Decisions by the numbers

SHARE   |   Sunday, 06 July 2014   |   By Othusitse Tlhobogang
Decisions by the numbers

SHARE selection can be a complex, if not bewildering, process. But it can be aided by applying the cold reality of performance metrics, of which the most fundamental is return on equity (RoE).
For good reason RoE is often termed the “mother of all ratios”. RoE — headline profit as a percent of average shareholders’ funds in a financial year — reveals a great deal about how effectively shareholders’ funds are being used to generate returns.

“We pay a lot of attention to RoE,” says Evan Walker of 36One Asset Management. “It plays a crucial role in determining a company’s rating over time.” As a general rule, a company with a high RoE will command a higher PE rating than a company with a low RoE. Quite simply, the high RoE company is generating a higher profit from a given amount of shareholders’ funds. As an example, a company with a 10% RoE on shareholders’ funds of R100m will produce a net profit of R10m while a company with a 20% RoE on R100m shareholders’ funds will produce a R20m net profit. The company with the higher RoE is clearly doing a better job for shareholders and is far better positioned to generate growth from its own resources and/or pay a higher proportion of profit in dividends.


For super-investor Warren Buffett, RoE has always been a key consideration, with his company picks having above-average RoEs. In SA this puts the RoE hurdle rate at 19%, which is the average of JSE-listed companies in October 2013 as reported by the International Monetary Fund. Notably, the data reveals that RoEs of South African-listed companies in general are under pressure, having declined from a medium-term peak RoE of 22.3% in March 2012.

While a minimum RoE hurdle rate provides a good starting point, there are other factors to consider. Ranking high among them is the sustainability of RoE. An excessively high RoE could be a reason for caution. This was the case when Pick n Pay reported a 132% RoE in its year to February 2009, three times Shoprite’s RoE. Pick n Pay was paying too much of its earnings out in dividends. This kept growth in shareholders’ funds low, thereby boosting RoE, but this was at the expense of under-investment in the sustainability of its business.


Companies with sky-high RoEs in sectors prone to high demand and price volatility should also be treated with caution. The mining and resources sector is replete with examples. One is Anglo American, which in 2007 recorded an RoE of 34%, way above its 50-year average of 18%. Anglo’s RoE came in at 4% in 2013. BHP Billiton also shot out the lights in 2007, hitting a 49.8% RoE. By 2013 its RoE had fallen to 15.9%, roughly in line with its long-term average.

The construction sector has also dished out some unpleasant lessons. One was delivered by Murray & Roberts (M&R) which in 2008, on the back of a construction boom, produced a 40.3% RoE. It was way over the norm for M&R, with an average RoE of about 16%. M&R’s profit and RoE proceeded to dive in 2010 and 2011. How a company achieves its RoE must also be considered, says Rhynhardt Roodt of Investec Asset Management. This is particularly true where high gearing is used to ratchet up RoE by companies in cyclical sectors. “They often increase gearing when things are looking good and banks [and bond investors] are eager to lend to them,” says Roodt.


The rationale for gearing is simple. When the cost of debt is lower than the return on the invested capital it is used to finance, it enables companies to boost profits and, hence, RoE.
A prudent gearing level for one company can be a risky level for another. British American Tobacco (BAT) is a good example of the prudent use of high leverage which it has used to produce a steady rise in RoE from 29% in 2006 to 52.9% in 2013. The rise in RoE was also assisted by hefty equity-reducing share buybacks totalling £3.5bn in the past three years alone.
At face value BAT appears to be heavily over-geared, with debt at 175% of equity. But BAT has a robust business model and is a dominant player in a non-cyclical consumer staple sector, with 60% of its profit generated in high-growth emerging markets. Most importantly, BAT has a strong, stable cash flow which is more than adequate to service its debt. Interest was covered 10.4 times by earnings in 2013.

