All Change in the Audit World

Readers don’t need to be told that the audit profession has come in for a lot of public criticism of late. Too many unexpected failures of companies and phantom profits being reported are the cause, apart from simple inability to detect fraud. There are three important announcements today that aim to tackle these issues.

The first is the Kingman Review of the Financial Reporting Council (FRC) published by the BEIS. Sir John Kingman basically says that the FRC is not fit for purpose – it should be scrapped and replaced by a new body called the Audit, Reporting and Governance Authority (ARGA). Not exactly a catchy title but the objective is certainly clear.

He wants the new body to have wider powers and a clearer remit. He also criticises the “consensual” approach it takes to regulatory work, that it has an inappropriate culture and staff recruitment is often informal. In summary it’s a pretty damning report on the effectiveness of the FRC and how it currently operates.

BEIS have also announced a review of audit standards by Donald Brydon which will look at the quality and effectiveness of the audit market.

Plus the Competition and Markets Authority (CMA) have proposed new legislation that would separate auditor work from consultancy activities (the latter is 75% of their revenue at present) – what they call a “structural break-up”. They also suggest that audits of the biggest firms (i.e. FTSE-350) be done by 2 firms of which one must be outside the big four audit firms. This might reduce their stranglehold on the market. The CMA also proposes “more regulatory scrutiny” of audit firms to ensure that not just the cheapest audit firm is selected. Does this mean there will be a lot more bureaucracy involved? Perhaps so.

No doubt all these proposals will be subject to public consultation so they may get watered down. But surely these are moves in the right direction.

See https://www.gov.uk/government/news/independent-review-of-the-financial-reporting-council-frc-launches-report and https://www.gov.uk/government/news/cma-proposes-reforms-to-improve-competition-in-audit-sector for more information.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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It’s Not Just Blood on the High Street – ASOS et al

The trading statement this morning (17/12/2018) from ASOS (ASC) has caused the share price to fall by 40% at the time of writing. Other internet retailers such as Boohoo (BOO) fell in sympathy.

ASOS reported that revenue was up by 14% over the previous year, but warned that they “experienced a significant deterioration in the important trading month of November and conditions remain challenging. As a result, we have reduced our expectations for the current financial year”.

In effect the previous forecast sales growth for the year of 20 to 25 percent has been reduced to circa 15% (last year it was 25%). In addition margins are down which they blame on a “high level of discounting and promotional activity across the market” which they have reacted to by increasing their own level of promotional activity with more discounting and clearance sales.

They blame the weakening in consumer confidence driven by economic uncertainty plus unseasonably warm weather in the last three months. Weather is normally blamed by retailers for poor footfall in their shops so why should it affect internet retailers? It’s because it allegedly has reduced the average selling price of items purchased. But the really interesting aspect is that it is not just the UK that has suffered. Trading in France and Germany has also become “more challenging” with more promotional activity therefore required.

Note that I do not hold either ASOS or Boohoo although I have done in the past. Before this profit warning, ASOS was on a prospective p/e of 36 for the current financial year according to Stockopedia which I considered rather fanciful even given the high growth rates. Estimates will now be revised down substantially, the company is cutting capital expenditure which is always a negative sign, and they “continue to anticipate returning to a free cash flow positive position in FY20”. In other words they are still burning cash.

So it would seem that the dire stories about trading on the High Street is not just caused by the move to internet shopping. Both High Street and internet traders have been hit by declining consumer confidence, with the former also damaged by high business rates and increased staff costs.

There has been no Santa Claus rally in share prices as normally expected this year. It may be too soon to judge the outcome of all retail sales over the Xmas period but this news does suggest that there will be no Santa Claus effect there either. One has to question whether internet retailers such as ASOS will ever return to the heady 25% annual growth rates. There are too many companies getting in that game because there are no significant barriers to entry. Internet retail start-ups are spending money on marketing on the basis that they will make money sooner or later, but will they? Competition to the likes of ASOS and Boohoo can only increase.

