Value Investing using Economic Value Added (EVA)

Driving Ongoing Profitability With EVA at Briggs and Stratton

John S. Shiely continues to expand a turnaround at Briggs & Stratton Corp. that was begun by integrating a business philosophy based on Economic Value Added (EVA). The essential principle of EVA analysis is that a company only makes economic profit if the company earns more than the cost of its capital. The results: EVA has helped the company achieve an impressive record of producing economic profits. Briggs & Stratton has made money every year since the late 1980s. For the fiscal year ending June 30 net income is predicted to grow 32%. Revenue is at record levels ($1.6 billion). Exports account for 25% of sales, and this U.S. producer expects to continue to undercut foreign competition even in some new market sectors.

IW: How do you define the EVA philosophy?

Shiely: EVA is both a measure of the true economic performance of a company and a strategy for creating shareholder wealth. EVA succeeds by changing corporate priorities and behavior throughout a company, right down to the shop floor. Properly implemented, EVA frees the measurement of corporate performance from the vagaries of accounting conventions and aligns the interests of managers with those of shareholders, ending the all too common conflicts of interest.

IW: What are the elements of EVA?

Shiely: An EVA program comprises three parts: a measurement system, an incentive system and a system of financial management. In measuring performance, for example, EVA's key ingredient is the recognition of a capital charge -- the cost of capital in a company, in a division, in a branch store or in a product. Research shows that companies using EVA outperform competitors of comparable market capitalization by an average 49% over a five-year period, as measured by total return to shareholders.

IW: How has EVA been applied to Briggs & Stratton?

Shiely: We began by returning our manufacturing focus to high volume business and began treating our people as owners. Back in 1989 we had to recover from a mistaken effort of trying to be all things to all people. For example, we began making a line of premium engines, but found that we couldn't make any money because the volume was too low. Step two of the recovery process was splitting the business into six divisions that serve as EVA centers. In addition to managing costs, the general managers of the divisions became responsible for managing their capital assets according to EVA principles. The third piece of the turnaround puzzle was the economic discipline, the full EVA program with EVA incentives, EVA training, using EVA metrics to measure new products, acquisitions and joint ventures. By 1992 the company was beginning to earn the cost of capital and that has continued for 10 of the past 11 years. That's quite an achievement because only between 30%-40% of companies earn the cost of capital in any given year.

IW: How does EVA impact capital equipment expenditures -- the plant floor investments?

Shiely: What we're trying to do is make our people owners by training them to view the world as owners do. We want them to learn to invest money in the business the way they do in their personal lives. The idea is to apply the same principles of economic analysis. That means that budgets are not a mandatory license to spend. For example the first year we put EVA in, we had a capital spending program of about $70 million and by requiring EVA justification, the analysis authorized only $47 million. A similar thing will happen this year with expenditures falling $10 million under budget. Under conventional [non-EVA] budget regimes, people will find a place to spend that money. Without EVA, that [spending] will tend to happen even if the capital investment isn't needed.

IW: How was the premium-priced engine project resolved?

Shiely: Mitsubishi now makes and brands this low volume engine line for us. If we had an EVA program when we decided to enter this premium market we could have avoided not only the $70 million we invested in production equipment, but also monthly losses of $1 million. That engine project should have been earning $10 million annually, but instead yearly losses were $12 million.

IW: What challenges confront managements who want to implement EVA?

Shiely: The challenges include unions who are not active in the value creation process and investors who focus on accounting earnings and ignore the higher correlation between economic profit and the value of the business. What unions ought to do is implement EVA incentive programs and get rich! Ideally all the corporate constituencies -- the customers, the employees, the communities where a company is located -- can help with the EVA value creation process.

BERK: Shiely is a great advocate for value based management and EVA.  He literally wrote the book! Check-out The EVA Challenge: Implementing Value-Added Change

 

Deere (DE) Investor Relations Touts Its Use of Shareholder Value Added (SVA)

Today at the Bank of America Securities Merrill Lynch Industrials Conference Marie Z. Ziegler, VP of Investor Relations for Deere (DE, $52.40) made three observations about her company:

1. Favorable macroeconomic tailwinds in Deere's agriculutural businesses.  DE is getting popular in places where incomes are relatively low but growing fast.  And as populations earn more, they tend to upgrade their diets.  "If you are going to eat chicken, it takes four times the amount of grains to produce an equivalent amount of chicken, beef is up to seven times."

