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Are Australian CEOs asleep at the wheel?

Value.able | Comments (112)

Are Australian CEOs asleep at the wheel?

Have Australia’s lauded CEO’s earned a good reputation when it comes to the impact of their bigger-is-better ambitions on the shareholders for whom they work?

According to Richard Puntillo; “in theory, publicly traded corporations have shareholders as their kings, boards of directors as the sword-wielding knights who protect the shareholders and managers as the vassals who carry out orders. In practice, in the past decade, managers have become kings who lavish gold upon themselves, boards of directors have become fawning courtiers who take coin in return for an uncritical yes-man function and shareholders have become peasants whose property may be seized at management’s whim.”

When a listed company announces an acquisition, commerciality is often cited as the reason for failure to disclose the purchase price. But with Australia’s corporate graveyard littered with the writedowns of overpriced acquisitions past, it is about time companies treated their shareholders like kings.

I have long advocated the idea that companies should retain profits and reinvest them, provided they can achieve high rates of return on equity. The result? Much higher returns  – indeed returns that ultimately match the rate of return on equity being achieved by the company. But the rather worse-than-patchy record of Australian Merger & Acquisitions (M&A) in creating shareholder value, gives shareholders plenty of ammunition in their calls for companies to ‘hand the money back’.

Here’s a couple of examples…

Where, MQR: Montgomery Quality Rating; Value.able IV: Value.able Intrinsic Value; Today: Value.able Intrinsic Value as at today (5 May 2011); Ten Year IV Change: Ten year change in Value.able Intrinsic Value.

Foster’s

MQR: C5; Value.able IV 2001: $2.99;  Today: $3.50; Ten Year IV Change: 1.6%p.a.

Foster’s Share Price 2001 $5.71; Today: $5.51

Last week, Foster’s shareholders voted to spin off the company’s wine business. After buying Southcorp for $3.1 billion in 2005 (my valuation using the steps in Value.able was closer to $2.30 per share than the $4.17 Foster’s paid) Foster’s rejected a $2 billion private equity bid for its wine business, saying it “significantly undervalues” the Treasury Wine Estates.

When they bought Southcorp the execs were lyrical in their praise. Trevor O’Hoy said “The combination of our two great companies will create the world’s leading premium wine company”.

If you came to me to buy Southcorp in 2005, the year after it earned just $46 million in profit (the same profit as it earned ten years earlier by the way) and you wanted a margin of safety, I would advise that the right price to pay for Southcorp would be less than 65 cents. Try it yourself – plug 5% return on equity, $1.17 of equity per share and a payout ratio of just over 60 per cent into the Value.able formula. In 2005, when you came to me, the share price was $4.20 and using the price as a reference point, you would have thought I was crazy. The $3.5 billion in writedowns however since then, suggests it is the ‘too-cheap’ price for a copy of Value.able that is crazy!

PaperlinX

MQR: B2; Value.able IV 2001: $2.29; Today: $0.17; Ten Year IV Change: -23%p.a.

PaperlinX Share Price 2001: $4.93; Today: $0.28

On 9 September 2003, PaperlinX announced that it had purchased Buhrmann Paper for $1.1 billion. In June of that year Paperlinx’s share price was $3.77.

At the time, Ian Wightwick, Managing Director of PaperlinX said, “It is very pleasing that the hard work put in by our team undertaking due diligence has confirmed our initial view of the quality of Buhrmann’s Paper Merchanting Division business, its people and its assets. This business has great potential, and we are confident that the acquisition will deliver strong earnings per share growth for our shareholders.”

Ten days after the announcement the share price had shot up to $4.93. My Value.able Intrinsic Value estimation suggests it fell from $2.50 to $1.82! Nine hundred million was borrowed that calendar year and $150 million of capital was raised, to fund the acquisition.

For the year prior to the acquisition, PaperlinX earned $147 million. Since then profits have generally declined every year, and in 2009 PaperlinX lost $197 million and another $29 million in 2010. The share price has fallen from $4.93 to 28 cents today. Worse, there were 447.9 million shares on issue in 2003 and now there are almost 50% more.

AMP

MQR: A3;  Value.able IV 2001: $4.01; Today: $3.97; Ten Year IV Change: 0%p.a

AMP (adjusted) Share Price 2001: $13.90; Today: $5.29

AMP launched a cash and scrip bid for AXA Asia Pacific in late 2010. Under the deal with AXA’s French parent, AMP paid more than $4 billion for AXA Asia Pacific’s New Zealand and Australian businesses. The deal valued the entire AXA company at $13.3 billion, but the Value.able intrinsic value of AXA is significantly lower.

AMP bid about $5.40 per share. And just like Southcorp shareholders, AXA shareholders wanted a higher bid. Well of course they did, and as I have said previously, I would rather receive a few million more for my house too. But AXA’s performance doesn’t justify it.

AMP’s chief executive Craig Dunn said that the deal would create an effective competitor to the big four banks and makes AMP the biggest player in all segments of Australia’s $1.2 trillion wealth management sector with 20 per cent market share.

In a bout of déjà vu (reminiscent of PaperlinX), AMP’s shares rallied after the deal was announced.

According to analyst estimates at the time, AXA would generate a return on equity of about 13 percent over the next two years. With the exception of the 2008 loss, the return on equity for the last ten years has ranged between 6.8% in 1999 and 27% in 2003. Based on the forecast ROE and a payout ratio of between 61% and 67%, AXA’s 2010 equity of $2.58 per share is worth a little more than $3.00 per share. At the time of the bid, AXA’s shares traded at $5.84.

When Oxiana and Zinifex merged to form OZ Minerals, the market capitalisation of the two individually amounted to almost $10 billion. Today the merged entity has a market cap of $4.6 billion.

The above examples are not rare. With more space, we could go through many, many more.

Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors. CEOs in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. PaperlinX, Fairfax, Foster’s – the past list of companies and their CEOs that have overpaid for assets, driven down their returns on equity and made the Value.able value of intangible goodwill carried on the balance sheet look absurd, is long.

