Value Investing using Economic Value Added (EVA)

Focus On The Short-Term Hurts Companies - Bill George

One of the important qualities of ValueAligned companies is that its management team and its processes are organized around maximizing "economic value", called "intrinsic value" by Warren Buffett, not some vague notion of maximizing "shareholder value", which almost always degenerates into short-term management of accounting earnings, or "making" the number.  The sad result of this is that public companies rarely overcome what the Aspen Institute calls "short-termism".

The statement, “Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management,”identifies three leverage points for encouraging a renewed focus on long-term value creation and for addressing one part of market short-termism, shareholder short-termism: 

1. Market incentives:  encourage more patient capital through tax policy

2. Alignment: better align the interests of financial intermediaries and their ultimate investors

3. Transparency: strengthen investor disclosures

We would also add better "alignment" between corporate managers and shareholders - whether financial intermediary or not.  Of course, we prefer to eliminate financial intermediaries like mutual funds and directly to own the shares of great companies.  

The best way we have seen to signal to investors that a company is well-aligned is for top management and other employees, all the way down to the shop floor, to have implicit incentives within the management systems and explicit incentives within the reward and compensation systems, to maximize economic value.  That's what Value-Based Management (VBM) is all about.

On his blogand in the WSJ, Bill George the former CEO of Medtronic (MDT), makes his plea for managers to do the "right" thing and reject short-termism: 

This crisis wasn't caused by subprime mortgages; it was caused by subprime leadership. Its root cause is leaders who practice short-termism. The culture of short-termism—investing for short-term gains at the expense of long-term accumulation—has taken hold on Wall Street. Managerial capitalism has replaced financial capitalism as holding periods for stocks dropped from eight years in the 1960s to as low as six months today.

George goes on to remind investors that if they do not demand economic value creation from their companies they own then it isn't likely that much will change anytime soon.

Warren Buffett once said that the best holding period is "forever." That philosophy earned him $40 billion and the reputation as America's best investor. Unfortunately, long-term value investing is decidedly out of favor these days. Instead, investors pursuing short-term returns pressure corporate leaders to meet quarterly expectations rather than creating long-term sustainability and growth.

Many corporate leaders fell prey to playing this short-term game. They bought into the widely-believed myths that a company's stock price represents its true economic value and that success can be measured by comparing quarterly earnings to security analysts' expectations.

They hyped their stock prices with short-term actions or made value-destroying acquisitions that crimped their long-term competitiveness, often putting their entire business at risk. Many of their firms, like General Motors, AIG and Citigroup, are barely surviving now.

It is the very idea that maximizing stock price in the market at any given moment is what managing for value is all about that has given Value-Based Management (VBM) a bad name.  The corporate objective function in a well functioning capital market ought to be singular, but ought not to be share price.  It ought to be "intrinsic or economic value" - which can mathematically tied directly to "economic profit dollars per share".

BERK

CARPE DIEM: The Wal-Mart Effect

CARPE DIEM: The Wal-Mart Effect.   On the Carpe Diem blog today, Mark Perry notes an article in Foreign Policythat highlights WalMart's largest international growth in the best growing international markets.

Foreign Policy--Wal-Mart's debut in a country is a bellwether for future growth. Indeed, Wal-Mart has started operations in 15 countries since 1991, and 13 of them have had boom economies, with an average of 4.4 percent annual growth since Wal-Mart arrived. Over the last five years, the economies of Wal-Mart countries outside the United States have grown 40 percent faster than the world average. So what's going on?

Does the ability to buy giant bags of Froot Loops at cut-rate prices inspire economic growth? More likely, Wal-Mart is simply a smart, cautious investor. "Wal-Mart chooses to go places with a sizable middle class," says Nelson Lichtenstein, a historian who just published a book on Wal-Mart's rise. And Wal-Mart's attention to middle-class growth could pay off for the company in the future. Next up for the Wal-Mart effect, Lichtenstein says: Russia and Eastern Europe.

