Today, a small company in the U.K. called Conviviality Plc (LSE:CVR, Financial) collapsed, taking with it 2,500 jobs. Compared to other corporate failures, this is not a big deal, but the reason why I am interested in it is that it's an excellent case study of what can go wrong for companies, and what warning signs investors should be looking for to avoid.
A case study in value destruction
Conviviality was one of the U.K.'s largest alcohol distributors, with a range of outlets for consumers around the country as well as distribution agreements with more than 25,000 restaurants, hotels and bars (compared to the total market size of approximately 45,000, giving the firm a 56% market share). The distribution business model generally comes with low margins and high competition, but due to Conviviality’s size, experience and competitive advantage (from lower costs), the firm appeared to have the edge over in a niche sector of the industry.
The firm's collapse follows a string of profit warnings and the discovery of an unpaid £30 million tax bill, which was due 30 days after its discovery. The scale of this company's implosion is staggering. In the space of a month, a business with nearly £1 billion in revenue collapsed, and it seems as if the group's management had no idea what was going on with the underlying business.
The warning signs have been flashing red for some time. Even though the company's implosion took less than four weeks, in its latest results, for the six months to October, Conviviality announced total revenues to £836 million (up 9%) and a pre-tax profit of £6.4 million. It generated just £528,000 of cash from its operations. Such a razor-thin profit margin left the company for no room for error. Meanwhile, the amount of money the firm owed to investors jumped to £322 million, up from the last reported figure of £256 million. The company was predicting debt of £150 million for the end of the period.
Supplier obligations and debt totaling £472 million against cash generation of £528,000 is a definite red flag. Even though due to the nature of the distribution industry, cash flows tend to be irregular and unpredictable, the lack of money the company had available to it was a big red flag.
The next major red flag arrived at the beginning of March when the company issued a profit warning stating “a material error in the financial forecasts" of the business would mean forecast Ebitda would be 20% lower than expected for the fiscal year.
The fact that a company of this size could make such a mistake should have been enough of a warning to investors to get out while they could.
A week later, the company revealed that it had discovered the unpaid tax bill (presumably thanks to the new controls put in place) and a week after that, the shares were suspended. A £125 million fundraising to improve business liquidity has failed as; understandably, few shareholders were willing to support the business any longer.
Looking at this disaster gives a clear roadmap of the most undesirable qualities of companies. Investors cannot always avoid tragedies such as this, but by avoiding companies that display a few dangerous traits, we can significantly reduce the risk of falling into a trap.
Lesson learned
The lessons to be learned from the Conviviality scenario can be easily distilled:
1. The company was struggling to generate enough cash to keep the lights on. Without cash no business can survive. It's as simple as that. The lack of cash flow should have been an early warning sign for investors.
2. Despite the lack of cash flow, the company was paying a dividend right up until its very end. For the financial year ended April 30, 2017, Conviviality generated -£22 million in cash from operations and paid a dividend of £20 million. For the six months to the end of October 2017, the company distributed £15 million in dividends, despite only generating cash of £500,000.
3. Obligations to suppliers were rising rapidly, which shows that the company was having problems paying its bills on time.
4. Debt was expanding rapidly.
5. Management did not have a significant stake in the business. In fact, it seems management knew so little about the company that they were still willing to buy shares in the two weeks before its demise.
This is not a comprehensive list of what went wrong, but it is a simple checklist of the critical factors that resulted in the collapse. Avoiding companies that have too much debt, too little cash, are paying out more than they can afford and where management has no skin in the game, will help you avoid falling into the same trap.
Disclosure: The author owns no stock mentioned.
