Truth in Financial Reporting

And GlaxoSmithKline

Truth by Olin Warner (1896) - bronze door, Library of Congress, courtesy Wikipedia.

In this image, Truth holds up a mirror and a serpent. She can look in the mirror to report faithfully what she sees or she can be tempted by the serpent to distort what she knows. Human nature has a tenuous link to truth. Company managers often bend the truth when reporting the results of their companies to shareholders and other interested parties. This is often related to the criteria for deciding their bonus payments. It is a bad business.

Investors are generally aware of the risk that exploration companies overstate their potential reserves and that new tech companies overstate their potential sales. What is more worrying is the cosmetic presentation of its accounts by a large, established company. Unfortunately, this is fairly common and it can dupe the investing public.

Vodafone is a case in point. This is its 'performance reporting' in the 2013 preliminary results.

Performance reporting                                                                    2013                      2012

(In pounds million)

EBITDA                                                                                                 13,275                    11,193

EBITDA margin                                                                                    29.9%                   29.4%

Adjusted operating profit                                                                11,960                    11,452

Adjusted profit before tax                                                               10,528                    10,156

Adjusted effective tax rate                                                              24.5%                    24.5%

Adjusted profit attributable

to equity shareholders                                                                     7,696                    7,680

Adjusted earnings per share (pence)                                            15.65p                    15.61p

Free cash flow                                                                                    5,608                      5,501

Net debt                                                                                              26,958                   24,425

A cursory reading of Performance reporting suggests that all is well with Vodafone. This is not the case.

Vodafone's 2013 GAAP (Generally Accepted Accounting Practice) earnings per share were 0.9p, not the 'performance' figure of 15.65p. Further, without the 6.5 billion pound contribution from Vodafone's 45% stake in Verizon Wireless, Vodafone would have made a pre-tax loss of 5.8 billion pounds in 2013. As Vodafone's management has no control over Wireless, a 5.8 billion pre-tax loss is a better starting point for reporting management's contribution than the 'performance' figure of a 10.5 billion profit. And see an earlier post at http://thejoyfulinvestor.blogspot.co.uk/2013_05_12_archive.html

It will not surprise the reader to learn that EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) and 'adjusted cash flow' (a figure not reported in the 2013 prelims) form two of the performance indicators for calculating the bonus payable to top management. Earnings per share do not. Most companies use performance indicators to calculate bonus payments, and it is always enlightening to see what the Board believes to be the most important measures of success.

The focus on EBITDA is dangerous, because it is a misleading indicator of a company's profitability. This is particularly true of Vodafone, which has a long history of taking huge charges for goodwill impairment (26 billion these last 5 years). And Vodafone cannot survive without spending large sums on capital expenditure (6.2 billion pounds in 2013), which also gets written down. Neither is included in EBITDA.

This selection of favourable 'adjusted' figures enables Vodafone's CEO to write, “Thanks to further strong progress this year in our key areas of strategic focus − data, enterprise and emerging markets − and an excellent performance from VZW, we have achieved good growth in adjusted operating profit and adjusted earnings per share." Adjusted is the operative word.

The following table would be my starting point for evaluating the business actually managed by Vodafone's management. I have excluded 'Other income' as it includes foreign exchange gains and losses and the profit on the sale of assets. Neither are core management activities. Instead of the 71 billion pounds EBITDA, management should be concentrating their efforts on the negligible profitability of the non-Wireless business these past 5 years.

Vodafone results	2013	2012	2011	2010	2009	2009-2013
Pounds million
REVENUE	44445	46417	45884	44472	41017	222235
EBITDA	13275	14474	14670	14735	14490	71644
Depreciation, Amortization & loss on disposal of assets	7792	7906	7967	8011	6824	38500
OPERATING PROFIT	5483	6568	6703	6724	7666	33144
IMPAIRMENTS	7700	4050	6150	2100	5900	25900
INTEREST	1483	1932	429	1512	2419	7775
MANAGEMENT PROFITS	-3700	586	124	3112	-653	-531
ASSOCIATES	6477	4963	5059	4742	4091	25332
OTHER INCOME	478	3999	4315	820	751	10363
Profit Before Tax	3255	9548	9498	8674	4189	35164
TAX	2582	2546	1628	56	1109	7921
Profit After Tax	673	7002	7870	8618	3080	27243
MINORITIES	-244	-46	98	27	-2	-167
ATTRIBUTABLE TO SHAREHOLDERS	429	6956	7968	8645	3078	27076
EARNINGS PER SHARE	0.9p	13.7p	15.1p	16.4p	5.8p

Vodafone makes much of 'free cash flow', but it is a flawed measure of a company's cash generating capacity when that company requires sizeable other outlays to keep going. Vodafone is repeatedly required to make license and spectrum payments, but these expenses are not included in Vodafone's definition of 'free cash flow'. Once these are deducted, Vodafone's free cash flow of 5.6 billion pounds falls to 3.1 billion pounds. This is insufficient to cover the dividend payment of 4.8 billion. Wireless came to the rescue with a 2.4 billion pound dividend payment to Vodafone in 2013.