These attributes have made BAT a favourite among fund managers taking a defensive stance. BAT grew earnings in sterling at 10.8%/year over the past five years and its dividend at 11.2%/year despite paying out 70% of earnings in dividends. Vodacom presents a similar picture to BAT. Operating in a stable, mature sector, Vodacom has used gearing — now at 59% of equity — to lever up its RoE to 62.5% in its year to March 2014. Interest was covered almost 20 times by earnings. Vodacom also represents a classic example of stable RoE, which over the past 10 years has averaged 59.6%. Vodacom’s business model is spewing out cash, of which a key measure is free cash flow — operating cash flow minus capital expenditure (capex). After capex of R8.5bn in its latest reporting period, Vodacom’s free cash flow stood at R13.2bn, positioning it to pay out 92% of its headline EPS (HEPS) in dividends. It left cash on the balance sheet of R5.8bn, not far short of the R7bn Vodacom will pay for its acquisition of landline operator Neotel.


A classic example of where a high RoE combined with aggressive gearing should have been treated with suspicion is African Bank (Abil), which in 2011 and 2012 boasted a 32% RoE, double the banking sector’s then average. “Abil has a high-risk business model but opted for high gearing and the lowest capital base possible,” says 36One’s Walker. “Abil is now asking shareholders to recapitalise its balance sheet through a rights issue.”

Arguably the ideal situation is a company with minimal or no gearing producing a stable, high RoE. It is notable that Buffett has favoured companies with no or low gearing throughout his 60-year career in investments. Buffett wrote in his 1987 Berkshire Hathaway chairman’s letter: “Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.” It is a view he continues to express.


Affirming Buffett’s view in style is Famous Brands which, off a balance sheet with gearing at only 5% of equity, delivered an RoE of 44.9% in its year to February 2014. Growth has also been abundant, HEPS rising at a 23.8% annual average over the past 10 years. Also proving Buffett’s view is Howden Africa which, off an ungeared balance sheet, produced a 76.8% RoE in 2013, the highest of any industrial company listed on the JSE. In part the specialist engineering equipment company’s high RoE has flowed from its business model, which has enabled it to return significant amounts of surplus cash to shareholders by way of special dividends without retarding growth.

Indeed, a combination of strong sales growth and operating margin uplift enabled Howden to increase HEPS by 211% over the past five years, with the biggest jump, 94.5%, coming in 2013.
“Howden has a lean business model with a lot of intellectual capital and requiring relatively low fixed capital,” says Walker. Howden paid two special dividends over the past five years and, with cash now back at two-thirds of shareholders’ funds, another appears to be not far off. Hard on Howden’s heels in the RoE race is cement producer PPC which tipped the scales with a 70.9% RoE in its year to September 2013. Impressive, for a capital-intensive business in a weak economic environment. But it is an RoE requiring scrutiny.


At work, at first glance, appears to be gearing — a sky-high 198% of equity. In reality PPC’s balance sheet is distorted by the structuring of a BEE transaction undertaken in 2009 which reduced PPC’s equity by R1bn and added R1bn to its debt. This will change with the restructuring of the BEE programme due to be completed during the course of this year. Due from PPC is an initial R1.4bn perpetual preference share issue and a 5.6% increase in ordinary shares in issue, which will more than double its equity base. This in itself will reduce the cement producer’s RoE by more than half. Further pressure on RoE is likely to come from an aggressive expansion strategy into Africa, including new cement plants in six countries, which will add considerable earnings-eroding depreciation.

There are also instances where seemingly low RoEs are deceptive. An example is Shoprite. Although the food retailer’s RoE was a respectable 26.3% in its year to June 2013, it was well below that of others in its peer group, including Pick n Pay’s 28.9% RoE and capital-light wholesale distributor Spar’s 45.9% RoE. There are a number of reasons. One was a 5% increase in the retailer’s equity through a R3.5bn rights issue in March 2012. A simultaneous convertible bond issue raised a further R4.25bn. The issues positioned Shoprite for accelerated growth, its CE Whitey Basson said at the time.


