Return on Capital Employed Review of 2019 Returns Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 2 Contents

Foreword ...... 3 Executive Summary ...... 4 Top Performers ...... 5 Market ...... 6 Listed Companies – Performance by Sector ...... 7 International Comparisons ...... 8 Crown Entities ...... 9 Distribution of Results ...... 10 Spotlight: Transport & Logistics ...... 11 Individual Entities ...... 15 About Armillary Private Capital ...... 19 Sources of Data ...... 20 Appendix 1 – Detailed Results ...... 21 Appendix 2 – ROCE explained ...... 29

Disclaimer

The information contained in this report has been prepared by Armillary Private Capital (‘Armillary’). While the intention is to provide accurate information based on historical performance and market information, Armillary accepts no liability for any errors or inaccuracies in this report. The reader is advised to perform their own research to confirm the accuracy of the information contained in this report before relying on it for any investment decision making. This report has been prepared as a ‘class service’ as defined by the Financial Advisers Act and is general in nature. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 3 Foreword

We are delighted to present the tenth Armillary Private Capital Return on (but not limited to) gains/losses on asset sales, revaluations, and Capital Employed (‘ROCE’) report. This year the total number of entities unrealised gains. Previous years’ reports were compiled using the CapIQ in our data set of NZX, USX, and selected Crown entities is 142. data base, and so prior year results may differ slightly to previously published results. The ROCE methodology we use in this report was developed by Du Pont Corporation and is therefore not proprietary to us, although we We continue to advocate the ROCE methodology in our work with are proponents. As it is simple to apply, anyone who understands the businesses as a simple to use and easily understood tool for measuring methodology can use it. We regularly use this methodology as a tool in business performance, identifying improvement strategies, creating our client engagements and in our financial training curriculum. incentive remuneration programs, and for testing budgets and forecasts, especially those applied in valuations. We also see the data A benefit of the ROCE methodology is that the performance of an and results in this report as providing useful benchmarks for business entity can be broken down into its components of Profitability and performance in the New Zealand market. Activity, for deeper analysis. Profitability, as measured by EBIT margin, provides an indication of operational efficiency; Activity, as measured We trust that the insights contained in this report provide value to by asset turnover, provides an indication of balance-sheet efficiency. investors, business owners and managers alike. Combined the two ratios give overall ROCE. A full explanation is provided in Appendix 2.

Again, this year’s report includes an overview of the major sectors in the economy to demonstrate the effect that differences in business models have on profitability, activity and overall ROCE performance.

Analysis has primarily been conducted using the Pitchbook financial platform and where data was not available, information was entered from annual reports. EBIT has been calculated on a normalised basis, adjusting for non-recurring items and non-trading items, including Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 4 Executive Summary Median ROCE (NZX, USX & Crown) 10% 9% 8.62% 8% 6.92% 7% 6.58% This year’s ROCE review of the 2019 financial results included 114 6% companies with primary listings on the NZX, 14 companies from 5% ROCE USX, and 14 Crown Entities. This has resulted in a total sample size 4% of 142 Crown and Listed (“NZX and USX”) firms which is 2 less than 3% last years’ report. 2% 1% Companies have been categorised by eight sectors: Business Products 0% and Services (B2B), Consumer Products and Services (B2C), Energy (incl. 2017 2018 2019 Utilities), Financial Services (incl. Investments), Property, Healthcare, Information Technology and Materials and Resources. • The top 10 performers in 2019 were primarily from the Consumer The median 2019 ROCE performance across all Listed and Crown Products and Services and Business Products and Services sectors, entities has increased to 6.92% from 6.58% in 2018 1. This result remains comprising 7 of the 10 top performers. Consumer Products and shy of common estimates for the market average weighted cost of Services was the best performing sector (median ROCE of 11.9%) capital (WACC) of around 8%. whilst the Healthcare sector recorded the lowest median ROCE of 0.9%. In large part this reflects the sector including several retirement • Zespri Group, listed on the USX, was the top performer with a ROCE village operators and the way normalised EBIT is calculated, which of 234%. This result was due to an improvement in profit margins while excludes fair value gain on properties. also maintaining high Activity. Of all listed firms analysed, Zespri Group strikes the best combination of high Activity and high margins and is • The median ROCE of NZX50 constituent companies was 7.5%, consistently a top performer in our analysis. remaining well behind the median for companies in the S&P500 (15.4%), the ASX200 (13.6%), and the S&P EURO 350 (12.6%).

• For the Crown Entities the 2019 median ROCE was 5.0% (down from 8.8% in 2018), with AsureQuality recording the best performance in 1 Please note that we have changed data providers and historic results may well differ from previously published results. that group with a ROCE of 33.4%. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 5

Top Performers The top 10 entities by 2019 ROCE performance are dominated by businesses that optimise high levels of Activity (Revenue/ Average Net Operating Assets) and high profitability (EBIT (norm.)/Revenue).

The top performer was Zespri Group, which had a ROCE of 234% Top 10 ROCE 2019 made up of an 8.1% Profitability Ratio (up from 5.8% in 2018 and 4.5% in 2017) and a 28.9 × Activity Ratio (up from 24.0 × in 2018). This was 2017 2018 2019 also the highest Activity Ratio of our sample. The a2 Milk Company and Hallenstein Glasson both recorded strong ROCE results in 2019 with 240% 156.4% and 71.6%, respectively – albeit that both of these were slightly below their respective 2018 ROCE results. 200% Both Briscoe Group and Fisher & Paykel Healthcare feature again in 160% the top ten with ROCE of 44.6% and 40.7% respectively. QEX Logistics returns for the third year in a row while AsureQuality, Syft Technology, 120% NZX and Plexure are all newcomers to the top 10 with Plexure improving ROCE performance from negative ROCE in each of the last 2 years to a 80% positive 30.9% in 2019.

40% The top three ROCE performers in 2019 for each of the three markets analysed were as follows:

0% • NZX market: The a2 Milk Company (156.4%), Hallenstein Glasson

NZX (71.6%) and Briscoe Group (44.6%). Zespri Plexure • USX market: Zespri Group (234.0%), Syft Technologies (33.0%) and AsureQuality QEX Logistics

Briscoe Group Briscoe Pharmazen (18.8%). Syft Technology Syft Hallenstein Glasson Hallenstein

The a2 Milk Company • Crown Entities: AssureQuality (33.4%), Airways Corporation (17.0%) and Meteorological Service (16.2%). Fisher & Paykel Healthcare Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 6

Market Median Annual ROCE by Market

2017 2018 2019

12%

The median result for USX companies improved markedly compared to 10% the previous two years with a 10.6% median ROCE for 2019 up from 3.9% in 2018. With a small sample size of 14, even medians of this segment 8% are prone to be skewed by outliers and Windflow Technology2, Martin Aircraft3 and Sports & Education4 were not included in the 2019 sample. 6%

Three newcomers to the market include Palliser Estate, TMP and Future ROCE Mobility Solutions which all posted negative ROCE in 2019. 4% The NZX5 companies posted a median ROCE of 7.2%, being a 0.7% increase from 2018. 93 companies (81.6% of the NZX listed companies) 2% recorded positive ROCE (21 companies recorded negative ROCE), which is in line with 2018 results. 0% USX NZX Crown

The Crown entities fell from an 8.8% ROCE in 2018 to 5.0% in 2019. This Market decline firmly places the median ROCE for Crown entities as the lowest of all New Zealand cohorts, contrasting its performance in 2018 as the best performing cohort. Five companies posted improved ROCE in 2019, whilst the remaining 9 all declined, and three companies posted negative ROCE in 2019 compared to only one in 2018.