Nothing gets the blood racing more than a takeover and when blood leaves the head for other regions, common sense usually follows. You should be on your guard when your company announces an acquisition.

Posted by Roger Montgomery, author and fund manager, 3 May 2011.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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112 Comments

  3. garry
    :

    Off the track a little, but with interest rates a hot topic at present, it got me thinking.
    Its no wonder that cracks are appearing in the housing market, which are more like canyons here in queensland, and also some sectors of the business community, after the recent bout of rises. We here the reports that interest rates have moved up around 2% plus in the past 2 years (banks move). Official cash rate has moved from a low of 3% to now being 4.75%.You say thats not bad, only 1.75% and still at historically low levels.
    I wonder how the poor first home buyers feel, that had money thrown at them by the government and banks in 2008/2009, and were given honeymoon rates as low as 4.5%..By now they are back on the variable rate, and most are probably paying around 7.5%..This is an increase in mortgage payments or the interest banks are charging of over 60%. I wonder if most realised that a meager 1.75% increase in the cash rate would have had such a huge impact..I presume not.
    The same can be said for costs to business debt, although there rates were never as low. No wonder some sectors of the economy are showing significant weakness.
    Maybe when reported by the banks, the rate should be reported as what the actual increase is on top of what is already being charged..
    just a thought??

    • Steve I
      :

      Gary,
      They don’t source all their funding from the RBA so the cash rate should have no impact on advertised rates.
      On another note, I’m sure it’s all going to end well with regards to rising rates in a severely overleveraged housing market.

    • matt
      :

      I’ve always thought default rates as a future indicator. That this trend might b changing bears close watching.

  4. Andrew
    :

    Hi Roger,

    I think we have another example of what you talk about. I just had pop up on my news feeder at work about one of your homework examples RFG (Retail Food Group) launching a takeover of Oaks Hospitality of around $0.545 per share.

    With this blog fresh in my mind i thought out of curiosity i would calculate the target. I have not seen the details but calculated it quickly based on the 2010 annual report.The most optimistic calculation i can get is $0.24 a share meaning that Retail Food Group would be paying about twice as much as what it worth on my most optimistic calculation.

    Thats even ignoring the detail too that the company they are buying seems to be up to its eyeballs in debt as well. Is this a case of a B grade MQR company taking over a C grade?

    • Roger Montgomery
      :

      Its a C5 (ASX:OAK) and I don’t have a forecast for 2011 but I get 12 cents for 2010. RFG are a B3 (like Telstra) and I get a valuation in 2013 of $2.78 but there’s a few calcs to do to take into effect the terms of the acquisition and the acquisition itself.

  6. Andrew
    :

    Hi Roger,

    Just thinking, you have been in the game a while and probably have been to your fair share of AGM’s.

    Could there be an element of blame in shareholders. My thinking would be that there would be groups at certain companys who push for the board to make a takeover or aquisition to be more aggressive.

    I think you wrote about this in your book, but can’t remember off the top of my head, sorry.

    I think shareholders can sometimes be their own worse enemey by wanting the boards to make bad acquisiton activitys. If only people like Warren Buffet could be in charge of all companys, i remember when a berkshire shareholder wanted to try and pressure him to buy into a series of companys (tech related i think) his answer was to simply buy his stake from berkshire.

    I think other board members if confronted by shareholders wanting the company to take part in a takeover would think all their christmas presents have come at once.

    You should team up with a university and design a course “Bachelor of Capital Allocation” (you can major in sensible takeovers and aquisitions) and send it off to all CEO’s and senior managers.

  7. Ed M
    :

    Jim asked about thoughts on RIO and BHP takeover legacy. Alcan not good for RIO. And for BHP, Terry McCrann wrote a terrific article earlier this year about the BHP and Billiton merger. His analysis showed that of the huge profits BHP is making only about $800 million was attributable to the old Billiton. He argued the case that without this dilution, BHP would now be about an $80 share at present. As a long time BHP shareholder this was an OUCH moment.

  8. Graeme
    :

    Well my recent experience with this situation was with West Australian Newspapers (WAN) and their takeover of part of channel 7 and its debt. I bought WAN before I bought Value’able and to be honest it was doing quite well.

    Then I read Rogers book and realised it was over priced, so I thought I would just get the next set of dividends (which were not far away at all) and then sell. Then to my horror there was a trading halt, which secretly I was hoping that someone was buy WAN, not the other way around. But Stokes want to rearrange his bisnesses and and valued the WAN and & company at $5.30 nore than a dollar less then current share price. By then it was to late with the trading halt in place.

    As mentioned here before, the big boys don’t really care about the retail investors.

    • Ron shamgar
      :

      Graeme, my advice is if u decide to sell or buy a company – don’t wait – just do it!
      And always be sure ur happy with ur decisions. Don’t try to sell at the top or buy right at the bottom, as long as ur close enough and have followed the steps in valuable.
      Cheers

  9. Peter Wallace
    :

    anyone know how many shares are on issue for MCE -after the capital raising- finding it hard to find this info -does anyone know a good website that contains the kind of info you need to do roger’s valuations -i use annual reports from each company but require a bit of web surfing to get some of the other indicators
    cheers

    • Gavin
      :

      Go to ASX announcements (ASX site or via your broker etc) and look for Appendix 3B. A company is required to lodge a 3B every time they issue new shares.

      Latest for MCE = 76,514,098 on 11/4/11 following institutional placement.

      There will be another one once the retail allotments are made.

    • Greg Mc
      :

      G’day Peter,
      76,514,098 is the number of shares on issue after the capital raising but before the SPP is complete. Given the share price has been well below the SPP price for a week or two, it probably won’t get too many takers but you never know. The easiest way to find out the current number of shares on issue is to go to their announcements and find the most recent ‘Appendix 3B’.
      ooroo!
      Greg

    • Robert
      :

      Hi Peter,

      MSN money has all the information you need for a current valuation. Here is a link to MCE’s financials: (link to third part site removed)
      to use this for other Australian companies you must use the prefix ‘AU:’ before the company code in the “get quote” field.. e.g AU:MCE The data on this page however will probably not have an updated shares on issue figure.

