why is sustainability is an issue now, why is value creation critical? · why is sustainability is...

Hiroki Sampei Director of Research

Why is sustainability is an

issue now, why is value

creation critical?

6th November 2012

The Corporate Reporting Lab The 3rd Meeting of Planning Committee

To urge crisis of accessibility to

capital and actions to lead

lower cost of capital

Introduction

Reminder of Communication Gap（１）

Key takeaways and evidence of communication gap from

“Integrated Reporting Tokyo Forum 2012” and other relevant

recent meetings

Typical Communication Gap is found in the discussions on

1. Value creation

2. Stakeholders

3. Short-termism vs. Long term

A gap exists between companies and investors, and between

domestic parties and foreign parties

2

“Of course, companies want to raise more capital.”（Corporate Reporting Tokyo Forum

2012, 1st November 2012）

- Prof. Marvin King, Chairman, IIRC

“Value means financial value in the end.”（WICI Symposium 2012, 31st October 2012 ）

- Paul Druckman, CEO, IIRC

“The 6 capitals – financial, manufactured, human, intellectual, natural and social capital. Social capital includes relation with community, network,

suppliers, and customer loyalty.” （WICI Symposium 2012, 31st October 2012 ）

- Charles Tilley, CIMA & IIRC TTF Chair

“Don‟t mix up value with valuation, what we mean by value is sustainable earnings power or economic value.” （Corporate Reporting Tokyo Forum 2012, 1st November

2012 ）

- Christianna Wood, the former Chairman, ICGN

3

Reminder of Communication Gap（２） Domestic vs. Foreign parties

（Appendix） The 6 Capitals – to drive business model and value

creation

4

Contents

5

1 Definition of “Value Creation”

2 Perception Gap on Stakeholders

3 Perception Gap on Short-termism vs.

Long term

4 Degree of distance b/w Companies

vs. Investors × Domestic vs. Foreign

5 Conclusions and Key Action Points

(proposal)

6

1. Definition of “Value Creation”

１）Ambiguity of “value” among parties in Japan

Corporate Value ?

Enterprise Value ? ・・・Market Value＋Debt－Cash, or Present value of future cash flow

Shareholders Value ? ・・・Book Value, Market Value, or Present Value

• Ambiguous “Corporate Value” in Japanese cannot be translated into

English

• An interpretation of “value” varies according to the stakeholder

1. Definition of “Value Creation”

２） “Don‟t mix up value with valuation, what we mean by value is sustainable earnings power or economic value.”

earnings power : ROIC

economic value: ＞１

ROIC: Return on Invested Capital

CoC: Cost of Capital

7

CoC

ROIC

C

R

8




Long term




(proposal)

shareholders

investment banks

bond holders

creditors

banks

Academy

R&D org

ad agency industry

association

revenue office

authority

trade partners

suppliers

Employees/hiring customers

企業

9

２．Perception Gap on Stakeholders

１）Although the Social Capital defined by IIRC is one of the 6 Capitals, Social Capital is the majority of non-financial capital

in Japan

Social capital

Financial capital

(Human capital,

Intellectual capital)

(Intellectual capital)

Stakeholders on the Income Statements

Income Statements Stakeholders

Net Sales Customers

CoGS Trade Partners, Employees

SG&A Trade Partners, Employees

EBIT

Interest expense Banks, Creditors

Pre-Tax Profit

Tax Government, Local government

Net Income

Dividends Shareholders

Retained Earnings Shareholders<Recycling>

Stakeholders on Balance Sheet

Assets Liabilities & Equity Stakeholders

Cash All stakeholders

A/C Receivables A/C Payables Customers, Trade Partners

Inventories Customers, Trade Partners

PP&E and other investments Subsidiaries, Affiliates, others

Int Bearing Debt Banks, Creditors

Retirement Benefits Employees

Equity Shareholders

10

２．Perception Gap on Stakeholders

Japanese

companies say

that they are

“responsible to

public society”

…

The lower net

income is, the

less effective to

contribute to

whole economy

due to less

expansionary.

