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Dynamics of TSR Turnarounds

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The Dynamics of TSR Turnarounds

July 15, 2014 By Gerry Hansell , Jeff Kotzen , Eric Olsen , Frank Plaschke , and Hady Farag

TSR turnarounds are companies that deliver superior value creation after an extended period of below-average TSR performance and a below-average valuation multiple. It turns out that companies with this starting position not only deliver more TSR, on average, than the other companies in the 2014 BCG Value Creators database. They are also overrepresented among the top ten value creators in 26 industries.

The Importance of Starting Point

To analyze the dynamics of TSR turnarounds, BCG took a look back to the TSR performance of the companies in this year’s Value Creators database during the previous five-year period from 2004 through 2008. First, we divided the companies into two groups: those that delivered TSR below their industry average during that period and those that delivered TSR above their industry average. Because not all companies in this year’s sample were public companies during that earlier period (either because they did not yet exist or were held privately), we were able to do this analysis for 1,330 out of the total 1,620 companies in our sample.

Next, we categorized these companies according to whether their valuation multiple (measured as the ratio of enterprise value to EBITDA) was either above or below the average valuation multiple for their industry at the end of 2008 (the end of the previous five-year period and the beginning of the five-year time frame of this year’s Value Creators report). This metric gives a sense of how investors were valuing the companies’ likely future performance at the time.

The result of this segmentation is the four-box matrix on the left in Exhibit 1. Note that the number of companies is largest in the lower-left quadrant (that is, those companies with below-industry-average TSR and below-industry-average multiples) and the upper-right quadrant (those with above-industry-average TSR and multiples). That outcome reflects the fact that change in a company’s valuation multiple (whether positive or negative) is an integral part of the calculation of TSR. (See “The Components of TSR.”)

The Components of TSR

TSR is the product of multiple factors. Regular readers of the Value Creators report should be familiar with BCG’s model for quantifying the relative contribution of TSR’s various sources. (See the exhibit below.) The model uses the combination of revenue (sales) growth and change in margins as an indicator of a company’s improvement in fundamental value. It then uses the change in the company’s valuation multiple to determine the impact of investor expectations on TSR. Together, these two factors determine the change in a company’s market capitalization and the capital gain (or loss) to investors. Finally, the model tracks the distribution of free cash flow to investors and debt holders in the form of dividends, share repurchases, and repayments of debt to determine the contribution of free-cash-flow payouts to a company’s TSR.

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The important thing to remember is that all these factors interact with one another—sometimes in unexpected ways. A company may grow its revenue through an EPS-accretive acquisition and yet not create any TSR, because the new acquisition has the effect of eroding gross margins. And some forms of cash contribution (for example, dividends) have a more positive impact on a company’s valuation multiple than others (for example, share buybacks). Because of these interactions, we recommend that companies take a holistic approach to value creation strategy.

What is striking, however, is the way these different starting points affected the future performance of the companies in our sample. Having segmented the companies into the four groups shown in the matrix, we then calculated the average TSR performance of these four groups in 2009-2013, relative to their industry average. The results of this analysis can be seen in the matrix on the right in Exhibit 1.

Those companies that in the previous five-year period had both a below-industry-average TSR and a below-industry-average 2008 multiple performed significantly better than the rest, delivering TSR that was nearly 5 percentage points above their industry average. Meanwhile, those companies with above-industry-average TSR in the previous five-year period and above-industry-average multiples did poorest, delivering TSR that was nearly 2 percentage points less than the industry average.

What about the top-performing companies in this year’s Value Creators database? We repeated the same analyses for the 180 companies that had ten-year TSR data out of the 260 in our industry top-ten rankings. As the matrix on the left in Exhibit 5 illustrates, companies with previously poor TSR performance and a low 2008 multiple are substantially overrepresented in the top-ten rankings for 2009-2013. Seventy-five out of 369 companies in this category—or 20.3 percent—are in the industry top-ten rankings. These are the companies that we are calling TSR turnarounds. In contrast, only 31 out of 397 companies with previously high TSR performance and a high 2008 multiple made it into one of the top-ten rankings for 2009-2013—roughly 8 percent. Put simply, a company with previously poor performance and a low 2008 multiple had a 1 in 5 chance of making it into one of this year’s top-ten rankings, whereas a company with previously superior performance and a high 2008 multiple had less than a 1 in 12 chance.

