MAKING MONEY SWEAT
Introducing its first ever Capital Efficiency Survey, CFO Asia shows which companies in the region are delivering the greatest returns in relation to their capital base.
By Justin Wood

For John Stanhope, life must sometimes feel a little hemmed-in. As CFO of Telstra, the A$20.5 billion-a-year (US$14.3 billion) telecoms giant, Stanhope is encircled by forces trying to hold back his company's growth.

For one, Telstra's traditional fixed-line telephone services - roughly 40 percent of sales - face regulatory pressures as the Australian government tries to lower prices. For another, Australia's telecoms market has opened up to ever more competition in recent years, putting enormous pressure on the remaining 60 percent of Telstra's business. In the mobile phone segment, for example, Telstra competes with Optus, Vodafone, and Hutchison 3G - all of them battling hammer and tongs for market share. Finally, like all telcos, Telstra faces uncertain technology risks, such as voice-over internet protocol, that threaten to erode existing businesses. "Revenue growth will be tricky," notes David Wilson, an analyst at JPMorgan. "Telstra has said it expects to grow revenues by 4 percent going forward, but the market doesn't believe it."

Stanhope acknowledges the challenges Telstra faces in growing its top-line. But that hasn't stopped him from going all out to boost Telstra's performance. With little room to move in the external environment, Stanhope has concentrated on internal matters, slashing costs, ramping up productivity, and squeezing assets to deliver ever more dollars of revenue.

So far, his efforts are paying off - and new research shows just how much. According to the CFO Asia 2004 Capital Efficiency Survey, Telstra has racked up an average return on capital employed (ROCE) over the past five years of 30 percent. Of the 19 telecom companies included in the survey, Telstra's performance stands head and shoulders above the competition - the average five-year ROCE for the telco sector was a modest 12.3 percent.

Capital clarity

In compiling the survey, CFO Asia teamed up with Andrew Lee, an accounting professor at Singapore Management University, and calculated the average ROCE for 321 companies across the Asia Pacific for the period 1998 to 2002. The results are designed to give finance managers a useful framework with which to benchmark their own firm's performance against the best and worst in their sector. They also reveal Asia's capital efficiency champions - ie, those companies that are generating the greatest returns from the capital at their disposal (see "Capital Efficiency Champs,").

For the purposes of the study, we defined ROCE as income from continuing operations before interest and tax divided by total capital employed by the firm - both debt and equity. To be included in the research, companies had to have a turnover of at least US$250 million, and have five years of data.

Of course, no single measure can sum up the financial health of a company, and examined in isolation the ROCE ratio has its limitations. As Lee at Singapore Management University says: "By focusing on ROCE alone we are ignoring the effects of capital structure on performance."

So, while a company may post a good ROCE, it may also have too much debt relative to total capital, making its financial risk unacceptable.

What's more, as a book measure, ROCE doesn't take into consideration different accounting policies across companies. For example, some firms may lease rather than buy their equipment without capitalizing the leases on their balance sheet. For another example, look at Telstra: at least part of its fine ROCE performance comes from the fact that its extensive network assets have been written down and recorded at historic rather than current cost.

Return journey

Nonetheless, as a measure of capital efficiency, ROCE offers valuable insights. At Telstra, Stanhope says ROCE is one of three key return ratios he uses, the other two being return on equity and return on assets. Alongside these measures, Stanhope's capital efficiency dashboard includes a clutch of turnover ratios - fixed asset turns, total asset turns, and debtor turns. Finally, Stanhope has a list of leverage ratios too, including net debt to book capital (which has to be between 45 and 50 percent), net gearing ratio (with a target of 40 to 45 percent), and EBITDA interest cover, which must be above ten times.

When it comes to improving Telstra's ROCE performance, Stanhope sits firmly in the driving seat. As well as being CFO, he also heads up the company's "Productivity Directorate", a unit tasked both with cutting costs and raising efficiency. In recent years, the unit has notched up a number of successes in areas such as reducing headcount and rationalizing IT systems. And this year Stanhope set a new target: to deliver permanent savings of A$800 million from the company's underlying cost base by 2007.

Key to improving productivity at Telstra is the use of Six Sigma, a set of management tools designed to help companies improve the quality of their internal processes. Of the A$800 million of savings that Stanhope is working towards, roughly half will come from straight cost-cutting projects - such as current efforts to strip out unnecessary layers of management across the business. The other half will come from Six Sigma projects, like redesigning the way Telstra handles customer service.

"Cost control at Telstra has been very impressive," notes one analyst at a US investment bank who requested anonymity. "It is pretty much a best-practice firm in terms of managing its expenses."

The results will all feed through into an improved profit margin. But as CFOs know, profits form only one half - the numerator - of the ROCE equation. The denominator centers on the capital tied up in a company.

Denominating the denominator

As part of the 2004 Capital Efficiency Survey, CFO Asia and Professor Lee decided to explore these two parts of the equation in greater depth. In particular, we took the ROCE performance for each of the companies in our study and broke it down into two further ratios: a profit margin and a capital turnover ratio - sometimes calculated as an asset turnover ratio - which shows how many dollars of revenue a company is generating for every dollar of capital employed. Needless to say, companies can improve their ROCE performance by concentrating on either their margin, their capital turnover, or both.