A similar trend is being seen in the on-line estate agent market (Purplebricks et al) where competition is growing, some are giving up after running up losses, and nobody is making money due to high levels of marketing expenditure so as to grab market share.

These are markets where I have no urge to dabble in the shares of such companies at present.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Missing Dividends and the Small Claims Court

There is an interesting article in today’s FTMoney supplement about the merits of pursuing claims using the small claims court versus the financial ombudsman. The former seems to be both quicker and more effective from the comments of FT readers. My own experience of using the small claims court a few years ago was likewise positive. I complained about a headboard delivery from Dreams and after some lengthy correspondence I filed a claim in court, which is very simple to do electronically, and promptly received a response from their finance director resolving the issue. A letter from a court clearly grabs attention. To show there was no hard feelings as a result we recently ordered two new beds from Dreams and are totally satisfied with both them and the delivery process.

I mentioned the problem of missing dividends on a company held in two different ISAs back in November – see https://roliscon.blog/2018/11/21/missing-dividends/ . They have still not arrived. I could complain to the Financial Ombudsman but it might prove to be best to file a claim in the small claims court instead. I’ll give the ISA suppliers a final warning before doing so but I am certainly losing my patience over the matter.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Big Audit Firm Break-Up and Northern VCT AGM

A report commissioned by the Labour Party has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al, even goes so far as to suggest that their share of that market should be limited to 50% and that joint audits be promoted. In addition it argues that audit firms should be banned from doing non-audit work for the same company, and an independent body to appoint audit firms and agree their remuneration should be set up.

It also calls for the auditors to owe a duty of care to shareholders, not just the companies they audit, which would enable shareholders to pursue litigation over audit failings which they have great difficulty in doing at present. It is surely sensible to reinstate what was always assumed to be the case before the Caparo judgement.

These are revolutionary ideas indeed to try and tackle the problems we have seen in recent years and it seems to be now generally accepted by investors, if not the audit profession, that there have been too many major failings and the general standard is low. Even the Financial Report Council (FRC) seem to accept that view at a recent meeting with ShareSoc/UKSA.

But would breaking up the big four, effectively forcing some larger companies to use smaller audit firms improve the quality of audits? I rather doubt it. In my experience problems with smaller audit firms are just as common as in large ones – it’s just that the big companies and their audit failings get more publicity. Larger firms do have more expertise in certain areas and more international coverage. So there are good reasons to use them. But this report is certainly worth reading because if Mrs May continues to make a hash of Brexit and proves unable to stop dissension within her party we may see a Labour Government looking to implement these policies. See http://visar.csustan.edu/aaba/LabourPolicymaking-AuditingReformsDec2018.pdf . I may make more comments on the report after I have read the whole 167 pages.

Note that this issue of audit firm size came up at the Northern Venture Trust (NVT) Annual General Meeting which I attended today. This is a long-established Venture Capital Trust – it was their 23rd AGM, many of which I have attended. One shareholder voted against the reappointment of KPMG on the “show of hands” vote, and there were 1.2million votes against them on the proxy counts (versus 10.9 million “for”). It is unusual to see so many voted against such resolutions. When I asked the shareholder why he voted against I was told it was because he thought that a smaller audit firm might do better as VCTs are relatively smaller investment companies. However I pointed out that VCT legislation is very complex so it makes sense to use an audit form that is more knowledgeable in that regard.

The other possible reason for high proxy votes against the auditors is that Nigel Beer, who chairs the Audit Committee is a former partner in KPMG although he told me later that he had departed many years ago. Anyway I did raise this issue in the meeting and the fact that both Nigel Beer and Hugh Younger had just passed 9 years of time on their board. In addition, Tim Levett, who is Chairman of NVM, the fund manager, is on the board. So according to the UK Corporate Governance Code that’s three directors out of 6 who should be considered non-independent.

