Buchler Phillips Quarterly Bulletin No. 13

When is the right time to throw in the towel?

AMIR KHAN refuses to quit boxing just yet, despite a recent comprehensive beating at the hands of 1/10 priced American Terence Crawford. Bolton-born Khan, a former unified world champion at light welterweight, was floored in the first round and then took an accidental low blow in the sixth, prompting his corner to stop the fight. Khan insists he didn’t quit the bout and is now claiming he sustained an elbow injury ahead of the showdown. He wants to finish his career on a high note, after one or two more fights, promising they will be big ones.

 Most boxing pundits think 33 year old Khan, an Olympic medallist at 17, is in denial about his last fight and delusional about the next. His situation is often mirrored by those at a crossroads in their businesses: their insistence on continuing with a flawed strategy sometimes refuses, as well as fails, to recognise clear signals to stop. While turnaround specialists are happy to mop up the blood, they are more effective if engaged earlier when there is still time to change direction - or indeed to dispense unpalatable but sound advice before a business inevitably folds. 

 Acceptance is the friend of good business decisions. There are lots of sensible reasons for giving up and moving on: a strategy taking far too long to work; knowing for certain there are better returns elsewhere; obstacles limiting upside; an industry in irreversible decline; lack of a market for the goods or services offered; or simply lack of enthusiasm for the business.

It would be unkind to suggest Amir Khan should swap his gloves for a commentary microphone or get in line for Strictly Come Dancing, but the still young man - who is already also a fight promoter, sponsor and philanthropist - is better placed than most to optimise his portfolio.

Mike Ashley cries foul at Debenhams

Magpies are among the world’s most intelligent animals. Prone to opportunistic theft from other nests, they enjoy a surprising degree of protection. Foiled Debenhams suitor Mike Ashley won’t miss the irony that while his Newcastle United Football Club is nicknamed after these swooping robbers, it is a marauding band of hedge funds and lenders that has snatched control of the stricken retailer from under his nose, wiping out his near-30% stake and that of all other shareholders.

 The situation is far from black and white, it seems. Sports Direct owner Ashley might be ‘Marmite’ and controversial elsewhere in his business empire, but the pre-pack administration of Debenhams, giving lenders and US fund Silver Point Capital control of the trading businesses, raises the important issue of directors’ obligations to shareholders. The wisdom (and freedom) of the directors in appointing administrators is questionable. It is alleged that administrators FTI had been in dialogue with Debenhams since before mid-February and had engaged with the company’s lenders, whom they had previously advised. In such a case, a conflict of interest might be spotted when the administrator would later sell the retailers’ operations to the same lenders in a pre-pack. 

 Two factors seem to have cemented the board’s determination to keep Ashley’s tanks as far from their lawn as possible. The already uneasy relationship between the board and its significant shareholder-cum-commercial partner is likely to have soured further when Ashley rescued department store rival House of Fraser from administration in August 2018. That is somewhat understandable and firmly set the tone between the parties up to the end. The second factor is harder to fathom, namely the point at which directors’ heads were turned by a supposedly better route to recovery offered by debt funds and lenders.

In December 2018 Sports Direct’s offer of a £40m interest-free loan, in return for security over some of its assets, was rejected for not being in the interests of other stakeholders. In football speak, Ashley said it was like being offered Messi on loan and turning him down.  Two months later, the board agreed a loan of equal size from existing lenders, on terms stating that any fresh debt would require the lenders’ consent. Ashley was effectively shut out from that point. 

 While directors were planning in March to raise £200m from these lenders, Ashley offered £150m interest-free, on condition he became CEO and the new debt plan was dropped.  later in the month, he considered a £61m cash offer for Debenhams’ equity - double the market value. Finally, in the 24 hours ahead of the group falling into administration, Ashley offered to underwrite a rescue rights issue for £200m.

The pre-pack deal agreed by directors immediately sold the business to a new entity.  Offers were being sought for that company - a process now abandoned - but on tough terms that stopped a buyer contacting landlords or concessionaires for 18 months – a ridiculous restriction, not least since Debenhams is now in a Company Voluntary Arrangement with creditors to reorganise its debt stack.  Did this restriction apply to the lenders and current owners?  No wonder Sports Direct has complained to the FCA that the sale has not genuine.  The Americans have arrived, riding roughshod over UK insolvency law while regulators sit and watch. 

 Directors would insist they have acted in good faith all along, putting the interests of the company first. That’s all well and good, but the Companies Act 2006 is clear on fiduciary duties to shareholders as a whole, as well as on exercising powers to reduce the influence of dissenting shareholders.Something is up with the Debenhams process, the scale of possible wrongs ranging from simple lack of judgement by directors, to what Ashley has described as a “long planned theft.”

