Monday, 22 May 2017

A Tale of Two Companies

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Benjamin Graham
You may think that you are immune to the story that management tell you about their companies. However as charities & marketing professionals know, the reality is we are hard-wired to respond to stories far more than facts & figures. The market votes for the stories it likes with capital flows and it can take a long time for those stories to be weighed by actual future results.

Take for example the tale of two companies that I know well. Both are in the business of designing & manufacturing technology products (although in different fields.) Both have recently gone through a difficult period due to increasing commoditisation of their markets. Consequently both companies have undergone restructuring including outsourcing of manufacturing to China to reduce their production costs. However they have taken very different approaches to their accounting treatment of this period. Company A has presented all of their restructuring costs as exceptional costs to be removed from reporting. Company B has presented only a small bad debt as exceptional. Company A has also been regularly capitalising development costs whereas Company A has expensed theirs’. If you took the adjusted figures at face value you would likely conclude that Company A has been the most successful in their turnaround:

And looking at both the company fundamentals & chart the market appears to have voted this way:

(Blue is company A, Grey is company B, compared from the start of 2014)
However let's do a bit of weighing.

When we adjust for the capitalised development & exceptionals we get a different story:

Although the net margins for both companies clearly indicate companies undergoing challenges it is Company B that appears to have better navigated those challenges.

Net margins are of course not the only factor to consider. The story that the management of company A are telling is one of strong operational gearing. However when we compare gross margins we see that although company A has done well to increase theirs’ over the last few years they are still 10% below those of company B:

It would seem that company B is likely to have better operational gearing and a greater competitive advantage.

Free Cash Flow margins also seem to be the same or better for Company B:

What company A has been successful in doing is driving higher revenue higher, particularly in 2016H2:

(For ease of comparison revenue of company B has been normalised to company A 2014 H1.)
Although looking at the previous charts we see it has been at the expense of Net Margins & Free Cash Flow.

In these times of low economic growth in developed markets & record low interest rates the market has been paying a high price for revenue growth. Could this be the source of the difference in rating? I don’t think so since it is company B that has double the broker forecast revenue growth of company A:

All in all it would appear that company A is overvalued or company B is undervalued. Maybe both. It really does matter what story you tell investors and certainly at the moment investors are willing to ignore the adjustments made to tell the story. I think it is telling that company B is run by highly paid turnaround specialists with large stock option grants whereas company B is run by a long term managers. I look forward to the market weighing. 

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