QUINTON IVAN: Offshore heaven?
It’s well-known that the road to hell is paved with good intentions, and in a weak domestic economy, virtually every management team must feel the temptation to diversify offshore
Warren Buffett frequently uses the concept of the "circle of competence" to illustrate the importance of staying focused. This also applies to capital allocation decisions.
Despite building formidable businesses in a closed domestic economy before 1994, many SA management teams seem to feel that the grass is greener elsewhere. This led many of them to expand offshore, usually by acquisition — mostly with disastrous consequences for shareholders. And it was pervasive: virtually every major life insurer and bank bought some business outside SA.
True, there is the odd success story, but this is the exception — not the rule.
Woolworths spent R21.4bn buying Australian chain David Jones in 2014, equal to nearly a third of its market capitalisation. Even though SA retailers have a dismal track record in Australia — like Pick n Pay with Franklins, or Truworths with Sportsgirl — investors backed Woolworths senior management.
The rationale for buying David Jones sounded compelling. For a start, it had been undermanaged for several years and basic retail discipline had slipped. Also, the underinvestment in IT systems meant it lagged its peers in online retail, and there was a chance to improve its margin by selling private-label brands. Woolworths believed it could get an uplift of between A$130m and A$170m a year in earnings — significant, considering David Jones was generating just A$143m operating profit.
Initially after the deal, profitability improved at David Jones. Margins expanded and nearly a fifth of the purchase price was recouped when it sold its Market Street property in Sydney to the Scentre Group for A$360m.
Then trading took a turn for the worse in 2017. Australia’s retail environment deteriorated, leading retailers to discount heavily. At the same time, the private-label products failed to resonate with the David Jones consumer.
It meant Woolworths senior management and other SA managers became increasingly involved in the daily running of David Jones, at the expense of the (also struggling) SA operation.
David Jones’s profitability fell to A$102m, 29% down since 2014. This weighed heavily on Woolworths, which impaired David Jones by A$712m (R6.9bn) in 2018 — effectively writing off a third of its initial investment.
Even if the rest of the Lake Charles project goes as planned, real economic value has been destroyed
While Woolworths may be able to extract some value from David Jones in the short term, there is a significant risk that it has acquired a "melting ice cube". Department stores globally are increasingly under threat from online retailers and changing shopping habits. This model may continue to lose relevance.
Quite how this will pan out will become clear over the next 18 months.
Sasol is another case in point.
In 2012, Sasol announced its plans for the Lake Charles Chemicals Project (LCCP) — an ethane cracker and gas-to-liquids (GTL) project in Louisiana, on the Gulf of Mexico.
The growth in the shale industry meant the US had surplus natural gas, including ethane (which is "cracked" into ethylene and other derivatives) and methane (which is converted into hydrocarbons, such as diesel). The price of both products is linked to the oil price.
Effectively, Sasol wanted to exploit the price differential between cheap feedstock (due to a surplus of natural gas caused by the booming shale industry) and a high oil price.
In October 2014, Sasol gave the final approval for the LCCP, with beneficial operation expected to begin in 2018. The total expected cost was $8.9bn. The economics was based on an assumption of the long-term real oil price at $100 a barrel, with the long-term gas price at $3 to $4 per metric million British thermal unit.
Sasol said the internal rate of return (IRR) would exceed its hurdle rate of 10.4% in dollar terms — 1.3 times its weighted average cost of capital.
Anyone who has renovated a house knows big projects hardly ever finish on time and on budget. Add in the oil price, and the LCCP was doomed to overrun.
In late 2014 the oil price crashed, and Sasol had to slash its long-term oil price assumption to $80 a barrel.
In March 2016, Sasol said the project would be delayed by six to 12 months and then, three months later, it revised the cost to $11bn due to various construction delays, including above-average rainfall. But worse was to come.
In February 2019, Sasol announced the costs would rise to between $11.6bn and $11.8bn. Rattled investors got another shock in May, when Sasol revised the costs higher yet again — this time to between $12.6bn and $12.9bn.
It has meant that Sasol’s expected IRR has fallen to between 6% and 6.5% — well below its cost of capital. Even if the rest of the project goes as planned, real economic value has been destroyed.
Sasol’s debt has ballooned too. Before it green-lighted the project, it had R10bn in net cash. Now, Sasol’s debt-to-equity ratio sits at about 49%.
In response, Sasol has announced a plan to cut R30bn to R50bn in costs, but this raises its own issues: for example, if maintenance spending is cut, this raises concerns about plant underperformance.
Nor has the risk facing the LCCP abated, as there still remains the potential for further overruns.
It’s well-known that the road to hell is paved with good intentions, and in a weak domestic economy, virtually every management team must feel the temptation to diversify offshore.
But these are not regions in which SA companies have a competitive advantage. Worse, it is almost certain to distract them from their local business.
As active investors, we engage with all companies where there is a risk of value being destroyed. Sasol and Woolworths remain cautionary tales of how heaven can become hell for investors.
• Ivan is head of SA equities at Coronation
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