Brexit, HBOS, Globo and the FRC

Is it not heartening that the Brexit divorce bill, and other terms, have been settled? The exact cost is unclear but it could be up to £40 billion – a lot of money you may say! However, the fact that the key negotiators, Mrs May, Barnier et al, all looked somewhat glum about the deal when announced perhaps tells us that it was a compromise in which both sides had to concede ground. Or perhaps they were just tired. The terms of any future arrangements including trade deals still need to be worked out so it’s a long way from being concluded.

Now that £40 billion figure, sounds a lot, even if it is spread over some years. Hard line brexiteers will be unhappy. But it’s all relative. For example the annual UK Defence Budget is over £35 billion and rising. In addition, I have just read the Financial Reporting Council’s report on the HBOS audit and you can see there on page 7 that HBOS had to write off £63.3 billion in loan losses. That was only one smaller sized UK bank. According to the Bank of England, the financial crisis that affected HBOS caused £7.3 trillion of losses in total in the UK.

The report from the Financial Reporting Council (FRC) on the audit of HBOS is a quite tedious and turgid document. To remind you, HBOS was a bank that almost went bust after making imprudent commercial property loans financed by short term debt. When Lehman’s collapsed and debt became difficult to raise, HBOS had to be supported by the Government and then bailed out by a merger with Lloyds TSB. The latter’s shareholders are currently pursuing a claim against the company and its directors over that event.

The reason the audit of HBOS was examined by the FRC was because the company obtained an unqualified audit report suggesting that it was a “going concern” when it soon turned out to be otherwise. These events date back to 2008 – that’s 9 years ago which shows the speed with which the FRC typically operates.

One interesting comment made in the FRC report is that it suggests on page 11 that liquidity support from central banks may be considered “a normal funding source…..and therefore reliance on such support does not mean that the bank is not a going concern…..”. As banks with a positive balance sheet are usually assumed to be eligible for “lending of last resort” from the Bank of England that might mean that HBOS would be considered to be a going concern even if it ran out of cash (which is the reason most banks go bust, not because of defective balance sheets – Northern Rock is a good example).

The report also refers on page 29 to “market expectations” at the time. Market participants did not expect the financial crisis to get worse which affected the auditor’s views. So now we know why the FRC let the auditors of HBOS (KPMG) off the hook!

As I mentioned in a blog post a couple of weeks ago (see https://roliscon.blog/2017/11/22/standard-life-uk-smaller-companies-and-frc-meetings/ ), I attended a meeting with the FRC organised by ShareSoc/UKSA. One of the issues raised was the lack of feedback from the FRC on the progress of investigations. I followed up with one of the speakers after the meeting, specifically about the case of Globo. I asked what was the status on the investigation of the audit of their accounts by Grant Thornton. As readers may know, Globo was a company that went into administration in 2015 after it was revealed that the revenue of the company was probably fictitious (see https://www.sharesoc.org/campaigns/globo/ for details). The report of the administrators made it clear that the cash on the balance sheet of Globo plc seemed to have disappeared, bringing into doubt the preceding audit report on that ground alone let alone the revenue recognition issue.

The FRC announced an investigation in December 2015, i.e. two years ago. What have the FRC been doing, when will the investigation likely conclude, are there any preliminary conclusions, etc, etc? All of these questions are very relevant as the answers might provide the basis for legal action by shareholders against the auditors and others. After several email exchanges with FRC staff, the only answer I managed to elicit is that the investigation is on-going. It has not even been turned into a “Formal Complaint”.

The reason more information could not be supplied is that it might prejudice “the overarching requirement for fairness”. My response was “I really do suggest that the FRC needs to reconsider its policies in this area. You have too much emphasis on treating those who have been complained about (i.e. auditors) fairly, while those who have complained are treated unfairly. This rather suggests, as we already knew, that the FRC is dominated by auditors who are the people it is supposed to be regulating”.

You will be amused to read in the FRC’s Publication Policy document (para. 3) that “Transparency contributes to public confidence in independent disciplinary arrangements….” but then proceeds to spell out all the restrictions it imposes that thwart it.