      RobF

      • Roger Montgomery
        :

        Hi Robert, thanks for that. I have keep the references (so everyone can still find it) but had to remove the link as it relates to data that I cannot check for accuracy.

  11. Stuart
    :

    Ouch! Roger, that hurt. You brought back all that pain I thought I was over. I worked for Paperlinx from their start until they sold their manufacturing operations. The people behind these poor decisions are usually not the ones to suffer. CEO’s and Boards need to be more accountable. Paperlinx shares dropped 90% before some were finally called to account. His The leadership of some was a disaster over those 6-7 years. Your Richard Puntillo quote is right on the money for far too many companies. Our corportae regulators must lift their game.

  12. Robert Pearson
    :

    Buffett Step by Step: An investors workbook by Richard Simmons. Pitman publishers. 1999, which is
    not the same year (1998) or Publisher as the one quoted in Value.able contains a formula that allows me to know approximately how Roger obtained Table 11.2. (as Value.able said it would)
    Its not the detailed maths used to go from this formula to the table. This book suggests that the the Incremental Principle or ROE can be used. The IP being preferred when this make sense. Lots in the book about cases when it does not make sense. In my view after an aquisition this IP, particularly when compared to past ROE helps in understand the destruction of wealth (when IP does make sense, if not sensible still may help).

  13. Tim
    :

    Hi Graduates,

    Thoughts on ANG? I like the look of it!

    2011 IV $5.30
    2012 IV $6.21

    Not a huge MOS though!

    Cheers,

    Tim.

    • Tim
      :

      Another one I like and may have been discussed before is Medusa Mining (MML).
      No debt, good ROE and below IV!
      Others thoughts?
      Cheers,
      Tim.

    • Paul Rehill
      :

      Hi Tim

      For those that haven’t looked at Austin Engineering, it specialises in steel fabrication of mining dump truck bodies, excavator buckets, mineral processing equipment, tyre handles, service vehicles etc.

      ANG has a reasonable track record of successful acquisitions since its listing in March 2004 but I am unsure about the profitability of one or two of their most recent acquisitions such as Phillips Engineering (now Austin Engineering Hunter Valley) (normalised ROI of 5.2%) and maybe COR Cooling (normalised ROI of 15.7%). However, ANG have been very successful at taking fabrication products from past acquisitions to be produced at newly acquired sites (e.g. John’s Engineering and Cranes (JEC) products in 2004 and USA-based Western Technology Services Inc. (Westech) in the 2008FY). The acquisitions move ANG closer to its customers allowing it to reduce the freight costs associated with heavy dump truck bodies, excavator buckets etc.

      ANG’s ROE is around 27%-28%. Its net profit margin has risen from 3% to over 10%. This gain can be attributed to establishing fabrication facilities near customers, product sharing across facilities and higher throughput achieved through R & D investment in robotic and automated welding technology. In the 2005FY, ANG announced that it had appointed Dr Nasir Ahmed, who specialises in welding and advanced manufacturing. “Dr Ahmed has a worldwide reputation and brings considerable experience and credibility to the Company.” R & D costs seem low relative to revenue given their effect. The robotic welding technology allows ANG to employ more unskilled workers to help overcome labour shortages. For example:

      “Comalco awarded Austin a contract in May 2005 for the manufacture of 8000 anodes for the Boyne Island Smelter. This was the first contract received that enabled Austin to utilise its robotic welding technology. Normally, such a project would require 60 skilled and 25 unskilled personnel. The robotic technology led to only 32 unskilled personnel being needed.”

      Total debt/NPAT has risen to 2.5 times which should be watched although the $19m US denominated debt interest rate was 1.16% at 30 June 2010 so interest cover is respectable at the moment. Total debt at Dec 2010 was $53m so look out for future changes in debt.

      The Managing Director since listing, Michael Buckland, has had a contract extension and management remuneration doesn’t seem excessive. Management is continuing its strategy of establishing fabrication facilities close to mining operations around the world, more recently in Chile, Peru, Columbia and Indonesia

      The company’s dividend payout ratio policy is 25%-40% so you can calculate IV based on this.

      As always, do your own research and valuations but this gives you a broad background to investigate further.

  14. Ken
    :

    One of the most annoying “takeovers by stealth” is the way in which FGE have almost gifted large chunks of the company to CLO. Originally, it was stated that FGE would benefit from joint ventures with CLO, but to date this has not produced anything, and now they are letting CLO dictate the composition of their board.

    One of the problems with owner/operators having large shareholdings is that they can enter into deals such as this which disadvantage retail shareholders who have no recourse.

    I am not sure that CLO have done such a great job of running their own company, that they should now be telling FGE how to run theirs. No doubt they will end up owning all of it before long, and I doubt the FGE shareholders are going to benefit when it happens.

  15. John G
    :

    Roger,
    How can you forget the blunder that MCE is doing, raising $40 million to build a corporate office rather than repaying debt or expansion. With their plans to be listed on NYSE your A1 looks very risky to me.
    Or as you have rightly said the CEO has been publicly caught asleep at wheels, with Yes men in board and yes for profit managers.
    My view is that all our valuable community friends should rethink about this one and closely watch it.

    • Peter M (Mully)
      :

      Your statement that MCE is “raising $40 million to build a corporate office” is factually incorrect. According to the lead manager of the capital raising (Austock), part of the capital raising will be used to fund stage 2 of the Henderson expansion with the new office block, the first building, costing $5 million. Further product development is likely to consume the bulk of the funds and be part of stage 2. The funds will also be used for the ramp up of the Henderson plant.

      Unless i’ve missed something, I don’t recall Roger ( or anyone else) suggesting that the CEO of MCE has been publicly caught asleep at the wheel. Rest assured, i watch all of my investments very closely with this one being the least of my concerns at the moment.