2 Liquidated in December 2019. 3 Not able to calculate. Adjusted net tangible assets are nil. 4 Annual report 2019 not filed. 5 The NZAX market was closed in 2019. Companies previously listed on the NZAX have been included in the NZX market. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 7 Listed Companies – Performance by Sector

Sector Performance, 2019 Median ROCE The outcome of different business models and market conditions can be examined by comparing the median performance of companies ROCE Profitability Activity in different sectors. For this analysis, we have used the 2019 median profitability, activity, and ROCE performance of each sector for all Listed 14% 180% and Crown companies. 160% 12% The top three performing sectors based on 2019 ROCE are Consumer 140% Products and Services, Materials and Resources and Business Products 10% 120% and Services (11.9%, 9.0% and 8.9%, respectively).

8% 100% The Property sector exhibits a high Profitability Ratio (49.9%) but has

ROCE its ROCE dragged down by a low Activity Ratio due to the capital- 6% 80% intensive nature of the sectors. 60% 4% Activitiy & Profitability Conversely, the Information Technology sector shows high levels of 40% Activity (1.18 ×) yet has similar median ROCEs as a result of lower median 2% 20% Profitability Ratios (2.5%).

0% 0% Although it has one of the best performing stocks (Fisher & Paykel Healthcare), the worst performing sector was the Health Care sector at

Utilities) ROCE of 0.9%. This sector has median profitability of 2.3% and a median Property Resources Healthcare Information Technology Activity Ratio of 0.54 ×. As noted previously, this is impacted by the way Energy (incl. (incl. Energy and Servicesand Servicesand Materials and and Materials our data provider normalises reported profit numbers for the Retirement Business Products Products Business Financial Services Services Financial (incl. Investments) (incl.

Consumer Products Products Consumer sector (to exclude fair value gains on properties) but also because there are several smaller, early stage companies in this sector. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 8

Median International ROCE

International 2017 2018 2019 Comparisons 18% 16%

14%

To benchmark New Zealand’s performance, we have also reviewed 12% the performance of companies in the European, Australian and US 10% markets, as represented by the S&P/EURO 350, S&P/ASX 200 and the

ROCE 8% S&P500 index, respectively. For comparability, we have isolated the performance of the NZX50 index constituents from that of the entire 6% group of NZX main board listed entities. Note that the average cost of 4% capital in the comparison markets will vary from that of New Zealand. 2% There are a number of factors as to why this would be the case, for example, sector composition (less exposure to regulated utilities in 0% S&P 500 S&P/ASX S&P/EURO NZX50 NZX overseas markets compared to New Zealand), market risk premium and 200 350 government bond rates varying between markets analysed.

The NZX50 index group of companies once again had a higher median The ASX S&P200 index is recognised as the institutional investable performance than the overall NZX main board in 2019. The NZX50 benchmark in Australia. The index covers approximately 80% of the companies represent more than 90% of the NZ listed equity market equity market capitalisation in Australia. Median ROCE performance capitalisation. The NZX50 recorded an increase of 0.5% on 2018 to finish declined in 2019 to 13.6% (14.1% in 2018). Nevertheless, this is still the year with a 7.5% median ROCE (7.0% in 2018). The NZX main board noticably higher than that of NZX companies and marginally higher experienced a 0.7% increase on 2018, recording a median ROCE of than returns in Europe. 7.2% (6.5% in 2018). This is the only market from our sample that showed The USA S&P500 index captures approximately 80% of the total US improved ROCE in 2019 compared to 2018 results. listed equity market capitalisation. The companies in this index have The S&P/EURO 350 index covers 350 blue-chip stocks from 16 developed consistently produced a significantly higher ROCE than the other European countries. This index outperformed both the NZX and NZX50 in markets examined. In line with previous years the S&P500 returned a 2019 with a median ROCE of 12.6% (13.7% in 2018). median ROCE of 15.4% in 2019 (17.0% in 2018). Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 9

Crown Entities

Crown Entities 2017 2018 2019

35%

30% The overall performance of the 14 Crown Entities analysed declined again in 2019 with the median ROCE down 3.3% to finish at 5.0%, posting 25% the lowest return from all markets analysed. 20% Compared to the listed companies, the notable feature of the Crown Entities is a tighter range of returns with the highest at just over 33% and 15% ROCE the lowest at (2.5%). Three of the fourteen firms analysed reported a 10% negative ROCE compared to only one in 2018 and only five companies recorded improved ROCE from 2018 (AsureQuality, Meteorological 5% Service, KiwiRail, Geological and Nuclear Sciences and AgResearch). 0% The Institute of Environmental Sciences recorded the largest ROCE decline in 2019 following strong performance in 2017 and 2018. (5%) Despite revenues growing by $2.4m (3% increase), EBIT fell by $3.5m (66% decrease), resulting in a 4.7% drop in its Profitability Ratio. Combined with a lower Activity Ratio (2.21 × in 2018 compared to AgResearch AsureQuality 2.06 × in 2019) this resulted in a 10.8% decline in ROCE (15.5% in 2018 Kordia Group KiwiRail Holdings KiwiRail New Zealand Post compared to 4.7% in 2019). Landcorp Farming Airways Corporation Plant & Food Research Meteorological Service

AsureQuality showed the greatest improvement of all Crown entities Transpower New Zealand

analysed. Revenue increased by $42m (20% increase) and EBIT New Zealand Forest Research increased by $16.2m (120% increase). The Profitability Ratio increased Water and Atmospheric Research Institute of Environmental Science Geological and Nuclear Sciences from 6.4% in 2018 to 11.7% in 2019 and the Activity Ratio improved slightly to 2.86 × increasing ROCE from 16.7% in 2018 to 33.4% in 2019. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 10

ROCE Distribution

Distribution of Results 2017 2018 2019

35

30 The ROCE returns for the last three years follow a normal distribution, with outliers at either side of a bell-shaped curve. The 2019 distribution 25 tracks the 2018 distribution, however the number of firms posting 20 negative ROCE are more concentrated just below breakeven (between

– 5%-0%) but there is also a small increase to firms posting negative Count 15 ROCE below – 50%. 10 Overall the bell curve has again slightly shifted to the left with a greater weighting on ROCE between – 5%-0% relative to 2018 returns. 5

