Introduction Tomkins Plc was incorporated in 1925. The company engages in manufacturing and engineering activities on a global scale.
Operationally, the company is split into two distinct strategic business units. The Industrial & Automotive business segment is involved in the manufacture of a wide array of systems and components for car, truck and industrial equipment. This business unit is further defined under the following broad categories:Power TransmissionFluid PowerFluid SystemsOther Industrial & AutomotiveThe other strategic business unit is the Building Products segment, which manufactures components for heating, air conditioning and ventilation, and other building related products. This business unit too is broadly defined into two broad categories:1.
Air Systems2. Other Building Products As at August 2008, Tomkins Plc (2008, P.2) boasted 138-production facilities worldwide with 33,452 employees. The company is styled as a holding company with 54 companies under its portfolio.
How Is Wealth For Shareholders Created & MeasuredBPP (2008, P.45) states Ordinary shareholders, by virtue of them having a residual interest in the business, are the true owners of the company. These owners of the company then appoint management to act as stewards for their investments. By virtue of this appointment as stewards, the management becomes the agents of the shareholders (who are the principal) and an agency relationship comes in force with the agents (management) owing a fiduciary duty to the principal (shareholders).
Hence, it is from here that financial management theory derives the basic idea that the supreme aim of management is to maximize the wealth of its ordinary shareholders. Before we decide how shareholder wealth is created, we have to first look at how shareholder wealth is measured. FTC (2007, P.25) says that Shareholder wealth is primarily derived from two things; cash flow in terms of dividend and the capital gain that a shareholder realizes on disposing off his investment.
The extent of both, capital gain and dividend is a result of management policies. Another important note to consider, before we move on, is that the dividend policy of every company varies. Capital gains are directly related to the amount of further investment in the company. High profit retention increases the amount of capital gain to the detriment of a nice fat dividend payout.
On the other hand, high dividend payouts mean less cash available for capital investment and the result is a stable share price with low opportunities for major capital gains. The choice between high dividends and high capital gains is not so clear cut as management constantly figures the specific needs and characteristics of its shareholders, its own needs, the signaling effect of dividends and the long term effect of dividend policy on company and shareholder wealth. Having said the above, shareholder wealth is created through anyone or both of the following measures:High ProfitabilityHigh Growth OpportunitiesSchweser (2009, P.140) states High profitability increases the amount of distributable profits and hence the chance of a high dividend.
Even if the high dividend pay out expectation does not materialize, the cash is retained in the business and used for further capital investment (to improve the efficiency and economy of the current company structure) or used for strategic investments (like mergers and acquisitions). This lends argument to the second point of high growth opportunities. When markets are strong form efficient, they correctly price share values and hence all past and current data is reflected in share prices. So for example, the announcement of a new capital investment project might lead to a share price jump equivalent to the amount of Net Present Value of the project in question.
Thus, there is a capital gain. Shareholder Wealth Creation Strategies Employed at TomkinsAs mentioned earlier, Tomkins Plc is structured like a holding company with investments (controlling and interests having significant influence) in a portfolio of 54 companies as of 2008, spanning the industrial and automotive as well as the building products industry. As part of its 2007 Annual Statement, the board of directors announced their strategy for shareholder wealth creation through a combined mix of organic growth, strategic acquisitions and geographic expansion. While organic growth would aim at increasing the returns from present operations, strategic acquisitions would help find synergies and hence efficiency in the overall organization.
The entry into new markets will help spread systematic risks and help take advantage of high returns in emerging markets. Do note that as of 2008, the company has taken a U Turn and put balance sheet strength and a reshaped portfolio of investments as a more immediate goal as part of it shareholder wealth creation (rather wealth preservation given the current bleak economic outlook) strategy. Surprisingly, however, while the company speaks of increasing shareholder wealth, it does not specifically speak on how it intends to accomplish this. As the sections of financial performance, share price performance and dividend payout below detail, the company has lacked any solid trend in strategy.
