RBS, Akzo Nobel and Hornby

The Royal Bank of Scotland (RBS) AGM is tomorrow and it will be interesting to see what excuses the board of directors give for rejecting the requisition of a resolution to establish a Shareholder Committee. ShareSoc believes the rejection has no sound legal basis and ShareSoc directors will raise this issue at the meeting.

Another similar case is that of Akzo Nobel in Holland where Elliott Advisors have been pushing the board to consider a takeover offer from US company PPG Industries. But they have stubbornly refused to entertain it. Elliott submitted a requisition for a General Meeting to consider the removal of the Chairman of Akzo, Antony Burgmans. Elliott had the required support of over 10% of the shareholders. The company rejected the request so Elliott are taking the matter to the Amsterdam Court of Appeal. The legal position is complicated by the presence of “priority” shares held by a foundation which was established as a defence against hostile takeovers.

Comment: this looks like a similar blatant attempt to defeat shareholder democracy by the directors, as at RBS. Let us hope that it is not successful.

Meanwhile the extraordinary General Meeting called by Hornby following a requisition to consider changes of directors by Alexander Anton and other shareholders will be adjourned indefinitely as the requisition has been withdrawn. That follows a declaration by the company that they had committed votes to defeat the resolutions proposed.

Roger Lawson

Pearson Pay Vote Lost

Shareholders in Pearson (PSON) yesterday rejected the Remuneration Report on a vote at the company’s AGM. That was by 61% opposed to 32% supporting with 6% abstaining. But they approved the Remuneration Policy.

Opposition to the Report seemed to be based on the fact that CEO John Fallon achieved a 20% rise in total pay despite a record loss and several profit warnings.

However the share price rose on the day substantially by 12% perhaps because of a positive first quarter trading statement issued in the morning in certain areas, although the overall 2017 outlook guidance was unchanged.

What is puzzling is that the remuneration votes at Rolls-Royce the previous day were passed with ease, where there were similar negative comments by ShareSoc, some proxy advisory services and the media on the bonuses achieved by CEO Warren East even when underlying profits fell substantially. See my previous blog post for more information. Why did that revolt turn into a damp squib, when it was just as justified as the opposition to pay at Pearson?

Is this simply the perversity of institutional voting, better communications from the company or was there some other specific reason?

Roger Lawson

Rolls-Royce – Audits Investigated and AGM

Yesterday (4/5/2017) I attended the Rolls-Royce (RR.) Annual General Meeting in Derby. In former years they used to hold the meetings in London but it’s been Nottingham and Derby the last couple of years. As a result, from talking to a few attendees it seemed to be mainly Rolls-Royce employees and retirees attending rather than the normal private investor crowd. The choice of venue may of course be deliberate so as to achieve a more sympathetic audience.

But the story promoted by the company is much the same – orders up, sales down and profits down, but the company says it has a bright future in summary. In the last year we have also had the settlement of past bribery in the company, and the issue of needing to change their revenue recognition on maintenance contracts (these issues have been well covered in past ShareSoc blog posts). In addition there was a massive reported loss arising from foreign exchange hedges being revalued.

The same day it was announced that the audit of the company’s accounts by KPMG in 2010-2013 are to be investigated by the Financial Reporting Council. Which seems very appropriate bearing in mind what was disclosed at the AGM.

Here is a brief summary of what was said by Chairman Ian Davis and CEO Warren East, and what I said in the Q&A session (not verbatim – summarised for brevity) . There is a fuller report on the ShareSoc Members Network:

Ian Davis confirmed the outlook for 2017 was unchanged – a trading statement was issued in the morning which said trading was in line with expectations but that profit and cash flow would be weighted towards the second half of the year. Cost savings were given as being “on-track” and the company priorities includes continuing to “rebuild trust and confidence in our long-term growth prospects” which is a clear admission that investors had lost faith in the company. The share price has improved over the last few months but it’s still considerably lower than it was back in 2013-2015.

Mr Davis said he was impressed by Warren East’s building of his management team, and that the long-term prospects for the company remain outstanding. The order book has grown to £80 billion.

After that short presentation, Warren East spoke at more length. He said that 2016 was a year of stabilisation and was a great foundation for moving forward. Underlying revenue was down slightly but underlying profit was down significantly [49% down in fact]. He explained the large “headline” fall in profits has being due to derivative contract revaluation. But he did say that underlying profit (which excludes derivative charges) fell due to significant headwinds in the civil aviation business. However they have grown the wide-body engine market share from 30% to 50%. There was a once in a generation transition to more efficient engines. The launch costs will decline and the installed base will grow.