At Telstra, Stanhope says he's working on both. "We focus pretty hard on improving our asset turns, especially debtor turnover," he says, although he adds that "improving asset turnover is much harder than improving our margin."

One company that has recorded great success in driving results through its asset turnover ratio is Singapore-based Venture Corporation, a contract designer and manufacturer of electronic goods such as printers for Hewlett-Packard and storage products for Iomega.

Unlike Telstra, Venture has been highly successful in increasing revenues - for the past 14 years, it has grown sales by an annual average of 40 percent. But even though turnover has blossomed, Venture enjoys almost no control over the prices it can charge.

"Competition is really tough," sighs Pay Cher Wee, CFO of the S$3.2 billion-a-year (US$1.9 billion) company. "Prices for electronics never go up, they only ever go down." As such, Venture - just like Telstra - is locked into the relentless pursuit of trying to cut costs faster than its competitors. The result is a profit margin that's hardly spectacular - an average of 9.2 percent for the past five years.

But while Venture's profit margin may be nothing to write home about, its ROCE is nonetheless an extremely healthy 24.4 percent, and that's thanks to the company's uncanny ability to squeeze phenomenal amounts of revenue from a tiny asset base. Indeed, over the past five years, Venture's capital turnover ratio stands at an average of 2.67 times, a figure that includes the company's extensive cash balances (excluding cash, the ratio would be an astounding 7.14 times).

"It's something of a mystery how Venture is able to use so little capital to give so much turnover," says Dharmo Soejanto, an analyst at Kim Eng Ong Securities in Singapore. He suspects the company does much of its manufacturing on a consignment basis, whereby Venture's clients provide the raw materials and even some of the equipment. For Venture, the arrangement gives a highly asset-light business model, with little in the way of working capital or capital expenditure required.

Another Singapore-based analyst, who prefers to remain anonymous, is equally impressed by Venture's asset turnover performance. "For every dollar invested in capex in 2003, Venture generated around $19 in incremental revenue," he says. "The rest of the industry only managed between $1.5 and $10 in incremental revenue."

For his part, Venture's Pay acknowledges that manufacturing on a consignment basis has helped boost Venture's asset turnover performance. More importantly, though, Pay praises his company's engineers and the manufacturing system they've created. In particular, he points to Venture's ability to reconfigure its fixed assets - its factories and machinery - at the drop of a hat to make new products. "Every day of downtime is money lost," Pay stresses, "so we've put our ability to reconfigure production lines at the heart of everything we do."

Equally important in driving asset turnover, reckons Jatin Doktor, an analyst at GK Goh Research in Singapore, is Venture's canny approach to investing. 'Venture runs a very tight ship," he notes. "Some companies build capacity first and then look for orders, but Venture makes sure it gets the orders first and then invests."

Cash and carry

But despite the plaudits, Venture could do even better at managing its capital turnover ratio. As mentioned, Venture sits on a mountain of cash - S$546 million at the end of 2003 - equal to exactly half of the company's balance sheet. Strip away those low-returning assets, and Venture's five-year average ROCE would climb to as much as 51 percent. Pay defends the company's policy of hoarding cash by pointing out that Venture's customers like to have partners with strong balance sheets. In fact, he suggests, having a good amount of cash is a prerequisite to being a contract electronics manufacturer.

It is partly for this reason, argues Lee at Singapore Management University, that ROCE calculations should generally include cash. In some cases, he notes, having a mountain of cash is part of a company's business strategy. In others, excess cash points to an inefficient use of capital. "Whichever it is," he states, "the ROCE should reflect the cash, to highlight either the cost of the business strategy or else the cost of inefficiency."

Another company grappling with similar issues to Venture is Infosys, the US$1.1 billion-a-year Indian IT software and services company. For years now, Infosys has been growing its cash pile, reaching US$662 million - or 60 percent of total assets - at the end of March this year.

Mohandas Pai, CFO of Infosys, believes that technology companies need vast troves of cash as part of their business strategy. "We operate in a high-risk environment. Technology changes swiftly, so you never know when we may need to reconfigure the business," he comments. Pai's yardstick is to have enough cash to cover an entire year's worth of costs without any revenue coming in.

At the same time, adds Pai, he's acutely aware of the need to deliver decent shareholder returns. For that reason, Infosys has stringent "return targets". Each year, the company aims to deliver a ROCE - including cash - of twice its cost of capital, and a return on invested capital (ROIC) - which excludes cash - of three times its cost of capital. So far, Infosys is delivering on its promises. Indeed, with a five-year average ROCE of 49.3 percent, Infosys is the top performer in this year's Capital Efficiency Survey.

What's more, at its most recent results meeting, Infosys agreed for the first time to hand back US$150 million of its cash via a special dividend. "We continue to balance the cash required for growth with that of enhancing returns to shareholders," says Pai. "Our special one-time dividend payment is a reflection of our focus in this direction."

Telstra too, has handed back excess capital to shareholders in recent months - in November 2003, it spent A$1 billion buying back 1.9 percent of its share capital. The move won't help Stanhope loosen the strictures surrounding his company, but it will ensure the company continues to impress with its capital efficiency.

Justin Wood is managing editor of CFO Asia, based in Singapore.