    • Nick Mason
      :

      Hi John,

      I know of no other company on the ASX which has such promising immediate and long term prospects as MCE .

      The money Matrix raised is going to be put towards Henderson stage 2, capital expenditure relating to new products and the expansion of overseas facilities enabling the company to fully realise these incredible near and long term opportunities.

      In my opinion the only blunder was that Matrix payed a dividend when it could have preserved this capital to put to use in the before mentioned activities.

      The current stock price depression will be temporary and in the years ahead I have no doubt shareholders in this wonderful business will be richly rewarded.

      • Ash Little
        :

        Hey Nick & Mully,

        Nice Work

        But my view is I would very much like the nay sayers to talk the stock down. Let them go at it.

        Might give us a bigger MOS next time we buy

      • Ash Little
        :

        Hi Ken

        No labels here.

        Very happy to have people to disagree with me

        That’s what makes the market

    • Ken
      :

      John,

      I don’t think it is all being spent on an office block. Their announcement said it would be used for “..the construction of new headquarters,capital expenditure relating to new product developments, expansion of overseas facilities and general corporate purposes”.
      Some of it will be spent on the office block but just how much is a mystery. It’s not unreasonable for them to do this, by the way, because I presume they will move their entire operation to Henderson somewhere down the track and they will obviously need office space when they do.

    • Adam
      :

      John, raising capital to pay off debt can often be one of the most value destrying things a company can do. (I think this was also covered in Roger’s book.) This is because the return on equity of the capital raising will be equal to that of the interest rate of the debt – i.e. very low compared to MCE circa 50% ROE.

  16. Ann
    :

    Great article, what do you think FMG is worth at the moment.

    Given the Chinese want to buy steel making minerals, I think there could be a play in 2011.

    • Steve I
      :

      Based on consensus forecasts, I have 2011 at $17.44 rising to 2012 at $19.08 which would represent a significant MOS.

      However, this assumed that current EPS increases 3x to 2011 and 4x to 2012 and is sustainable. I think the sustainability is the issue.

      The lower estimates (assuming relevant), would result in $6.88 in 2011 and $13.31 in 2012. Current ROE is 39% and average forecast eps expects ROE to sustain between 60-80%. I’m doubtful this is a sustainable number for a commodity which is as common as iron ore and I personally think that increasing supply will reduce iron ore prices. I don’t know when, but it seems to be happening in the next few years. At what point does this expectation factor in to forecast eps and share prices?

      I personally think that FMG is probably around fair price. Yes there is upside if you don’t think about the issues that exist. There is also significant downside if margins are compressed. It’s not a space that I find attractive to invest in.

  17. Sean
    :

    Roger

    Not investing related; but the photo accompanying this post is an absolute gem! My sister gave birth recently and the little bundles certainly put in perspective a lot of the things we worry about and do.

    Cheers

  18. Daksha
    :

    Roger,

    As usual another great article. There is so much information on the blog it is hard to keep up, not complaining it is really an appreciation for your efforts including your team and all value able graduates.

    I have recently subscribed to Eureka report just to read your articles, I am glad that I paid the subscription, Eureka report has so much material on not only shares but SMSF etc.

    I found the Value Line – Divorce article between Fosters and South Corp very informative. Roger you really have a gift of the words not only writing but speaking as well it looks like words comes to you so naturally one just to watch you on sky business channel.

    You analysis complex business stories in simple and easy to understand to pass the message across to so many people in a step by step process. Looking forward to reading more articles and publications in future and of course holiday homework from you every now and then.

    I did not send my results to you but you would be pleased to know that I was not to far out from your calculations. I would also like to thank all fellow value able graduates for putting so many value able comments.

    What you think of McMillan S MMS take over of Interleasing. Thoughts on the above topic from fellow value able graduates most welcome

    cheers
    Daksha

    • Ken
      :

      The majority of MMS debt is related to the vehicle leasing business, and is effectively their operating funding – they are a finance company after all, and with no recourse to the holding company.
      Further, the level of default on corporate vehicle leases is extremely low so it is a fairly low risk. Finally, the debt incurred by the holding company will be paid out in 2012.

      I personally avoid any company with debt to equity higher than 30%, but MMS is an exception to that rule.

      • Gavin
        :

        It’s interesting to contrast MMS to TSM.

        TSM’s operating financing is through a third party so funding is off balance sheet yet they still carry a lot of the liability for any defaults and need to post funding deposits. I much prefer the transparency of MMS with the operating funding on the balance sheet, yet TSM gets an A1 and MMS a B3. Go figure!

      • Ash Little
        :

        Plus the budget changes re FBT regarding cars will have a big effect on MMS in my view.

        Lots of people just lost a big salary packaging advantage.

        That said I have only seen a summary of the budget at this stage so I will wait and see.

        Personally I have always found it difficult investing in a business that is entirely tied to government legislation

      • Roger Montgomery
        :

        A quick analysis of the budget impact, as Ash suggests, is worthwhile immediately.

        Back in September I wrote:
        “Hi Tim,

        I have met with the CEO of MMS recently and they are most definitely the guys to pull it off. The synergies are genuine and they are already proving the acquisition of the operating leasing business was a smart move. Interestingly, even after my meeting, the best valuation I can get is $6.68. I have sent an email to the broker that invited me to the meeting with the company requesting their modeling so I can see whether my estimates are too conservative.” Submitted on 2010/09/21 at 7:58pm

        The valuation subsequently rose and is currently $7.22 (share price has been above that level since December but future valuations were rising). In the absence of any downgrades, the value will rise to $8.29 next year. Its now trading above even my current 2013 valuation. As you know however the valuations change and are likely to in the short term so stay tuned.

      • Gavin
        :

        The 20% flat statutory rate was officially “leaked” about a week ago.

        It’s a good reform because it takes away the incentive to travel extra distance to gain a greater tax advantage.

