A key part of Airlie’s investment process is to look for any directional changes in the quality of a company’s business, as Airlie believes a stock’s valuation will eventually reflect business realities.
Consider the recent fates of Telstra and CSL over the past three years as a way to explain this analysis. In 2015, Telstra and CSL boasted returns on equity of 30% and 47% respectively. Telstra had a market value of $75 billion, making it the sixth-largest stock on the ASX, while CSL had a market cap of $40 billion.
Three years later, CSL’s market value has more than doubled to $82 billion, while Telstra’s has halved to $34 billion. Given the favourable returns both businesses enjoyed in 2015, how might we have predicted the opposite paths their share prices would take?
In Airlie’s view, the answer lies in looking first at the cash or reinvestment needs of each business and then at the returns the pair generated on this capital.
The businesses of Telstra and CSL have demanded much reinvestment over the past three years. Telstra has reinvested $12 billion of the $24 billion in cumulative operating cash flows it has generated since 2015. CSL’s core plasma business has soaked up $2 billion in investment over the past three years, funded from $5 billion in cumulative operating cash flows.
|3 yr cumulative||TLS||CSL|
|Operating cash flow
|3 yr change in EBIT||-$1bn||$0.4bn|
|3 yr incremental ROIC||-8%||20%|
While the two companies may have similar capital intensity, roughly 50c in each dollar earned has been reinvested; the difference is the returns enjoyed on the reinvested capital. CSL has generated over $400 million of extra profit from its plasma business since 2014, for a 20% return on the capital reinvested (often known as incremental return on invested capital, as per the table). In comparison, despite investing six times the amount that CSL has in dollar terms, Telstra’s group profit has declined by $1 billion over this time.
CSL enjoys high returns on reinvested capital for several reasons. Foremost is that the plasma industry is concentrated among three global players because it has among the highest barriers to entry of any sector. Patents, manufacturing know-how, demanding investment requirements, long product lead times and patients who are reluctant to switch serve to keep out new entrants. So when CSL invests to meet the growing demand for its plasma products, it generates a healthy return on this capital. As such, the bulk of the $2 billion CSL has spent over the past three years can be thought of as CSL taking advantage of ‘reinvestment opportunities’.
By contrast, Telstra has needed to reinvest capital just to maintain its business, with no such boost in profit. Earnings have declined in fixed voice and fixed broadband due to the transition to the National Broadband Network. Telstra charges a premium price for mobile and needs to convince users that it has the best network. This means Telstra can’t reduce investment through this decline in group earnings – it must spend huge amounts to maintain its perceived network advantage.
The differing paths of Telstra’s and CSL’s share prices over the past three years are largely due to this investment truism; an ‘earnings compounder’ that has the ability to reinvest in its core business and earn attractive returns will generate far greater shareholder value than a capital-hungry business that doesn’t generate a return on that investment.
Investing, of course, requires assessing how things might change in the future. Airlie holds a position in CSL but not Telstra. Having fallen over 60% in the past year, Telstra looks ‘cheap’. To buy the stock, however, Airlie would need evidence that it can improve returns on invested capital.
Telstra has announced a program to reduce costs by $1.5 billion in the coming three to four years, which on the surface points to higher returns. There are concerns, however, that when it comes to Telstra’s profitability these cost reductions will be offset by investment it can’t avoid – Telstra has flagged it needs to spend $0.5 billion to maintain its network lead – and lower mobile margins as new entrant TPG drags down industry prices.
Until there are signs of a directional change in the realities surrounding Telstra’s business model, the stock won’t be found in Airlie’s fund.