I urged the Chairman to look at “refreshing” the board although I did not doubt their experience and knowledge. It was also pointed out to me after the meeting that there are no women on the board. So effectively this is really a stale, male, pale board. However the Chairman said they do regularly review board structure and succession.

Other than that there were some interesting comments given by Tim Levett in his presentation. He said that due to the change in the VCT rules in 2016 they have changed from being a late staff investor to being an early stage one. In the last 3 years they have built a new portfolio of 22 early stage companies and are probably the most active generalist VCT manager other than Titan. NVM have opened a new office in Birmingham and built up the Reading office. There were also a number of new staff who were introduced at the meeting.

He also said that like all the top 10 VCTs, an awful lot of special dividends had been paid in the last three years. This was because of realisations and the VCT rules that prevented them from retaining cash. This has meant a reduction in the NAV of the trust but in future they will try and maintain that at the same time as maintaining a 5% dividend. Note: that historically it means that capital has been paid out in tax-free dividends that investors might have reinvested in the trust and hence collected a second round of up-front income tax relief. One can understand why the trust does not want to continue doing that as it may otherwise spark some attention from HMRC. I also prefer to see VCTs maintain their NAV as otherwise the trusts shrink in size which can create problems in due course as we have seen with other VCTs.

NVT are doing a new share issue in January which will of course improve their NAV and I was glad to hear that at least some of the directors will be taking up shares in the offer and adding to their already considerable holdings. That inspires some confidence that they can cope with the changes to the VCT rules that mean there will be more emphasis on investing in riskier early stage companies.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Blancco AGM and Regulatory Landscape

Today I attended the Annual General Meeting of Blancco Technology Group (BLTG). This technology company is now focused on the data erasure market which is surely a growing one. I have commented on this company before (see links below), particularly as the company, and its shareholders, seemed to be a victim of false accounting – an issue that is way too prevalent of late.

The legal framework under which companies, their directors and the regulatory bodies operate just seems to be too weak to bring errant directors and auditors to account. This is not just obvious from this case but from the discussions at the recent ShareSoc/UKSA sponsored meeting with the Financial Reporting Council (FRC). See my previous comments on the Autonomy case in addition. As you will see below, no action seems to be being taken against the former directors of Blancco by the company, although complaints have been made to the FRC and to the Financial Conduct Authority (FCA) about past events and the latter may still be investigating – but as usual feedback is non-existent. As regards the complaint to the FRC, they have passed the buck to the ICAEW (the regulatory body for accountants) on the basis that it is too small a company to be bothered with.

There were about a dozen shareholders at the Blancco AGM in the City of London. The Chairman, Rob Woodwood, opened the meeting by introducing the board. That included new CEO Matt Jones who joined in March and new CFO Adam Maloney. Rob said the last year was a period of positive change for the company, which one can hardly dispute. He said after a turbulent year, they are on a positive track.

Shareholder Bruce Noble, first queried comments on the impact of currency movements (see page 9 of the Annual Report). The CFO admitted it could perhaps have been explained better.

Bruce then pointed out that the report made it clear that management controls had been avoided in the past as a result of which the accounts were false. This resulted in the management obtaining £400,000 and shareholders losing £135 million. The board responded that investigations were on-going and as result they were unable to comment about what is being done due to “legal privilege”. Both Bruce and I complained that we did not understand that comment, and I said that they were in breach of their legal obligations to answer questions put by shareholders at a General Meeting (see my past articles on similar issues at Abcam and Patisserie). As usual they refused to respond further due to “legal advice” so I suggested they should get better advice.

As I said to the Chairman after the meeting ended, we don’t expect him to disclose their conversations with the FCA or FRC, but there is no reason why they cannot pursue a civil case against the former management if there are justifiable grounds. They need to give reasons if they choose not to do so and simply saying they wish to concentrate on rebuilding the business is not good enough. I suggested I would be voting against his re-election in future (not on the agenda at this meeting) if he failed to take action on this matter.

