The 11 red flags you should have spotted.
For starters, none of us (however bearish we are) knew Conviviality Plc is heading into bankruptcy in less than four months. Even Enron lasted much longer before it went tits up. More surprisingly, the share price showed no sign of duress and was trading over £4 with a valuation of £770m.
Everything is now gone. Shareholders lost all their money. And an investigation is likely to commerce.
A Brief Background
For those who aren’t familiar with Conviviality, it’s a cheap booze retailer branching into wholesaling and distributing booze to the hotel, restaurant and pub industry (another clue why it went bust).
If you want a commentary coverage of how fast Conviviality went from hero to zero, click on the title here “The events that shook Conviviality and its share price”. In my last post, I mentioned lessons must be learned. To do this, we need to examine the company inside out and upside down. And reading from the tagline, it is a list of red flags correlated nicely together.
This will be a long and informative post. So, let’s get down to business.
The Red Flags analysts should have spotted
First, we begin with the latest red flag.
Red Flag one: Falling operating cash flow
The obvious sign of distress is when Operating Cash Flow fell from £7.3m to £528k when they reported their half-year result. Also, people should pick up on the reported profit declining by more than 10%. Two clues signalling Conviviality wasn’t going to achieve this year earnings forecast. Add in the high valuation multiple of 30 times vs. other retailers’ multiples of 20 times, then this stock was ripe for you to sell.
Red flag two: Boasting free cash flow
Every company has a right to highlight free cash flow. When Conviviality highlighted theirs, it generated £51m in 2017. Their definition is accurate.
One weakness is it wasn’t fully honest because the model was very acquisitive. To illustrate how misleading since 2014 it spent £38.2m in capital expenditure (an item deducted from net cash flow to derive free cash flow). Now, compare this to acquisitions totalling £304.6m, or 8 TIMES GREATER than capex. So, investors need to watch levels of acquisitions before believing in sustainable free cash flow.
Also, during their latest half-year result, it stopped highlighting free cash flow because it isn’t great when they record free cash OUTFLOW of £13.6m vs. outflows of £9.6m last year.
Red flag three: Restating “repayment of borrowing” in the cash flow statement
The bizarre restating of repayment of borrowing by excluding the receivables financing facility means its intentions were to increase the cash and cash equivalents reported in the prior period by £20,255,000 by decreasing the repayment of borrowings of £20,255,000.
Strange enough, compare the cash and cash equivalent item from the balance sheet to cash and cash equivalent from the cash flow statement (without restatement) you get this:
|Cash (£m) (balance sheet)||9.974||1.203||9.54||10.424|
|Cash (£m) (Cash flow statement)||9.974||1.203||(10.715)||10.424|
*Quoted without restatement.
Regardless whether its accurate or justified, Conviviality needed to find £20.25m from somewhere. And it isn’t out of the realm of possibility this led the company unable to pay their tax bill.
Red flag four: Acquisitions of Matthew Clark and Bibendum
When a business makes a big acquisition, please read the details in the annual report. In Conviviality’s case, you would have saved yourself a lot of money.
So, the red flag here is comparing the book value and fair value of both Matthew Clark and Bibendum.
Starting with Matthew Clark, on Conviviality own admission it has written down their book value from £34m to a fair value of £9.8m. Still, it went ahead and plough £199m in acquiring the business.
For those who don’t know what fair value is, it’s the value the assets will fetch in the open market when using mark-to-market. Technically, Matthew Clark could fetch for £9.8m, but given the bull market, most businesses would pay a premium, but is it worth £199m? Probably not.
Next, the fair value of Bibendum (according to Conviviality) is a negative £1.67m, down from a book value of £13.3m. Despite this, it paid £40m, which include debts of £20m.
Given both businesses have net margins below 1%, it is hard to place that kind of premium. Also, any savings from this highly taxed business is minor at best.
Red flag five: Cash flow cycle differences between retailer and wholesaler
Knowing your booze retailer and booze wholesaler/distributor is very important because of CASH FLOW.
Before 2015, Conviviality was known for selling booze in store. Now, 70% of the business derived from being a distributor/wholesaler of booze, especially premium booze. Why the distinction? A booze retailer receives cash (almost) immediately or waits for 20 to 30 days, but branching out to the wholesaler leads to larger credit sales and the wait for cash payment comes to 50, 60 or 70 days.
To prove the dynamic this, here’s an example: Matthew Clark is JD Wetherspoon supplier, so the relationship between Matthew Clark (supplier) and JD Wetherspoon (customer).
Work out JD Wetherspoon’s days’ payables comes to 64 days (2015). It takes on average 64 days to pay off their suppliers like Matthew Clark. Now, compare this with Matthew Clark Debtor days in 2015 this came to 36 days. Remember Matthew Clark distribute to other clients some would pay their credit off much earlier than JD Wetherspoon. For Bibendum (also a supplier to JD Wetherspoon and smaller than Matthew Clark) their debtor days came to 78 days.
For further proof, Conviviality debtor days from 2014 to 2017 resulted in an increase of 22 days to 52 days.
Does that mean a cash flow constraint beckons?
No, because Days payables, grew by 31 days to 82 days!
Conviviality saw debtor days and days payables increasing by 22 days and 31 days respectively, the question we now ask: “Is this sustainable?”
The answer lies within Matthew Clark and Conviviality’s accounts (before 2015) because it accounts for more than 55% of total receivables and total payables. Compare Matthew Clark and Conviviality debtor days in 2015, it comes to 36 days and 30 days respectively, that’s much lower than the 52 days, today.