44% of Listed & Crown entities in New Zealand achieved a ROCE greater 0 than 8% being a common estimate of the market WACC, just below the previous year’s result of 47%. > 50% < (50%) 0% 5% to 5% 10% to (5%) 0% to 10% 15% to 15% to 20% to 15% 20% 25% to 25% 30% to 35% 40% to 45% 50% to 30% 35% to 40% 45% to

28 companies recorded a ROCE less than zero in 2019. A negative (10%) to (5%) (15%) to (10%) (20%) to (15%) (25%) to (20%) (45%) to (40%) (50%) to (45%) (40%) (35%) to (30%) (25%) to (35%) (30%) to ROCE implies negative profitability. 7% of the total sample (10 firms) had a ROCE of less than negative 50%. Three of these companies were from the technology sector and three were from the Healthcare sector, including the newly listed Cannasouth. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 11 Spotlight: Transport & Logistics

It has been a strange start to the year to say the least. The Coronavirus The question is complex and solutions/outcomes exponentially more so pandemic has wreaked havoc around the world, drastically altering as the pandemic continues to develop; border shutdowns, quantitative the economic outlook. Seven months after the virus first appeared, easing and government stimulus, supply chain disruptions, a potential there remains substantial questions over what the impact will be, both second wave, a strong recovery in the stock market with widely varying economically and socially, and what the recovery will look like. outcomes between countries. We do not attempt here to define or answer this, and instead have taken an observatory approach.

Forecast Real GDP Growth Against this backdrop, Armillary has undertaken some research and Annual Percentage change 2020 analysis of New Zealand companies in the Transport & Logistics sector. We found that the sector is broken down to two sub-categories with different fundamental market metrics – port companies and transportation companies. Port companies are more closely aligned to infrastructure assets. Interestingly the ROCE components of companies in both sub – categories differed significantly, but most notably within the port sector.

By establishing a benchmark to review in a year’s time, we wanted to test the thesis that balance sheet flexibility will lessen reductions in ROCE relative to highly operating leveraged companies.

6% or more We will provide follow up analysis in next year’s annual ROCE report 3% –6% with the objective to draw comparisons to the pre/post-Covid results 0–3% from a sector expected to face significant headwinds in widely forecast -30%–0 Less than -3% declines in domestic and global GDP. no data Source: IMF (March 2020) Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 12

From our understanding of some companies we work with in the sector, Figure 2: ANZ Heavy Traffic Index and GDP Transport and Logistics will be naturally affected by changes in GDP and Heavy Traffic Index (LHS) GDP (RHS) the resulting impact and response by sector companies will show up in ROCE analysis. Transport companies are often seen as ‘bellwethers’ 1,700 65 of the strength of the economy and we anticipate results to vary with 1,600 operating leverage and that companies with a higher fixed asset base 62 1,500 to be more at risk of increased, adverse impact to ROCE. We also will 59 look at operating efficiency metrics, as we expect those companies 1,400 56 $bn 2009/10 Real with greater productivity and systems efficiencies will out-perform others. 1,300 53 1,200 To further assess the impact, we have referenced analysis by ANZ 50 Research’s ‘Truckometer’, which is a set of two economic indicators 1,100 47 derived from traffic volume around New Zealand. Index Jan 04 = 1000 1,000 44 Traffic flows are a real time proxy for economic activity, particularly in 900 41 New Zealand where road transport accounts for over 90% of freight 800 by weight6. The ANZ Truckometer represents a timely barometer of 38 economic momentum given its strong relationship with GDP. 700 35 04 06 08 10 12 14 16 18 20 Figure 2. is an excerpt from ANZ Research Truckometer July 2020 report7 which illustrates the impact of New Zealand’s nationwide lock Source: ANZ Research July 2020 down. The Heavy Traffic Index8 tracks heavy truck and bus movement around New Zealand and has been a reliable indicator of real time GDP in the past. The data reveals weekly heavy traffic has recovered to prior year levels from Alert Level 2, however is more likely a result of an accumulation of demand from the prior period of essential deliveries only, and businesses replenishing inventory rather than a return to normality.

6 National Freight Demand Study 2017/2018. 7 Data is to May 2020. 8 The Heavy Traffic Index is adjusted for seasonality. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 13

Real GDP Growth New Zealand Annual Percentage Change The IMF is forecasting a 7.2% decline in real GDP growth for New Zealand and the value of imports and exports over the February 8% – June period both show a notable year on year decline. The full impact on the Transport and Logistics sector remains uncertain, 6% however it seems reasonable to presume there will be a pronounced 4% adverse impact on the sectors balance sheet from lower volumes of imports and exports. 2%

We have selected eight companies from New Zealand in the Transport & Logistics subsector (including ports) below: (2%)

• Freightways (4%)

• Mainfreight (6%) • Marsden Maritime (8%) • Napier Port Holdings 2000 2005 2010 2015 2020 • New Zealand Post • Port of Tauranga Source: IMF June 2020 • QEX Logistics • TIL Logistics

There is a significant difference in ROCE inputs for ports, characterised Activity Ratios for ports are all less than 0.5 × compared to a by higher Profitability Ratios and lower Activity Ratios. Median and range of c. 1.0 × – 5.5 ×, reflecting much higher capital intensity. average ROCE for ports is less than half of the other companies Interestingly, Freightways and Mainfreight have similar ROCE but quite in the sample. different composition.

Profitability Ratios for ports have consistently ranged from 30% to 200% Mainfreight has a higher Activity Ratio, despite land and buildings over the last 3 years, whilst other transport and logistics companies accounting for over 50% of its net operating assets compared to are around half of this (or less) with Freightways leading the way Freightways, where land and buildings account for less than 10% of net in profitability. operating assets. The difference in Activity is instead driven by different Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 14

Transport & Logistics ROCE 2019 business mix, with Mainfreight having c.$1.1bn (approx. one third of its revenue) in lower margin international freight forwarding. 2017 2018 2019 New Zealand Post profitability was affected by $40m of impairment 60% losses relating to systematic uncertainty over future mail volumes as 55% well as $38m of additional employee expenses from remediating non- 50% compliance to the Holidays Act. 45% 40% Marsden Maritime has a different operating structure to the other two 35% ports, with the operating port held in a joint venture, resulting in different 30% ROCE composition. 25% ROCE 20% 15% 10%

5% Company Profitability Activity ROCE 0% QEX Logistics 5.8% 5.41 × 31.3% (5%) (10%) Freightways 15.8% 1.46 × 23.1%

Mainfreight 6.8% 3.15 × 21.3%

TIL Logistics Group 4.1% 3.35 × 13.6% Mainfreight Freightways QEX Logistics New Zealand Post (3.4%) 0.72 × (2.5%) Port of Tauranga New Zealand Post Marsden Maritime TIL Logistics Group Logistics TIL Median 5.8% 3.15 × 21.3% Napier Port Holdings Port Napier

Napier Port Holdings 30.1% 0.33 × 10.0%

Port of Tauranga 43.6% 0.20 × 8.6%

Marsden Maritime 163.1% 0.04 × 6.3%

Median 43.6% 0.20 × 8.6% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 15

The following four charts show the individual ROCE performance for Individual Entities each of the 142 listed and Crown Entities reviewed in 2019. Note that for the purposes of presenting this chart, entities with ROCE greater than 100% have been capped at that level.

