The Hut Group’s share price has fallen by over 70% in recent weeks, following critical broker comment. My friends at influential research boutique The Analyst initially raised questions about the company and its valuation. More recently, Sky News revealed that a Numis salesman later sent an email to clients, also suggesting accounting irregularities. Numis, which helped float THG, also apparently cut its target price in half for the group. According to that article, the company apparently fell out with Numis at the time of or after the float; this is just one of a number of red flags which should have raised investor concern.
Part of the pitch by the Analyst apparently relates to the significant adjustments the company makes to its accountants’ standard earnings number (a £538.2m loss) to derive management’s preferred metric of adjusted EBITDA (quoted 29 times in the 2020 annual report) of £150.8m.
The definition of adjusted earnings numbers is one of those grey areas where company Finance Directors often disagree with my views. One of us has share options, but it’s only fair to point out that there are sometimes legitimate arguments on the other side. It’s easiest to think of the -£538.2m loss turning into a positive £150.8m in two stages – the real “GAAP” earnings number is a loss of £538m. First, the company makes £531m of adjustments (which we shall examine below) to derive an adjusted loss of -£7.1m.
Second, the difference between the -£7.1m of adjusted earnings/losses and the £150.8m of EBITDA represents the exclusion of tax, interest charges and depreciation and amortisation. All of these are costs, but investors (private equity in particular) often like to look at EBITDA-based metrics as they exclude the effects of different debt levels and tax treatments. This is preferred by private equity because they frequently load companies with debt and don’t pay any tax as a result; hence they are interested in a cash earnings measure, depreciation being a non-cash item.
In the company’s P&L, the £531.1m of adjustments are broken down into:
· tax impact of £3.8m being the additional tax levied on the £527m of pretax adjustments – the additional earnings being presented are largely not taxable, which might give an indication of their quality
· a credit to distribution costs of £55m
· a £472m credit to administration costs
In the notes to the accounts, there is a useful breakdown as shown in the table, explaining adjusted EBITDA:
Note that the heavy use of adjusted EBITDA is a yellow flag and one which I highlight in my YouTube video Finance Demystified #2 – 7 Flaws with EBITDA which explains why EBITDA is over-used and can be dangerous to investors’ wealth.
The £48m of depreciation and the £57m of amortisation are “normal“ adjustments. The £332m of share-based payments (more on this below) and the £105m of impairments are similarly conventional adjustments employed by many public companies. The £90.6m is the most interesting number which we can investigate further. A more detailed explanation in note 4 to the accounts is more granular and therefore easier to analyse:
Adjustments to Reported Profit
My usual method of dealing with this is to review the elements line by line:
1) Transportation, delivery and fulfilment costs in relation to Covid-19 £39m. This is a logical addback for many companies as the costs of dealing with the pandemic were significant and presumably non-recurring. But generating an accurate picture of Covid-related costs is tricky and I would generally be sceptical.
The company explains that this relates to “specific and identifiable additional costs such as chartering THG exclusive flights, identified Covid surcharges as specified on invoices and identifiable external costs relating to the use of alternative routes”. In my view, it would be extremely tricky to assess how much of the cost was Covid and how much non-Covid. And while there were certainly additional costs, there was also a large uplift in Covid-related revenues. The conservative investor should therefore be sceptical about this adjustment.
2) Commissioning – new facilities £16m. I have followed logistics and transportation businesses for many years. The cost of commissioning new facilities is an ordinary part and parcel (sorry) of the business. This is especially true for a growth company valued at 6x sales last year. The company has identified non-recurring costs such as testing and commissioning, the costs of migrating operations, and bulk internal warehouse transfers.
I have moved office twice in just a few weeks (thanks WeWork), but I doubt my accountant will let me set off the costs of the moves as an exceptional item. The last logistics company which adjusted for these expenses went bust. In my view, these costs should not be an adjustment to reported earnings.
3) Decommissioning – legacy facilities £0.2m. It was larger the previous year and most companies would just take this on the chin. The accounts state “There is commonly a period of overlap of operations of both a legacy warehouse and the new facility designed to replace it, and duplicated costs are recorded as adjusted items as they do not reflect the underlying cost base of the Group. The costs associated with the decommissioning and closure of these facilities, from the period they are deemed to be surplus to the closure/exit date, are included within adjusted items”.
Again, I don’t think that this is an appropriate add-back. If you are going to add back the commissioning costs, then I suppose it’s only logical to add back the decommissioning. And while the company says that “these costs are not expected to be recurring for each specific site and do not reflect the underlying cost base of the Group”, I would disagree. If this is to be a growth business, it will continuously need new sites. Amazon is a classic example of ongoing investment in new facilities. But last time I looked, Amazon did not make any adjustment for the cost of opening a new warehouse, or closing an existing one.
