Lloyds Case Impressions, Ideagen AGM and Return on Capital

Yesterday I attended the Annual General Meeting of Ideagen (IDEA) at 12.00 noon in the City of London – see below – and afterwards spent an hour in the High Court listening to one of the witnesses being cross-examined in the Lloyds Banking Group case. What follows is just an impression of the scene because the whole case is running for months so in no way can this be considered a comprehensive report. I have covered some more details of the case in previous articles, but to remind you the litigants are suing Lloyds and the former directors of the company over the takeover of HBOS which they declare was contrary to their interests as shareholders in Lloyds TSB. Lloyds deny liability.

The case is being heard in the Rolls Building in New Fetter Lane – a modern building very different to the ultra Victorian main Courts of Justice building in the Strand. See this link for a video tour of the building: https://www.judiciary.gov.uk/you-and-the-judiciary/going-to-court/high-court/the-rolls-building/virtual-tour/

The witness being cross-examined on the day was Tim Tookey, the former Finance Director of Lloyds TSB. Richard Hill QC was undertaking the task for the litigants under the eyes of a single judge, Mr Justice Norris (sans wig). It was a pretty impressive scene with at least 6 barristers in wigs and gowns plus about another 10 supporting legal staff. Why do barristers still wear wigs? To quote from the web: “The courts didn’t officially add wigs to the legal dress code until the 18th century when they became culturally chic. … They continue to wear them because nobody has ever told them to stop”.

It was a pretty impressive scene, somewhat lost on the few members of the public present – half a dozen litigants and members of the press. But the court was digitally up to date with every desk holding a screen on which the written evidence was displayed as it was invoked. However the witness being cross examined still referred to a paper copy, extracted from 150 large A4 binders stored in shelves on the left hand side of the court – filling almost the whole wall.

Mr Tookey gave his responses to questions firmly and without emotion. A confident witness giving clear answers. He was questioned about the events leading up to the announcement of the acquisition of HBOS and over how much capital Lloyds anticipated would be required to ensure the deal was “bullet-proof” (i.e. not creating unacceptable risks if the economic circumstances worsened). He was questioned about the extent the risks had been considered and whether enough due diligence on HBOS had been done before the decision was taken to proceed. Apparently it came down to a decision at 4.00 am on a Monday morning to proceed. They we being forced to decide to proceed or not by the Government before the markets opened on Monday. But he said that he thought all the risks had been considered and the board was supportive of the deal because of the strategic advantages of the HBOS takeover in the longer term. Recapitalisation involving the Government was necessary because there was no way it was possible to raise even £3 billion (underwritten) by the Monday, which was the minimum requirement. Government involvement “de-risked” the deal. The case continues….. for another dozen weeks.

One can see from the above exactly why the costs of such cases are so enormous.

Ideagen AGM

Ideagen (IDEA) is a software company in the Governance, Risk and Compliance sector. I have held the shares for some years when it has grown revenue and profits considerably, both from acquisitions and organic growth. They have a strong emphasis on the importance of recurring revenue. They are presenting at the ShareSoc Seminar on the 8th November, although that event is fully booked I understand.

There were fewer sharesholders at the Ideagen AGM than members of the public at the Lloyds hearing, but that’s not exceptional for small companies. But it was still a useful event – a brief report follows.

One question I raised was about return on capital. Now you might think this was prompted by an interesting article on that subject by Leon Boros in the latest ShareSoc Newsletter, but I did not get around to reading that until later in the day so it’s somewhat of a coincidence. Leon compared the return on capital at Bioventix (one of his favourite stocks which he likes to talk about regularly), and YouGov. He pointed out that not only are measures such as Return on Equity (ROE), Return on Capital Employed (ROCE) and Return on Assets (ROA) better at Bioventix calculated on the headline numbers, but that those for YouGov are somewhat doubtful because they capitalise and amortise the cost of recruitment of their survey panels. Plus they capitalise and amortise software development costs. But they then produce adjusted earnings figures that excluded the amortisation of both those costs, effectively pretending they are not real costs. He has a point.

Now I always look at returns on capital when I am investing in new companies because I consider it one of the most important measures of a company’s performance – as I told the directors of Ideagen. Hence at the Ideagen AGM I asked a question on that subject. On page 18 of their Annual Report they give the “Key Performance Indicators”, 9 of them, that the directors use to monitor the performance of the company. They all look good, but none of them measure return on capital. Should they not include a return on capital measure?

In reality the headline figures for ROE, ROCE and ROA reported by Stockopedia for Ideagen are all less than 2%, and that ignores even the large number of shares under option that the company has that would dilute the earnings. The reason for this is partly the fact that the profit measures used are “unadjusted” and as the company has very substantial amortisation of goodwill from past acquisations, and £1.2 million of share-based payment charges, these distort the numbers. The CEO David Hornsby, responded with “what measure would I like to use?” to which I responded that I did not mind so long as it was consistent from year-to-year. Companies often publish such figures, which are frequently based on “adjusted” profits. I also suggested cash return on assets might be a good measure, something I also look at.

The company actually generated Net Cash From Operating Activities of £8.3m last year which on Net Assets of £30m at the start of the year is very respectable, although technically one should probably write back the cost of past acquisitions that have been written off. In addition some of the cash generated was spent on contingent consideration on past acquistions and on “development costs” which they class as “investing activities”. This demonstrates that for some businesses, looking at headline return on capital figures or those reported by financial web sites can be misleading. One needs to look at the detail to get a real understanding on what is going on in such a business.

A short debate on the issue followed. Otherwise after a couple of other questions, the CEO mentioned the half year for the company ends today, and shareholders should be very pleased with the results.

In summary, a short AGM meeting, but a useful one. And the ShareSoc newsletter is well worth reading – it even includes some articles from me.

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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