11




Long term




(proposal)

１）Short-termism as a phenomenon and its driving factors

Short-termism as a phenomenon is no doubt true, but it is questionable to accuse

companies of their disclosure (corporate reporting) for misleading investors, or

investors of their impatience of lead time to deliver return.

Macro economic environments shouldn‟t be irrelevant to the outcome,

moreover, the responses to the economic environment change weren‟t

necessarily appropriate, and hence various side effects were derived from the

inappropriate responses.

As the developed economies become mature, a low growth and a low return

environment continues, investors have become more cautious about long term

prospects. In other words, earnings power becomes subdued and investment risk

arises. The first response to the investment environment change was to enhance

leverage. Leverage was used to enhance return. However, some savvy investors

attacked this low quality returns and hedge funds took advantage of leveraging

and short-selling to participate the opportunities. Highly leveraged short-selling

strategies should bear high risk and hence cause high turnover of transactions

12

３．Perception Gap on Short-termism vs. Long term


(short term trading). Securities brokers prioritised dealing with these high turnover

hedge funds to maximise commissions, i.e. focusing on providing trading ideas to

drive high frequency trades. FYI, these trading decisions are often driven by

„direction‟ (e.g. positive news or negative news) rather than „valuation‟.

While companies sought for M&A opportunities to counter slower organic growth

(foreign companies in particular). Incentives such as stock option which were

originally designed for alignment of interests between corporate management

and shareholders were misused autotelic way and caused M&A boom to

maximise short term share price surge.

In contrast, Japanese companies dealt with arising uncertainty with strengthening

their balance sheet, i.e. reducing debt and piling up cash. As a result, their

earnings power (e.g. ROE, ROIC) failed to improve and hence they become

“value destructive” rather than “value creative” companies.

Japanese companies in general are known as low growth (indecisive, no action,

and slow execution), value destructive or value trap, and hence not suitable for

long term investment. In other words, they became short term trading vehicles

(commoditised equities: no economic values, but providing volatility for trading).

13


Lower risk tolerance (or doubt for return) for equity investment would cause

disadvantage for capital intensive businesses and put them in inferior position to

have access to the capital to the high monetise-cycle business, such as SNS, and

the competitors in the emerging market. Sustainability would be at risk.

14

１） Short-termism as a phenomenon and its driving factors

３． Perception Gap on Short-termism vs. Long term

15

Long term value creation is

very critical for viability of

long term investment


２）Investment opportunities and time horizon

16

Return opportunity

by time horizon

Decision factor

1) Day, week position, news flow, technical

2) 1-6 Months theme, sentiment, quants, monthly indicators,

quarterly earnings

3) 1 Year company fundamentals, theme

4) 1-5 Years corporate strategy & execution

5) 5 years or more corporate management: hands-on involvement


(Pharmaceutical company, Japan) (Const. & Mining equip. company, Sweden)

Eisai Co, Ltd. (Japan - Pharmaceutical)

0

2

4

6

8

10

12

14

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

CF

RO

I (%

)

Cash Flow Return on Invested Capital (%)

66% (9% p.a.) 553% (48% p.a.)

0

5

10

15

20

25

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

CF

RO

I (%

)


17

E.g.１）Investment opportunity in a good company

(Source：Bloomberg) (Source：Bloomberg)

（Source：Credit Suisse HOLT, Fidelity Worldwide Investment）（Source：Credit Suisse HOLT, Fidelity Worldwide Investment）


Victor Company of Japan, Ltd.

-12

-10

-8

-6

-4

-2

0

2

4

6

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

CF

RO

I (%

)

Cash Flow Return on Invested Capital (%) Infineon Technologies

-10

-5

0

5

10

15

1999 2000 2001 2002 2003 2004 2005 2006 2007

CF

RO

I (%

)


(Audio/Video Products company, Japan) (Semiconductors company, Germany)

-89% (-53%p.a.)

-34% (-6%p.a.) +43%

+138% +148% +107%

-80% (-15%p.a.)