2. Global Infrastructure.  While not as big as the agricultural opportunity for DE, the company has established a joint venture in China and India.

3. Growing Returns on Capital or EVA growth. 

...we've talked for almost a decade now about returns, improving our returns, our measure that we call shareholder value added. It's really, we're earning the positive return on our invested capital, it's been very powerful driver for the company even in these incredibly difficult times, you thought to generate 1.4 million in cash flow. We come into this with our inventories extremely well positioned. We've talked for many, many years frankly about how our inventories are well relative to the ag industry in North America, got the same observation on the construction side. And although we did cut production in underproduced retail last year in both the ag and the construction equipment businesses as those businesses were softening, we still managed to produce $900 million of income. So really a very, very powerful driver for the company, and that cash flow, that profitability enables us to invest for growth in the first two items that we talked about, global ag and global infrastructure.

Nice!

BERK

Employees Lead ValueAligned Company's Success

Joel Stern, CEO of Stern Stewart & Co., suggests on its web site that the purpose of Stern Stewart and the EVA value based management system is "to make important ideas in financial policy and strategy workable for boards, senior management, and to promote the training and development of all employees so they can acquire an understanding of what it means to create shareholder value.  Nothing is more important in any firm than the quality of its human capital."

Look at how Bill Rhodes, CEO of AutoZone, talks about how his people in the field contribute to making the company operate better:

What is personally my favorite part of the three day event is our President's Club lunch in. We invite the best store managers, representative of stores across the U.S. to an afternoon meeting to share their ideas and opinions on how we can operate better.It's always impressive how many of our best ideas come from our store leadership. This year was certain no exception. From ideas around being more environmentally conscious to reducing tender type fees, to streamlining our return processes, to delivering parts on a more timely basis through our hub store model, we routinely learned an extraordinary amount from our AutoZoners who are on the frontline serving our customers everyday.

BERK

Disclosure:  We own AZO

AutoZoners Lead the ValueAligned Pack - ROIC +24.9%!

AutoZone 1st Quarter Sales Increase 7.5%; EPS Increases 26.4% to $2.82

MEMPHIS, Tenn., Dec. 8, 2009 (GLOBE NEWSWIRE) -- AutoZone, Inc. (NYSE:AZO) today reported net sales of $1.6 billion for its first quarter (12 weeks) ended November 21, 2009, an increase of 7.5% from the first quarter of fiscal 2009 (12 weeks). Domestic same store sales, or sales for stores open at least one year, increased 5.6% for the quarter. Net income for the quarter increased $11.9 million, or 9.1%, over the same period last year to $143.3 million, while diluted: Earnings per share increased 26.4% to $2.82 per share from $2.23 per share in the year-ago quarter. Gross profit, as a percentage of sales, was 50.3% (versus 50.1% last year). AutoZone repurchased 1.4 million shares of its common stock for $204 million during the first quarter, at an average price of $144 per share. The Company has $105 million remaining under its current share repurchase authorization. Inventory increased 3.5% over the same period last year, driven by new store openings. BUT Inventory per store was down to $508 thousand versus $512 thousand last year. Net inventory, defined as merchandise inventories less accounts payable, decreased on a per store basis to $17 thousand from $43 thousand last year. We are pleased to report a 26.4% increase in diluted earnings per share, which is our 13th consecutive quarter of double digit EPS growth. I would like to thank all AutoZoners across North America for their dedication and commitment to providing the type of customer service and trustworthy advice our customers have come to expect from AutoZone. This past quarter, both our Retail and Commercial businesses reported strong sales growth. We remain committed to our plan of continually improving our parts coverage, hiring, retaining and training the best automotive parts professionals, and growing our Commercial business. Additionally, we reported a 24.9% trailing four quarter return on invested capital ratio this past quarter, as we remain committed to our disciplined approach of growing operating earnings while utilizing our capital effectively.    Bill Rhodes, Chairman, President and Chief Executive Officer. Too many critics of this company have argued for a long-time that their reutrns were unsustainable, their growth was too slow and their share repos were destroying value.  I guess they would prefer the company to spend their cash flow to over expand as long as sales and "market share" go up.  AutoZone gets it - They value a lot of things but the over-arching objective is to create intrinsic value per share.  The company does this by opening stores when it is prudent.  Advertising when there is a sufficient return on that advertising.  Testing initiatives before they roll out expensive failures.  Truly ValueAligned. BERK Disclosure:  BerkAdvisory and Rapidan Capital clients own AZO.

