Wednesday, 26 June 2013

Regime change – one way to help capital discipline

With US profits having reached a record share of GDP, central banks talking about withdrawing stimulus and markets suffering a wobble, some investors fear that the current economic rally is becoming mature. The corporate environment, however, offers little evidence to support such fears. A key indicator in this regard is capital discipline among listed companies, which is broadly improving. We therefore believe the capital expenditure (capex) cycle should lengthen. An important part of our thesis is increased institutional investor scrutiny of senior management. For this scrutiny to have any impact, it is essential that management are sanctioned for mistakes or over-exuberance.

This has been happening and there are many recent examples. One of the highest profile dismissals of recent times is of course Leo Apotheker, former CEO of Hewlett-Packard, over the purchase of Autonomy, which was a UK-listed software company. HP bought Autonomy for $11bn in 2011 then wrote it down to $2bn only twelve months later. This may have put some boards on edge, perhaps moving some to act more quickly after poor acquisitions in their own companies.

David Brennan announced his resignation as CEO of AstraZeneca in April 2012, after the purchase of MedImmune for $15bn in 2006. MedImmune has not yet been impaired in the company accounts but has generated essentially no revenues under AstraZeneca’s ownership.

All ‘big four’ UK-listed mining CEOs have recently announced that they will leave. Cynthia Carroll of Anglo American resigned in October 2012, substantively for the disastrous acquisition of the Minas Rio Brazilian iron ore project in 2008. Estimated capex increased from $2.4bn to $8.0bn and it is five years late so far. Rio Tinto’s Tom Albanese resigned after a second impairment of its aluminium assets (write downs total a staggering £25bn since the purchase of Alcan in 2007) and a $3bn impairment of the Riversdale coal assets in Mozambique purchased only 18 months earlier. The $1.8bn impairment of the Fayetteville US shale gas assets bought for $4.8bn in 2011 (along with less controversial impairments in aluminium and nickel) are likely to have contributed to the resignation of BHP Billiton’s Marius Kloppers. Shareholder discontent over the handling of the Glencore takeover has resulted in Xstrata’s Mick Davies stepping down after the merger closes (the original plan was for him to be CEO of the combined group for six months).

In contrast, the longest serving CEOs have a good M&A record and have been very conservative. Here we have far less people to choose from. Paul Walsh, the outgoing CEO of Diageo had been in his post for 12 years. Under his watch Diageo made relatively few acquisitions and did not overextend the company’s balance sheet at any point – investors broadly agree that most acquisitions have been successful.

Although Ian Marchant of SSE (formerly called Scottish and Southern Energy) recently announced that he will soon step down, this comes after ten years as CEO during which dividends have grown ahead of inflation every single year. Again, investors broadly agree that he has had a good M&A record. Another example is Lord Simon Wolfson who has been chief executive of Next since 2001. Lord Wolfson has been extremely conservative, and has made only a few, very small, bolt-on acquisitions.

New CEOs tend to be far more likely to focus on capital discipline and shareholder value, especially if previous management destroyed value. HP’s new CEO, Meg Whitman, has said she is not planning any significant M&A and will focus on cost cutting, strengthening the balance sheet and turning around existing businesses. All new mining CEOs (Rio Tinto’s Sam Walsh, BHP Billiton’s Andrew Mackenzie, and Anglo American’s Mark Cutifani) have put forward a message of increased capital discipline, cost control and increased returns to shareholders (the strongest message being from Rio Tinto). Glenstrata (to be headed by Glencore CEO Ivan Glazenberg) plans unashamedly to grow by acquisition, but both Glencore and Xstrata have a relatively good M&A track record. Another exception is AstraZeneca. At his first investor presentation in March new CEO Pascal Soriot said that he intends to support organic growth with acquisitions. That said, pharmaceuticals is one of the few sectors where investors are willing to take a positive view of sensible, small acquisitions.

A good example of how a new CEO can instill capital discipline is Vittorio Colao of Vodafone, who drew a line under the large value-destructive M&A of his predecessors. Since he became CEO in 2008, Vodafone had made only two, very small, strategically important acquisitions, divested all Vodafone’s low cash generating non-controlled minority stakes and returned much of the cash to shareholders as dividends and buybacks (the impairments in the chart below relate to assets already owned before Mr Colao took over with the extra large write downs in 2006 and 2007 relating mainly to the £112bn Mannesmann deal in 2000).

Vodafone has written down £67bn worth of assets since 2001

Source: Company accounts, Brewin Dolphin

Mr Colao, however, is no longer new, and we had feared that Vodafone may need to buy European fixed line assets in order to defend its position following regulatory changes which favour fixed line incumbents. Sure enough, Vodafone announced this week it intends to buy Kabel Deutschland for €7.7bn although few feel that this marks the start of an M&A boom.

No discussion on big mergers would be complete without at least one mention of AOL and Time Warner. Time Warner bought AOL for $147bn in early 2001 and then booked $100bn of impairments and write-downs in 2002. This and other bad deals remain part of the collective investor consciousness.

In the short term, all this could lead to better management accountability and corporate governance. Perhaps because of investor discontent, boards seem to be reacting more quickly to investor concerns – some of the more recent resignations have been board, as opposed to shareholder driven (e.g. Rio Tinto). As debt is paid down, companies’ managements will be loath to return cash to shareholders but the knowledge that one poor acquisition can lead to them being out of a job, might just sway some against ill-advised deals.

While equity returns are hard to come by, we believe that investors will continue to actively scrutinise management decisions. However, fund managers have short memories. If and when we eventually re-enter a sustained bull market, this scrutiny could well fall away. The Holy Grail would be provisions in CEO employment contracts to claw back large proportions of their pay, if acquisitions made or investments sanctioned under their watch are subsequently impaired. Right now that seems a remote prospect.

The sector which remains under the microscope in this regard is the emotive and politicised banking sector. Here the complex web of stakeholders extends even further than the competing rights of bond and equity investors. This is creating an increased focus on accountability and value creation such that the days of earnings per share-driven remuneration may be numbered. Although whether this heralds part of a structural change to management’s relationship with investors, or is simply a reflection of the business cycle, remains questionable.

Nik Stanojevic, Divisional Director

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