After decade of neglect, New Zealand boards are again focusing on capital expenditure’s crucial role in company wealth creation. Capital expenditure is, after all, the key to delivering more effective governance.
Wise directors and well run boards understand that innovation is must and that strategic planning must fully account for cost of capital. Corporate strategy is about making vital choices to allocate scarce and often diminishing financial resources.
Corporate New Zealand is waking up to the reality that assessing capital’s opportunity cost should be fundamental to business strategy formulation, along with disciplined programme of capex priority setting. Capex must be managed as limited resource.
Consider how one board I know of approved poor investment:
An established Auckland corporate had 46 trucks and trailers. The trailers, with replacement cost of $118K each, were almost 15 years old and fully depreciated. Capex decision: replace all trailers at an all up cost of $5.4 million. However, 40 of the old trailers were bought by truck lease and hire firm. Aware the trailers had an economic life of 25-plus years they were given body makeover, repaint and refurbished the brakes and running gear. Cost: $26,000 per unit, little more than the annual leasing revenue per unit. Projected routine maintenance cost: just $3000 year for the next five years and practically no unscheduled downtime.
Failure to analyse project value robustly can destroy shareholder wealth.
Capex focus must be long term. The New Zealand Shareholders’ Association warns that high short-term incentive payments focus executive attention on short-term goals to the future detriment of shareholders. Company workers and local communities also suffer, because without return on invested capital, companies are forced to downsize.
As American management guru Peter Drucker wrote: “… until business returns profit greater than its cost of capital, it operates at loss…until then it does not create wealth; it destroys it”.
Capex lies at the heart of the “corporate performance crisis” according to ANZ Regional Investment banking head Joseph Healy’s book Corporate Governance and Wealth Creation in New Zealand.
Healy complains that conventional measures of senior executive performance don’t consider the cost of using shareholder funds. Worse, they encourage senior managers to build bigger businesses at the expense of destroying shareholder wealth. He pinpoints poorly specified or non-existent return on capital objectives. To ensure that capital is allocated where it can best boost returns, he advocates Economic Value Added (EVA) performance measures.
Positive corporate governance measures such as EVA, or implementing robust capital management infrastructure, can achieve triple win, attracting capital, increasing the share price and reducing the cost of capital. It is also powerful risk management safeguard for shareholders and other key stakeholders.
American quality control champion Edward Deming believed poor capital allocation occurs when business lacks well-designed capital allocation system disciplining management to optimise shareholder value.
In an August 2002 article in this magazine entitled “How EVA Exposes Non-Performers”, then Comalco chief executive Kerry McDonald said that “what’s lacking is effective management infrastructures – lack of commitment to developing the tools, practices and processes that let good managers and leaders achieve the best results”.
Sensing growing shareholder performance concerns, astute boards are turning to ‘best practice’ capex management systems to safeguard shareholder value.
Port of Tauranga for example, has achieved stunning 24 percent compounding return for shareholders over the past decade – compared to the 5.6 percent NZX Index average. It is the best performing share on the NZX over the past 15 years. Judged the most efficient port in Australasia, its board has backed innovation-driven capital investment with rigorous economic and financial analysis.
Fourteen years ago Port of Tauranga implemented capex software to help business case compilation and priority setting. Chief financial officer Stephen Gray manages capex as limited resource and rejects ad-hoc spreadsheet building as inconsistent, time-wasting and error prone.
Even plant replacements undergo rigorous financial analysis. Port of Tauranga doesn’t spend hard-earned capital resources on “gut feel” or doubtful “strategic” projects and it considers disciplined capex management essential to meet environmental, staff health and safety, service quality, and compliance objectives.
It understands that the need to rigorously evaluate alternatives, test assumptions, systematically assess risk and carefully analyse true value, often falls through the cracks. I believe that between 20 and 35 percent of capital expenditure is unnecessary in many corporates. great opportunity for financial improvement exists in reaping these gains, and reinvesting the funds in value-adding projects that pay for themselves.
A 2011 study of the project planning processes of 100 New Zealand companies by global accounting firm KPMG raises serious concerns. It found that many companies begin projects with only vague hope of achieving return. Sixty percent don’t measure project benefits, so can’t determine whether their investments prove worthwhile. The study concluded that many firms are unable to translate project investments into valuable returns.
As KPMG’s Perry Woolley stated: “The productivity and profits of New Zealand companies are being impacted by their inability to consistently deliver projects that fulfil the expected objectives.”
If boards don’t focus on shareholder value, managers and directors may lack principled criterion for measuring performance. Such “stakeholder-based” business may fail if competing with shareholder-value-based business. Politicking happens when people promote projects based on loose criteria. “Woolly thinking” prevails and the organisation becomes dysfunctional.
The board is the heart of corporate governance. As agents of the shareholders, directors must monitor management performance. If management mismanages, board members place themselves at risk of being negligent.
Today, more than ever, boards should ensure appropriate financial management information systems are used to assess returns on invested capital. They must insist that management use robust capital management infrastructure based on current best practice. And compensation for the management team must be aligned with shareholder interests.
Tony Street is director of Capex Systems.