        I wouldn’t expect the impact on MMS to be too great tomorrow – but you can always hope. The news was already out and there is probably as many people in MMS potential customer base that would be positively affected (travel under 15,000 km) as those that will be disadvantaged (travel greater than 25000 km) by the new flat rate.

      • Roger Montgomery
        :

        Hi Gavin,

        I may have deleted in error. See below.

        I made the following comments earlier this evening.

        I am noticing a few poster’s comments have been directed at an individual rather than staying ‘on topic’. If any of you are wondering why your post has not been published, it is because that comment contained something that was offensive to another. As I don’t have the time to edit comments, I will simply delete them. So please play the ball, not the (wo)man
        If on the other hand you believe there was nothing offensive and your comment was deleted in error – it is entirely possible – then simply repost.

      • Jeff Burnett
        :

        Hello Roger

        I am a little confused. In the Easter Homework results you have MMS 2011 IV as $12.64, more than double the 2010 IV of $6.27.
        Then, in your blog entry dated 10/5/11 posted at 11.34pm, you state that the valuation currently is $7.22, rising to $8.29 next year(2012 I presume).

        Are the large variances a result of using a 10% RR for the homework but you assigning a higher RR for the $7.22 valuation?

        Like Ken, I do not like holding companies with more than 30% debt to equity, but MMS is a closely watched exception.

        Your ardent admirer and C pass graduate.

        Jeff Burnett

  19. Gale
    :

    Steve,

    I think you have put your finger on it – company executives (and boards for that matter) do not have “respect” for capital. Maybe its because they are not really capitalists themselves. They forget that they are the shareholders’ employees; but the problem is that they get to set their own salaries!

  20. John R
    :

    Roger,
    Excellent blog, agree with you entirely. When I worked in a major multi national there was immense pressure for deals to be completed whatever the cost! Have a few AMP which was considering disposing of – you have galvanised me to action. Thanks.

  21. Andrew
    :

    This post makes me think of one of my previous follys. When Crown was spun off from PBL they had a big warchest of cash. They then went buying casino’s all over the place most of which were written down to zero not long after and one “investment” they are still locked in after obviously overpaying.

    I think anyone who wants to find a church for bad decision making can go to Las Vegas Boulevard and worship outside the Fountainebleu Hotel and Casino which is a 67 odd story glassed shell of a building. It sits above most other buildings on the strip but was never finished. Crown owned 20% of it.

    Looking at this building and knowing what was spent on it as well as Rogers examples and others, you can’t help but question management decisions for ASX listed companys and whether they were truly done for shareholders benefit.

    • Scott T
      :

      After I finished reading Value.Able for the first time, the very next day I sold all my Crown Shares.

      All the best

      Scott T

  22. Ash Little
    :

    Suncorp’s takeover of promina has to be fairly high up in wealth destroying transactions as well

    • David King
      :

      At the risk of starting a frenzy of reporting other examples of overpaying, what about Rio’s acquisition of Alcan?

    • Chris
      :

      Depends on whether you are the hunter or the hunted. Overpaying for an acquisition is okay if and when you are the one selling it !

  23. Michael
    :

    To clarify the discussion on the accounting treatment of goodwill – when a company acquires a business for a price higher than the value of the tangible assets, the difference is not automatically called goodwill. The rules described in the previous post are the rules that applied prior to 2005.

    A company under todays rules must identify what the intangible assets are that it has acquired. It These may include patent and trademarks, customer contracts and customer relationships. A valuation on any of these identifiable intangibles must then be made. Only once this exercise is complete, and there remains an excess from the comparison of the purchase price and the assets identified is goodwill created. Some eg MMS may determine that they got a bargain, in which case they book a gain immediately.

    When the new rules came in, a company could choose to either restate prior acquisitions, or carry forward the accounting from under the prior rules. So you will see a variety of treatments.

    Goodwill is not amortised, but is tested for impairment annually based on modelling of expected cashflows. Where a write-down is required, these will often be called ‘abnormal’, or ‘non-recurring’.

    Some have suggested that intangibles have no value, but may be surprised to know that if that were the case that they should probably go and sell all of their stocks as soon as possible. Your valuation of a stock could end after your have calculated the equity per share.

    For example, the net assets of MCE are around $85m. At the current share price, the company is valued at in excess of $600m. The intangibles that the market is factoring into the share price are not on the balance sheet, but based on expected earnings of the company in the future.

    • Sean
      :

      Hey Michael

      The idea of the post was to put in the simplist terms the treatment of goodwill/intangible assets for non-accountants; not necessarily to quote verbatim international or Australian accounting standards and treatments. I really like to follow the KISS principle.

      Fosters write downs have probably been called abnormal & non-recurring but it has been said here before that if it happens more than once; it’s normal!

      The gist of the post was that if the intangibles in a balance sheet are not readily quantifiable; further review of their worth is necessary.

      As Roger states in his book; the “invention” of goodwill shows that accountants are very creative indeed for supposed left -brainers; even though it is just an end result of the fact that we must make debits equal credits.

      Cheers.

      • Michael
        :

        Thanks Sean. The abnormal/non-recurring theme is very topical for me at the moment. ASIC have put some draft guidelines out re the reporting of abnormal items that are due to come in from 30 June 2011 with the aim of creating some consistency in this area. Companies often like to think bad news is abnormal and good news is normal.

        An analyst from Merrill Lynch related a story recently of a company that lost a contract with a major customer. As a result profits were down significantly from the prior year. In their calculation of the underlying profit however, they restated the prior year numbers to exclude the significant customer – and the underlying profit was now up on the prior year!

      • Roger Montgomery
        :

        When you look at, say the 2010 annual report you invariably have, 2010 and 2009 results included. Its always worth looking at the 2009 annual report to check the two 2009 results are identical.

      • Andrew
        :

        Hi Roger, i have seen this (can’t remember what company). Can you just help me out as to what this might indicate?

        Would this indicate that profits were revised downwards due to a write off that they didn’t take into account in the annual report or have they just went down to their local bank account and realised that they didn’t have as much as they thought they did?