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

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National Grid, Johnston Press, Crown Place VCT, Lloyds Bank, LoopUp and Brexit

I had a busy day yesterday, but let me first comment on the news today. National Grid (NG.) published their half year results this morning. They reported “Adjusted operating profit, excluding timing up 4%….” but statutory earnings per share were down by 12%. What exactly does “adjusted for timing” mean? I have no idea because the announcement does not explain it in any sensible way. For example, it says under “UK Timing”: “Revenues will be impacted by timing of recoveries including impacts from prior years”. Why are these revenues not being booked in the relevant period? Why are they not being recognised as revenues in the period concerned? Looks like a simple “fudge” to me as “adjustments” to reported figures in accounts often are. Many analysts seem to have a negative view of the stock, and I am coming to the same conclusion. I sold some of my holding in the company this morning.

I have previously mentioned the requisition of an EGM at Johnston Press (JPR), but the company has rejected this on the basis that it is “not valid”. It seems this is because the shareholder who requested it holds their shares in a nominee account (i.e. are not on the register). Yet another example of the obstruction caused by the use of nominee accounts. Changes to the law in this area are required to fully enfranchise all shareholders. See the ShareSoc Shareholder Rights campaign for more information: https://www.sharesoc.org/campaigns/shareholder-rights-campaign/

Yesterday morning I attended the AGM of Crown Place VCT, managed by Albion Capital. No excitement there. Just a competently managed VCT and a well run AGM with a presentation from one of their investee companies (PayAsUGym) who have developed an innovative business selling gym sessions. Crown Place made a total return of !4% last year and currently provide a tax free dividend yield of 6.9% which is covered twice by earnings. The expense ratio is 2.4% which is certainly better than many of the VCTs I hold. Previously this company had a strong focus on “asset-based” investments but they are now restricted by the new rules for VCTs so they are moving into more “exciting” fields. There are also concerns about further rule changes or removal of tax reliefs in the budget next Wednesday. Investors in tax incentivised vehicles seem to be getting nervous.

After lunch with representatives of AGMInfo, I filled an hour or so before the ShareSoc AGM by dropping into the Lloyds Bank legal action nearby which I have mentioned in previous blog posts. On the witness stand was former CEO of Lloyds TSB Eric Daniels being cross examined by the littigants QC. He gave a confident performance and was clearly well prepared. He said he was “bitterly disappointed” over the need to raise £7 billion in capital and was also disappointed that they would end up more highly capitalised than other banks. It was clear from his other comments that there was a certain momentum to go through with the deal (the acquisition of HBOS) and that they did not revisit the benefits of the transaction at every turn (e.g. as more information came out of the due diligence work for example).

He disclosed that in a conversation with the FSA there were real concerns that they could lose the vote of shareholders. This could be because there were views that HBOS could remain independent, although the Government had already indicated that it was promptly going to be nationalised if no rescue deal could be done; and because Lloyds TSB shareholders might vote against it.

The case continues. Lloyds Bank and the former directors continue to say that the claims have no merit of course.

It was then onto the ShareSoc AGM. Again no great excitement there. Mention was made of a possible merger with UKSA and as a former director of both I spoke in favour of that. Spreading the fixed costs over two organisations of a similar size makes a lot of sense. It should never have been necessary to set up a rival organisation to UKSA, but interesting to note that ShareSoc has more members now so my efforts in recent years were not in vain.

The ShareSoc AGM was followed by one of their company presentation seminars. Of interest to me (being current holders) were the two by LoopUp (LOOP) and Ideagen. I reported on Ideagen recently on coverage of their AGM so will only cover LoopUp herein. The presentation by their joint CEO Steve Flavell was slick but it was more a sales pitch for the product/service to customers than one to investors. The issue of them having two joint CEOs was raised in a question later.

The emphasis was on the simplicity of the service, so anyone could take it up easily and quickly. This is the major USP as there are lots of other conferencing products around. Most interesting was his explanation that they leapfrogged the “chasm” by ignoring the early adopters (who often like techy products) by aiming straight for the “mainstream majority”. His reference to “Crossing the Chasm” is from a book of that name by Geoffrey Moore which is essential reading for all sales/marketing executives in the software field, or investors in early stage technology companies likewise. Just had a chat with an Uber driver about this book – he has a degree in marketing – that’s the modern world for you. It will be a great shame if Sadiq Khan manages to put Uber out of business – might miss out on intelligent conversations with cab drivers. I read the book when it first came out back in the 1990s and Mr Flavell had read it also. I highly recommend the book. LoopUp is clearly a sales/marketing driven organisation but the technology is sophisticated enough to make it all look simple.

