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Taking companies to task

12 December 2015

IS this the new normal?

Many companies today are a result of having smaller companies grouped under a larger corporate banner.

But what if growing in that way, that is, by becoming a conglomerate, gets out of hand – for example, when a conglomerate’s management cannot get better returns on its assets?

If there is one thing we have learned from reviewing companies – and we learn plenty of interesting practices from our reviews – it is that becoming a conglomerate is not always the best way to expand in the market.

Recently, we reviewed a leading conglomerate, scrutinising its balance sheet. It had assets of about US$26.6bil, but its return on investment was under 5.3% a year. We were puzzled why this conglomerate could not muster a higher return than that?

Also, despite having a tidy sum of US$9.5bil in cash, this conglomerate had also borrowed US$25.2bil in total. We looked through their past statements and could clearly see that they have had continuous borrowings within the range of US$22bil to US$25bil in the past four years. The knee-jerk response of any reasonable investor would be to find a way to lighten the conglomerate’s debt load as soon as possible.

In fact, with just a few simple tweaks, this conglomerate could improve its profit-before-tax numbers quite easily.

For example, at an effective borrowing rate of 3.2% per annum, if the conglomerate used its US$9bil cash stash instead of taking out loans, it would save US$288mil in interest payments. These savings, in turn, would increase its pre-tax profits by 23.4%.

In addition to that, in terms of boosting its return on investment, if they raised the ROI by 1%, that move would also improve its pre-tax profits by US$265.6mil.

The above adjustments are so elementary that one has to wonder why the conglomerate’s management has not pursued these steps as a strategy that should improve their numbers significantly. All it takes, really, is to implement two plans:

Plan 1 – increase the group’s ROI; and

Plan 2 – reduce its borrowings by paring down its stash of cash; after all, returns on cash today are nearly negligible.

We know very well that one would need a progressive management to act on both plans, that is, by inching up ROI by 1% – which is really not that much to expect – as well as dip into its cash levels.

In the case of this conglomerate, however, it appears that its management is not quite focused for now on securing better returns for it. What the group needs is sharper vision and a surer strategy to keep the whole ship afloat. Its management might even want to spin off some of the loss-making entities within the conglomerate as well as invest more deeply in areas that are directly linked to those parts of their business model that are sturdy revenue earners.

At first sight, investors would look the other way at a company in troubled waters, like this conglomerate with its significant plunge in profits before tax, a result of collapsing revenue. But after careful screening, one can identify the rainmakers within the group.

Can’t its management, then, leverage on these money-making sections within the group to offset the losses from elsewhere within the conglomerate? Incidentally, its loss-incurring divisions have, over a few years, chalked up annual losses between US$240mil and US$300mil. These numbers are not too small and shouldn’t be ignored.

The conglomerate’s management has responded – by renewing its faith in its loss-makers, and suggesting that once they can draw on capital expenditure, these loss-makers will turn around and leapfrog their competitors to reach more potential users and so gain a bigger share of the market.

The challenge for this management, as far as we see it, is that their competitors are also employing that very same strategy; the upshot is that this is now a race in which rivals try to outspend one another faster.

The question that investors in this conglomerate should be asking its management is: Do they have a target date for their loss-making divisions to turn around and be profitable? Not having such a target means that all the management can hold on to is hope, and we all know that hope is not a strategy.

The management should also be asking itself how much more capital expenditure is needed for its loss-making divisions to reach that target turnaround date.

The conglomerate’s more resilient divisions are not necessarily in calmer waters either. In fact, our review shows their future to be also plagued with uncertainty. That is mainly because management has made huge investments, but their yields remain disappointing at best.

Solid suggestions

To strengthen the conglomerate, we are of the view that it should hive off its loss-making divisions by selling them to a company in that related space that does not have any existing market share. If the sale goes through, the conglomerate would immediately improve its group profits by almost 20%. It would make sense for the conglomerate to look at options like this.

Sometimes, a company’s management is reluctant to listen to, let alone act on, solid suggestions. It tends to only relent when the market pushes for change through naming and shaming or, more drastically, for the management or the board of directors to be replaced. We are seeing such pushes in other parts of the world, with strong hints of this going to happen more often in our region.

If history is anything to go by, many intransigent corporations in this region are in for a very rough ride from investors and market watchers who will take companies like this conglomerate to task for its flabby approach to growing profits for investors.




© CORSTON-SMITH ASSET MANAGEMENT SDN BHD 2014