Over the last few years there have been few stocks on the JSE that have divided opinion quite as much as Steinhoff. While there must always be buyers and sellers to make any market, attitudes towards the furniture retailer have been far more polarised than most.
There have always been those who argued that the business was simply too complex to properly understand, and what they did understand they didn’t like. On the other end of the spectrum were people who believed strongly in Markus Jooste’s deal-making abilities and that Steinhoff was a great company run by an outstanding management team.
It’s a story not unlike what the market experienced with African Bank (Abil) only a few years ago. There were those who were convinced that the Abil business model was fatally flawed, and others who believed that Leon Kirkinis was a brilliant CEO who had the unsecured lending market at his feet.
‘The cash just isn’t there’
Adrian Saville, the CEO of Cannon Asset Managers, has been, in both instances, in the former camp. He points out that the forensic tools that they use in their investment process had been raising flags over Steinhoff’s numbers for some time. This, he says, is a clear parallel with African Bank, as in both cases it appears that “accounting trumped cash flows”.
“There are two elements of Steinhoff that have stood out for a long time, and I don’t think this is being expert after the fact,” Saville says. “Each time they made an acquisition it tended to get bigger and bigger, which often is the nature of a type of sheltering where in order to hide historically rearranged financial furniture, you have to buy bigger and bigger rooms of furniture.”
These big acquisitions, he argues camouflaged the shortcomings in the earlier transactions.
“But as the transactions got bigger, the return on invested capital fell increasingly below the cost of capital,” Saville explains. “This meant that they were either borrowing money or issuing equity, and inevitably they’ve been a furious equity issuer to fund transactions that were not particularly good transactions.”
This is where the second issue becomes apparent.
“If you can get past the fairly anaemic return on invested capital and satisfy yourself that the accounting number is what it is, it really becomes a glaring anomaly when you go look for the cash flow,” says Saville. “The cash just isn’t there.”
He points out that this is not a new or even particularly uncommon view. Many people have been noting for years that there are these two problems with Steinhoff – that it is acquiring underperforming assets and that there is no cash flow from the business.
“It’s not necessarily the case that if you are making bad acquisitions it’s fraud, but it is often the case that once you have started to chase your tail the activity becomes increasingly furious,” Saville argues. “And the activity they have undertaken has been absolutely frenetic. We had no exposure to Steinhoff in our active mandates for the simple reason that we didn’t believe the numbers. And we weren’t alone in that observation.”
South Africa’s Enron
Steinhoff is, however, far bigger than African Bank ever was. Until this week it was one of the top 10 shares in the FTSE/JSE All Share SWIX Index.
This has caused some commentators to compare it to Enron, the US energy company that collapsed into bankruptcy at the start of this century. At it’s peak, its stock traded at over $90 per share, and it was a Wall Street darling.
At this point, it might be premature to predict that Steinhoff’s current troubles must doom the company to total collapse, but there are striking similarities with what happened at Enron. In both cases the issue is questionable accounting involving off-balance sheet transactions and inflated revenues that made the business appear far more attractive to the market than it actually was.
Where to now?
Steinhoff won’t necessarily go the same way as Enron, but if it is to survive things are going to have to change radically.
“I think it’s clear that this is a business in deep distress,” says Saville. “There are at least three or four issues that have to be worked through.”
The first is getting clarity on the real earnings in the business, which has both income statement and balance sheet implications.
“For the income statement, whatever you’ve been looking at for the last few years is simply the stuff of financial manufacturing,” says Saville. “It’s going to have to be restated. That will transfer into the balance sheet. They also have to bring the off balance sheet stuff onto the balance sheet.”
He adds that there is now no chance of recapitalising the business at its historical multiples. Any recapitalisation will almost certainly require new investors and therefore necessitate a change of ownership.
“The other element is that there are clearly criminal and civil legal actions that could be brought,” Saville concludes. “Steinhoff has issued a whole lot of equity on the back of numbers that are manufactured. The board would have been aware of these structures and they were issuing equity and raising debt on the back of numbers that were simply not true. And that’s criminal.”