On the current valuation, the company has obviously a long way to go to grow into that valuation. Questions were raised about whether growth could be accelerated (revenue only up 39% in 2016m and 44% in the interims this year). But I expressed scepiticsm on attempts at a faster growth rate to Flavell after the meeting.

The Financial Times continue to publish anti-Brexit stories and editorial every day. My letter to the editor on the dubious bias, which they published, has obviously had no impact whatsoever. Tim Martin, CEO of JD Wetherspoon, had a lot to say about the subject of the impact of Brexit on food costs in his latest trading statement. He accused the media, and the Chairman of Sainsburys and that of Whitbread, and the head of the CBI, for completely distorting the facts. Rather than food prices rising after Brexit, he suggests they will fall. For his arguments see:

https://www.investegate.co.uk/wetherspoon–jd–plc–jdw-/rns/fy18-q1-trading-update/201711080700068513V/

My conclusion is quite simply that some foods might become more expensive, others might become cheaper, and home-produced products might also be cheaper; plus the Government might be able to save a lot of money on contributions to subsidising inefficient farmers. But that of course means that food buying habits might change as consumers react to price changes. Is that a bad thing? Readers can ponder that question.

Whether the Chairmen or CEOs of public companies should be making comments on essentially political issues, one way or the other, is also a question to consider. I suggest that might best be left to bloggers like me. Sainsburys and Whitbread (Costa, Premier Inns) might find they disaffect half their customers while having minimal impact on public opinion.

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

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Why I Still Won’t Invest in Banks

I do not hold any bank shares at present, and have no plans to change that policy. But I thought it would be worthwhile to look at the results announced by Lloyds Banking Group (LLOY) yesterday for the third quarter. That particularly is so now that the revelations about the HBOS takeover are coming out on a daily basis.

The announced results were positive. The prospective dividend yield on Lloyds is now near 6% and the p/e is about 9, which is all that some investors look at. But I learned from my experience of investing in Lloyds and RBS before the financial crisis of 2008 to look at the balance sheet.

The latest figures for Lloyds Banking Group show total assets of £810 billion and liabilities of £761 billion, which you might consider safe. But if you look at the asset side there is £161bn in “trading and other financial assets at fair value”, i.e. presumably marked to market. They have £27bn in “derivative financial instruments”, which Warren Buffett has called “weapons of mass destruction”, and £480bn of “loans and receivable”, again probably marked to market.

Shareholders equity to support the £810bn of assets is £49bn. Which does not strike me as particularly safe bearing in mind what happened in the financial crisis. For example, that small bank HBOS, which Lloyds bailed out, eventually wrote off £29.6bn alone on their property loans after everyone suddenly realised that their lending had been injudicious and the loans were unlikely to be recovered in full.

In addition, banks can conceal their assets and liabilities as we learned at RBS and more recently in the Lloyds case. Indeed tens of billions of loans from Lloyds and others to HBOS were concealed and hidden from shareholders in the prospectus with apparently the consent of the FSA.

So I follow the mantra of Terry Smith of Fundsmith who said in 2013: “We do not own any banks stocks and will never do so” having learned from my own experience that it is a very risky, and cyclical sector. I am not convinced that improved regulation, and better capital ratios have made them “investable” when one can invest in other companies with far fewer risks.

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

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ADVFN Results and More on Lloyds

ADVFN Plc (AFN) published their results for the year to June yesterday. I have a very small holding in the company (acquired for reasons I won’t go into). ADVFN are information providers on the stock market, primarily to private investors. Many people monitor their bulletin boards although like many such boards frequented by private investors, they are somewhat of a curate’s egg so far as serious or sophisticated investors are concerned.

But they certainly have a large following – they say they have 4 million registered users. Does this enormously large mailing list ensure they have a profitable business? In reality no.

