Once a market darling, EOH now finds itself on the unwanted list after admitting to long-time allegations of corrupt activities. It’s now obvious departed founder Asher Bohbot’s acquisition spree ended up biting hard. The story rings like a lesser Steinhoff, fortunately without the equivalent of Bernie Madoff’s “17th floor”. EOH’s newly in-spanned CEO Stephen van Coller has had to navigate the ship through these choppy waters, while simultaneously cleaning the decks. Analyst Ryk de Klerk commends Van Coller and his team, but says while the group is busy healing the market remains unimpressed. De Klerk holds no financial interest in EOH or its BEE partner Lebashe. His analysis was first published in Business Report. – Stuart Lowman

EOH is healing, will the 37% discount to NAV narrow?

By Ryk de Klerk*

The market is seemingly unimpressed by the cleaning up by EOH Stephen van Coller, the new CEO. The news media also has a field time as accusations of wrongdoing and assumptions continue to fly.

But what is really behind the stock’s implosion? Are there other market forces in play that are causing an abnormal market in EOH shares?

EOH’s success story as measured by its once rocketing share price, eventually led to a growth at all costs strategy. Its highly rated paper allowed the company to overpay for assets with shares, resulting in goodwill and intangibles going through the roof. Goodwill and intangibles as a percentage of shareholders’ interest grew to 74% in FY 2018 from 64% in 2013. It was 81% at the 2019 interim stage. Since 2014, 40-50% of the increase in capital employed was financed by borrowings. 

While the company was able to achieve a return on the incremental capital employed of more than 15% – 50% higher than the prime overdraft rate – in 2014 and 2015, margins were squeezed in 2016 and 2017. In a rising interest rate environment the company was barely able to achieve returns higher than the prime overdraft rate. Total borrowings as it increased to 55% of shareholders’ interest in 2018, up from 35% in 2013. Borrowings were secured by trade debtors and cash and near cash assets.

The falling margins, increasing competition and untenable borrowings position put the company under severe strain. The company’s share price collapsed by 76% from R172 at the end of the 2015 financial year to R41.5 at the end of the 2018 financial year.

On 12 March last year, as part of a proposed BEE transaction to enter into a long-term strategic partnership with Lebashe, EOH would establish a R5bn domestic medium term note programme (“DMTN Programme”) pursuant to which EOH Notes would be issued by EOH and listed on the interest rate market of the JSE. “Pursuant to the Lebashe Facility, Lebashe shall undertake to subscribe, at EOH’s request, for EOH Notes up to an aggregate nominal value of R3bn, …”. This would have alleviated the debt burden of EOH as the company’s long-term and short-term borrowings reached R3.1bn and R1.3bn respectively at the 2018 interim stage.

Yes, maybe the white knight had arrived.

It seemed Lebashe and/or its financiers got cold feet though, as the final transaction excluded the R3bn funding as envisaged in the proposed transaction. Instead, the agreement entailed a total equity investment of R1bn whereby Lebashe would initially subscribe for R250m worth of new shares at a 10% discount and a subscription for R750m worth of new shares at a discount of 10% to prevailing market prices in 3 tranches over a 12-month period. Furthermore, 40 million “A” shares would be created by EOH and issued to Lebashe for a nominal sum of R1.

The 40 million “A” shares issued to Lebashe are effectively European call options which are exercisable four years from now at a strike price of R90 per share but the shares have voting rights as if they were ordinary shares. To date the total number of shares issued to Lebashe amounts to 22.494 million shares at an average price of R33.34 per share – consisting of the initial issue and two of the three tranches of R250m each. 

Lebashe is committed to hold the 7.371 million EOH ordinary shares subscribed for in the initial issue for five years after the subscription date. According to the Circular to Shareholders in August last year the shares issued in the three tranches subsequent to the initial issue “… will not be subject to any disposal or encumbrance restrictions …”

The total number of shares subscribed for in the first two tranches amounts to 15.1 million. Lebashe’s current holding in EOH equals an average of 2 month’s volume (June 2018 to January 2019) traded in EOH on the JSE. Lebashe would have felt very uncomfortable when Microsoft South Africa terminated partner agreements with EOH in February this year, specifically after subscribing for 8.3 million EOH shares on 11 December last year.

At a price of R17 per share, Lebashe’s impairment on the shares subscribed for so far is already more than R360 million. It is reasonable to expect that Lebashe and/or their financiers would have and still are managing their position to limit losses.

Perhaps the tail that is wagging the dog or EOH’s share price movements at the moment is Lebashe’s obligation to take up the third tranche of R250m worth of shares before 1 October 2019, a year after the implementation date. The price will be at a 10% discount to the 30 day volume-weighted-average-price (VWAP). No announcement on the take-up of the third tranche has been made on SENS yet.

Lebashe therefore has a call option to the value of R250m that can be exercised at any time until 30 September by issuing a notice to EOH offering to subscribe for EOH ordinary shares. The 30-day VWAP of EOH is currently sitting at R20 per share. At a discount of 10% it means that EOH will issue approximately 14 million new EOH ordinary shares to Lebashe.

Should Lebashe issue the notice today or in coming days it will mean that the average price Lebashe has paid for its holding in EOH will be R27.50, spot on EOH’s net asset value at the 2019 interim stage.

But what about EOH as a company? Will it survive the onslaughts? From the 2019 interim results it became clear that the company would have been in serious trouble if it was not for the R750m capital injection by Lebashe. My “debt death cross”, when total borrowings exceed shareholders’ interest, would have set in.

The funds raised by the sale of 70% of CCS (R444m) and other asset sales of R110m in the next 6 months as well as the Lebashe’s pending subscription for R250m worth of shares are likely to underpin EOH’s net asset value of R20 plus per share. Yes, even after allowing for another impairment of R1bn.

Van Coller and his team of advisors should be commended for what they are doing and have thus far achieved under extremely difficult circumstances. Allegations of wrongdoings and other negative news will probably continue over the next few weeks and are likely to work in favour of Lebashe.

At some point the market in EOH shares will normalise. It is unknown what the situation with EOH shares is in regard to script lending or short positions – where money is made by selling an asset not owned by the seller. The normalisation of the market in EOH shares is likely to lead to the covering of short positions and reversals of script lent.

As trust is earned, it may take a long time before the company may once more attain a market capitalisation of several multiples to its net asset value. What is certain though is that EOH is healing. So when will the 37% discount to net asset value narrow?

• At the time of writing the author held no financial interest in Lebashe or EOH. Ryk de Klerk is an analyst-at-large. Contact [email protected]. His views expressed above are his own. You should consult your broker and/or investment advisor for advice.