The lesson for the investor is:

1. Do not trust headline reporting by management. Unfortunately, the financial press and blogs tend to use the same figures. Management's figures are at hand and many journalists do not have the time to check them.

2. Whenever you see the adjective 'adjusted', work out what the adjustments are. Do they make sense? Or are they merely a way to make management look better?

3. Free cash flow is useful, but it is calculated in differing ways and is company specific.

4. There is no substitute for studying the consolidated accounts and relevant notes to the accounts.

5. It is worth reading the Chairman's, CEO's and CFO's reports in the annual report. Self-congratulation when business is not going well is a sign of worse to come. An honest appraisal of what needs to be done is a sign that it might actually happen.

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GlaxoSmithKline

Selection of pills, courtesy Wikipedia

Glaxo is the 7th largest pharmaceutical company in the world by revenue. Considering the growing proportion of spending on healthcare worldwide, it is disappointing that Glaxo has made so little financial progress these last 10 years. Consider:

1. Revenue has increased by an average of 2% a year since 2003. And it has actually declined by 7% since 2009.

2. Profit after tax in 2012 (4.7 billion pounds) was the same as in 2003 (4.6 billion pounds).

3. Shareholders' Equity has barely increased over the decade.

Glaxo has had to contend with the expiry of its patents and the consequent competition from generic drugs. It is increasingly difficult to discover new drugs and the cost of getting them approved by America's Food and Drug Administration has escalated. In the last few years, austerity has hit European market. The 4-billion pound US legal settlement for the side effects from taking Avandia for diabetes, with the consequent loss of market share, was a further blow to the company. Sales to the US are down by 11% since 2003.

Management has not been idle. The 2005 Annual Report was titled New Challenges: New Thinking. In 2008, Glaxo identified a new strategy based on:

1. Grow a diversified global business: to move away from the traditional 'white pills and western market'. Revenues from outside Europe and America have grown from 31% of the total in 2003 to 41% in 2012. And the company has developed a big vaccine business.

2. Deliver more products of value: to concentrate R&D on the most profitable sectors and increase productivity. It is difficult to evaluate the success of this strategy.

3. Simplifying the operating model: the prime objective was to make annual cost savings of 2.2 billion pounds by 2014. In 2012, the company reported that it had made 2.5 billion in annual savings.

Management has leveraged the company to buy back shares and pay for the new strategy. Glaxo is, as a result, weaker financially now than in 2003. In 2003, Glaxo had net cash of 1.6 billion pounds; in 2012 it had net debt of 14 billion pounds. It would take more than 3 years of free cash flow to pay it back. In 2003, the dividend was covered 1.68 times by free cash flow; in 2012 this had fallen to 1.23 times (after excluding the payment of 2.7 billion in legal expenses).

Return on equity (ROE) has also suffered. While the historical ROE was 82% on 2003's unleveraged balance sheet, the average return on retained earnings since then is but 7%. This helps to explain the lack of growth in earnings. Earnings per share have increased by 10% these past 10 years only because Glaxo has bought back 15% of its shares in this period.

With no real growth in its business, but with a steady cash flow that can be relied on to pay dividends for the foreseeable future and with an A+ credit rating for long-term debt, Glaxo shares resemble a bond more than a common stock. Perhaps this explains its current rating.

Glaxo's shares, like its UK competitor Astra-Zeneca, have risen substantially more than the FTSE-100 in recent months. Both have outperformed the FTSE 100 handily since 2008. And both weathered the financial crisis well, reflecting the stable nature of their businesses.

Courtesy Yahoo, click to enlarge.

Glaxo shares are currently rated on an historical PE ratio of 19 and they yield 4.2% at 1765p. The 5-year earnings model for Glaxo gives a value of 1250p a share, assuming a discount rate of 8.3% (3.3% investment grade corporate bond and I add 5% for risk and a profit).