The 36 entities in the top quartile are dominated by the Consumer Products and Services and Business Products and Services sectors, which combined make up 69% of this top quartile. Top quartile ROCE performance ranges from 234.0% to 14.6%.

2019 ROCE – Top Quartile

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% NZX Serko Zespri Skyline Plexure Z Energy Z Skellerup Synlait Milk Pharmazen Mainfreight Freightways AsureQuality QEX Logistics Briscoe Group Briscoe Allied Farmers Allied Syft Technology Syft BLIS Technologies BLIS Solution Dynamics Solution Green Cross Health Cross Green Blue Sky Meats (NZ) Spark New Zealand Hallenstein Glasson Hallenstein CDL Investments NZ Airways Corporation Kathmandu Holdings Kathmandu AFT Pharmaceuticals Restaurant Brands NZ Brands Restaurant The a2 Milk Company The Warehouse Group Warehouse The Burger Fuel Worldwide Fuel Burger SKY Network Television Meteorological Service South Port New Zealand Michael Hill International Michael Fisher & Paykel Healthcare SKYCITY Entertainment Group Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 16

The 35 entities in the second quartile had 2019 ROCE ranging between 14.2% and 7.1%. At these levels we estimate that most are trading at or above their individual WACC.

2019 ROCE – Second Quartile

16%

14%

12%

10%

8%

6%

4%

2%

0% Vital NZME Air NZ Telstra Sanford Downer Delegat TrustPower Terra Vitae Terra Mercury NZ Ebos Group Ebos Connexionz Transpower NZ Just Life Group Life Just NZ King Salmon King NZ Contact Energy Contact Meridian Energy Meridian Silver Fern Farms Fern Silver Gentrack Group Tourism Holdings Tourism Fletcher Building Port of Tauranga Scott Technology Scott TIL Logistics Group Logistics TIL Scales Corporation Scales AWF Madison Group Madison AWF Napier Port Holdings Port Napier Veritas Investments (NZ) Investments Veritas Vista Group International Group Vista Colonial Motor Company Motor Colonial Metro Performance Glass Performance Metro Abano Healthcare Group Healthcare Abano Augusta Capital (Auckland) Capital Augusta Water and Atmospheric Research Livestock Improvement Corporation Improvement Livestock Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 17

The third quartile ranges from 6.8 to 1.6%. At face value this level of returns would suggest that the companies are earning below their individual WACC.

2019 ROCE – Third Quartile

8%

7%

6%

5%

4%

3%

2%

1%

0% Infratil Rakon Vector Pushpay Seeka Ltd Rangatira Chorus (NZ) Foley Wines Foley Speirs Group Speirs Asset Plus Ltd Rural Equities Rural NZ Windfarms NZ Arvida Group Mercer Group Mercer Cavalier Corp PGG Wrightson PGG Tilt Renewables Argosy Property Argosy Tower InsuranceTower KiwiRail Holdings KiwiRail Auckland AirportAuckland Turners & Growers & Turners Investore Property Marsden Maritime NZ Forest Research Genesis Energy (NZ) Kiwi Property Group Property for IndustryProperty for Stride Stapled Group Steel & Tube Holdings Precinct Properties NZ Evolve Education Group Education Evolve Goodman Property Trust Fonterra Co-operative Group Institute of Environmental Science Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 18

The bottom quartile mostly consists of entities with a negative ROCE, focused on a significant growth strategy at the expense of short-term ranging from 1.1% to negative 2,416.3%. Note that for the purposes of profitability. In contrast, those mature businesses with negative ROCE this chart, those entities with a ROCE of less than negative 100% have may need to reconsider the viability of their business models if their been constrained at that level. negative results are a recurring theme.

25% of firms in the Consumer Products and Services sector fall into this Several of the retirement village operators are in this sample. If quartile. Whilst typically seen as a profitable industry, and for many the analysis were repeated on underlying non-GAAP measure of companies it is, the ones in this quartile tend to be small and/or focused profitability, this is would not be the case. on more volatile based earnings. Others within this bottom quartile are

2019 ROCE – Lower Quartile

0%

(20%)

(40%)

(60%)

(80%)

(100%) TMP ikeGPS EROAD NZ Post Comvita TruScreen Paysauce SeaDragon Metlifecare Moa Group Moa AgResearch Cannasouth NZ Oil & Gas Pacific Edge Pacific Rubicon (NZ) Kordia Group Palliser Estate Enprise Group Smiths City Group Landcorp Farming SmartPay Holdings SmartPay Ryman Healthcare Ryman Promisia Integrative Cooks Global Foods AFC Group Holdings Group AFC Oceania Healthcare Oceania NZ Refining Company Plant & Food Research Future Mobility Solutions Turners Automotive Group Automotive Turners Chatham Rock Phosphate Rock Chatham Summerset Group Holdings Group Summerset Wellington Drive Technologies Vital Healthcare Property Trust Geological and Nuclear Sciences Geo (Business/Productivity Software) Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 19 About Armillary Private Capital

Armillary Private Capital is an investment bank providing investment banking, advisory and asset management services focused on the New Zealand capital markets. Our purpose is enabling success for businesses, business owners and investors.

Our approach is based on a combination of influences grounded in our culture, methodology and experiences. We have worked with a range of New Zealand businesses through all stages of the business lifecycle from start-up to maturity. Be they private, listed or government-related, we have seen and experienced the roller-coaster rides business owners and managers endure. These experiences allow us to quickly identify clients’ needs and find the right solution(s).

An important part of our approach is the use of proven financial tools and methodologies to provide a concise but comprehensive view of business performance. A key methodology that underpins our work is the DuPont method. This powerful but highly practical method of analysis allows us to develop a rapid understanding of the underlying performance of a business and to identify key business drivers. This disciplined approach helps us with quality decision making in our work.

Armillary Private Capital is the manager of Efficient Market Services Limited, operator of the Unlisted Securities Exchange (USX). Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 20

Sources of Data

The data for this analysis and report has been compiled by Armillary Private Capital from annual reports and data obtained through Pitchbook. We note that we are reliant on the categorisation used by Pitchbook for this analysis and such categorisation may vary from the categorisation we have applied to those companies for which we have sourced the data directly from their annual reports.

Profitability has been calculated on a normalised EBIT basis, predominantly excluding revaluations, gains/losses on fixed assets and unrealised gains. Calculations have been extracted from Pitchbook and entered manually when required. These results from Pitchbook have not been extensively audited by Armillary, and results may vary. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 21 Appendix 1 – Detailed Results

Appendix 1 contains a table of individual entity results of 2018 and 2019 Profitability and Activity Ratios along with ROCE for the last three years.

