FCL's ebit comparisons disguise poor returns on shareholders' investments

By Peter V O'Brien

Friday 8th September 2000

Fletcher Challenge (FCL) last week reported a "near four-fold" increase in consolidated group net earnings for the year ended June 30 and earnings before interest and tax (ebit), excluding unusual items, of $942 million, the best for 10 years.

Those comments could lead shareholders and others to think the company, through its divisional or "letter stock" structure, had performed well. Anyone who thought that should have gone through the figures and key ratios before celebrating.

FCL has always faced problems outside the company's control. It is subject to international commodity price fluctuations and the general economic climate in the countries where it has operating units. The expansion and contraction of residential house building is an example of the latter.

After allowance for those matters, the latest result was not an impressive financial performance, irrespective of the 278.5% increase in net profit, including unusual items, and the discontinued Paper division.

Group chief executive Michael Andrews last year described the 1999 profit of $101 million as woefully inadequate. That should be remembered when looking at percentage changes.

Comments about ebit in company reports are a guide to the trading climate in which organisations find themselves at any time but are unhelpful in terms of return on net investment, which is also shareholders' wealth.

A company must pay interest on its borrowings and has to cough up to appropriate governments that tax due, after probably engaging expensive experts to minimise the impost(s). Undue emphasis on ebit could indicate a company's interest bill, and the borrowings from which it flowed, were too high in relation to the overall financial structure.

A lack of uniformity in the divisional reports complicated assessment of FCL's performance. The section on Building, for example, referred to the "return on permanent capital," defined as "ebit before unusuals/net debt less deferred income tax benefit plus equity and capital funds at book value." That ratio was absent from reports on the other divisions and from comments about the consolidated performance.

Call me old-fashioned but we go back to a common figure used in assessing companies; the return on shareholders' funds. The preliminary report said nothing about this either on a group basis or for each division. The figures will probably be in the formal, glossy-paper document.

The company's reference to ebit performance over 10 years lets us go back further than 1990, when FCL had more interests than today, although some of them were a drain on returns. Between 1984 and 1993 the company's return on year-end (as opposed to average) shareholders' funds ranged from 28% in 1985 to
-3.2% in 1992 when the group had a net loss of $158 million. The return dropped each year from 1984 to 1992, before recovering to 8% in 1993.

In calculating the return on shareholders' funds, the figure of $6.497 billion shown as Fletcher Challenge Group equity was used, which excluded the group's capital funds and minority equity. Year-end funds were used, rather than the more acceptable average of two years, to conform with FCL's earlier calculations.

The group equity figure used was favourable to the company because it was less than the $9.43 billion of group equity, which included group capital funds and minority equity. Returns are shown in the table. Most companies would consider a return of 6.4% "woefully inadequate."

The divisional reports were uniform in the figures for diluted earnings a share that treat convertible capital notes and options as converted.

Forests' diluted earnings per share were 9.0c; Building 14.41c (including unusuals); and Energy 63c. Share prices for the divisions last Friday were respectively 84c, $2.25 and $8.71. Energy's investment in Capstone Turbine Corporation was included in revaluation reserve as required under US accounting practice. The value has increased again since balance date.

Diluted eps and share prices translated to historic price/earnings multiples of: Forests 9.3, Building 15.9 and Energy 13.8.

FCL's annual meeting will probably see media publicity given to a few questions but the facts of performance suggest people would be better off when the three divisions are sold or made standalone companies.

Fletcher Challenge - return on equity

Entity	Equity ($m)	Profit ($m)	Return %
FCL Group	6497	416⁽¹⁾	6.40
FCL Forests	1432	81	5.66
FCL Building	777	63	8.11
FCL Energy	2497	261	10.45

⁽¹⁾ Excludes discontinued Fletcher Paper

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