Life Cycle of a CEO
by Mark Causer
When Financial Keys ‘interviews’ an investment manager to form part of its investment stable, a lot of time is spent researching the skill set, background, track record and general overall performance of the manager. One area that Financial Keys looks at closely is each manager’s qualitative ‘screening’ techniques on what they look at when selecting underlying investment.
One investment manager that Financial Keys has researched recently, Perpetual, looks closely at the life cycle of the CEO when trying to understand if their company is worth investing into.
Perpetual’s Head of Investment Markets Research, Matthew Sherwood, says:
One of the most important things we spend time on when analysing a company is understanding the motivation of a CEO. Understanding what drives a CEO is extremely important. We invest substantial amounts of our unitholders' money in companies managed by these CEOs, so understanding why they make certain decisions is extremely important. As fund managers we do not have access (nor do we want access), to all the information that management use when making important operational and strategic company decisions. Like investing, every major decision made by a CEO involves taking a risk and we are very well aware that even decisions made with the best intentions may end up being mistakes. What is important to us is that behind closed doors, with all the information they have and using all their experience, CEOs are motivated to make the right long-term decision to create value for shareholders. When coming to a conclusion on this we think it is important to make a few observations:
Analysing the life cycle of a CEO is extremely important
his is especially important when it comes to long serving CEOs
We think it makes sense to take great care when investing in companies where a long-serving CEO is about to leave.
It may surprise some to learn that the average length of time that a CEO spends serving a company is less than four years. The behaviour of CEO can therefore often be compared to prime-ministers and premiers, who usually serve through a four year political cycle. Given how short the life-span of a CEO usually is, even the best intentioned CEOs have to balance the short-term demands of the board and shareholders, with the responsibility of trying to create long-term value for shareholders. It is our view that understanding where a CEO is positioned within their life-cycle is extremely important when it comes to understanding why decisions are made and this in turn makes up an important part of our investment process.
A recently appointed CEO will often conduct a full business review to ensure that there are no hidden problems within the business and is probably incentivised to over-emphasise problems/issues with the company and implicitly blame the previous management. However, this is when the new CEO will typically make the best long term decisions for the company. On the other hand, when a CEO is coming towards the end of their tenure, short-term decisions designed to maximise the short term share price and earnings of the company are not unusual. Practices commonly used to maximise the short term share price include reducing costs unsustainably, adopting aggressive accounting methods that over-state true earnings potential, making acquisitions in an effort to hide underlying business issues and implementing aggressive capital management strategies such as buy-backs/capital returns/increased pay-out ratios.. Not only will this behaviour tend to result in the outgoing CEO hitting his/her STI and LTI targets, but it also helps to build the perception that they have done an excellent job running the company. This perception also assists the outgoing CEO’s ability to secure future CEO or board positions.
We have provided below a few recent examples of where we believe some long serving, well respected CEOs approaching the end of their respective tenures have started to make short term strategic and operational decisions designed to boost the short term share price at the expense of longer term value creation. While there are many examples of such activity occurring throughout the market, we have focussed on Coca-Cola Amatil, Metcash and Leighton Holdings.
Terry Davis was CEO of CCL for almost 13 years from 2001 to March 2014. He should rightly be remembered as a CEO who left the company in a better state than when he started. As was trumpeted by the Chairman at the 2013 AGM (just after Davis announced his intention to retire), since 2001 when Davis started shareholders had received a total return was 430%, with average EPS growth of 10% pa and average DPS growth of 14% pa. This was during a decade which included the GFC, and hence was no mean feat for Davis to achieve this. However, in the last eighteen months of his tenure, we believe that decisions were being made in order to maximise the company’s short term earnings and share price.