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Abano Healthcare Group NZX 9.4% 7.5% 1.0 × 1.0 × 9.1% 9.2% 7.3% 8.5%

AFC Group Holdings NZX (5.7%) (37.8%) 1.6 × 0.7 × (37.1%) (8.9%) (26.1%) (24.0%)

AFT Pharmaceuticals NZX (12.5%) 8.8% 2.7 × 2.4 × (51.9%) (34.4%) 21.1% (21.7%)

AgResearch Crown (3.1%) 0.8% 0.8 × 0.8 × 2.0% (2.3%) 0.7% 0.1%

Air New Zealand NZX 10.4% 7.0% 1.1 × 1.1 × 12.8% 11.9% 8.0% 10.9%

Airways Corporation Crown 14.8% 14.5% 1.2 × 1.2 × 21.9% 18.5% 17.0% 19.1%

Allied Farmers NZX 51.5% 23.4% 0.6 × 0.9 × 46.6% 33.4% 21.1% 33.7%

Argosy Property NZX 49.8% 49.1% 0.1 × 0.1 × 5.5% 4.1% 4.0% 4.5%

Arvida Group NZX 22.0% 14.6% 0.1 × 0.1 × 2.9% 2.7% 1.6% 2.4%

Asset Plus Ltd NZX 58.3% 54.6% 0.1 × 0.1 × 4.1% 5.8% 5.2% 5.0%

AsureQuality Crown 6.4% 11.7% 2.6 × 2.9 × 14.1% 16.7% 33.4% 21.4%

Auckland Airport NZX 53.6% 52.4% 0.1 × 0.1 × 5.7% 5.0% 4.7% 5.1%

Augusta Capital (Auckland) NZX 43.8% 42.7% 0.2 × 0.2 × 7.8% 7.4% 8.9% 8.1%

AWF Madison Group NZX 3.1% 1.8% 4.1 × 4.2 × 16.1% 12.6% 7.6% 12.1%

BLIS Technologies NZX (19.6%) 4.9% 2.1 × 3.0 × 0.9% (41.2%) 14.7% (8.5%) Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 22

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Blue Sky Meats (NZ) USX 4.3% 3.9% 3.1 × 3.7 × (5.6%) 13.2% 14.6% 7.4%

Briscoe Group NZX 13.9% 13.7% 3.1 × 3.3 × 45.2% 43.1% 44.6% 44.3%

Burger Fuel Worldwide NZX 4.6% 8.7% 2.9 × 3.4 × 14.9% 13.5% 29.1% 19.2%

Cannasouth NZX - (4,167.4%) 0.0 × 0.0 × - - (67.5%) (22.5%)

Cavalier Corp NZX 4.3% 2.7% 1.4 × 1.5 × 4.5% 6.1% 4.1% 4.9%

CDL Investments New Zealand NZX 53.0% 50.7% 0.6 × 0.5 × 36.2% 31.6% 26.8% 31.5%

Chatham Rock Phosphate NZX (25,849.9%) (13,541.6%) 0.0 × 0.0 × - (27.4%) (16.1%) (14.5%)

Chorus (New Zealand) NZX 12.0% 7.7% 0.3 × 0.3 × 5.7% 3.9% 2.2% 3.9%

Colonial Motor Company NZX 4.7% 4.3% 3.4 × 3.1 × 16.2% 15.9% 13.1% 15.1%

Comvita NZX 8.7% (3.5%) 0.7 × 0.6 × 0.8% 6.4% (2.2%) 1.7%

Connexionz USX (31.0%) 2.5% 2.5 × 3.8 × (30.7%) (76.7%) 9.6% (32.6%)

Contact Energy NZX 10.9% 12.4% 0.5 × 0.6 × 6.3% 5.5% 7.5% 6.4%

Cooks Global Foods NZX (58.8%) (58.6%) 0.5 × 1.0 × (48.4%) (28.4%) (60.0%) (45.6%)

Delegat NZX 28.4% 28.1% 0.4 × 0.4 × 9.7% 12.7% 12.3% 11.6%

Downer NZX 3.4% 3.8% 2.8 × 2.9 × 8.9% 9.7% 11.1% 9.9%

Ebos Group NZX 3.2% 3.1% 4.6 × 4.3 × 14.9% 14.8% 13.6% 14.4%

Enprise Group NZX 2.2% (5.7%) 1.6 × 0.9 × 11.7% 3.6% (5.3%) 3.3%

EROAD NZX (8.6%) (3.4%) 0.0 × 0.8 × (10.2%) (0.3%) (2.6%) (4.4%)

Evolve Education Group NZX 9.7% 20.1% 0.7 × 0.3 × 11.7% 7.2% 5.9% 8.2% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 23

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Fisher & Paykel Healthcare NZX 30.3% 29.8% 1.4 × 1.4 × 42.6% 42.5% 40.7% 41.9%

Fletcher Building NZX 0.5% 7.6% 1.7 × 1.7 × 9.9% 0.9% 12.7% 7.8%

Foley Wines NZX 10.9% 13.4% 0.3 × 0.3 × 7.0% 3.7% 4.6% 5.1%

Fonterra Co-operative Group NZX 4.4% 4.1% 1.6 × 1.6 × 8.9% 7.0% 6.6% 7.5%

Freightways NZX 16.4% 15.8% 1.4 × 1.5 × 23.8% 23.4% 23.1% 23.4%

Future Mobility Solutions USX (6.2%) (4.3%) 2.7 × 3.6 × 10.0% (16.8%) (15.5%) (7.4%)

Genesis Energy (New Zealand) NZX 1.7% 3.6% 0.7 × 0.8 × 5.2% 1.2% 3.0% 3.1%

Gentrack Group NZX 25.9% 14.3% 0.6 × 0.5 × 17.6% 14.8% 7.9% 13.4%

Geo NZX (78.4%) (43.9%) 0.5 × 1.5 × (36.0%) (41.8%) (66.1%) (48.0%)

Geological and Nuclear Sciences Crown 0.3% 0.6% 3.1 × 3.5 × 15.2% 0.9% 2.0% 6.0%

Goodman Property Trust NZX 79.5% 70.2% 0.1 × 0.1 × 3.9% 4.5% 3.7% 4.0%

Green Cross Health NZX 6.1% 5.1% 3.2 × 3.2 × 23.0% 19.3% 16.4% 19.6%

Hallenstein Glasson NZX 13.8% 13.6% 5.7 × 5.3 × 53.8% 78.2% 71.6% 67.9%

ikeGPS NZX (83.4%) (61.2%) 0.9 × 1.4 × (114.4%) (77.6%) (84.4%) (92.1%)

Infratil NZX 18.8% 21.5% 0.3 × 0.2 × 5.6% 6.0% 5.3% 5.6%

Institute of Environmental Science Crown 7.0% 2.3% 2.2 × 2.1 × 18.2% 15.5% 4.7% 12.8%

