Government To Review Share Buy-Backs

The BEIS Department of the Government has announced a review of share buy-backs. That’s where the company buys its own shares in the market, a practice that used to be illegal but is now very widespread.

Business Secretary Greg Clark said: “…there are concerns that some companies may be trying to artificially inflate executive pay by buying back their own shares. This review will examine how share buyback schemes are used and whether any action is required to prevent them from being abused.”

If a company buys back its shares, then it will increase the earnings per shares (EPS) because the same profits will be spread over fewer shares. But EPS is often an element in the calculation of performance related bonuses, e.g. in LTIPs. So effectively management can earn bonuses by simply deciding to buy back shares rather than really improving the underlying performance of the business.

Obviously cash has to be used to buy back the shares, and another concern is that this is money that should be used to develop new products, services or markets. In other words, it contributes to the lack of investment in the UK economy. In extremis companies can borrow money (i.e. gear up) to provide the funds to cover the buy-back which increases the risk profile of the company.

There is also the suspicion that some companies undertake large scale buy-backs to support their share price, often encouraged by institutional investors who wish to exit. The directors always deny this, but one can see the sub-conscious motive to “clear-up a share over-hang” that may be present. In practice, share buy-backs may benefit shareholders who are departing more than they benefit shareholders who remain.

In theory, if a company cannot find a good use for surplus cash, i.e. cannot reinvest it in the business profitably, then buying in shares where the per share intrinsic value of the company is more than the market share price should make sense. But determining what is the “intrinsic value” is not at all easy.

There are also tax issues to consider. Some investors think it’s best to retain the cash in the business because paying it out in dividends might incur more tax, and sooner, than the capital value growth that might otherwise be obtained.

You can see there are many complex issues around this topic that could fill a book, or at least a pamphlet. But here are some comments on the approach I take:

  1. I always vote against share buy-backs unless there are very good justifications given by management (and that’s about 1 in 20 votes in practice).
  2. The only general exception I make is investment companies (e.g. investment trusts) where it does make logical sense and can be used to control wide discounts.
  3. I prefer management to reinvest in growing the business if they have surplus cash (and as I rarely invest in no-growth businesses, you can see why the above rules are easy to apply).

If the advisors to the Government determine that share buy-backs are being undertaken for the wrong motives, what could they advise the BEIS to do about it? Reading the minds of directors about their motives for share buy-backs will not be very practical. If they simply wish to stop the abuses related to incentive schemes they could insist that all such schemes (including all share options) should be adjusted for the buy-back – they often are not at present. But would it not be simpler just to revert to the old regime and outlaw them except for investment companies? I do not recall it created any major practical problems.

If a company’s shares consistently trade below “intrinsic value” then someone will buy them sooner or later – after all many people believe in the perfect market hypothesis and it’s probably true to a large extent – particularly with large cap companies where share buy-backs are the most common. So simply banning share buy-backs should not create significant problems.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

VE and Pre-Packs

There was an interesting report in today’s FT on the case of Ve Interactive, a UK company once allegedly worth more than $1 billion (at least they had several hundred employees) which went into administration after making heavy losses. It is alleged that CEO and founder David Brown mismanaged the company and he has subsequently be made bankrupt.

The business was taken over by a consortium of investors (including Douglas Borrowman and Mark Pearson) some of whom became directors before it went into administration. It was subsequently sold quickly to those directors via a pre-pack (for £2 million).

But the administration (by Smith & Williamson) has been challenged in court and they have been removed by the court. Mr Brown and two former members of the consortium mounted the challenge based on the claim that the administrators were “completely blind” to the conflict of interest in selling the business to the directors. They also claim the sales process was mishandled and bidders only had one day to make an offer. They say there was no chance of a meaningful bid being made because of insufficient information being provided to potential buyers. Ve Interactive is now trading as “VE” and is owned by Ve Global UK Ltd.

At least that’s the gist of the story so far as one can understand such complex events.

In essence this is a typical example of a pre-pack administration which I have commented on many times in the past. A business is sold in extreme haste, often to related parties as in this case. The process happens so quickly that there is no chance of adequate marketing of the business to get a fair price. The administrators can ignore anyone but their chosen buyer and deter them by restricting information and giving them little time to raise finance or adequately consider the matter.

