There are danger signs to watch for in trading statements which may be issued separately or alongside a company’s results.
Note that directors can be as reluctant as investors to face up to the fact that they got it wrong. Being human, they often do not go out of their way to highlight the problems.
Case study: easyJet
Budget airline easyJet put this headline at the top of its results for the year to 30 September 2017: “easyJet delivers robust performance, demonstrating strong cost control with enhanced network position and customer proposition”.
Meaningless jargon such as this is a warning to look carefully at the statement. The company is not putting clarity as a top priority.
Among 20 boastful bullet points were these three:
· “Headline profit before tax of £408 million, demonstrating the resilience of easyJet’s business model, despite an adverse headline currency impact of £101 million;
· “Reported profit before tax of £385 million, after non-headline costs of £23 million mainly relating to sale and leaseback charges;
· “Dividend proposed of 40.9 pence per share, in line with the Company’s increased payout policy of 50% of headline profit after tax.”
Did you get the impression that profits and the dividend had increased?
There was an unpleasant surprise awaiting in the table below.
Table 16
|
easyJet |
2017 |
2016 |
Change |
|
Revenue |
£5,047m |
£4,669m |
8.1% |
|
Profit before tax |
£408m |
£494m |
(17.3%) |
|
Pre-tax margin |
8.1% |
10.6% |
-2.5ppt |
|
Earnings per share |
82.5p |
108.4p |
(23.9%) |
|
Dividend |
40.9p |
53.8p |
(30.2%) |
Source: Company results
Despite a substantial rise in revenue, profits were actually down sharply, margins were squeezed to the tune of 2.5 percentage points and earnings per share were down nearly a quarter. The outcome was a 30% reduction in the dividend.
Carolyn McCall, easyJet chief executive, finally got round to admitting that it had been “a difficult year for the aviation industry”.
If you are superstitious and believe that bad news always comes in threes, then you will feel at home with profit warnings. When things go wrong, it is rare for them to be sorted out in one go. Three profit warnings is the norm, though there can be more.
Case study: Carillion
Few companies have fallen from grace quite so spectacularly as Carillion, which was riding high when it launched a bid for rival construction and facilities management group Balfour Beatty in 2014.
At first the Balfour directors looked to have made a mistake by rejecting the approach, as Balfour soon ran into trouble. However, events took a dramatic twist in mid-2017, when Balfour’s recovery was well underway and it was Carillion that fell apart.
On 10 July a trading update admitted that revenue had failed to grow in the first half of 2017 and operating profit would be lower than expected. There had also been a deterioration in cash flow from a number of construction contracts and net debt was substantially higher than in the previous year. Carillion set aside £845 million to deal with problem construction contracts.
Among other measures taken to reduce costs, Carillion suspended its dividend.
The shares, which had been sliding gradually but consistently since the failed bid for Balfour, dropped from 192p to 55.5p in the next four days.
When the actual results for the six months to 30 June came out at the end of September, the news was worse rather than better. Underlying pre-tax profit was down 40% and a further £200 million provision was made, this time for support services contracts.
A month later Carillion was forced to negotiate new loans from its main lenders, secured against its assets. In addition, it postponed previously agreed contributions to its pension fund and deferred of the repayment of some existing debt.
Chart 6
It got worse. Less than a month after that Carillion effectively admitted that it was likely to breach the terms of its bank loans by the end of the year. It had been confident of avoiding this ignominy when it announced its half-year results, but a failure to complete a number of disposals to raise cash, plus a shortfall in revenue from contracts, meant that Carillion would have to raise money through the issuing of new shares.
That would mean either existing shareholders stumping up more cash in a rights issue or the issuing of shares to new investors, which would dilute the holdings of existing shareholders.
Projections for net borrowings for the year were revised upwards for a second time.
Then in January 2018 Carillion revealed that its lenders had rebuffed a rescue plan as inadequate and that administrators were standing by to take over the running of the company and rescue whatever they could from the wreckage. By then Carillion shares were trading at 14p.