        As a non-accountant sometimes i have trouble udnerstanding aspects of this.

    • Joab Soh
      :

      Michael,

      Thank for the post. It’s good to have clarifications and different views, that’s what make this blog interesting.

      Broadly, I believe the accounting rules are working well. But the key limitation comes from the concept of fair value. That is, Fair value = price exchanged between two willing parties. As I always tell my staff, if I am willing to pay $10 for a pencil you own (which cost you $1) and you are willing to sell it. The pencil is worth $10 in accounting. I am sure you are well informed that the standard setters are looking at it, but I can tell you, it has taken ages before accountants (including myself) accept the concept of Day 1 gains/losses.

      Back to the acquisition rules, I still believe that are limitations from the current rules you have described, namely:
      1) Impairment testing based on discounted cash flow model: DCF models are not full proof. Slight change in assumptions can change the result very easily. If you are an auditor, can you really question your client if they project sales growth to be 20% instead of 10%?

      2) Intangibles do have value. In fact, there’s alot of value in them. But the method to assessing its value is challenging. The fair value ‘true up’ exercise at acquisitions is ultimately an accounting exercise. If management paid $100m for a business, I don’t see much difference is you call the premium paid goodwill or intangible. Plus, pardon my ignorance but how do you put a price tag on customer relationships as an intangible asset?

      I fully concur with you that we should be looking at expected earnings on the company, rather than what’s actually recognised on the balance sheet. As Roger has suggested some time ago, I believe a more elegant exercise is to look at the ROE post acquisitions to determine whether value was really created as a result of acquisitions. So if a company’s ROE decreases post acquisition, and you see there’s alot of goodwill and intangible on balance sheet, you know something is wrong.

      And to reiterate my point, the world is full of structures and transactions driven by accounting, tax, legal and other rules. There’s nothing wrong with it except that as investors, we want to avoid businesses whereby management are kings and shareholders are peasants.

      • Michael
        :

        Thanks Joab.

        As an auditor, you definitely would question sales growth estimates, but it is difficult to prove the company wrong, and as you say changes in assumptions can have a big impact on your DCF model. In my experience, it is fair to say that for many entities that have made poor acquisitions, the acquired goodwill/intangibles are worthless long before the company confesses that they are and takes an impairment charge. Management will remain optimistic of turning poor performers into good performers. However, you will pick up that assets are overvalued by seeing declining profits/returns on equity, so the lack of taking this charge should not cause too much of an issue.

        The difference to take into account when the purchase accounting is performed is that for identifiable intangibles that have a defined useful life – these are amortised as an expense in the profit and loss, while goodwill is not amortised. For example if I bought Vocus I might treat the contract with Vodaphone as an intangible asset, put a value on it and amortise it over the contract period. This creates an expense each year of the contract, but if I just call it goodwill there is no such expense.

        Valuation is subjective for intangibles – if it was straight forward, stock prices would probably behave in a more rational manner, and provide value investors with less opportunities. However when an acquisition is made, in comes a specialist valuer who can place a value on anything. Methods include DCF, present value of expected cost savings, comparable sales data – the accounting rules don’t specify the valuation method to be used. Are these valuations accurate – who really knows? Only hindsight will can provide a definitive answer.

        I agree that the world is full of structuring and rules. Accounting knowledge does not guarantee success in investing, but it does help. I can give an example of this. If we assume an entity has a US subsidiary that has say US$100m in cash at the start of the year when the rate was 0.85 (AUD$118m). Assume no movement in the cash amount, but the FX rate has moved to 1.10 at year end. The cash is now in AUD terms worth $91m. So do I book a loss of $27m? No, it goes through a reserve called the foreign currency translation reserve. It also helps to boost the return on equity!

        Morale to all this – your valuations are an estimate!

      • Roger Montgomery
        :

        Its easy to back out changes to reserves if you want to. I tend to take the view that currencies go up and down over time and its a part of business life.

      • Michael
        :

        Agree you can make these adjustments, which I do take into account. I would be interested to know though from the non-accountants if the rules described make sense to them and they would know what the issue is, and the adjustments they need to consider making. This is just one example, but there are others.

        Another example may be – under the Accounting Standards, you can change your presentation currency. So if you have a significant US subsidiary, when you retranslate your subsidiary into AUD, your profit is less when the AUD/USD FX rate is rising. The reported profit is less favourable than the prior year. Analysts have started downgrading price targets for this very reason for some companies.

        The company may however decide that it should be reporting in US dollars. Using the same information, there is now no decline in performance when measured in USD. I know this is being considered by some listed entities. I won’t risk boring everyone with more accounting talk with more examples.

        I read the financial report from cover to cover before making an investment, and recommend the same to anyone. I think accounting knowledge is key in value investing and encourage anyone to learn more if you are not from an accounting background.

        This is not to say that I think the valuation methodology is flawed – I am more concerned with whether the company is as good a company as it would appear at first glance and whether I see any red flags.

      • Roger Montgomery
        :

        Hi Michael,

        You can run all the numbers through in US dollar and you will get a USD valuation. You then have to translate it into Aud. You will end up with a similar result, if not the same.

      • Ken
        :

        In his excellent book The Numbers Game, Trevor Sykes had this to say about intangibles.

        Ask yourself who would buy the asset and for how much. If the answer is nobody and nothing, then you have your valuation.

        Also this;If it doesn’t earn profits this year and won’t next year, it is’nt an asset, whether tangible or intangible.

        And finally ; Friendly takeovers may not be friendly for shareholders.

      • Roger Montgomery
        :

        Yes, sentiments that many have mentioned and discussed here at the blog for some time. Also see page 90 and 91 of Value.able! Back to return on equity.

  24. Joab Soh
    :

    Another good post. With this and recent interest on Goodwill, I did a little research on accounting for acquisitions.