+52% +66% +264%

+42%

18

E.g. ２）Investment opportunity in a bad company

（Source：Credit Suisse HOLT, Fidelity Worldwide Investment）（Source：Credit Suisse HOLT, Fidelity Worldwide Investment）

(Source：Bloomberg) (Source：Bloomberg)


(Pharmaceutical company, Japan)

Price Street EPS PER

FY1 FY2 FY1 FY2

27 Dec ‘00 4000 59 75 68 53

02 May ‘03 2050 144 164 14 13

Change -49% 146% 119% -79% -77%

Expectation was stretched

Short of expectation

caused share price fall

Eisai Co, Ltd. (Japan - Pharmaceutical)

0

2

4

6

8

10

12

14

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

CF

RO

I (%

)


66% (9% p.a.)

-49% (-25% p.a.)

15 Aug ‘05 4010

It took 4.6 years to exceed 27 Dec ‘00 price

19

E.g. ３）Good company = good investment?

（Source：Credit Suisse HOLT, Fidelity Worldwide Investment )

(Source：Bloomberg)


Summary of examples1-3

A good business vs. a bad business … does this matter?

Yes, …Why does this matter?

– A good business: ROIC>CoC, and IC Growth

– A good business can be a bad company • Business fundamentals vs. the parent of the business

– Investing in a good company and investing in a bad company is essentially different

Where do the investment opportunities exist?

– A good company can be a terrible investment

– A bad company can be a great investment

– All depend on what is in the share price

20

Long term investment

stance doesn‟t necessarily

mean long term holding

period due to the share

price often fully or overly

discounts long term

prospects.

Day-Wk Month Quarter 1～2yrs 3yrs 5yrs 10yrs 40yrs 60yrs 100yrs

Traders ○ ○

Short term investors ○ ○

Typical institutional investors ○

Long term investors ○

Bond investors ○ ○

Monthly sales レ

Quarterly results レ

Full year results レ

Mid term plan レ

Restructuring レ

Long term projects レレ

Lifetime employment レ

Retirement benefits レ

Sustainability レ

21

３）Time Horizon


22

High time disc rate “impatient” group：time preference to the near term and discounting higher risk

Low time disc rate “patient” group： time preference to the long term and discounting lower risk

Pro

fits

Lo

sse

s

time


４）Behavioural Finance approach（time discount factor）

Perception Gap

Disc rate

Disc rate

Loss bias

Loss bias

23




Long term




(proposal)

（Authority, Self-regulatory body,

accountants, etc.）

24

Foreign

investors

Domestic

companies

Domestic

investors

（Authority, Self-regulatory body,

accountants, etc.）

Foreign

companies

４．Degree of distance between Companies vs. Investors × Domestic vs. Foreign parties

４． Companies vs. Investors × Domestic vs. Foreign

×: No, △: Yes, to some extent,

〇: Yes, ◎: Of course, yes!

Japan Foreign

Cos Investors Cos Investors

Is “Value” common language?

Earnings power: ROIC

Economic Value：＞１

×

△

△

△

△

○

○

○

○

◎

◎

◎

Cognition of the 6 Capitals ◎ ○ △ △

Are there various “R‟s” specific to each

capital (６R）, or is “R” Financial Return?

６R FR FR FR

What are the critical factors for

Sustainability, LT Value Creation?

Accessibility to ６ Capital Cost of Capital

△

×

△

×

○

◎

○

◎

25

CoC

ROIC

26

The recent comments from overseas investors

– Subdued economic performance or lack of leadership in politics are NOT the key reasons for the “Japan Passing”

– Low ROIC, low ROE is evidence of disregard for shareholders – this is the key reason for not interested in Japanese companies

– Low growth – indecisive, no action, or slow execution

– Value of company is often less than the sum of the value of businesses – because the company is NOT the best parent of the businesses

⇒ Hard to expect sustainable value creation（not suitable for long term investment）

⇒ Could be a trading vehicle（commoditised equities）


（appendix） A good business doesn’t necessarily mean a good

company

Is the company the best parent of the businesses?

