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EDINBURGH — The Steinhoff scandal has hammered investments far and wide, as unit trust fund managers and other money managers failed to spot signs of trouble in the dual-listed company and held onto the share on behalf of their clients. Questions have been asked about how it is that professional investors at Coronation, Foord, Sanlam and other investment houses did not notice there were irregularities in the Steinhoff financial statements. In this piece, seasoned stockbroker Nigel Dunn sets out some ratios that should have been examined by experts assessing their weightings of Steinhoff. He notes that Steinhoff’s aggressive approach to tax should have set off alarm bells. Dunn warns, too, that there are probably lots of Steinhoffs out there right now as the investment herd fixates on earnings growth. – Jackie Cameron
By Nigel Dunn*
WHO MOVED MY SHARE PRICE?
I have borrowed the title from the book by Andy Andrews and Ted Black; if not on investors’ shelves. I would highly recommend it. A quick read in language all can understand, it sets out a father’s guidance of a son embarking on his first job interview; and the questions he should be asking of management. It is ostensibly the story of Dimension Data, (DDT); irrespective, it is as pertinent today, as it was then. Bar rumoured accounting irregularities and possible fraud in Steinhoff, (SNH), the parallels between DDT and SNH, are uncanny. Acquisitive businesses that grew rapidly and culminated in offshore listings, both being large enough to be included in the indices of their jurisdictions – being London and Frankfurt respectively.
DDT listed on the JSE in 1987 at 150c per share, it peaked at over 7000c in July 2000 upon listing in London and inclusion in the FTSE. Thereafter it fell from grace. It bottomed below 300c before being bought out by NTT in 2010 at 1300c and delisted. I am not going to detail the history of SNH; Figure 1 below shows the price from the late 1990s to the implosion this week
What I would like to look at is the simple ratio Andy Andrews and Ted Black focused on in their book, namely ROAM, (return on assets managed).
ROAM is derived from two ratios: EBIT margin * Asset turn.
EBIT: (earnings before interest and tax)
ROAM = EBIT margin * Asset turn
This ratio marries up both the income statement and balance sheet, which too many often view in isolation. Analysts tend to fixate on earnings, (income statement), often ignoring the health of the balance sheet; which in effect is the engine of the business; one must look at both. Could we have foreseen a problem with SNH using these simple ratios? I have looked at the period 2005 – 2015.
The income statement looks fine; the trend in EBIT is slightly up if anything (Figure 2); the red flags should have been triggered immediately one married up the income statement with the balance sheet; asset turn has halved over the period, (Figure 3), reflecting a sharp deterioration in ROAM, (Figure 4). Alerted one should be digging deeper; especially if earnings have been rising; as that could only have come through acquisitions.
Figure 5 confirms that immediately; intangible assets now account for 43% of total assets; in 2005 the figure was zero; shares in issue have trebled. What has been the effect on ROCE, (return on capital employed)?
There have been persistent concerns over the low tax rate; never satisfactorily answered by SNH management; a quick look:
The tax rate has been consistently low; normalise it and earnings and by definition returns are negatively impacted, similarly the cash generated by the business. If not satisfied with management’s explanation; make the adjustment; if only to satisfy yourself the revised multiples and returns are acceptable. The acquisitive spree has been financed through a combination of equity and debt; see Figure 8.
Post 2015 SNH report in Euros; I am not going to include another batch of graphs; suffice it to say that the trends have not changed for the better; in most cases worsened; intangibles are now slightly more than half fixed assets; up from 43%; the debt equity ratio has climbed to 39% (14%).
What I have done is compare SNH in Euros to Ikea, the iconic brand that is generally regarded as the leader within this space. Ikea is not listed; however they do provide enough financial information to make some comparison possible. I have used the SNH results for the 12 months ended 31 March 2017; Ikea for their F2016 year.
The comparison is instructive on many fronts; Ikea’s operational metrics are superior to SNH on all counts. In addition they are sitting with net cash of €16bn on the balance sheet vs. net debt of €6.5bn in SNH. In other words a more profitable, more conservatively funded company with a tax structure that does not look aggressive.
