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Some companies are better at turning cash into shareholder value than others.
Randy Myers and Jason Karaian, CFO Europe Magazine
November 5, 2007
In the fast-consolidating steel sector, with multi-billion euro megadeals now commonplace, Salzgitter has kept a low profile. In March, when news broke that the German steel group was sizing up Algoma, a Canadian rival, expectations of a bidding war among cash-rich trade and financial buyers pushed the share price of Salzgitter's target sharply higher. The German company backed away from a deal.
"For the time being, it's difficult to find anything in steel for a realistic price," says Heinz Jörg Fuhrmann, Salzgitter's CFO. No matter: the €8.4 billion company has managed to grow revenues, largely organically, by an annual average of 13% over the past five years, outpacing global steel production growth of 9%. Even more impressively, Salzgitter's pre-tax profits have increased 63% a year over the same period, while last year's return on capital employed of nearly 50% smashed the company's 12% target. Shareholders responded by driving up Salzgitter's share price from €8 at the beginning of 2002 to more than €135 in late October 2007.
Thanks to its stellar performance, Salzgitter ranks in the top ten of a global sample of more than 600 large, listed firms (excluding financial institutions) in terms of total shareholder return (TSR) over the past five years. That's according to a new analysis for CFO Europe by The Boston Consulting Group (BCG). (See "The Value Creators.")
Given its 65% five-year TSR, Salzgitter has had the luxury of piling up cash on an underleveraged balance sheet at a time when investors are pushing many companies to make big payouts to shareholders. Despite doubling its dividend, Salzgitter now holds more than €2 billion on its balance sheet in June. Its debt-to-equity ratio fell from 261% in 2002 to 102% in 2006.
Although the cash cushion is "very comfortable," says Fuhrmann, "from a long-term perspective, we cannot deny that it is too much." While near-term prospects for the company's main line of business remain bright, "these extraordinarily good times will end one day," the CFO says. When that time comes, a large cash pile will ensure that "our ship won't sink when the first storm comes." What's more, the company's spare debt capacity will allow it to snap up less fortunate rivals during a downturn, "when nobody else is interested in acquisitions in steel, in contrast to the situation today," Fuhrmann says. As the company bides its time, a number of important capex projects are under way to bolster organic growth.
Building for long-term growth is, of course, what business schools have been preaching for generations. But conventional wisdom has been changing, says Eric Olsen, senior partner in the Chicago office of BCG, a global business-consulting firm. What was once viewed as a strong balance sheet is increasingly viewed by analysts and investors as a lazy balance sheet — one that under-exploits a company's assets, either by holding too much cash earning low rates of return or by having too little debt. (Olsen says the credit crunch hasn't changed that perception, except perhaps in sectors directly affected by the crunch, such as mortgage lending.)
Yet the cash keeps piling up. Thanks to strong balance sheets and improved cash flow return on investment, corporate profits have soared to record levels, notes BCG. As at Salzgitter, the recent upheaval in the credit markets and the growing fear of an economic slowdown are making companies reluctant to draw down cash reserves anytime soon.
In this environment, investors either hold back on giving a cash-rich company's stock its full due or push for a way to get that money into their own pockets, typically through a share buyback. If management won't pull the trigger, private-equity firms and activist investors are happy to do the job. The challenge, then, is for companies to satisfy their investors' short-term expectations while retaining enough resources to execute long-term strategy — without stumbling into what BCG calls a "cash trap." (See "Avoiding Cash Traps" at the end of this article.)
Many companies have, of course, turned to share buybacks. In the US, through to the end of last year, companies in the S&P 500 had bought back more than $100 billion (€69.5 billion) in shares in each of the past five quarters, nearly double what they were paying out in dividends. There's some logic to that, given that many companies are carrying cash and excess debt capacity equal to 20% to 30% of their market capitalisation. Still, BCG argues that buying back shares doesn't deliver much in the way of long-term value, meaning that corporate executives must still find ways to differentiate their companies from their competitors and demonstrate that they can deliver profitable, above-average growth.
