Earnings quality and shareholder value: getting to one version of the truth

Earnings and earnings growth together provide the basis for current and future dividends for shareholders and therefore are primary drivers of shareholder value. These indicators of success, in turn, are largely driven by a company's ability to grow revenues and improve both cost control and asset efficiency. Figure 1 ties company earnings to these three primary levers of shareholder value: revenue growth, operating margin, and asset efficiency. Historic values for these levers of profitability, along with an assortment of earnings-related measures, are provided in Table 1 for five global, integrated oil companies.

All of the five companies covered in Table 1 showed considerable earnings growth over the past 5 years, with ConocoPhillips being the highest and Royal Dutch Petroleum being the lowest. Scale, however, is important when considering growth. The largest entities, like ExxonMobil and Royal Dutch Petroleum, have more difficulty showing sustained high growth than companies with smaller scale. ConocoPhillips, followed by ChevronTexaco, while large in comparison with most other corporations, are the two smallest companies in the sample. At the same time, these two companies have the highest average annual earnings growth over the past 5 years.

A commonly used profitability measure within the energy industry that facilitates comparison of differently sized companies is return on capital employed (ROCE). Unlike the level or growth of earnings, this measure is not distorted by scale. Table 1 provides the 5-year average ROCE for each of the five integrated oil companies. Against this income-statement and balance-sheet metric, Royal Dutch Petroleum is strongest with 19%, followed by ExxonMobil with 15%, and then ChevronTexaco with 14%.

To show the source of these profitability measures, Table 1 also includes historic performance on revenue growth, operating margin, and asset efficiency. In light of the difficulties the supermajors have in growing upstream production, revenue growth for their upstream segments depends largely on oil and gas prices. Upstream margins are affected by historical finding and development costs and current operating costs, while downstream margins are primarily driven by the spread between crude oil and petroleum product prices, as well as the efficiency of the operations and business processes supporting refining, transportation, retail, and marketing segments. Asset efficiency, or asset turnover, measures the extent to which companies are utilizing their assets to generate sales revenue. The higher turnover ratio (relative to peers or over time) provides some indication that a company is using its assets more efficiently to generate revenue.

ConocoPhillips demonstrated the best revenue growth over the past 5 years, 1999-2003, followed by BP.² ConocoPhillips achieved the highest average operating margin of 18%, with Royal Dutch Petroleum averaging 17%. ExxonMobil, closely followed by ChevronTexaco, demonstrated the best asset utilization over the sample period.

Information quality

Building shareholder value is as much about reducing the risk around earnings as it is about growing earnings. While the market might have been predominantly fixated on earnings growth prior to the demise of Enron, investors now clearly have a more balanced view of the importance of earnings quality relative to quantity.

Earnings quality is driven primarily by the market's perception of the "riskiness" of those earnings. Figure 2 lays out some of the key factors processed by investors as they evaluate earnings quality.

Figure 2 presents a different view of the shareholder-value framework, including earnings quality along with growth as the key drivers of share value. Earnings risk is conventionally measured in terms of year-to-year earnings variability, although management's use of financial leverage to improve earnings growth also increases shareholders' risk. Table 2 provides historic data for these two conventional earnings-risk measures for each of the sample companies, along with year-to-year variability of ROCE.

Again, due to scale issues, earnings volatility included in Table 2 is measured as a percentage of average earnings. Given the complexity of earnings quality and the high degree of aggregation and simplicity in the risk measures, data for the sample of integrated oil companies prove to be inconclusive with respect to this quality dimension of company earnings.

Although ConocoPhillips does appear to have a higher risk profile than the other integrated oil companies according to these metrics, identification of the lowest-risk integrated oil company over the 5-year sample period is not clear. Royal Dutch Petroleum has the lowest earnings volatility, followed by ExxonMobil, yet BP has the lowest ROCE variability. ExxonMobil and Royal Dutch Petroleum have negligible financial leverage. Using these specific risk metrics, Royal Dutch Petroleum appears to have the lowest risk, followed closely by ExxonMobil and then BP.

In addition to these various risk measures, the market places growing emphasis on information quality in its overall assessment of earnings quality. Unfortunately, information quality is not an earnings-quality driver that can be easily measured. Information quality is, however, linked directly to the transparency, accuracy, and timeliness of information that management reports to the investment community.

This driver's role in overall share valuation becomes clear in an examination of a common valuation method used by investors: the price/earnings (P/E) multiple. The P/E multiple represents the price the market is prepared to pay for a dollar of a company's earnings. It reflects the market's consensus on both earnings quality and growth at any point in time. The significance of information quality to investors can be measured by observing how the market responds to new information that may, rightly or wrongly, impact the consensus view of information quality embedded in the earnings multiples.