In summary: SNH has been a business with deteriorating operational metrics for years, earnings growth being mostly acquisitive. ROAM has fallen; ROCE has halved as has asset turn; the tax structure looks aggressive; there were sufficient signs flagging caution. In growing earnings acquisitively a basic principle of Buffett’s has been overlooked, namely:
“Price is what you pay, value what you get.”
Some general comments in ending. This has been a catastrophic failure at multiple levels; many analysts have fixated on earnings growth at the expense of the “driver” of growth, that being the balance sheet. They work in unison; not in isolation; overpaying for assets has resulted in a burgeoning balance sheet inflated by intangibles that is struggling to achieve acceptable returns; possibly cash as well; it might explain rumoured accounting irregularities and possible fraud; a need to “paint a better picture” than there was, so their cost of capital did not increase.
Investors are not off the hook either; such is the premium they place on instant returns. Many management teams feel compelled to make decisions that are short term in nature; often to the longer term detriment of the business. Fund managers equivalent is to herd and track momentum, value being less relevant; in the case of passive index trackers; irrelevant. Non-executive directors must shoulder some of the blame; they are there to act as a check and balance in the business, not as an echo chamber.
Perhaps certain things were “hidden” from them, however there is no escaping the fact asset turn for one has been trending lower for years. Capital has been poorly allocated; that is obvious in the falling ratios, be they ROCE or ROE. Government are not blameless; the current political scenario is providing corporates with very little, if any, incentive to invest in South Africa; unfortunately in looking abroad many are ignoring value and the basic principle that the initial price paid for an asset determines its return in perpetuity or until disposed of.
Central banks are also at fault. Interest rates are far too low and have been for a long time; see Figure 9 below for the US; Europe is no different. When your hurdle is marginally better than zero; most investments look attractive; the folly of many will only become apparent when interest rates normalise; economies slow down, or some combination; the worst being rising rates and slowing economies. Given central banks are so far behind the curve; that is a not inconceivable possibility; a hiking of rates when growth is about as good as it gets.
It is worth pointing out to critics of active fund managers invested in SNH that passive index funds were also exposed to SNH; the only difference being the fee structure and exposure; they lost money at 35bps rather than 100bps. Passive investing does not insulate investors from an implosion of a large high profile company included in an index. In reality in an era where valuations are rich; investing in a passive index tracker heightens risk. I am concerned: Is SNH the Bear Sterns moment of 2017/2018?
I do not believe for one moment SNH is going to be unique. The world is addicted to cheap debt; corporate and investor greed pervasive; the industry inundated with financial engineers; and an investment community where many have a tenuous grip on valuation; price is what you pay for the value of future expected cashflows from an asset discounted at an appropriate rate; not hope; vision or any other feel good factor.
Money has been cheap for too long. When that happens, people do silly things as the cost of overpaying for assets is not penal; at least at first. In time unproductive balance sheets struggle to do the lifting required, be it earnings to sustain multiples, generating cash to service debt or offer investors an acceptable return on their capital. A hiccup can quickly morph into a full blown credit crunch. We may be witnessing one now; sadly I suspect it won’t be the last. When both components are looked at in conjunction, ROAM is a useful ratio that alerts investors to possible – not certain – problems; conversely opportunities. It is not a timing tool, and should not be viewed as such.
- After graduating with a B Com Honours, Nigel Dunn moved into stockbroking close on three decades ago. He has been a registered member of the South African Institute of Stockbrokers since 1994. He started his career in 1987 advising individuals, moved to research, company specific and of a strategic nature, before settling in fund management, both for private clients and pension funds. He was a partner of Anderson Wilson, subsequently acquired by Standard Bank, where he became a director of Standard Equities. Thereafter he moved to Investec Securities where he managed funds for private clients, family trusts and helped on the corporate broking desk. Most recently he has been managing discretionary funds for clients, proprietary trading in addition to generating his own corporate research. Of late he has started to write articles of a market related nature intended to stimulate thought and debate.
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