Cheap not always best There are many good quality companies going cheap in the current market environment. But to make the right long-term choices requires potential outside passive minority shareholders and an understanding of all the dynamics involved in the decisions a company’s management will make over time, argue Daniel Malan and Chris Boehmke.

“When two friends have a common purse, one sings and the other weeps.” – a proverb taken from The Students’ Companion by Wilfred Best. “I’d say it’s been my biggest problem all my life... money. It takes a lot of money to make these dreams come true.” – Walt Disney “A lie keeps growing and growing until it’s as plain as the nose on your face.” – the Blue Fairy to Pinocchio, in the 1940 Disney film. With stocks sold off tremendously on a global basis during 2008 we are having no trouble in finding (apparently) good quality companies trading at low multiples, making them (apparently) cheap. In our opinion, the fact that many companies are trading at statistically attractive levels means that the ability to generate satisfactory long-term investment returns from the current market will depend crucially on distinguishing between good companies and good investments. The dartboard method (or passively buying the index) of investing may be at a strong competitive disadvantage if one can successfully pick the cheap, good quality companies that are shareholder orientated. We offer two examples of good companies with strong brands which may turn out to be poor long-term investments but, importantly, we explain why – incorrect incentives. In the January 2008 edition of RE·VIEW, we referred to incentives (see Incentives and ethics, on page 31). We now examine the effects of incentives in more detail. The companies we want to focus on are Walt Disney (listed in the United States) and Spur Corporation (listed in South Africa). Both companies have strong franchises with very defensible moats against new entrants. This is mainly due to their strong brands: Disney’s brand has been built up over 80 years, while the Spur brand has been going for over 40. Both enjoy large ‘share of mind’ in their respective target markets, because of their long head start in building their brands. Disney is obviously the much stronger company with its global reach, but in its own market Spur enjoys similar characteristics: kids demand the product and adults have no option but to buy it if they want to keep the peace. Let’s examine each company separately. Walt Disney Co. – The Grinch in Santa’s clothing? Originally identified only by a mouse created by Walt Disney, this iconic brand represents one of the truly great consumer franchises in the world. This is one of the few businesses that sells products with a competitive advantage called ‘customer share of mind’ across virtually every geographic, cultural, religious and language barrier. With the Disney share price recently reaching a historic multiple of 10 times earnings and trading close to net asset value, one cannot but take notice. As excited as we were prior to getting our hands dirty, so disappointed we were when the numbers suggested something we did not expect to find. Throughout the analysis of the accounts we kept coming back to the same question – why does this great company generate such lousy returns on shareholders’ equity funding? The average return on equity over the past 11 years was 7%, below the cost of equity capital. This implies that this business can only be worth around net asset value and no more, but this conclusion simply felt wrong so we dug deeper and decided to look more carefully at its capital allocation over time. We turned the traditional cash flow statement around to a more useful format by basically working out the total cash that management was trusted with by shareholders to allocate over the whole 11-year period and then focusing on what management decided to do with it. Basically over 11 years from 1996 to 2007 Disney generated $48 billion of operating cash flow (after funding working capital) and also raised $19bn mainly through the issue of new shares due to share options being exercised. Some debt was also raised. Thus management had a total of $67bn to spend over this 11-year period to enhance and grow Disney’s businesses. Of the $67bn, it spent 30% on maintaining its resorts and parks, 25% on buying other businesses (i.e. growth investments) and 30% on share buybacks, while 15% was spent on dividends. How is it then that a company that spends 30 cents every year on buying back shares ends up with more shares outstanding than when it started? Disney achieved this by continually issuing share options to executives and employees. Buybacks (at relatively high prices) were continuously swamped by options exercised (at relatively low prices). In effect the buyback simply represents a transfer of value from shareholders to management. As such one wonders why buybacks are always welcomed by the market! Also, cash from operations compounded by only 3.5% per year over the whole period. Again, placed in context of the brands and market position of the business, this is not great. We think that a clue to the answer lies in the opening quote by Walt Disney himself about the need for money to sustain the business. Talented creators are few and far between and the successful ones are expensive. We suspect they are the more powerful participant in this particular system. Much like investment banks and professional sports teams, the lion’s share of the spoils accrues to the talent and not to the owners. The rewards to ownership are mainly psychological. In these cases, ROE stands for Return On Ego, not Return On Equity! This great franchise is basically not much more than a giant