In summary, pre-packs are ethically dubious, legally corrupt and should be outlawed as soon as possible. As I said only recently in an article about events at Carillion: “Regrettably in the UK, insolvency law seems to have been devised mainly in the interests of insolvency practitioners and bankers. It is time for a complete reform of the law and practices in this area.”

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

More on EMIS Profit Warning

A few days ago I commented on the announcement by EMIS Group that warned about a failure to meet customer service levels and a possible hit to profits as a result of up to £10 million. As I said at the time, I wrote to the Chairman and asked several questions. Today I received a response by letter from Peter Southby, CFO. He has been there since 2012 it is worth noting.

The letter was the typical “brush-off” that individual investors tend to receive – for example it commenced: “I am afraid we are not able to respond to questions from individual shareholders on this matter for standard reasons around customer confidentiality and commercial sensitivities”. So I phoned him up and reassured him I was not seeking inside or price sensitive information. He then proved more amenable. This is what I learned:

The failure was to meet service level agreements with NHS Digital for the GP software (EMIS Web). The current contract was signed in 2014 but there was a previous similar contract.

EMIS discovered the problem themselves, following a review of customer services, rather than the client reporting it. The issue is a “low level” service issue, and not a critical item to the customers who have not been impacted significantly. The problem was not known to senior management until it was recently reported (certainly the CFO was not aware of it). It is not currently known how long the failure to meet contract terms had been running. They are working to get back within the contract terms as soon as possible. As regards the past failure and associated financial liability, it is possible the customer will accept an alternative rather than a cheque – for example, provision of software enhancements. But that is subject to negotiation.

EMIS have an active “user group” and the problem has apparently been discussed with them already.

In my original note I suggested auditors KPMG might have been at fault for not picking up this problem in their last audit, but it does sound as though that might not have been possible. However I suggest that is a question to be revisited later and it still leaves the issue of major risks not being noted in the Annual Report.

In conclusion, the problem may be less serious than first apparent, although there is still a risk in this kind of situation that more issues may be discovered the more investigations are performed. Will have to wait and see for the moment.

One thing I am certain about though, which is why I like the company. The GP end-users would hate to switch to another software product. Admittedly EMIS will have to negotiate their way out of this difficulty with NHS bureaucrats rather than end-users but when an on-going relationship of some years standing is in place, then some horse trading is the usual outcome. I’ll have to ask my GP what he knows about this problem next time I see him.

Just one final point: If you get the kind of response I got, then it’s always worth a phone call. Personal contact can make the difference.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

The Market, Renishaw and ASOS

We seem to be in one of those markets where investors are nervous because of a few big failures, some market commentators being bearish and the uncertainties caused by Brexit. While some of the “hot” stocks continue to power upwards, and the overall market trend in the UK is still positive, it only takes the slightest ripple to cause some stocks to fall sharply. That particularly applies to those where prices seemed to have got ahead of fundamentals.

Yesterday (25/1/2108) Renishaw (RSW) issued a trading statement. The figures were positive with adjusted earnings per share for the last 6 months to end December up by 75%. Forecasts for the full year were given as profit before tax to be between £127m to £147m which on my calculations matched the consensus forecasts of analysts for the full year. The share price promptly fell by 14.5% on the day.

Why the abrupt fall then? Well another announcement on the same day from the company contained the news that Sir David McMurtry, founder and Executive Chairman (age 77) was handing over the CEO role to William Lee (age 42). But Sir David is remaining as “Executive Chairman” with responsibility for “group innovation and product strategy”. No great change in reality then! Will Lee joined the company in 1996 so the culture is not going to change is it. Perhaps investors were disappointed that Sir David is not handing over more responsibilities with a view to retiring. Who knows?

Renishaw is in the business of selling metrology products and other high-tech engineering solutions such as additive manufacturing. It has a very global spread of revenue and is benefiting from the falling pound. But it was on prospective p/e of 34 for the current year before the price fall, which is now more like 30. Perhaps investors suddenly realised that the price was high, and succession issues remained.

