The promenade in Sea Point is home to an unusual sculpture consisting of a row of apparently random pieces of metal, none of which seem to have any artistic merit. Only if you stand at a specific point do the pieces line up to reveal a stunning sculpture of a rhino. The artist has basically hidden a huge steel rhino in public.
Similarly, annual reports provide a wealth of information from which interested parties can form a picture of the company – and their view of a company can change very quickly, as Pepkor shareholders have discovered these past few weeks.
A disturbing picture starts to develops on page 67 of the first and last annual report published by Steinhoff Africa Retail (Star), detailing its results for the year to September 2017 (a few months before Star was renamed Pepkor). This page discloses directors’ remuneration and shows that Ben la Grange – who until December 2017 was chief executive of the newly listed retail group – received a salary of R50 million.
This in itself is not unusual as executives do earn high salaries. However, it’s a concern that a footnote specifically discloses to shareholders that the R50 million was not paid by Star, but by holding company Steinhoff. A few pages later it is revealed that Steinhoff also covered the cost of the shares in La Grange’s incentive package.
Conflict of interest
This raises questions relating to his priorities, and at very least conflict-of-interest issues, during a period when several businesses were sold by Steinhoff to Star/Pepkor. In response to questions from Moneyweb, Pepkor said that conflict of interest is not relevant in this case. “Star was established by an internal restructure completed by Steinhoff and Steinhoff owned 100% of Star at that stage.”
But the sale of Tekkie Town to Pepkor soon after its acquisition by Steinhoff for R3.4 billion seems to indicate that concerns about conflict of interest are valid. This particular deal reveals another piece of the Pepkor picture.
Tekkie Town vendors were paid mostly in Steinhoff shares, but a note in Pepkor’s interim results for the six months to March 2018 states that “[for] Steinhoff Group purposes the Tekkie Town purchase was settled through a combination of shares and cash”. Pepkor responded that questions about this transaction should be directed to Steinhoff.
Pepkor also dismissed concerns about the flow of huge amounts of cash from Pepkor to Steinhoff after Star’s listing. With La Grange at the helm, the total of R15 billion raised in what was then called the biggest rights issue ever on the JSE appears to have left Pepkor’s bank account as soon as it arrived.
The cash flow statement in the annual report shows a cash inflow of R15.37 billon as the proceeds of the rights issue, and a nearly equivalent cash outflow of R15.13 billion as a capital distribution as settlement for businesses bought from Steinhoff.
Despite the huge rights issue less than a year ago, Pepkor is strapped for cash. In fact, sceptics might argue that the rights issue by Star is starting to look like nothing more than a Steinhoff rights issue.
The outflow of this huge amount of cash raises concerns about Pepkor’s position to fund a huge retail chain going forward. This is a valid worry, given the cash flow situation that transpired during the subsequent six months.
The interim results for the six months to March 2018 show net cash outflow from operating activities of R387 million, while investing activities claimed another R999 million. This forced Pepkor to increase its debt by R801 million and still saw net cash decrease by R585 million.
Directors were then probably pining for the R2 billion cash spent on dividends a few months earlier. The 2017 financial statements disclosed that most of this cash also went to Steinhoff.
It looks like a total of around R18 billion was funnelled to Steinhoff in just six months. And according to Pepkor’s latest balance sheet, the group still owes Steinhoff another R16 billion – with R11 billion shown as a long-term loan due to Steinhoff and another R5 billion as a current liability due to Steinhoff. Pepkor says this has since been replaced by independent funding and that the Steinhoff debt has been repaid.
This means a total of R34 billion has moved out of Pepkor – and out of SA – to the troubled Steinhoff.
The picture that emerges is as bizarre as one of Picasso’s later paintings: shareholders paying dearly for a stake of just 20% in Pepkor while Steinhoff gets the cash and retains 77% of the group.
Superimpose another random fact over the pieces already assembled – earnings for the latest six months – and the Pepkor picture become even more worrisome.
In the interim report for the six months to March, Pepkor management focuses on adjusted earnings figures. The difference between the statutory figures and Pepkor’s so-called comparable figures is the inclusion of the much-maligned R500 million loss on management’s share incentive scheme, as well as another R90 million sweetener to jumpstart a new one.
In short, the R500 million comprises losses on a management share incentive scheme based on Steinhoff shares, which fell 95% when Steinhoff management acknowledged accounting irregularities. Star/Pepkor management felt that shareholders, rather than the beneficiaries of the scheme, should shoulder this burden.
The importance of a share incentive scheme was the first point of business that Leon Lourens, who succeeded La Grange as CEO in December 2017, discussed at a presentation of Pepkor’s interim results to stakeholders in June. He also included the issue – twice – on a list of eight things that were achieved during his first seven months at the head of the table.
Comparable versus real profit
At the same time, management felt these losses shouldn’t be included in the income statement and drag earnings down, neither should the additional R90 million cost of the new incentive scheme. Thus, shareholders are urged to consider the comparable profit of R1.82 billion and earnings per share of 52.6 cents rather than the real profit of R1.26 billion and EPS of 36.2 cents for the six months to end March.
In addition, Pepkor doesn’t include losses on derivative instruments utilised to hedge cash flows and currency movements in its calculation of EPS, nor the capitalisation of foreign exchange losses in Africa. These losses reduced earnings by another R850 million to only R405 million, and translates to EPS of 11.7 cents for the six months based on the total issued shares of 3 450 million.
Unfortunately, the picture gets even worse. The flurry of acquisitions resulted in a balance sheet bloated with R61 billion worth of goodwill, but little else. The valuation of goodwill is very important in Pepkor’s case as it amounts to nearly 70% of the total assets and, effectively, 100% of shareholders’ value in the balance sheet.
It raises further questions. How were the businesses in these acquisitions valued? The valuation of businesses being moved around between subsidiaries in Europe was one of the concerns at the centre of the Steinhoff debacle.
Any change to Pepkor’s goodwill will influence both the balance sheet and earnings figures. It will certainly have an impact on the share price in a market reeling from one surprise after another.
The big fight over the 380-odd Tekkie Town shops, although only a small part of Pepkor, starts to make sense. There is probably close to R3 billion included in the goodwill figure, which will require adjustments if court cases around the deal favour the Tekkie Town vendors. It will also focus attention on the valuation of all the companies that were bought from Steinhoff.
It is amazing that Pepkor could hide a huge rhino of adjusted earnings, negative cash flows, a weak balance sheet and a questionable share incentive scheme from investors, analysts and fund managers.
Meanwhile, it seems investors are becoming cautious, given the string of nasty surprises the market has served up in the last few months. Pepkor’s share price has declined from its high of around R27 to the current levels of below R17, which has knocked around R35 billion off the group’s market capitalisation.