CKF – Management is aligned to Incentives
Collins Foods owns and operates KFC stores in Australia and Europe.
It recently released its 2017 Full year financials as well as an acquisition of another 28 KFC stores from Yum! Brands.
In this note I will briefly look at the 2017 results and then consider the acquisition of the new stores to try and establish whether management is adding shareholder value.
The company reported revenue for FY2017 of $633.6m with a Statutory Net Profit of $28m.
The following table shows the Return on capital since 2012. Invested capital includes goodwill and I have excluded all cash as the business runs negative working capital. NOPAT is defined as EBITA less tax. ROIC is calculated as NOPAT divided by the average of the opening and closing invested capital for the year.
From the table we can see that in 2017 the company increased its invested capital but NOPAT fell. This in itself is not a great concern as the company has acquired a number of assets during the year which will not reflect fully in NOPAT. The guide will be over the next couple of years if the company can extract cash flow from its previous acquisitions.
Currently management is achieving a return which is ahead of its cost of capital. I will not go into this calculation here.
Acquisition of 28 new KFC stores
The company also announced it will invest $110.2m in capital by purchasing 28 stores from Yum! The details of the transaction are as follows:
Management has made a decision to allocate capital, so how do these new numbers compare to the existing return profile?
So the company is adding $110m of new capital and reinvesting this at a rate of 6.47% vs the ROIC achieved in 2017 of 12.2%.
Now the company will argue that it can improve scale and drive extra returns from these franchises. Maybe but the previous owners Yum!, had considerable scale as well. The margins on these purchased businesses are consistent with the existing CKF operations.
To achieve a ROIC of 12% consistent with the current portfolio then the company would need to achieve NOPAT of around $13.2m on sales of $93.7m from these new assets.
To express it another way, to get the current NOPAT of $7.1m to $13.2m then the company would need to compound growth at 5% for the next 11 years. I believe the company has paid a lot for this future growth.
ROIC is the ultimate driver of shareholder value not EPS growth
The following is an extract from a Michael Mauboussin paper titled “What does a Price-Earnings Multiple Mean? Dated 29th January 2014:
CKF is growing EPS by financing this acquisition with $69.3m in new debt. This will improve the return on equity but financial engineering does not improve the cashflow of the underlying asset.
Earnings are improving but the company is achieved a lower return on this new capital than the existing business currently earns.
Why would management do this? Well you have to look at the incentive program of management.
The following are taken from the 2017 Financial Report. The Short term incentive plan (STIP) considers that EBITDA is the primary driver of shareholder value. Therefore it is natural for management to align itself to increasing EBITDA.
This acquisition does just that it increases EBITDA, management have indeed delivered this.
Furthermore the Long Term Incentive Plan (LTIP) has determined that EPS compound growth is the appropriate measure for long term performance.
Again management has aligned itself to this goal. It will increase EPS by adding leverage onto the acquisition.
It is worth pointing out that on page 9 of the report, return on capital was considered but was dismissed as the business is not deemed to be capital intensive.
However I would argue that allocating or deploying capital is one of the most important decisions management should make. They are allocating $110m in new capital on this purchase alone as well as the recent European purchases announced on the 23rd March 2017 where another $87m of capital was allocated.
These are not insignificant amounts and while the ongoing operations are not capital intensive, acquiring the assets are.
Management should be then judged on its ability to allocate capital accordingly. If management is allocating capital and the return on this capital is less than the combined cost of this capital then management is destroying shareholder wealth. Growing revenue under this scenario only accelerates the destruction of shareholder value.
Increasing earnings does not equal an improvement in shareholder value, in fact, increasing earnings can destroy shareholder value if the return is less than the cost of capital.
Do you think CKF management would have done this deal if incentives were aligned to allocating capital that increases existing Return on Capital?