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Capital Management: The Missing Performance Driver

Does your company measure up?

Fortnightly Magazine - September 2005

average total return to shareholders (TRS) over the period of approximately 15 percent, with an average return on invested capital (ROIC) spread of 2 to 3 percent, versus the industry average TRS of 3.2 percent and average ROIC spread of close to negative 1 percent. Empty growth was common. More than 50 percent of the industry had returns on invested capital that were less than their weighted average cost of capital over the period from 1999 to 2004, though more than 70 percent saw positive revenue growth. And these unsettling ROIC trends continue ().

Higher performers fell into two groups based on the variables that most statistically predicted their TRS performance over the study period. These two groups are what we have called capital-efficient operators and profitable growers.

  • Capital-efficient operators encompass, in particular, emerging diversified energy companies that are beginning to crack the code of commercially focused reintegration of the business across both the regulated and competitive sectors ( e.g., Constellation). These companies had an average TRS performance of 8 percent.
  • Profitable growers, which tend to be companies with "maturing" acquisitions, had an average TRS performance of 11 percent.

This performance can be contrasted against the bulk of the industry that we refer to as balanced regulatory managers with an average TRS of 6 percent. The majority of companies showing positive TRS performance fell within the capital efficient operator segment. Its lower TRS performance, relative to profitable growers, reflects some market skepticism of the value story of the diversified energy companies and the often higher current capital investment requirements to implement their strategies.

A Capital-Intensive Business

Why is effective capital management becoming increasingly critical? The industry rapidly is approaching another period of supply-side disruption and volatility while capital demands across all business segments are increasing concurrently under the need for new supply, replacement of aging infrastructure, environmental compliance, etc. This demand for capital is exacerbated by increasing interest rates and balance-sheet limits on capital.

Despite the importance of capital efficiency to high performance and a relatively aggressive "back-to-the-basics" focus on operating performance, capital management has not been addressed comprehensively by the industry. Rather than looking at the broad management and governance issues associated with effective capital management, it typically has been addressed as a budget-cutting, micro-prioritization exercise—often disconnected from its impact on long-term, bottom-line performance.

Effective capital management cannot be achieved in isolation. Capital management is part of a broad and inter-related set of management and governance processes. This set of processes typically is referred to as portfolio performance management. Portfolio management processes are the common thread between strategy and execution—and hence, are a key enabler of market success. The ability effectively to allocate and reallocate limited capital across businesses and functions is a key differentiating characteristic of high performers in capital-intensive industries.

A Need for Best Practices

Our experience with multiple types of capital-intensive industries suggests that most utilities lack best-practice capital management practices. The challenge is not one of simply adjusting the particulars of capital planning, i.e., hurdle rates, plan/request formats, and timing. The challenge encompasses all aspects