There’s growth, and then there’s growth

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If it looks like a duck and quacks like a duck, is it necessarily a duck? That’s the mindset that is sometimes required to fully understand the numbers that are being reported by companies in Australia and around the world at this time of year.

One of the first numbers examined by investors and analysts when a company reports its results is revenue. And more specifically, most are interested in the growth in revenue from, say, one year prior. A company that is growing revenues strongly is more likely to be growing earnings strongly, and therefore more likely to be growing its dividends to shareholders strongly. Furthermore, revenue growth is considered to be a relatively clean metric in that it is independent of the company’s cost structure and is typically untainted by management’s accounting policies.

But not all revenue growth is created equal. And investors and analysts need to carefully dissect the nature of the revenue growth.

Consider a retailer that owns a number of stores. While revenue growth in each store might be weak, the company can boost its headline revenue growth number by opening new stores. We observed this at JB Hi-Fi (ASX: JBH) which reported full-year 2014 revenue growth of 5.3% per annum. Yet on a store like-for-like basis, revenue only grew by 2.0% per annum over the same period.

Similar to the idea of opening new stores is the idea of acquiring new businesses to boost headline revenue growth. This is the strategy of childcare and education provider G8 Education (ASX: GEM). The company recently reported revenue growth of a whopping 59% per annum for the half-year ending 30 June 2014. Most of this has stemmed from the acquisition of additional learning centers. This can be clearly observed in G8’s cash flow statement: payments for the purchase of businesses were $218 million in the six-month period to 30 June 2014. These are significant cash investments given reported revenues in the same period were $187 million.

Sometimes companies can simply benefit from fortuitous macroeconomic tailwinds that serve to inflate revenue growth. A company that has operations offshore with revenues denominated in other currencies will typically go through periods of tailwind and headwind as the foreign currency strengthens or weakens relative to the currency in which the company’s financial results are reported.

The Australian medical device manufacturer and distributor, ResMed (ASX: RMD), has benefited from exactly this dynamic over recent quarters. While the company reports in US dollars, it sells its devices in many countries around the world, in particular those in the Eurozone. Over the last five quarters, the strength in the Euro relative to the US dollar has added around 2-4% in additional revenue growth from ResMed’s international businesses.

Finally, investors and analysts need to be cognisant of the accounting rules around consolidation when examining revenue growth. If company A owns 49% of company B, then company A will typically report no revenue for company B and instead report just its 49% share of company B’s earnings on its income statement. Yet if company A were to increase its ownership to, say, 51%, then all of company B’s revenues would be reported on company A’s income statement under the rules of consolidation. The perceived growth in reported revenue can be substantial, simply by increasing ownership in an associate company to a level above the 50% threshold. This quirk in the accounting rules has certainly been a contributing factor to the very strong reported revenue growth of online employment advertiser, Seek (ASX: SEK). Seek owns a portfolio of interests in online employment portals around the world and has slowly increased its ownership in these associate companies over the years. As Seek’s ownership level in each associate crossed the 50% threshold, it was required to consolidate 100% of the associate’s revenues into its own income statement, providing a substantial tailwind to its reported revenue growth.

There is nothing inherently right or wrong with each of the examples described above. They simply reflect different versions of the same thing: reported revenue growth. Each has different implications, however, and investors and analysts need to consider these carefully. Perhaps the most important consideration is around the sustainability of the revenue growth that is reported. Understanding the underlying drivers of revenue growth serves to inform this assessment of sustainability for the investor or analyst.

Finally, investors and analysts should be cautious of very high rates of reported revenue growth. It is not that high rates are inherently unsustainable, it is just that they cannot exist in aggregate across the corporate sector. Roughly speaking, the growth in aggregate corporate revenues should be roughly equal to the GDP growth of the economy. So if a company or a sector is growing at rates well above this level, one needs to believe that there are other companies or sectors growing at rates well below this level.

 

Andrew Macken is a Senior Analyst at Montgomery Investment Management.

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