BERK

Unlocking the power of Chinese consumers: An interview with Stephen Roach

One of our investment themes for the last decade was the steadily growing influence of the Asian consumer.  Back in the early 1990s when I managed a portfolio of stocks of companies based in Hong Kong mainly, the idea then was to take advantage of the emerging Chinese consumer.  Unfortunately, many, many US companies tried to get into the market only to realize that it was way too early - few companies had early success.

Back then the Hong Kong dollar was"pegged" to the US dollar just as the Chinese yuan is basically pegged to the US dollar today.  That peg has been a great subsidy for the US consumer where she could buy high quality goods like clothing, home stuff and electronics at lower and lower prices. But there is always the flip side which has been the building of the great Chinese export machine - whereby the US consumer subsidized Chinese employment and export infrastructure investment.  We all know where the profligate US consumer got us.  So now we think it is time for China, India and other Asian economies to start consuming and helping out US employment.  So far it's not working out so well as we have unemployment approaching 10%. 

Morgan Stanley Asia’s chairman Stephen Roach discusses the roots and prospects of China’s next revolution led by the consumer below.

Asia has proven comparatively resilient against the current downturn, but hurdles still lie ahead. In order to maintain robust growth rates in the face of weak US demand, the region’s dynamic economies must stoke domestic consumption and embrace environmentally sustainable development policies. So says Stephen Roach, chairman of Morgan Stanley Asia and author of The Next Asia: Opportunities and Challenges for a New Globalization. In this video interview, Roach discusses prospects for increased integration and cooperation between the region’s economies, explores the pitfalls and potential for countries like India and Japan, and considers whether the “Asian Century” has finally arrived. Clay Chandler, Asia editor with McKinsey’s publishing group, spoke to Roach in Hong Kong in August 2009.

 

We are investing in companies like WalMart who some see as a low P/E grocer.  We disagree.  We think WalMart is a leader in building an efficient and economically profitable consumer supply chain. In F'10, Wal-Mart will open more stores (more organic square footage growth) outside the  U.S. than inside (19.5 mm sq ft international vs 15.5 mm sq ft domestic). We noticed this shift with the international strategy when the company exited Germany and South Korea in October '06. It signaled a new direction for the international segment. The company would limit international investments to  markets where Wal-Mart had the potential for a sustainable competitive advantage and significant market share due to its leadership in the development of the new markets' supply chain. 

Management expects sizable multi-year cost reduction as it replicates best practices around the globe. Over time, it expects to bring the international operating margin (5.0% in F'09) in line  with the U.S. Wal-Mart segment (7.3% in F'09).

BERK

We own WMT and may buy more or sell it at anytime for any reason.
 

Google Does Not Eat Percentages!

 

FROM BRIEFING:

During the call, GOOG says that it is seeing many signs that the economy is strengthening and now has the confidence to invest heavily in growth areas. This will include headcount and acquisitions. GOOG plans on adding employees mostly in the engineering and sales areas. For acquisitions, the company will look at both smaller and larger acquisitions. Smaller, technology-based acquisitions could happen as frequently as on a monthly basis. The company says a larger acquisition would have to substantially increase its user base, and would be fairly rare. GOOG says they are very pleased with YouTube's performance, saying profitability is nearing. The company says it is continually adding key advertiser relationships for YouTube deals with large customers like Hewlett-Packard (HPQ) and McDonalds (MCD). Company says Android ramp is going well, with the platform in 12 devices and with more than 30 carriers. Chrome -- GOOG's new operating system -- is progressing well, and GOOG states that it will significantly increase the speed of web-based applications. In terms of geographic performance, company says China and Brazil continue their strength, while areas in Europe, such as Spain, have shown renewed strength.

One of my favorite parts of the Google conference call was when CEO Schmidt said that margins don't matter.  He said that GOOG does not have a margin target.  The collective gasp could be heard over the mute buttons on the web conference call.

