Everything exciting always comes at once with stocks, and so it's been with Albemarle & Bond Holdings (LON:ABM) , the pawnbroking company I've looked at in the past - mostly in comparison to a portfolio constituent, H&T Group. I took great pains in my previous post on them to point out the level of similarility between ABM and HAT at an operating level, but it's a ex-operating consideration which has seen ABM's share price completely collapse this week. In that post, I'd said that I thought the market was being too optimistic on ABM's potential results, and that the shares would come down to a level in line with H&T; but my pessimism didn't stretch quite this far!
As ever, it's debt. As I say, the two companies are very similar at an operating level, but at a financing level ABM were more aggressive with their debt usage. I say more aggressive - they had about £15m more in gross debt. Net debt was even higher, but net debt can be a misleading figure if the cash on balance sheet is needed to fund everyday busines operations and keep the wheels turning.
On the 30th of September, then, Albemarle & Bond made two regulatory statements. The first, rather innocuously, was the appointment of a new CEO - they've been looking for a while. The second was the bad news; 'weakness' in the group's core markets, and while profitability is expected to be in line with expectations this year, next year looks ropey. In short - the earnings based covenants on their debt are likely to be breached next year, which effectively hands the playing cards over to the debtholders.
Something of a ray of light came at the end of the RNS, where ABM said that they were in discussions with EZCorp - their largest shareholder, a large American alternative credit company, with regard to their underwriting an equity raising at 50p. Predictably, the share price bombed down to far closer to that 50p level on the news.
More bad news on the 2nd of October, though, and one that surprised me - EZCorp aren't interested in underwriting the equity. This is a real hammer-blow for the business, since it has all sorts of connotations for their viability going forward. Again, the share price collapsed - when I first looked at them over a year ago, I thought 280p was an unfair premium to HAT. At the start of last week, they sat at 130p. They now trade for 25p.
How and why?
Well, two things immediately spring to mind. Firstly, on the mechanics of the situation itself; it's a bit of a strange one. I didn't expect a constriction of this severity, to be honest, but it does show what financial covenants do - they represent a line which, when crossed, everything goes downhill from very rapidly. It also does a nice job of showing how deceptive one-point balance sheet figures can be. Companies are obliged to provide us with two balance sheets - one in their interims, and one in their annual report. This tells us nothing about the cash requirements and debt levels between those two dates, though, and gives management room for merrily shifting things around. ABM's stated net debt, at £51m, is significantly higher than that on last year's annual report. Then, it was £43m; and you would hope there was cash inflows this year given they did make a profit and have ~£4m of depreciation and amortisation, non-cash costs which allow for a little more flexibility of the cash front.
I'd like to see companies giving an explanation of their seasonal cash requirements, debt levels and so on in their annual report.
Back to the balance sheet though, and it's interesting because it's unusual. It's unusual because for a company in this situation there are rather a lot of assets. The current assets side of its balance sheet is bloated with all the inventory and loans outstanding you'd expect from a pawnbroker, and would suggest that - given time - you would have thought the company could recoup cash by winding down its pledge book. There's £91m of current assets against £44m of borrowings as of the last annual report and, even given a deterioration due to the 'one-off generosity' I've talked about above, that seems like quite a buffer.
Here's the problem as I see it, though - it's a combination of financial and operating leverage. It'd be nice to say that company could wind down its pledge book and bring in cash, but it can't. It overexpanded heavily during the recession, and the baseline profits on which its financial covenants were set were hugely inflated by gold buying. Winding down the pledge book is cash-positive but earnings-negative; and given the company has a number of loss-making stores on operating leases to keep up, they're stuck between a rock and a hard place.
So apparently their preffered recourse is to raise more equity, which seems reasonable given the above. The most worrying bit about the whole scenario is the bit that came on the 2nd - EZCorp not underwriting the equity raise. EZCorp are a 30% shareholder, so the cost/benefit of the situation from their point of view surely gives a lot away. My basic assumption was that, since the pawnbroking business was earning decent returns on capital pre-recession, they should be able to do so post - perhaps after a period of realignment where some of the overzealously expanded stores have to close. I should say at this point that what's meant by them 'underwriting' the equity raise is that they would become the buyer of last resort - if ABM couldn't find sufficient buyers in the market, EZCorp would be obliged to purchase the shares.
Think about it from EZCorp's point of view. In a worst case scenario, they have to put in £35m into the business, but that's a £35m which looks like it should stave off any debt problems for the forseeable future. Just glancing at EZCorp's latest balance sheet, it doesn't look like they'd have a problem stumping up the cash if they thought it was prudent to do so.
Are they playing a game? I don't like conjecture, but the motivations of the parties involved should always be considered. Since the company will breach its convenants, the effective control in this situation is passed to anyone who can alleviate the stress on that obligation. Most obviously, the banks. More subtly, a large shareholder who has the knowledge and position to recapitalise them on their own terms. Individual, smaller shareholders become significantly disenfranchised in situations like this. Don't buy into companies that might find themselves in a bad debt situation - that's really the moral of that story.
As I've said before, I think the market price - and therefore the enterprise value - ceases to reflect the reality of the underlying business in situations like this. The assumptions you need to make for the profitability of their rapidly-bought recession stores has to be deeply negative; enough to cancel out the profitability of the old estate and its organic growth. Alternatively, your assumptions for the health of the industry in general need to be very bearish.
The trouble is, the realisation of that value isn't just complicated and volatile, as with most shares - it's downright dubious. If they're bought out by EZCorp, the negotiations start from a position of absolute strength. The banks want their money back, and have absolutely no care for minority equity holders and their perception of unfairness. If the banks have to muscle in, again, they'll take the path of least resistance in getting their money back - the residual value is basically irrelevant to them.
It's all a little unfortunate, really, but it's hardly the first time - and it won't be the last, either. Debt levels that look reasonable in the bright mid afternoon sun turn onerous when the conditions aren't quite so generous.