all of our core business areas. Therefore, I am happy to reaffirm that (the company) remains on track to deliver Net Profit After Tax of at least $750m in the current year.”


DAY 80:
Ratings agency Standard & Poors slaps negative watch on the company.
No specific response from the company.


DAY 81:
Ratings agency Standard & Poors slaps negative watch on the company, due to market capitalisation threshold reasons (the company’s Market Capitalisation has fallen below $2.5bn).
No specific response from the company.

[For shareholders, it’s all a bit bizarre at this stage: how can this be happening to the wonderful business? After all, management hasn’t said anything other than everything is travelling swimmingly.]


DAY 90:
Company puts out a “Market Update” announcement in response to “certain incorrect and misleading commentary in relation to its debt facility”, confirming that “the market capitalisation clause in its corporate debt facility does not constitute and default or breach of covenant.”

Moreover, the CEO says, “We will move as quickly as possible to restore investor confidence in a decisive, yet orderly, manner.”

Also, “Our employees are strongly aligned and committed to the ongoing success of the company and we have received significant support from our partners globally who recognise the depth and expertise of (our) people and business. As always we will continue to update the market on the update for the business.”

[Except that they aren’t keeping the market updated at all... all reference to “NPAT of at least $750m” has been dropped]


DAY 120:
Presentation to major investor conference. Message is Business-as-Usual. Well, sort of.

“Company continues to work on multiple transactions in a variety of jurisdictions with several recently completed transactions and a solid pipeline.” Also, “...excellent continued support from the banking syndicate.”

But, importantly, guidance is reaffirmed, but this time with some seriously qualifying commentary: “Full-year guidance was re-confirmed at the AGM...but is subject to the resolution and impact of current discussions around our corporate debt facilities, market conditions, and outcomes of the asset sale program.”

[What?!?! But we all thought the banks were “excellent supporters” of the company. What discussions are having to take place around corporate debt facilities? After all, the company just raised equity a few months ago. Also, now the sale of assets are required in order to meet NPAT expectations?]


DAY 160:
NPAT Guidance update: “Interim Group NPAT is expected to be 25%-40% BELOW the $250m interim NPAT reported in the previous year.”

And: “...Fully-year earnings are now not expected to exceed the prior year’s Net Profit of $643m”

Explanation given: “...volatile global capital market conditions and uncertain business conditions...”

So, in a little over three months the profit outlook has deteriorated from “at least $750m” to “less than $643m”. That’s a 15% wipeout.
How is this possible given the supreme track record of the business, its high ROE, and management’s supreme confidence (until very recently, that is)?


DAY 180:
Interim Result announced.
NPAT down 30% (“at the more favourable end of the revised guidance range”)
Management restructured
Dividend cut
Major Strategic Review commissioned, with the objectives of:
- “focus resources and capital on sectors where the company has clear and proven competitive advantage”
- “reduce risk profile...consistent with this we will target a lower ROE of 15%-20%”
- “adopt a more disciplined approach to allocation of capital..”
- “enhance the alignment of interests between interests of shareholders, fund investors, and other stakeholders”

[Clearly not good!]

Hereafter, thing start accelerating down the slippery slope of bad news:

DAYS 180 to 240:
Several directors resign
New CFO is appointed
Ratings agencies withdraw ratings on the company
Stock price plummets, prompting two separate requests from the ASX for a response

Several asset sale announcements (reflecting, it has to be said, the company being a distressed seller)

Articulation of the outcome of the strategic review commenced earlier – involves splitting the business in two (share price continues to fall anyway)

Announcement of a potential strategic partner that might buy a strategic stake in the company (share price continues to fall anyway)


DAY 280:
Dramatic changes to banking facilities “in order to address the immediate funding requirements of the business” including immediate cash flow relief from converting all interest on the corporate facilities to a “Pay-If-You-Can” basis, and the suspension of all financial covenants.

[In other words, the company has now been placed on life support by its bankers.]


DAY 320:
Announcement relating to an update on full-year result: “....asset impairment charges will be such that the company will be in a substantial negative net asset position.”

And then, this shocker: “...the company is in discussions with its banking syndicate regarding a debt for equity swap or equivalent restructuring to stabilise the long term capital structure of the Group. Any debt for equity swap or similar arrangement will be designed to allow the company to continue operating its business and to sell assets with a view to lowering its overall levels of debt. Any such capital restructure is expected to significantly dilute existing shareholders, negatively impacting the value of equity.”


DAY 325:
Trading in the stock is suspended.


DAY 355:
Administrators are called in.


Ugh!

What a sorry saga.

That a company can go from being a perceived high-quality, sensational business with confirmed profit outlook, to insolvent, in the space of just 10 months, should be something about which I believe all individual investors should be made aware.

[Some readers might have guessed who the company is (or, at least, WAS): It was Babcock and Brown, the once market darling through which many mom and pop investors lost 100% of their capital]

Whenever anyone asks me, “Cam, can you teach me how to invest smartly and prudently”, I always tell them to do two things:

First, to read every Babcock and Brown announcement and presentation during 2008 and until its final demise in early 2009, especially taking note of the apparent profit profile, the bold profit "outlook" pronouncements, the apparently high “ROE”, and the positive tone and the effervescent “body language” offered by management commentary right throughout the process of the company’s decline.

Then, after that, as a juxtaposition, to study the cash flow statements published in each of the three Annual Reports published by the company during its short listed life, as well as the cash flow statement published in the half-year result during 2008 (this was the last official set of financial statements published by the company before going into administration).

This will give cash flow statements for four-and-a half years (the FY05 Annual Report would have financial statements for the FY04 year as well).


The reasons I point debutants to the equity market in this direction is, besides it providing an excellent example of why it is important not to take what management says at face value, but it also provides and excellent lesson in why P&Ls and Balance sheets can – and often do – completely misrepresent the underlying performance of the business - and especially why ROE is often a meaningless concept, and requires “scrubbing” and “sanitising” in order to establish its veracity - while the Cash Flow Statement never lies.


To save readers the trouble of accessing those Annual Reports in question, I’ll summarise the salient Cash Flow Statement elements below:

OPERATING CASH FLOW
2004: -$250m
2005: -$13m
2006: - $76m
2007: - $507m
1H08: - $236m

i.e., cumulative OCF over this period = MINUS $1.08bn (!!!!!)

INVESTING CASH FLOW
2004: $756m
2005: $2.14bn
2006: $4.42bn
2007: $4.71bn
1H08: $1.85bn

i.e., cumulative ICF over this period = $13.9bn (!!!!!)

SO BNB HAD A CUMULATIVE CAPITAL DEFICIT OVER THIS PERIOD THAT AMOUNTED TO OVER $15BN!!!!

And that had to be funded somehow.

As it turns out, the bulk of it took the form of increased borrowings (BNB raised a little over $1bn in equity capital during the period...and gave $150m of it back to shareholders in the form of dividends).

And the house of cards keep standing for as long as the banks were happy to keep pumping in the debt.

But when they stopped...all came crashing down in the spectacular fashion described herein.

And the lesson here....definitively and unequivocally...is for us an individual investors to not believe everything we read that is published by a company, an advisor or an “analyst”.

Because these same "specialists" were all loudly and in perfect harmony singing the praises of this “plus-30% ROE business”, right up until the very last days.

If they had only looked at just 10 numbers contained in a few cash flow statements, they would have seen that the ROE was all one big mirage.


Cash Flow Statement is king...ROE is a mere accounting construct, and it needs to be treated that way.

For here is one great example why it signalled BUY, when it should have signalled SELL.
The cash flow statement certainly did.


In the interests of prudent investing

Cam