You can't eat percentages.  Or what would happen if a basketball team maximized shooting percentage instead of points - right, they would stop when they hit their first shot, but would lose every game.  Obsession about margins and growth for growth's sake causes many unintended consequences and mis-aligned behaviors.  In the after-call GOOG just got another question about percentages and margins - these analysts are ridiculous.

GOOG is a well-aligned company. 

BERK

Dell (NASDAQ:DELL) Should Reboot Perot Systems (NYSE:PER) Acquisition

The ValueExpectations blog was quick to show, not just state, how unlikely DELL's purchase price of Perot Systems (PER) will prove to be value-adding. 

Beginning with PER’s historic profit margins, what can Dell expect from the unit going forward? Looking at the EBITDA Margins in the chart below from 2000 through 2008, PER delivered EBITDA margins ranging from a low of 2.8% to a high of 11.8%. For our analysis, we will use what seems to be a reasonable figure of 11% to represent PER’s normalized long-term EBITDA Margin. In fact, given the volatility of PER’s margin historically, many can argue that 11% is a generous assessment. That said, let us use 11% nonetheless. Next, review the chart depicting PER’s Asset Turn Over ratio, which tracks how much a company must invest in its balance sheet to support a dollar of sales. For PER the figure recently was about 1.4x, or for every $1.40 of sales the company generates, it must invest $1.00 in assets to support those sales. Though PER has been much more efficient historically, its trend has been towards requiring more and more capital to support a dollar of sales. By using the most recent figure, we will assume it will minimally arrest that slide.

What sales growth PER needs to generate to justify a $30 share price? An astounding 26% each year over the next 4 years! This compares the to the 13% annual growth PER has delivered over the past 5 years, the 6.4% it delivered in 2008, and an expected but rather certain decline of 10% in 2009.

Bottom line, Dell’s management team believes it will double PER’s growth rates over the next four years relative to what PER achieved during the past economic boom, while maintaining historically aggressive profit margins. While it is not impossible, it seems very unlikely. In fact, Dell executives did not give any targets for revenue, saying more details would come after the deal closes. They did touch upon expected opportunities for cost savings, saying the two companies spend a combined $4 Billion in the areas they plan to integrate, and its sees cost savings of about 6-8% in 2 years. If Dell hits those synergies, which justifiably the market rarely pays for, the new Perot would likely have profit margins approaching that of Accenture, arguably the best in class provider of these services. Again, while such an outcome is possible, it is much like betting on the expectation of hitting an inside straight – generally not a very good strategy.

What then is the strategy?  How can Dell claim "profitable growth" as their primary objective - rather than market share or margins and still justify paying a high premium?

It's government services and health-care IT in particular.

Peter Altabef, President and CEO of Perot Systems said this on yesterday's conference call:

I'm glad you asked the question because as important as health-care is to Perot Systems, it represents about 48% of our revenue, 25% of our revenue is generated by the government sector. Obviously, Dell is a major player in the government sector as well, and we think combining our relationships with Dell's current relationships in government will be actually a very powerful force.

With respect to commercial, that's 27% of our existing revenues and includes some very exciting areas for us. I would tell you one of the things that this transaction does for our capabilities is greatly expand our ability in the commercial sector. And when you look at Dell's footprint and you look at their existing customer base as well our customer base, we think there are great opportunities for the commercial businesses to expand on the services side.

So we really are looking at this from the services side across the board, from commercial to government to health-care, and we think there are significant opportunities throughout that spectrum.

And when asked directly about the high price paid, DELL CEO Brian Gladden said:

...the key value drivers for us really were, this is a really an anchor acquisition that for us gives us a lot of potential strategic flexibility going forward around services. We saw it as really a premier IT services asset and with revenue growth potential that we think is significantly better than other targets that we looked at. In addition, the size makes sense from a scalability standpoint, given our direct customer relationships, we think we can grow it quickly.

On a standalone basis the price is difficult to justify.  But the 26% revenue embedded in DELL's purchase price is high from Perot Systems vantage point, it's not so much from the DELL vantage point.  I'm the last guy to accept management's synergy fantasies until they show us they can make it work, but DELL is slowly, if not carefully, building their services business from a scalable, read high economic margin, model based on intellectual property and more remote infrastructure management.

