Better Information or Wiping-out Traces? – The Re-Segmentation Financial Analysis Problem

Change is part of doing business. Today more than ever. And where there is change in the business there is also need for change in the reporting structure. IFRS 8 (Operating Segments) requires companies to disclose more or less detailed information about their operating segments. Important: This reporting should be based on internal management reports (the so called “management approach”). US-GAAP (FASB ASC 280) follows basically the same rules, with some differences in the details (for matrix organisations and regarding the disclosure of liabilities). All in all, a new structure of operating segments also entails a new reporting structure in both reporting systems.

This “management approach” should allow analysts and investors to put themselves into the shoes of management and align their forecasting structure with the internal view of those who run the firm. This is a nice idea in theory. However, as always, in practice things are not that simple. Lagged decision making processes in companies, motivations to present the company’s state rather positively or simply unclear or often changing corporate structures can make the life of an investor quite complicated. And there are a couple of situations where particular caution is necessary for everybody interested in the real value drivers of a company. That is why we think it is necessary to discuss some of the typical cases of the “corporate segmental reporting game” below. Here we go:

• The slow Reporting-Adjuster: Sometimes, the change in overall economic exposure is simply too fast for companies for both internal and external reporting adjustments. E.g., Trimble Navigation Ltd., a California-based, Nasdaq-listed technology company focussing on positioning and geospatial solutions, has been running a real buy-and-build business model over the last 15 to 20 years. The company acquired more than 60 other companies and kept their original product-based segmentation over time. As a matter of course, the steadily increasing number of different products/solutions resulted in an extremely complex reporting structure and consequently in a steadily decreasing transparency of the real value-drivers of Trimble. It took until 2017 that the company switched from the product-based reporting approach to a clearly much more transparent and investor-information-requirements-oriented customer segment reporting approach.

• The high-frequency Re-Organizer: Sometimes companies have to find their way of structuring the company even when there is no change in the overall exposure of the group – and some managers need a long time for doing this. The consequence is a constant periodical re-segmentation until the group has reached its best-solution state. Bad thing for investors: A retracement of the performance of single business units on a comparable basis over time is nearly impossible, with an accompanying strong deterioration in investors’ forecasting ability. A case which once funnily “exploded” in a now-famous analyst call was that of E.ON SE in May 2012. Since the beginning of this decade the German utility company tried to find a good place for its European gas business which was undergoing strong structural changes due to the new market price orientation of a former bilateral-contract business. In the Q1/2012 call, a (here unnamed) quite experienced analyst couldn’t hold on. He took the very first question of the Q&A section and started with: “I’ve got two questions and a request. I’ll start with a request to make myself popular. Could you please make sure you don’t change the reporting in the next quarter? It would be nice because it’s all a bit complex to understand where your gas earnings are going.” And with this he spoke from the heart of basically every other person in the call. E.ON management seemed to be a bit surprised by this request but promised to keep the structure now ongoing (I have been in the call myself, but I quote here from the ThomsonReuters Streetevents Transcript). And E.ON did so for quite some time. Some said later that E.ON didn’t dare to change the structure again (but this is only anecdotal information that I got).

• The high-level Aggregator: Sometimes companies feel as too much information for investors is perhaps not good for keeping the picture of own performance. What could be more useful than swamping some of this information in the bigger picture? Malaysian Airline System Berhad (which later went into technical bankruptcy not far after the well-known lost MH370 plane in March 2014) already found itself in a quite tough competitive environment challenged by budget airlines in 2013. Since 2011, costs clearly exceeded revenues and drove the company into a deep loss-making situation. So, as part of its Q3/2013 reporting change the company decided to put a lot of the general overlying cost categories such as advertising (so far reported in detail) into a big cover-it-all cost position. No possibility to retrace their development over time anymore for investors (and to gauge the future benefits thereof). By the way: There is a strange coincidental side-note to this particular Q3/2013 analyst call where investors criticised a lot the new intransparency: One analyst complained that these cost components “just magically disappeared” (Source: ThomsonReuters Streetevents Transcript) – he chose these words less than 4 months before the MH370 plane has in fact been lost under mysterious circumstances and is not found until today despite the most costly search in aviation history so far. Magical disappearance, part 2.