Restatement of reserves

A case in point is the new information the market received from Royal Dutch/Shell related to reserve revisions after market close Jan. 8, 2004. By focusing on P/E ratios for the integrated oil companies just before and just after the Royal Dutch/Shell reserves restatement, we can get some indication of the importance of information quality as the market assesses earnings quality pre- and post-announcement. Restricting the analysis period to 90 days before and after the event keeps the likelihood low that results were affected by changes in the market's consensus view of other earnings-multiple drivers, such as other risk factors like earnings volatility.

Figure 3 shows the P/E multiples for the large integrated oil and gas companies and the S&P 500 index 3 months before and after the Jan. 9, 2004, announcement of the reserve restatement by Royal Dutch/Shell.

One of the first observations regarding the P/E ratios plotted in Figure 3 is that notwithstanding the size and diversification of the large integrated oil companies, their earnings multiples are still well below the average multiple for the S&P 500 index. Even ExxonMobil, with the highest earnings multiple among the large energy companies, faces a 20-30% discount relative to the S&P 500 average. This is interesting given that the large integrated oil companies have capital-market-based risk measures (i.e., beta risk) approximately equal to the market average (i.e., beta = 1). The lower P/E ratios for the supermajors may reflect low average growth expectations by investors for the integrated oil companies versus the "average" S&P 500 company. Consistent with our earlier reported profitability and risk measures, ConocoPhillips appeared to have both the highest growth as well as the highest risk metrics. At the same time, ConocoPhillips trades at a significantly lower multiple than the other integrated oil companies considered here. Up to Jan. 8, ExxonMobil and Royal Dutch Petroleum traded at the high end of the range for industry earnings multiples, again consistent with the risk metrics presented in Table 2.

Figure 3 also shows, however, the significant downward adjustment (almost 10%) in the price the market was willing to pay for $1 of Royal Dutch Petroleum's earnings on Jan. 9. Once Royal Dutch Petroleum released the news on the 20% proven reserve revisions (after the market close on Jan. 8), its P/E multiple dropped quickly at the start of trading the following morning. In addition, there appeared to be a type of contagion effect that hit the other integrated oil companies as well, although the impact of approximately a 1% average multiple decline over the following week was minimal by comparison. While the S&P 500 P/E multiple drifted upward gradually over the 90 days after Jan. 9, the large integrated oil companies saw market pressure on their own multiples for a week or so (shaded area in Figure 3) and then resumed their upward drift.

The figure also indicates that after Jan. 15 the P/E multiples of the other integrated oil companies gradually improved, while Royal Dutch Petroleum's multiple has remained flat. This in part reflects the subsequent unfavorable reserve-related announcements after Jan. 9 by Royal Dutch/ Shell, but it also highlights a fundamental characteristic of information quality in the capital market. Building or restoring information quality in the market is a long, arduous process, while undermining it can occur with the disclosure of a single piece of negative news. Other companies, such as El Paso, Nexen, Vintage Petroleum, Forest Oil, and Talisman, experienced a similar negative reaction when information important to the marketplace was revised.

The market has come to expect the highest standards from the largest oil and gas companies. Royal Dutch/Shell has a long history of exceeding these high standards. The market has shown, however, that it will react quickly and unforgivingly when evidence emerges that those standards, particularly around financial and operating data, might have been compromised.³ While it would be difficult to argue that the magnitude of the capital market's reaction to Royal Dutch/Shell's announcement was reasonable, it is a behavior that is increasingly common in today's investment community.

Higher requirements

Investors now set higher quality requirements on all the information they receive from companies, both energy and nonenergy companies, in the post-Enron world. The new Sarbanes-Oxley regulations attempt to legislate higher information-quality standards. Energy-company earnings quality is primarily driven by commodity prices and the exposure of the energy company to price fluctuations. In theory, management should be prepared to accept higher earnings volatility and related risks only if the resulting increase in earnings growth more than compensates investors for the additional risk. In other words, more risk may be in shareholders' interests if it is coupled with superior return prospects. It is only when risk increases with no obvious improvement in the outlook for returns that a rational marketplace would react negatively.

The information-quality driver of earnings quality, on the other hand, is unambiguously positive in its relationship and ultimate impact on the company's P/E multiple. Everything else being equal, improving information quality should correspond to higher multiples just as weakening information quality should hurt those multiples. A growing amount of evidence suggests that any data that weaken the market's perception of a company's information quality will create net selling pressure.

