Recently we were talking about the benefit of hindsight when assessing company under-performance. We considered the recently reported challenges confronting of C&J Clark (Clarks Shoes). Today we have learned about a potential £25m overstatement of inventory by Ted Baker plc.
Ted Baker is a very successful business, generating sales of over £600m. The balance sheet is strong with over £200m of retained profit invested in property, inventory and cash deposits. We are confronted with a constant stream of bad news about the High Street and the businesses that have failed or are facing severe challenges. Ted Baker, to the casual observer, seems to have avoided the High Street hit. Stores tend to be located in primary sites, are very well presented and offer a cornucopia of high margin items.
The case of Ted Baker
Let’s be clear, Ted Baker is not going to fail tomorrow. But in the shoes of an underwriter, being asked to renew existing banking facilities, what would you do? The reported £25m over-valuation of inventory should allow an underwriter to ask some probing questions of management. Underwriters may have access to management accounts and more detailed performance information. We are restricted to the information contained in the financial statements for the year ended 26th January 2019.
At the end of January 2019, reported turnover and operating profits were £617m and £54m respectively. If the overvaluation of inventory is confirmed and the overstatement written back into the January 2019 results, operating profit would reduce to £29m. This converts to an operating profit of 4.7%. Is this margin sufficient to sustain a premium brand business?
Ted Baker operates 237 stores, concessions and outlets, mainly in the UK and US.
Assuming that turnover is spread evenly across the stores and throughout the financial year (which it will not), each operating unit generates £2.6m of turnover. This equates to around £50k of turnover each week. The inventory overvaluation of £25m equates to around £105k per operating unit. Given that each operating unit generates a weekly turnover of £50k, the inventory overvaluation suggests that each operating unit was carrying additional inventory, equivalent to two weeks of turnover. Is this a significant enough anomaly to be detected by an efficient inventory management system?
Inventory days have increased on a cost of sales basis from 296 to 321 days, an increase of 8.4%. Turnover increased by 4.4%. Is the increase in inventory out of step with the change in turnover? We require further detail from management to answer this question.
The independent audit report in Ted Baker’s financial statements
The independent audit report is often overlooked in a review of financial statements. The independent audit report in Ted Baker’s financial statements runs to five full and closely typed pages. On page three of the audit report the following paragraph is included:
Of the Group’s 26 reporting components (2018: 24 reporting components), we
subjected 4 components to an audit for Group reporting purposes (3 UK components and
1 US component) and 1 component (Canada) to specified risk-focused audit procedures
over revenue, cash and inventory. The latter was not individually financially significant
enough to require a full scope audit for group purposes, but did present specific individual
risks that needed to be addressed.
The paragraph suggests that the auditors identified risks in either revenue, cash or inventory in the Canadian business. Although those risks were not significant enough to require a full scope audit. This does imply that there may have been an issue around inventory. All this paragraph does is raise a yellow flag. An underwriter would ask questions about the extent of the risks identified in Canada, have they been resolved and what is the likelihood of the same issues being replicated throughout other group, operating units?
It is quite straightforward to shape the questions that should be asked of management. However, it could be quite challenging to ask those questions of a global Chief Financial Officer who oversees a £617m turnover business. This re-emphasises the need for underwriters with both experience and the confidence to ask probing questions of management teams. That can be a tall order if you are a relatively inexperienced underwriter or are confronted with a stone-walling Chief Financial Officer.