– Maximizing value of the business portfolio in the long term

– The best provider of resources (supplies, professionals and financial)

to their businesses

Good steward of capital

– Allocation of capital

– Efficient capital structure

A good company creates value for shareholders:

ROIC > CoC, and IC growth

27

28

標準偏差

0

10

20

30

40

50

60

70

OP Margin (%)

ROE

ROIC

PBR

EV / IC

EV / EBITDA

Japan 492 companies

US 1397

Europe 604

Asia ex-J 1133

Japan US Europe Asia ex-Japan

Standard deviation of KPIs

（Source： Macquarie’s, Fidelity Worldwide Investment）

Relentless challenges to the competition (foreign companies) vs.

staying at the average and the average is losing competitiveness

(Japanese companies)


29

Although Japanese companies claim their emphasis on the relationship with

stakeholders and intangible values …

Can intangibles such as customer loyalty, employee loyalty, brand value

be visible?

– Has their high technical advantage translated into profit margins?

– Has their brand value translated into profitability?

– Has employee loyalty translated into per head productivity?

– Has customer loyalty translated into profit margins?


30

製品・サービスの価値

0102030405060708090

0 20 40 60 80 100

GP-R&D (% Sales)

SG

A-R

&D

(%

Sale

s)


Operating

losses

High products value

Hig

h m

ark

eting c

osts


Can intangibles such as customer loyalty, employee loyalty, brand

value be visible?


Value of products

31




Long term




(proposal)

５．Conclusions and Key Action Points (proposal)

Lower Cost of Capital – critical for companies and investors to

speak common language and to be on the same page

To avoid being overwhelmed by global competition,

a) Win the support from capital providers and secure accessibility to capital,

b) Lower Cost of Capital,

c) Deliver superior return and strengthen competitive advantage

Why communication should act key role?

Because investors‟ perception drives risk premium which is a key component of the

cost of capital

How to enhance sustainability?

Connect ecosystem of the business with competitive return on capital

Hence, being able to a) sustain corporate motto, and b) maintain relationship with

stakeholders

32

５．Conclusions and Key Action Points (proposal)

Companies Investors

Points of Communication：

Accountability

with regard to relevance of ６Capitals to Return

＞ CoC is the desirable outcome. To

achieve this, understand and

resolve investors‟ concerns over

visibility for growth, return, and

risk management

Articulate sustainable value creation in

relevance to ecosystem of operating

activities and recycle of capital

（Note：6C・・・financial, manufactured, human,

intellectual, natural, and social capital）

Points of Evaluation：

Pay (premium) for growth,

Pay (premium) for return,

Pay (premium) for visibility,

Pay (premium) for management

Lead lower cost of capital, and

hence support company to

create long term value

33

C

R

6

C

R

6

34

Data（１）

Region

Mkt.

Value ($

mn)

