Why Smart Money’s In-word Now Begins With ‘c’

After a decade of neglecting the matter, it is encouraging that some New Zealand Boards are now sharply focused on capital expenditure’s crucial role in company wealth creation. For them C is the important word, with Capex the key to providing more effective governance.

Such Boards realise that innovation is a must but also that strategic planning must fully account for cost of capital. For them it is a given that corporate strategy consists of making vital choices to allocate scarce and often diminishing financial resources.

Better late than never, corporate New Zealand is waking up to the truth that assessing opportunity cost of capital should be fundamental to business strategy formulation, as should a disciplined program of capex priority setting. Board members must be satisfied that capex is being managed as a limited resource.

Consider how one Board approved a very poor investment:

An established Auckland corporate had 46 truck and trailers. The trailers (replacement cost $118K each) were nearly 15 years old and fully depreciated. Capex decision: replace all trailers at an all up cost of $5.4M. However, 40 of the old trailers were bought by a truck lease and hire firm. Aware the trailers had an economic life of 25-plus years they gave them a body makeover, repaint and refurbished the brakes and running gear. Cost: $26K per unit, little more than the annual leasing revenue per unit. Projected routine maintenance cost: just $3K a year for the next five years. Effect on unscheduled downtime : practically none.

 

It’s a prime example of how failure to robustly analyse project value results in shareholder wealth destruction. Many others could be cited to show the need for a corporate culture that demands innovative and lateral thinking by management.

And the focus must be long term. The NZ Shareholders Association warns that high short-term incentive payments focus executive attention on short-term goals to the future detriment of shareholders. Company workers and local communities also suffer, because without return on invested capital, companies are forced to down-size.

As Peter Drucker stated (1998): “… until a business returns a profit greater than its cost of capital, it operates at a loss…until then it does not create wealth; it destroys it”.

Capex lies at the heart of the “corporate performance crisis” highlighted in ANZ Regional Investment banking head Joseph Healy’s book “Corporate Governance and Wealth Creation in NZ”.

Healy complains that conventional measures of senior executive performance do not consider the cost of using shareholder funds. Worse, they encourage senior managers to build bigger businesses at the expense of destroying shareholder wealth. He pinpoints poorly specified or non-existent return on capital objectives. To ensure that capital is allocated where it can best boost returns, he advocates Economic Value Added (EVA) performance measures.

Positive corporate governance measures such as EVA, or implementing a robust capital management infrastructure, can achieve a triple win, attracting capital, increasing the share price and reducing the cost of capital. It is also a powerful risk management safeguard for shareholders and other key stakeholders.

Deming (1990) asserted that poor capital allocation occurs when a business lacks a well-designed capital allocation system disciplining management to optimise shareholder value. NZ Management Magazine featured an article entitled “How EVA Exposes Non-Performers” in Aug 2002. Then Comalco CEO Kerry McDonald charged that “what’s lacking is effective management infrastructures – a lack of commitment to developing the tools, practices and processes that let good managers and leaders achieve the best results.”

Sensing growing shareholder concern, astute Boards now see the need for ‘best practice’ capex management systems to safeguard shareholder value.

Port of Tauranga (POT), for example, has achieved a stunning 24% compounding return for shareholders over the last decade – compared to the 5.6% NZX Index average. POT is the best performing share on the NZX over the past 15 years.  Judged the most efficient port in Australasia, POT’s key has been to back innovation-driven capital investment with rigorous economic and financial analysis.

Fourteen years ago, POT implemented Capex software to assist in business case compilation and priority setting. CFO Stephen Gray manages capex as a limited resource and rejects ad-hoc spreadsheet building as inconsistent, time-wasting and error prone. Even plant replacements undergo rigorous financial analysis, performed at the click of a mouse using a dynamic and independently audited system. POT refuses to spend hard-earned capital resources on “gut feel” or doubtful “strategic” projects.

POT know that “must do” capex – which may not have financial benefits – is deemed essential to meet environmental, staff health & safety, service quality, and compliance objectives.

Specialist consultant in the field, Tony Street applauds POT’s innovative approach to capital spending. “The need to rigorously evaluate alternatives, test assumptions, systematically assess risk and carefully analyse true value, very often falls through a crack in the floor. As a consequence, 20 – 35% of capital expenditure is unnecessary in many corporates. A spectacular opportunity for financial improvement exists in reaping these gains, and reinvesting the funds into value-adding projects that truly pay for themselves.”

 

Sadly, a 2011 KPMG study of 100 NZ companies and their project planning practices raises serious concerns. It found that many companies begin projects with only a vague hope of achieving a return. Sixty per cent do not measure project benefits, so cannot determine whether their investments prove worthwhile. KPMG’s conclusion: Many firms are unable to translate project investments into valuable returns.

KPMG’s Perry Woolley states: “The productivity and profits of NZ companies are being impacted by their inability to consistently deliver projects that fulfill the expected objectives”.

If shareholder value is not the focus, managers and directors may lack a principled criterion for measuring performance. Such a “stakeholder-based” business may fail if competing with a shareholder-value-based business. This is because politicking occurs as people promote projects based on loose criteria. “Woolly thinking” prevails and the organisation becomes dysfunctional.

The Board is the heart of corporate governance and as agent of the shareholders must monitor management performance. If management mis-manages, board members place themselves at risk of negligence if they do not take corrective action.

Today more than ever the Board should ensure appropriate financial management information systems are used to assess returns on invested capital. It must insist management use a robust capital management infrastructure based on current best practice. And compensation for the management team must be aligned with shareholder interests.

Tony Street is a director of Capex Systems Ltd, a leading Hamilton based capital planning consultancy and software development company. He can be contacted at www.capex.co

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