Improving, and the top Performers deliver break-out performance
We advise several Services firms as part of our business transformation consulting services practice. We decided to start a continuing review of the financial performance of firms in our practice areas. Our objective is to explore the relationship between Business Transformation and financial performance. We are operating under the belief that business transformation has a positive correlation with increasing enterprise valuation, stronger competitive performance, and correspondingly higher stock performance. We will explore these ideas in this and subsequent articles.
Every company has its own story, and certain trends tend to vary by industry. So, our research data are summarized by industry, as are these articles. We hope that readers will find it easier to relate to the summary conclusions if they are influenced or driven by industry-specific data. This article and series will be focused on the Services Industry, as defined by how companies identify themselves to NAICS industry codes. Over 60% of listed public companies are categorized as ‘Services’ firms using SIC and NAICS codes, so we elected to create a subgroup to follow going forward. Our data are for companies listed as public companies in the United States, which means we do not include companies with divisions in the US but listing on overseas exchanges.
The Services Industry group we track is sizeable industry segment: in excess of $179B in Total Assets, over $70B in annual Revenue, $12B in industry Net Income, and over $22B in annual capital investments. We found that the 1st and 3rd quartiles contain some of the largest industry participants. The 2nd, 3rd, and 4th quartiles on average have significant competitive room for improvement in enterprise valuation, net income margin, and Return on Assets compared to 1st quartile performers. Services is a diverse industry, with significant dependence on the rate of technology change, innovation, and global economic growth patterns tied to both business and consumer spending behavior. Given these significant external factors, it is imperative to seek every cost and expense efficiency to achieve competitive operating margins AND return on assets – or pay the price by trading at a discount to higher performing peers for an extended period of time.
Bigger is Not Necessarily Better, Bottom-Line Profitability Rules
Our database includes 62 services companies who publicly report quarterly and annual financial data in the United States. We subscribe to the ValueSource data service, and we update our data on a quarterly basis. Our analysis was based on annual financial data, as reported and captured by ValueSource for the most recent annual financial reporting period for each company. We further grouped the firms into four quartiles, and compared their performance to the other quartiles as well as the average for the industry.
We used a statistic called the Z-score to assess and rank companies based on their financial health. The statistical measure includes income statement and balance sheet ratios to develop a composite measure for each company, which is known as the Z-score. It was originally developed by Dr. Edward Altman of New York University, and has been refined over time to become the ‘gold standard’ of financial risk assessment. While most firms in the pharmaceutical industry are well above the parameters which indicate cause for concern, it is a helpful technique to rank firms into four quartiles for comparative purposes.
Services is by its very nature a diverse industry group based on the services and clients they serve, and their financial results are far more divergent than other industries we analyzed such as Pharma and Chemicals. Though diverse, certain basic patterns emerge. Bottom-line profitability matters in the Services industry, combined with a wise hand on the Capital Expenditure lever.
Now will summarize and contrast the performance of the industry in the areas of revenue and margins, asset utilization and returns, impact of prior investments and asset efficiency, and market returns and the relationship of debt.
Revenue & Margins
We analyzed data for the 62 companies included in SIC codes 2711 (Newspapers & Publishing), 3572 Computer Storage Devices), 3578 (Calculating Machines), 3663 (Radio & TV Broadcasting), 5045 (Wholesale Computers & Peripherals, Hardware & Software), 5999 (Wholesale Durable Goods), 7363 (Services), 7372 (Services-Prepackaged Software), 7374 (Services-Computer Processing & Data Preparation), 7375 (information Retrieval Services), and 7389 (Business Services), for their most recently reported annual financial results. The Services industry is filled with instantly recognized names, including Google, Thomson Reuters, ADP, Nielsen, NCR, Dun & Bradstreet as well as other firms such as WebMD, Digital River, Pegasystems, Opentable, and TheStreet. Two firms in the industry had annual revenues in excess of $10B, with total assets between $38B and $58B. The next eight firms ranked by revenue have total assets between $1B and $34B. The top ten firms have cash assets in excess of $18B, or approximately 11% of their total assets. There are a number of smaller firms in the industry, with 21 firms each reporting revenues less than $50M annually. Average revenue per firm in the industry was $1.3B, with a relatively loose range across the four quartiles for gross margins (51.4%) and a narrower range of operating profit margins (28.0%).