Banking covenants
When companies borrow money from the banks, they give promises known as covenants. These will be along the lines of profits being sufficient to cover interest payments and assets being worth more than the loans secured against them.
If you are a homeowner, you may have covenants on your house, such as not being allowed to annoy the neighbours or park a caravan on the front lawn. The big difference is that while there is usually no one to enforce housing covenants, the banks will certainly be keeping an eye on the ones that they impose.
Nor does a company find it any easier to wriggle out of its commitments than you do when you stray over your credit limit. Breaching banking covenants is bad news.
If the indiscretion is a minor one, or merely a technicality, the bank may decide to overlook it, especially if the company has kept the bank fully informed ahead of the actual breach.
At the other end of the scale, the bank may call in the loan and force the company into receivership. It will take such drastic action only in extreme cases. Banks, as you know, prefer to get their money back if they possibly can – and more besides.
So when a company goes along cap in hand, the bank demands lengthy talks, for which it charges, and imposes higher interest rates. Thus the struggling company now finds it even harder to meet the bank’s requirements.
It can take years of sound trading, and more expensive chats with the bank manager, to get out of this bind.
Case study: Petra Diamonds
The diamond miner Petra Diamonds was generally bullish in its mid-year update for 2017, but was forced to admit that production had built up more slowly than expected, so that revenue for the year to 30 June 2017 would fall 8–9% below previous forecasts, which meant profits would fall short of expectations.
Petra had sensibly taken the precaution of talking to its lenders about its banking covenants, which required interest payments to be covered no less than 3.85 times by earnings and net debt to be no greater than 2.8 times earnings. This calculation was made twice a year and it was clear that the production shortfall would cause a breach of the covenants in the June 2017 calculation.
Nonetheless, Petra was confident that this would “not be an issue”.
In the event, the lenders accepted assurances that production problems would be sorted for 2018 and they agreed to scrap the June 2017 calculations and relax the covenants.
However, results for the year warned investors that Petra was sailing close to the wind. Despite an 11% increase in revenue compared with the previous 12 months, underlying profit was down 54% and net debt had spiralled from $383.8m to $555.3m.
Its ability to comply with the relaxed debt ratios still depended on changes in diamond prices, exchange rates and the size and quality of production from the group’s mines.
Labour disputes at three of the company’s South African mines, and uncertainty over the volume of sales from a mine in Tanzania, forced Petra to go back to its lenders to warn that it would again breach its covenants in the December 2017 calculation.
Kitchen sink accounting
You know the expression ‘everything but the kitchen sink’? Struggling companies sometimes throw in the kitchen sink as well, usually when new management is installed to try to rescue an ailing business.
It doesn’t mean that the company has branched out into plumbing. What happens is that all the adverse items that can be dredged up are thrown into one set of very poor results in the hope that all the bad news can be got out of the way and things can only get better.
So assets are written down in value to zero, underperforming parts of the group are put up for sale and suddenly have no value, doubtful debts are declared uncollectible, stock is declared unsellable… anything that can be counted as a loss is thrown in immediately.
This does mean a very poor set of results, probably with a horrendous pre-tax loss, but never mind because it can all be blamed on the old management.
The dividend, if there was one, is also scrapped but that too can be blamed on the outgoing directors.
Next year’s results are almost certain to be better, since there are no more nasties to put in. Depreciation will be minimal since as much as possible was thrown out with the kitchen sink last time. If any of those doubtful bills get paid after all, that is a bonus that can be counted into future years’ profits.
So even if the second year’s results show another loss, as long as it is a smaller loss, the new management can claim that the worst is over (thanks to them, of course).
Strategic reviews
Companies are particularly keen on strategic reviews. They imply dynamic management seeking to take the business on to greater things and are always announced with a great fanfare.
Investors should not, however, get too carried away. Strategic reviews are popular with new chief executives and may have more to do with the new incumbent’s desire to make a mark than any need for change.
In these cases the review does give the new chief a chance to get to know the business rather than leap prematurely into changing the direction of the company and regretting the haste later.
The review allows fresh ideas to emerge and provides an opportunity for dead wood to be cleared out – just as long as it does not lead to change for the sake of it.
