Financial targets show what ‘good’ looks like

In conversation with Nordea On Your Mind author Johan Trocmé (JT), SKF CFO Niclas Rosenlew (NR) highlights how targets tie into management's view of the long-term outlook and into the overall strategy. He also stresses the importance of targets having an ambition level that requires a strong effort to reach them.

Targets should not be used dogmatically, he says, but changed when circumstances require it, and potentially with some flexibility, should for example opportunities for major acquisitions arise.

JT: How do you decide what financial targets to use? What are the roles of group management and the board of directors, respectively? And do you have a process for reviewing targets and target levels, for example, at different time intervals?

NR: We are a big user of targets internally, which include financial targets, as well as sustainability targets and human resources targets, such as staff retention and diversity. We also have customer satisfaction targets. All of these have various different time horizons, and tie into our public, external financial targets. Our public financial targets originate in how we in group management, with input and approval from the board of directors, see the future for our business over a ten-year period. We look at prospects for different industries we serve and their growth outlook, and we aggregate this information and use it as a basis for identifying and estimating our business opportunities, which should be reflected in our targets. This is all fairly abstract, with limited visibility for such a long time horizon, but it is important for making our targets well founded and coherent. We last did this exercise just under two years ago, and it laid the foundations for our group strategy. 

We have internal medium-term targets with a three-to-four-year time horizon, which we review annually, including to ensure that they are consistent with our ten-year view. They are quite granular, reaching down to the business area level and even business unit level. Every year, we apply these, using the same target matrix, to what we call annual plans, which we use for the calendar year. In December last year, we decided – together with our board – the annual plan for 2023. We then follow up continuously and evaluate our progress with respect to our one-year, three-year and ten-year time horizons. The metrics we monitor, such as revenue growth, operating margin and return on capital employed, are exactly the same for the short-term and medium-term targets. Our targets originate with management, based on the view we have articulated, with the board of directors having an important role in approving the annual plans and being briefed and weighing in on the medium-term plans. When we set them, we want them to be relevant and appropriate for a long time period.

That is our internal world of 13 different targets. Our five external financial targets have been set to be achieved over a cycle, which can be interpreted as three to five years, and are consistent with our internal medium-term plans. Our external and internal target metrics and levels are, of course, the same, but five are external and eight are internal only. It is fair to say that we change our external targets less frequently than our internal goals. In order for us to change our external targets, there must be a clear and relevant reason for it. An investor saying in a meeting, for example, that they happen to like the EBITDA margin better than the operating margin as a measure of profitability would not prompt us to go and immediately change our existing target. Making such changes is a fairly major process, and should be done when a change in circumstance is significant enough that a review is clearly warranted. Constant tweaking would be wasteful and potentially confusing.

JT: What is your thinking around the level of ambition for SKF's financial targets? Are they more "aspirational" or are you "confident in delivering"? Have current ambition levels been affected by some historical difficulties in reaching targets?

NR: You could say that we have a basket of ambition levels for our targets. We aim to double SKF's revenues over a ten-year period. We have faced some criticism for this goal. Doubling our top line by 2030 looks like – and is – a big number. It is a directional marker showing what we are – ambitiously – aiming for. It is not a financial target in the traditional sense. It is a vision.

Our specific public financial targets are meant to be balanced, just as consultants talk about balanced scorecards. Owing to climate issues, the economic environment and business conditions, some of the targets are more ambitious than others. And how challenging each target is to reach can vary from year to year. We think this is natural, and it aligns well with our choice to define our financial targets as to be reached over time, over a cycle.

We have chosen a level for our targets which requires us to a good job in order to reach them. The targets do not represent any form of utopia. With hard work, they should be achievable. This is arguably the essence of having targets. They are a way of telling ourselves and the outside world what "good" looks like. We are sometimes asked about our 14% operating margin target – could we not do better than that? A quick answer could be "yes". Is 14% the highest operating margin SKF could ever achieve? We don't believe so. But our perspective is that if we start at a level of 12-13%, let us target 14%, and if we succeed in reaching our target, we can review it and get back with an updated view of what should be achievable in the long term. And this could be said of any of our financial targets. There is no point in having targets which you can easily beat. We are here to push and ensure that the business performs at its full potential. Equally, having targets that are so ambitious that they are almost unattainable as soon as they are introduced would be demotivating and counterproductive. Looking at our margin, growth and ROCE targets, we have been able to reach our target levels in some historical years. We know that the business can achieve those levels, but we have not yet delivered it consistently over a three-to-five-year cycle. And this is where we think we should be in order for our performance to be "good". I should add that our payout ratio and leverage targets do not require any significant stretch, but should be seen more as policy parameters. They reflect what we see as suitable and healthy levels for dividend payouts and indebtedness over time. One year, we might pay out 40% of our profit in dividends, and another year, we may pay 60%. But our board of directors considers that 50% is the sort of level you should expect over time. In recent years, we have had lower net debt to equity than our target. We have "tolerated" this, as the target is mainly intended to show roughly the level we feel sustainably comfortable with. It could, for example, give investors an idea of how much we would be prepared to stretch our balance sheet in order to make and absorb an acquisition.

