BerkAdvisory

Democratic Economic Policies - They Don't Work Except in the Minds of Intellectuals

Wealth Creators vs. Wealth Destroyers: Best Buy Co., Inc. (NYSE:BBY) vs. Circuit City

Analysts tend to miss the forest for the trees.  In retail they are obsessed with the business model drivers like sales per square foot, same store sales or gross margin.  Certainly, these metrics are important for understanding the dynamics of a retail business - but to what end? 

The bottom line is whether a business model and management team create value per share - that's the single minded objective function for any for profit business.  It's the only one that allows for principled trade-offs between competing subordinate goals.  The answer is always the combination of drivers that will yield the most value over time.

AFGview.com's economic margin framework accomplishes this simple but overlooked goal.  See below for an example comparison of Best Buy to Circuit City. 

On ValueExpectations.com we always talk about a company’s true economic profitability (Economic Margin) to see through some of the distortions caused by traditional accounting practices and better understand what a company is truly earning above or below its cost of capital# We have shown through numerous examples that a company’s Economic Margin (EM) level is highly correlated with its market performance and an increase in margins typically leads to market out performance, where a decline in margins leads to market under performance# The example below shows both ends of the spectrum, one company that generates positive EMs and is able to grow its business while maintaining its profitability while the other company was unable to earn its cost of capital and consistently deteriorated its EMs.

It is no surprise based on economic profitability that Best Buy Co., Inc. is still doing quite well in the retail arena and has done a good job of growing its business while maintaining its profitability. The market tends to reward companies that grow profitable businesses and relative to the market BBY has consistently outperformed the S&P 500. Circuit City on the other hand deteriorated its EMs over time and eventually was unable to survive.

 

The Economic Margin (EM) Framework was developed to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic strength.

EM is meant to serves two purposes: Create a measure of a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use this EM as a function in our valuation model.

EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital.

It is not uncommon for companies to grow EPS while having declining or negative EM’s. This occurs when the cost for the investment required to yield the EPS (cost of capital) is more than the cash flow generated from the investment. From an economic perspective, this is growing EPS at the expense of the economics of the business.

Unlike traditional measures, EM considers the “profitability” of EPS growth, eliminates accounting distortions, and are comparable across time and industry. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

via www.valueexpectations.com

Disclosure: Our clients own Best Buy (BBY).

ValueAligned companies know it's "how", not "how much" executives get paid that matters.

Obama said yesterday that he knows how much is too much executive pay - he does not begrudge anyone making an honest killing - just make sure its not some undisclosed too big for his tastes.  The more he and his government regime keep harping on the issue the more their lack of real world experience shows.

Geoff Colvin of Fortune just wrote a great little article that explains that this current proxy silly season where the media and politicians think they win polling points by showing outrage about executive pay disclosed in this spring's proxies, should really be about "how" executives get paid, not "how much". 

ValueAligned companies get paid for reaching for "economic profit" not accounting earnings. 

Some Companies Afflicted by 'Quadrophobia' - WSJ.com

"There's a million ways you can adjust your earnings per share," said Jack Cieselski, publisher of the Accountant's Analyst Observer, a trade journal. "It's no revelation that companies can come to a desired earnings figure. [The study's authors] have pretty good circumstantial evidence that this does happen."

The power of new computers and programs allows researchers to identify evidence that suggest that companies manipulate earnings.  I knew this of course. 

A new study provides further evidence suggesting many companies tweak quarterly earnings to meet investor expectations, and the companies that adjust most often are more likely to restate earnings or be charged with accounting violations.

The study, which examined nearly half a million earnings reports over a 27-year period, reached its conclusion by going beyond the standard per-share earnings results that are reported in pennies and analyzing the numbers down to the 10th of a cent.

That deeper look showed that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent. Investors often snap up shares of companies that beat earnings expectations, even by a cent, and, likewise, sell off shares of companies that don't make their numbers.

One of my surprises as an EVA consultant was the extent of the perverse "implicit" incentives to manipulate.  I believe this comes from a misunderstanding of what drives stock prices.  CFOs and controllers of think that their job is make the number. That is not their job.  Their job is to report performance.

Never-mind, we're covered anyway, because we know that EPS is manipulated and earnings are adjusted.  We adjust everything back.

via online.wsj.com

BERK: ValueAligned companies should not engage in the ridiculous practice of using their wide discretion allowed in GAAP accounting to meet or beat analyst expectations. It's a loser's game anyway.  As the study mentioned above shows - companies that manipulate earnings to try to meet targets or "fool" the investment community, eventually have to fess up as future earnings cannot bail out this quarter's shenanigans.

Good investors and users of financial statement "adjust" the financial statements to see past these machinations.

High EVA Companies Had Lowest Returns in 2009 - Expected to Reverse in 2010

Money managers ignored economic profitability and bought stocks that dropped the most in the credit crisis, leaving opportunities for value investors in 2010.  Smart managers are buying this year’s laggards, betting companies with the highest EVA  will be rewarded as the Federal Reserve prepares to raise interest rates and the government removes stimulus.

According to Bloomberg.com using data compiled based on consulting firm Stern Stewart & Co.’sEVA model less than one half (about 215 companies) in the S&P 500 had postive Economic Marginsin 2009 as the U.S. economy experienced the worst contraction since the Great Depression.

As the economy moves from the brink of collapse and companies that were given up for dead - the ones that fell the most through March 2009 - are going to have to do more than just survive.  This "bounce back" effect is the reason that negative economic margin firms have risen the most.  But in 2010 the bet will be that companies with the best EVA performance will out-perform as the recovery takes hold.

Joel Stern, the CEO and chairman of Stern Stewart & Co. reminds Bloomberg readers this morning that changes in EVA are four times likely to rise and fall with share prices than per-share earnings. 

EVA, also known as economic profit, is a more reliable gauge of management performance because it treats the price of intangible assets such as research as an investment, while measuring all returns against the cost of raising money for the business, according to Stern.

The argument that “earnings per share is a driving force on value fails in the face of actual evidence,” he said. “It’s not earnings or dividends that create value, but economic performance.”

via www.bloomberg.com

BERK: We clearly overshot on the down-side as panic about solvency reached its crescendo in March.  Going into 2010 those companies with relatively high economic profitability and a low stock price relative to its value should do best going forward.

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

 

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

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

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

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