Investment Matters

What the company says is profit versus what really is profit. Skulduggery?

What companies highlight in the media and to shareholders is often different to that which is in their statutory accounts.  Skulduggery?

A recent article by investor Peter Morgan in the AFR struck a cord with me.  It raised concern about companies using 'underlying' reporting numbers, which are not audited or signed off, and are "open to skulduggery".  The article also raised concern about ASIC's monitoring and response (or lack of) in relation to underlying numbers. 

You may recall that in Investment Matters during reporting seasons, we present company summary tables containing both statutory and underlying figures.

This week's Investment Matters provides a perspective on this subject from your Investment Team.

Firstly, some back to basics

Statutory figures are those presented by the company in their formal company reports.  Strict accounting standards apply, and the figures are subject to independent audit.  They include all items and costs that impact profit (Income Statement), financial position (Balance Sheet) and cash flow (Cash Flow Statement). 

Underlying figures are also usually presented by the company.  The underlying figures (sometimes also identified as normalised, or cash figures) are adjusted to remove the impact of items that are considered 'one-off'.

Why are underlying numbers important?

As investors we look to the future - what can we expect a company to earn in coming years.  It is these expectations for the future that are a key driver in ascribing a valuation to a company. 

Underlying numbers provide a better baseline on which to make future predictions.  For instance, in the case of a property trust, a windfall gain based on a one-off property valuation increase, should not be assumed to be repeatable in coming years.  Instead it is the recurring rental income from that property, which is included in underlying earnings, that matters.

One of your investments, Challenger, is also a case in point here.  Its normalised figures remove the impact of market movements.  Simplistically, Challenger invests monies it receives from the purchasers of annuities in fixed interest / bonds (and to a lesser extent in the property and equity markets).  Income from these investments is used to pay the annuity holders.  Market movements of bonds (the trading price at a given point in time) are essentially irrelevant, as Challenger holds them (usually) to maturity, when face value is to be returned.  Such market movements are also outside Challenger's control.  Thus it is important to consider Challenger's normalised figures when assessing their financial performance.

So ignore statutory earnings?

Not at all.

Asset write-downs are an item that is usually excluded from underlying earnings.  But a write-down should not be dismissed as unimportant or insignificant.  Far from it.  In fact, write-downs of asset valuations are particularly concerning.  By writing down an asset's valuation, the company is in effect saying to shareholders that it is not going to earn as much money from that asset (or investment) as was planned when it acquired it (or entered into it). 

The bigger the write-down, the lower the expected future earnings as compared to the expectation at acquisition.  And in effect the more the company overpaid for the asset when it acquired it.

Woolworths' shareholders incurred $1.9b (not million, billion) of write-downs associated with the failed Masters hardware store joint venture in FY-16.  This shows how much value destruction there has been for shareholders.  (But it is really just the tip, for example, the opportunity cost i.e what if value creating investments had been made instead, management distraction etc.) 

The following chart shows the Woolworths share price vs the All Ordinaries - showing the market penalising the company for the Masters performance, along with other issues (such as increasing competition from Aldi and Coles, and BigW trading issues).

Woolworths

Each write-down has its unique circumstances.  But to us, as investors, it is also a red flag to question whether management and the company's Board made a flawed decision when it acquired the asset (and thus whether the acquisition undermines their credibility; whether they should be ongoing managers of the company - assuming management and the Board haven't changed since the acquisition was made).  This feeds into the more qualitative considerations of investing in the company.

Reconciliation

Underlying figures are also not subject to the same level of independent audit, and are thus more open to be influenced by management determination. Thus it is important to review the reconciliation table/s that the company presents.  Companies usually provide a reconciliation between the statutory and underlying numbers.

We have found property trusts perhaps the worst sector overall in presenting underlying numbers.  We actually use statutory numbers as the starting point, and do our own calculation of underlying numbers.  Then we look at what the property trust's reconciliation says. 

The AIFRS (International Financial Reporting Standards - Australia) standard was introduced in 2005 as an attempt to set a standard for doing the adjustments for REITs (Real Estate Investment Trusts, i.e. property trusts).  But even with this, our experience is we generally don't like what we see in terms of reconciliation for property trusts.

However, most companies we invest in are pretty good - with clearly traceable reconciliation tables between statutory and underlying numbers.  Then the principal check before using the underlying numbers is whether any of those costs are in a grey area, and should be put back in the numbers that we use for modelling.  Restructuring and software system costs are classic examples of this.  Our view is that if the company would have had to incur the restructuring cost (or whatever the adjusted item is) as a normal part of doing business, then it is included in our financial model.   Also, if there is insufficient disclosure as to the removed cost, we will put it back into the model.  If in doubt, we err on the conservative side.

What we would like to see

All that said about reconciliation, we don't consider the lack of independent audit or standards regarding underlying numbers as ideal, and would like to see this change.  Also, to reduce management incentive for wrongdoing, bonuses paid should be based on rolling years, where underlying figures form part of the assessment mechanism.  (We note that bonus claw back is difficult, for example assets have often been acquired by a previous management team and Board.)

The bottom line

Consideration of both underlying and statutory figures is important when analysing a company.  Asset write-downs should always be of concern and not dismissed (as management is oft inclined to do).  Statutory-to-underlying reconciliation data needs to be reviewed, to provide confidence in relying on the underlying figures.