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The deadly accounting trap that can destroy your investments
Support services group Connaught gave investors a nasty shock at the start of this week. But the warning signs were there on its balance sheet all along, says Bengt Saelensminde. Here’s what you can learn from this disaster.
Oh dear, oh dear, oh dear. The financial engineers have been at it again. And this week, a British company that had been worth over half a billion pounds lies in tatters.
Of course we've seen it all before. But wary investors avoided this disaster stock. Why? Because they knew all about the weird and wonderful accounting principle that helped bring it down.
And that is goodwill' - a strange name for such a dangerous idea.
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Earlier this week, Connaught group lost 80% of its market value, falling from around a pound to 20p. Worse, the price was around £4 at the end of last year. That's a 95% loss!
Now on paper this company looks like a good business. It maintains social housing, public areas, street cleaning and things like that. And it's got £2.6bn in forward orders. Seemingly secure contracts from solid payers - what could be better?
But the problem is, like so many businesses, Connaught took a short cut to the top. The quickest way to grow a business is to buy up competitors and integrate them. Hey presto! You've got a massive business and management can earn massive salaries.
Just look at Connaught's chart over the last four years. It was barely affected by the financial crisis... I'd call that a stock market darling.
Click here to enlarge
But there's a potential problem when you buy in' growth by acquisition. Let's see how it brought down this company.
Competitors won't sell their businesses for book value' - that is, the value of its assets (unless it's a loss-making business). So for instance, if you're buying a park maintenance contractor that's got £5m in assets (buildings, vans, mowers etc), you may have to pay £20m, because of its loyal staff, its good reputation, etc. These are the things you can't really put a value on, but are what makes the business tick.
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This extra £15m you've paid goes onto the balance sheet as goodwill'. But there's a problem here - there are no assets to back up that £15m. There's nothing to sell and there's nothing to borrow against if you run into cash-flow problems.
So you'd better make sure you can afford your acquisition.
A potential double whammy...
If you've got a great business, with a strong balance sheet, you may not need to borrow any money. You've got nothing to worry about from the goodwill on the balance sheet.
But if you borrowed a load of money to acquire businesses in the first place (like Connaught did), then you've got a potential double whammy. You've already got high debt and you've not got much chance of borrowing more for any unforeseen' circumstances.
And this is what investors MUST, MUST be alert to. Don't assume that assets on the balance sheet are real' tangible assets. If a business has goodwill, you need to beware.
Here's how many investors missed it. You could be forgiven for thinking that Connaught's balance sheet was okay. At a glance, it had £508m in assets and £315m in debts (as at the end of February this year). I wouldn't normally be happy with so much debt, but then again, with long term contracts in a stable industry, why not?
But looking a little closer, you see that about £220m of the company's so-called assets are goodwill. Oops. That doesn't leave much leeway if something goes wrong. It's got more debt than it has real tangible' assets!
And then something goes wrong...
As we all know by now, this government wants to reduce public sector spending. And that's already hitting Connaught. Delays in projects have impacted cash flow and there's great uncertainty over new contracts. Basically, there's less cash coming in and likely less in the future too.
But the bad news doesn't end there. Connaught employs sub-contractors and suppliers, all of whom get nervous if there's a sniff of financial weakness in a client. Any decent supplier or sub-contractor will keep a close eye on his customer's financial position.
They won't supply, or work for anyone that may end up bust. Or, if they do, they'll be asking for cash up front. That's cash that Connaught just hasn't got!
Suddenly a bad situation gets a whole lot worse.
That's why you can't trust anything management says
Just three weeks ago in its Interim Management Statement (IMS), Connaught told shareholders that revenues were robust, it had a good pipeline of business, the business was performing well and the outlook for the group remains robust'.
Well what else could they say? Any sign of weakness would bring on a crisis of faith.
Then this week they said they urgently need funds to remain in business!
Connaught won't be the first victim of Downing Street's swingeing budget cuts. But these cuts needn't bring a business to its knees as it did here.
Don't think a company is safe just because it's got assets to balance debt. Remember, goodwill is not a normal asset. It can be written off at the stroke of a pen and banks won't lend against it if the business is in trouble.
This article was first published in the free investment emailThe Right Side
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