They are losing mid-range and corporate jet market share, and defence is still a challenging market. In power systems there was a stable performance and the installed base grew. Marine suffered from extreme weakness due to a dearth of orders for new vessels and servicing. There have been major job losses. In nuclear there had been some investment in the development of small modular reactors.

Mr East continued by saying they had invested a lot in 2016 in R&D, in assets and in operational excellence. But they had not forgotten cost control. He said investors were now more confident in the company now – hence the improvement in the share price. They have restored trust in the company.

Mr East then talked about the new management appointments and said they still need to follow through on strategies set in 2016 while also thinking about the future.

He explained the deferred prosecution agreement over the bribery allegations (£671 million in fines, plus an obligation to change their behaviour). There had been extensive action within the business to change policies in this area.

I covered a number of issues when questions were invited:

1) I questioned whether the former management (e.g. the CEO) should be subject to clawback on bonuses because of the bribery and other issues. The answer given by Ruth Cairnie (Chair of the Rem Comm) was that the management who were involved in the bribery scandal had lost all their bonuses and options and that clawbacks had been introduced. But the Chairman said that the former CEO knew nothing about the matter at the time. Incidentally there was an amusing comment from Matthew Vincent in the FT today which was “All of this prompts the question: which euphemism did Rolls-Royce use for the £100,000 or so it spent on a Silver Spirit car to indulge the automotive appetites of an Indonesian intermediary? Miscellaneous travel?” That question was directed at KPMG but it might just as well be directed at the former CEO surely.

2) I suggested a shareholder committee would perhaps help Rolls-Royce deal with the various problems they faced.

3) As regards the accounting change to future maintenance, which had been explained away as a “technical accounting issue”, I said that it was not just a technical matter but a question of prudence. In my view it was not prudent to recognise future sales and profits in the current year. And it was certainly not clear in the past that this dubious accounting treatment was being used.

4) I also commented negatively on the complexity of the Remuneration Policy. Ruth Cairnie said it had been simplified but I pointed out that the maximum salary multiple in the LTIP had actually been increased. I spoke to Ruth at some length after the meeting on remuneration. I pointed out that such LTIPs result in enormous payouts at companies like Persimmon and Berkeley Group (WPP is another example incidentally) and that a recent Commons Committee said they should all be scrapped. She responded that they had to pay a competitive “package”. I agreed with that but said it would be better to have a higher fixed base salary and do away with LTIPs, or pay bonuses in cash or shares annually. There was no incentive provided by LTIPs as anyone familiar with business management would know – rewards for good performance need to be made soon after achievements. I also said to her that if public companies did not reform their attitude to pay and the levels they considered appropriate that the Government might take a hand. I did say to her that it was her responsibility and she could do something about it. She did not seem happy with my comments but reiterated the usual stance about having consulted all their major investors. Indeed they did achieve 95.6% support on the Remuneration Policy vote and 98.7% support on the Remuneration Report vote.

It was only a moderately useful meeting to attend. As in previous years, treated more like a PR exercise for company pensioners than a serious meeting for investors by the Chairman. Bearing in mind that the Chairman has been Chair of this company for several years, it surprises me that he is still there when the company has had so many problems on his watch. I would certainly prefer a new Chairman. Matters such as remuneration tend to be driven by the Chairman and his response to criticism of any kind is not helpful. But he still got 99.5% of votes to re-elect him. Surely an example of how corporate governance by institutions tends to be brain-dead. The votes on remuneration also demonstrate a pathetic response to the pay issue.

In essence the old problems are still there. Orders going up, but sales falling, i.e. orders not able to be delivered and turned into cash. They need to start using a different measure of likely future business. With such a large and complex business, it is difficult to say yet whether Warren East has really got to grips with reforming the company. We will have to wait and see.

Meanwhile there was a good editorial in the FT on how the defects in auditing at companies such as Rolls-Royce “highlight the failure of the accountancy profession and its regulators to resolve in the intervening 15 years [since Enron and the demise of Arthur Andersen], the fundamental question of how far auditors should be expected to go in their efforts to uncover bad behaviour”. One cannot but agree with that and with their view that 4 major audit firms is not enough to ensure competition and that it tends to encourage cosiness between auditors and their clients. But there are surely more substantial reforms necessary to really improve auditing standards which the profession itself seems to not accept as being required in any way.