FY2007 FY2008 FY2009 FY2010 FY2007 FY2008 FY2009 FY2010 FY2007 FY2008 FY2009 FY2010

Japan count 492 452 454 456 na 487 489 492 450 482 487 489 482

mean 6229 30.9 28.6 29.4 na 12.4 7.1 9.0 8.7 9.8 1.7 4.6 7.9

median 2664 26.7 24.6 24.4 na 8.5 5.2 6.1 6.5 8.7 3.3 4.9 7.0

std 10675 18.3 19.0 19.3 na 11.4 14.6 11.7 9.8 8.1 14.1 11.5 8.1

US count 1397 1239 1243 1245 na 1387 1392 1394 1354 1323 1341 1358 1349

mean 9447 38.5 37.1 37.0 na -72.7 -47.2 -146.8 16.6 8.1 1.1 11.5 18.9

median 3033 34.7 34.5 34.1 na 14.7 12.9 12.9 15.7 13.5 10.7 10.1 13.1

std 23193 21.9 32.6 22.9 na 2930.2 1707.0 5805.5 34.7 381.1 331.0 58.1 63.9

Europe count 604 521 529 523 na 592 597 598 577 577 586 588 569

mean 11131 43.1 42.4 41.9 na 16.9 -6.7 25.5 18.3 24.9 16.9 26.4 22.2

median 3490 41.6 40.8 40.6 na 14.2 11.8 11.3 13.9 17.3 12.4 10.9 14.6

std 22285 29.0 22.9 23.4 na 116.2 377.0 356.6 20.6 67.5 73.1 289.1 61.9

AxJ count 1133 1086 1091 1090 na 1125 1129 1131 986 1074 1115 1126 1030

mean 5784 28.6 28.1 29.7 na 59.7 7.7 14.4 20.0 17.0 14.6 11.7 18.6

median 2196 25.8 24.8 26.4 na 15.1 12.2 13.8 14.5 17.1 12.2 13.4 15.6

std 17083 51.7 42.7 21.7 na 1345.6 379.5 199.0 17.9 147.7 26.9 103.9 19.2

ROEGP Margin OP Margin (%)

FY2007 FY2008 FY2009 FY2010 FY2007 FY2008 FY2009 FY2010 FY2007 FY2008 FY2009 FY2010 FY2007 FY2008 FY2009 FY2010

487 489 492 450 481 486 490 491 482 488 491 492 486 471 479 415

9.9 5.4 6.7 7.5 1.7 1.2 1.5 1.4 1.7 1.4 1.5 1.4 7.5 10.6 11.1 8.0

8.3 4.3 4.7 5.8 1.3 1.0 1.2 1.1 1.2 0.9 1.0 1.0 5.5 7.7 7.3 6.4

8.0 10.1 8.3 7.4 1.6 1.3 1.3 1.2 2.0 1.8 1.6 1.6 10.8 14.6 31.3 9.8

1376 1393 1397 1355 1304 1304 1336 1365 1325 1340 1366 1397 1341 1317 1325 1313

17.9 12.4 13.6 15.0 4.7 2.6 3.9 3.9 3.7 2.8 2.9 3.3 25.6 21.4 17.6 12.0

9.1 8.5 7.4 10.3 2.6 1.7 2.1 2.3 2.0 1.3 1.6 1.8 10.4 10.6 10.7 8.7

50.3 87.8 42.8 23.0 14.5 4.8 18.4 12.9 8.6 10.2 4.8 5.0 201.7 70.0 41.2 25.1

598 602 603 579 575 577 588 595 582 589 597 604 590 567 571 556

18.2 8.0 9.2 11.5 3.8 2.1 3.0 4.7 3.4 1.7 2.1 2.3 14.8 15.6 13.7 9.9

8.6 7.1 6.6 8.7 2.7 1.5 1.9 2.1 1.6 1.0 1.3 1.4 9.1 9.5 9.8 8.3

112.4 17.0 15.4 11.6 6.3 2.7 5.8 35.9 20.1 2.8 2.4 2.7 35.4 35.2 18.1 8.6

1118 1130 1133 987 977 1012 1069 1131 982 1017 1072 1133 1112 1092 1106 917

12.6 9.6 8.7 14.4 6.6 2.3 4.1 4.9 3.4 1.8 3.1 4.0 54.4 36.2 26.4 18.1

8.9 6.8 7.2 8.9 4.2 1.7 3.2 3.5 2.9 1.2 2.2 2.5 21.3 21.4 17.0 13.2

20.6 16.0 36.6 40.8 23.6 2.3 3.6 5.2 28.7 3.7 3.5 4.6 338.6 61.6 30.8 23.4

EV / IC EV / EBITDAROIC PBR


35

Data（２）

OP Margin

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

FY2007 FY2008 FY2009 FY2010

ROE

0

2

4

6

8

10

12

14

16

18

20

FY2007 FY2008 FY2009 FY2010

ROIC

0.0

2.0

4.0

6.0

8.0

10.0

12.0

FY2007 FY2008 FY2009 FY2010

PBR

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

FY2007 FY2008 FY2009 FY2010



36

Data（３）

EV/IC

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FY2007 FY2008 FY2009 FY2010

EV/EBITDA

0.0

5.0

10.0

15.0

20.0

25.0

FY2007 FY2008 FY2009 FY2010



37

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