Mark Ingham: Still value left, but it’s eroding fast at shuttered-up Steinhoff

LONDON — It becomes obvious early during this interview that independent investment analyst Mark Ingham knows his way around Steinhoff’s financial statements. And he holds out hope that despite what the share market suggests, there is value in the listed company. But that depends on two things – first, he warns that the longer that Steinhoff keeps a lid on information, the greater the value destruction. And secondly, he is assuming that the “accounting irregularities” are not material in the context of the once huge business. Ingham unpacks his reasoning in this deep dive into the Steinhoff’s reported numbers. – Alec Hogg

It’s a warm welcome to Mark Ingham who joins us from Johannesburg. Mark, the Steinhoff saga has been absorbing many investment analyst’s attention. It’s something that you’ve also written a couple of notes on for Easy Equities. Just lets kick-off on the first point. You did a note on ruptured reputation. What is it about reputation that’s just so critical when you are a listed company?

Hi, Alec. Yes, I mentioned that the damage Steinhoff faces is that it’s firstly one of reputation and perhaps even more so than financial. I think we need to recall that this is a company that has its listing in Frankfurt but it’s incorporated in Holland and therefore, you’ve got a slightly different South African take on this. It’s not a typical South African board. You’ve got a supervisory board and you’ve got a management board. Now, it’s the job of the management board to provide the supervisory board with the information required to the performance of its duties. So, the management board is required to inform the supervisory board in writing of the main aspects of its strategy, its financial risks, what’s going on with the management side of things, the auditing systems, and they’ve got to do that at least once a year. From a governance point of view, they have to adhere to that.

So, the supervisory board, and Mr Wiese is the chairman of that, has an oversight role. Therefore, it doesn’t involve itself in the day-to-day minutia of the business. That’s the role of the executives. The other board, the management board, is the executive body and it’s entrusted with the management of the company’s operations, strategy, and its subject to the supervision by the supervisory board. So, from a governance point of view that’s pretty much how things work and it’s fairly similar to the German way of actually running firms. It seems as though there’s been a disconnect here, between the two. I think possibly you could maybe argue that, we actually don’t know yet but it could well be that the executive, and we’re not saying the entire executive. It may revolve around one or two individuals, and we’ll find out in due course. It maybe that the economic or the truth and disclosure, and possibly even to the degree that it bypassed the auditors so, from that point of view, I think there’s been a clear breach. The other thing to do with reputation is the balance sheet. Now, the thing about this group’s balance sheet is that it is quite goodwill rich.

What do you mean by that, Mark? Just for people who don’t understand balance sheets as well as you do, what does that mean?

Okay, it’s goodwill heavy and that’s been built up over many years because they’ve acquired a company so that’s different from property, plant, and equipment where you’ve got tangible assets that you can kick. Goodwill is, by its very nature, intangible but it’s an incredibly important of part of doing business. So, maintaining goodwill in the literal sense of the word, in the business is absolutely imperative and that speaks to customers, clients, funders, among others. You need to have confidence in the business that they prioritise or have turns with. If you look at the balance sheet, to give out €18bn of goodwill on the balance sheet, and that’s 70% of non-current assets, and plants, equipment, and property – property is quite valuable I might add, about €3.6bn. That’s 20% of long-term assets and goodwill is effectively equivalent to the total equity of the business.

In an extreme case you may assume that there’s no real equity in the business if you exclude goodwill but most companies, and I think more modern companies, which are not as fixed asset intensive as they probably would have been many decades ago, do tend to have these types of financial structures. I think in the light of what we’re seeing at the moment, it’s quite important that the company actually be proactive in managing the reputational risk and the expectations of people who deal with the company. It seems as though they’ve been a little tardy there and I think with the absence of information therefore you get a vacuum, and that vacuum is filled by rumours, conjectures, and fear because of the current situation where we’re not privy to the information. Therefore, it makes it very difficult to price risk and you see that behaviour being shown in the market and the extreme pricing pressure that the stock has been under. To the extent, in fact, at the moment that Steinhoff is valued at less than zero and that’s including the STAR asset.

