What you can learn from balance sheets, and what you can't
As we pass the mid-point of another company earnings season, it's a good time to reflect on the value of healthy scepticism around financial results.
"Specifically, the use of 'normalised' earnings is becoming increasingly common, and potentially hides what is really happening," says Anthony Serhan, CFA, Morningstar's managing director of research strategy, Asia Pacific.
The most recent example of a company that has played "fast and loose" with disclosure rules is software-as-a-service provider, GetSwift, whose share price crashed from $3 to less than $1.50 between January and February 2018. The rapid declines came after it emerged the company had failed to disclose price-sensitive information to the Australian Securities Exchange.
Several similar examples have occurred in recent times, particularly among ASX-listed small-cap technology companies--video platform company Big Un and Buddy Platform also saw large share price drops.
Adam Fleck, Morningstar's regional director of equity research, says his team doesn't rely on company share price movements as an indicator of long-term value.
This forms part of its assessment, but far more weight is given to the long-term fundamental value of a company over a much longer time-horizon. The earnings figures that are regularly reported are secondary and are often not even mentioned in Morningstar's equity research reports.
A core aspect of Morningstar's research methodology, the economic moat rating, refers to a structural competitive advantage that allows a firm to earn above-average returns on capital over a long period of time.
Digging holes, filling them
Issues around the clarity of reporting are often most prevalent in industries or sectors where there are large mergers, acquisitions and divestitures.
The materials sector is one key example of this. The world's largest mining company, BHP Billiton (ASX: BHP) saw its fair value estimate slashed and was downgraded to a no-moat company by Morningstar on the back of large capital write-downs. "After adding back the meaningful write-downs, BHP's invested capital base has nearly quadrupled in the last decade."
"This significant procyclical investment, and subsequent dilution to returns, is a key reason why we no longer think BHP moat-worthy," said Morningstar equity analyst Mat Hodge at the time.
A report from Citi suggests around 90 per cent of the value of mergers and acquisitions between 2007 and 2015 were written off by the world's largest mining groups.
It calculates that miners impaired assets collectively valued at US$85 billion over the seven-year period--representing around 18 per cent of their average asset base. Rio Tinto (ASX: RIO) had impaired about 34 per cent of its asset base. Its ill-fated US$38 billion takeover of Alcan comprised most of this--US$25 billion--followed by iron ore (US$1.03 billion) and nickel (US$7.8 billion).
"We argue a buy decision only changes ownership and the biggest risk is of overpaying, while a build decision is subject to a number of risks, including execution risk, time lag, and more importantly the incremental supply for a long period," Citi said.
Though Morningstar's Hodge emphasises resource companies are currently being very disciplined with their capital.
"Managers got burned in the 2014-2015 bust. We haven't really seen any silly behaviour yet, such as large-scale acquisitions typical of normal excesses, or large-scale expansions. But balance sheets are generally very strong and investors/sell side analysts are asking companies what they will do with the cash and how they will grow, so I think it will come.
"It’s hard to tell when though--maybe 2018 is a bit early. Some sections of the market are incentivised to encourage miners to do deals--via transaction fees--and if we start to see significant movement here, then you’ll be able to start to suggest that history is repeating," Hodge says.
However, he says that now "the prevailing market feeling is that the managers will do the right thing".
When are non-recurring costs actually recurring?
Share registry business Computershare is another example where investors need to be careful in parsing the numbers.
"We have some concerns about the level of Computershare's earnings transparency," says Morningstar equity analyst Gareth James.
"Between fiscal 2012 and 2017, abnormal acquisition-related costs averaged US$117 million per year after tax…we are also a little concerned about management's preference for non-audited management earnings, rather than statutory earnings…earnings transparency improved in 2016 but still leaves a lot to the imagination," he wrote earlier this year.
More from Morningstar
• Make better investment decisions with Morningstar Premium | Free 4-week trial
Glenn Freeman is a senior editor at Morningstar.
© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.
