Australian Equities

Recognising corporate complexity

We feel our job should be to assimilate all the available information and history in determining whether the price we are paying for companies is fair, cheap or expensive. We must think.

06/09/2017

Martin Conlon

Martin Conlon

Head of Australian Equities

Fans of Robin Williams and Dead Poet’s Society might remember the wonderful scene where John Keating (Robin Williams) is first teaching his students about appreciating language and poetry.  He facetiously draws a chart on the board plotting the importance versus perfection of a poem and slowly assassinates the theory of J Evans Pritchard on understanding poetry before asking the students to rip the pages out of their text books.  “Excrement.  That’s what I think of Mr J Evans Pritchard”. “In my class you will learn to think for yourselves again” https://www.youtube.com/watch?v=LjHORRHXtyI

In reflecting on yet another results season, it reinforced the need to think, interpret the numbers and understand the history and development of a company.  Companies are collections of assets and people which management teams attempt to harness, with the intention of meeting a customer need and making profits in the process.  Financial statements are snapshots of how those efforts are translating into profits and cash flow at a point in time.  As the determination to react more quickly to the snapshot, analyse short-term guidance and study correlations in stock movements overwhelms the propensity to think, it is difficult not to feel we are moving more towards Mr J Evans Pritchard than Mr Keating.  We feel our job should be to assimilate all the available information and history in determining whether the price we are paying for companies is fair, cheap or expensive.  We must think. There will be no Mr J Evans Pritchard here.

Amongst the raft of post result management meetings there is always much food for thought. In some cases, management teams convey thoughtful and coherent interpretations of the challenges and opportunities facing the business and their plans to deal with them.  In others, the challenge of negotiating a shallow stream between them and a pot of gold would almost certainly find them dripping wet in the stream.  One of the more topical is CBA (-6.9%).  The AUSTRAC issues have added to a litany of disasters which have left the company under siege from media, politicians and regulators.  Despite these pressures, and the need to sacrifice someone at the altar of public opinion we believe Ian Narev is a highly intelligent executive dealing with the problems facing the company as sensibly as possible.  When asked about the source of the issues facing CBA, Ian Narev’s response was “complexity”.  We couldn’t agree more.  The life cycle of companies invariably drives a desire for ‘growth’.  Motivating staff to operate in a culture which is lean, ruthlessly efficient, customer focused and doing exactly the same thing as last year, is tough.  Letting bureaucracy permeate, making acquisitions to create new interest for management teams and ‘career paths’ for ambitious employees whilst increasing employee remuneration for unchanged output, is an easier way to improve employee opinion surveys.  Years of pursuing the latter (and far more common) path invariably delivers inefficiency, cost and complexity.  This must either be paid for through higher prices to customers or lower profits (or both).  Nearly all companies are somewhere in the phase of either starting to dig the complexity hole, making it deeper, or trying to dig their way out.  It permeates businesses of all sizes yet is undoubtedly exacerbated by acquisition driven growth and easy credit.  Our summation would be that Ian Narev has been trying to dig his way out, but the hole is wide and deep.  The hypocrisy of regulators, governments and central banks now suggesting CBA culture is at fault, despite their integral role in providing the fuel for bank credit growth, profits and vertical integration, is galling to say the least.  Nevertheless, the role of complexity is obvious.  Problems have taken many years to accumulate and are deeply ingrained.  Anyone who believes these can be resolved through changing the bonus calculation methodology is delusional.  The first step, however, is identifying and acknowledging the problem, which CBA have done.  Simplification will be painful and costly but hugely beneficial.  There is a reason Roger Federer does not divide his practice schedule relatively evenly between tennis, golf, water polo and snooker.  His tennis is better because he doesn’t.  Companies are no different.

In using the result snapshot to assess the positioning of companies on the ditch digging continuum between complexity and simplicity, there were examples across the spectrum.  At the more concerning end were Suncorp (-6.0%), Telstra (-6.6%) and QBE Insurance (-10.1%).  Despite superficially appealing valuations,these businesses remain mired in complexity. In all cases there is undoubted expertise and capability within the organisation.  Telstra are great network engineers whilst QBE and Suncorp both deliver high quality insurance products. Suncorp, however, are convinced customers are desperately in need of a financial services marketplace on which they must quickly accelerate spending (a solution in search of a problem if ever there was one).  When performance versus peers in insurance, banking and life insurance is mediocre, the solution seems unlikely to lie in trying to be Amazon.  We believe the core issue of customer churn and cost in insurance stems from the propensity to give new, disloyal customers a better deal than existing customers, not in the insatiable desire for a single app covering all your financial services.

