Kiwi Love Affair

New Zealand's zeal for value-based reporting

New Zealand's affection for shareholder value continues to blossom. Some might say it's turning into something of a love affair, such is the fondness for talk of shareholder value in the boardrooms of Auckland and Wellington. Among the latest moves is a requirement for all state-owned enterprises (SOEs) to include value-based reporting within internal reporting documents, and eventually to move this into the annual report.

Reforms that swept through the government, commercial and private sectors in the mid-1980s set the groundwork for the acceptance of valuation reporting measures, the most popular of which continues to be Economic Value-Added (EVA).

Common Sense

'A clear focus on what adds value can only be beneficial,' says Peter Robertson of Transpower New Zealand. 'There are many consulting firms marketing shareholder value measures, but this tends to confuse the issue: how can a company add value? If you can add value then by all means invest the money. If you can't, then it is better to pay out to shareholders and let them make their own judgement. It is common sense. EVA is a methodology that brings the value issue to the minds of managers.'

Reform of the state sector was based on sound economics and included corporatization, privatization and a comprehensive switch to accrual accounting, as applied in the business sector. SOEs were created and corporatized, deliberately exposing them to competitive pressures. This made it essential for the new SOEs to have a way of measuring performance and the value of projects so they could allocate capital efficiently. EVA was a natural development.

Shareholder value measures and reporting methods have become so popular that, according to a recent protocol document on value-based reporting, SOEs must now include value-based information methods when reporting internally to shareholding ministers. 'Originally, it was envisaged that value-based reporting would be included in the annual report but, as an initial step, a compromise was reached to report on an internal basis,' says Professor Tony van Zijl, a consultant on the committee that drafted the protocol document. 'I see an increasing focus on this economics-based approach as a refinement within business enterprises. I would like to see more companies focus on this, not only in terms of internal management but via external reporting. The smart analysts must already be making these calculations when looking at share price. So it's only a matter of time. Airways Corporation and Transpower, both SOEs, have already adopted value-based reporting for external purposes.'

Companies like New Zealand Telecom, Fletcher Challenge and Fernz Corporation, which represent a major segment of the market, have adopted EVA within corporate mission statements. And these three companies account for over 40 percent of a total market capitalization of NZ$48.34 bn. Telecom is the largest, with 25 percent.

'EVA is a leading-edge technology but it is not everyone's cup of tea,' says Chris Butchers, formerly of New Zealand Telecom and now vice president at Stern Stewart & Co, the value-based consultancy group which developed EVA. 'After the initial rush that has seen large companies implementing reporting measures, other smaller companies will move in this direction. There is no requirement to adopt this policy in the private sector, but it is proven that companies which have initiated EVA structures have seen value grow faster than the ones who don't.'

EVA, which Fortune calls 'today's hottest financial idea', has become an important corporate governance and performance tool around the world. Pioneered by US-based Stern Stewart, EVA is a form of residual income, a measure of profit that remains after earning a required minimum rate of return on capital. EVA is the equivalent of free cashflow, a standard measure for valuing companies and business units.

National Facelift

'No-one in the world has done value-based reporting to the extent of New Zealand,' says Garth Ireland from New Zealand valuation consultancy Ireland Wallace. 'Part of the reason is that we have reformed the government sector. We knew we had to get smarter with what we were doing. It is characteristic of New Zealand. We are so far away from everyone that we are left doing many things ourselves.'

The reform process began in 1984, when the country reached its economic breaking point. Government interventions and controls were more pervasive and rigid than in any developed country, exercising power over prices, wages and other incomes.

'New Zealand went from being one of the more restrictive countries in the world, to one of the least,' says Robertson. 'The government follows a light-handed approach, where there are no regulators. Instead, they rely on comprehensive disclosure of relevant information. Putting such information out into the public arena empowers people affected by monopolistic entities to judge whether they are receiving fair value. If they find something lacking, they have recourse to the courts. The uncertainties generated by this regulatory approach make life difficult for monopolies but the recognition of the benefits which followed from the provision of useful information has been the driving force behind value-added measures.'