I have been following the bad habit over the years of selling Renishaw when I thought the price was too high, and buying it back when it retreated. That’s probably cost me a lot of money in the long term. But as the price has now fallen back to well below when I last sold some shares, I bought them back today.

Another company with a trading statement yesterday was ASOS (ASC). This is not a company I currently hold but I have briefly in the past. ASOS reported group revenue for the 4 months to end December up 30% with a particularly strong showing in the EU. Even the UK improved by 23% when most other UK general retailers are reporting dire figures. It rather demonstrates the way the market is changing with shoppers, particularly the young, moving on-line.

But they do have a few more elderly customers. For example I recently bought a fedora hat from them as I thought it interesting to try out their service. Certainly a low price and very quick delivery but otherwise unexceptional in terms of “user experience” and could even be improved.

The share price rose 3% on the day and for the current year and next the prospective p/e’s are 73 and 59. There are many on-line competitors (Boohoo is a similar one in terms of target customers which I hold), and not many barriers to entry so I find it difficult to justify such high valuations years into the future. So I think I’ll stick with shopping with them rather than buying the shares.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Quindell, Carillion and Brexit

The Financial Reporting Council (FRC) have announced that they have fined audit firm Arrandco (formerly RSM Tenon) £750,000 and the Audit Partner Jeremy Filley £56,000 in relation to the audit of the financial statements of Quindell for the 2011 accounts. They also “reprimanded” both parties and Tenon had to pay £90,000 in costs. Both parties admitted liability. Two of their errors were a “failure to obtain sufficient appropriate audit evidence and failure to exercise sufficient professional scepticism”. In other words, quite basic failings. The FRC is still looking into other issues that do not affect those parties.

So after seven years shareholders in Quindell have finally seen some action. But the penalties are hardly sharp enough to cause the targets any great suffering. Quindell which was primarily a claims management company, and a favourite of many private investors, had accounts that were in essence grossly misleading. For example, the FRC reported in 2015 that the restatement of its accounts in 2013 turned a post-tax profit of £83 million into a loss of £68 million. Revenue recognition of future contracted profits was one issue.

Now I never held Quindell despite having looked at it more than once. One thing that put me off was talking to someone about the previous involvement of Rob Terry, CEO of Quindell, in Innovation Group. The FT have a good article on his previous career here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . I also did not like the look of the accounts at all and the recognition of revenues. Paul Scott, that well-known commentator on small companies, said yesterday: “…its accounts were fairly obviously highly suspect. Excessive debtors, excessive capitalisation into intangible assets, and a flurry of acquisitions to muddy the waters, are the usual give-aways of fake profits, so these dodgy companies are really terribly easy to spot.”

In essence, just a little background research combined with some understanding of accounting, would have put off most investors. But both private and professional investors (even institutions were fooled by Quindell) do not put in the work, or get carried away by the management and company promoters. Rob Terry has yet to be brought to account for the events at Quindell.

There was an interesting letter in the Financial Times yesterday signed by a number of people including Martin White of UKSA. It said the blame for Carillion’s demise was causing fingers to be pointed in all directions, but most are missing the real culprit – namely that faulty accounts appear to have allowed Carllion to overstate profits and capital. This enabled them to load up on debt while paying cash dividends and big bonuses to the management.

One problem again was recognition of future revenue from signed contracts, but the letter says “anticipated revenues from long-term contracts cannot count as distributable capital, and foreseeable losses and liabilities need to be taken into account”. Carillion effectively reported profit that was “anticipated”. They suggest KMPG’s audit should be investigated as I also said in a previous blog post.

The letter writers suggest that faulty standards mean that today accounts cannot be relied upon and the results for all stakeholders can be devastating. Indeed the fall-out from Carillion is going to be really horrendous with potentially thousands of small to medium size businesses that relied on sub-contract or supply work from Carillion likely to go bust. The letter writers suggest that Carillion is yet another “canary in the coal mine”. Perhaps when MPs get deluged with letters from disgruntled business owners and their out of work employees, they will actually get down and demand some reform of the accountancy and insolvency professions.

