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3 reasons poor stewardship doesn't mean poor performance

Glenn Freeman  |  31 Jan 2020Text size  Decrease  Increase  |  
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A trio of companies spanning broadcasting, mining services and building materials show why bad leadership is no reason to scrap them.

The conduct of senior executives can be both a blessing and curse for company reputations, performance and shareholder returns.

The Hayne royal commission for instance will go down in Australia's financial history for the tales of corporate misconduct it unearthed, which in turn tarred reputations and knocked share prices.

While unsavoury newspaper reports may damage investor sentiment in the short-term, Morningstar analysis takes a much broader view of company management.

The Stewardship Rating - exemplary, standard, or poor - is based on how well Morningstar analysts think a management team protects shareholder interests.

It considers management's allocation of capital and whether company decisions enhance or detract from competitive advantage, in addition to management incentives and company ownership structures. The rating system also factors in:

  • financial leverage
  • investment strategy
  • investment timing and valuation
  • dividend and share buyback policies
  • related-party transactions
  • accounting practices.

For example, none of the big four banks is regarded by Morningstar analysts as having a Poor Stewardship Rating.

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AMP was downgraded to a Poor Stewardship Rating, from Standard, in May 2018 on the back of the royal commission.

Using Morningstar Direct, we've identified three Australian companies that are competitively sound and undervalued, despite holding a poor rating for stewardship.

Seven West Media (ASX: SWM)

Economic Moat: None | Fair value: 60c | Price: 27c

Seven West Media – which derives about 90 per cent of its revenue from free-to-air television – has made headlines for all the wrong reasons in recent years.

The inter-office affair between former CEO Tim Worner and his erstwhile staffer Amber Harrison made for ample newspaper fodder and raised in the company’s first-half 2018 results briefing.

But Morningstar's Poor Stewardship Rating preceded the controversy by more than a year. Morningstar senior equity analyst Brian Han referenced the scandal at the time, but was more concerned at Seven's "mixed" track record of capital allocation.

The company's 2011 acquisition of West Australian Newspapers is a prominent example, having given it "material exposure to the structurally challenged print media industry," Han said.

With the backing of chairman and major shareholder Kerry Stokes, Worner remained at the helm until stepping down last August. He was replaced as CEO by James Warburton, who was a Seven executive between 2003 and 2011.

Soon after the appointment, Han reduced his fair value estimate to 60c a share because of what he views as permanent, structural challenges facing free-to-air television.

But less than six months after his appointment, Warburton has sought to streamline operations. This includes a merger with regional TV competitor Prime Media, the sale of West Australian radio assets and a deal to divest Pacific Magazines.

"Investor confidence with Seven remains fragile, not helped by the current uncertainties in the wider advertising market," Han says.

"However, significant changes are afoot, and their potential benefits are worth waiting for."

Mineral Resources (ASX: MIN)

Economic Moat: None | Fair value: $20 | Price: $16.96

According to Morningstar equity analyst Mark Taylor, this company holds a poor stewardship rating because of the opacity of earnings within its mining services business, a core revenue driver alongside iron ore and lithium mining.

"Poor financial and operational disclosure means it is unclear exactly how profits are generated or how sustainable they are," says Taylor.

He notes the company has a good financial record and low debt levels, but says its "insufficient" reporting "clouds performance and profitability evaluation."

"The company does not disclose the earnings split between crushing activity and contract engineering and construction, where the outlook is softer," he says.

But in the fourth quarter of last year, Mineral Resources' sale of a 60 per cent stake in its Wodgina Lithium project in Western Australia to US miner Albemarle Corp received approval from the Foreign Investment Review Board.

The deal largely underpins Taylor's $20 fair value estimate.

At the close on Thursday, Mineral Resources was trading at $16.96 – a 15 discount to Taylor’s price.

Fletcher Building (ASX: FBU)

Economic Moat: None | Fair value: $6 | Price: $5.40

There are a few reasons for the poor stewardship rating of the New Zealand-based building materials company, says Morningstar equity analyst Grant Slade.

These include poor capital allocation over several years, organisational complexity and weak risk controls.

"This has led to low returns on capital and poor share price performance," Slade says.
The company operates across seven divisions: building products, distribution, steel, concrete, construction, residential and development, and Australia.

Losses in the construction business highlight the difficulty in managing and controlling risks in such a complex, highly diversified organisation, Slade said at the end of last year.

But he notes that CEO Ross Taylor, who took over in November 2018, has driven some rationalisation, "though we would like them to do still more."

"While Fletcher's concrete and Australian businesses are being impacted by cyclical weakness, we retain our long-term view and expect margin improvement medium term," Slade says.

For a change in the Stewardship rating, Slade says he needs to see a credible strategic plan toward delivering higher returns and a set of measurable benchmarks against which progress can be assessed and management held to account, as well as evidence of exceptional corporate governance.

Slade forecasts improving margins across most divisions, with the most pronounced improvement in building products and Australia.

Fletcher is trading at 10 per cent discount to Slade’s fair value estimate of $6.

is senior editor for Morningstar Australia

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