ValueAligned Companies Go Green Without Altering Overarching Objective of Managing for Value

Best Buy: An Emerging Green Giant

By Marc Gunther

Published December 03, 2009

 

By now, everyone paying attention to the greening of corporate America knows about Walmart's sweeping sustainability programs. Big-box rival Best Buy has not been nearly as visible about its efforts to become more environmentally and socially responsible. But I recently visited Best Buy's headquarters in Richfield, Minnesota, on assignment for FORTUNE, and came away impressed with what the $40-billion a year company has been doing.   My story, headlined Best Buy Wants Your Electronic Junk, appears in the current issue (December 7) of the magazine, as the latest in a series on FORTUNE 500 companies. This one showcases a corporate responsibility leader, and we settled on Best Buy.

Why, you may wonder? Predominantly because Best Buy is a pioneer when it comes to electronics takeback, which is the focus of the story. In all probability, Best Buy has become America's biggest collector of electronic trash. You can bring back just about anything electric to any of the chain's 1,044 stores, and they will recycle it safely, sometimes for a small fee. (Read the story, and the fine print, before loading up the trunk of your car, please.) Takeback is an important and radical idea -- it's a pathway to a world where everything gets recycled and nothing goes to waste.

But Best Buy's doing lots more when it comes to corporate responsibility, and most of it seems tied to its business goals. The company would like to help customers make their homes smarter and greener -- part of a shift away from just selling boxes to providing services. It's taking responsibility for the way its suppliers treat their workers, by policing its supply chain. With a young workforce and young customers, its philanthropy is focused on teens 

Best Buy wants your electronic junk

The retailer's recycling program seems expensive to run, until you look at the benefits: a green reputation and a way to get customers into stores.

One of my roles as CEO is to be the chief listener," Dunn told Fortune during an interview at Best Buy's headquarters outside Minneapolis. "I don't believe that the model is any longer that there are a few really smart people at the top of the pyramid that make all the strategic decisions. It is much more about being all around the enterprise, and looking for people with great ideas and passionate points of view that are anchored to the business and connected to things our customers care about."

Best Buy, as a result, has decided that being a good corporate citizen makes business sense. As a manufacturer of electronics, Best Buy audits the factories of its suppliers, mostly in Asia, to make sure they don't exploit workers or pollute the environment. (It severed ties with 26 factories last year, out of about 200.)

I guess there are at least two lessons here. 

1.  Managing for intrinsic value per share does not preclude being socially responsible - whatever that means, but it is defined here as recycling and sustainability.  Also, it is more evidence that the critics are wrong about EVA and VBM - or managing for value - or capitalism.  You can be a capitalist. Target value maximization and socially responsible behavior "emerges" without the heavy hand of regulation or central control.

2. And this "emergent"  behavior is enabled by the value-based mindset that promotes the development of all employees so they know what creates value.  Certainly, a program like Best Buy's cost some to implement upfront - in fact the story makes that clear - but it creates long term customer relationships, new customers and more frequent visits to the stores.  That sounds like a positive EVA project.

BERK

EVA Dimensions: Any Idiot Can Increase Accounting Profits.

Video: FMN October 2009 - Segment Two: “EVA Momentum: One Ratio That Tells the Real Story”

Bennett Stewart, EVA father, talks about his new measure - EVA Momentum - The only ratio that encourages profitable growth.

BERK

via evadimensions.com

Where have all the EVA-ngelists gone? Less than 10% of US companies manage for value.

Very interesting that I asked a group of current and ex-EVA consultants whether Value-based Management was still relevant, or I think I said, "does anybody care about EVA and VBM anymore?

The one answer I got was from a Stern Stewart leader in India.  Yes it's really relevant, but it's difficult to describe and differentiate from a host of other management practices.  But most relevant I think is that at least in India managing for value is alive and kicking if you focus on outcomes - behaviors - to label a company.  And that is precisely what we do - We identify ValueAligned companies and then build portfolios around them.

EVA and VBM are red hot in India; and in China too.  Read here.

Here's what Sanjay Kulkarni, Managing Director at Stern Stewart & Co - India wrote to me.

In today’s economic environment, the principles (of EVA/VBM) are more than relevant – the PE/VC houses, businesses, investors are more clued on to value creation (and economic bottom line) ‘outcomes’ than ever before. However the ‘means’ (approach, process, methodology or any other suitable word) may well be unique – therefore if one is ‘wedded’ to a specific approach that may be in/out of vogue.