Asset Utilization and Returns – Asset Turnover is low and troublesome
Financial performance tended to track margin performance when scanning across balance sheet results. Asset Turnover (Sales/Total Assets) showed some variation across the quartiles, and Return on Assets showed significantly greater variation compared to the average firm. Asset Turnover ranged between 0.37 and 0.74 for across the four quartiles, with an average turnover of 0.45 for the prior 12-month period. Essentially, it took 26 months of revenue to reach the equivalent level of Total Assets for the average firm. By contrast, the average Services firm had an asset turnover that was nearly 13 months slower than the Pharmaceutical industry (see our related article on the Pharma industry).
Return on Assets (Net Income/Total Assets) showed significant differences across the four quartiles when compared to each other and the industry average. The Return on Asset performance ranged from -1.4% to 14.1% in the 1st quartile, with an industry average of 6.9%. The bottom three quartiles reported Return on Assets ranging between -1.4 and 3.6%, far below the top quartile.
Impact of Prior Investments on Asset Efficiency
The relative higher levels of Depreciation & Amortization incurred by these firms, thereby reducing their Net Income Margin % or bottom-line performance, explain much of the difference in the ROA performance of the bottom three quartiles. In summary, firms in the Business Services, Information Retrieval, and Computer Processing and Data Preparation segments in the industry are able to achieve competitive operating profit margins, before accounting for prior asset investments which are being depreciated and amortized over time. Their proportionate income statement impact for Deprecation and Amortization and their relatively higher Operating margins result in superior Return on Assets and Market Value to Debt. Simply said, the Services sector must begin to deliver sharply better sales to assets results – Asset Turnover must improve/increase or the improving income statement results will be swamped by bloated Balance Sheets. Divestitures may become a safety valve to move less productive assets to firms willing to make acquisitions based on different strategies – even if the cash received seems to be at a discount to net book values.
Market Value and relationship to Debt
We also looked at the market value of firms compared to their total debt book value, and found an interesting trend. The market value of services firms to total debt book value ranged from 1.31 to 16.38 across the four quartiles, with an average value of 3.88. Said another way, a higher value suggests the enterprise has a stronger balance sheet compared to lower values, presuming the firm can access the public equity markets to translate some of the ‘paper’ value into equivalent asset value. The third quartile’s market value to debt was roughly one-fourteenth the top quartile, suggesting borrowing related to previous investments and less attractive profit margins combined to create a far less competitive position. Top quartile firms have significantly greater opportunity to raise funds to invest in either new lines of business, growth, innovation – or acquisitions. That being said, 4th quartile firms, the firms with the weakest Z-scores, paradoxically managed superior market values to debt compared to 3rd quartile firms. 4th quartile firms had average revenues one-eighth the 3rd quartile and Operating Margins 25% higher than the 3rd quartile. However, the 4th quartile’s market value to debt statistic is based on a limited sample size, as several firms did not report market value in this quartile. Their overall Z-Score of financial health was adversely affected by the fact that 14 of the 16 firms in this quartile reported negative Net Income.
At this point, we have taken a fairly in-depth look at the Services industry’s performance from top to bottom, and in the next blog posting we will move on to an assessment of risk levels and summarize our findings.
Third and 4th quartile firms operate with significant balance sheet risk levels. A value of 1.31 in the 3rd quartile suggests the market value of a firm’s public equity is about 30% higher than the level of debt of that firm –risky and represented by their Z-score of 1.99. Firms with a Z-score less than 1.81 are perceived to be highly distressed, with a high risk of bankruptcy (or acquisition targets with discounted valuations) in the next 12-18 months. Firms with a Z-score between 1.81 and 2.99 are in a Grey Zone — risky. Put a different way, firms with Z-scores around 1.8 to 1.9 might receive a “B” Bond Rating from Standard & Poor’s. These firms have some elevated credit risk, and their market value to debt is provides limited room for additional equity if necessary. Many of the 3rd quartile firms have significant cash balances as part of their total assets (a total of $5B+ of cash on the Balance Sheets of the 3rd quartile firms). These firms made nearly $11B in capital investments during their last reporting period — approximately twice their level of cash balances. They will remain at risk until they lift their level of profitability and/or reduce the level of annual capital investment or get more revenue from their prior asset investment (improved Asset Turnover). Either can be accomplished with reduced growth rates, so the 3rd quartile firms will be challenged to grow and maintain market share unless they begin to achieve more competitive profit margins—and the capital markets are willing to provide more attractive valuation multiples.
The table below summarizes the data and you can see some interesting patterns in the second and third quartile metrics as we have discussed.
