Autonomy, FRC Meeting, Retailers and Brexit Legal Advice

The big news last Friday (30/11/2018) was that former CEO Mike Lynch has been charged with fraud in the USA over the accounts of Autonomy. That company was purchased by Hewlett Packard who promptly proceeded to write off most of the cost – see this blog post for more information: https://roliscon.blog/2018/06/02/belated-action-by-frc-re-autonomy/. As this was a UK company, are we anywhere nearer a hearing in the UK over the alleged “creative accounting” that took place at the company and the failure of the auditors to identify anything amiss? That’s after 8 years since the events.

As I was attending a meeting held by the Financial Reporting Council (FRC) for ShareSoc and UKSA members yesterday, I thought to review the past actions by the FRC on this matter. In February 2013 they announced an investigation but it took until May 2018 to formally announce a complaint against auditors Deloitte and the former CFO of Autonomy Sushovan Hussain who has already been convicted of fraud in the USA. On the 27th November, the action against Hussain was suspended pending his appeal against that conviction, but other complaints were not. But why the delay on pursuing the auditors?

The FRC event was useful in many ways in that it gave a good overview of the role of the FRC – what they cover and what they do not cover which is not easy for the layman to understand. They also covered the progress on past and current enforcement actions which do seem to have been improving after previous complaints of ineffectiveness and excessive delays. For example PWC/BHS was resolved in two years and fines imposed are rising rapidly. But they still only have 10 case officers so are hoping the Kingman review of the FRC will argue for more resources.

It was clear though that audit quality is still a major problem with only 73% of FTSE-350 companies being rated as 1 or 2A in the annual reviews when the target is 90%. The FRC agreed they “might be falling short” on pursuing enforcement over poor quality audits. So at least they recognise the problems.

One useful titbit of information after the usual complaints about the problems of nominee accounts and shareholder rights were made (not really an FRC responsibility) was that a white paper on the “plumbing” of share ownership and transactions will be published on the 30th January.

There were lots of interesting stories on retailing companies yesterday. McColl’s Retail Group (MCLS) published a very negative trading update which caused the shares to fall 30% on the day. Supply chain issues after the collapse of Palmer & Harvey are the cause. Ted Baker (TED) fell 15% after a complaint of excessive hugging of staff by CEO Ray Kelvin. This may not have a sexual connotation as it seems he treats male and female staff similarly. Just one of the odd personal habits one sees in some CEOs it seems. Retail tycoon Mike Ashley appeared before a Commons Select Committee and said the High Street would be dead in a few years unless internet retailers were taxed more fairly. He alleged the internet was killing the High Street. But there was one bright spark among retailers in that Dunelm (DNLM) rose 14% after a Peel Hunt upgraded the company to a “buy” and suggested that they might be able to pay a special dividend next year. There was also some director buying of their shares.

Before the FRC meeting yesterday I dropped in on the demonstrations outside Parliament on College Green. It seemed to consist of three fairly equally balanced groups of “Leave Means Leave” campaigners, supporters of Brexit and those wishing to stay in the EU – that probably reflects the composition of the Members in the House across the road. You can guess which group I supported but I did not stay long as it was absolutely pelting down with rain. There is a limit to the sacrifices one can make for one’s country.

But in the evening I did read the legal advice given to Parliament by the attorney-general (see https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/761153/EU_Exit_-_Legal_position_on_the_Withdrawal_Agreement.pdf

Everyone is looking very carefully at the terms of the Withdrawal Agreement that cover the Northern Ireland backstop arrangements. The attorney-general makes it clear that the deal does bind the UK to the risk of those arrangements continuing, although there is a clear commitment to them only lasting 2 years when they should be replaced by others. There is also an arbitration process if there is no agreement on what happens subsequently. However, he also makes it clear that the Withdrawal Agreement is a “treaty” between two sovereign powers – the UK and the EU.

Treaties between nations only stick so long as both parties are happy to abide by them, just like agreements between companies. But they often renege on them. For example, the German-Soviet non-aggression pact in 1939 was a notorious example – Hitler ignored it 2 years later and invaded Russia. Donald Trump has reneged on treaties, for example the intermediate nuclear weapons treaty last month. Similarly nations and companies can ignore arbitration decisions if they choose to do so.

What happens after 2 years if no agreement is reached and the UK insists on new proposals re Northern Ireland? Is the EU going to declare war on the UK? We have an army but they do not yet have one. Are they going to impose sanctions, close their borders or refuse a trade deal? I suspect they would not for sound commercial reasons.

Therefore my conclusion is that the deal that Theresa May has negotiated is not as bad as many make out. Yes it could be improved in some regards so as to ensure an amicable future agreement but I am warming to it just like the Editor of the Financial Times recently. He did publish a couple of letters criticising his volte-face when previously he has clearly opposed Brexit altogether, but changing one’s mind when one learns more is just being sensible.

Note: I have held or do hold some of the companies mentioned above, but never Autonomy. Never did like the look of their accounts.