Just to stop a little bit there and go into it in a little bit more detail, if I understand you correctly, because there’s so much goodwill on the balance sheet you have a requirement as a company like this to communicate aggressively to withhold your reputation but what’s happened here is sending the signal that, well, the reputation actually doesn’t exist anymore because the CEO has departed. He hasn’t said a word. The board has issued a couple of statements, which haven’t really addressed any issues on that score, and the auditor’s who were to sign off on the accounts, they’ve said, there are accounting irregularities. The Financial Times of London is making a meal of it. Other international investors would have read that and thought, ‘well, what’s left here?’ Into that breach, everything that the hedge funds have been alleging for quite some time, when I say ‘hedge funds’ those who have been short of the stock. Now, suddenly, has huge credibility if you look at it as an external observer.

I think so, and they came out with a figure the other day of €6bn in long SA assets that have yet to be verified and there appears to be no certainty of the degree to which this can be fully verified or recovered. Now, we aren’t quite sure what that refers to, and it clearly implies that you can’t take the historic audited accounts at face value. So, they’ve given no colour on that, as to what it could be, and so I think that also adds to the uncertainty that we have. As each day goes by, and there’s no proactive management of the situation that goodwill towards the company that has been built up over many years, actually very quickly falls away.

If you take a step-back, I’ve been looking at this for quite some years now and in fact, in notes to clients as far back as 2014, I advised that there was a taxation aspect when you assess Steinhoff as a whole. I referred to it at that stage to the creative brand management structure that they had, which inter alia kept the tax rate very low. I unpacked for clients, what that meant and the effect it would have on earnings and there was quite a substantial difference between the earnings I had and the earnings that the company reported, and two-years ago we had the German tax investigation, which the outcome of which is not known. I said at the time, in 2014, that I think we were looking at a transfer pricing issue here. I did indicate that there are consequences to this.

However, I had a value on the company and to me, R50 to R60 wasn’t a bad number. That’s lower than some of the target prices that have been doing their rounds and very bullish people who’ve been looking at R100 plus. I think I adequately factored in that risk and the fact that there could be aspects that weren’t quite as kosher as you may well have thought. Notwithstanding the fact that the accounts were audited. I think any good analyst should not necessarily take audited statements at face value. I think sometimes you have to dig a bit deeper and make your own adjustments as to where you think true earnings are and true cashflow.

I also, in the earnings numbers that I had done, I backed out what I estimate to be certain non-cash related items. I backed that out so, I end up, roughly speaking with an earnings number, historically that’s probably in the region of 20% plus, lower than that has been reported by the company. I reversed brand management income, the estimate thereof, and the non-cash. I also make the tax line adjustments as well, I assume a full tax, and we’ve got figures dating back quite some years on that. I’ve got figures dating back to 2002, where I’ve made regular adjustments to get what I think is a normalised figure.

Mark, why would bankers not have made these kinds of or similar adjustments and indeed, if not bankers, then active asset managers? It was the fifth most valuable share on the JSE. Why is it that these things that you’re looking at weren’t being raised sufficiently that the majority of investors didn’t take heed? I’ll give you the point on Bloomberg of 20 analysts who they polled. Not one made it a sell. The majority of them made it a buy and a few said, it was a hold but there wasn’t a single investment analyst on Bloomberg ahead of the disaster, of course, who felt that Steinhoff was a stock not to own.

Alec, although there’s a lot at the moment that we don’t know. What we do know is that these are very good businesses. Yes, we can make adjustments and what I also do is I cross-reference peers and say, ‘fine, are the figures that you’re showing comparable to a peer?’ In fact, what’s quite interesting is that even if you take the figures as published by the group, and they aren’t dramatically out of line, and even when I make a fairly big adjustment. So, for instance, let’s say they report €2.2bn in EBITDA, and I think well, perhaps a more conservative number would be €1.5bn. Then you say to yourself, okay fine, let’s take that number and then let’s again cross-reference that to peers. There’s no doubt that the group assets were sound assets. These were well managed businesses. They get a reasonable margin and so, in their own right the constituent parts of the group are good.

I think this is more of a crisis of confidence and not operational liquidity, per say. The companies are in profit. They produce operational cash but I think what’s transpired over the years is that you’ve had a flurry of share activity. The company has not been shy to issue shares so, you sometimes have to make some fairly heroic assumptions as to what the like for likes are. For instance, if you go back to 2006, there were 1.1bn shares in issue. There are now 4.23bn shares in issue, and in fact, about 2.4bn were issued in the last three years alone. They’ve had a capital raise in September 2016, they in fact, raised €2.4bn in new equity and that was over €5, plus they sold a further 152 million other shares out of group treasury but we’ve seen earnings too. Then you look at what the earnings per share rises. Are their earnings per share numbers in line with the capital that’s been raised? Are they using the capital properly?

