How to spot which company turnarounds may work, ahead of time

‘The best turnarounds don’t need dilution, and that’s always the sign that their core is right’ – Keith McLachlan of Integral Asset Management.

SIMON BROWN: I’m chatting with Keith McLachlan, investment officer at Integral Asset Management, talking about turnarounds: how do we spot them in advance, and how do we know if they’re really working? There’ve been a number on the market. Keith, I appreciate your time. I say [there’ve been] a number – we’ve got Invicta and Omnia. Omnia still has a Sars issue. Adcorp – that’s kind of working. We’ve got Tongaat; EOH still looking a bit bleak, maybe; and Nampak. How do we spot those winners, those that have succeeded, so far in advance? Or do we need to wait until the price is up five times and markets are rewarding them?

KEITH McLACHLAN: Hi, Simon. First of all, we’ve come out of about 10 years of no growth in South Africa, which has just ground corporates into the ground. There’s no surprise, especially on the back of the pandemic and lockdowns and the recession, that there’s a proliferation of turnarounds. That said, it is very hard to make a successful turnaround. Warren Buffett has a really, really good saying which is, as a generalisation, not always correct, the nature of it is really that you can take the best captain in the world and you could put him on a boat with a hole in it; the boat will still sink.

So turnarounds are challenging.

I think to get to your question, the starting point is look at the core of the business. Is the core of the business profitable? What I mean by that is exclude group overheads, exclude non-core subsidiaries and other things – and even exclude financing.

You’re looking at the core of the group at a gross profit margin level and an operating profit margin level – and is that profitable? If that is not profitable you have a sinking ship.

There’s little you can do, and in my opinion the odds are deeply against you then. But if that core is profitable, the odds are that the problem lies in what I call the ‘two Bs’ – either in the boardroom or on the balance sheet, being that the management and overheads are bad, or that the balance sheet has holes in it; that is, too much debt.

Those are both addressable. You can get rid of management, you can dilute or restructure the debt, or dilute and pay off the debt. But if the core isn’t profitable there’s not much you can you about that.

SIMON BROWN: That first point – I want to come to debt in a moment – on management. We were chatting with David Shapiro earlier in the week and he was talking about the value of management.

It’s important, I imagine, that they are new blood; in other words, not just like, ‘hey, take the 2IC’, because truthfully they were part of the problem. Of course, it’s often hard to tell that the new management [is going to work].

If I think of Seelan Gobalsamy, who has come into Omnia, I think he has been in asset management before. He wasn’t someone who you naturally just assumed … was going to be a fit. It’s tough to tell what the new management – aside from being new and being able to make some easy wins (such as getting rid of the corporate jet and so on) – [can do]. It’s tough to identify.

Listen/read: Management shows its true quality only over time
Read: Omnia’s remarkable turnaround

KEITH McLACHLAN: Let me put it this way. A huge amount of value on the stock market has been unlocked [in] getting rid of bad management.  Even if the new management turns up and they just get the basics right, if they are not actively destroying the business and they have shareholder support, you can often manage your way through it.

But that is a fair point. You don’t know what the quality of management is turning up. I would say in terms of turnarounds, a starting point is to ask what went wrong, and therefore what has changed [so] that this won’t go wrong anymore. In many instances, at the core, management has made bad decisions.

I would argue it is very difficult to turn around a business unless you change management, because you can’t have the same guys that made the mistakes sitting in the room, trying to fix them.

Egos get in the way; they have a lot of psychological anchoring on what they did. They probably don’t even think they made mistakes. You’ve got to change management.

I would say the starting point then is look for the incoming management, look for them having a good track record wherever they’ve operated. It may not be in the same industry. Omnia is an interesting example, because he has come in from a different industry. But at the core of Omnia’s problem was capital allocation – and how is running a portfolio of companies different from running a portfolio of investments? Very different. The long answer is you’re making the same decisions. You have over-geared, you need to work out what are core assets, what are not core assets, get the balance sheet right.

Omnia did a very, very large rights issue that helped them correct the balance sheet. The moment you’ve corrected the balance sheet you’ve got breathing room. The debt is now not burning a hole in the balance sheet, and you’ve got breathing room to make tactical intelligent decisions around the assets.

Read: Omnia performs in a difficult environment

SIMON BROWN: Yes, and also selling some non-core [assets]. But I like that idea. Both Omnia and Invicta kind of did rights issues quite early and at horrible prices. It was massively dilutive. As opposed to Tongaat, which is now doing one quite late. EOH is still sitting on a pile of debt and maybe can trade its way out of it, but I can’t help thinking there’s a rights issue coming. Perhaps part of that trick is rather do it early, do it quick so that you can, as you say, fix that balance sheet sort of straight away.

Read: A look at how EOH’s turnaround is going

KEITH McLACHLAN: I would argue do it early, do it quick and do it big. Rather do it bigger, and have absolutely solved that problem and be sitting on a net cash balance sheet, than do it too small and a couple of years later you’re still struggling with the debt.

You want to do only one rights issue in the market.

My advice to management teams is always, if you’re going to raise capital, whatever you think you’re going to raise, raise a little bit more than that because you only get a few times to come back to the market to do that, and you want to minimise the number of times.

SIMON BROWN: In the case of Invicta and Omnia [they are] now sitting on good cash – and it starts to come back. Adcorp as well was a fairly successful one. Although that was – if my memory serves – less about debt, more about egos and bad businesses and the like. I suppose if you get the right person who’s an outsider, who’s prepared to do the hard decisions, one of which is that massive rights issue, you’ve probably got a chance of success, but no guarantees ever.

KEITH McLACHLAN: Definitely. In fact, if we go even further back in time, Super Group is an example of large rights issues. A little more recently, but also back into time, is Altron. Altron is a fantastic case study of turning around the business, and it involves changing the legacy management. You needed new guys in to unlock that. And then more recently, as you said, there’s Omnia and the like.

The best turnarounds don’t need dilution, and that’s always the sign that their core is right. So something that we at Integral then, and we back in terms of a turnaround – and it was a very, very quiet turnaround, but it is worth looking at – is in fact Momentum Metropolitan. Right at the core is an incredibly profitable business with great scale and reach and distribution. We’ve had the change in management. New management have walked in, they’ve dramatically changed the culture; they’ve cut non-core [assets] and have focused and streamlined operations – and the share is still trading at a huge over one standard deviation discount to its embedded value. This is a good example of a turnaround that didn’t need to go and dilute, and perhaps one that the market hasn’t yet woken up to.

SIMON BROWN: I’d completely forgotten about them. I know we we’ve chatted that stock before. But I like your upfront point – look to those core operations, because core operations are broken and not profitable, well, there is nothing to turn around.

We’ll  leave it there. Keith McLachlan, investment officer at Integral Asset Management, I appreciate the time.

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We need to see more debt holders take a bath as part of the restructure. Privately their credit committee has probably under new rules already provided against the full debt.

If the new plan involves a one third haircut and repayment plan (plus handbrake on company dividends and bonuses pending agreed hurdles), it should be possible. Of course if the debt holder has great assets as security, then they dictate.

Why should they take a haircut?
– they contributed to most messes by lending too much. Cowboys don’t cry.
– a haircut is better than waiting for pennies after the liquidators fees have taken 3 years to slash the payout by half.

But pundits beware : as steinhoff showed after its first collapse to 15 or so, there is never only the one cockroach you see.

End of comments.

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