When looks can be deceiving

As happens four times per year in global equity markets, publicly-listed companies recently reported their results for the third calendar quarter of 2018. This is not only an enormous undertaking for the disclosing businesses, it is also a busy time for equity analysts and fundamental investors who carefully dissect disclosures looking for new insights.

When multinational businesses report their revenue growth, many also report their rate of “organic” revenue growth which is often a different number. Organic revenue growth typically eliminates the distortions of acquisitions and divestitures; as well as any changes due to currency translations which are often volatile.

Why report this organic growth rate? Generally, this is a helpful data point for fundamental investors. You see, not all sources of growth are created equal.

If I grow my revenue line by $100 as a result of investing $2000 in new capital equipment or an acquired business, this is actually low-quality growth and likely value-destructive. If I own a business in the US which is not growing at all, but given the recent deterioration of the Australian dollar, appears to be growing when the results are translated into Aussie dollar terms, this is also a low-quality and non-persistent source of growth.

Whereas, if I can grow my revenue line organically, say, by increasing prices, then this is a wonderful source of growth. In the case of a price rise, the incremental revenue translates into pure incremental profit; and no capital investment was required to achieve this. It is organic forms of revenue growth that translates into higher returns on invested capital. And ultimately, it is high returns on invested capital that increase the value of a business over time.

But as is the case with most accounting metrics, there are instances when even good-looking organic revenue growth can be deceiving.

One such instance was observed in recent weeks when Kimberly-Clark (NYSE: KMB), owner of Kleenex tissues and Huggies brands, reported their quarterly results.

Now, Kimberly-Clark is a true multinational. Headquartered in Dallas and listed in New York: the company generates roughly half of its revenues outside the United States. Much of Kimberly-Clark’s international revenue stems from markets including Eastern Europe, the Middle East, Africa, Latin America and Asia Pacific.

During the quarter, Kimberly-Clark delivered organic sales growth of positive one per cent. This was in line with guidance and was likely the bare minimum rate of organic growth deemed acceptable by the market. But scratching beneath the surface, even this positive one per cent may be a little misleading.

On the company’s conference call, management referred to very high rates of organic sales growth in segments based in Brazil, Argentina and Eastern Europe. And organic sales growth in these regions are meaningful contributors to the company’s overall reported organic sales growth.

But these countries are experiencing significant inflation and associated currency depreciation. Australians know something about currency depreciation with the Aussie dollar falling from around 80 (equivalent US cents) to around 71 over the last year or so. Well, in the case of Brazil, the deprecation in the currency is like the Aussie falling to around 60; or as low as 40 in the case of Argentina.

Reporting high rates of organic sales growth in high-inflation regions is misleading. While it is true that the rate of growth is high in local currency terms, it is also true that local currency costs are also inflating; and any profits generated will be worth a lot less given the currency devaluation.

Organic sales growth is typically a high-quality source of growth. For Kimberly-Clark last quarter, their reported positive rate of organic sales growth was anything but.