Sounds good - we'll have to see.  In the meantime this investment and the expected value destruction does very little to the fair value estimate for DELL's shares.

BERK

High and Low Finance - Inside G.E., a Little Bit of Enron

Seeking Alpha reports on Floyd Norris' article about General Electric's recent settlement with the SEC over accounting issues.  It introduces it's breaking news article this way:

With Jack Welch at the helm, General Electric (GE) used to be a shining star of business. What's inside the company now, in the wake of its $50M SEC settlement over charges of book-cooking? Floyd Norris says maybe a little bit of Enron.

High and Low Finance - Inside G.E., a Little Bit of Enron - NYTimes.com.

This seems to suggest that GE was a paragon of virtue when Jack Welch ran the joint.  It just ain't so.  Jack Welch invented the idea that "managing for value" was "making your EPS numbers".  Complicit Wall Street analysts lauded the company for its consistency in always making the numbers - keeping your promises I guess Jack Welch would say.

The problem?  The real world does not and did not work out the way GE's EPS numbers smoothly progressed.  There is so much leeway in GAAP accounting that the bigger and more complex a conglomerate is - the easier it is to "make the numbers".  Whether it's hiding away excess performance in good times or tweaking valuation reserves in the finance subsidiaries, there seems to be endless ways to make the numbers - until there isn't.

Norris says his story reminds him of Enron.  And if you are talking about companies that manipulate their EPS by using off-balance sheet financing, advance selling agreements, big bath accounting or just plain uneconomic investment using loads of debt, the list is long.  Lets take a look at Enron's "Risk Manual":

Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics.  Risk management strategies are therefore directed at accounting rather than economic performance.

Performance is measured by "accounting" not by the economics - not by creating economic value!  And so it was with GE and 90% of the companies in the Russell 3000. 

As the two graphs above suggest, companies can make EPS or accounting income look good while EVA is going straight down.  Why don't all investors and analysts use EVA?  Great question.

BERK

"We're focused on profit-share, not market-share"

Back in February of this year Jim Cramer shouted, “Sell, sell sell Dell.”  Just the other night I heard him call DELL a "horrible company - worst in class "- or something like that.  How does he decide how well a company is doing?  or what is a good or bad company?

It seems that Cramer is just the tip of the EPS (expectation) fanatics spear.  It's too bad (or good from our prospective) because he gives the rest of us cheap stock to buy.  To this crowd, if a company does not let the market know whether or not they will meet or exceed analysts' estimates for EPS then they are doing a bad job.  And heaven forbid they miss expectations - that's a bad quarter, of course. 

The chart below shows that DELL is a very profitable company.  Are there challenges to its competitive advantages? - yes.  Does that mean that DELL is done? - no. Even during this recession DELL has cash returns on capital well above its cost of capital.  That is the definition of a value creating business model.  We noticed that DELL's economic profitability has eroded over the last fifteen years, but we also note that it is cyclical.  However, the long run cash returns above the capital costs are still quite large and they do not indicate that DELL is simply a commodity producer - commodity producers by definition have trouble earning much more than their cost of capital. 

Conclusion: DELL's competitive advantages have eroded a bit over time, but the company is not a "bad" company with a "bad" business model.  On the contrary, DELL is highly profitable company with important opportunities for increased profitability and new growth areas - consumer, Asia and services.

It's clear that DELL understands how to create long-term shareowner value.  It is not about your market share or level of earnings or how many quarters you beat analysts' guesses about your EPS - it is all about how much value you deliver on a per share basis.  Dell's CFO Brian Gladden made it clear by telling Bloomberg that they are not interested in buying Acer for the market share accretion - that's not the objective of a value-aligned company. Value-Aligned companies' objective is to create intrinsic value per share. 

But as Dell CEO Michael Dell told a gathering of financial analysts earlier this week, his company isn't interested in a unit shipment battle with Acer. Acer boosted its position largely by selling netbooks, the popular, no-frills and tiny laptops aimed primarily at providing Internet access.

