Commentary on Political Economy

Sunday, 30 August 2020

 This article should be read in conjunction with Prof. Pettis's two days ago. It shows at the corporate level what he argues at GDP level, namely,  that national and corporate accounts can understate impairments and losses and overstate profitability and earnings. I have argued for years that this is precisely what Ratland China does by refusing to 'mark to market' its abysmally wasteful allocation of social resources, which is revealed eventually by falling incomes and living standards.  The reality is that Ratland is growing poorer and weaker by the hour, which explains its desperate attempts to attract foreign direct investment, to export loans to weak and corrupt regimes, and to lower domestic competition and allocate finance in favor of State Owned Enterprises. As Prof. Pettis has adroitly demonstrated,  all of these convulsions lead straight to catastrophe for Ratland. 

The $29b credibility gap confronting investors


For the ASX 200, underlying profit came in 76.5 per cent higher than statutory profit, as companies massaged the message and minimised problems. 

When is a profit not a profit? When it’s delivered by one of Australia’s biggest companies, it seems.

Analysis by this column of the 172 members of the ASX 200 that reported profits during August has revealed their combined statutory net profits were 76.5 per cent, or $28.6 billion, lower than the underlying profits they also trumpeted.

Finding the profit metric to focus on isn't necessarily easy.  David Rowe

While underlying figures are used to try to give investors a better picture of the performance of a company, they can also be used to massage the message of companies under financial pressure.

In notable examples from the August reporting season, blue chip companies including Qantas, Boral, Santos and Woodside Petroleum reported statutory losses of well over $1 billion – but also said they were profitable on an underlying basis.

While the quartet were comprehensive in their disclosures, the fact that no fewer than 24 companies posted a loss on a statutory basis and profit on an underlying basis suggests investors need to remain vigilant about interpreting financial results.

This is particularly the case with the growing vogue for companies to use underlying earnings before interest, tax, depreciation and amortisation as their chosen measure of profitability.

In some cases, what’s included and not included in underlying measures can be crucial in getting an accurate picture of performance.

Underlying might not be lying but it’s a signal for shareholders to probe further.

In total, ASX 200 companies with a June 30 half-year or full-year balance date posted combined statutory net profits of $37.3 billion. But underlying net profit came in at $65.8 billion, a difference of 76.5 per cent.

The collation of the figures was a long, frustrating and at times bemusing process that involved about six hours of trawling through profit announcements, investor presentations and annual reports to track down the numbers.

Trend to using EBITDA

Most companies include their statutory profit number at least somewhere in their results media release, although some firms, such as rare earths miner Lynas, didn’t include any net profit number in their release, let alone a statutory figure; it used EBITDA as its key profitability metric.

Often the statutory number was buried below the non-statutory headline earnings figure. Operating earnings was popular, profit before tax was another favourite and core profit popped up several times.

But the trend towards management using EBITDA seems unstoppable.

The idea behind this measure is that it strips back earnings to their simplest form, particularly free from constructs such as depreciation and amortisation.

But promoting this metric as the best measure of profitability seems strange. While depreciation and amortisation and non-cash items set by accounting standards, interest and tax are very much cash items, and very much real costs for a successful business. Few companies would pay a dividend without taking into account their interest bill and their tax bill.

Woolworths chief executive Brad Banducci has overseen booming online sales, in one of this seasons few positive sets of results.

In a profit season like no other, companies are forced to adapt

On top of this, there’s been a push to use ever more exotic forms of EBITDA by some companies.

Digital services group Spark New Zealand uses EBITDAI, with the “I” standing for investment income, which is excluded presumably to present a more accurate version of the performance of the core business; like Lynas, it makes no mention of any form of net profit included in its profit media release.

Or take tech company Appen, which this year reported not one, but two, underlying EBITDA measures, the second of which excludes investment sales, marketing and engineering. If that’s not at the core of what a company does, it’s hard to know what is.

The more common practice is to present a statutory profit and an underlying profit, which typically excludes items that the company sees as one-offs or not to be repeated.

These items can take many forms.

One of the most common in recent years has been to strip out the impact of a new accounting standard – AASB16, which requires companies to reflect leases on their balance sheet – to make it easier for investors to make comparisons from one year to the next. The need for such presentation should fade as investors become more used to AASB16.

Then there are items that companies see as out-of-the-ordinary matters.

Not an ordinary part of doing business

This year that includes $US150 million ($200 million) in extra costs related to COVID-19, as well as costs associated with the cancellation of some power contracts in South America, and its now annual costs associated with the Samarco tailing dam disaster in November 2015.

The intention is to show that these were not an ordinary part of doing business and so should be excluded from that underlying number to make it easier to chart operational profitability over a longer period. Whether it’s always reasonable to treat these as extraordinary items and not part of doing business in a company with sprawling operations – we now have five years of Samarco costs, for example – is of course a matter of judgment.

But by far the biggest factor in the gap between statutory and underlying profit during this reporting season was the large write-downs companies took on the valuations of their assets.

It was these impairments that drove the biggest statutory losses of the season, including Boral’s $1.1 billion loss for the June half, Qantas’ $2.7 billion full-year loss and Woodside’s $5.6 billion full-year loss.

And yet this trio all managed to report profits on an underlying basis. Woodside claimed a $411 million profit, Qantas a $124 million profit and Boral a $177 million profit.

The argument that nearly all big companies use when announcing these big write-downs is that they are non-cash items, and are instead theoretical valuation changes driven mainly by accounting standards. The implicit – and slightly mind-bending – argument is that just because a company slashes the estimated value of its assets by billions of dollars doesn’t mean the company itself is worth billions of dollars less.

The non-cash argument is weak. While a write-down might not trigger a cash hit at the time it is taken, the company is effectively saying that cash it invested previously has and will deliver a much lower return than first advertised.

For example, Boral spent $3.5 billion in cash on the acquisition of US group Headwaters in late 2016. The $1.2 billion write-down it took on the business last week is essentially an admission that a good chunk of that cash was wasted.

If some write-downs reflect mistakes made in the past, then others reflect problems looming in the future.

Woodside’s write-downs of the value of a slew of oil and gas assets reflected its assumptions that oil prices will be lower, carbon prices will be higher and the environment for energy companies will generally be tougher.

Similarly, the $1.4 billion of write-downs taken by Qantas on its A380 airplane fleet points to the pain that the airline is scrambling to stay ahead of, as the aviation sector faces a long and difficult period in the wake of pandemic.

To be very clear, we accept that the intention here is clearly to provide more disclosure and try to give investors the clearest possible picture of how its business is performing.

The best example of the flight to quality is Commonwealth Bank.

The four trends that shaped profit season

But the use of metrics such as underlying profit risks minimising the major problems that asset write-downs describe.

While it is true that these write-downs might not hit an investor’s hip pocket in the year they are taken, they can speak how shareholder cash was spent (or misspent) in the past and how it might be affected in the future.

Further, it is worth asking whether investors are being bombarded with so many metrics of something as seemingly simple as profitability that they might become confused about which is the most important.

It shouldn’t be this hard.

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