Similarly, Telstra, despite shedding a significant proportion of its asset base to NBN, are accelerating spending in an undying quest for network superiority.  Although I like getting a mobile signal in the carpark as much as the next person, Telstra’s price premium is already high and its profits rest firmly on this premium and the scale advantages in customer base.  As TPG (-2.1%) seek to roll out an entire network for a fraction of Telstra’s outlay on improving a network that’s already there, cementing this advantage seems more likely to stem from lowering the cavernous gap in cost and capital efficiency versus peers rather than relying on ever high prices.  Becoming a health and any other sort of fashionable technology company, is heightening complexity and cost in an already lumbering giant.  In the quest to become Microsoft, there is little ‘micro’ emerging in its workforce, capital spend and simplification but possibly more ‘soft’ in profits if customers tire of paying for this inefficiency through high prices.  On the refusal of NBN to allow the securitisation of some payments, we will attempt to convey our views simply.  Was the company going to make any more money as a result?  No.  Will the transaction result in additional cost?  Yes.  Will the company be more complex afterwards?  Yes.  Decision made.  Send NBN Co a thank you letter.  Lastly, if one is after lessons on the pitfalls of countless acquisitions tenuously tethered to the ideal of being a global insurer, look no further.  Writing insurance policies in countless geographies and classes of business would appear relatively devoid of synergies.  Despite a seeming desire to simplify, QBE is now so complex that no-one seems to know where to start.  However, having blown off more arms and legs than Monty Python’s black knight, shareholders are understandably tiring of excuses.  It’s more than a flesh wound!

On the positive side, some companies are beginning to reap the rewards of filling in the complexity hole rather than digging it deeper.  Woolworths (-2.6%) and Origin Energy (+10.5%) are both making strides towards unravelling previous missteps in the quest for ‘growth’ and benefiting accordingly.  Resource companies which had necessarily refocused on cost efficiency and productivity gain as commodity prices plummeted have retained an admirable proportion of gains delivered from higher prices.  Fortescue Metals (+4.7%), BHP Billiton (+5.9%) and Rio Tinto (+5.3%) all delivered results which attested the benefits of focusing narrowly and executing well.  Stronger premiums for higher grade ore as Chinese efforts to improve blast furnace efficiency favour those bestowed with good quality resource provided an additional boost for the latter two.

Outlook

Life isn’t getting easier.  A governmental business plan which involves tax collections significantly below outlays and a reticence to break any bad news to beneficiaries of transfer payments, be they companies or individuals, means unsustainability remains the order of the day.  When it comes to the complexity fight, government makes even the slowest and dumbest companies look like Floyd Mayweather.  Beneficiaries of government largesse (through regulation, government protection or direct payment) such as healthcare companies, health insurers, toll roads, airports, regulated utilities and financials have remained effective in sidelining free market impacts and substituting price rises for productivity gain in driving profits.  Free market businesses which facilitate consumers receiving goods and services they desire at prices which are set by customers’ willingness to pay have borne the brunt of compromised levels of disposable income dictated by the success of lobbyists for the former group.  In the short term, energy prices and health insurance premiums seem likely to continue outpacing groceries at Woolworths, while airport parking charges seem unlikely to be halved as competition bites.

However, sustaining egregious profits does not become progressively easier and we remain wary of the combination of exceedingly high return on capital and high multiples where a free market customer is not interposed.  As low interest rates and high multiples dominate, an ever larger percentage of the market value of companies is necessarily dependent on the distant future.  Whilst it is not always necessary for shareholders to control tangible capital in order to offer a value proposition, we continue to place great emphasis on trying to understand why a business offers sustainability as the future does not appear to be growing more certain.  Thinking may be becoming less fashionable and ‘artificial intelligence’ may provide all the answers to everything, but we’re still inclined to side with Mr Keating over Mr J Evans Pritchard.

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