"We're focused on profit-share, not market-share," Dell said, according to the Bloomberg report.

Amen to that.

Berk

Disclosure:  Long DELL for our clients' accounts. 

When General Motors was an EVA Company

Bennett Stewart, the author of the Quest for Value and co-founder of Stern Stewart & Co. - the EVA Company, writes a short essay (here) at HBR Now about the meaning of the bankruptcy of General Motors.  He explains how any company can become a ward of the state or go into liquidation if the financial management system bows at the alter of the accounting based EPS metric.  Accounting does not charge for equity capital, only debt capital, so the mandate for the operating managers and the board too, is SPEND, SPEND & SPEND.  Spend until the company fails. 

He begins by recounting the last time GM almost went under before the Great Depression, and how DuPont, not the government, stepped in with cash and one Alfred Sloan:

 

GM was at death's door, and only a healthy infusion of cash and financial restructuring saved it. Actually, not just saved GM — made it great.

But unlike this time around, when the heavy hand of the government is at the wheel, it was an investment from DuPont, whose chairman was instrumental in bringing in the legendary Alfred Sloan to run GM, and a financial restructuring orchestrated by J.P Morgan, that saved the day.

By 1923, Sloan had arranged for the GM management team to acquire a large block of the company's stock from DuPont, financed with a non-recourse loan that would be repaid by diverting bonuses. GM's management effectively participated in the incentives of a leveraged buyout of the firm, but without imposing a like financial risk on the company itself. As for the bonuses, they were based on simply allocating a sizable portion of GM's operating profit above a 6% cost of capital hurdle rate, which gave the managers unlimited upside for achieving income efficiency and balance sheet asset management. There was no calibration of the bonuses to a market pay scale, which only tends to institutionalize a guaranteed level of pay irrespective of performance. There was the risk and the return of the owner on the shoulders of management.

And that, coupled with excellent management, set the stage for greatness.

Basically, Sloan's magic formula was to incentivize operating managers of semi-autonomous divisions by paying them some pre-determined fixed share of operating profits above a 6% hurdle rate - low, but much higher than the after-tax cost of debt - the hurdle rate in an accounting-based system even today.

A fixed-share of "excess operating profits" is the same thing as a fixed share of the Economic Value Added or "EVA" of the divisions.  The best part was that it was a pre-determined formula which meant the operating managers could shoot for the moon as long as they figured they could get an excess return on their investments/spending.  It was as though Sloan had created a way to give a fixed share of the intrinsic value growth of their specific operating units.

What happened?, you may be asking.  Well Stewart says:

Over the years, GM moved away from the incentives and value focus of an owner to the incentives of a bureaucrat. Bonuses were hitched to growth in earnings-per-share, and a raft of situational metrics that obscured responsibility for delivering real value.

Spend, spend, spend is the mantra of the EPS-addled manager. And so they did, and now, it's time to pay the piper.

Indeed.

 

BERK

The Death Spiral in the "Accounting Based" Financial Management System

Insanity is doing the same thing in the same way and expecting a different outcome. 

Maybe businessmen in regulated or unionized industries, like steel and utilities, are insane.  Probably a better explanation is that they work in an insane system.  After-all, as Nietzsche said “Insanity in individuals is something rare, but in groups, parties, nations and epochs it is the rule”  He left out bureaucratic companies with antiquated decision making systems.

My good friend Marc Hodak at Hodak value Advisors sent me a note this morning - really early - about this Wall Street Journal story "Fixed Costs Chafe at Steel Mills".

It turns out that a few steel mills are raising prices even though demand is stalled at best at a very very low level.  Sounds like madness doesn't it?  Raise prices and demand should fall more, right?  But you see the guys that run those plants get paid on productivity usually measured by margins - and as the quote below shows their unit costs are rising fast so unit profitability is crashing.

