KERRY GROUP - Short seller expresses scepticism
8th April 2021
Share price: €112.10
Dividend yield: 0.8%
Historic P/E ratio (based on earnings for 2020): 36 times
Prospective P/E ratio (based on forecast earnings for 2021): 33 times
I had a feeling of deja vu when I read recently that a hedge fund was short selling* Kerry Group shares, and had expressed scepticism about the value of acquisitions that Kerry had made.
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Back in the early 2000's, I was lecturing for an evening course titled 'Introduction to the stockmarket', originally set up in the Cork College of Commerce by my former colleague, Padraig O'Riordan, and subsequently presented at many other centres throughout Munster. I often emphasised how accounting policies gave considerable room for companies to adjust upwards their reported profits.
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On one memorable occasion, I reviewed the accounts of Elan Pharmaceuticals and expressed my concern that it was flattering its results by dumping some research and development expenditure into off Balance Sheet entities - ironically named 'SPIVS' ... special purpose investment vehicles.
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The spivs at Elan got their comeuppance a few weeks later, when the shares collapsed due to short selling by US hedge funds who spotted the same vulnerability in the accounts.
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Enthused by this success, I picked apart the accounts of many Irish companies at later presentations. I wasn't always bearish, and I remember giving Paddy Power (now Flutter) a particularly positive review - it is now almost 50 times the price it was then.
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However, my bullish and bearish prognostications did not always work out. But I was a young man in my thirties and early forties in those days, and now as I stare down the barrel of 60, I realise that I probably learnt more from my failures than from my successes.
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One of my notable failures was Kerry Group, where my view was bearish for a few years, until I reversed course in 2010 and became bullish with the share price around €20.
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Hence my feeling of deja vu, when I read of a hedge fund 'shorting' the shares on alleged vulnerabilities exposed by Kerry's aggressive accounting policies.
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The hedge fund expressed scepticism about the value in Kerry's balance sheet of many of the acquisitions it had made. That was also a concern of mine, but the main item I identified back then, was the frequency of 'exceptional items' in the accounts, which were almost always costs rather than credits.
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Was Kerry Group classifying some expenses as 'exceptional items' so that it could report higher profits and adjusted earnings per share? 'Adjusted' earnings per share omits these exceptional items and is invariably emphasised in the results, instead of basic earnings per share where exceptional items are included.
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The market paid no heed to my bearish prognostications, and the shares continued to head upwards. Then suddenly, during the tenure of Hugh Friel as CEO, Kerry Group had a profits warning. Had Friel inherited a poisoned chalice from his long-standing predecessor, Denis Brosnan, who had achieved legendary status due to the growth rate enjoyed by Kerry in his era?
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It didn't seem to matter. The market quickly shrugged off this setback and the shares soon resumed their upward course. Technical analysis continued to identify Kerry Group shares as an out-performer in the Irish market, so I resolved to change course at the next suitable opportunity.
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That opportunity came during a serious market wobble in 2010, caused by fears of a breakup of the eurozone. I noticed that Kerry Group shares had fallen less than the other 'blue chip' stocks on the Irish market - always a good technical indicator, highlighting the resilience of the stock and pointing to outperformance in the event of a recovery, which followed not long afterwards. I was working for Redmayne Bentley at the time, and recommend the stock at around €20 in its monthly publication 'Equity Insight'.
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So what of the exploitation of 'exceptional items' - surely it is suspicious if a company has 'exceptional' costs every other year (and is reporting adjusted earnings per share before these exceptional costs)? Well, it now looks like Kerry is merely guilty of being an early mover in that regard. Nowadays, pretty much every acquisitive company that is classified as a 'growth stock' is doing this.
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'Just because everybody else is doing it, that doesn't make it right' ....I hear you say. Perhaps, on the moral high ground, yes. But down here in the commercial world, where we 'fumble in the greasy 'til' as Yeats described it, there is safety in numbers.
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Assuming therefore that tolerating the frequent recurrence of 'exceptional items' has become the norm, what then of the alleged questionable values of acquisitions per Kerry Group's balance sheet?
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The generally accepted accounting standard for valuing acquisitions is rather complicated. Therefore, if you would rather not be bothered going through the numbers - just skip to the concluding paragraphs of this article from here.
