Economic Value Added – A true measure of corporate success
The title of this post is from Page 2 of the book entitled The Quest for Value by G. Bennett Stewart III. (Every serious long-term investor should have this book as a reference.)
In the previous post, The Race for Efficiency, McKinsey uses the term ‘economic profit’ and relates it to aircraft age. But what is economic profit? It’s another name for Economic Value Added or EVA. EVA is operating profit less the cost of all the capital employed to produce those earnings. EVA is not an accounting measure; rather, it’s a performance measure developed by the Consulting firm, Stern Stewart in the late 1980s to help managers create value for their organizations.
EVA is different from return on invested capital because it considers both the return on capital and the magnitude of the investment.
Here are three important passages from Page 3 of Bennett’s book to help you better understand the concept:
‘EVA is important because it is the only performance measure to tie directly to intrinsic market value.’
‘EVA, in short, is the fuel that fires up a premium in the stock market value of any company or accounts for its discount. That is EVA’s greatest significant, and it is a property that sets EVA above every other financial performance measure, including cash flow.’
‘However important cash flow may be as a measure of Value, it is virtually useless as a measure of performance. So long as management invests in rewarding projects – those with returns above the cost of capital – the more investment that is made, and therefore the more negative the immediate cash flow from operations, the more valuable the company will be. It is only when it is considered over the life of a business, and not in any given year, that cash flow becomes significant.’
Along the same line of thinking, Clayton Christensen, a professor at Harvard Business School, argues that an undue focus on financial metrics, including return on invested capital (ROIC), has led to underinvestment in growth and innovation. He calls this the “capitalist’s dilemma.” Slavishly beholden to financial metrics that measure value creation, business leaders fail to create value.
What Stewart and Christensen are essentially saying is that it is the misuse of financial measures such as FCF and ROIC that is the problem. Instead of focusing solely on maximizing FCF or ROIC, management needs to focus on maximizing economic profit, which necessarily means undergoing the burden of capex not only for competitiveness, in its race for efficiency, but also for value creation.
So how has this thinking played out in the North American airline industry since 2010. Let’s compare Air Canada with Delta and have a look at how the two companies pursued different paths in creating value.
Delta Airlines began a debt reduction program in 2008 and from 2010, a focus on improving ROIC. While I don’t mean to diminish the efforts of Delta management to achieve their goal through other initiatives, ROIC improvement was largely accomplished through nominal growth and by buying used aircraft, rather than undergoing a major fleet renewal program. Early on, Delta enjoyed healthy ROICs, a leverage ratio below 1, healthy free cash flow, and one of the better EV/EBITDA multiples in the industry. The Airline achieved investment grade a few years back and began paying a reasonable dividend. However, of the three US legacy carriers, Delta also has the oldest (and lease efficient) fleet; and it has only recently begun its fleet renewal program in earnest, a program that will see the Airline spend $20-$25 billion over the next five years, which will be followed by another program. Their fleet size is over 900 aircraft. Last year, Delta released new financial targets, increasing its leverage ratio and lowering its ROIC range.
Air Canada, on the other hand, followed a different path in value creation. After successfully dealing with a $4 billion pension deficit problem, and the only one of the four NA legacy carriers that currently enjoy a pension surplus ($2.5 billion), the airline began in 2011 a fleet renewal program (a decision to buy additional B777s while waiting for their first B787) that by end-2021, will have exceeded $12 billion in capex spend. It is clear that Calin, as chief architect of Air Canada’s turnaround, elected to take the capex ‘burden’ up front, accepting lower margins, a lower ROIC, and at times a higher leverage ratio, but knowing that the value created over the long-term was going to be far superior to the path followed by Delta. Over the next two years, Air Canada’s current invested capital base of $11.7 billion will grow to $15 billion (with planned capex in 2020-2021). Given the current 2019-2021 ROIC target range of 16%-20%, the $15 billion capital base will enable the Airline to generate much higher EVAs and free cash flows beginning in 2021 (as capex spend is reduced) than would otherwise be the case.
Many investors who considered Air Canada as an investment over the past 6-7 years were turned-off by the seemingly slow pace of recovery (compared to US airlines) and successive years of mostly negative free cash flow, compressed margins and sluggish ROICs. Unfortunately, they chose to put their money elsewhere.
On the other hand, long-term investors who understood the role economic profits play in value creation and the ‘burdens’ of growing a capital base, could wait patiently, and with certainty, knowing how it will all play out over time. Keeping in mind what Bennett said in the third passage above, these longer-term investors understood that the frequent years of negative free cash flow was actually positive and necessary for long-term wealth creation.
If I were to assign a grade to Calin for how he allocated capital over the last 10 years, it would be an A+ because he clearly did his homework and understood the role economic profit plays in valuation creation. I would still give Delta leadership a B+ but I know where I would be putting my money now.