The above is an abbreviated summary of what was a rather long discussion on this issue.

Bruce Noble also criticised the proposed re-election of Frank Blin, who was Chairman of the Audit Committee when the past events occurred. He asked him to do the “honourable” thing and step down, which Mr Blin refused to do. Bruce also criticised the appointment of PWC to take over from the former auditors (KPMG) when Mr Blin had a previous relationship with PWC and PWC had received criticism about other audits. Mr Blin responded that the relationship mentioned was more than 6 years ago and PWC had been appointed after an open tender process. Another shareholder suggested they might get better attention from a smaller audit firm but Blin responded that they did need a firm that could cover a complex international business particularly their operations in Finland and India. Comment: I don’t think having a smaller audit firm would help – Grant Thornton has had similar problems to larger firms. There is a more general problem with the overall quality of audits which has been recognised in the national media and by many investors.

I questioned the presentation of the income statement in the Annual Report, where “adjustments” are mixed in with normal “reported” figures and confuse the reader. They will look at this issue.

We then had a brief presentation from the new CEO Matt Jones. He is clearly an experienced manager of IT businesses. He said they have good customers and good staff but were spread too thinly. They need to focus more. He will be focusing on those with good growth opportunities, namely ITAD, mobile and enterprise solutions (note: they each represent about one third of current revenue).

There was a question about cash flow and operating margins. The response was that they are making investment this year to increase growth and hence margins will come down this year, but will grow thereafter. It was noted later that the investment will be mainly in R&D and to a lesser extent in sales and marketing. The CFO said the key was to avoid major exceptionals and improve cash flow.

One shareholder raised the issue about reliance on one customer at 11% of turnover but the board expressed no concerns and it might fall slightly this year.

I asked about the competitive landscape. Answer given was the main area for that was in mobile and they are working to improve their offering to meet that.

Another shareholder questioned their presence in 26 countries – are they spreading themselves too thinly? The answer was they are not planning any cut back in the geographic perspective. It transpired later than some of their locations are only very small sales operations, even though the CEO clearly spends a lot of time on planes (incidentally he mentioned he is based in California and works from home with an office above his garage). Modern communications methods assist a great deal.

The CEO said they have adequate sales/marketing staff and productivity is improving.

Lastly a question was raised as to the apparent votes from large shareholder M&G who abstained on some of the resolutions. Does the board know why? The answer was no, and it was not clear whether they had even been asked why although the Chairman did say he had been in communication with them and other large shareholders. Could it be I wonder that they were also unhappy with the openness of the board and their apparent failure to pursue past wrongdoing?

In conclusion, it does seem that the Chairman and the rest of the board are at least taking sensible steps to rebuild the company. The new executives seem to be good appointments but we will have to wait and see whether they can actually produce the goods. In the meantime, investor confidence in the company may take time to rebuild but even so it’s still quite highly rated on the normal financial ratios. My concern is that revenue growth does not seem particularly high for this kind of business and the current valuation. But there is certainly business opportunities to pursue given the growing populations of IT and phone equipment that need erasure or disposal at some point.

https://roliscon.blog/2018/01/15/sharesoc-takes-up-blancco-complaints/ https://roliscon.blog/2017/12/20/lse-general-meeting-and-blancco-agm/

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Political Turmoil, Investor Confidence and Brexit

With the latest news that Theresa May faces a leadership challenge and recent events in Parliament, it’s worth commenting on the impact on the stock market. These gyrations have generated an enormous amount of uncertainty among investors. The result is that few investors are buying even after share prices have fallen substantially.

The general trend in the UK market is down, the pound is falling and overseas investor confidence (which is key to prices of large cap stocks) must have been damaged by the headlines that they see. Will the UK face a “hard” and damaging Brexit, or even a change to a Labour Government? Overseas investors will have even less of a handle on those risks than UK investors so are running scared.

