Australian companies falling at the first hurdle

Given yesterday's interest rate announcement, I believe that most Australian chief executives and boards are making fundamental mistakes in their investment decision-making criteria.

Perhaps unfairly I am going to use Wesfarmers' Richard Goyder as representative of the chief executives who are getting it wrong and Goyder's main rival, Woolworths' Grant O'Brien, as illustrative of a somewhat different approach.

Goyder, along with almost every other Australian chief executive, says that cost of capital is 12 per cent – a hurdle rate that most Australian enterprises have not changed significantly in the last five years.

Any capital investment project that does not meet the 12 per cent hurdle finds it very hard to get past the board unless it is strategically significant. I believe the 12 per cent hurdle rate is too high for current Australian conditions.

And without picking out Wesfarmers, in principle, ANZ Bank chief executive Mike Smith agrees with me, as you will see below.

In yesterday's statement the Reserve Bank indicated that the next move in interests rates is down so, in other words, the Reserve Bank is telling us that low interest rates are with us for the foreseeable future.

But the Reserve Bank goes further to show how the cost of capital has fallen: "Capital markets remain open to corporations and well-rated banks, and Australian banks have had no difficulty accessing funding, including on an unsecured basis. Borrowing conditions for large corporations are similarly attractive. Share markets have generally risen over recent months”.

Let's put it another way: 12 per cent is not the real cost of capital in Australia for companies like Wesfarmers when the official cash rate is 3.25 per cent and heading lower and there is abundant money available.

Leading Australian companies can borrow long term at half the 12 per cent cost of capital rate, or even lower. And equity investors have a far lower return requirement than they did when interest rates were much higher – hence the rise in shares.

The 12 per cent hurdle rate for capex in most local situations is simply too high unless you believe there is about to be a global calamity that will send rates through the roof. And if you believe that then you would not consider any new project.

Once you bring the hurdle rate down to 8 to 10 per cent it makes a lot more projects worthwhile.

Woolworths' Grant O'Brien appears to have a different strategy to the Wesfarmers' Coles-Bunnings operation.

Woolworths has invested heavily in new stores in its supermarket chain and in the Master hardware chain where, unlike new Bunnings stores, big start up losses are incurred. This expansion lowers Woolworth's returns on capital.

In fairness to Goyder, Wesfarmers has been investing heavily in Bunnings although, as the dominant player, the Bunnings hardware chain has been delivering the 12 per cent cost of capital hurdle and new stores are usually profitable from day one.

But Wesfarmers has not been investing in new Coles stores, although that policy is changing.

In our KGB interview with Mike Smith (KGB: ANZ's Mike Smith, October 26) I raised the subject:

Robert Gottliebsen: Mike, most Australian companies are saying that their cost of capital is 12 per cent and that's how they do all their investment sums and then they're of course looking for returns above that. But in this new environment the cost of capital is well below that old level. Do you believe this is causing Australian companies to be much more inhibited about investing because they've in fact got their cost of capital wrong?

Mike Smith: "I think it is an issue. I think that costs of capital haven't been adjusted correctly, even been priced properly and therefore return – their expectations are too high. But again I think you've got to be a little bit careful with this because you've got to really look at it on a more global or at least a regional basis and you could say that cost of capital of 12 per cent in China, for example, where it's probably not unrealistic. I think you've just got to be a little careful as to how your business mix affects that cost of capital. I think one of the things we do need to learn is that you do have to utilise different costs of capital for different projects when you're looking to expand internationally”.

Lower interest rates should be fostering non-mining business investment but it is not happening partly because the hurdle rates are too high. It's not going to be easy to change the hurdle rate. But change it we must or large Australian businesses will slowly die or be replaced by overseas operators who understand the new game.