Another top-performer is Terex, a $7.6 billion Connecticut-based manufacturer of construction and mining equipment, boasting a five-year annualised TSR of 49%. The company launched a $200m share buyback programme last year, but against a market capitalisation of $9.3 billion that's not terribly aggressive.
"We consider our first priority to grow the business we have, meaning through investment in capex or acquisitions that help further our franchise," says CFO Phillip Widman. "We have a return on invested capital of 40% the way we measure it, so investing in our own business makes sense right now."
When it comes to convincing the markets, actions always speak louder than words. "Five to ten years ago, we were a company still trying to prove ourselves," Widman says. "We had made several acquisitions, and investors were still asking themselves whether we could integrate and operate them effectively. Over the past five years, though, I think we've built up sufficient credibility that we have earned the right to pursue our long-term strategy. And I think that's part of what's created the increase in shareholder value that we've seen."
BCG readily concedes that finding the right balance between delivering results over the short term while retaining the financial flexibility to invest for the long haul is a tricky undertaking — one that will require different approaches from companies in different industries. But it also offers clues as to which factors managers should focus on.
Those factors aren't always intuitive. For example, many executives tend to focus on revenue growth — growth that generates returns above the company's cost of capital — as a major driver of shareholder returns. Indeed, over the long term it is the key driver. But when it comes to near-term returns, growth's contribution to shareholder returns is secondary to improvements in the company's valuation multiple — market value divided by earnings before interest, taxes, depreciation and amortisation.
A relatively small number of factors explain as much as 80% to 90% of the differences in valuation multiples among peers, BCG says. Those factors tend to cluster into four broad categories: revenue growth, profitability, risk and "fade" (BCG's term for the confidence investors have that current levels of growth or profitability can be sustained). Which factor plays the greater role in determining a company's valuation multiple depends on its business. Revenue growth can be a key differentiator in high-growth industries such as software, for example, but a secondary factor in, say, pharmaceuticals, where the research-and-development spend relative to revenue is a better indicator of long-term prospects.
On the other hand, BCG argues that a number of broad trends are affecting valuation multiples across many industries. Most strikingly, it says concerns that companies will deploy accumulated cash poorly have made investors sensitive to any signs of either fade in a company's current profitability or increased risk related to its growth strategy.
To invest for long-term growth without alienating investors, BCG says companies should re-examine how their investments align with investor expectations. Growth companies might weed out businesses that operate with a value proposition; value companies might temper risky growth plans and pay more attention to increasing the dividend. At the same time, BCG urges companies to look for new opportunities for growth, whether through innovation or by leveraging what it calls "megatrends," such as the rise of China as a major industrial power or the increasing scarcity of energy resources.
Kuehne + Nagel (K+N), a SFr18.2 billion (€10.9 billion) Swiss freight forwarder, is reaping the rewards of the most "mega" of all megatrends: globalisation. As companies increasingly scour the globe to produce, source and sell their goods, the demand for logistics has exploded. In the past five years, K+N's revenue has grown 17% per year, on average, with pre-tax profit rising 21% over the same period. Its five-year TSR, at 42%, is by far the highest among European logistics companies, and ranks second globally.
But the company hasn't simply risen with the tide, asserts CFO Gerard van Kesteren. "Half of the growth comes from the market and the other half comes from us," he says. Indeed, in the first nine months of this year, every unit — sea, air, overland and contract logistics — grew at least twice as fast as the underlying market.
The roots of the company's performance date back to 2000, when sourcing from low-cost countries, just-in-time inventory management and other trends associated with globalisation were taking hold. Van Kesteren and other company veterans took over the management board, launching a restructuring plan shortly after. As customers' supply chains grew more complex, the company refashioned itself as an integrated logistics provider, offering clients global, end-to-end services. To this end, "we eliminated all obstacles," says van Kesteren, describing the divestment of non-core businesses, such as travel services and port operators, and the termination of all joint ventures. "With a profit-after-tax margin around 2.5%, you can only optimise what you standardise," he adds. "If you own the network, you can standardise by instruction."
