Toll Holdings Limted (ASX: TOL) was long likened to a corporate Pac-Man, seemingly eating everything in sight.

The business had a strategy which was designed to deliver success through growth – harnessing the economies of scale that come with increasing the company’s size, and the opportunity to harness incremental profits through owning more parts of the logistics supply chain.

Revenue grows, margins fall

While sound in theory, the company hasn’t been able to execute the strategy in a way that has delivered gains for shareholders. In fact, the acquisitions have seen Toll’s return on capital fall from the mid-teens to single figures in the last few years, and return on equity halve from just over 20% in the 2006 financial year to 10% last year.

The reason can be traced straight to operating margins. Toll’s business is  high-volume one, and margins were never going to be generous to start with, but after hitting a high of 13.8% of revenue in 2007, the most recently completed financial year saw operating margins fall to a 9-year low of 8.3% – in effect, a reduction of almost 40% per dollar of revenue. It’s one thing for volumes to fall, but quite another to be systematically making less and less profit out of each dollar of sales that comes through the door.

EPS becomes the victim

Unfortunately for shareholders, that margin erosion has led to an earnings per share drop of close to 40% since 2007, even as sales grew 10%. For all of the hard work required to bring more customers through the door, it has counted for nought by the time that revenue hit the bottom line.

Disappointingly, that trend has continued into 2012. Toll’s results released on February 23rd 2012 reported first-half sales of $4.4 billion, an increase of 5% on the same period of the prior year. Again, however, profits fell, this time by 8% to $161 million.

Retailing has undoubtedly suffered in the past couple of years and Toll is somewhat captive to that activity as it manages all or part of the supply chain for many large and small retail businesses. There has also been increasing pricing pressure, with carriers fighting harder for the lower freight volumes.

Poor returns on capital

The jury is out on whether this is a business that can improve with management focus, or simply one that has insufficient pricing power to achieve an adequate return for investors.

Fortunately for shareholders, Toll’s new CEO, Brian Kruger seems to understand that Toll has simply become too big and has invested in businesses that do not provide an operating return for shareholders that is sufficiently above Toll’s cost of capital.

Time for some decisions

Perhaps signalling his willingness to undo part of the previous management’s strategy, Kruger has begun reporting the capital employed for each business, and the Australian Financial Review has reported that Toll is prepared to consider offloading underperforming assets.

Shareholders can only hope that includes some of Toll’s capital-devouring divisions such as its Global Resources and Global Logistics units. If not, Toll is one business that investors should leave on the docks.

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Scott Phillips Is The Motley Fool’s feature columnist. Scott doesn’t own shares in any company mentioned in this article. You can follow him on Twitter @TMFGilla. The Motley Fool’s purpose is to educate, amuse and enrich investors.This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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