I think from a corporate point of view, that’s been running ahead of what the underlying operating businesses are doing. They’re pretty good. They’re going about what they do every single day and doing a good job of it but I think some of the financial structures around that have got a little out of whack, and particularly with the flurry of share issuance over the years, and I think it’s always good for any management team to say, ‘what’s our run rate on capital employ?’ Are we getting a decent return on the funds that we have? So, some of that has been quite a bit hazy, given the flurry of activity that we’ve seen.

Mark, one of the issues that has been raised in this context is that there’s a lot of off-balance sheet vehicles that have been used to hide losses. So, although you’re saying, and clearly reading the income statement and the balance sheet as presented to us it did look like it was offering great value. This was a vertically integrated business model, which is very easy to understand and to see why, if it’s pumping, it will work well. Yet, there’s the allegations that it wasn’t working well but whenever it wasn’t they were just channelling those losses off-balance sheet and then raising money by issuing shares that they didn’t disclose, and using that to pump up the cashflows. When you listen to that kind of thing it’s a horror story of enormous proportions. It’s almost impossible to have worked out.

I did say in a note two years ago, it seemed that off-balance sheet structure could have been deployed but it was impossible to say with any conviction. Let’s assume, and we don’t know but let’s assume that there are these hidden losses. The question is where have those losses come from because Conforama and all these other operations, they compete in fiercely competitive markets but they compete well and they seem to appeal to a good range of customers. But the question is where are these losses coming from if they’re not actually reflected on the group P&L?

In fact, if that is the case and somehow, it’s escaped the auditors for at least ten years, or maybe even five, then clearly its an issue of management not running these businesses properly. There’s no evidence from the actual businesses that we know, who occupy the properties that are owned by the company itself. I mentioned that property values on the balance sheet is about €3.6bn. Now, that’s run as a profit centre. There’s an arm’s length arrangement and then the inhouse companies pay rent, and the yield on that is 7%. I estimate that the profits that they generate out of the actual physical property is about €250m a year. They have to be running a number of businesses extremely badly over a prolonged period of time for potentially, large accumulated losses to have built up. I can’t, based on the information at hand and the publicly available information, I haven’t got any evidence that off-balance sheet losses have been incurred. I do know though that there are off-balance sheet structures. What lies within them we will probably only find out in due course.

So, your hope, potentially Mark or the hope of shareholders, or those who are holding on, would be that somehow that’s been overstated. They do exist. There’s off-balance sheet structures, they exist. There is a concern with the accounting that’s clear. There is a CEO who’s departed and he’s not speaking. There’s a board that seems to be panicking, and saying, ‘how do we show you that we’ve got liquidity to survive?’ They’ve postponed their bankers meeting, which should have been on the 11th, in London – they issued a statement on that, but the best-case scenario from your perspective, is that yes, there is stuff there but hopefully it’s not very big?

Yes, the company wasn’t without cash liquidity. It was trading normally. I think the one thing that does worry me is that maybe there’s more debt than meets the eye. Where that’s come from we’re not quite sure. I think at the half-year there was about €6.5bn net of debt, that’s after cash, which was roughly €10bn on a growth basis. What we also need to factor into is that with the listing of STAR, the parent company, Steinhoff received cash of €1bn, and that was after year-end so, we won’t see that in the actual figures but we can add it back into the numbers. So, they got a €1bn, the parent company, and that €1bn is within Steinhoff. If all else stays the same and you had net debt of €6.5bn in March. On a proforma basis that would be €5.5bn now. They also have assets that are sustainable, very good assets, the biggest of which is PSG. That’s taken a hammering. In fact, anything that’s been associated, even obliquely, has been taking a hammering at the moment.

Why would they be taking a hammering, the stocks that are associated with them?

Well firstly, they have a big stake in PSG, at 25.7%. They’re probably going to have to realise it so, I think the price may partly be marked down on the back of that. Even Capitec was clobbered a bit. The largest single asset in PSG is Capitec, it’s roughly 50% of the value and that stake, it depends where the pricing is, but at my last count it was worth roughly R15bn so, call that €900m. Let’s round that up to €1bn, and your cap stake. They’ve got 43% of cap that’s good industrial business, nothing wrong with that. That’s valued at about €500m so, that alone, is about R5.50 combined, in fact there’s two and that’s R5.50 a share combined, and then your land and buildings are about R13 per share too.

