Desperate times for Ellies

Value destruction leaves sour taste for investors.

After months of speculation Ellies directors have taken steps to resolve the company’s liquidity crisis and strengthen its balance sheet.

The company, which manufactures and sells electrical products from consumables to generators, as well as telecommunications products, has announced it will be selling ‘non core’ assets, rescheduling debt and entering into a rights offer.

This is an act of desperation as the group has a severe liquidity crisis on its hands. In July Ellies reported a 68% drop in headline earnings per share (HEPS) for the year ended April 30 2014. While cash flow from operations was R62 million, the group’s working capital needs were R232.5 million.

At the time CEO Wayne Samson blamed the poor results on a ‘perfect storm’ of events, which resulted in revenue falling drastically.

Unfortunately that perfect storm is still playing out. Further participation in the Eskom consumer programme, known as the Residential Mass Rollout, which contributed substantially to the group in 2013, is unlikely due to the parlous state of Eskom’s finances.

Ellies’ other big project – supplying the necessary set top boxes and antennas to enable millions of South African households to receive a signal when South Africa moves from analogue broadcast to digital – is likely to be delayed beyond the June 2015 deadline.

This is according to this M&G report, which says that a turf war between the two Cabinet ministers charged with implementing the migration is holding things up.

With its consumer products division in the doldrums, Ellies is focused on its commercial lighting business to drive revenue growth. But this is not enough.

Its smaller infrastructure business, Megatron, which sells generators and electrical substations into Africa’s renewable and conventional power sector, is a cash gobbler. “This business is very cash hungry. The order book is growing, but it needs funding,” says an analyst who can’t be named. “As a result cash is tied up in this business for long periods, without any real returns.”

Anthony Clark, small cap analyst with Vunani Securities is more blunt: “Megatron was the goose that laid the golden earnings egg…but its ravenous working capital needs to fund growth was just too much for the sickly and weak Ellies balance sheet to bear.”

While a rights offer is clearly necessary, it will result in a massive destruction of value. “Selling assets at the same time as holding a rights offer is never ideal,” says the analyst. “Potential buyers know you are desperate.”

Shareholders will be forgiven if this sticks in the craw. There are rights offers and rights offers.

Companies like Medi-Clinic, Curro and Capitec have had multiple rights offers in the past. Each time the strategy was well communicated – ahead of time – to shareholders by management teams that have proven themselves. This inspires investor confidence.

African Bank and Gijima are two companies that have failed at crucial points in their history to inspire investor confidence in their strategies and in management’s ability to execute.

What of Ellies? This is a highly entrepreneurial management team that spots a market opportunity and goes for it – witness DTT and Eskom. In the case of Eskom it paid off handsomely, DTT has yet to pay off.

The problem is the underlying consumer business is not robust enough to maintain momentum and support the company through the dips. Results for the six months to October are not likely to be any better than they were in June. Yet management has waited until the last possible moment to act. “[In June] management told me categorically it would be ‘suicide’ to have a rights issue and ruled it out,” says Clark.

Aside from a rushed rights offer and asset sale, what also leaves a sour taste in the mouth is that some in management took steps last year – just before the price peaked at R9.90 in May – to protect their share positions through the use of ‘collars’. 

Collars are usually used after a stock has experienced substantial gains. It is created by purchasing an out of the money put option while simultaneously writing an out of the money call option. This is usually viewed as a bearish to neutral strategy as any potential losses are limited, while the upside is also limited.

Both the chairman Ellie Salkow and Megatron CEO Ryan Otto have several million of their shares protected in this fashion.

Their downside (the ‘puts’) is limited to about R9, while the upside (the ‘calls’) is limited to around R11.00. The collars have staggered expiry dates and range from January 2015 to December 2015.

These types of arrangements are perfectly legal, and were communicated to the market via sens.

However this does not change the fact that for some people they leave a bad taste. “These actions should send a message to investors. When management starts to protect its profit in this way, we become skeptical,” says the analyst mentioned earlier.

Keith McLachlan, fund manager at Alpha Wealth adds: “Insiders are welcome to buy and sell their stock. But I do have a problem when insiders start to enter into derivative positions in their company’s stocks. By their very nature, derivative positions are short-term, thus why is a “long-term” set of management suddenly taking a “short-term” position in their company’s stock?”

Samson says there was nothing sinister in the sales. “Hindsight gives you 20/20 vision. We were expecting DTT and OpenView to pick up. We did not expect this perfect storm.”

Further details on the rights offer and asset sale – rumoured to be Megatron – will be released next week.

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