The first nine SOEs were created in 1987. Two years later there were 15. And the number more than doubled after 1990. Throughout the new corporations, dramatic improvements in service, lower prices and higher returns to shareholders were in evidence. Prior to corporatization, the government received no return from NZ$20 bn in assets. By contrast, in 1992 SOEs were paying NZ$537 mn in dividends. Nonetheless, there were substantial costs of public ownership which outweighed the benefits, and so those companies hungry for capital, technology, management and commercial freedom were privatized. Privatization proceeds so far have amounted to NZ$13 bn.

Now that SOEs have been established, EVA is a standard for improving the specification and assessment of performance. Where the government has a monopoly of mixed-commercial and non-commercial objectives, as in airways and electricity, problems still arise. Driving managers to increase returns from a monopoly means raising prices to extract rents from the monopoly position. The key is to separate the actual - or potentially competitive - activities where competitive pressure is real and place them within an EVA framework.

'Some managers are reluctant to adopt EVA because they believe the market is more interested in earnings per share than value,' says Butchers. 'EVA is a higher hurdle than net income, and so numbers look smaller. You can be a profitable company and have a negative EVA. And you hold managers more responsible for performance. Any company can grow with projects that don't return the cost of capital, but that is not what shareholders want, and they will catch on eventually.'

Corporate Highlights

One of the most successful of New Zealand's privatized companies is New Zealand Telecom. It also happens to be one of the largest companies to embrace the EVA doctrine, although for internal reporting purposes only.

'For Telecom, the advantage of having EVA is that it keeps people honest,' says Philip King, manager of IR at Telecom. 'You can no longer hide behind growing profits. You have to account for what you invest. You are forced honestly to measure what your business has contributed to the value of shareholders. Our EVA was set up by Stern Stewart, and they demonstrated to management the correlation between stock performance and EVA. In addition, we are a capital intensive business and that is one of our biggest cost drivers. EVA is ideally suited for this business.'

Telecom became an SOE in 1987, when it acquired the business of the New Zealand Post Office as part of a corporatization program. It remained an SOE until 1990, when the government sold Telecom to a wholly-owned New Zealand subsidiary of Bell Atlantic and Ameritech for $2.46 bn. According to the sale conditions, Bell and Ameritech were required to reduce ownership to a maximum 49.9 percent. By the end of September 1993, both companies had a 24.8 percent shareholding in Telecom. Telecom, the principal supplier of telecommunications services in the country, is ranked 362nd in the world by market cap, similar in size to British Airways.

Telecom is an example of how efficiently an enterprise can be run when it is not in government hands. The company's tax bill for 1995 was NZ$308 mn, 400 percent more than the profit returned to the government in Telecom's first year as an SOE in 1987. The price for services for residential customers has dropped 50 percent, while business customers have seen a 58 percent decrease since 1986.

'One of the unique aspects of our EVA policies is that they are tied with management incentives,' says King. 'So managers either have to buy into EVA or leave. And, managers do not get all their EVA percentage on any given year. You have to achieve next year's target to get the balance of this year's. You can't maximize profits for any one year and run. You must keep on performing to get benefits.'

According to Butchers, one effective way of motivating management to make market-focused decisions is to link incentives to goals that relate to shareholder wealth. Under this measure, managers stand to gain when EVA increases. If EVA goes down, their wealth is at risk.

'It is pointless to say EVA is a great measure, but we are going to pay you on the basis of net income,' says Butchers. 'If you change the measurement and nothing else, then you change nothing. You have to change management's behavior, and turn them into owners. This provides them with motivation to make decisions that the market will reward.'

Flying High

Airways Corporation of New Zealand is a unique company when it comes to shareholder value. The first company in the world to formally adopt EVA within its internal reports, Airways went a step further by reporting EVA to the public in its annual report. In addition, Airways wrote its corporate plan according to EVA terms and audited EVA statements precede normal accounting standards in the report.