 Swooping magpies are a protected species unless they are shown to be a threat to conservation. What Debenhams’ lenders have conserved, as distinct from Ashley’s rescue plan, is debatable. Not his 29.7% stake, that’s for sure, at an estimated loss of £150m. Nor the chance, however long term, for other shareholders to participate in a turnaround. Regulators have their own duty to take a much closer look. 

The High Street’s death by a thousand cuts

Debenhams’ experience is symptomatic of major structural changes throughout the retail industry, an ongoing shift in shopping patterns that will continue to remove capacity from the High Street until retailers take drastic steps to adapt to the new order. 

 Some of Debenhams’ more obvious woes are shared with many other suffering retailers: too-high rents in the majority of its stores; lack of innovation in-store and slowness to grow online; high staffing needs… The list goes on. Major store closures have also been announced by Boots, Marks & Spencer, New Look, Paperchase and Monsoon.  

High Street retailers will continue to shrink unless they provide an engaging in-store experience for millennial consumers who have almost grown up shopping online. Most of these need a very good reason to venture beyond their front doors to partake in discretionary shopping as a leisure activity.

While it may be convenient to blame Brexit for every blot on the business landscape, the retail sector’s woes could never be fixed by even a universally acceptable solution to EU relations.

The inevitable Brexit section…

Several British MPs, though apparently not the Prime Minister, have been ‘pivoting’ (still a fashionable business word in 2019) their thinking on exit from the European Union in recent months. More punch-drunk than Amir Khan from inconclusive votes, extensions for negotiations and a seemingly widening range of unpopular options, politicians have been quitting their parties, leaving the government benches and even accelerating their retirements. Lack of clarity on Brexit has even delayed our own Quarterly Bulletin as we attempt to weigh the eventual impact on the business world.

 Investment bank giant Goldman Sachs estimates that this same lack of clarity has cost the UK around £600m a week since the 2016 referendum. Over 148 weeks, that’s almost £89bn. The cost is said to be the hit to business investment growth in the immediate aftermath of the Brexit vote, which has been compounded by the intensification of Brexit uncertainty. The figures were based on running a ‘doppelganger’ model of a UK economy that did not feature a Brexit shock. The model version’s GDP was 2.4% than the real-life Brexit-impacted case.

At grassroots level, the British Chambers of Commerce (BCC) underlines that that businesses’ focus on costs instead of investment against a background of uncertainty is likely to see investment fall by 1% in 2019, its largest annual fall since the 2008 financial crisis. The BCC also expects net trade to make a negative contribution to GDP growth in 2019 and 2020, reflecting uncertainty over the UK’s future trade arrangements. Growth in the dominant services sector is expected to weaken to 1.1% in 2019, which would be the slowest growth since 2009, while the BCC also expects growth in manufacturing and construction to slow further.

Perhaps the most sobering thought, however, is that the vast majority of independent economic forecasts available still assume that the UK will avoid a disorderly exit from the EU. The ‘messy’ scenario, which would cover much more than just ‘no deal’, could prompt significant further downward revisions.

Economic Outlook

Mark Carney, described by some as the Bank of England’s first ‘rock star’ Governor, is leaving the Old Lady and headhunting is already advanced. Financial Conduct Authority boss Andrew Bailey is hotly tipped to take over, but whoever gets the gig will have the unenviable task of stabilising monetary policy post-Brexit. In the short term, the Bank’s rate-setters are remain on the fence until the withdrawal picture is far clearer, notwithstanding currency wobbles in the coming months.

Of the 75 economists polled by Reuters at the end of April only half a dozen predict a rate rise before Brexit is due. The median forecast is for a rate rise in the first quarter of 2020 — when Carney hands over. A large minority do not expect rates to rise at all this year or next. Wage growth, retail sales, job creation and overall economic growth have been slightly stronger than the BoE’s expectations in early 2019, even if businesses and consumers are downbeat, but some of this growth came from businesses stockpiling to protect themselves against a no-deal Brexit. This particular element lifted GDP growth in Q1 to 0.5%, from 0.2% in Q4 2018.

The outlook for consumer price inflation is benign for the rest of 2019, with a combination of higher oil and household energy prices offset by downward pressure from across a range of goods including food and motor vehicles. The apparent balance is set to keep the headline rate close to the 2% target for the time being.Businesses say they are struggling to absorb the high cost of imported raw materials amid tightening cashflow – a task made more difficult by the raft of extra upfront costs imposed on firms at the start of the new tax year. 

Wage growth remains a much bigger inflation concern: at 3.2%, regular pay growth is not far off a post-2008 crisis high, owing to skill shortages in many sectors of the economy. Average earnings are rising at their fastest pace in a decade, with unemployment at a 44-year low of 3.8% in Q1. Unit labour costs pose a further long term threat. Against the current background of flat productivity, this measure of how the cost of labour affects a company’s cost of production  is rising. It was up 3.1% in 2018 and the Bank of England said in March that the surge in unit labour costs remains “notable”. Wage growth may prove to be illusory for households if it forces inflation - and therefore interest rates - higher.