Investore Property NZX 82.0% 75.6% 0.1 × 0.1 × - 5.2% 5.5% 3.6%

Just Life Group NZX 17.9% 9.5% 0.9 × 1.3 × 20.0% 15.4% 12.4% 15.9%

Kathmandu Holdings NZX 15.3% 15.6% 1.3 × 1.2 × 17.1% 19.9% 19.1% 18.7% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 24

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Kiwi Property Group NZX 48.7% 44.2% 0.1 × 0.1 × 4.8% 4.3% 3.5% 4.2%

KiwiRail Holdings Crown 2.5% 9.1% 0.7 × 0.7 × 13.3% 1.8% 6.4% 7.2%

Kordia Group Crown 4.1% 0.1% 2.3 × 2.1 × (1.6%) 9.2% 0.1% 2.6%

Landcorp Farming Crown 23.0% (2.1%) 0.1 × 0.1 × 3.7% 3.4% (0.3%) 2.3%

Livestock Improvement Corporation NZX 6.3% 11.8% 0.9 × 0.9 × 12.8% 5.7% 10.6% 9.7%

Mainfreight NZX 6.2% 6.8% 3.0 × 3.1 × 17.6% 18.4% 21.3% 19.1%

Marsden Maritime NZX 190.2% 163.1% 0.0 × 0.0 × 7.0% 6.6% 6.3% 6.7%

Mercer Group NZX (15.0%) 1.1% 2.0 × 3.2 × (11.9%) (29.9%) 3.5% (12.8%)

Mercury NZ NZX 23.6% 16.8% 0.4 × 0.4 × 8.4% 9.3% 7.1% 8.2%

Meridian Energy NZX 13.7% 17.8% 0.4 × 0.5 × 5.0% 6.0% 9.4% 6.8%

Meteorological Service Crown 8.6% 8.4% 1.8 × 1.9 × 13.9% 15.6% 16.2% 15.2%

Metlifecare NZX (0.1%) 0.3% 0.1 × 0.1 × (0.1%) (0.0%) 0.0% (0.0%)

Metro Performance Glass NZX 11.5% 9.4% 1.1 × 1.1 × 15.1% 12.1% 10.1% 12.5%

Michael Hill International NZX 7.0% 6.2% 2.5 × 2.6 × 20.5% 17.7% 16.5% 18.2%

Moa Group NZX (23.8%) (17.9%) 2.2 × 3.1 × (48.6%) (52.4%) (56.1%) (52.4%)

Napier Port Holdings NZX 30.6% 30.1% 0.3 × 0.3 × 8.9% 9.6% 10.0% 9.5%

New Zealand Forest Research Crown 5.8% 3.4% 1.9 × 1.6 × 11.1% 10.8% 5.3% 9.1%

New Zealand King Salmon NZX 14.7% 9.7% 1.0 × 1.0 × 23.8% 14.7% 9.9% 16.1%

New Zealand Oil & Gas NZX (5.9%) (2.6%) 0.9 × 0.9 × (38.3%) (5.4%) (2.4%) (15.4%) Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 25

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

New Zealand Post Crown 0.7% (3.4%) 0.7 × 0.7 × 3.8% 0.5% (2.5%) 0.6%

New Zealand Refining Company NZX 13.8% 1.0% 0.3 × 0.3 × 12.8% 4.2% 0.3% 5.8%

NZ Windfarms NZX 10.5% 15.7% 0.1 × 0.2 × (3.3%) 1.3% 3.6% 0.5%

NZME NZX 6.2% 8.6% 1.0 × 1.1 × 8.7% 6.0% 9.2% 8.0%

NZX NZX 31.0% 32.8% 1.0 × 1.0 × 32.4% 30.6% 32.8% 31.9%

Oceania Healthcare NZX 1.7% (3.0%) 0.2 × 0.2 × 5.1% 0.3% (0.5%) 1.7%

Pacific Edge NZX (556.4%) (458.0%) 0.9 × 3.3 × (304.0%) (511.3%) (1,532.2%) (782.5%)

Palliser Estate USX 5.7% (3.6%) 0.4 × 0.4 × 1.6% 2.1% (1.3%) 0.8%

Paysauce NZX (78.7%) (571.7%) 6.7 × 4.2 × (195.8%) (524.4%) (2,416.3%) (1,045.5%)

PGG Wrightson NZX 3.6% 1.5% 2.7 × 2.5 × 15.4% 10.0% 3.6% 9.7%

Pharmazen USX 16.0% 24.6% 0.6 × 0.8 × (0.9%) 10.3% 18.8% 9.4%

Plant & Food Research Crown 4.7% 4.8% 1.4 × (0.5 ×) 7.5% 6.6% (2.2%) 3.9%

Plexure NZX (0.1%) 7.5% 2.2 × 4.1 × (115.7%) (0.2%) 30.9% (28.3%)

Port of Tauranga NZX 44.6% 43.6% 0.2 × 0.2 × 8.8% 8.9% 8.6% 8.8%

Precinct Properties New Zealand NZX 63.4% 72.7% 0.1 × 0.0 × 4.4% 3.7% 3.1% 3.7%

Promisia Integrative NZX (391.1%) (694.4%) 0.4 × 0.3 × (61.6%) (167.6%) (224.9%) (151.4%)

Property for Industry NZX 83.8% 83.9% 0.1 × 0.1 × 1.9% 5.9% 5.7% 4.5%

Pushpay NZX (29.5%) 0.7% 7.0 × 5.6 × (219.5%) (207.6%) 4.0% (141.0%)

QEX Logistics NZX 6.5% 5.8% 7.7 × 5.4 × 178.7% 49.7% 31.3% 86.6% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 26

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Rakon NZX 2.5% 4.7% 1.3 × 1.3 × (2.3%) 3.1% 6.0% 2.3%

Rangatira USX 7.2% 5.3% 0.4 × 0.5 × 13.7% 2.9% 2.7% 6.4%

Restaurant Brands NZ NZX 8.2% 7.9% 2.5 × 2.0 × 26.6% 20.3% 15.9% 20.9%

Rubicon (New Zealand) NZX - 0.2% 0.0 × 0.3 × - - 0.1% 0.0%

Rural Equities USX 41.9% 40.5% 0.1 × 0.1 × 2.4% 2.5% 2.7% 2.5%

Ryman Healthcare NZX 4.3% 1.4% 0.1 × 0.1 × 0.5% 0.4% 0.2% 0.4%

Sanford NZX 12.6% 11.9% 0.7 × 0.8 × 8.6% 8.7% 9.0% 8.8%

Scales Corporation NZX 13.1% 8.8% 1.4 × 1.5 × 18.3% 18.0% 13.0% 16.4%

Scott Technology NZX 8.3% 4.8% 2.2 × 1.9 × 21.7% 18.0% 8.9% 16.2%

SeaDragon NZX (167.1%) (117.4%) 0.2 × 0.5 × (41.5%) (39.3%) (53.7%) (44.9%)

Seeka Ltd NZX 7.6% 7.0% 1.0 × 0.9 × 9.1% 7.5% 6.6% 7.7%

Serko NZX 12.3% 8.2% 5.9 × 3.0 × (119.0%) 72.9% 24.7% (7.1%)