remuneration scheme for both the talent and the management, viewed from a long-term minority shareholder perspective. Perhaps the final and unbiased verdict can be given by simply looking at Disney’s total investor return (price and dividends), compared to the whole US market over the past 20 years, a period of unprecedented consumer prosperity and entertainment budgets that created a rising worldwide tide of demand for all of Disney’s products. In conclusion, the Disney investment case is simple. A great underlying business franchise comes entrenched with poor capital allocators and a weak negotiating power with respect to the talent that drives the brand. From an economic perspective, this is not an enticing deal for prospective shareholders, even at around net asset value per share. With a current enterprise value of $62bn, you are buying around $5bn of annual operating cash flows, pre the incumbent management capital allocation decision-making process. This does not exactly strike us as the bargain of the century. Spur Corporation – A finger in every Spur burger? Again this is a company we have long admired for its strong brand, asset-light business model and great cash margins. It has a very defensible moat against new entrants into the South African family sit-down restaurant market where it opened its doors in 1967. However, we were recently disillusioned – after 41 years the company produces a mere R60 million in annual profits for shareholders. This struck us as being fairly counter-intuitive and we set out to find why this may be so. Spur’s business model is that of a franchiser/food services provider. The bulk of the entity’s fixed assets is intangible – being essentially the Spur brand as valued by management and their accountants. As a franchiser its object is to somehow monetise that brand. It achieves this by charging restaurant franchisees a percentage of their revenues for the rights to trade under the Spur banner. In addition franchisees have access to various corporate benefits such as centralised marketing and decor, operational support and quality control. Testament to the strength of the brand: Spur reportedly has a queue of people lining up to be franchisees from which it can pick the best. So it may follow that the percentage of revenues to be passed on to Spur is a function of demand (from would-be franchisees) and supply (completely controlled by management), resulting in a relatively high percentage. Instead it appears the actual number – at 5% – is on the low end of the industry average (source: Franchise Association of Southern Africa). This is the first clue to the low absolute profit number after 41 years of building a brand. This immediately pointed towards their being asymmetrical incentives on the part of management versus shareholders. It is well known, and disclosed by the company in some detail, that senior managers are part owners in several restaurants. Indeed their part ownership frequently dates to before they attained levels of authority within the Spur Corporation. Such on-the-ground experience is undeniably beneficial, and we fully support the idea of Spur executives having a history as Spur franchisees. From the point of view of a Spur shareholder the problem comes if management can earn substantial amounts from their alternate role as franchisees. Their efforts as franchiser may then be impinged. In any science it is one thing to come up with a hypothesis and another altogether to prove it. As analysts we like to quantify things before placing any reliance upon them. We have tried to calculate the aggregate economic interest of Spur Corporation management in the underlying restaurants and place this alongside total disclosed remuneration as management of the company in order to understand to what extent the Spur management benefit from the entire Spur system and how this impacts the shareholders they are hired to serve. Using the information disclosed in the related-party section of Spur Corporation’s annual report we calculate the cumulative ownership percentage of management in restaurants. The result suggests an aggregate notional interest in over eight whole restaurants. From this we can use our own restaurant profitability assumptions to estimate the profits accruing to management. The resulting amount is close in size to the total amount of disclosed benefits, which would lead one to conclude that management, in the aggregate, are indifferent to the needs of shareholders versus franchisees. Management’s system-wide interest adds up to about a third of total shareholders’ earnings – quite a large amount we think. It is in shareholders’ interests that the business looks after its franchisees. But this particular system seems to be rife with opportunities for conflicts of interest, and financial results over time – R60m profit after 40 years of brand building – seem to bear this out. One could argue that on a historic multiple basis, both Disney and Spur look cheap and that an acquirer would be willing to pay a hefty premium to buy the whole company, but both arguments are flawed from an investing perspective because: • the economic reality from the perspective of a long-term minority shareholder suggests these companies have never warranted a premium; and • building an investment case based on mergers and acquisition valuations for a business where the underlying economic reality is not attractive and fraught with conflicts of interest is not a sensible way of allocating capital. We believe there are many good quality companies going cheap in the current market environment. But incentives play an important role in such choices and understanding how these incentives work can help to narrow the list of potential investee companies.