The cautious investor will note:

1. Glaxo shares have increased in value by 34% since November 2012 (from 1314p a share).

2. The PE ratio of 19 cannot be justified by a company with essentially no growth.

3. In the search for yield, the present 4.2% yield on Glaxo shares could well be the overriding attraction for the stock. If corporate bond rates increase significantly, or if Glaxo's dividend is seen to be vulnerable to a cut, the shares could lose this premium rating. For years Glaxo traded on a PE in the 9-12 range.

 

 

 

 

 

 

 

Risk and the Asset Allocation Dilemma

And Reckitt Benckiser PLC

Griffin panel Knossos, Crete, courtesy Wikipedia

The ancients created the most marvellous hybrid animals by artistically crossing different species. Wall Streeters and City slickers have created hybrid assets classes that have complicated the asset allocation decisions for individual investors. As has the liberal monetary policy of the central banks since the 2008 financial crisis.

Once upon a time, it seemed to be so simple. Bonds were only issued by governments and the most solid of companies. They paid coupons that gave a return above inflation, didn't default and were senior to unsecured creditors. Equities soaked up speculative funds, rarely paid dividends, and were the first to be hit by any calamity. And cash you held on deposit at the bank, which paid an interest rate that usually covered inflation. These old idealised and simplified categories of assets pervade the thinking on asset allocation. They shouldn't.

The following graph compares the trajectory of the price of UK funds invested in high yield (junk) bonds (in pale blue)to the common shares of Reckitt Benckiser PLC (Reckitt in dark blue).

Courtesy Morningstar, click to enlarge.

The graph covers the period between May 2007, prior to the financial crisis, and today. Reckitt shares withstood the financial crisis months of November 2008 to March 2009 much better than high yield ("Junk") bonds. 44% of Reckitt's business is outside Europe and North America. It is the world leader in cleaning products. Reckitt's earnings per share continued upward, as if there was no financial crisis.

In Margin of Safety (1991), the hedge fund manager Seth Klarman noted that some equities "may demonstrate the stable cash-flow characteristics of high quality bonds." Reckitt is one. And some bonds "more closely resemble options on a future improvement in business results than fixed and secure claims against the current value of a company."

But risk is not a function of an asset class. Risk, as Klarman insists repeatedly, is a function of what you pay for an asset. Consider the present yield on financial assets.

1. Cash. Instant access accounts offer up to 1.7% gross interest. Even for nil rate investors, this is 1.1% below the current rate of inflation of 2.8%. Put it away for one year and the top rate increases to 2%. 5 years and the top rate is 2.55%.

2. Index linked Gilts. At the latest auction (April) they yielded a negative 1.26% p.a.

3. 10-year Gilts yield 1.88% p.a. If inflation continues at the current rate, investors are locking in a loss of 10.4% for the next ten years.

4. Investment grade corporate bonds (SLXX) are on a redemption yield of 3.37%.

5. High Yield Bonds ("Junk bonds") now yield only 5%.

6. Equities (FTSE 100) are on an earnings yield of 7.4% and a dividend yield of 3.4%.

The topsy-turvy relation between inflation and the yield on cash, bonds and equities is the result of the central banks' monetary policy. They aim to bring interest rates, via money market rates approaching zero and 'quantitative easing', to the lowest level possible. Devalued sterling and inflating asset prices contribute to inflation. Asset bubbles have been created and the investor will note:

1. Cash kept in pounds is the one asset that does not decline in nominal terms. It is safe from bubbles, but not its enemy, inflation. Present returns on cash are guaranteed to reduce its value slowly in real terms.

2. All forms of gilts and corporate investment grade and junk (high yield) bonds are firmly in bubble territory. Their prices are at, or near, record highs. If they are safe, they offer no protection against inflation. If they are risky, the margin over inflation does not compensate for their risk.

3. Equities, like other asset classes, have benefited from the largesse of the central banks. But the equity bubble has been suppressed by the major stock market crashes of 2001 and 2008-9 that are still fresh in investors' minds. The FTSE 100, in terms of its price earnings ratio, is not obviously in a bubble:

Courtesy Retirement Investing Today at http://www.retirementinvestingtoday.com/2013/01/the-ftse-100-cyclically-adjusted-pe.html data is from 1993 to April 2013. Click to enlarge.

In the above chart:

The olive line is the Price Earnings Ratio (PE) of the FTSE 100 for the earnings of the year in question.

The blue line is the PE of the FTSE 100 on rolling ten-year average earnings (the Cyclically Adjusted Price Earnings Ratio).