The fall in the pound should help the profits of many UK listed companies. But even the shares prices of those companies who might benefit have been falling. That applies particularly to small cap companies. Many small cap stocks have limited liquidity and the liquidity provided by private shareholders has been disappearing as those with limited stock market experience have suddenly realised that the markets are not a one-way system where you consistently make money after ten years of positive market trends. They are taking their profits and sitting on their hands.

We are in a “negative momentum” situation where falling share prices drive further falls as trend followers ignore fundamental valuations and sell regardless. This will not change until share values start to look very cheap. The decline in US markets has also undermined investor confidence generally, and has a big influence on the UK market.

There could be a sharp recovery in share prices if confidence returns – after all the UK and worldwide economies are doing well. But confidence will not return until there is some sight as to how the Brexit problem will be resolved.

Theresa May has certainly got herself and her party into a very difficult situation. She signed up to an agreement with the EU over withdrawal that many in her party, and in the DUP who she relies upon for votes, do not like at all. Instead of simply telling the EU that the deal has to be renegotiated, as any firm leader would have done, all she has been doing is going around Europe asking for “reassurances” on the back-stop. The EU bureaucrats (Juncker et al) might have said that they won’t renegotiate it – so would I knowing that Mrs May does not have enough support to take a firm position and time is rapidly running out. But the EU needs a deal to protect its economic interests. They might hope that Britain will reconsider and stop the Brexit process altogether but that is not consistent with the views of the majority of the UK population so is unlikely to happen. Even if a general election was called over the issue, it is not clear that Labour would run on a manifesto committing to rejoin the EU as a lot of their traditional supporters do not like the EU and are affected by the unlimited immigration that has resulted from free movement of people.

The answer therefore is to replace Mrs May with someone who can provide firmer leadership including taking a risk on a “hard” Brexit with no withdrawal agreement if necessary. The latter would not nearly be so damaging as some predict and would put the UK in a very strong position to negotiate a trade deal that is in our interests (and with no complications over Northern Ireland as that issue could then be simplified to avoid a hard border).

My view is all deals are renegotiable if either party no longer supports it. Therefore we need to “withdraw from the withdrawal agreement”, i.e. repudiate it and start again. There are many aspects of the EU Withdrawal Agreement and the proposed future relationship that make sense, but some aspects of the former need changing.

Well those are my views on the political situation. Others might disagree. But so far as investors are concerned, improving confidence in the future economic and political landscape is the key to improved share prices. That seems unlikely to happen under Mrs May’s leadership however much one recognises that she has been trying her best in difficult circumstances.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Bioventix AGM, Babcock Attack and FCA Measures on CFDs

On Thursday (6/12/2018) I attended the Annual General Meeting of Bioventix Plc (BVXP) at Farnham Castle. There were about a dozen ordinary shareholders present. Bioventix develop antibodies for use in blood tests. Their Annual Report contains a very good explanation of the business.

This AIM company had revenue of £7.9 million last year and post-tax profits of £5.6 million. They did that with only 15 staff. Total director pay was £362,000 even though CEO Peter Harrison’s pay went up by 54% – but no shareholders even mentioned that. With consistent growth, good dividends and high return on capital, there’s not much to complain about here.

There is a copy of the last presentation the company gave to investors here: https://www.bioventix.com/investors/overview/ which gives you more information on the company.

I won’t cover the meeting in detail but there were a few points worth mentioning:

Peter explained that the Vitamin D antibody market is “plateauing”, i.e. unlikely to show the same growth as historically. The key product for future revenue growth is their new Troponin test for which there are high hopes, but take-off seems sluggish. This is a marker for heart attacks and is used to check when someone turns up in A&E with chest pains whether they are having a heart attack or some other problem, the former being much more serious of course and needing rapid treatment. The new Troponin test is faster and more accurate which helps speedy and more accurate diagnosis. However adoption of it to replace the older test is slow. This seems to be because hospitals are slow to change their “protocols”. There is also some competition but it is not clear how the company’s product stands against that in terms of sales. It would seem more education and promotion of the new product is required but Bioventix is reliant on the blood-testing machine partner (Siemens) to promote it and it seems there is little financial advantage in doing so to them – the new product is no more expensive than the old. That you might think makes it easy for customers to convert to the new, but also provides little motivation for the supplier to promote. However, NICE and others are promoting the new tests. That’s a summary of what Peter explained to the shareholders with my deductions.