Silver Fern Farms USX 0.4% 3.7% 3.8 × 3.9 × 6.4% 1.6% 14.2% 7.4%

Skellerup NZX 16.4% 17.0% 1.2 × 1.2 × 17.4% 19.8% 20.0% 19.1%

SKY Network Television NZX 22.0% 17.4% 0.6 × 0.9 × 11.2% 12.3% 15.0% 12.8%

SKYCITY Entertainment Group NZX 24.5% 31.5% 0.6 × 0.5 × 14.7% 15.0% 14.6% 14.8%

Skyline USX 32.3% 31.3% 0.6 × 0.6 × 17.7% 18.1% 17.5% 17.8%

SmartPay Holdings NZX 18.8% (1.1%) 0.5 × 0.5 × 9.7% 10.2% (0.6%) 6.5%

Smiths City Group NZX (7.1%) 0.5% 2.1 × 2.1 × (3.7%) (15.3%) 1.1% (6.0%) Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 27

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

Solution Dynamics NZX 8.6% 3.2% 9.2 × 8.8 × 89.8% 78.7% 28.3% 65.6%

South Port New Zealand NZX 34.0% 33.3% 0.9 × 0.9 × 26.8% 29.9% 30.6% 29.1%

Spark New Zealand NZX 15.5% 16.2% 1.4 × 1.2 × 21.8% 21.1% 19.1% 20.7%

Speirs Group USX 6.6% 1.9% 2.4 × 2.4 × (3,422.5%) 16.2% 4.6% (1,133.9%)

Steel & Tube Holdings NZX 3.3% 3.4% 1.6 × 1.8 × 10.1% 5.3% 6.2% 7.2%

Stride Stapled Group NZX 80.8% 48.4% 0.1 × 0.1 × 3.6% 5.5% 4.5% 4.5%

Summerset Group Holdings NZX (1.9%) (1.4%) 0.1 × 0.1 × (0.1%) (0.2%) (0.1%) (0.1%)

Syft Technology USX 7.9% 22.4% 1.6 × 1.5 × 17.2% 12.9% 33.0% 21.0%

Synlait Milk NZX 12.9% 12.2% 1.7 × 1.5 × 13.8% 22.4% 18.3% 18.2%

Telstra NZX 17.9% 12.3% 0.8 × 0.8 × 17.2% 15.0% 9.7% 14.0%

Terra Vitae USX 31.9% 94.8% 0.2 × 0.1 × 3.6% 4.9% 11.6% 6.7%

The a2 Milk Company NZX 30.7% 32.3% 5.5 × 4.8 × 153.2% 168.4% 156.4% 159.3%

The Warehouse Group NZX 3.1% 3.7% 4.6 × 5.1 × 15.0% 14.3% 19.0% 16.1%

TIL Logistics Group NZX 4.2% 4.1% 6.6 × 3.4 × (118.2%) 27.8% 13.6% (25.6%)

Tilt Renewables NZX 15.6% 25.5% 0.1 × 0.2 × 5.4% 2.2% 4.6% 4.1%

TMP USX (38.4%) (14.8%) 0.2 × 0.2 × (27.4%) (8.1%) (2.6%) (12.7%)

Tourism Holdings NZX 14.7% 12.2% 1.0 × 0.9 × 15.4% 14.9% 10.9% 13.7%

Tower Insurance NZX 2.7% 5.6% 1.3 × 1.2 × 30.9% 3.4% 6.8% 13.7%

Transpower New Zealand Crown 49.2% 46.9% 0.2 × 0.2 × 11.5% 12.0% 10.6% 11.4% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 28

2018 2019 3 Year 2018 EBIT 2019 EBIT Activity Activity Average Company Market Margin Margin Ratio Ratio ROCE 2017 ROCE 2018 ROCE 2019 ROCE

TruScreen NZX (521.0%) (180.6%) 0.1 × 0.2 × (31.3%) (39.8%) (32.6%) (34.6%)

TrustPower NZX 21.9% 14.3% 0.5 × 0.5 × 7.8% 10.1% 7.5% 8.4%

Turners & Growers NZX 2.4% 2.1% 2.1 × 2.3 × 7.4% 5.0% 4.8% 5.7%

Turners Automotive Group NZX (1.5%) (0.5%) 0.6 × 0.3 × 2.1% (0.9%) (0.2%) 0.3%

Vector NZX 19.7% 19.4% 0.3 × 0.2 × 6.1% 5.2% 4.8% 5.4%

Veritas Investments (New Zealand) NZX 13.9% 17.6% 0.7 × 0.7 × 20.3% 9.6% 12.5% 14.1%

Vista Group International NZX 19.1% 14.8% 0.9 × 0.9 × 13.2% 18.2% 13.5% 15.0%

Vital NZX 24.4% 19.8% 0.6 × 0.6 × 14.0% 15.5% 12.6% 14.0%

Vital Healthcare Property Trust NZX 29.8% 2.1% 0.1 × 0.1 × 5.8% 2.1% 0.1% 2.7%

Water and Atmospheric Research Crown 5.4% 5.0% 1.5 × 1.5 × 5.6% 8.4% 7.4% 7.1%

Wellington Drive Technologies NZX 0.8% (3.5%) 6.1 × 5.2 × (11.6%) 4.8% (18.0%) (8.3%)

Z Energy NZX 9.1% 5.6% 2.7 × 3.2 × 30.4% 24.2% 17.7% 24.1%

Zespri USX 5.8% 8.1% 24.0 × 28.9 × 121.2% 140.1% 234.0% 165.1% Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 29 Appendix 2 – ROCE explained

What is Return on Capital Employed and what does it show? ROCE can be used to test operational efficiency, balance sheet management efficiency and the adequacy of return on total capital Return on Capital Employed (ROCE) is a measure of business employed to assess a business’s performance. effectiveness and capital efficiency. ROCE is a function of profitability, how much profit a business generates before interest and tax (EBIT) ROCE can be used to help management improve both the profitability and activity, how much a business has invested in operating assets to (EBIT) and balance sheet management. Improvements in these areas generate that level of profitability. will lead to improvements in the Return on Capital Employed.

In the 1920’s Du Pont Corporation developed what is commonly known as Du Pont accounting and ROCE as a measure of business Calculating ROCE performance to enable it to compare the performance of its many different business units. The Du Pont accounting method is a It is important to note that some changes need to be made to powerful and relatively simple approach to determine the impact of traditional thinking to gain the benefits of this dynamic approach. To management decisions on financial performance. The advantage achieve this there are two concepts that need to be considered: of this method is that it provides a consistent form of evaluation for a business to use when measuring performance. Concepts At an individual business level ROCE: 1. The separation of funding from operating decisions • allows comparison between business units of different size over time; • shows where to invest further and where to cut back; Consider the traditional formula for presenting financial statements. • shows whether it is worth borrowing further to invest; • shows if expectations of shareholders are being met; EQUITY = (Current Assets + Cash – Current Liabilities) + Non-current • indicates the maximum sustainable growth of a business; and Assets – Debt – Non-current non-interest-bearing Liabilities • is used to track whether a project is performing according to plan. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 30

In order to calculate ROCE, all forms of funding need to be removed The Activity Ratio is a measure of how many times a business turns over from the right-hand side of the equation. Total Net Assets should exclude its CE in a financial year. any external funding or debt thereby representing the true value of By way of example, an Activity Ratio of 2.50 × means that for every scarce resources employed in the business. $1.00 invested in Capital Employed the business produces $2.50 in sales. The financial analysis format can now be structured as follows. It answers the question of whether the net operating assets are being utilised efficiently in the production of income.