Incidentally I never held Carillion either probably because it was mainly in the “construction” sector which I avoid because of low margins, unpredictable and “lumpy” revenue and high risks of projects or contracts going wrong. It also had the Government as a major customer which can be tricky. So from a “business perspective”, such companies are bound to be risky investments.

Another good letter in yesterday’s FT was on the subject of Brexit from Dr Ian Greatorex. It said “For too long, some FT contributors have peddled the line that Brexit is the result of a “populist” backlash that might be reversed”. He restated the “remainers” causes for why they think they lost the vote, but then said “The main reason I voted to leave, often based on FT reports over the years of reported EU mess-ups, was that I believed EU institutions lacked proper democratic control and were complacently trying to create an ever-deeper political union against the instincts of the average voter………”. It’s worth reading and good of the FT to publish a more sober letter on the subject than they have been doing for some months. Perhaps the FT have finally realised that not all their readers are so opposed to Brexit and that the reason a number of educated and intelligent people supported it was for factors other than the possible trade difficulties that will need to be overcome.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Carillion, EMIS and KPMG

Now that the dust has settled somewhat after the demise of Carillion (CLLN), it’s worth adding some more comments to my previous blog post on the subject. Ultimately it went bust for the same reason most companies do – it simply ran out of cash and could not pay its debts as they became due. As I said before, it collapsed eventually because of ballooning debt, poor cash collection and risky contracts.

Unfortunately it seems that private investors were some of the biggest losers in this debacle. Big investors had either bailed out, hedged their exposure or were actually shorting the stock. According to a report in the FT retail investors held 16% of the shares through Hargraves Lansdown towards the end, 7% on Barclays platform and 7% on Halifax meaning that overall they must have held a much higher proportion of the shares than in most large companies. It would appear retail investors are suckers for a “cheap” stock, or those that are paying nominally high dividends.

As Terry Smith of Fundsmith says in his recently published newsletter to investors, which is well worth reading, he is “asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not”. He looks at the latter rather than former when investing.

Why did Carillion go straight into liquidation rather than administration? Apparently there was very little cash left in the business and potential administrators were concerned about getting paid. Administration was of course devised as a way to keep companies trading and hence protect jobs and the business of suppliers while potentially enabling it be restructured and sold in due course. Liquidation is an abrupt process where the liquidator just closes everything down immediately. In both cases, trade and other unsecured creditors, plus shareholders, usually end up with nothing although there is some flexibility and more chance of repayment in an administration. In Carillion the Government is picking up responsibility for its own contracts with the company, and the associated jobs may remain, but all others are likely to face severe difficulties and many smaller suppliers may go bust. That applies even to those contracts where Carillion was only a “partner” in a larger consortium.

Now there is one similarity between the two. Administrators or liquidators, and the major secured creditors (normally banks) to which they report, are as keen to dispose of any assets as soon as possible so they can get paid (or recover their debts) quickly. Hence any assets get sold very quickly, often to related parties at prices that the original owners think are ridiculously low. I have written extensively in the past on the abuses associated with “pre-pack” administrations where this problem is particularly rife as there is often little or none “open marketing” of the assets.

Carillion is a very good example of what is wrong with insolvency law in the UK. Carillion employed many skilled staff and some parts of the business may have been viable but the whole lot was brought down by a few dubious contracts taken on at low margins by incompetent management. The damage, and associated costs, of this debacle will be enormous – and in this case will fall on the public to a large extent as the Government has had to step in. Is there a better way? It is my opinion that the Chapter 11 process in the USA is much better. It does enable a company to be protected from its creditors before it gets into an impossible situation, i.e. it allows time for restructuring. The result for ordinary shareholders may not be a lot better, and jobs will be lost, but for everyone else it is superior.

Regrettably in the UK, insolvency law seems to have been devised mainly in the interests of insolvency practitioners and bankers. It is time for a complete reform of the law and practices in this area.