• The internal/external Diverger: Sometimes manager do not really follow the ideas of IFRS 8. Why not setting a reporting structure that is different from the internal management perspective (at least for some time)? It sometimes comes in quite handy that transition is always a tedious process. Comet AG, a Swiss industrial X-ray solutions and semiconductor industry supplier which is also running a surface sterilization business, once reported to investors in four segments (X-ray modules, X-ray systems, surface sterilization and Plasma Control Technologies) while the internal organisation focussed on only three segment (X-rays, radio frequency surface sterilization) – at least this was the situation to our knowledge of 2017.

• The bad-performance Hider: If a lot works quite well for the group but the ONE segment (from which the company originally expected perhaps a lot) does not perform, managers sometimes feel that it is better to hide away the weak segment within the rest of the business. Consequence: On average the performance still looks quite good and – importantly – now the spotlight-effect on the weak segment (which seemed to be so important before) is gone. For analysts and investors it is then extremely difficult to make a sound forecast on this segment (which would be so necessary for a sound analysis as this segment performance is exactly NOT in line with the overall drivers of the group). The Germany-based Adidas AG, one of the world’s largest sports equipment manufacturer, acquired the US sport equipment company Reebok International Ltd. in early 2006 for roughly 3.8 bn USD. This acquisition did not prove to be successful. The Reebok unit showed heavy losses in the quarters after the acquisition (despite Adidas could even highlight not-insignificant cost and even revenue synergies to the group). In fact, in Q3/2009 Reebok was showing almost survival-critical losses on a stand-alone basis. As a consequence, Adidas decided in Q4/2009 to change its reporting structure and to integrate Reebok as part the other core business. Since then it was not possible for investors to clearly retrace the performance of this business unit. Adidas explained this by an internal reorganisation but for investors this led to a big loss of transparency – namely as the brand still exists today. And to make this clear here: The separation of business units is of particular relevance (Sic!) for investors if they show different performance paths. If segments perform in line to each other (probably because of the same drivers and end-markets) then investors do not need a separation – but then management can also run them jointly. We guess that Adidas really planned to change the Reebok case to be run in the context of the other Adidas brands. But we doubt that still today it can level-up with the rest of the Adidas business.

A more recent case is the re-segmentation of Koninklijke Philips NV since the beginning of 2019. Philips still reports in its three segments (Personal Health, Diagnostics & Treatment and Connected Care) but with a quite different mix of sub-segments. This reorganisation follows a shift in management’s understanding of running the company – before as a product-focus one and now a solutions-driven one – which is understandable but which also masked the performance situation of one of the main weak spots of Philips: The Connected Care business which recently experienced massive negative margin slides. The new sub-segment composition (e.g. the relatively high growth, ca. 1.6 bn Euro revenue-heavy “Sleep & Respiratory Care” moved from Personal Health into [some say: has been stuffed into] Connected Care; Healthcare Informatics, however, has been shifted away from Connected Care) combined with a rather qualitative explanatory approach for the sub-segments makes the situation for many analysts more opaque than it was before the re-segmentation.

• The non-economic Splitter: Sometimes management has a totally different view than investors on what matters in terms of structuring down the company for reporting reasons. While this might be explainable simply by a certain management approach towards the running of the company, this is often not very-helpful for making sound forecasts – in particular if this is combined with the already above discussed “high-level Aggregator” approach. And it is often a special case of the “internal/external Diverger” approach. Admittedly, this is not a typical re-segmentation case (as no re-segmentation takes place) but rather a missing-re-segmentation case. Siemens Gamesa Renewable Energy S.A., a German-Spanish wind turbines producer, structures down its reporting into two segments: Wind Turbines and Operation & Maintenance. However, the Wind Turbines segment services two totally different solutions: Onshore-wind and offshore-wind. The growth prospects for the two different solutions are quite heterogeneous with offshore being the clearly stronger growing one. Additionally, management even admitted that margins in offshore are higher than in onshore. But when everything is reported as one, it is not possible to clearly identify future mix-effects and adequately apply multiples to the different business exposures. A sound analytical basis for investors would certainly require a more granular split. This is even more so true as we think that either the company is run in a different way than reported (split into offshore and onshore) or management here simply follows a not so smart internal segmentation approach.

