QUALIPORT
Companies with Assets To Avoid

By Maynard Paton (TMFMayn)
June 18, 2001

Carburton Street, London -- When considering a company as a possible long-term investment, it pays to ignore those businesses that have a real hunger for tangible fixed assets.

There are two reasons:

1) If the company has a significant reliance on tangible assets, what competitive advantage does it have when a rival can go out and purchase the exact same tangible assets?

2) Heavy capital expenditure tends to lead to back-end loaded returns. Establishing a telecom network, digging a mine or building a cruise liner usually means lots of expenditure today in return for income that may only be generated many years down the line. Contrast that expenditure to, say, that on advertising or salaries, the return on which is produced almost immediately. Overall, the further out your expected returns, the more uncertain those returns will be.

Measure

Identifying a company's reliance on tangible fixed assets is a relatively straightforward task. There are two key figures within the accounts to pinpoint:

1) Within a company's balance sheet, an entry for tangible assets will always be shown. Delve deeper into the accounts and a further note will breakdown the nature of those assets. Tangible assets are separated into such sub-types as land and buildings, plant and machinery, fixtures and fittings, and motor vehicles.

2) The purchase cost of any fixed asset is charged against a company's profits during the useful economic life of the asset concerned. This charge, called depreciation, thus reflects the gradual "wear and tear" of the company's fixed assets.

The depreciation charge can also indicate the ongoing expenditure needed to replace "worn out" assets. However, given that the depreciation charge is calculated on a historical cost basis, and that the prices of most assets tend to rise over time, the depreciation charge usually undershoots any "asset replacement cost" to the company.

Perspective

Simply comparing a company's profits to those two accounting items will highlight the company's reliance on tangible assets. Companies that generate greater profits from fewer tangible assets will obviously possess more in the way of intangible assets, such.as:

* Patents;
* Brands;
* Government licences;
* Customer loyalty, and;
* Reputation.

These, and many other types of intangible assets, are difficult for rivals to replicate. They generally lead to more durable competitive advantages and enhanced pricing power over customers. Companies full of these intangibles are the ones long-term investors should seek.

While comparing a company's profits to its fixed assets and depreciation charge is straightforward enough, some perspective is needed. With that in mind, I've performed the necessary calculations on the 100 largest companies on the London Stock Exchange. With such a range of different companies to form a benchmark, it should be easy enough in future to determine whether a company really is fixed asset-light or not.

Caveats

It goes without saying that any statistical compilation of a 100 accounting performances has a number of caveats.

First and foremost, there is a reliance on a third party supplier of company data. In this respect:

* Companies issuing recent annual results have yet to have their figures fully updated by the data supplier. In these cases, the previous annual results were used, and;

* Certain companies were excluded because of their accounting presentations. These included banks, insurers, financial service providers and property companies. Individual companies excluded due to a lack of historical data were Granada (LSE: GAA) and Compass (LSE: CPG).

And secondly, there are individual company issues, namely:

* Companies reporting an "unusually" bad year will be adversely affected by any profit-based measurements, and;

* Subjective accounting policies can affect the book value of tangible assets and depreciation charges.

Benchmark

Bearing all that in mind, here are the top and bottom fifteen companies ranked by their overall lack of tangible fixed asset use. For this exercise, I've simply divided each company's operating profit by its annual depreciation charge and year-end tangible asset value. So, the higher the result, the better. (Loss-making companies obviously fare badly in the analysis!)

Then, to give an overall table ranking, I've taken the average position (shown in brackets) that each company showed in the two individual calculations.

    Company                Operating Profit/    Operating Profit/ 
                             Depreciation        Tangible Assets  

   1 Provident Financial         27.70 (1)           6.16 (1)
   2 CMG                         14.11 (3)           4.34 (2)
   3 Imperial Tobacco            16.93 (2)           2.94 (6)
   4 Emap                        10.38 (6)           4.21 (3)
   = Misys                       10.83 (5)           3.97 (4)
   6 Sage                        12.01 (4)           2.39 (7)
   7 Gallaher                    10.34 (7)           1.50 (12)
   8 United Business Media        6.08 (16)          3.08 (5)
   9 Smiths Group                 7.24 (12)          1.07 (15)
  10 Allied Domecq                9.35 (8)           0.92 (21)
  11 Dimension Data               5.40 (21)          2.17 (9)
  12 Capita                       5.80 (18)          1.46 (13)
  13 AstraZeneca                  9.13 (9)           0.91 (22)
  14 ARM Holdings                 5.22 (25)          2.19 (8)
  15 Logica                       5.25 (23)          1.71 (11)


  86 Scottish Power               2.26 (70)          0.09 (92)
  87 Billiton                     1.79 (82)          0.11 (83)
  88 Powergen                     2.02 (78)          0.10 (88)
  90 Lattice                      2.09 (76)          0.08 (94)
  90 Severn Trent                 1.80 (80)          0.10 (91)
  91 J Sainsbury                  1.58 (90)          0.10 (89)
  92 RMC                          1.37 (93)          0.11 (84)
  93 Cable & Wireless             0.47 (95)          0.10 (85)
  94 Safeway                      1.62 (88)          0.08 (93)
  95 Railtrack                    0.64 (94)          0.06 (95)
  96 British Airways              0.14 (96)          0.01 (97)
   = Energis                      0.11 (97)          0.01 (96)
  98 Corus                       -0.10 (98)         -0.03 (98)
  99 Telewest                    -0.38 (99)         -0.05 (99)
 100 Colt Telecom                -0.82 (100)        -0.07 (100)

It's very pleasing to see the only three Qualiport-related companies on the list within the top ten. Portfolio member Emap (LSE: EMA) is at number 4, while Qualiport watch list members Imperial Tobacco (LSE: IMT) and Allied Domecq (LSE: ALLD) are at positions 3 and 10 respectively. Indeed, my view of Allied Domecq has improved considerably after this analysis. The company compares very well to its sector peers, with rival Diageo (LSE: DGE) the nearest at position 28.

With that table as a benchmark then, how do the other portfolio constituents (excluding the troubled MMT Computing (LSE: MMT)) and watch list members fair?

     Company                Operating Profit/    Operating Profit/    
                               Depreciation        Tangible Assets  

  (7) Metal Bulletin             11.91                 2.32   
  (8) Ulster Television          10.08                 1.83   
  (9) Ultraframe                 11.49                 1.43   
 (12) Latchways                  10.02                 1.11    
 (16) Halma                       6.93                 1.03   
 (22) Johnston Press              7.49                 0.84   
 (41) Carpetright                 4.81                 0.51    
 (42) SSL International           4.19                 0.55   
 (44) PizzaExpress                5.57                 0.35     
 (56) Games Workshop              2.53                 0.66    

Quite a favourable outcome. Adding these ten companies to the other 100, only Games Workshop (LSE: GAW) would come in the bottom half of the table, ranked 56 out of 110.

Summary

To summarise:

* Companies reliant on fixed assets are more liable to have their competitive advantage eroded by rivals purchasing the exact same tangible assets.

* Companies that can generate greater profit from fewer tangible assets will obviously possess more in the way of intangible assets. Such assets generally lead to a more long-term competitive advantage.

* Companies involved in heavy fixed asset expenditure tend to generate back-end loaded returns for shareholders.

More: The full table of calculations used for this article can be seen here.

Disclosure: The author owns shares in Carpetright, Latchways, MMT Computing and Games Workshop.