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The Financial Director interview – Forget about the earnings

Ken Lever doesn’t believe in making life easy for himself. As finance director of Tomkins, he bears a large part of the credit for the group’s return to the FTSE-100 index, and for helping to keep it there. At the time of our interview in early March, Tomkins was ranked number 92 – just high enough to avoid demotion to the FTSE-250, the fate that would befall the former industrial giant Invensys just a week later.

Lever says that Tomkins is benefiting from an inversion of the imbalance between market value and economic value that saw it kicked out of the FTSE-100 in March 1999 as industrials and conglomerates lost out, making way for telcos and dotcoms. The truth is that Lever got Tomkins rerated (and, last November, back into the FTSE-100) the hard way – restructuring, divesting, changing its strategic focus of the business and its managers, and, for a-year-and-a-half, doing all this without the benefit of a CEO at the helm.

Tomkins, you will recall, was a hugely successful business built up by Greg Hutchings, a former executive with Hanson, where he learned the trick of growing earnings by making acquisitions and doing some quick fixes to the cost base. For a while, it didn’t much matter what the acquisitions actually were. But by the time Tomkins came to own the American handgun company Smith & Wesson and the British baker Ranks Hovis McDougall (RHM), it was being weighed down by the ‘guns-to-buns’ label. Analysts didn’t know what RHM was doing in a manufacturing group, and they didn’t know what Hutchings was going to do next. Even after the bakery business was sold and Tomkins moved toward the automotive industry, it got the even less attractive handle, ‘wipers-to-snipers’. By the late 1990s the gloss had come off the growth-by-acquisition formula that had taken the group to £5bn of turnover and some £500m of pretax profit.

Enter Lever, an arch critic of management for earnings growth and a well-versed proponent of managing for value. “From the mid 1980s to 2000, I guess the compound annual growth rate in the earnings was 11% per annum,” he explains. “But the share price didn’t actually go up from 1992. At the end of the period it was no higher than it was at the beginning.”

Lever gives an example of how earnings growth can fail to add value. Say a business acquires a £10m-turnover company for £10m, and that the cost of borrowing is 4%, “In order for it to be earnings-enhancing, you’ve only got to make a profit of £450,000 – a return on sales of 4.5%. That’s not a terribly stunning business,” Lever says. “You can justify (the acquisition) in earnings per share terms, but you can’t necessarily justify it in terms of being able to add value.”

As Tomkins’ share price languished, Lever, who was then FD at chemicals group Albright & Wilson, proved to be just what Hutchings was looking for – someone who could bring an intellectual rigour to managing businesses on an economic basis, managing for value rather than earnings growth.

“The key thing is to make sure you recognise there is actually a cost associated with the capital that’s being used to drive (the business),” Lever says. “It doesn’t require a massive change in mindset, it just requires a shift away from what people have been traditionally used to. That was one of the reasons why I found Tomkins an interesting prospect and I think why Greg (Hutchings) found it interesting.”

By the end of 1999, at which point Lever was putting his ideas into effect at chemical group Albright & Wilson, he convinced Hutchings that it was possible to create a strategic framework for Tomkins that could focus on “trying to position the businesses into areas where they can actually create value”. Meanwhile, Tomkins wasn’t even using discounted cash-flow techniques. Lever got the FD job and one of his first tasks was to overhaul the capital expenditure appraisals processes.

Hutchings, who Lever has described as “a character”, was actually open-minded about this strategic shift that Lever wanted to introduce. “Greg is a very thoughtful individual; very cautious and creative in terms of his ideas. I was putting a framework to try to fit in some of his ideas and really giving some structure to it.”

Lever says: “We use the expression here that ‘organic growth is safe growth’ because you are growing in those markets where you understand the customers, you understand the business, you understand all the dynamics.

Acquisitions shouldn’t be viewed any differently from any other form of investment: it’s helping you add to the strength of the business, or trying to mitigate a particular weakness. Our focus is really to say that organic growth is the way to go, but sometimes you need to make an acquisition to accelerate the speed with which you can achieve the organic growth.”

Shortly after Lever’s arrival at Tomkins, a strategic review was initiated, helped by blue-chip stockbrokers Cazenove and consultants McKinsey. The review was still underway when, in October 2000, Greg Hutchings resigned under a cloud of accusations about the misuse of company jets and two London flats. As much as the City’s confidence in Hutchings had been dented by the failure to create lasting value in the group, the departure of the entrepreneurial driving force did nothing to encourage investors to flock back to the group. Chairman David Newlands, a former GEC FD, became acting CEO, while Lever and COO David Snowdon looked after much of the day-to-day running of the business.

The ongoing involvement of McKinsey and Cazenove held out some hope that some value might yet be shaken out of the group. Ironically, the 2001 annual report contained many charts on the strategic positioning of Tomkins which, as he laughingly acknowledges, people probably thought had come straight from McKinsey, but they hadn’t – they were Lever’s. “It was stuff that we’d already started doing, and then McKinsey worked with it,” Lever says. “They actually gave the thing a lift because they endorsed and supported the approach, so it gained some credibility by the fact that McKinsey were prepared to support it. I don’t have any pride of authorship, so if a way of getting it in place was that people thought it was McKinsey’s, that was fine.”

