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The great recession that has ravaged many developed economies since the global financial crisis has profoundly changed management practices, especially in public companies. There has been a shift towards maximising profitability rather than leveraging asset growth. In many countries, especially the United States, this change of emphasis has resulted in companies becoming “cashed up” because of their efforts to reduce debt and cut costs. In the US, productivity and profitability are strong.
In Australia something similar has occurred. Public companies responded to the global financial crisis of 2008 by raising more than $100 billion in fresh equity. This allowed them to sharply reduce debt levels. Net debt-to-equity (not including the banks and real estate investment trusts -- REITs) is at a 30-year low. Gearing is about 20% for the overall market, 38% for industrial stocks and 18% for the resources sector – down from 70% in 2008.
Goldman Sachs analyst Hamish Tadgell comments that Australian companies have done a lot of "balance sheet repair work" over the past five years. They also have gotten into the habit of giving profits to shareholders. To protect their share prices in bearish conditions, they have concentrated on keeping their dividend payouts high.
This strategy is now coming under pressure; the post-crisis cycle is coming to an end. According to a report by Macquarie Equities, many Australian public companies are farming out yet more of their profits in order to keep their dividends up. The result is a squeeze. Rather than reinvesting profits for growth, they are passing more profits back to investors.
“After a long period in which earnings per share growth either exceeded or was equal to dividend per share growth, the last year has seen this trend reverse,” the report says. “The overall market’s dividend per share growth remained modestly positive in 2011-2012, although growth was lower than in the previous year. Earnings per share growth, however, was negative.”
As a consequence, the report says, dividend payout ratios (the proportion of profits returned to shareholders) have been increased to an average of 75%, the sharpest rise in six years.
This is putting leaders of public companies in a difficult position. According to Macquarie, share price growth over the last three years has been “negligible”. Dividend yields have “come to the rescue” when it comes to providing value to shareholders: the average dividend yield is 5.7%, which is above the long-term average. But as profit growth becomes harder to sustain, maintaining dividends will become more difficult. Pressure will grow on management.
Christopher Selth, chief investment officer for Five Oceans Asset Management, says what is happening in Australia is part of a worldwide trend. Globalisation has created a mismatch between labour and capital. Companies have been able to reduce their expense on labour by using low-wage countries, but this has meant that there is often weak demand for their products, especially in the middle market, because employees in developed economies are struggling to maintain their wage levels and employees in developing countries do not earn enough to replace the lost demand.
“A lot of bears in the stock market will say that profit margins are too high globally, which goes hand in hand with the idea that profit share [corporate profits as a percentage of gross domestic product] is too high in global economies,” he says. “Corporates are sitting on huge piles when their governments are hungry for cash. Is that sustainable? The answer is probably not. It doesn’t matter what your politics are, you would probably say we are at the high water mark for that. US companies kind of know that things are out of kilter. Demand for luxury goods is high, but the middle market is declining hand in hand with the decline of the middle class.”
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This picture is supported by a report by Towers Watson, Global Markets Overview, which records that big companies have been able to control their costs. “Globalisation has allowed many large multinationals to produce in low-cost geographies and protect profit margins.”
In Australia, the imbalances created by globalisation can be seen in the two-speed economy. The resources sector has benefited from fast growth in the developed world -- especially China, which has benefited from providing cheap labour to Western corporations. But the rest of the Australian company has suffered from the kind of pressures that are more typical of what is occurring across most developed economies – weak demand and high household debt. This is one of the main reasons for the slowing earnings growth reported by Macquarie.
How are Australian leaders likely to respond to the pressure to keep dividends up in an environment of slowing profit growth? Graham Haines, consultant and author of Execution to Die For, says that faced with pressures to repatriate more profits to shareholders, the likelihood is that management will cut costs. “I think cutting costs has an enormous impact on the ability of the company to execute. There is often simply not enough people at the coalface of the organisation serving the customer. Another common problem is that investment that should take place gets cancelled.”
Taking a more aggressive approach in difficult economic times can yield results, says Haines. “If you look at Apple, when you go to their shops you are overrun with people wanting to serve you. They are a company that offers fantastic customer service because they are prepared to pay the cost.
“In Australia you get a lot of oligopolies, and I just sense that a lot of people pay lip service to meeting customer needs, but the standard is actually fairly low. For all the talk about leadership, teamwork and employee empowerment, it is really quite poor.”
A potential danger is that managers will become overly short term in their focus. Sean Spence, director of consultancy Sean Spence & Associates, says managers have to match the abstract idea of building for the long term with the short-term need to satisfy shareholder expectations.
“It is a hard call to cut dividends,” he says, adding that it can create unhealthy thinking in managers. “At exactly the time you need to be creative and have a sense of agency, your brain shuts down. If the organisation’s senior team is put under stress they can start to eat their young.”
Spence says executives placed in pressured situations tend to hang onto what they have, becoming negative about new ideas. “That can often lead to active discord in the senior management team. Small issues can be argued over with extraordinary intensity.”