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

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Low Margin Companies, and McColl’s AGM

Should you invest in companies with low profit margins? Phil Oakley of Sharescope wrote a very interesting article a few days ago which questioned whether they are likely to be good investments. This was one complaint about Conviviality which recently went into administration.

As Phil said, high margins suggest that a company has pricing power and limited competition while low profit margins make a company vulnerable to tough trading conditions or a weak economy. The reason for this is simple. If the overhead costs are relatively fixed but revenues fall even by a small amount, or costs rise, then profits can rapidly disappear. In addition if margins are already tight, then when competitors cut prices to retain volume, a company with low margins can find they simply cannot respond without incurring losses. Low profit margins are often linked to low returns on capital which is always something to avoid.

In essence, companies with low profits margins can be living on a knife edge and hence one needs to be careful about investing in them. A margin of 10% or higher is preferable, and a number of companies I am investing in have operating margins of over 50%. But what about retailers? Their operating margins are often very low. For example, Sainsbury’s is at 1.66% according to Stockopedia, Tesco is at 3.2%, ASOS is at 3.79%, Boohoo at 8.43% and Dunelm at 9.43%. The more specialist the retailer, or the higher the value items of sold, the greater the operating margin should typically be.

Carpetright which has just announced a major restructuring and refinancing was at minus 0.15% a year ago so their recent problems are perhaps no surprise. Likewise Conviviality was at 1.62% although they had both wholesale and retail operations. But ignoring all retailers because they report low profit margins is not a strategy I would follow.

McColl’s Retail Group whose AGM I attended yesterday are a convenience store operator. Their average “basket” size is only £5.62. Their operating margin is only 2.1%. Well at least it’s better than Sainsbury’s and I suspect it’s been low for many years – indeed when I first purchased the shares 2 years ago it was only 2.5%. But if you look at the more conventional valuation metrics it does not look so bad. Prospective p/e of 11.9, dividend yield of 4.7% and like many retailers it generates a lot of cash as it sells its merchandise before it has to pay its suppliers – at least that’s true until they go bust.

They are therefore companies that you need to keep a close eye on to see that margins are not falling, and that revenue on a like-for-like basis is not declining. That’s particularly so when we have a bad patch of weather affecting footfall as we had recently, or where they are vulnerable to erosion from internet retailers. Are McColl’s in that regard? Probably not because 60% of their customers live within 400 meters of their local shop and they provide both fresh/chilled food and services such as a post office. The company is looking to “engage” even more with their customers who typically visit very frequently.

It was a useful AGM with a number of good questions from the audience (less than 10 shareholders attending at the company’s head office in Essex). One question related to the success of the acquisition of 290 stores from the Co-Op which have now been fully integrated but the CEO rejected a suggestion the stores were below targets and said the deal “met the business case”.

However one problem the company has faced in the last year is the collapse of supplier Palmer and Harvey. The business was closed by the administrator almost immediately so McColl’s had to make alternative arrangements very rapidly. This resulted in analysts forecasts of profits being reduced from £54m to £50m according to the CFO. In future they will be reliant to a large extent on Morrisons who they have done a deal with to retail products under the Safeway name. It seems to me that these two companies might become so closely linked that sooner or later it might make sense for Morrisons to acquire the business. Morrisons sold off their own convenience store chain in 2015 which was losing money and not easy to scale up.

One shareholder complained about the remuneration arrangements – a typical complex scheme including LTIPs. He said “why do people need a bonus to do their job?”. The Chairman said there is competition for talent. I also discussed this with the CFO after the formal meeting closed and suggested there were better solutions to incentivise staff.

I also talked to the Company Secretary about the problems with voting via Link Asset Services (see previous blog post on that topic).

One unusual aspect of this AGM was the issuance of the Minutes of the last AGM and request for shareholders to approve. Companies normally do minute their AGMs but don’t publish them.

The votes were taken on a poll with the results only announced later in the day. About 13% of votes were against the Remuneration Policy, against the Chairman and Rem. Comm. Chair Georgina Harvey and over 18% against share allotment and pre-emption resolutions. Plus 13% against company share purchases and the change of notice of General Meetings. These are unusually high figures and the board has committed to look into the reasons why and report back. Note that Klarus Capital hold over 11% of the company having bought the stake held by former Chairman James Lancaster.

My conclusions about this company: The management seem to be making the right decisions but they do need to improve the profit margin and return on capital. However it seems one reason for the deal with Morrison’s was to obtain “improved commercial terms” so that suggests they recognize this. Moving into growing segments such as “food-on-the go” and out of declining ones such as newspapers and tobacco should help as will store refurbishments and the addition of a few more stores.

The share price of McColls has been picking up recently from a low point. But like a lot of my holdings it seems to be somewhat volatile of late. Is that as a result of the holiday period with lower trading volumes, a tax year end effect, or investors being nervous about war in Syria? Will it be war or no war? Investors never like binary bets. Perhaps Donald Trump should get on the hot-line to Russia and negotiate an alternative scenario. After all he has written a book called “The Art of the Deal” so he should know how to finesse a face saving way out of the problem.

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

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