During the prolonged interregnum, the management team completed some of the major disposals that had been slated when Hutchings was CEO (Smith & Wesson and a few others – RHM had already gone by the time of Hutchings’ departure), ultimately shedding about a third of the group. There were no major acquisitions – the board had decided not to change the strategic direction of the group while looking for a new CEO – but they did continue to roll out the value-based management programme. Fortunately, when Jim Nicol was eventually appointed in February 2002, he not only embraced the value approach, he could give it his own extra spin. “He’s been able to better articulate the day-to-day aspects of value-based management.”

Lever says the most important thing he learned from this process was the need to keep it simple. “There is a danger that finance people can get a bit intellectual and academic about some of these things.” Given that programmes like this fail without buy-in from operational management, Nicol’s ability to “convert it into day-to-day, practical, pragmatic thinking has helped enormously”, Lever says. “I don’t think we’re anywhere near getting to the stage where everybody is on board and supporting it, but I do think that people are looking at it with a curiosity as to what it’s actually all about.”

Lever’s preferred performance measurement metrics fall into three broad categories: accounting metrics, such as return on sales and return on capital employed; cash-flow metrics focusing on working capital and free cash flow, and the relationship between depreciation and capex; and economic metrics, including return on invested capital (ie, including goodwill) and a measure called cash added value, which Lever regards as a simpler version of Stern Stewart consultancy’s economic value added methodology.

It’s a lot of numbers, and there are a lot of businesses to manage, so the whole lot is churned out via a red-yellow-green “traffic-light” system supplied by Metapraxis, so that attention is focused immediately on the reds and yellows. The system also has a ‘windsock’ by which it can see to what extent a business’ forecast is low, to what extent it’s high.

It’s similar to the ‘feather diagrams’ you sometimes see accompanying economic forecasts, enabling you to look more closely at those businesses that are performing out of range, either above or below, Lever explains.

For Lever, the emphasis is on looking forward. Indeed, like most FDs, the first thing that’s occupying his mind at present is where the global economy is going and the impact on his business. Little wonder, then, that his management focus is on measures and systems that try to shed light on future outcomes than past results. And little wonder, too, that Lever is frustrated by the ever-growing complexity of accounting rules and financial reporting which, he says, “obfuscates the real message in terms of how business goes about creating value and how it projects that sort of information to the market”. A dedicated team now has the task of producing “information which is required by accounting standards and regulations but which isn’t really used to manage the business,” Lever laments. “The amount of time, effort and resource needed to do that is becoming a significant issue.”

The whole financial reporting framework is quite ill-suited to the job of explaining how a business creates value. “The value created in business is all about the future. It isn’t actually about the past,” he insists.

Lever holds out some hope that the new operating and financial review (OFR) regulations will improve the quality of reporting generally, especially as companies get used to the idea of comparing what they said they were going to do and explaining what they’ve actually done.

For his part, Lever has been including more and more information in the Tomkins’ annual reports, publishing details such as cash flow and return on invested capital down to the level of individual business groups, so he can’t just bury the impact of goodwill in the aggregate figures at the plc level. Transparency is an important issue for Lever and he has worked on an ICAEW working party with David Phillips of PricewaterhouseCoopers, who is renowned for his work on value reporting.

Still, Lever doesn’t claim that Tomkins is a ‘pathfinder’ in the value reporting field. One key issue is commercial sensitivity. Reveal too much detail and you may upset customers who will start wondering why they should be making their suppliers so profitable. But it’s easy to overplay this card, he says. “If you need to look at a set of reports and accounts to actually know that information about your competitors, then you’re not doing a terribly good job in terms of understanding and analysing them. People expect you to know that stuff,” he argues.

Tomkins is now about to move to quarterly reporting, in dollars and sterling, and in both US and UK GAAP. This sounds like an awful lot more accounting from an FD who isn’t a big fan of reported earnings. But with 70% of the business and more than a fifth of the investors US based, it seems worth the effort.

Yes, he is concerned that investors will start putting too much emphasis on each quarter’s earnings per share figure, “but value creation is not a linear process,” he maintains. “It has its ups and downs. So long as you’re focusing the business in the right direction and doing all the right things to take it in that direction, I think the business will create the value.”

Name: Ken Lever
Age: 49
Qualifications: FCA

1999- : Finance director, Tomkins plc
1995-1999: Finance director, Albright & Wilson
1991-1995: Finance director, Alfred McAlpine
1987-1990: Finance director, then MD, CB plc
1974-1987: Arthur Andersen

Biggest challenge in your job? Ensuring Tomkins has a world-class finance function. We’re also trying to move to quarterly reporting, sterling, US dollars, under US and UK GAAP.

Biggest hassle? Driving to and from the office. I get in early and leave late (to avoid traffic). I don’t have trouble filling my day, but it would be nice not to have to do it.

What other company would you like to be FD of? A business that is more recognisable, say, Cadbury Schweppes, so if you tell someone you’re the FD, their eyes don’t suddenly go blank.

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