Roger Lawson

Sainsbury (SBRY) Results

Supermarket and other goods retailer Sainsbury issued their preliminary results this morning. Growth in everything except profits and dividends is what one might say from a quick read of the data. Lots of positive noises about out-performance in the markets where Sainsbury and newly acquired business Argos compete. Group revenue up 11.6% due to the acquisition, but earnings per share down by 27% and the dividend has been cut. The latter decline was forecast by analysts but the share price has fallen by 5% on the day. Perhaps it was the rather bland “Outlook” statement that spooked investors, or they were hoping for more. When one says things like “The market remains competitive…” is that really saying anything we did not already know? When has the grocery sector not been competitive anyway?

But profits are due to fall in the next six months in comparison with the last due to rising costs according to CEO Mike Coupe.

The announcement also said: “…we continue to innovate in quality and to invest in price”. I think the latter means they are cutting prices but what does the former mean? Are they improving product quality or changing it in some other way?

Whoever wrote this surely needs to take some lessons in how to write announcements that are clear, concise and to the point.

But there is quite a lot of positive news. General Merchandise and Clothing in Sainsbury grew and Argos grew sales by 4.1%.

Digital sales continue to grow and it said 53% of sales were now made online. However, having used the Sainsbury on-line service today (a rare occasion), I can’t say I found the site very exciting. Bland presentation and limited product range. Even as a very small shareholder in the company, one does need to experience the customer proposition occasionally.

In conclusion, the company seems to be heading in the right direction, but clearly the price competition in the traditional supermarket segment from low cost competitors is still proving to be a headwind. Like-for-like sales were down again this year. As readers may have noticed, our household food bill has actually declined in the last couple of years, and that’s not just down to more dieting or more eating out. However food price inflation is increasing so that might help food retailers because they apparently made hay when prices were constantly rising as folks just did not notice that profit margins of retailers were also rising. However, price inflation on general merchandise and clothing may reduce demand as consumers reduce expenditure.

So it’s a mixed report, or still a “work in progress” so far as this company is concerned in relation to revitalising the business and achieving some growth. It will be interesting to see what retail analysts and the media make of this announcement in due course.

Roger Lawson

Banks and Bank Credit Card Accounting

It’s going to be exciting week next week for RBS and Lloyds Bank shareholders with both AGMs on Thursday in Scotland – we expect to issue a report on events. Indeed it’s going to be an exciting period ahead because the law suits by those investors in the RBS rights issue who have not yet settled, and an action over the takeover of HBOS by LloydsTSB, are both getting into court in the next few months. Having Fred Goodwin on the witness stand, as expected, will be particularly interesting.

But the really astonishing recent news to this writer was the revelation on Monday (1/5/2017) by the FT that bankers are recognising future profits on zero-interest credit card customers. Bankers who offer zero interest balance transfers recognise some of the revenue and profits from new such customers based on the expectation that the customer will remain a customer, and not fully pay of the debt, when the interest free period ends.

Now a lot of them might not, but surely it is imprudent to recognise the cost of such promotions as other than a marketing expense which is surely what they are? And recognising future profits in the current accounting period is definitely neither sound accounting nor prudent in my view.

Was this not what Rolls-Royce had been doing which they have had to back-track on? With a major impact on their bottom-line as profits were routinely being overstated (see previous blog post on that).

The level of credit card debt is currently of concern to the Bank of England, and they might bring in tighter regulation on such offers and the level of debt. Or the customers might suddenly realise that not paying off such very expensive debt was nonsensical, particularly as the ability to roll it over to another credit card company might disappear. So all those future bank profits on credit card lending they are recognising now, and paying bonuses to management on them, might vanish.

Virgin Money is one bank where it is suggested they could lose as much as 18% of their earnings if there was a move to “cash accounting” on such arrangements, i.e. profits can only be recognised when the cash arrives.

So there are two questions that investors in banks might wish to ask at this year’s AGMs: 1) Are you doing this and if so why are the directors following this imprudent accounting practice? and to their auditors: Why are you approving this imprudent practice and under what accounting principles?

I fear this may be yet another example where banks will face regulatory action, and have to write off some of their claimed profits. And will investors ever learn to trust the reported accounts of banks when this kind of sharp practice continues?

Roger Lawson

 

Open-Ended Property Funds – Our Views

ShareSoc has now submitted our response to the consultation by the FRC on “Illiquid Assets and Open-Ended Investment Funds”. This follows on from the problems experienced last year where property funds had to close to redemptions but it can affect other types of funds also such as private equity ones.

