QUALIPORT
Companies With Assets To Avoid

By Maynard Paton (TMFMayn)
June 10, 2002

When considering a company as a long-term investment, it pays to avoid 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 similar assets?

Take the fixed asset-heavy supermarket industry. All the major players have the same out-of-town superstores and local geographical monopolies, yet it's the intangible assets of Tesco (LSE: TSCO) (i.e. management talent, logistic efficiency, buying power, advertising creativity and so on) that make all the difference and give the company its sector leadership.

2) Heavy capital expenditure tends to lead to back-end loaded returns for shareholders.

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. 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 stuffed full with 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, the necessary calculations for the 100 largest companies on the stock market have been calculated. With such a range of different companies to form a benchmark, it should be easy enough 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;

* Banks, insurers, financial service providers and property companies were excluded because of their accounting presentations.

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 twenty-five companies ranked by their overall lack of tangible fixed asset use. For this exercise, each company's operating profit is divided by its annual depreciation charge and the average tangible asset value employed during the year. So, the higher the result, the better.

Furthermore, the average position that each company showed in the two individual calculations (highlighted in brackets) has been used to give an overall table ranking.

    Company                Operating Profit/    Operating Profit/
                             Depreciation        Tangible Assets

 1 Provident Financial         22.37 (1)           5.70 (1)
 2 Emap                        10.38 (3)           4.21 (2)
 3 Imperial Tobacco            12.44 (2)           2.82 (4)
 4 Sage                        10.02 (4)           2.65 (5)   
 5 Shire Pharmaceuticals        8.25 (7)           3.60 (3)  
 6 Gallaher                     7.91 (9)           1.12 (20)  
 7 Allied Domecq                9.31 (6)           0.81 (12) 
 8 GlaxoSmithKline              8.16 (8)           0.92 (17)  
 9 Electrocomponents            6.57 (13)          1.03 (11) 
10 BAT                          6.73 (12)          1.01 (13)  
11 Reckitt Benckiser            7.57 (11)          0.95 (16)   
12 Bunzl                        6.52 (14)          0.97 (14)  
 = Signet                       6.05 (16)          1.02 (12) 
14 Capita                       4.94 (22)          1.54 (8) 
15 Lonmin                       9.51 (5)           0.66 (11)   
 = Matalan                      7.70 (10)          0.80 (22)   
17 ARM                          4.60 (27)          2.55 (6)  
18 Smiths Group                 4.67 (26)          1.47 (9)  
19 Cadbury Schweppes            5.76 (17)          0.81 (21) 
20 AstraZeneca                  5.08 (19)          0.82 (19) 
21 WPP                          4.80 (25)          0.97 (15)  
22 Next                         4.85 (24)          0.90 (18)  
23 Alliance Unichem             5.15 (18)          0.69 (27)   
24 Wolseley                     4.85 (23)          0.74 (25)
25 Diageo                       5.01 (21)          0.68 (29) 

It's very pleasing to see the only four Qualiport-related companies on the list within the top ten. Portfolio member Emap (LSE: EMA) is at number 2, while Qualiport watch list members Imperial Tobacco (LSE: IMT), Gallaher (LSE: GLH) and Allied Domecq (LSE: ALLD) are at positions 3, 6 and 7 respectively.

With that table as a benchmark then, how do the other Qualiport constituents and watch list members fair?

     Company                 Operating Profit/    Operating Profit/
                               Depreciation        Tangible Assets   

 (6) Metal Bulletin              9.23                 2.59      
 (7) Ulster Television           9.09                 1.85     
 (8) Ultraframe                  9.25                 1.11    
(14) Johnston Press              7.97                 0.84    
(26) DFS Furniture               7.88                 0.65 
(30) Renishaw                    5.50                 0.64 
(32) Carpetright                 5.35                 0.54      
(38) SSL International           4.42                 0.55    
(42) Games Workshop              2.61                 0.75     
(44) PizzaExpress                4.83                 0.35      
(47) London Stock Exchange       2.95                 0.51     

Quite a favourable outcome. Adding these 11 companies to the other 100, none would come in the bottom half of the table.

Reality

While the theory is one thing, reality is another. Do those companies with little reliance on tangible assets -- and thus (in theory) have greater competitive advantages and be less prone to profit declines -- have more 'reliable' profits in real life? The asset analysis featured in this article was initially performed twelve months ago and it provoked discussion board poster BillMunny to to ask that very question:

"Care to forecast the profit for those [asset-light] companies for us then in the next year to back up your assumption?"

The table below shows the ten FTSE 100 companies with the fewest fixed assets as at June 2001. The ten FTSE 100 companies with the greatest amount of fixed assets then follow:

Company               Year to     Predicted EPS      Actual EPS
                                   (June 2001)          (p) 
                                       (p)              

ARM                   Dec 2001         3.3              3.7
Provident Financial   Dec 2001        51.6             50.3
CMG                   Dec 2001         8.8              4.6
Misys                 May 2001        16.0             15.9
Emap                  Mar 2002        46.5             27.4
Capita                Dec 2001         7.4              7.3 
Serco                 Dec 2001         8.0              6.7
Sage                  Sep 2001         6.8              6.6
Shire Pharmaceuticals Dec 2001        30.0             43.8
Logica                Jun 2001        24.0             25.1

Railtrack             Mar 2002        58.1               - 
Rio Tinto             Dec 2001        93.0             62.6
Tesco                 Feb 2002        12.6             12.2
British Airways       Mar 2002        19.7            (34.1)
Scottish Power        Mar 2002        34.5             25.7
Cable & Wireless      Mar 2002         8.9            (26.2)
Shell                 Dec 2001        36.0             30.3
Lattice               Dec 2001        11.3             12.3*
BT                    Mar 2002        14.5              6.8
BP                    Dec 2001        40.1             27.9

(*annualised 15 month figure)

Although the data covers just one year, readers can judge for themselves whether asset-light companies have more reliable profits than their asset-heavy counterparts.

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 difficult-to-replicate 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.

The author owns shares in Carpetright, Games Workshop, Johnston Press and PizzaExpress.