Indeed last year they barely managed to break even (£47k operating profit) on £8.2 million of turnover. That is however a massive improvement on the previous year when they lost £650k on similar revenues.

At least they showed postive cash flow but the net assets of the company are £1.7 million so they have a long way to go before they show a decent return on the capital employed. Current liabilities also exceed current assets. At least they have changed their strategy so as to stop further investing with a focus on “profits rather than growth”.

Regretably this kind of business model just shows that private investors are reluctant to pay money for good information provision. Folks can sign up a lot of “free subscribers”, which is no doubt ADVFN’s customer base, by spending money on marketing but monetising those eyeballs is another matter altogether. Relying on advertising to do so is also getting more difficult as Google and social media platforms are tending to dominate that market.

The other moral of this story is that one needs to be wary of investing in companies with unproven business models. It’s easy to spin a good story about the enormous demand for a given service, but the real proof of the pudding is when the model generates profits (and cash as well of course). Companies like Uber and Deliveroo appear to be chasing the same mirage. Lots of people like the services and are willing to pay their low prices, but whether they can compete profitably is another matter.

Lloyds TSB/HBOS case. My previous blog post was on the topic of the current legal case being heard in the High Court. One of the witnesses called in the case is Hector Sants, former head of the Financial Services Authority (FSA) at the time of the takeover of HBOS by Lloyds. His evidence is to be heard in secret, for reasons unknown. Indeed, even the fact that this was to be so, was kept secret until challenged by media organisations.

Why is this relevant? Because it was suggested at the time that without the takeover of HBOS, Lloyds would not have had to raise extra capital (and it was that which diluted shareholders interests). But the FSA told them they would still have to raise more capital even if they did not proceed with the takeover. Some shareholders allege that this was a forceful encouragement by the Government to go ahead, regardless of the interests of their shareholders. Perhaps that might have been in the public interest, as was similarly argued on the re-capitalisation of the Royal Bank of Scotland (RBS) and other banks, which was effectively a partial nationalisation. But many shareholders are more concerned with their own immediate interests rather than the public interest although it could possibly be argued that ensuring no melt-down of the UK financial sector took place was also in their interests. So Mr Sants evidence might be very revealing about the motives and actions of the Government, but the public may not learn much about it, even at this late date.

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

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HBOS and Lloyds Legal Case

This week sees the start of the legal case in the High Court by investors in the Lloyds TSB over the acquisition of HBOS – opening submissions are on Wednesday and it’s scheduled to run through to March next year. Anyone can attend these hearings of course but I think it will take a very patient person to sit through all of it. I have submitted written evidence on behalf of the litigants (represented by Harcus Sinclair) but it seems I am unlikely to be called for cross-examination by the defence which is somewhat disappointing.

I cannot comment further for that reason, but the claim is in essence based on the allegation that relevant information was not disclosed in the prospectus that was issued at the time in 2008 when investors in Lloyds TSB approved the deal. Lloyds reject that the claim has a sound basis, but the cross examination of former directors Sir Victor Blank, Eric Daniels and Truett Tate should provide some excitement and will no doubt be assiduously reported upon by the press. The directors who signed off the prospectus are of course defendents in the litigation as well as the company.

This is a similar case to that of the Royal Bank of Scotland (RBS) litigation which was recently settled before it got into court, which is the way these matters often end up. Sky News has reported that Harcus Sinclair have offered to settle the case but that has been rejected by Lloyds. As in the RBS case, legal costs on both sides will no doubt be enormous.

Lloyds Banking Group are also involved in claims over the activities of management in HBOS (particularly in the Reading branch) which has resulted in the conviction of several people for fraud. The FT Magazine ran a very good, and lengthy, article on this subject in their October 7th edition. In summary this was where people exploited the fact that businesses in financial difficulty, who were dependent on loans from the bank, via consultancy fees and other strategies extracted large sums of money or gained control of businesses from the original owners. Large numbers of business owners lost their companies and in some cases were forced into poverty as result. This disgraceful episode was very similar to the activities of the Global Restructuring Group at RBS which I covered in a previous article, but will not be raised in the current legal proceedings. Lloyds are compensating the people affected, at least to some extent.

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

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