JT: Do your targets feature in your regular dialogue with investors, rating agencies and lenders? How?

NR: Yes, absolutely, and it varies according to the type of investor we are talking to. Our targets help give them a frame of reference for our dialogue. Investors often refer to our targets. They often ask us about our view on the level of ambition for our targets. Our targets are also a tool for us to simplify and clarify our communication on current performance and future expectations.

I would not say that there are any disadvantages in our dialogue with investors from having financial targets. One challenge can be when you decide to change targets. The threshold for changing them can be fairly high, as there is always a signal value when you do so. Something happens, and you make a change. When talking to investors, you must be prepared and be very clear about what it is that has changed, and what has prompted you to change your targets. Investors may need to be reassured that you are not changing targets or target levels to hide anything, but because you have reassessed what level of performance can be reached in your relevant time horizon, owing to factors X, Y and Z. 

JT: What made you choose <40% net debt/equity as your leverage target? Why this metric and level?

NR: We monitor several metrics for indebtedness continuously, of course. One reason we chose net debt/equity as our only external leverage target is that it is a bit more stable than the other key candidate, net debt/EBITDA. The latter can be volatile from quarter to quarter or on a monthly basis, which can be an unwanted distraction under some circumstances. We are well aware that investors, lenders and rating agencies all pay a lot of attention to net debt/EBITDA. If we at some point going forward revise our financial targets, I would not rule out introducing a target for net debt/EBITDA. It is one of the metrics we do follow very closely, and it is a discussion we have regularly with the board. I think the core message we would like to convey with our leverage target would not change if we opted to change the metric on which we base it. We have a very solid leverage position, and we want to keep it that way. We try to be very clear and transparent in our communication to all relevant stakeholders that we want to maintain a strong credit rating score.

JT: SKF used to have an inventories/sales target, but captures working capital at least partly through the ROCE target. How has your thinking evolved in terms of what you are seeking to achieve and how?

NR: Coming back to how financial targets feature in our dialogue with investors, we are still occasionally being asked why we abandoned our inventories to sales target. Is it not important anymore? Of course it is. But we would like to limit the number of public, external financial targets we use, to minimise complexity. When choosing between targets, we consider return on capital employed more important than inventories to sales. And inventories are a key determinant of ROCE, meaning that we at least partially still capture our aim to be disciplined in this area through our ROCE target. 

There is also a time horizon aspect. In the long term, we argue that ROCE is the key metric to focus on, as it is a key and direct driver of value creation. But in the short term, one of our most prioritised internal targets is to reduce working capital, including inventories. We have not forgotten about inventories, and I would say our old external target for inventories to sales of 25% is still relevant. Today's level is around 30%, and so we have work to do here.

JT: Your target of >5% annual growth includes acquisitions, but there is no adjustment for any acquisitions in your targets for the EBIT margin, leverage or ROCE. Could there be any constraints on making attractive acquisitions from how they might affect these other targets – at least in the short term?

NR: Coming back to this concept of balance, we don't think it is necessarily wrong that the mix of targets discourages any extreme focus on only one variable to be optimised at any cost. Theoretically, you could "buy" more growth by sacrificing profitability and returns. Or you could push growth by accepting higher leverage. Sure, we could to some degree be constrained by the combination of targets we have chosen. But this isa deliberate choice, based on what we see as healthy and desirable room formanoeuvre among growth, profitability and leverage. We have put a lot of thought intoour ten-year outlook, which is the basis for our strategy. In terms of what we would want to do with the business on that journey, we expect to find a good balance with room to deliver on all our financial targets.

Should we see the potential "investment opportunity of a century", we would, of course, be pragmatic. Say, for example, that we had the opportunity to make a very big acquisition with exceptional synergies at an attractive price. The deal would ensurethat we reached or exceeded our growth target – but would reduce our operating margin well below targeted levels for several years. Then we would need to have a discussion with the board on how we view that situation. Our financial targets are clearly there to be reached. But we should not be dogmatic about them. Shocks in the outside world and the economy, or potential big structural deals, will in practice need to be considered and responded to on a case-by-case basis. I think an example of pragmatism is the debate on dividend payouts in the spring of 2021, during the COVID-19 pandemic. Some companies withheld their dividends. Others, including SKF, paid out half their dividends and withheld the other half. And some companies paid a full dividend. In our case, paying out half sent a signal of confidence under the circumstances, and made it possible for us to return when visibility had improved and resume full dividend payments.