I received not one other response - nothing  - not from anyone. 

No wonder Steve O'byrne and David Young recently found (here) that less than 10% of the companies in the Russell 1500 use a return on capital measure at all.  I guess half of those were EVA.  Steve and David Young introduce their study:

To estimate the prevalence of capital efficiency measures in top management incentive plans, we used the word search facility on the U.S. Securities & Exchange Commission’s EDGAR database. We identified 220 companies using capital efficiency measures; 47% use an economic profit or “EVA” measure that deducts a capital charge from earnings and 53% use an ROE or ROIC measure. 142 of these companies are members of the S&P 1500.

With all the government interference in executive pay, you'd think some smart ass would let some of these companies know that they are targeting the WRONG stuff.  In my experience it leads back to the misunderstanding of what managing for value is all about - Most of the companies that do not use EVA/VBM - the one concept that is sure to push and pull everyone in the "right" direction - are the same ones that end up targeting what they think makes their stock prices go up or down, not what makes their intrinsic values go up or down.

They are making policy decisions based on the polls registered by moment to moment changes in stock prices -  they do not base policy decisions on creating sustainable increases in EVA driving today's intrinsic value. Bill George the former CEO of Medtronic (MDT), makes his plea for managers to do the "right" thing and reject short-termism: 

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.

Does anyone see the big picture?  I think I do.  The big shots on Wall Street and in executive suites think that managing stock prices is managing for value - wrongo sparky - Managing for value is managing for sustainable increases in intrinsic value per share.  We all know how to do that by now - don't we?  EVA, EVA, EVA, EVA - manage for intrinsic value per share and the stock price will take care of itself.

Bill George is describing "EVA" - EVA companies don't put off investments or big strategic goals because of short-term performance considerations - no matter what the stock price does today - look how Herman Miller (MHLR) has handled the financial panic and continuing collapse in jobs and commercial real estate.  Herman Miller makes office furniture. The high end stuff is their specialty - when offices are closing and people are getting laid off, their sales go way down.  This company has been pro-cyclical forever, but still manages to innovate and invest right through the cycle.

 
Last time they had less bodies to put into those awesome chairs in 2000 -2002 they planned for 2010, invested more in diversifying away from technology companies and spent money in severance and process improvements.  They expanded their furniture into, you guessed it, medical, government and education - the three growing sectors of our economy in terms of more and more bodies to put into more and more furniture.  Also, they did not stop investing.  The new products queue is robust; the are expanding by acquisition into health care and education and still investing in the long-term vision of programmable environments that will save energy and increase work efficiency.

You guys get my point I hope.  Herman Miller ain't like those non-believers (non-users).

Sanjay is right - it's the outcome not the means. But there are many many companies that need some means because their outcomes don't look like EVA/VBM companies. 

BERK

WHAT`S NEXT FOR CHINESE ENTERPRISES? EVA, OF COURSE

In WHAT`S NEXT FOR CHINESE ENTERPRISES? Terry Qin, Vice President of Stern Stewart & Co. located in Beijing, writes that as many of China's largest enterprises gains influence in capital and traded goods markets, management (and the state, it is still ruled by the Communist Party after all) realizes that "they need a world-class, more complete measure of performance."

And the State-owned Assets Supervision and Administration Commission (SASAC) has asked the central state-owned enterprises to enforce prudent capital management and enhance their risk control procedures. 

Tough to do when it seems that the purpose of the state owned enterprises is to employ and to pacify as many people as people - not to allocate capital to its most prudent, I assume, wealth creating use.

But there is hope.  From 2010, the SASAC will use EVA to evaluate performance at the enterprises under their supervision. 

Big, and Strong Too

And this is also encouraging:

"China's current top 500 enterprises are actually still the 500 largest enterprises. Enterprises not only should grow larger, but also should become stronger. If the enterprises are only strong but not large, they may be lack of influences and still survive the global market. However, if the enterprises are only large but not strong, they will crash down sooner or later” commented Li Rongrong, Director of the State-owned Assets Supervision and Administration Commission (SASAC) under the State Council.

Let me translate: Growth in sales and profits for their own sake is not the GOAL.  Growth in VALUE or EVA is the GOAL.

That's a lesson that the boards and management of the 90% of the Russell 3000 that do not use a capital efficiency measure like EVA or Return on Capital or Economic Profit to make decisions should learn. 

Hmmm...who are the capitalists now?

BERK

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