Steinhoff: These 6 charts should have alerted the board – Ted Black

JOHANNESBURG — The spectacular implosion of Steinhoff will still have many a South African investor fuming and grumbling. The company’s shocking accounting has resulted in former CEO Markus Jooste going to ground and facing a complaint by his company to the Hawks. But the writing for the company may have been on the wall for a while if its management shifted their focus from share price performance to good old Return-on-Assets Managed (ROAM). Here is another excellent piece from Ted Black on the topic. – Gareth van Zyl

By Ted Black*

In October 2016, I wrote an article using the ROAM model (Return-on-Assets Managed) to look at Steinhoff after another of its big deals. My last comment was: “Rapid growth will lower ROAM. That is legitimate. But management may have to apply the 80/20 Law for diagnosis and action. If they don’t do some well-managed pruning, in time someone else will”.

I didn’t think my prediction would be triggered a year later by fraud. It shocked everyone including an unsuspecting Board. In Parliament Christo Wiese said: “Steinhoff, like most groups is hugely complicated. How can management run such a company? The only way is in a decentralised fashion”.

Christo Wiese exits after listening to the mid-term budget speech in Cape Town on October 26, 2016. Photographer: Waldo Swiegers/Bloomberg

His remark reveals some truths. First, most boards are ineffective. Because they review results through a smudged rear-view mirror, they are always the last to know how well or badly a firm is doing so what can you expect?

Secondly, if business corporations are central to a modern capitalist economy, then the way we pay CEOs and top teams puts capitalism under serious threat. Rewarding them with share options does not make CEOs think like “owners” – the original aim. Instead they think like investment bankers and analysts. If the goal is to maximise shareholder value rather than the value-of-the-firm (VOF) – based on productivity, not the share price – then you will get unethical, even fraudulent, behaviour.

Read also: Taking a closer look at Steinhoff’s board structure: Did it add fuel to the fire?

Fundamentally, the VOF derives from the productivity of the asset base that’s funded by shareholder equity and debt – the investment. “Owners” make a return on investment but managers make a return on the assets they manage. That’s how the CEO and teams should be measured – not by the share price.

After the banking collapse in 2009, Deloitte’s Center for the Edge issued the first edition of its Shift Index. Through analysing more than 20 000 US firms’ results since 1965, this masterly study identified some major trends. One important conclusion was that the best financial measure of a company and its managers’ competence is Return on Assets (ROA). Deloitte measures it as profit after tax as a percent of assets.

This chart comparing ROA with CEO pay from 1965 shows a 47-year plummeting trend – a fall of 70% with a sharply rising CEO to worker pay ratio that increased from 20 in 1965 to 300 in 2015.

Moreover, MBAs graduating in the US went from 3200 in the mid-1950s to over 200 000 today. Worldwide, hundreds of thousands more graduate every year. Couple that to technological advances and what does it tell us?

Clearly, there’s little or no link between asset productivity, CEO pay, business school education and technology.

For a context, here are some Steinhoff trends from 2000 to 2016 (the numbers used will of course change after revised ones are published).

The curves tell us something about the capital markets. They seem a bit like “donkeys” – the corporate “bureaucratic” type. Keep feeding them the “right” information – “carrots” – and they’ll gobble them up as fast and as often as you can send them. The carrots they like to munch are all about growth – growth in assets, sales and profits. That’s why the market cap number closely tracks growth curves, especially assets, even as the ROA% falls.

A better measure than Deloitte’s ROA is ROAM – it reflects market strategy and includes a measure with a significance that few seem to understand. It is the sales productivity of the asset base, or “Asset Turnover” measured as Sales ÷ Assets.

It explains why Steinhoff’s after tax ROA has declined and a few other issues too. As a rule, don’t managers focus mainly on sales, costs and margins? They do not ignore the asset base, but do they give it the same day-to-day priority, or pursue it with the same precision as margin control?

How would Steinhoff’s operating executives have reacted if told to include another line in their income statements that reflected a 10% charge from “Owners” for the assets under their control? This is the operating margin chart Jooste would have had to show his Board:

It means the Group would show a loss before tax which leads us to another critical measure – Economic Profit – driven by asset productivity, especially ATO.

A plunging economic loss, (based on Cash Profit after Tax less a 15% charge for Owner’s Equity) can become unstoppable and the capital markets eventually wake up to it.

The final chart shows how Steinhoff compared with other retailing firms before its crash.

Eventually people realise that the organisation is in dire need of redesign. Doesn’t a chart like this signal that the time has come? If Jooste’s Chief Financial Officer had shown the Board some trended charts like these – only six – wouldn’t its members have been able to ask better questions … especially about the firm’s strategy?

We’ll ponder some of those next time …

  • Ted Black runs workshops, and coaches and mentors using the ROAM model to pinpoint opportunities for measurable, bottom-line, team-driven projects. He is also a freelance writer with several books published. Contact him at [email protected].
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