Comparing competitors - Part 2
If last issue's comparison of Reece and Crane didn't convince you of the superior company, heres the clincher.
There’s an old proverb which says ‘comparisons are odious’. Well, not in the sharemarket. Comparing companies over several years is a great way to separate the good from the bad, and the bad from the downright hideous.
In Part 1, we began our comparison of Crane Group and Reece Australia , comparing various financial ratios, including profit margins and returns on assets, from 1999 and then 2003. In this issue we’re going to complete our analysis by using the net debt-to-equity ratio and return on equity.
Before that, though, you may want to grab the last issue. We’ll be discussing ratios in the table from issue 156’s Investor’s College . Don’t forget that you can download an Excel spreadsheet from the Special Reports section of our website if you want to see our calculations.
Now, let’s take a squiz at Crane and Reece’s debt positions over the period. Crane’s 1999 net debt-to-equity ratio (see Investor’s College in issue 150/Apr 04 for details on how to calculate this ratio), was 40.9% (from last issue’s table). For highly cyclical, low-margin businesses like Crane, we think that’s at the top end of comfortable. By 2003, though, Crane’s debt position had deteriorated, to 57.5% in fact. But get this—for the 2004 results just released, Crane’s net debt-to-equity ratio is now 70.3%, at a time when the construction cycle may be teetering on the edge of a precipice.
This upward creep in debt in cyclical companies is typical of short-sighted management. As the cycle matures and profits surge, management becomes increasingly confident that ‘this time it’s different’. Of course, it never is.
Reece is a different animal altogether. In 1999 its net debt-to-equity ratio was -16.3% and, in 2003, the same ratio was -18.6%. The minus signs indicate that Reece has ‘net cash’ on its balance sheet (or, more simply, the company’s cash exceeds its debt). In fact, Reece did not borrow a cent during the period. The banks must be absolutely livid that a company can finance growth without ever requiring their services.
This point is especially telling. How can Reece grow its profit substantially over the period without borrowing, while Crane is up to its eyeballs in debt?
The answer is quite simple—Reece’s high margins mean it can reinvest profits in the business. Philip Fisher noted that ‘a greater than average profit margin should enable a company to earn enough to generate internally a significant part or perhaps all of the funds required for financing growth’. In summary, high margins ensure a company has less need for additional debt, or equity for that matter.
To reinforce this point, let’s turn to another important ratio—return on equity (ROE). We discussed ROE in detail in issue 87/Sep 01 . In summary, ROE is a company’s net profit after tax divided by total equity on the balance sheet. It measures the return shareholders get on the capital invested in the business.
Once again, the difference is stark. Crane improved its ROE slightly—from 8.6% in 1999 to 10.2% in 2003. Still, this is hardly surprising because higher debt levels tend to boost ROE. Reece’s ROE, though, has remained consistently high—18.7% in 1999 and 19.3% five years later, even with no debt.
So Reece, with an ROE of 19.3%, is employing shareholders’ funds almost twice as efficiently as Crane. Companies with high ROE and further growth opportunities tend to pay low dividends because they can reinvest retained earnings (profits less dividends) at a relatively high rate of return.
All a shareholder then needs to do is sit back and let compounding work its magic on profits. Everything else being equal, if Reece and Crane’s ROE each remained the same and neither paid any dividends, in five years the former’s profit will be 50% higher than the latter’s. In reality, Crane’s situation could well be worse because it pays out a greater proportion of earnings as dividends.
Now, if all this sounds a little confusing, don’t lose heart. Understanding the mathematical intricacies of financial ratios is less important than recognising their implications. Ideally, you should be looking for higher than average profit margins, ROA and ROE well into double digits, and conservative gearing. In this case, Reece is clearly the superior company.
The table makes this crystal clear. Crane’s growth in earnings per share has been inferior to Reece’s over the period. The former issued shares—and debt—to finance profit growth; the latter required neither. Reece is also valued more highly by the market, as you can see by the expansion of its PER and growth in its market capitalisation—without issuing more shares.
Whilst we don’t always publish ratios in our reviews, we do consider them in our analysis. Why? Because, as this comparison makes it abundantly clear, the numbers do matter. In time, we hope to get a chance to buy Reece at a more reasonable price, perhaps with the aid of a housing downturn. As for Crane, it’s been a useful comparison but will, in all likelihood, turn out to be a pretty poor investment.
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