4) Share-based payments £332m. I have written a much more detailed blog on this subject which may be of interest to the accounting geeks. It was titled “Stock-based comp – the disappearing expense” as the item is not presented anywhere in most companies’ analyst presentation materials and many analysts simply ignore it. This is pretty dangerous as of course, it is a real expense and one which dilutes shareholders.
“The charge relating to share based payments has been treated as an adjusting item as the underlying driver for the share awards (e.g. the IPO) is also an adjusting item. Any share-based payment charges relating to employee reward and retention remain as an underlying cost”. I haven’t managed to find any cost for share-based payments actually charged against adjusted profits. 216m shares vested on listing alone; at a listing price of £6, this amounts to c.£1.3bn and I estimated a slightly higher net cost based on the accounts disclosures. It’s a big number and one which shareholders should monitor carefully going forward.
There are various ways of measuring this, but by far the simplest is just to look at how many shares are being issued to employees for free or at a discount and adding these to the share count and market capitalisation, adjusting for any cash received. More is in the blog.
5) Impairment on assets held for sale, and sale and leaseback charges £105m. This is a non-recurring item, and might involve assets transferred to the founder; the assets include two hotels which raised an eyebrow. But it’s quite normal to exclude this from the adjusted earnings. The sale and leaseback charges would commonly be added back as a deduction from the profits on sale although the property sale profits are not separately identified here.
6) Donations and other covid-19 related costs £11m. The accounts state “ the Group made several charitable donations to the local region, totalling £6.6m…with the remainder relating to additional costs incurred as part of making the business Covid-19 secure (temperature sensors, PPE etc) for its people and customers. This is expected to be non-recurring”. On a £1bn revenue base, a £4m “investment” in sanitisers etc is hardly a big deal. It’s £740 per employee, which is more than I would expect. And would temperature sensors not be capitalised?
There is a useful lesson here. Some analysts will not worry about this line as it’s just £11m and not worth investigating. But this is exactly the sort of adjustment which tells you something about the psychology of the management team which is trying to sell you the shares. Everything is in the shop window here, certainly all the good stuff.
7) Acquisitions – restructuring and integration £6m. It’s quite normal for a company to add back the costs of integrating acquisitions to calculate adjusted profits and it’s a reasonable thing to do to give a picture of the underlying performance. But I am often suspicious that the add-back is generous and that the amounts adjusted include other “normal” costs. It’s a very easy way for a company to flatter its performance. I cannot say that this is unfair in the case of The Hut Group. They spent £102m on acquisitions in 2020 (£84m in 2019) and added back £6m of integration costs in both years. The level is enough to buy quite a lot of integration but I haven’t looked at how many deals they have done and it’s not sufficient to move the earnings needle.
8) Acquisitions – legal and professional costs £3m. Again it’s quite normal to exclude these from the operational performance but fees are usually included in the cost of acquisitions and it’s not clear why these would be charged against profit in this case.
9) Other legal and professional costs £2m. I was surprised to see this as an add-back, with the accounts explaining “The Group incurs legal and professional costs that are non-recurring, one-off in nature and not related to trading activities. These costs are included as adjusted items and can include, but are not limited to, costs associated with equity raises that occurred before the IPO, and other fees associated with investor activities”. This loss-making company’s capex averaged £150m pa for the last two years. Legal and professional costs related to capital raising are an essential part of the operational activities and such costs should not be added back in my view.
An additional motivation behind all these adjustments may be to represent the cash flow more positively:
It’s unusual for a company to present its cash generation in this way and a £98m “exceptional” cash outflow certainly makes the numbers look better. But how the £90.6m of P&L adjustments (outside the share based comp and the property impairment) translates to £98m of cash flow is not obvious. The company generated a £103m adjusted increase and a £22m actual increase in cash from operations on a £473m increase in revenues. Working capital was a net positive as increased payables more than offset higher inventories and receivables. I haven’t investigated further but the company’s representation of its cash flow is unconvincing at first glance.
After a 70% price fall, I don’t know if The Hut Group is still a short, as was suggested by my friends at The Analyst. The company’s equity is now valued at £2.8bn for sales last year of £1.6bn and of course, it’s loss-making and not generating any free cash flow, and limited cash flow before investment in the business. The extensive explanation of adjustments to reported earnings may indicate a management team anxious to give investors a faithful representation of underlying performance in an unusual year. Or it may reflect a management team trying to paint an unduly flattering picture. What do you think? Why not email me and let me know?