Much has been said about how numerous South African corporates have “wasted” capital through their offshore diversification strategies. Some commentators have gone a step further and argued that if the capital had been invested in South Africa instead, it could have contributed to the creation of sought-after jobs, a pain point in a country courting investment and with one of the highest unemployment rates in the world.
Most commentary has, however, fallen short of distinguishing between whether the firm’s selected strategy was the correct one and the discipline of execution of that strategy.
One of the most maligned international local acquisition failures was by Woolworths of David Jones in Australia for about A$2.2-billion (R21.4-billion at the time) in 2014. The planned transformational deal saw Woolworths lever up its balance sheet and a few years later impair the investment twice, with a total write-off of A$1.149-billion — more than half the purchase price.
Woolworths set itself the strategic goal of becoming a prominent Southern Hemisphere retailer. Did this strategy make sense? In many respects, yes. The store has its largest footprint in South Africa and services mid- to high-end consumers with fashion, beauty, food and homeware goods.
South Africa has had minimal to no economic growth in the past few years and as a result, there has been limited middle-class upward mobility, implying that Woolworths’ targeted consumer base in its home market would eventually offer limited growth potential.
It goes without saying that Woolworths’ shareholders (and it is important to point out that shareholders include local retirement funds, which are further constrained by the requirements of Regulation 28 and are therefore hungry for access to international growth) would naturally expect its CEO and executive team to look for new areas of growth to support future returns on capital and value creation.
And that’s exactly what Woolworths set out to do when it decided to diversify its global footprint and increase its exposure to the Australian retail market. It could have achieved this diversification in one of two ways: organically or acquisitively.
The company, like many other South African corporates, chose the latter route and came up short in the execution of the acquisition, both in terms of price (over-) paid and post-acquisition execution of extraction of expected synergies, value creation and also in terms of the relative capital allocation across the full group portfolio, hence the drag on the rest of the group.
The management team had previously turned around Country Road on acquisition and with that feather in its cap believed it could do so again, this time on a much larger scale. The intention is not to pick on Woolworths, but to simply distinguish between strategy selection and actual strategic execution.
There is a litany of corporates in SA found wanting and who have had to impair international investments. Examples include Truworths, with its Office acquisition; Sanlam, with its Saham acquisition; and Famous Brands, with its acquisition of Gourmet Burger.
These impairments often involve impairing goodwill which has arisen due to paying expected synergies away, used to justify a premium for the acquisition. Although an argument can be made for paying a premium for control, it seems silly in retrospect to pay away cash upfront for synergistic value creation that you are not completely sure will materialise.
It is like buying a pair of jeans in advance, in your desired figure size, and hoping that if you pursue an adequate dietary and exercise plan, you will fit into said jeans. After all, who knows where and how your body will change and how successful you will be with execution? This issue is further magnified when debt is raised to fund the acquisition, because as the equity related to the acquisition erodes, the rest of the company’s balance sheet needs to stand in for this debt.
South African executive teams favour acquisitions in international markets because it’s quicker to execute upfront than it is to grow organically — you simply buy an already operating and (hopefully) profitable business, or in some cases one you believe you can turn around.
This choice may also be linked to the contractual term of the CEO — for example, if the CEO has a five-year term and has internationalisation of the company as a key performance target, she or he is unlikely to choose the organic route, which would entail a much longer slog to profitability and growth, possibly beyond the contractual term of his or her performance measurement.
This is not to say that organic growth is necessarily always successful, as has been evidenced by Mr Price closing its test stores in Australia and Shoprite pulling out of many of its markets in Africa. But organic strategies often come with less capital wastage/loss if the internationalisation strategy is approached in a measured manner, because you have far greater control over the full operational execution process.
Why have so many acquisitive internationalisation strategies gone wrong? Warren Buffet says, “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes institutional politics.
“Once they become CEOs, they now must make capital allocation decisions, a critical job that they have never tackled and is not easily mastered. To stretch the point, it is as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead, to be named the chairman of the Federal Reserve.”
In a different but also applicable analogy, David Epstein speaks about what he calls kind problems/environments and wicked problems/environments in his book Range. A kind learning environment is described as one where patterns recur, a situation is constrained, every time you do something you get feedback quickly — basically it’s an environment you know very well and in the context of SA corporates you may have had a hand in shaping that specific area of the industry you play in, so you would have a good grasp of the impact a business decision is likely to have.
In wicked environments, on the other hand, some information is hidden, and feedback may be delayed, infrequent or non-existent. Applied to SA corporates, this would be an unfamiliar environment/territory where you are an outsider and your view on the impact of your business decisions is limited because you have not been around long enough. In this type of environment, the question that also needs to be asked is, if the deal is such a good one, why are local operators who understand the market not rushing to acquire the company?
SA corporates may suffer from a combination of both the Buffet and Epstein analogies, which often leads to large failures in acquisition executions. Many head off into foreign countries, perhaps not fully appreciating that their local operational success has come in a largely cushioned (and kind) economy, an economy they understand well.
Several of SA’s long-standing companies were established in a closed economy with limited competition present and many companies simply took off even further when the economy was opened to all South African citizens.
A growing economy helps mask poor corporate decisions, because, as the cliché goes, “the tide is in”. Of course, errors of judgment and mistakes do happen, and in the same vein, so does success. Risk-taking is necessary in the quest for value creation, but so too is minimising that risk where you can manage it. There is also room for extending Buffet’s argument to include that capital allocation should also be the responsibility of the CFO and by extension the board of directors too. There, however, seems to be an increasing shift in SA towards the CFO role being viewed more as a compliance role.
So, whose job is it to ensure that the necessary capital allocation skills exist in an executive team? It is simply not okay to farm out this skill-set to the advising investment bank or any other advisory firm when a deal is being undertaken. The ultimate buck stops with executive management and the board of directors.
Capital allocation is the root of all corporate value creation. As the South African economy’s anaemic growth continues, executives managing companies with a largely South African focus will come under increasing growth performance pressure, and while excellent management skills may initially slow the rate of decline, eventually underlying economic fundamentals will win.
If a South African corporate is unable to achieve additional growth without internationalisation and is unsuccessful in its quest for geographical diversification, perhaps the alternative is to admit that the company is ex-growth and that it won’t be able to achieve much more growth beyond inflation in its main market, let the cash accumulate and return capital to shareholders, either through share buybacks (if you believe the share price is undervalued) or declare a larger and larger annual dividend so that shareholders may invest it as they please. That kind of decision would require a healthy dose of humility, but in the long run may be the best way to strategically allocate capital and not destroy value. DM/BM