There are assets here that can be realised. In fact, I felt for a while in fact that the property assets could be unbundled and listed potentially, but you need to have a credible and realisable value, and we need to be reassured that those values are true. So, if the situation was handled properly and we had proper management of expectations, full disclosure, we don’t quite know yet that this is what we do know and we just want to keep you informed on a regular basis. We can manage the situation but as each minute and as each hour goes by that goodwill we’ve referred to erodes, and so a business that’s on the face of it should be humming, where we are at the moment you’re almost pricing in a bankruptcy situation where in fact, there need not be one.

Again, I mention I’m comfortable with what we know from a balance sheet point of view. I’m just not comfortable with any dark things that may lurk outside of that that we may need to take into account and effectively write down. I’ve no doubt in my mind that the financials are going to have to be restated, going back some years, and then we’re going to get a clearer picture of where the true net asset value is and the degree to which this business may need to be recapitalised or to have assets sold off in order to give it the metrics that I think many people would be comfortable with.

Mark, when you listened to Magda Wierzycka, and she’s come from a completely different angle. Obviously, she’s extremely astute, she’s an actuary and has been in the financial services industry for a long time. She says that to her it’s a corporate Ponzi. That’s the way she describes it and she says it’s a Ponzi in layman’s terms, by they issued this debt, a lot of it undisclosed, raised money used offshore vehicles to pump up the profits effectively and, also issued equity that was undisclosed to keep this whole machine going. One would presume something was one step too many, it always is, if she’s right. Could this be what happened at Mattress Firm in the USA, which was their biggest ever acquisition and a massive acquisition, even in US terms?

It’s hard to say. You could get some round tripping type of stuff and that’s why I’ve always looked at the cashflows in relation to the reported profits, with a little bit of circumspection because they don’t quite add up, and that’s why I get back to my earlier point. That I tend to make a cash and earnings adjustment. I mentioned on cash and that kind of speaks to what you’re saying now. Again, we don’t know but we can surmise but if that’s been done they’ve been levitating literally, for years. Now, you can maybe do some of these exercises for a year or two but eventually it catches up with you. You can’t do it for ten years or more so, while I kind of hear that argument, I would need to be convinced as to what structures were in place so successfully for so long that they pulled the wool over the eyes of not only auditors but other financial professions as well.

Ultimately cash doesn’t lie but given the flurry of equity issues, you can tend to hide some of the drawbacks and I think the equity issuance has certainly resulted in perhaps the figures being murkier than they should be. Again, you’ve had, just in ten years, a fourfold increase in the number of shares issued but that was real cash that was brought in. I also think that there was a report that came out, which wasn’t attributed to anybody. I think if it was they may well be facing some legal challenges, a company called Viceroy, which you may have seen – Viceroy Research.

Yes, it’s well circulated.

Yes, and they referenced stuff and it reads like this novel. I felt that they add that to get to an adjusted earnings number where on the hindsight, and in fact at midpoint reduced earnings to a quarter of starting points. In fact, they subtracted something like €1bn in earnings – and they also have backed out about €300m, which they referenced as other operating income. That was 24% of their earnings and in fact, in working the numbers back that they did, I came to the conclusion that it would imply Steinhoff generating profit margins, which are significantly less than the competitors, which is very unlikely. You can write back so much that you end up with nothing, which is pretty much close to what the Viceroy report came out with. So, one can do these exercises but again, until we get proper disclosure from the company, until PwC (PricewaterhouseCoopers), who’ve stepped in also with the blessing of Deloitte, until they’ve done an investigation we won’t know and that could take some time.

Also, I think, with the tax investigation and related matters in Germany – that’s being dragging its heels. That added a separate cloud of doubt too and so, I think it’s quite interesting that you’ve now got the new auditing team in, independent arm’s length, it will be interesting to see what price PwC come up with that Deloitte’s haven’t come up with and what that will mean. I think the actual resignation of the CEO – what seems to have happened is that the supervisory board, late in the day became privy to some information possibly that they hadn’t known before. That was ahead of the results being released and probably resulted in the results being delayed. So, it will be interesting to see what they’ve unearthed and it clearly relates to actions, possibly in which the CEO was complicit, but again, we don’t know.

That’s quite a long and involved story, but you really have helped to unpack a lot of it for us, Mark. Thanks for those insights. Mark Ingham is an independent investment analyst.