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Here is how it works. The acquiring company pays, let's say €500 million cash for the target company. The target company has €200 million of net assets. That €200 million worth of net assets will subsequently appear on the balance sheet of the acquiring company in its next set of accounts. The difference between the amount paid of €500 million and the net assets of €200 million, which is €300 million, is described as 'goodwill on acquisition' and this will also appear on the balance sheet of the acquiring company.
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What happens next is that every year thereafter, the acquiring company assesses the value of that goodwill. This is done by examining the business acquired and separating it into 'cash generating units'.
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The value of these 'cash generating units' is assessed by estimating the cash flows that these will produce in the next five years, and applying a discount rate to these to get their 'net present value'. Added to this 'net present value' is something called the 'terminal value'. This 'terminal value' is the value of projected cash flows arising outside this five year period, and the company is expected to take a more conservative view here, given that this period is further into the future.
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The resulting 'net present value' of the 'cash generating units' is then compared to their value on the balance sheet (net assets plus goodwill). If the 'net present value' is higher, then no action is necessary. But if that value is lower, a write down of goodwill is required.
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How does Kerry Group measure up here?
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'Pushing the envelope somewhat', would be a fair response, in my opinion.
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Let's compare Kerry's assessment of the value of 'cash generating units' acquired, which thereby impacts on whether or not a write down of goodwill is required, with that of the lower rated Glanbia.
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Kerry is taking a much more optimistic view of the value of its acquired 'cash generating units' than fellow peer Glanbia. Hereunder are the key points:-
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(i) Kerry is applying lower discount rates than Glanbia to the projected cash flows for the next five years (thereby resulting in higher values for its cash generating units).
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Kerry applied a discount rate of 6.9% in 2019 (the 2020 annual report had not been published when I examined the accounts) to the 'Americas' division, whereas Glanbia applied a discount rate of 7.39% for it's 'North America' division in 2020.
(ii) Both Kerry and Glanbia adjusted their discount rates slightly, year on year, some up but most down. However the biggest reduction (and therefore most optimistic/least conservative) was Kerry's reduction for it's European division from 6.8% to 6.5% (resulting in an increase in the valuation).
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(iii) The 'sensitivity analysis' done by Kerry is less robust than that done by Glanbia.
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'Sensitivity analysis' is an examination of how much the assumptions made (in valuing the cash generating units), could deteriorate, without having an impact on the goodwill value.
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Both Kerry and Glanbia state that a 1% increase in the discount rates used (in absolute terms), would not require a write down of goodwill. Kerry goes further and proudly states that an increase of up to 5% in the discount rate applied to projected cash flows, would still not require a goodwill write down.
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However, the next statement from Kerry is quite illuminating.
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Kerry states that a 1% decrease in the "growth rate per management estimates" would not require a goodwill write down.
Therefore, if the earnings growth rate turns out to be more than just 1% less than management's estimates (which are unlikely to be overly conservative) then there is a problem - because this would result in a required write down of the massive goodwill on acquisitions figure shown as an asset on the balance sheet.
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I am assuming here that the 1% decrease referred to in the 'sensitivity analysis' is in absolute terms, not percentage terms. For example, the projected annual growth rate for cash flow in the 'Americas' division is 1.1%, so a 1% decrease in absolute terms would result in an annual growth rate of 0.1%.
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In contrast, Glanbia says that it could handle a 10% reduction in the EBITDA (earnings before interest, tax, depreciation and amortisation) annual growth rate projected by management, without having to write down goodwill on acquisitions.
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Kerry tries to provide some further comfort here by adding that a 5% decrease in cash flows per management estimates, would have no impact on the goodwill on acquisitions figure.
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That indicates that cash flows will be higher than earnings. Yes, that is better than if the reverse were the case. But it is by definition, a temporary divergence. For example, if there is a very high charge for depreciation on plant and equipment, then cash flow will be higher than earnings for a few years (as no cash is paid out for depreciation). However, a few years later, the plant and machinery needs to be replaced, and this involves a huge cash outflow for new capital investment (which is later expensed over time by the new depreciation charge in the profit and loss account).
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Where do the auditors stand on all of this?
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Back in my day as an auditor (the 1980's), all we said in the audit report was that the accounts gave a 'true and fair' view of the company's financial position, or otherwise the audit report was qualified.
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Nowadays the audit report is a lengthier affair, and the main risky areas are listed in the report as 'key matters'.