As part of the government's restructuring initiatives in the mid-1980s, Airways Corp became an SOE - the first commercialized air navigation services organization in the world. Airways provides air traffic services and navigation systems in New Zealand airspace.

'Airways has been a successful company since corporatization,' says Pete Proulx, former CEO of Airways and now vice president of operations at NAV Canada. 'The government lost NZ$120 mn in the five years prior to selling Airways. In the first eight years, it paid the government profits exceeding NZ$86 mn. The board of directors decided to publish EVA statements in annual reports, as well as have EVA statements evaluated by accountants.'

As a monopoly enterprise, it is hard to determine if the organization is providing a cost-effective service, explains Proulx. Airways has tried to maintain the value of its shareholders' investment and, to date, EVA has served as the best measurement tool. Most businesses operate in an environment where prices are set by the market. If EVA is positive within such a market, the shareholder will enjoy the benefits.

'In a competitive environment, there should be no limit to the amount of EVA a business should aspire to earn,' adds Proulx. 'In a monopoly, the owner has to be more cautious in how much is taken out of the company. We set an objective that EVA should be zero, so that the business produced a fair return that compensated for the risk that investments bear.'

Under these circumstances, prices are set by the single supplier and not by the market. The appropriate price for a monopoly service is that which in the long term produces zero EVA. So the EVA on monopoly activities is returned to the customers via reduced prices.

'The shareholder wanted the cost of capital to be in the business,' says Proulx. 'As a monopoly, the risk is low, and our customers were supportive of this approach. The question was how quickly could we give back the surplus to customers,' he continue. 'In some years we had positive EVA so we increased discounts. But our customers wanted lower prices. So we did that too. We felt this wasn't so prudent because if you happened to have a bad year, you have to take off the discount. Customers then perceive it as an increase in prices.'

Powering Ahead

A bright light in the New Zealand SOE sector, Transpower is one of the few companies to have incorporated value-added statements in annual reports. It is one of those monopoly industries that makes the issue of shareholder valuation more difficult to pin down, and the company's efforts to establish sound corporate governance measures makes for a unique story.

Transpower is owner and operator of the National Grid, linking electricity generators to distributors and direct supply customers throughout the country.

Because of its monopoly position, some observers have a difficult time evaluating the company and EVA reporting facilitates the process. EVA is a way of communicating to customers and stakeholders how the company is earning 'no more than a fair and reasonable return'. Economic Reporting shows the extent to which the returns earned by Transpower compare with the fair rate of return shareholders could reasonably expect from an investment with Transpower's risk. The company uses the Capital Asset Pricing Model (CAPM) to determine that fair rate of return.

'The change in value of Transpower assets over time is a key element in determining economic value,' says Peter Robertson, CFO of Transpower. 'Valuing the assets of a monopoly is difficult. In our case, there are contrary views on the validity of the asset valuation model we use. You are never going to get an agreement on these issues. We have done our best to come up with a methodology.'

Statements included in the 1996 annual report show Transpower reporting a negative EVA with an economic loss from operations for the year ended June 30, 1996 of $47.3 mn. The need for Transpower to increase the return to shareholders is apparent and the company has slashed costs over the past two years accordingly. Further reductions and increased efficiency are expected.

Transpower recently commissioned Coopers & Lybrand to design an effectiveness assurance program. The purpose of this is to provide an independent and external assessment of the relative effectiveness of Transpower in performing its functions to the complete satisfaction of customers and other parties.

Associated with Economic Reporting statements, Transpower is putting in place management reporting systems which enable it to assess performance of business units on the basis of contribution to the total result measured in economic terms. This reporting system will enable it to establish where effort needs to be targeted to ensure the efficient operation of its assets and to maximize the value of its contribution to the electricity industry and the economy as a whole. The allocation of value created will ensure that shareholders receive a fair and reasonable return, with any surplus available to customers.


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