    In accounting (at least until 2-3 years ago), companies were allowed to capitalise costs in connection with the acquisition. This means that payments to lawyers, investment bankers, accountants, valuers and anyone involved in the acquisition are capitalised as an asset and ultimately included in goodwill. Additionally, if management can prove that incremental costs are incurred internally (e.g. setting up a M&A team for the sole purpose of one acquisition), there’s a chance that it is capitalised too. (That said, these rules were recently changed 2 years ago).

    Another area is intangible asset. When management buys another company, it gets a “once in a lifetime” chance to recognise intangible assets internally created by that company when it pays too much for the business. I am not referring to trademarks and patents here. Instead, items such as customer lists, database, production backlogs can be recognised as intangible assets. To the accountants defense, the rule is an attempt to explain why companies pay too much for an acquisition. So rather than having a one big item called goodwill, goodwill is being broken down into smaller intangible assets. But what accountants didn’t do is to acknowledge that when price paid is significantly higher its value, there is no asset.

    The point of my comments is not too highlight the limitation of accounting rules but to reinforce the idea that as “Managers have become kings”, there’s a long queue of advisors wanting to gain the kings’ favour (and their gold) by showing the kings what they can do.

    • Gavin
      :

      A question about competitive advantage needs to be answered before you can deal with goodwill from an investor’s perspective.

      If the business has no competitive advantage then any extraordinary return it may make will soon be competed away. This sort of company’s value to an investor is the REPLACMENT COST of the companies TANGIBLE assets.

      If the company has a sustainable competitive advantage then a company can make extra-ordinary returns and should be valued on its earnings power.

      If the competitive advantage diminishes over time then the value is a time proportioned combination of the above two.

      The accounting treatment of the balance sheet neither values assets at their replacement cost nor necessarily carries goodwill at its earnings power value. – An investor needs to judge these values for themselves – that’s our job in the scheme of things – It might be a bit tricky but it pays damn well if your judgement is good – so we shouldn’t complain too much about accounting standards.

  25. Jim
    :

    Hi Roger

    Another thought-what do you think of BHP and RIO’s history of M&A in the last decade?

    Cheers
    Jim

  26. Jim
    :

    Hi Roger
    Love and hate this posting. Love it because of all I’ve learnt. Hate it for bringing back painful memories (Oxiana & Zinifex-I owned both!). OK ,hate is a bit strong but “Oh, the pain,the pain…”

    Glad I sold Fosters some years ago in, believe or not, a share buyback. What they didn’t buyback, I sold almost immediately after for more than their share price today.

    I’m puzzled how PPX rates as a B2, not a C4 or 5. Appreciate your thoughts

    Cheers
    Jim

    • Scott W
      :

      Jim I am also one of the bruised shareholders from the marriage that created Oxiana. What hurts me is how the man running the worse of the 2 businesses at the time was then given the reins, then within a short period and following official releases to the market that the combined company was a great financial shape the new CEO shortly (a few months later only) released news that the company was in deep debt trouble and needed to sell asset at a fire sale price.
      I was at the AGM following where the shareholders ripped into him for what should have been prosecuted as fraud and he resigned to take the helm at the Chinese Government Owned business who he sold our assets to for well below value. At the current time the market would have poured in the capital to keep the massive pool of mines developing around the world. But No, he and other had done the deal to give themselves ongoing rivers of the gold they had been extracting as a pioneer of the Laos region…

      Without Zinifex I sometimes still wonder how great Oxiana could be at this stage, sure the CEO was a great salesman but these companies need that to keep the ability to develop through lower cost finance flowing.

      The new CEO was certainly a great example of ‘asleep at the wheel’

  27. Ryan Murray
    :

    Another great article, Have just finshed the book, and after being an investor for about 12 years now, starting with property and migrating to shares about 5 years ago. I have been reading and studying different types and styles of investing for awhile. Am mostly agreeing with Value investing ( Buffet Style ) this book is my light bulb moment . It makes perfect sense to me and suits my style and temprement. Fantastic read, will share it with others that are interested .

    Working out the IV of something before buying is so obvious and basic, I can only wonder what I was thinking when buying some of the stuff I have over the years.

    Anyway to my question of how to work out the IV of a property ? Not using the market price of stocks when valuing them is obvious. But how do I work out the equity ( and hence the IV) i have in a property without using the market price. So I can work ROE? . I can then work out if there better opportunities are out there

    Is the equity the difference between what I paid for it and the debt
    ? or the current maket price? or something else. This has been vexing me over the last few days..

    anyone with some ideas?

    Thanks

    • Matthew R
      :

      Welcome Ryan! This blog is a great resource, look forward to more posts from you

      Property equity = price paid – mortgage

      • Ash Little
        :

        Yes Ryan as usual Matt is correct

        Don’t cut your wrists when you calcualte the IV of property.

        You will get a shock though I think

      • Ryan
        :

        Yeah, it is a fair bit dissapointing, even on one place I’ve had for 15 years, ( after 15years the ROE is appraoching 5%, that’s a long time to wait for that sort of return!! )

        But at least it’s nice to know what I have, to work out future plans…

        thanks

    • Paul Rehill
      :

      Hi Ryan

      Assume the property is debt free, then value it as the present value of net rental income after-tax. That is:

      IV= (After-tax net rental income) / (RR – g)

      RR=Required rate of return (by you)
      g=Annual expected growth in after-tax net rental income from increasing rent

      If you substitute price for IV and do a bit of algebra, then:
      Expected future return (was RR) = Rental yield + g

      • Ash Little
        :

        Hi Guys

        Very true Paul

        This is just my view but if G is higher than the average growth in wages then as Dale Kerrigan says.

        You’re Dreaming

      • Gavin
        :

        Rent to Income Ratio is currently historically high and as such there is a risk of it reverting to the mean.

        Rental yields need to economical returns that allow for the upkeep of the building. It seems to me a lot of rental yields are enhanced by skimping on maintenance in the short term and this is really just converting capital into current yield.

        Paul’s formula assumes a perpetual growth rate and so Ashley’s comment on sustainable growth not being above wage growth is spot on in my view.