Both show that equities, in terms of PE, are cheap by recent historical standards. It should be noted that the decade prior to 1993 the FTSE PE ratio was much lower, averaging around 12.

In terms of risk, it can be argued that:

Currently, cash and equities are the lowest risk asset classes, depending on the period they are to be held. Gilts, corporate bonds of all natures and sovereign debt are the highest risk asset classes at the moment. (But see http://thejoyfulinvestor.blogspot.co.uk/2013_01_13_archive.html and http://thejoyfulinvestor.blogspot.co.uk/2013_01_20_archive.html for further comments.)

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Reckitt Benckiser PLC

Sunshine Cleaning poster courtesy Wikipedia

Reckitt Benckiser (Reckitt) has built a successful, cash generating, recession resistant business on the sale of cleaning products. 19 'power' brands in health, hygiene and home cleaning products account for 70% of revenues. According to the company, these are all ranked one or number two in their respective world markets. They include Strepsils, Durex, Nurofen, Scholl, Dettol, Lysos, Harpic, Veet, Finish, Clearasil, Air Wick, Vanish, Calgon, Woolite and Cherry Blossom shoe polish.

56% of Reckitt's revenues derive from North America and Europe and 44% from the rest of the world. Shares in Reckitt (blue) have comfortably outperformed the FTSE 100 (green) these past 5 years.

Graph courtesy of Yahoo, click to enlarge

The company is highly profitable, growing and cash generating:

1. Reckitt's net operating margin is steadily in the 25-26% range, and the historical return on equity (ROE) is 30%. ROE on retained earnings is 21%.

2. The company's growth in earnings per share has slowed from 20% (2004-9) to 10% pa. (2009-2012). Equity per share and dividends per share have followed a similar pattern.

3. Between 2009 and 2012, Reckitt has generated 7.1 billion pounds in operating cash flow. After paying out 3.9 billion in capital expenditure and dividends, it still had a surplus of 3.2 billion. It has used these funds to buy new businesses and to buy back shares. The company is in the fortunate position of having negative working capital. So the more it sells, the less capital it requires.

Reckitt's balance sheet is strong, with net debt at 40% of equity and a mere 7% of the company's 34 billion-market capitalization. It could pay off its entire debt with one year's earnings. The defined pension scheme deficit is low (0.4 billion) and Moody's rates its unsubordinated debt A1.

Reckitt's current share price of 4828p puts the company on an historic PE ratio of 18 and it pays out a dividend yield of 2.8%. The only large director transaction occurred on 3 May, when the outgoing CEO realised 1.3 million pounds from the sale of shares at 4642p.

Reckitt is a good addition to an investor's long-term portfolio. But at what price?

It is easy to overvalue a company with the growth characteristics of Reckitt. But a too cautious approach can lead to undervaluing a growth company. I have used the following assumptions:

1. Earnings per share (EPS) growth. From 2004 to 2009 Reckitt's EPS grew by 20% p.a., and from 2009-2012 it grew by  10% p.a. Assuming a continuing decline in growth, I have used 8% p.a. for the period 2013 to 2017.

2. Return on Equity (ROE). Based on its historical cost of assets, Reckitt's ROE is 31%. But on retained earnings, from 2004 to 2012, it has averaged 21%. I have used 20% for the period 2013 to 2017.

3. Equity per share (EqPS). From 2004 to 2009, Reckitt grew its EqPS by 18% p.a. This declined to 14% p.a. between 2009 and 2012. I have used 10% p.a. for the period 2013 to 2017.

4. My discount rate of 10.3% is based on the return on investment grade corporate bonds (3.3%) plus 2% for operational risk plus 5% for a margin of safety.

5. The dividend payout ratio is based on the company's policy of paying out 50% of EPS as dividends. And the PE ratio for the last 5 years has averaged 19.

On this basis, Reckitt is valued at 4454p compared to a present price of 4828p. More optimistic assumptions (EPS growth of 10% p.a., EqPS growth of 14% p.a.) would value the shares at 5448p. This illustrates the sensitivity of growth assumptions.

The prudent investor will note:

1. Reckitt will have a new CEO, and this introduces a new level of unpredictability.

2. If growth falls further, the PE ratio might well fall, with the consequence that the shares would lose twice over. Lower earnings on a lower PE.

3. Reckitt's competitors include some of the strongest marketing companies in the world (Unilever, Colgate-Palmolive, Procter & Gamble, SC Johnson and Henkel).

4. Reckitt's share price has increased by 47% since June last year, well ahead of the FTSE 100's 29%.