One aspect of Carillion that has been raised is whether the company should have obtained a clean audit report less than a year ago (auditors were KPMG). One thing auditors should report on is whether the company would be likely to be going concern for the foreseeable future – and that typically means more than one year. Otherwise the accounts should be “qualified”. Were the financial difficulties and potential cash flow problems not already apparent to the auditors and to the directors of the company? Is this yet another audit that the Financial Reporting Council (FRC) should be looking into?

EMIS Group (EMIS)

Yesterday, EMIS Group, issued a trading statement and a note on a “review of customer and product support processes”. The share price dropped 20% on the day. EMIS provides medical software and services to GPs and the NHS. It is one of my longer standing holdings, so I am none too happy about this. It’s one of those issues that however diligent one is as an investor, one can get caught out on.

What’s the problem? It seems that “certain service levels and reporting obligations with NHS Digital” have not been met. The financial impact might be up to £10 million which is about a third of last year’s profits.

I have sent the following note to the Chairman to try and elucidate the issues (I’ll advise subsequently on the answers):

“I was of course most disappointed to read the announcement of today’s date regarding “customer and product support processes”.

I would like to receive more information about the nature of the contracts that have resulted in the large potential liability. I understand you are still assessing the potential liability but the announcement should really have spelled out the nature of the commitments that seem to have been made by the company previously, and which have not been adhered to. I am also surprised that such a large liability is being announced when no apparent claim has been received (at least none is indicated), and no financial loss to the third party concerned is being reported.

I also question why the potential liability and risks associated with the relevant contracts were not disclosed in the Annual Report for the year ending December 2016. Indeed there is extensive discussion of “risk” in the business in that document and the risks the business face were apparently reviewed in that year by the board of directors. The risks of all kinds were generally reported as “low”, when it seems that a major undisclosed risk was being run.

One could also question why the audit by KPMG failed to identify this apparently major defect in the company’s systems and accounting for the liability. Did they not review this aspect of the company’s activities?

Lastly there is no indication in the announcement as to how long this failure which has caused the potential liability has been going on. Perhaps you could answer that question, and also indicate whether it may be necessary to restate past accounts.”

As noted above, KPMG were the auditors to EMIS as well as Carillion so this is yet another company where perhaps the FRC should look into the audit. My opinion is that investors should be able to rely on the published accounts of a company but all to frequently of late we see that this is not the case. Grossly misleading accounts resulting from incorrect if not fraudulent revenue recognition (Blancco, Redcentric, Globo, Quindell – you can probably name others), or over optimistic statements about the financial health of the business (possibly Carillion, and HBOS) are simply too common.

Auditors often say investors expectations of what an audit can achieve are too high. But surely there is something fundamentally wrong with their processes if such major failings are not identified?

One other aspect of this problem is I suggest the use of aggressive bonus schemes, particularly LTIPs, that can pay out many times the base salary of executive directors. The result is an incentive to report higher revenues and profits and to conceal the bad news from the company’s shareholders. This may have been a factor at both Carillion and EMIS. Incentives of some kind are all very good if they motivate appropriately. But when they are such a large proportion of the likely remuneration, they distort behavior in the extreme, often with perverse results.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Carillion Goes Into Liquidation

Carillion (CLLN) has gone into liquidation. No messing about with “administration” – it’s gone straight into liquidation with a receiver being appointed. The Government may apparently take over direct responsibility for some of the contracts that Carillion operated to provide public services, but it is unclear what will happen to the commercial contracts. Up to 43,000 jobs are at risk. In addition, many other companies are at risk who acted as suppliers to Carillion because as trade creditors they are likely not to get their debts paid.

Why did this £5.2 billion revenue business collapse? In essence ballooning debt, poor cash collection and risky contracts. The construction sector has been one with low profit margins in the last few years (builders seem to take on work just to help their cash flow from advance payments regardless of the likely profitability according to a conversation I had with a director of such a company). But building anything is risky and the bigger the projects, the bigger the risks. Managing such complex projects (such as building part of HS2 which is a contract they won) is tricky however experienced you are. Time over-runs can kill you, and fixed price contracts are anathema in any business, but the Government tends to insist on them.

This was and is the kind of business to avoid investing in however cheap it looks.

Needless to say, the equity shares in Carillion are now almost certainly worthless.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.