In summary after listening to a number of our members on this topic, we have chosen to say that although we would not be opposed to the banning of such funds entirely, we suggest the best way to ensure there are no problems in future is to ensure that very strong health warnings are given to investors who chose to invest in such funds. Obviously in the case of commercial property funds, there are a number of closed end funds (e.g. investment trusts) covering that sector so most investors should have very good reasons to choose open-ended ones instead.

You can read our full response here: Open-Ended-Funds which also contains a link to the FRC consultation document.

There were a couple of interesting articles related to this topic in the Financial Times recently. One reported that big UK property funds are hoarding cash – in several cases well over 20% of their assets. Presumably this is because of fears of a repeat of last year’s run on the real estate sector. Holding large amounts of cash obviously provides the liquidity to enable high requests for redemptions to be met and to counter market volatility, but it also reduces the returns from the fund in the longer term as cash typically yields less than property. It would be unusual for a real estate investment trust to hold that much in case, and often they are more than fully invested as they use gearing to improve returns.

Another article reported on the Association of Real Estate Funds (Aref) response to the aforementioned consultation. Their report called for a “comprehensive review” of the rules governing retail property funds as it was unclear what fund managers were allowed to do. A somewhat odd comment and the FRC consultation document clearly covers the matter in some detail already. But another suggestion made is that the problem could be resolved by having a range of different fund structures because most investors are not actually looking to “day trade”. So a range of products reflecting the different liquidity needs of investors might be offered.

Comment: An interesting idea but would it really be practical? It would also add confusing complexity to investors choice. Investors find it difficult to anticipate when they might want to sell, and some sales might be crystalised by the death or major financial/personal crisis of an investor. Would they be considered an exception, or just told it’s bad luck they chose to invest in a fund that requires six months or a year withdrawal notice – because that is how long it might take to dispose of commercial property? For private equity funds, it might take even longer to dispose of assets.

And would investors choose funds with lower returns in preference to others with higher returns? Which might be the result of them offering high liquidity at all times, and holding cash or other low return assets to enable the former to do so?

Behavioural responses to such scenarios could be complex.

Roger Lawson

Expensive Dividends – National Grid and Electra Private Equity

National Grid (NG.) are returning some of the cash received from the sale of their stake in a gas distribution business to shareholders via a large special dividend. And some will be returned via market share buy-backs, the wisdom of which may be questionable. But the real concern for private investors is that dividends are taxed as income even though this is in essence a “return of capital”. It is not being paid out of operating profits, but simply from the sale of part of the business.

In the past, companies would recognise this fact and the tax problem faced by private investors by offering a “B” share alternative that could then be redeemed and turned into a capital gain (as capital gains are less highly taxed than income for many investors). But this was outlawed in the 2015 Finance Act – there is a good article in the Daily Telegraph today that explains this in more depth.

But consider the plight of retail investors in Electra Private Equity which is much worse. They recently announced a similar return of cash via a special dividend of 2640p per share. The share price the day before it went ex dividend was 5,110p so effectively half the value of the company is being returned as a dividend. One investor who contacted me invested £20,000 in the company many years ago, and his holding is now worth near £150,000 so he will receive an enormous income tax bill. Needless to say he is not happy.

A particularly iniquitous aspect is that a lot of the “profit” he is being taxed on actually simply results from asset price inflation over the years.

Could the company have considered alternatives? Spreading the return of more than one tax year may have helped, but another possibility would be to return the cash via a tender offer to shareholders. Those taking it would realise a capital gain, while those not doing so would see the value of their existing holding unaffected (the share price would adjust to reflect the lower asset value per share and the proportionally similar fewer number of shares in issue).

There may be other possibilities that a tax and accounting expert could advise on, but unfortunately it’s probably the impact on institutional investors that is driving this desire to pay dividends and private investors are being prejudiced.

I may raise this issue at the National Grid AGM in July, but it will be too late to affect this and dividends can be declared by a company’s directors without a vote of shareholders. Similarly on Electra Private Equity, it is too late to object as the dividend has been declared and so will be paid.

This is yet another example where the taxation of capital gains and dividends is irrational and deeply prejudicial to the interests of investors. The solution, without prejudicing the Governments need to receive tax, would be harmonisation of dividend and capital gains taxes. But the latter should be index linked to avoid taxing fictitious profits.

Roger Lawson