DEBT − CASH + EQUITY = (Current Assets – Current Liabilities) + The activity drivers are: Non-Current Assets − Non-current non-interest-bearing Liabilities • Raw Materials, Work in Progress, and Finished Goods: the value of raw CAPITAL EMPLOYED (CE) = TOTAL NET OPERATING ASSETS (TNA) materials, work in progress and finished goods the business holds; • Trade Debtors: how much the business has tied up in receivables; • Trade Creditors: how much the business owes to its suppliers for goods The movement in TNA reflects operating changes made to the and services provided; and employment of scarce resources, whilst Net Debt (i.e. Debt – Cash) and Equity reflects how these changes are funded. It should be noted that • Non-Current Assets: how much is invested in plant and equipment where the directors of a business elect to retain minimum levels of cash and intangible assets which are required to operate the business and this cash should be included in TNA. produce the goods sold.

Other current assets and liabilities such as prepayments and accruals 2. Balance sheet efficiency – ACTIVITY RATIO are included in trade debtors and creditors. Non-current non-interest- bearing Liabilities, while typically a relatively small number, are also levers that management can use to influence the Activity Ratio. Definition: A measurement of how well the business manages its scarce resources Adjusting one or more of the activity drivers will increase or decrease the Activity Ratio and therefore improve or worsen ROCE.

Revenue Formula: Capital Employed Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 31

3. Operational Efficiency – PROFITABILITY MARGIN 4. Return on Capital Employed – ROCE

The link between the Balance Sheet and Profit & Loss is dynamically Definition: A measurement of the Return on Sales purely from an reflected in ROCE. operating perspective.

Earnings before interest & tax Definition: The percentage return yielded from the employment of Formula: scarce resources in the form of profit before interest and tax Revenue

EBIT Formula: OR Profitability Ratio × Activity Ratio The above formula ignores the impact of funding and concentrates on CE the entity’s ability to produce a return from revenue.

The four key profitability drivers are: The interactive nature of this ratio is seen in the alternative formula • Price: how much a business receives for the goods it sells; as the product of the Profitability and Activity ratios. Operational and Balance Sheet efficiency are brought to life in one single ratio. • Volume: how many goods the business sells; This should be the first area of review in the process of corporate • Cost of Goods Sold: how much it costs the business to performance assessment and it should be determined as to whether or produce the goods it sells; and not ROCE is adequate and which of its components contribute to both • Expenses: the overhead expenses of the business the strengths and weaknesses of the operational strategy. including depreciation. Irrespective of the type of industry ROCE should at least be equal to or Adjusting one or more of the profitability drivers will increase or decrease greater than the weighted average cost of capital (WACC) in order for the Profitability Ratio and therefore improve or worsen ROCE. a business to create shareholder value. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 32

Example ROCE calculation:

Revenue 100,000 EBIT 10,000 Profitability Ratio 10% Capital Employed 50,000 Activity Ratio 2 × ROCE 10% × 2 = 20%

It is worth noting that average Capital Employed for the period over that which Revenue and EBIT are derived will give a better result than just considering Capital Employed at the end of the period being measured.

It should also be noted that ROCE does not change when EQUITY is substituted for DEBT. This highlights the impact of ROCE being a true operational performance measurement.

5. Interfacing Profit and Loss with the Balance Sheet

The Balance Sheet is just a snapshot of the assets and liabilities of a business at a point in time. However, its interaction with profit and loss, through Earnings before Interest and Tax (EBIT), provides the platform for developing a completely dynamic analytical structure.

Two businesses, producing the same sales and return on sales can be viewed from an operational point of view as being identical even if one were funded by debt and the other by equity. This is because the cost of borrowing is purely a financial issue. Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 33

ROCE Uses expansion is unlikely to be experienced on an ongoing basis and the art of getting the forecasts correct is in challenging such ongoing ROCE can be used in many ways by organisations and management expansion assumptions. teams as a performance measure and as a tool when preparing budgets and valuations. Forecasts for growth businesses often have the opposite issues. Businesses often struggle to achieve EBIT margins in excess of 20% One of these ways is that the management team may set ROCE goals on an ongoing basis. At those levels competitors are likely to enter a for either the entire organisation or its sub-units and decision making market and customers generally start looking elsewhere or in-housing in respect of investing in new projects to ensure that the business is the supply. Revenue growth will also demand additional lock up in performing at a level that is greater than WACC. working capital and additional fixed assets to support the growth. Therefore, to create robust forecasts for a growth business at some ROCE is also able to be used to set up a performance remuneration juncture these charts are likely to level out and this levelling is usually plan for management and employees. As it is simple to calculate, ROCE earlier than anticipated generally because the business relaxes controls provides a transparent model for such programs. around expenditure.

Taking into account the ratios in the chart helps to reduce the risk of Budgeting and Valuation making a budget or forecast error and therefore improves the quality of the budget or forecast and by extension the quality of any valuation Businesses and analysts can often make an underlying error in based off the same. budgeting or forecasting business performance that impacts a business valuation. When undertaking a valuation, the biggest error usually arises from utilising overly optimistic forecasts. Discount rates are generally less What is a “Good” ROCE? susceptible to such errors. ROCE is a measure of a company’s profitability and its activity. Consider the following four charts that simplistically compare Quite simply, a good ROCE is a level that exceeds the WACC for the Profitability, Activity, Capex to Revenue and ROCE ratios for a mature business. Where this is the case the business will be creating value business and a growth business. The underlying issue is that budgets for its shareholders. for mature businesses more than often assume expanding profitability, increasing activity, reducing levels of capital expenditure for every dollar of sales and therefore increasing ROCE. More often than not a mature business is unlikely to see these improvements on an ongoing basis. While some improvement is always possible continuous Armillary Private Capital Return on Capital Employed – Review of 2019 Returns 34

Profitability Activity

Mature Growth Mature Growth

25% 3.50

20% 3.00

15% 2.50 10% 2.00 5% 1.50 0% 1.00 -5%

-10% 0.50

-15% 0 1 2 3 4 5 6 0 1 2 3 4 5 6

Capex/Revenue ROCE

Mature Growth Mature Growth

10% 80%

5% 60%

0% 40%

-5% 20%

-10% 0%

-15% -20% 0 1 2 3 4 5 6 0 1 2 3 4 5 6