Another tempering influence on Shoprite’s RoE is rapid expansion of its South African and African store-bases. Reflecting this, the value of property, plant and equipment more than doubled between 2009 and 2013 from R5.4bn to R11.7bn, driving up depreciation 75% to R1.34bn. MTN is in a somewhat similar situation to Shoprite. While MTN has a stable RoE at about 24%, it is far lower than Vodacom’s. Despite this MTN’s 17 PE is well above Vodacom’s 14 PE. MTN share price is also outperforming Vodacom’s, rising 70% over the past two years, double Vodacom’s rise.
The reason is MTN’s superior growth prospects, driven by expansion in Africa and the Middle East. “High growth companies often have lower RoEs than low growth companies in their sector,” says Roodt. Reflecting very different growth objectives, MTN’s average annual capex of R26bn over the past three years was 10 times Vodacom’s average. Again this has resulted in a far heavier depreciation burden for MTN: 19.3% of revenue compared with 9% for Vodacom.

Another aspect of RoE is a company’s ability to achieve acceptable profitability levels over the longer-term. This can provide useful insight as Barloworld, a share widely held by fund managers, reveals. Over the past 12 years its RoE has averaged a modest 11.5% with bouts of high volatility that have taken it from a best 18.7% in 2006 to at worst negative RoE in 2010. A bounce back to an RoE of 12.3% in 2012 made Barloworld a great recovery stock to ride but, as a long-term core investment, it has yet to prove itself.


Trends in RoEs can also provide useful insight when assessing companies, particularly those in the same sector. Tiger Brands and AVI provide an apt example. Back in 2001 Tiger was riding high, boasting an exceptional 75% RoE. It proved to be an unsustainable peak. In an increasingly competitive market, Tiger’s RoE went on to decline almost uninterruptedly to a still respectable but far lower 27.8% in its year to September 2013.

AVI was to prove the big winner in the food manufacturing sector, lifting its RoE from 17 in 2001 to 33.1 in its year to June 2013. “AVI ranks amongst SA’s top corporate success stories of the past decade,” says Walker. “It has done an excellent job managing its balance sheet and acquisitions.” The retail sector has also produced a number of notable RoE trends. Among them are diverging trends of Truworths and Woolworths, one-time stable mates in Wooltru. Following Wooltru’s dismantling in 1998 Truworths became the share to back as it honed its business model to perfection, growing RoE steadily off an ungeared balance sheet to a peak of 50.2% in 2007. This ranked Truworths as one of the three most profitable fashion retailers worldwide.


But Truworths became a victim of its own success, with key trading performance metrics such as operating margin and stock turn reaching levels that were all but impossible to improve on meaningfully. With no suitable acquisition to provide a much needed growth booster, this left it largely reliant on sales growth and hefty share buybacks to drive its bottom line. The result is reflected in a sharp decline in HEPS growth which fell from a total of 245% between 2003 and 2009 to 94% the following five years. RoE has suffered, falling steadily each year since 2007 to 40.1% in Truworths’ year to June 2013. While still a handsome return, it is the declining trend that is a concern.

In the shadow of Truworths for many years, Woolworths started coming into its own under former retail director Andrew Jennings’ tenure between 2007 and 2010. But it is under the leadership of Ian Moir, CE since November 2010, that Woolworths has soared to new heights. Moir tackled growth on all fronts, including driving up trading margins through greater efficiency and gaining market share rapidly through vastly improved product offerings and trading space expansion. Woolworths’ HEPS have risen 110%, more than double the rise in sales. Also reflecting success is the retailer’s RoE, up from 38% in 2009 to 50.3% in its year to June 2013.


There are more aspects to assessing RoEs. One is identifying companies with RoEs well below their potential. An example is Pioneer Foods, with an RoE that languished around the 11%-14% level for almost a decade. It’s a level former Tiger consumer brands head Phil Roux, CE since February 2013, is aiming to ramp up. And he is doing it, lifting Pioneer’s RoE to a healthy 20.6% at its March 2014 interim stage on the back of a 41% rise in HEPS. Undoubtedly, RoE as an aid used within the broader context of the assessment of a company’s fundamentals can provide abundant insight.


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