It would certainly be of advantage to patients if the new test was adopted. Might have saved me hanging around in A&E for most of the night a few years back just awaiting confirmation I had not had a heart attack.

There are other antibodies in the R&D pipeline although it can take 5 years from R&D commencement to product sales, even if the product is adopted. All R&D is written off in the year incurred though.

There were questions on cash and special dividends which the company sometimes pays. The business is highly cash-generative but they like to keep about £5 million in cash on the balance sheet and no debt so that they can take up any acquisition or IP opportunities.

On Friday (7/12/2018), there was an interesting article in the Financial Times on the attack on Babcock International (BAB) by Boatman Capital Research – a typical type of attack by an anonymous blogger probably combined with shorting. The article quoted an investor as saying “Boatman made some valid points…..but there were whopping inaccuracies which seemed calculated to drive the share price down”. For example, the article mentioned claims about overruns on a contract to build a dry dock at Devonport – there is no such contract.

Babcock has been trying to find out who Boatman Capital are, but with no success at all. The organisation or its owners cannot be located, and their web site is anonymised. So Babcock cannot even sue the authors. They may well be located overseas in any case which would make it even more difficult. Babcock share price has been falling as a result and is down 20% since the Boatman report was published. See the FT report here: https://www.ft.com/content/c2780d6e-f942-11e8-af46-2022a0b02a6c

Comment (I do not hold Babcock shares): The Boatman report seems to be the usual mixture of a few probable facts, mixed with errors and innuendo as one sees in such shorting attacks. There have been a few examples where such reports did provide very important information but because of the approach the writers of such reports take it is very difficult to deduce whether the content is all true, partially true, or totally erroneous and misguided. The shorter does not care because they can do the damage regardless and turn a profit.

The basic problem is that with the internet it is easy to propagate “fake news” and get it circulated so rapidly that the company cannot respond fast enough, and regulators likewise – the latter typically take months or years to do anything, even if they have a channel they can use. We really need new legislation to stop this kind of market abuse which can just as easily involve going long on a stock as going short. Contracts for Difference (CFDs) are one way to take an interest in a share price without owning the underlying stock and hence are ideal for such market manipulations.

Which brings me on to the next topic. The Financial Conduct Authority (FCA) has announced proposals to restrict the sales of CFDs and Binary Options to retail investors. Most retail investors in CFDs lose money – see my previous comments here on this subject: https://roliscon.blog/2018/01/14/want-to-get-rich-quickly/ . The latest FCA proposals are covered here: https://www.fca.org.uk/news/press-releases/fca-proposes-permanent-measures-retail-cfds-and-binary-options

You will note it contains protections to ensure clients cannot lose all their money and positions will be closed out earlier. But leverage can still be up to 30 to 1. The new rules might substantially reduce losses incurred by retail investors, the FCA believes.

But it still looks like a half-baked compromise to me. If the FCA really wants to protect retail investors from their own foolishness, then an outright ban would surely be wiser. At best most CFD purchasers are speculating, not investing, and I cannot see why the FCA should be permitting what is essentially gambling on stock prices. It creates a dubious culture, and the promotion of these products is based on them being a quick way to riches when in reality it’s usually a quick way to become poorer.

You only have to look at the accounts of publicly listed CFD providers to see who is making the money – it’s the providers not the clients. Those companies seem to be mainly saying the new rules won’t have much impact on them. That is shame when they should do and shows how the FCA’s solution is a poor, half-baked compromise.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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