Jilnaught Wong of the University of Auckland Business School crunches the numbers and determines that Mainfreight's staff & management deserve their bonuses

 By Jilnaught Wong*

Shareholders and debtholders provide capital to a firm, and the capital is invested in the firm’s net operating assets (property, plant and equipment, intangible assets, and net working capital).

The capital providers require a return on their investment in the firm, and this is the weighted average cost of capital (WACC). Shareholders, as one group of capital providers, require a higher return, known as the cost of equity, because they carry the residual risk.

PwC’s estimates as at 31 December 2016 of Mainfreight’s WACC and cost of equity are 6.0% and 6.4%, respectively. These expected returns are unlikely to have changed materially, so they provide appropriate benchmarks to judge Mainfreight’s financial performance for the year ended 31 March 2018. (And here's the company's investor presentation).

Mainfreight achieved a return on its net operating assets, also known as the return on invested capital, of 13.1% in 2018 and 11.6% in 2017. The 2018 and 2017 returns are near twice the WACC. That is, the management and staff of Mainfreight gave the capital providers more than their expected return of 6.0%, which means they created wealth of 7.1% (13.1% versus 6.0%) in 2018 and 5.6% (11.6% versus 6.0%) in 2017.

When you are performing above expectation – especially so far above expectations – there is a good reason to share the outcome of that superior performance with your staff. What the Board of Mainfreight is saying is “we’ve generated a return over and above what our capital providers require, so we are happy to share that excess with our staff who contributed to the wealth increase”.

The bonus of $20.7 million is equivalent to a $14.9 million after-tax effect, which is approximately 11% of the pre-bonus net operating profit after tax. The bonus
element is reasonable, and it should incentivize staff to continue performing at the higher level in the future.

The improvement in financial performance came about through improved profitability and improved productivity. In 2017, the company’s net operating profit margin – the profit margin per dollar of sales was 4.22%; this increased to 4.41% in 2018. Secondly, between 2017 and 2018, the company’s efficiency or productivity increased in that the net operating asset turnover – the sales generated per dollar of net operating assets – increased from 2.74 to 2.98.

The combined effects of improved profitability and improved productivity raised the return on net operating assets in 2018. Well done!

Let’s focus now on the shareholders. The returns on equity are 16.2% (2018) and 15.2% (2017). First, these are higher than the returns on the net operating assets above because Mainfreight’s net operating assets generated a return over and above the return paid to debtholders, thereby creating a positive spread, an additional return – called the nonoperating return – for the shareholders.

Second, the returns on equity are well above the cost of equity of 6.4%, indicating the wealth created by the management and its staff for the shareholders. Management and staff deserve the bonus!

Mainfreight’s last traded price (at the time of writing) of $25.75 is 3.63 times its book value of $7.08. The price-to-book (PB) ratio is greater than one, and it indicates that investors are optimistic that future returns on equity will continue to exceed the cost of equity.

*Jilnaught Wong is a Professor in Accounting and Finance at the University of Auckland Business School.

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