Of the companies in our top-ten rankings, those in all four quadrants delivered TSR that was substantially higher than the industry average. (See the matrix on the right in Exhibit 2.) Nevertheless, the TSR-turnaround companies, in the lower-left quadrant, delivered about 4.5 percentage points more relative TSR, on average, than the companies in the other three quadrants.

This data clearly illustrates an important fact about the dynamics of TSR: a company’s starting point matters enormously. Just because a company has been performing poorly doesn’t mean it can’t become a top performer. Indeed, in some respects, it is especially well positioned to do so. And just because a company has a history of superior TSR performance, that does not mean its senior executives should be complacent. It’s not merely that past performance is no guarantee of future performance. Previous superior TSR performance can actually become an obstacle to maintaining superior TSR performance because the expectation of high performance is already priced into the stock price in the form of a high valuation multiple, and delivering superior TSR is all about beating expectations, not just meeting them.

How TSR-Turnaround Companies Create Value

Of course, just because a company has a period of poor TSR performance does not automatically mean that it will become a top performer later on. Bringing about a TSR turnaround depends on making a series of moves that fundamentally redirect a company’s TSR trajectory. Although each company’s story is different, we found some common patterns in the way that the TSR-turnaround companies in our sample reversed their fortunes.

  • A Return to Fiscal Discipline. The starting point for many TSR turnarounds is getting the balance sheet in order by paying down debt, controlling costs, and improving free cash flow. This was especially the case in the period immediately after the financial crisis, when the paucity of available credit forced companies to become far more disciplined in their use of cash.
  • Focus on Margin Expansion over Growth. Similarly, in the trade-off between growth and margins, these companies tend to rely less on earnings growth than other top performers and more on margin improvement to deliver TSR. Whereas revenue growth was responsible for 5 percentage points of TSR at our TSR-turnaround companies, it was responsible for 14 percentage points of TSR at other top performers. That’s not to say, however, that finding new sources of quality earnings isn’t often a key part of the TSR-turnaround formula for many companies.
  • Growing the Dividend. In many situations, substantial dividend increases were part of the value creation strategy at TSR-turnaround companies. As their cash position improved, they increased their dividend both as a direct contribution to TSR and as a signal to the market of management confidence in the company’s prospects.
  • Benefiting from an Improving Multiple. All the companies in our top-ten rankings benefited from a greatly improved valuation multiple. But the TSR-turnaround companies benefited a lot more—as one would expect, given that their performance was beating the relatively low expectations that investors had at the beginning of the 2009-2013 period. Whereas multiple improvement accounted for 14 percentage points of TSR at the nonturnaround companies in our sample, it accounted for 22 percentage points at the TSR-turnaround companies.

Four Simple Lessons

Four simple lessons emerge from this analysis:

  • Successful value creators cannot afford to be complacent. The higher their past TSR and the higher their valuation multiple, the more insightful and disciplined about value creation strategy they will have to be in order to maintain their superior performance.
  • Poor TSR performers should never give up on the goal of delivering superior TSR. Indeed, they have the best odds of being a superior value creator in the future—but only if they make the tough choices to improve both their fundamental performance and their valuation multiple relative to their industry and their peers. (See “Gannett: A TSR Turnaround in the Making.”)
  • Know what factors drive your valuation. In whatever quadrant on our matrix a company finds itself, it pays to know the factors that drive its valuation multiple relative to its peers. In some situations, the multiple is directly linked to fundamental factors such as growth or margins. In others, it is linked to less tangible factors, such as the patterns of a company’s capital deployment, the nature of the risks it has taken on, or the transparency and credibility of its value-creation strategy. In our experience, roughly 80 percent of the the factors that drive differences in valuation multiples among similar companies can be identified and managed.
  • Develop a comprehensive value-creation strategy. Every company needs to have a value creation strategy that addresses all the factors that contribute to TSR. The relative importance of earnings growth, margins, dividends, share buybacks, and the like will depend on a company’s starting position. And business strategy, financial strategy, and investor strategy have to be integrated and aligned.

Read more in the The 2014 Value Creators series
The Dynamics of TSR Turnarounds
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