In effect, it can be argued that given the sustained economic growth in the past 10 years (excluding the hiccups caused by the dot com bubble) the company has, until as recently as the sub prime mortgage crisis concentrated itself on riding the tide of economic growth by investing heavily in a cyclical industry such as automotive and industrial products and the building products segment.An Overview of Company Performance In the Last 10 YearsThe company’s financial performance has see sawed over the past ten years with sales and profitability decreasing until 2004 as a result of a falling enterprise value. From there on a surge in the company’s performance is seen with sales and profitability rising. However, from 2006 onwards the trend has reversed with higher sales being accompanied by lower profits.
As of January 2009, the company reported not only lower sales but also its first loss in the period under review. 10-Year Share Price PerformanceThe share price performance for analysis purposes over the past 10 years can be divided into three phases. In the first phase, the company showed volatile share price movements with massive upside and downside movements. These are a result of profits falling of 2002 being almost half their 2000 level, a slow decline spread over three years.
The company saw seesaw movements in enterprise value during these years up to 2003, with share prices falling and rising rapidly (as measured from year end market prices). This was a result of constant buying and selling of interests that represent the portfolio. From 2004 onwards, share prices stabilized with little volatility. The situation remained the same until April 2006 when share prices peaked.
This was a result of increased sales and profitability and a stable portfolio aided by tremendous economic growth. After that there has been a downward trend in shareholder fortunes. This has been due to a worsening economic outlook and movements in the portfolio of interests that has led enterprise value to fall. The table on the following page summarizes the share price performance over the past 10 years along with a chart of share price: Current Share PriceGbp 158.
25Share Price 10 Years AgoGbp 269.0010 Year Growth-41.75%10 Year HighGbp 343.7510 Year LowGbp 89.
75Range (10 Year High – Low)Gbp 254Beta1.45Source: Google Finance (2009)As one can infer from the above, the share price today as compared to the share price 10 years ago is roughly 42% lower. As the graph below depicts, there has been massive downward pressure on in share price performance from April 2006 onwards. The 10-year High-Low, the range between the 10-year High – Low and the Beta of the stock all depict massive volatility in share prices.
The changes in enterprise value graph are also presented on the next page. Fig.1 Share Price Performance (5 Year)Retrieved From Reuters (2009)Fig.2 Enterprise ValueReterrived From Annual Reports For 2003, 2006 & 2008.
10-Year Dividend Payout Ratio TrendThe dividend payout ratio is the percentage of current year profits that is paid out as dividends and hence not retained in the business. Starting 2005, the company has paid a record amount of dividends with dividend payouts touching 83% on a high note by 2008. The company has in the meanwhile continued its string of acquisitions over the years and hence it can be concluded that increasing the dividend payout ratio might have been a strategy geared at returning excess capital back to shareholders. Overall, dividend payouts have been steadily increasing while profits have been falling despite increased sales growth.
This might have also affected share values as high dividend payouts result in a negative signaling effect. However, the recent downturn in the company’s share price can be directly attributed to increased stock market volatility as a result of the current recession and major bankruptcies and the overall negative effect on prospective sales for the company which itself primarily deals in cyclical products.Fig.3 Earnings & Dividend Payout TrendRetrieved From Annual Accounts For 2003, 2007 & 2008Holding Period Return (HPR)Using a conventional metric for looking at shareholder wealth creation, one may use the holding period return, which uses the following formula: P1-P0+CF / POWhere:PO = Purchase PriceP1 = Selling PriceCF = Dividend Payments Assuming that 10 years ago an investor bought a single share of Tomkins Plc at the then prevailing price and sold it exactly ten years later at today’s prices, ignoring inflation and consuming all cash dividends, the HPR is as follows: (158.
25-269+110.36) / 269 = (0.145) % Hence, an investor would have a generated an approximate return of 0.145% on his investment in Tomkins Plc over the past 10 years.