We are raising prices because of the increased costs of operating our mills at the current lower levels. We are not seeing an increase in demand," said Dennis Oates, chief executive officer of Universal Stainless & Alloy Products Inc. He has boosted prices 5% to 6% twice since the beginning of May.

Think about this.  If they sell 10 steel bars for $20 each they collect $200.  If it takes $80 of direct materials to make the product and fixed costs like union labor and overhead is $100, then the total costs per unit sold is $80 + $100 = $180 divided by 10 units of steel bar, for a cost of $18 per unit.  $20 price minus $18 cost = $2 profit.

OK that's fine and dandy but what happens when volume falls in half by 50% to 5 units sold.  They only produce 5 units.  What happens to costs?  The CEO above says they go up - I say they did not change.

Let's look at the answer Mr. Oates' accounting financial management system gives him.  We know that it costs $8 of materials per unit for $40 ($8 x 5 units of steel bar) and we know the fixed costs are $100 or $20 per unit.  The unit cost in his system is now $40 + $100 units or $140/5 units = $28 cost per unit of steel bar-a 55% increase.  So according to his accounting system his costs are going up 55% as his demand declines so let's say he raises prices to $30 per unit to maintain his $2 profit margin.

What happens?  Well marginal buyers for steel go somewhere else and now he only sells 3 units.  Uh oh, now costs are really high. $8 per unit plus $100 in fixed costs divided by only 3 units now = $100/3 per unit or $33.33 per unit, for a total unit price of $8+$33.33 = $41.33 cost per unit.  That strategy really worked, he gets $30 per unit for $33.33 cost = -3.33 is what his accounting system tells him he loses.  What now?

Unlike mill increases announced in recent years, this is obviously not driven by increasing global demand, but rather by fixed costs being proportioned across significantly lower demand," the company said in a letter to customers.

This problem is known technically as the "unitization of fixed costs" or as Marc likes to call it - the "death spiral".  It happens when performance evaluation for a plant manager or employee is based on "unit costs" or "average costs", which includes fixed costs.  The problem is that fixed costs do not change as volume varies.

In this type of system two things will happen: 1. the manager will raise prices to compensate for his increased average cost per unit and then volume will fall thereby raising cost per unit further, or 2. The plant manager produces and produces regardless of demand so his volume and capacity utilization stay high, but his unit costs stay low because fixed costs divided more volume = lower costs.  Never mind that all those units just fill up a warehouse or a supplier where there is little or no end demand. Basically the managers bury the costs on the balance sheet in inventory which is costly but not to them because they are evaluated by margin per product or by minimizing unit costs.

If we charge them capital maybe they'll do the right economic thing and REDUCE FIXED COSTS IN DOLLARS.  Layoff workers, sell extra factory space, etc.

Marc sums it up like this in his note to me:

This strategy is based on (1) illusion and (2) delusion.  The illusion is that one’s “costs” are increasing when volumes drop.  But the only cost going up is the accounting fiction called “average cost.”  Variable costs, i.e., the economic floor for pricing, hardly budge.  Total costs, i.e., those that affect EP (economic profit), actually come down.  The delusion is that prices can be based on costs.(my emphasis) 

Read all that carefully and you will see why single payer health care, that relies on some Politburo of unelected experts to set reimbursement rates for doctors, nurses, hospitals, drug companies and medical device companies based on 'average cost", will massively misallocate resources.  Pricing off of costs is not market pricing and gives false signals and misaligned incentives to the good faith actors in any economic system.

Short the companies that don't get it; buy their competitors that get it, like Nucor (NUE). 

BERK

Disclosure: Long Nucor (NUE), no position in Universal Stainless (USAP)

Search Market Share - Is MSFT Investing Wisely?

I wonder how Microsoft calculates the expeccted return on their search expenditures.  My guess is that it believes that trying to grow search is an attempt to keep its real options alive and worth something - perhaps it will allow for some breakthrough later on.  I don't know, but I do know that they are losing the battle.  I wonder if Ballmer knows when to say when just like he did with the Yahoo merger which showed great discipline.  We'll see.  BERK