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Evenlode Investment View – July 2010

The Accounting Smokescreen

When economic times were better, ‘restructuring’ was a dirty word in the lexicon of executive management teams. Nowadays, as our new Chancellor would put it, we are in an 'age of austerity' and it’s far more acceptable to talk of restructuring and its associated costs. In fact, it’s quite rare now to read a set of company results that don’t separate out some exceptional costs and/or present their close relation ‘adjusted earnings’ as the main measure for communicating earnings to investors. Unless we see a very significant pick-up in the economic environment, this mode of presentation is likely to persist.

We view exceptional costs and adjusted earnings as something of a smokescreen – a way in which the true economic reality for individual companies (and, at an aggregate level, the overall stock market) are being obscured from sight. In many cases the level and duration of costs incurred begs a simple question – when does an exceptional charge stop being exceptional? Is it two years, three years, four or five?

The best businesses – even cyclical ones – should ideally be able to react to a changing economic environment, pay for those changes, and still generate healthy earnings and cash. We commend WS Atkins, for instance, for not even attempting to disclose what many companies would separate out as exceptional costs in their own results. As Heath Drewett, finance director, put it on a recent conference call:

“The reason we put restructuring and redundancy costs above the line is that they’re no different to the investment costs of growing the business. Recruiting heavily, for instance, doesn’t come without one-off costs either. That’s the counter to restructuring and redundancies when you’re in a different stage of the cycle”

Of the offenders, we admit to owning a few. In particular, the healthcare sector contains some particularly choice participants in the game of long-running ‘exceptional’ charges. Astrazeneca, for instance, has been guiding investors and analysts on an adjusted earnings figure since 2007, which excludes all restructuring and exceptional costs. We suspect that 2010, the fourth year running for restructuring costs, won’t be the last. However, Astrazeneca generates very healthy cashflow even after these restructuring costs. If it didn’t, we wouldn’t be comfortable owning it.

Another favourite cost to be swept under the carpet and excluded from adjusted earnings are the write-downs of goodwill and intangibles from past acquisitions or investment projects – often referred to as ‘non-cash’ writedowns. Although described as ‘non-cash’, when viewed through the lens of a long-term shareholder they are just as much a cash item as any other cash cost. They are past mistakes made with shareholders’ cash. The cash was invested, then capitalised on the balance sheet, but ultimately lost in a project that failed to generate a return.

Vodafone’s earning record over the last decade is a good example of the impact of this type of write-down. The gap between ‘adjusted earnings’ and ‘earnings after all items’ is huge, mainly relating to write-downs due to capital allocation mistakes made in the late 1990s (shackles that the company has only recently managed to throw off):

Vodafone Earnings

Adjusted  After All Items
2001   3.5p        -16.1p
2002   5.2p        -23.7p
2003   7.2p        -14.4p
2004   9.0p        -13.2p
2005   10.8p         9.7p
2006   11.0p       -35.0p
2007   12.3p       -9.8p
2008   12.6p        12.6p
2009   17.0p         5.8p
2010   15.9p        16.4p

As Robert Louis Stevenson put it, ‘sooner or later, we all sit down to a banquet of consequences’. For companies that allocate capital poorly, the consequence is normally poor long term share price performance – regardless of how hard a company tries to hide its mistakes from view. On the other hand, companies that allocate capital well will ultimately be rewarded appropriately. We commend two of our holdings, Halma and Diploma, for explicitly embedding in their businesses a methodology that awards management for avoiding these capital allocation mistakes*. As might be expected, the consequences of this incentive structure have been very good for shareholder returns over the last decade. It is an approach that is as commendable as it is rare.

To summarise, we are most interested in businesses that:

(a) Are generating healthy earnings after all restructuring charges, and can continue to even if they require further restructuring.

(b) Are converting these earnings into cash-flow – again, after all restructuring costs.

(c) Are run by management teams that focus on return on capital (and are ideally incentivised by this measure too).

While not a perfect recipe for success, we think this approach helps reveal the worst misdemeanors that the accounting smokescreen tries to hide.

Hugh Yarrow
1st July 2010

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st July 2010 and does not constitute investment advice.

*Both use a 'Return on Total Invested Capital' measure,including goodwill and intangibles.

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