Note that although the capital gain component of the HPR is negative, the positive return only comes about through the dividend cash flow barely allowing the investor to breakeven. Another method through which this HPR can be utilized for shareholder wealth creation is to induct the impact of inflation into our analysis. The Economist (2009) states average annual rate of inflation over the past ten years in the United Kingdom is roughly 2.3%.
For ease of calculation, this has been approximated to 2% and the results of the HPR are as follows: 129.82 – 269 + 100.5 / 269 = (14.37) % Hence, in real terms, the shareholders have seen a 14.
37% decrease in wealth over the 10 year period with dividend payouts helping to keep the overall return better. Conclusion & RecommendationsAs at the time of writing, the company had through its dividend, financing and investment policies created a negative value (in nominal terms) of 0.145% and (in real terms) negative 14.37% over the past ten years.
Had it not been for the dividend payouts that the company has maintained despite volatile earnings and an ever-changing enterprise value, the overall return would have been deeper in the red. What is important to note here then is to understand that the company has to cut back on dividend payouts if it is to preserve the value of the company, as with falling profitability levels, the current amount of dividends cannot be sustained for long. As per the latest financial statements of the company (2008), the management of the company already intends to cut back on dividends starting this year so as to ensure balance sheet strength (See appendix for financial statements). Figure 4 produced below gives an over view of the lack of profit retention that the company has exhibited: Fig.
4 Distribution of Shareholders Profits Considering how the company can increase wealth creation for its shareholders, the company has to first bring a change in its dividend policy, which it already has embarked upon with lower dividend payouts expected next fiscal year. Having sent the signal to investors, the next step is to make a drastic attempt aimed at cutting down costs and returning to profitability. The company has amassed a large amount of companies in its portfolio within its two broad strategic business units. Therefore, a strategic action is required through which the overall company is restructured and loss making activities are reversed or disposed of.
Hence a major corporate reconstruction is the need of the hour. The company also has at its disposal USD 300M (refer to financial statements as part of the appendix) of free cash flow available, this can then be used for making strategic investments through under priced acquisitions given the distressed state of the industry and/or making investments in the company’s existing infrastructure so as to attain economy, effectiveness and efficiency. Another issue to consider is that of competitive advantages. As part of its reconstruction and restructuring efforts, the company should identify operating units in which it lacks competitive advantage and dispose them off while retaining those in which it has competitive advantage.
The overall aim is to see every venture as a capital investment project from hereon and to retain and improve on business units that offer a positive NPV so that overall shareholder wealth is increased through capital gains as the new dividend policy entails that a higher portion of the company’s shareholder returns. Lastly, it seems that the firm seeks diversification for its shareholders, which explains its constant acquisitions and divestures and a portfolio that is heavily diversified. Relating all this to what has been said in this paragraph already, the firm does not have to seek diversification for its shareholders as they can seek this diversification themselves. For shareholder wealth maximization, the company should maintain businesses, and only those businesses that provide competitive advantages.
Another important characteristic that should be included in the company’s new wealth creation strategy is to understand that while high and steady dividend payouts are liked by shareholders, it is important to comprehend that volatile earnings cannot compliment this strategy. Over the past ten years, the company’s enterprise value has not surpassed its 1999 level while earnings per share have been constantly lower then the 1999 level as a result of massive EPS dilution. Hence the company has, to ensure investor confidence in the company, bring about a smoothing effect on the financial statements of the company through which wide swings in EPS, Book Value & Market Value per share and the overall enterprise value is avoided and this volatility of returns that the shareholders of the company are subject to, due to the financial management policies of the board, is eliminated (Schweser, 2009). To conclude, the company has to tow a line between being an investment vehicle for its shareholders to invest in a large number of companies related to its two core business segments or to become an investment vehicle for its shareholders that invests in a small number of well integrated firms spanning areas where the company has competitive advantages over its peers.
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