One of the areas companies are focusing on to win back market confidence is corporate governance. A qualified and independent board of directors is critical to regain and build investor trust.

As important as the composition of a company's board of directors, however, are strong internal management governance and controls. An organization could have a highly independent and qualified board of directors that signs off on erroneous, nontransparent, or late information to investors. Decision-makers have difficulty making good business decisions when the internal information flow has problems. This has the effect of raising the risk profile for earnings and is reflected in a lower earnings multiple. Institutional investors would argue that many companies need improvements in both board and internal management governance.

A closer look

Integrated oil and gas companies are large, complex organizations that operate in a number of business segments. Each segment of the energy value chain for these companies is itself complex and geographically dispersed. Operating successfully in these many different businesses and geographies requires real integration of processes, data, and technologies.

Operations and transaction data get collected in the field, some bounded by well-defined processes and technologies. These data get converted into information as they are analyzed and then aggregated. Moving the information both within and between businesses units can, however, be a challenge to many oil companies due to nonstandard data definitions, business processes, and technologies.

Information-quality problems are common within the oil and gas industry for two primary reasons. First, oil and gas companies find that periodically it makes more sense to achieve growth and scale through acquisition than through the drillbit. A byproduct of acquisitions is often a tangled web of nonintegrated, nonstandard business processes, technologies, and data structures. The other driver of complexity in the energy industry is the commonly found decentralized organization structure. The upstream business, in particular, is often decentralized because of the need for decision-making flexibility in an often rapidly changing business environment.

The downstream businesses are different. For refining, transportation, retail, and marketing, the economic game is primarily about cost control and operating efficiency. Independent of the link to information quality, process and system standardization is critical to ensure acceptable profitability in the downstream business. Noncore processes like information technology, human resources, finance, and legal can be delivered through less costly standard processes and systems. Standardization would significantly lower the cost of these services and at the same time improve financial information quality. Due to both history and the significance of upstream profitability, however, many large oil and gas companies have both corporate cultures and organizational designs driven by their upstream business segments.

Nonintegrated processes, data, and technology resulting from past acquisitions or decentralized organization structures create material challenges for information quality. Lack of standardization does increase the risk of data revisions, some of which could affect reported financial numbers. Increasingly, executives are recognizing the linkages among earnings multiples, earnings quality, and the quality of information reported to the market. Investors continue to pressure management to deliver significant earnings growth, yet growth now usually has an unintended side effect of more complexity and consequent erosion of the earnings multiple. Complexity, as noted earlier, tends to be more pronounced in organizations that have a decentralized organization structure. Decentralized organizations as well as companies growing through acquisitions tend to breed nonstandard processes and systems and to inadvertently grow unnecessary complexity.

Complexity can have the effect of eliminating any true quality control that management has on the information that ultimately flows into financial statements. Attacking complexity requires focus, discipline, and direct involvement of both corporate and business-unit leaders. While it does not necessarily require comprehensive organizational redesign or centralization, it does require a commitment to standardize unless there is a compelling business case not to.

In the future, oil and gas company managers need to concern themselves with how to improve their companies' growth prospects in both the near and long terms. In the post-Enron environment, these same executives will also need to make the necessary internal changes to ensure that the transparency, reliability, and timeliness of information provided to the capital markets and regulators are also improved. Otherwise, the higher growth may be discounted by a suspicious marketplace needing to see significant improvements in information quality.

References

1. General Accounting Office, Financial Statements and Restatement Trends, GAO-03-138.

2. Results are affected by accounting methods used to record mergers involving companies in the sample. The BP-ARCO, BP-Burmah Castrol, and Conoco-Phillips mergers used the purchase method of accounting. Other recent mergers (Exxon-Mobil, BP-Amoco, Chevron-Texaco) used pooling accounting.

3. Royal Dutch/Shell has made a number of changes to restore the market's confidence, including the establishment of a group audit committee review process, group internal audits from outside the business unit, hiring of Ryder Scott related to reserves assessments, and requiring the Committee of Managing Directors to be directly accountable for annual reserve reports (Citigroup SmithBarney Shell report, Feb. 6, 2004).

The author

Richard S. Woodward (riwoodward@ dc.com) is a principal at Deloitte Consulting LLP, leading the energy practice for the West region. He has worked with many large and midsize energy companies over the past 20 years, including ChevronTexaco, Shell Oil, Petro-Canada, PanCanadian, TransCanada, Westcoast Energy and many others. Woodward holds a number of honors degrees in economics: Bsc from Wharton, Msc from the London School of Economics, and a Phd from Exeter University.