Of rather more concern is when the review indicates that something is seriously wrong with the business, which is why it needs looking at from top to bottom. In the worst-case scenario, the review may be needed to avert the impending collapse of the business.
So if you see the announcement that a company has launched a strategic review, read on to find out what it is really all about. As you read, ask yourself why potential improvements to the business have not been spotted sooner.
When the outcome of a strategic review is announced, check that it has real details of proposed action.
Pensions
Much has appeared in the press and on TV on the thorny subject of pensions and the potential black hole that they have created.
Briefly, there are two types of pensions:
1. defined benefits
2. defined contributions.
These are described in more detail below.
1. Defined benefits
Defined benefits schemes tell employees what benefits they will receive on retirement, typically a percentage of the employee’s final salary, and were funded by contributions from employers and employees.
The amount of money that needs to be available is determined by the commitment to pay pensions at a specified level.
It is hard to calculate how much money needs to be in the pot to meet pensions that will be paid many years in the future, but while the stock market was booming in the 1980s and 1990s and pension funds were largely invested in shares, nobody much cared. Indeed, companies took pension ‘holidays’ during which they did not have to contribute to the funds.
After the stock market crash in 2000–3, many pension funds found themselves in deficit and the rules have been tightened to cover the worst-case scenario. Companies have not only resumed contributions to these schemes, they have had to throw in extra dollops to fill the hole.
2. Defined contributions
In defined contribution pensions, the amount of money put into the pot by employer and employee determines the size of the pension at retirement age. This type of fund cannot be in deficit because the size of the pension is determined by the amount of money available, not the other way round as in the defined benefits scheme.
Naturally companies have been busy scrapping their defined benefits schemes and substituting defined contributions schemes in their place. In some cases existing employees are allowed to keep their perks and the new scheme applies only to new employees; in other cases, even existing employees have been forced to switch.
Why a pension deficit matters
These pension deficits are important to you as an investor for two main reasons. Where companies are saddled with a bill for filling up the hole, they will suffer from correspondingly reduced profits for several years until the hole is filled.
Companies do publish valuations of their pension fund assets and liabilities as calculated by specialists (known as actuaries) so you can see the size of any deficit. They will also report in their results how much extra they are putting in and how many years they expect to take to fill the hole.
Valuations are based on interest rates and the period of sustained low rates after the financial crisis of 2008 has meant that pension fund assets have been subject to low valuations, causing a ballooning of the deficits. Rising interest rates will reduce deficits over time.
Case study: BT
The telecoms provider BT was saddled with Britain’s largest private sector pension plan, a plan that at one stage had a black hole of £9 billion that plagued the group for years. It was so serious that BT actually went to court in 2010 to secure a ruling that in the last resort the British government, which had once owned BT before it was privatised, was responsible for the deficit.
The final salary scheme was closed to new members in 2001 but that still left about 350,000 employees and former employees entitled to a pension based on their final salary. Although the numbers are shrinking with time, the 2017 annual report showed that there were still 300,000 members and the deficit was shown as £8.6 billion.
In the 2016–17 financial year, BT paid £281 million into the defined benefits plan plus £209 million to cover interest on the deficit.
This cash could have been handed to shareholders in the form of dividends or share buybacks so the pension drain was a serious handicap from the investor’s point of view.
Pensions and bids
The pension deficit can also be of crucial importance when a company attracts interest from a potential bidder. The trustees of the pension fund have a duty to ensure that anyone buying the company has also got the finances to make up any pension fund deficit.
This can be particularly important if the bid approach has come from a venture capital consortium because these are almost invariably loaded up with debt to pay for the proposed acquisition.
Pension fund trustees can in effect have the power to block takeovers as they carry out their duties to protect pension fund members.
Time will tell
The pensions issue will gradually go away. The switch to defined contribution schemes will eliminate the danger of black holes in the future as the problem is effectively passed from the company to its employees, who simply get smaller pensions.
In addition, the extra contributions from the companies into existing defined benefit schemes, plus the rising values of investments, should eventually eliminate or at least alleviate the deficits.