This proved a potent recipe for profitable growth, with K+N building a balance sheet heavy in cash and light on debt. Though this is "inefficient from a capital structure point of view," van Kesteren says that shareholders question the company's financing strategy "only every now and then." Of course, with the Kuehne family holding more than 55% of K+N's shares, management is somewhat shielded from minority investors' criticism. However, K+N's quarterly segment reporting is far more detailed than its main competitors, and "if something goes wrong, we don't hide it," van Kesteren says.
Recently, with so many things going right for the company, the CFO and his colleagues have gained enough leeway from shareholders to allow them to focus on longer-term concerns. The company's strategy is validated by a significant rise in its earnings multiple, accounting for nearly half of K+N's impressive TSR rise, according to BCG. Because managing results on a quarterly basis is "absolute rubbish" in the words of the straight-talking Dutchman, he's thankful for the trust granted to executives, who "make decisions today to make sure there's growth two years down the road."
Salzgitter, too, has been rewarded for its hard work with an investor base that believes in the company's long-term potential. "We have a certain view of the world, and behave consistently with that," says finance chief Fuhrmann, who upgraded the group's medium-term forecast for profit, sales and return on capital employed in August. "Investors trust us to perform as we explain."
A key ingredient to Salzgitter's success, especially when it comes to acquisitions, is the ability to be "quick and secret," says Fuhrmann. Without investors and analysts fixated on minor quarterly variations, the CFO and his team can more easily hatch long-term plans, which recently included the purchase of a majority stake in Klöckner-Werke, a beverage equipment maker.
In the executive board's latest annual letter to shareholders, Salzgitter's managers apologised to investors for being "a little off the mark" in keeping past promises. After suggesting that the "exorbitant" profit in 2005 could not be repeated, they pleaded for forgiveness when 2006 earnings climbed even higher, setting a new record. "We are certain that you will understand," they said. After all, it's something that any company would be happy to apologise for.
View the "2007 Value Creators Scorecard."
Randy Myers is a contributing editor of CFO. Jason Karaian is a senior editor at CFO Europe.
Avoiding Cash Traps
In their efforts to balance short-term investor expectations with long-term strategic goals, The Boston Consulting Group (BCG) warns companies to avoid four cash traps that can have a negative impact on their near-term shareholder returns.
1. The Lazy Balance Sheet Trap
Companies that ignore investor pressure for near-term returns run the risk of reducing their valuation multiple and jeopardising their independence. While listed companies probably can't get away with leveraging their balance sheets as highly as a private-equity owner would, many will find they can squeeze out cash for stock buybacks or dividends without jeopardising their long-term goals.
2. The Reinvestment Trap
Beyond deciding how much to reinvest in their business and how much to return to shareholders, companies also need to be smart about how they reinvest for long-term growth. Companies fall into a reinvestment trap, BCG says, when management misallocates resources across the business portfolio — either by feeding all businesses at the same rate despite differing growth prospects or contributions to shareholder return, or by allocating too much capital to problem businesses.
3. The M&A Trap
Acquisitions are highly appealing, especially when they are immediately accretive to earnings. But such a deal won't necessarily boost shareholder returns if, as is possible, it also reduces the acquirer's multiple. BCG cites the example of a consumer-brands company whose CEO engineered the purchase of numerous low-tier, low-margin brands. The acquisitions boosted earnings in the first year but diluted the company's average organic growth rate and margins, causing investors to drive down the multiple on the company's stock and ultimately yielding no improvement in shareholder return.
4. The Share Buyback Trap
BCG doesn't discount the role that share buybacks can play in boosting near-term returns for some companies. But the firm's research indicates that buybacks do not change investors' estimates for long-term earnings-per-share growth, or induce them to accord a company a higher valuation multiple. By contrast, it says, dividends have a far more positive long-term impact. In a study of 107 companies that boosted their dividend, and another 100 that announced an increase in share repurchases, the dividend payers saw their multiples go up over the next two quarters by an average of 28%, and the top-quartile performers by an average of 46%. In comparison, the buyback companies saw their valuation multiples erode on average, and top-quartile improvements were only 16%.