This week, we presented you with detailed series – decomposition of Return on Equity (ROE) of selected Croatian companies, using 5-Step DuPont Analysis. DuPont analysis breaks down the underlying components of the ROE in order to analyze the contribution of each component. ROE is a measure of the profitability of a company in relation to equity. Today, we put things into perspective and compare the whole picture given by DuPont decomposition.

The difference compared to the industry mean – ROE (p.p.)

Source: ZSE, Bloomberg, InterCapital Research

We can notice all of the selected Croatian blue chips reported deviation in return on equity from their industry mean. Looking further ahead at all DuPont components, we will analyze the contribution of each component on return on equity. This way we will see the reasons for deviations in ROE more clearly, instead of just reporting the deviations in ROE are present.

The difference compared to the industry mean – Operating Margin (p.p.)

Source: ZSE, Bloomberg, InterCapital Research

We can notice that Podravka and Končar from selected Croatian blue chips in FY 2022 reported a higher operating margin compared to its peer group. To put things into perspective, Podravka also reported a higher ROE than its peers as a result of a higher operating margin. However, Končar reported ROE lower than its peers, even with achieved higher operating margin. This means other fields of business activity offset mentioned margin resulting in a lower return on equity.

The difference compared to the industry mean – Assets Turnover

Source: ZSE, Bloomberg, InterCapital Research

Asset turnover compares a company’s assets to its sales. This ratio helps us to determine how efficiently a company uses its assets to generate revenue. This ratio is crucial as every company has to utilize its assets. The higher the ratio is, the more efficiently company uses its assets to generate revenues.

As can be seen from the graph above, just as economic theory would indicate, the asset turnover of Croatian blue chips closely follows their industry mean. Asset turnover is closely tied to the nature of a company’s assets. It should not come as a surprise that Atlantic Group and Podravka have the highest absolute asset turnover, due to the nature of their sales and business. Also, conversely looking, on the other end, we have Valamar Riviera whose fixed assets amount to 86% of the company’s total assets. Asset-heavy hospitality companies hold a high amount of fixed assets so this also should not come as a surprise that Valamar’s assets amount to EUR 852.1m. Nevertheless, Valamar’s higher assets turnover than its peers indicates Valamar operates its assets more efficiently.

Končar reports interesting decomposed numbers, which DuPont analyses allow us to see it clearly. In the graph above, one can see that Končar utilizes its assets the most efficiently – if the deviation from its peers is considered as a measure.  Yet again, we looked at the return on equity of Končar and it was 4.4 p.p. lower than its peers, even with a higher operating margin combined. The answer lies in another mentioned DuPont variable – financial leverage. How can Končar have a lower ROE than its peers if the company uses its assets more efficiently and achieved a higher operating margin? The combination lies in much lower financial leverage, which does not let the company amplify its results as much as its competitors do.

The difference compared to the industry mean – Financial Leverage

Source: ZSE, Bloomberg, InterCapital Research

Financial leverage divides a company’s total assets with the company’s equity, giving us information on how leveraged the company is with debt. Financial leverage can be useful as it emphasizes the financial stability of a company. Financial leverage equal to 1 would indicate the company has no debt – that company financed its total assets with equity.

We can clearly see the trend of lower financial leverage of Croatian blue chips when compared with its regional comparable peer group. The highest deviation from its peer group is reported for HT and Končar. HT has financial leverage of 1.2x, while its peer comparables have much higher leverage to boost their operations, with median financial leverage amounting to 2.5x. This difference can be attributed to the large cash position of HT. The roots of this correlation between HT’s cash position and lower leverage lie within industry norms and structure. This industry is highly capital intensive, meaning a lot of CAPEX is necessary in order to operate within the industry. Consequentially, if a company does not have a large equity position, it has to finance growth – via debt. In this case, debt enables a company to operate and grow further and decrease its cost of financing. As HT has mentioned a large cash position, it doesn’t have to finance via debt, thus having much lower financial leverage. Further, we already touched on Končar – the lower financial leverage than its peers resulted in lower ROE overall.

The difference compared to the industry mean – Interest burden

Source: ZSE, Bloomberg, InterCapital Research

Interest burden tells us the extent to how much the net financial result of the company together with profit from associates (20-50% shareholding) and investments (<20% share) impacts its profit. If a company pays more interest on its debt than what it receives as interest from its loans or profits from its investments into associates or joint venture, this ratio will fall below 1, meaning that net financial & investment result has impacted its profit negatively. It is calculated as EBT divided by EBIT.

As can see from the graph above, the interest burden of all Croatian blue chips is higher, but closely following the industry mean, which should not come as a surprise. This is just a result of a similar capital structure within the same industry. Within the valuation context, this leads to a similar weighted average cost of capital (WACC), due to more similar capital and debt weights. Also, the reported situation can be partly explained due to companies operating in the same region and generating sales from a similar region. This leads to similar FX gains/losses, which are also affected by the company’s risk management and hedging strategy.

Nevertheless, Končar reported an interest burden >1 (1.5) as its EBT (EUR 51.2m) was higher than EBIT (HRK 48.9m). The reported interest burden higher of 1, by itself, indicates a positive net financial & investment result. Končar reported a slightly positive net financial result of EUR 290k and a net investment result of EUR 2m, as Končar has a joint venture with Siemens, Končar-Power Transformers Ltd. (Končar – Energetski transformatori d.o.o., Zagreb).

The difference compared to the industry mean – Tax burden

Source: ZSE, Bloomberg, InterCapital Research

Tax burden gives us a proportion of profits retained after tax. This indicates how much tax impacts on company’s bottom line. It is calculated as a company’s bottom line, net profit, divided by EBT, pre-tax income. If a company has to pay in the observed period, this ratio will naturally fall below 1, dragging a company’s profitability downwards.

As can be seen from the graph above, the tax burden of all Croatian blue chips closely follows the industry mean, which should also not come as a surprise. Tax burden indicates how much tax impacts on company’s bottom line. If any of the blue chips reported significant deviation from the industry mean, it would probably be due to some “one-offs”, for example, a tax incentive. Last year, Valamar Riviera reported exactly the above-stated scenario, while Group paid taxes this year normally.

Conclusion

To conclude, only Podravka reported ROE higher than the industry mean, as a result of a higher operating margin compared to its peers. However, higher operating profitability was partially offset by having asset turnover lower than the industry mean.

Končar reported a lower return on equity than its peer group (-4.4 p.p.). Končar’s ROE amounted under its peers due to lower financial leverage, which would allow the Group to amplify its results. Further, Končar also reported the highest positive difference when compared to industry mean assets turnover, indicating a more efficient use of assets. Another positive offset is a positive deviation from the industry mean in Interest burden, which is the result of Končar’s joint venture with Siemens, Končar-Power Transformers Ltd. (Končar – Energetski transformatori d.o.o., Zagreb). Further, HT achieved lower ROE than its peers due to a combination of both slightly lower operating profitability and lower financial leverage.