As you can see, the first and third quartile contained some of the largest firms in the industry. Services is by its very nature a diverse industry group based on the services and clients they serve, and their financial results are far more divergent than other industries we analyzed such as Pharma and Chemicals. Though diverse, certain basic patterns emerge. The path to superior financial health is with leadership gross profit margins and Operating Margins, with efficient use of assets. The top quartile invested in new Capital Expenditures at almost the same as the 2nd quartile, yet enjoyed a Net Income Before Interest and Taxes margin more than twice the 2nd quartile. Bottom-line profitability matters in the Services industry, with a wise hand on the Capital Expenditure lever.
External Factors are aligned for improved 2012 Financial Performance, how to take Unnecessary Risk out of the Future
C-level executives are increasingly turning to Business Process Management (BPM) to take unnecessary risk out of their business and to create more sustainable and agile business models across the enterprise. Why do we say so?
Cap Gemini recently completed a survey of C-level executives and the survey reported 45% of the respondents they now place more emphasis on BPM within their organizations. The research highlighted functional impediments to BPM adoption, and some concerns that BPM is viewed strictly as an IT matter. 48% of those responding identified IT as a barrier to more effective process improvement. In addition to IT being perceived as a possible barrier to BPM initiatives, 46% of the respondents identified a lack of change readiness or change willingness at their organizations.
Looking at the broader industry trends, US services firms with ties to the Internet should benefit from some or all of the following external factors: increased relative spending on Internet versus traditional media, pricing for online offerings has shown improvement, online advertising has increased at a rate higher than GDP the last several years, and mobile technologies are the widespread use of smart mobile devices opens a large Internet advertising segment. Balanced against those positive factors is an uncertain and increasingly gloomy global economic forecast. These external factors provide the potential to lift revenues and leverage profit margins and asset efficiency. Business Transformation strategic actions provide potential to return large dividends as there will be a high opportunity cost if revenue is left on the table due to missed or late initiatives and slow responses to competitive innovation.
We know, based on our own consulting practice, that many prominent chemical firms have some business process improvement initiatives underway. We also know these initiatives tend to be funded from IT, and while some non-IT functional areas are involved, there has yet to emerge a strategic commitment to BPM as a way of life across all functions and organizational levels at most firms. We believe a top-to-bottom commitment to continuous Business Transformation across all functions is a strategic imperative, and in addition to improving enterprise valuations it will also reduce risk.
Value of BT to ROI and Enterprise Value
We introduced a new term in the last section: Business Transformation. We view Business Process Management as just one element of a comprehensive set of tools, methodologies, technologies, and training needs which collectively fall into the larger category of Business Transformation. We employ our Confiance Transformation Framework℠ (CTF) to advise and assist clients with their Business Transformation Initiatives. Using the CTF at a Services client, we worked with them to identify and implement process changes within 4 months in excess of 100% Return on Investment. Also, we recently launched Confiance University, (www.confianceuniversity.com) our cloud-based content platform we are building out with our partners to bring all relevant content together for our clients and professionals who are committed to Business Transformation. We believe this will accelerate the acceptance and adoption of Business Transformation by private and public sector organizations, and we intend to provide testing and certification so individuals with different roles and responsibilities may mutually learn and use common approaches to improve performance.
We know organizations that are embracing Business Transformation and are expanding BPM initiatives across more than their IT organizations. They are experiencing positive ROI outcomes – both within the pharmaceutical industry and in other industry verticals. Again, let’s look at the Cap Gemini study for some additional insights. 98% of their respondents reported a positive ROI outcome on their BPM initiatives, and 55% reported returns of at least 2X their initial investment. BPM makes sense, and cents!
Confiance Transformation Framework & Business Transformation
To learn more about Business Transformation and how to get started, please view our webinar on the Confiance Transformation Framework℠. See how the Confiance Transformation Framework can help your organization with an in-depth discussion and case study.
Confiance is a global provider of business transformation solutions for commercial and government organizations. The company provides a comprehensive approach to Business Process Management, Enterprise Architecture and Service Oriented Architecture through a combination of consulting, education and technology that allows organizations to be more efficient, agile and improve service to customers and citizens. Confiance is recognized by its Global 500 and government agency customers as a trusted partner that helps implement change in order to achieve business results. Confiance’s customers include Alcoa, Bank of America, Bose, GE Commercial Finance, Kraft, State of New York, U.S. Army, Vodafone and Wyeth. For more information visit: www.confiancegroup.com.