It became clear during this time that there was pricing pressure in the grocery channel as Coles and Woolworths continued to squeeze their suppliers. It seemed that CCL's response was to keep prices high across their distribution channels and to reduce costs across the board in areas such as marketing and innovation. While such actions help the company’s short term earnings and share price, they are not sustainable in the medium to longer term. In addition to this, accrual earnings throughout this period were continuously well above cash flow earnings, as depreciation was well below capital expenditure. Over the last five years capital expenditure was $1.9bn in aggregate, almost double the aggregate depreciation of $1.1bn. While this was made out to be expansionary capital expenditure for future earnings growth, we suspect that a large element can be attributed to under-depreciation of the real amount of capital expenditure required for the company to stay in business. One could argue that this results in the accrual earnings overstating the true underlying cash earnings of the company.
When Alison Watkins came in as CEO in March 2014 she immediately called a strategic review which as of the time of this newsletter has not been released. However, in April 2014 (just one month after taking over as CEO), the company came out with a large earnings guidance downgrade stating that "Group EBIT (for six months to June 2014) before significant items will decline by around 15% from the previous comparable period". This took the market by surprise, which up until this moment was forecasting slight growth in earnings. In August, the company gave a little more colour on the content of the strategic review:
"It (strategic review) has highlighted the consequences to earnings of a focus on short-term tactical decisions without consideration of the longer-term challenges........We intend to invest in higher levels of marketing and innovation in order to build a stronger competitive position in the market and thereby provide a more sustainable earnings base...."
Put another way, it appears the previous CEO inflated short term earnings in order to leave on a relative high and shareholders now have to re-invest for the long-term sustainability of the business. There is always the risk that the new CEO may be overstating problems (like a new Prime Minister might), in an attempt to lower base line earnings and expectations and thus make it easier to leave as a perceived success story years down the track. However as independent outsiders we believe that there was some short-termism at the end of Davis' term as CEO
Another example of a long serving CEO who recently left is Andrew Reitzer from Metcash. Reitzer took over as CEO of David’s (which became Metcash) in 1998 and remained as CEO for fifteen years. There is no doubt that shareholders are better off now following his long tenure than when he started. As stated at his last results announcement in June 2013 "The market capitalisation of the company has increased from $130m in the year he took over to $3.1bn today. Sales have increased significantly over this period from $4.5bn to $13bn today. No matter how you look at this, Andrew has been very successful”. We agree, however we believe that over the last few years of his leadership, there is reasonable evidence to suggest that the company started to make shorter term strategic and capital management decisions. The actions resulted in inflated short term earnings and a higher share price at the cost of longer term pain to the company.
MTS's core business is the distribution of groceries to independent grocers (mostly to IGA branded stores). Over the last 5-6 years, MTS's customers (IGA store owners) had really started to struggle due to aggressive roll-outs and pricing by Woolworths and Coles as well as the entrance into the market of Aldi and Costco. MTS's customers were earning such skinny margins that they weren't re-investing in their stores which, if left unaddressed, would over time result in structural revenue decline for Metcash. Metcash needed to either reduce its own margins and pass this on to its customers or alternatively incentivise its customers to invest in their store network. The issue with each of these strategies is that they would hurt short term earnings (and likely impact the share price) making them unattractive courses of action for an outgoing CEO.
In August 2013, two months after Reitzer retired as CEO, the company downgraded FY14 earnings guidance, stating that underlying EPS for FY14 would fall in the high single digits. This resulted in consensus downgrades of about 10% to forecast earnings. In March 2014 the company issued a second downgrade, with FY14 EPS now expected to be down 13-15% on previous corresponding period. Later that month the company released a strategic review which addressed the issues facing the declining sales of its core business and admitted that it had been under-investing. The response strategy involved funding store refurbishments, network growth and DC automation among other things. The net result was that capital expenditure would increase from c$80m pa over the last five years to $150m pa over the next three years. On top of this the business would be hit with a step change increase in operating expenditure of $40-45m, beginning in FY15. The net impact of these changes was that within one year of Andrew Reitzer's departure the consensus FY15 underlying EPS forecast for the company fell 34% from $0.34/share to $0.23/share.