        Putting together current low economic yields a stretched rent to income ratio and a realistic growth assumption and House prices look expensive to me. (Expensive enough to pose an economic risk even if you are not overexposed directly)

      • Ash Little
        :

        Yes very right Gavin,

        Al that said I just written a hypthetical to a friend on how over an 10 year period you can still make very good money in property if we have high inflation even if propery prices don’t increases with inflation. It’s call leverage and my forward assuntions suprised me.

        Down side is a major correction which I think is unlikely(Steve I Please don’t bash me too much lol)

      • Roger Montgomery
        :

        I am noticing a few poster’s comments have been directed at another individual rather than staying ‘on topic’. If any of you are wondering why your post has not been published, it is because that comment contained something that was offensive to another. As I don’t have the time to edit comments, I will simply delete them. If on the other hand you believe there was nothing offensive and your comment was deleted in error – it is entirely possible – then simply repost.

      • Gavin
        :

        Hmmm

        Buying something that’s overpriced and using leverage to make the the numbers work.?????

      • Paul Rehill
        :

        Hi Ash and Gavin

        Spot on with a fair growth rate. The long-term nominal wage growth rate would be the one to use as opposed to real wage growth which I think is quoted most.

  28. Steve I
    :

    I think that there has been a sustained period of cheap capital to the point whereby capital is taken for granted. Shareholders are not given appropriate respect as a result.

    Takeovers and acquisitions are justified as ‘earnings accretive in year X’ without any required rate of return on that capital. It’s almost as if any return on capital is acceptable and that the rate is not considered important because there is always more capital available.

  29. Bruno
    :

    Great article Roger, and very true! I watched an interview on Insiders a few months ago with the CEO of wesfarmers, after the aquisition of coles. I watched him squirm and dodge questions and then eventually admit that the ROE was, and would remain very low for quite some time because of the price they paid for coles. I wish I could ask every CEO questions before I purchased shares in the company they run, Many times an interview or a speech given by a CEO can tell you alot more than the numbers on the balance sheets.
    There is also another side to your story as well, with CEO’s basically giving companies away through take over offers. For example, Forge group selling shares to Clough at a ridiculous price and ITX’s take over late last year.
    An A1 CEO is very hard to find, esspecially one who has an A1 team behind him/her.

  30. David Press
    :

    Quality blog Roger.

    A few more spring to mind…but none more so than Photon Group (PGA).

    Thankfully there are a few companies that do M&A quite well. QBE being one of my favourites. I’m interested in your thoughts on Hansen Technologies (HSN). They have a strong balance sheet, good ROE and have made some small acquisitions recently and are on the lookout for more in the future.

    Dave

  31. darrin
    :

    HI Roger

    What would your MQR and 2011 IV be for ESV?

    I am having trouble sourcing the necessary data to make calculation.

    THankyou

    cheers

    darrin

    • Andrew
      :

      Hi Darrin,

      Not sure about 2011 but for 2010 the IV would be $0.00. Had a quick look and in the first half of 2011 they actually made a loss on their operating cashflow. i.e the cash brought in from their everyday operations was less than the money going out.

      It appears that most of the surplus cash and the sole cause of their profit for the half year was the sale of assets. In fact if it weren’t for this sale than i would say that they would have posted a loss.

      Assuming that this is likely to be the case at the end of financial year i will again sign it a $0.00 IV as they won’t be able to keep selling assets forever.

      I am not convinced that this company will return a profit through operations for a while yet (if ever) and they are constantly paying more cash out then they are bringing in through their operations. This isn’t sustainable.

      Gets a big “NN2V” for me. There is no need to value it, a really quick look at the financials make me give it a miss. I could be wrong and this isn’t advice just my point of view.

      Also i don’t necessarily understand the what it is they do, just thought i would exercise my investing muscles and have a look at a random financial report to see what i find.

      • darrin
        :

        Hi Andrew

        Thankyou for your post. My IV for 2010 and 2011 was 0 as well.

        I am staying well away from that one. Browsing through there financials again brought up a few red flags.

        cheers

        darrin

      • Ron shamgar
        :

        The only point I may add, is that the MD is a very clever guy who has a track record of building IT businesses and selling them to the big boys!

      • darrin
        :

        HI Ron

        Hypothetically if you were to buy ESV what price would you wait to buy in at?

        cheers

        darrin

      • Andrew
        :

        Hi Darrin,

        There are two parts to the process one is to find quality businesses and the other is to buy those businesses at a discount to intrinsic value.

        My thoughts are that ESV do not fall into the quality business tags so I would be better off spending time elsewhere.

        Also, it is impossible to buy a company at a discount if its intrinsic value is $0.00.

      • Ron shamgar
        :

        I agree Andrew but it’s value is not zero!
        It’s currently a cash box with approx 100mil from memory. They will give back shareholders some of that but it’s value is definitely not zero.
        Cheers

  32. ben
    :

    Do you think there is value in the fosters demerger? As standalone business with a focus on core activities..

    • Andrew
      :

      It might help it in the future being able to focus on beer which is their core activity but i think (and i am no expert) that any value to come out of it will take a long time to show. I think the damage has already been done.

      I hear a lot about how splitting the businesses will make it more attractive and have analysts providing better forecasts leading to more people being confident enough to buy into the shares however i think this does not neccessarily happen.

      Mainly i think it is a form of admission that their growth strategy was flawed to begin with and not necessarily in the shareholders best interest.

      I think there is an expectation that it will make Fosters be more attractive as a takeover target but who knows what will happen there.

      Like i said their could be value but i think most of the damage has been done and it will take a while for it the mistake to be corrected.

      • ron shamgar
        :

        in my opinion the only value in holding this business is in its potential to be taken over sooner rather than later.

      • David Martin
        :

        I paid $4.78 per share in 1998 – I held on to them for a while and they did not even give share holders discounts!

        When they bought Southcorp not only did they destroy shareholder wealth but they ruined an otherwise good brand – penfolds!

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