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Sure enough, auditors PWC state that the goodwill on acquisitions figure in the balance sheet which is a significant number, is a key issue, as it depends on management's forecasts and assumptions etc. Yes, they say that management's assumptions and forecasts were reviewed and subjected to sensitivity analysis but that this involved a "high level of subjectivity".
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Over at Glanbia, the auditors Deloitte are given an easier ride as Glanbia's policies are more conservative than Kerry (that in itself provides cover for Deloitte should anything blow up at Glanbia). They content themselves with highlighting the goodwill value relating to one North American division (named "think!") as a key item, stating that a write down would be required if the projected terminal value growth rate fell from 2% per annum by 1.75% to 0.5% per annum.
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Will the hedge fund be forced to reverse course in its assessment of Kerry Group arising from alleged overstatement in the accounts of assets, namely the figure presented for goodwill on acquisitions?
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My guess is that it will, and that Kerry will shrug off this challenge to its accounting integrity for the following reasons:-
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Firstly, Kerry Group is a difficult stock for short sellers to attack because much of the stock is in 'safe hands'. 12% of the shares are held by Kerry Co -op and they are not selling. And they certainly are not lending out the stock to a short seller, to sell (and later buy back at a lower price - thereby realising a profit). Also a further 26% of the stock is held by private individuals, and neither are they lending out any stock to short sellers. Finally, Irish investment institutions will want to keep a major holding in Kerry due to its large weighing in the ISEQ index.
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Therefore, there is not very much stock available for lending out to short sellers, and this means that a short selling attack is unlikely to gain much momentum. Unlike Elan which suffered two successful short selling assaults - facilitated by its US listing, resulting in many US shareholders who were prepared to lend stock out.
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Secondly, in this era of extraordinarily low interest rates, there is probably still some scope for acquisitive companies to further reduce their discount rates applied to cash flow forecasts. These are related to the company's 'weighed average cost of capital' and that is falling as old debt is refinanced at new, and lower, interest rates.
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Yes, there was a sudden rise recently in the yield on the US 30 year treasury note. But I don't think that this presages higher interest rates in the near future. Governments are swimming in huge debt, arising from the financial bail out in 2008 and added to by the recent covid crisis. They will need to keep interest rates low and grow their way out of these huge debt levels by expanding the economy (thereby reducing debt to GDP) and creating some inflation.
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That is the type of low interest rate environment that is good for acquisitive companies such as Kerry Group (and conversely, bad for risk averse cash savers).
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Thirdly, Kerry Group's share price performance in the coming years will be largely determined by the next big acquisition it makes. The financing cost of debt is very low, so a modest return on the capital invested in the new acquisition will be sufficient to grow earnings per share.
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Furthermore, a large acquisition by Kerry would increase its weighing in the ISEQ index, forcing the passive index tracker funds to buy more stock. That will push up the share price and blow the short sellers out of the water.
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Yes, Kerry is probably guilty of some less than conservative accounting policies. But if I were a hedge fund manager seeking a short selling candidate, I would look elsewhere for a more vulnerable target.
Footnote:-
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Kerry Group's 2020 annual report is now up on its website. As regards testing for any required write down of goodwill on acquisitions, it has applied more conservative (ie higher) discount rates for the 2020 review compared to 2019, but these are still lower than Glanbia's, for 3 out of 4 cash generating units. However, the gap between it and Glanbia has now narrowed, and this more conservative approach from Kerry in the 2020 accounts is to be welcomed.
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I also note that 'exceptional items' have been described by Kerry as 'non-trading items' in the 2020 annual report, and in the reports for the previous few years, and these are not identified separately in the 10 year performance summary. Therefore one has to go back to the annual reports for each one of the previous years, to dig out these figures, before one can establish just how frequently these so called 'non-trading items' arise, and how material these figures are in the context of the overall results.
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If the hedge fund that is shorting Kerry Group shares questions the frequency of these 'exceptional / non-trading items' - perhaps CEO Edmund Scanlon should refer them to the Cranberries debut album, memorably titled 'Everybody Else Is Doing It, So Why Can't We?'....
* Short selling is a speculative trade, betting on a fall in a share price, by borrowing shares in that company from some existing shareholders, and selling these in the market. The short seller then hopes to profit by buying these shares back at a later date, at a lower price, and returning the stock to the shareholders who loaned it out.