It might sound like we are nit-picking, but there was also some acquisition accounting which helped the boost earnings for MTS in the last few years of Reitzer’s tenure. Specifically, over the last five years when the company made acquisitions in the food and liquor space, it recognised large levels of provisions for restructuring and rental costs (offset by high levels of goodwill which is not amortised). As these types of provisions are released they have a non-cash benefit to the profit and loss statement. We estimate that in the four years before Andrew Reitzer left the release of these provisions helped underlying NPAT by $95m in aggregate. In isolation this is no big deal, but when viewed in the context of other similar actions, it reinforces our belief that actions were being taken to boost the company’s short term earnings. The use of such provisioning has been a very common occurrence among some of the recent private equity IPOs and has been used by other companies to inflate short term earnings.
The company had a very high payout ratio in the last few years of Reitzer’s tenure, in the range of 80-90%, which culminated in a dividend in FY13 (his final year) of 28cps. However, following the two downgrades and a strategic review which indicated that the company needed to increase capital and operating expenditure just to stay competitive, the forecast dividend for FY15 has halved to 14cps. We would argue that given the weakness of the company’s true underlying earnings the weak state of the balance sheet it was never a good long-term strategy for the company to be running such a high payout ratio.
Wal King is another example of a CEO who built one of the great Australian businesses as the head of Leighton Holdings. As was mentioned by the company on Wal King's retirement;
“His time as CEO has seen Leighton grow from revenue of $1.3 billion and a profit of $7 million in 1987 to this year’s record result of $18.6 billion worth of revenue and $612 million of profit after tax with market capitalisation growing from $85 million to $10.2 billion."
This is long-term shareholder value creation in what is a notoriously competitive and tough industry, construction. We are not trying to debate whether or not Wal King did a good job over the fifteen years he was CEO of Leighton, but simply trying to understand some of the operational and strategic decisions made during his last few years. We would argue that many of these can be classified as short term decisions designed to maximise the company's short term earnings and share price at the expense of long term shareholder value creation.
At the full year result in August 2010, (the last before King’s departure as CEO), the company sounded like it was in fantastic nick with record work in hand, a 39% increase in profit after tax and a 30% increase in dividend (75% payout ratio). The company stated that, "over the longer-term, based on our projections, the Group’s five-year aspirational goals of $50bn of work in hand, $30bn of revenue and $900m of profit after tax can be achieved through internally generated funds.”
On 4th April 2011, less than four months after Wal King left, the company announced that:
"The Leighton Group now expects to report a loss of $427 million for the financial year versus its previous guidance for a profit of $480 million after tax."
The company later raised $757m in a deeply discounted rights issue to shore up the balance sheet. The stock has never reached the levels of 2010 despite the fact that the Australian stock market has rallied strongly since.
Accounting for contracts is an extremely difficult thing to understand for an outsider looking in. Given that fixed price contracts can take three years to complete, the recognition of earnings is subjective to the internal estimation by the company of the costs it will take for the contractor to complete the project. Therefore, in any given year there are hundreds of subjective assumptions made to get to the accrual profitability of a company like Leighton. We are of the view that there was no material change in the major contracts performance in the four months between Wal King leaving and the $900m downgrade to earnings. We can draw the conclusion that the assumptions made by the new management team were vastly different from those made by the management team under Wal King.
On top of this, we identified a red flag in 2009 when there was a change in accounting policies for the group with respect to revenue recognition. Before this change, revenue for contracts was not recognised until 20% of a project was complete. After the change revenue was able to be recognised "...once the contract result can be reliably estimated”. This further increased the level of subjectivity in the Leighton earnings. We believe that the large downgrade and capital raising started a process whereby the company started focussing less on work in hand growth and more on risk management. This, of course, has permanently changed the market's view on the sustainability and growth of earnings for the company. Maybe the old management under-estimated the cost to complete the problem contracts, maybe the new management over-estimated the costs. Either way, we think it pays to be wary of companies where there is any level of subjectivity in the accounting when a long-serving CEO leaves.
There are many ways to analyse companies that ultimately find their way into your investment portfolio. This is simply one of several angles that investment managers may use from time to time.
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