The above statement is more of an observation, this next red flag explains the problems of accounting for trade receivables.
Red flag six: Problems with Conviviality trade receivables
Previously, I mentioned the growth in debtor days. Now, we are studying the change in trade receivables.
The first sign of a problem is the way Conviviality accounted for “provision of doubtful debt.” Here is a table below:
|Provisions of receivables (£m)||1.63||1.385||1.86||2.78|
|Gross trade receivables (£m)||30.8||30.2||131.5||187|
Have you spotted the difference?
If nothing is wrong, then check below:
It shows the company wrote down 5% of gross trade receivables in 2014 and 2015 but decides not to write off similar level in 2016 and 2017, which helped them saved the company from charging an extra £11.5m or £5.7m to the Income Statement. Therefore, resulting in overstating profits. In 2017 it overstated operating profits by 20%.
Next, there is a big increase in past due from under £1m in 2015 to £42.3m. The “past due” has not been defined by the Conviviality in their 2017’s annual report, but in their 2015’s annual report it was less than six months, but question marks remain what is it greater than (could be more than 3 or 4 months).
Here a graph comparing past dues and provisions:
With past dues rising from 3% to 23%, Conviviality should be increasing the provision of doubtful debt beyond 5% for prudence. Conservative accounting for provisions leads to lower adjusted EBITDA resulting in a failure to covenants.
Then again, it’s a good exercise to spot weaknesses in company’s accounting.
Red flag seven: Lack of cash in the company’s balance sheet
A business with higher credit sales in proportion to cash sales should hold more cash on the balance sheet. That led to cash as % of total assets falling from 10% to 1.5%. It proves why lenders and major shareholders have no faith and trust in anything management had to say and another reason it is going into bankruptcy!
Red flag eight: Weak restaurant sector
Changing the business model isn’t the only problem, the other is supplying a sector that is experiencing a big slowdown. Yes, I’m talking about the food, drinks and pubs industry.
Those who invest in that sector knows what I’m talking about. If not, you can’t miss it in the financial media with famous chains like Prezzo, Jamie’s Italian Byron Burgers and Carluccio’s downsizing their empires.
According to accountancy firm Moore Stephens, 984 restaurant businesses went into insolvency proceedings in the year to last September (2017), a 20 percent rise on the same period a year earlier.
All this means is less demand for wine and less business for Matthew Clark. Even strong businesses like JD Wetherspoon has to delay paying suppliers to meet working capital as Days payable rose from 64 days in 2015 to 79 days in 2017.
And it explains the reduction in profitability from Matthew Clark and Bibendum.
Red flag nine: No Assets and lots of goodwill
When you have increased net debt, it’s wise to have sufficient levels of REAL and LIQUID assets to prepare for periods of lower profitability. With less than £3m in freehold assets and over £200m in goodwill, that is a big warning sign if operations were to deteriorate, the whole dominos could collapse unless more external financing comes to the rescue.
Red flag ten: Paying dividends with external borrowings
You know management cares about appreciating their share price when they’re paying increasing amounts of dividends. Who is actually paying the dividend to who? Since 2013, it paid a total of £34.9m, at the same time it asked £200m in shareholders cash.
For example, if company A asks for you for £100 in year one and agrees to pay you £5 in dividends. Then in year two, it asks for £800 and agrees to pay you £40 in dividends. The year after that it went bust!
In the end, you pay £900 and receives back £45, equivalent to a 95% loss. For Conviviality, shareholders lost 83% (assuming you didn’t sell the shares and invested in the stock since their IPO).
All in all, it sounds and feels like a smart Ponzi scheme that’s playing out in the stock market.
Red flag eleven: Management lying about synergy
First, it lied about buying more convenience stores and expanding their wine selection in their IPO admission. Then, in their half-year results, it lied about the success of combining all the acquisitions together and achieving synergy.
If you read this far, then thank you for reading. Now, you are wondering what to do next.
Take the Next Step
How do you safeguard and avoid investing in companies that suddenly go bust? The short answer is you can’t, (not completely anyway) because human nature leads us to be complacent from time to time. Other factors could be my position in Conviviality is so small it will hardly affect my investment portfolio.
For those taking a financial hit or those wanting to learn about avoiding these companies, then this book by Howard Schilit will help you understand how management manipulates accounts.
It is a one of a kind reading and it uses real examples from past businesses that cheat investors. The downside the examples used are American companies but is still a very useful book for anybody wanting to better themselves in stock picking.
Suggestion: If you happen to research companies, draw up an investment checklist to protect yourself from investing mediocre businesses. Example of questions are: “What are the trends in trade receivables look like?” Or, “Who are the company’s clients, are they experiencing a slowdown?”
Latest Update: C&C Group has bought out Matthew Clark and Bibendum. Here is my commentary:
C&C paid £1 for both Matthew Clark and Bibendum but paid £102m in debt to its lenders. In other words, the lenders, not the shareholders got any value. So, the purchase price is C&C paying £102m in enterprise value vs. £260m paid by Conviviality! Plus, C&C is a distributor and knows how to cut costs and find real synergy. I called it looking for bargains. Remember JD Sports follow the same strategies of buying low and creating value for their shareholders.
As for Conviviality, it is still responsible for £78m of debt and company size falls back to £400m-£450m level. And it still owes HMRC £30m. Make that £108m in liabilities.
I like to thank you for reading, this was a long post.
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