But sometimes in such cases, if investors only complain enough, their voices are eventually heard. Clinigen Group plc., a UK-based specialty pharma company, runs along with its core business a well-scalable platform business that aims at improving customers’ access to all Clinigen products (and which is particularly attractive for users of unlicensed medical treatment). For many years now investors have requested to more clearly highlight the growth and value prospects of the integrated unlicensed business. And just recently, in September 2019 the Clinigen-CFO finally commented in the full-year earnings call: “…something I believe that many analysts has been asking for, for quite a while, is moving to a divisional EBITDA reporting structure and something we will have in place by the end of this financial year.” (Source: ThomsonReuters Streetevents Transcript). Obviously, engagement works! Perhaps Siemens Gamesa also needs a bit more of investors’ activity in the coming months.

• The Bonus-Optimizer: What is more attractive for management than making use of a re-segmentation for optimizing its own performance basis? No matter, whether it is about remuneration or about only other internal measurement reasons. Just a couple of months ago, the Swedish-Swiss ASEA Brown Boveri (ABB) Ltd., a robotics and automation technology company, changed its reporting structure. As part of this move the former “Robotics and Motion” segment (former EBITA margin target: 14-19%) is now split down into a) Robotics & Discrete Automation (new EBITA target: 13-17%) and b) Motion (new EBITA target: 14-18%) (Source: ABB group strategy update presentation, 28 February 2019, slide 51). This is obviously clearly less demanding than it was before. While we have to admit that there are some cost allocation issues from overhead to the divisions, we still think that the re-segmentation came along with some less ambitious segmental performance hurdles.

With this list, we just chose some quite illustrative examples for the most often seen problem areas. There are many other such examples out there for each and every case. And we also find a lot of cases which at our opinion mix different motivations. But as a matter of course we do not want to hide here that there are also some good examples of re-segmentation.

A nice example of where many investors (including me) where wrong but which turned out to be a very smart way of re-segmentation is the case of French utility company Veolia Environment S.A. in 2014. The company changed its way of running the business and reporting from the seemingly well-logical activity-base (water, waste, power) to a geography base. While this initially looked like making things much more complicated for investors, it turned out to be a very good way of adequately accounting for the different utility-specific challenges in different jurisdictional regions and also gave country managers much more of the required decision power and clearer incentive structures. Well done Veolia, I was wrong.

And sometimes it is also the good old standards themselves which help to improve the presentation. When in early 2018 German specialty chemicals company Lanxess decided to put the highly cyclical Arlanxeo rubber 50%/50% joint venture with Saudi Aramco into non-continued operations for formal reasons – only as an intermediate step to put it into at-equity accounting later (that was the communicated plan at that time) – this immediately highlighted the very stable nature of the rest of the business, only by reclassification. Lanxess later in August 2018 announced that they have in fact sold the Arlanxeo stake to JV-partner Saudi-Aramco, but the big step in visibility enhancement was already taken before.

To summarize: Segment reporting can be a powerful tool for investors to base their analyses and forecasts on the way the company is run in reality. But – as always in financial reporting – where there is a good basic idea of standard setters there are also two major risks areas: a) that companies make use of the rule in order to mislead investors or b) that economic circumstances simply speak another language than the standards prescribe – even if it is only about intertemporal comparability. So, stay alert with segment reporting in general and with re-segmentation in particular. It is certainly not a pure substitute of own critical analyses of the real drivers of the company, not at all!