Steinhoff scandal: what the experts should have noticed

The Steinhoff scandal has sent shock waves through South Africa.  Its the biggest corporate failure in JSE history.  Over R100 billion of value was wiped out in a few days, destroying the wealth of millions of people, from the savviest investors like Christo Wiese to workers through their retirement and pension funds. Like scenes out of Hollywood blockbusters’ Boiler Room and the Wolf of Wall Street, there are allegations of earnings manipulations, uncontrolled acquisition sprees to pump up balance sheets and even tax and exchange control evasion.

The big question is how did all the experts in the wealth management industry miss this?  South Africa best and brightest get paid exorbitant fees to scrutinise financial statements, evaluate management and manage risk so that they can provide investors with superior returns. Yet look at the exposure of top asset managers to Steinhoff before the crash:

Coronation R3,6 Billion
Foord R2,7 Billion
Sanlam R2,0 Billion
Investec R1,5 Billion
Liberty R1,5 Billion
Nedgroup R1,2 Billion
Old Mutual R0,5 Billion
Allan Gray R0,4 Billion
Discovery R0,3 Billion

This collapse was not a freak accident. Steinhoff’s problems piled up over many years. Even if you didn’t know they were hiding losses through clandestine off balance sheet companies or that the Financial Statements were misleading, there were many warning signs. Here are four fundamental red flags that investors should always be on the lookout for:

1) All that glitters is not gold

The composition of a company’s assets is important. Not all assets are built equally. Beware, when the share of intangible assets gets too big.

Although on the surface Steinhoff leverage ratio seemed reasonable at just over 50%, analysts failed to look at the quality of assets backing the debt. Just a quick glance at the balance sheet and it should have hit you in the face. The bulk of the assets are intangibles, like goodwill and brand names, which are notoriously hard to put a value on.

Goodwill and intangibles had gone from an already supersized EUR 9.5 billion to EUR 17.7 billion within a year. By March 2017, they constituted a whopping 68% of noncurrent assets.

How did all these intangibles and goodwill come about? They were ‘generated’ through Steinhoff’s corporate buying spree. This in itself should have raised alarm bells that Steinhoff was overpaying for its investments. For goodwill is by definition the surplus over fair value of an acquisition’s identifiable net assets. Therefore it can only have come about if Steinhoff was paying more than fair value for the companies it was acquiring.   

2) Running up the down escalator

Ultimately companies create real value by generating good returns on their assets.  Share prices can be inflated with financial alchemy and spin for a while but it never lasts long. A very simple metric to see how firms are doing at creating real value is to compare their return on assets (ROA) to their cost of debt. If ROA is not above the cost of debt, then it’s the financial equivalent of trying to run up a very steep down escalator.    

Steinhoff’s return on assets is just about equal to its cost of debt. They are both estimated to be around 4% based on 31 March 2017 unaudited half yearly results. This should have been a very big red flag especially with debt growing at such a rapid rate.

Moreover questions should have been raised about what is driving the low returns. We keep on hearing that Steinhoff has great underlying businesses. And we now know from an in-depth report by financial research firm Viceroy that earnings have been artificially inflated. So why aren’t their report returns higher?  It reinforces red flag 1 above (All that glitters is not gold). Their assets are massively overstated.

3) Show me the money

Many a good business has been killed by bad working capital management. A business may well be solvent but if it doesn’t have enough liquid assets on hand to pay its creditors it could go under. There are many of great measures of liquidity risk out there: The ratio of total current assets to total current liabilities being less than 2, called the current ratio. Or the ratio of cash on hand and accounts receivable to noncurrent assets being less than 1.  There are also debtors’ days to see how long it takes customers to pay or creditors’ days to see how long it takes the company to pay its suppliers. Any of these would give you an indication if there was a problem.

In Steinhoff’s case, all of them raise massive red flags. The current ratio was well below the 2 rule of thumb at 1.5. More worryingly the quick ratio came in well below 1 at 0.83 (meaning it does not have enough very liquid assets on hand to pay its creditors). Its debtors take on average over 40 days to pay compared to an average of just 3 days for Steinhoff’s competitors. And it is taking almost 6 months to pay its suppliers compared to an average of just 2 months for its competitors

Its thus clear that Steinhoff has serious liquidity problems. How did analysts and asset managers miss this?

4) You can’t have your cake and eat it

Investors love a good dividend. More than just realising some returns upfront (getting cash in hand), dividend also play an important signalling role about management’s expectations of future profits. Increased dividends usually signal expected increased future profits. But a smart investor always needs to ask themselves if the signal management is sending is credible. Are these dividends sustainable? For the flip side of a company paying large dividends is that it will have fewer funds to invest in new investment opportunities if higher future profits don’t materialise.

Steinhoff reported in its 31 March 2017 unaudited half yearly results that it’s earning per share (EPS) had in fact fallen by 3%. Yet despite these disappointing profits, Steinhoff increased its dividends per share by a massive 50% to EUR 15 cents a share from EUR 10 cents previously.  Did anyone really believe future earnings would be able to catch up? Its clear, management was stripping the company of cash at the worst possible time: just as Steinhoff going on a spending spree for overpriced investments and debt was rising.   

Steinhoff was trying to have its cake and eat it: a sure way to destroy value.

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