Last week George Hadjia wrote an insightful piece that detailed Sports Direct’s difficulties when it comes to retaining and recruiting an auditor and reiterated our short thesis on the company’s stock. You can read it here. This week I want to go a little deeper into an accounting ‘misperception’ that contributes to the short thesis. Over the next few paragraphs I want to detail one reason why we think Sports Direct is reporting unsustainably high gross profit margins. It may also give a hint as to why the biggest and most reputable audit firms in the world are not interested in accepting Sports Direct’s business.
The best way to begin is with a statement from the Chief Executive, Mike Ashley, himself. See the below excerpt from the ‘Accounting Policies’ section of the Chief Executive’s Report and Business Review as it appeared in the preliminary full fiscal year 2019 results release last month.
Immediately there are red flags in the language used by management to describe their inventory policies and provisions. Words and phrases like “outlier”, “special case”, and “we cannot be compared” jump off the page and are immediate cause for concern. After all, Sports Direct sells sneakers and t-shirts out of stores – how different can it really be?!
If that wasn’t concerning enough then this line claiming management’s superior accounting methodologies, over and above standards and statistics that have served for hundreds of years, should be: “There is no black and white supporting evidence or historic analysis that supersedes our knowledge and experience which indicates that a level of provision is required that is not fully quantifiable through normal methods”.
In other words, Mike Ashley and his team are telling the investing public, the accountants, the auditors and anyone who cares to read these notes, that their company is so unique that a completely different type and extent of accounting for inventories is required. Sports Direct, in their eyes, is seemingly a unicorn – others might liken it to a tired old donkey.
Specifically, management has decided that it needs to take significant write-downs against stocks. Ashley explains why this is necessary further on in the passage, and it is a startling indictment of the deterioration occurring in the business, but for now, let’s think about what these large inventory write-offs or “provisions” mean.
A fortunate retailer
Consider a retailer with sales of $100 (it’s a small shop) and cost of stock sold is $60, thereby earning him $40 in gross profits each year and 40% gross profit margin. Before the end of each year he also restocks by buying in $60 of inventory required for the following year. This year, however, he determines that the stock he has bought is not on trend and may require discounts and promotions to clear it off the shelves. He thinks the inventory on hand will fetch maybe $50 and he recognises the $10 loss immediately.
Our retailer and his bookkeeper reflect this undesirable merchandising position by establishing a ‘provision’ on the balance sheet that reduces the net carrying value of the inventory to $50. It also requires a journal entry to acknowledge an additional $10 of stock costs. So, the profit and loss for the current year reads $30 gross profit resulting in a 30% gross profit margin.
The following year the retailer has a fortunate turn of events. All his stock is ‘on point’ (I am sure we have some gen-z readers) and he sells it all for $100 like every other year he has been in business. Against this revenue he charges cost of stock sold of $50 (remember, that’s all it is worth on the books) and reports gross profit of $50 and 50% gross margin. He then spends $60 to restock for the following year.
For a remarkably stable business that sells $100 of product – every year, that costs $60 to source – every year, our retailer has reported a jump in gross profits from $30 to $50 year on year. That is a 67% increase in gross profits and 20 percentage point rise in gross margin. An outside investor may think this business is improving out of sight and is on the way to further earnings growth. The wonders of accounting (misperceptions).
Yet, the trend of expanding profitability is a mirage. If our retailer gets back to business the year after he will also have $100 of sales, $60 cost of stock, and gross profit will return to $40 and 40% margin. The cash flows would have told us this story precisely. No matter what accounting policy was adopted the retailer would have brought in $100 (sales) and spent $60 (stocks) in each year, and the cash profits would always have been $40. The lesson is to always follow the cash.
Back to Sports (in)Direct
Sports Direct management has taken an approach to their inventory accounting that is much the same as the one our example retailer has taken – writing down inventories one year to recognise next year’s costs in the current year, thereby deflating next year’s reported costs and inflating next year’s reported profits. They say it explicitly. Here are some more excerpts from the preliminary report. Firstly, at an aggregate level:
Then, in the European Sports Retail segment that forms part of the key Sports Retail division:
It appears that management’s ability to bring costs forward into FY2018 has benefitted gross profit margin by up to a few hundred basis points in FY2019.
In isolation a few percentage points of profit margin may not seem like much, but it’s all relative. In FY2019 Sports Direct earned GBP161 million in pre-interest, pre-tax profits on a revenue line of around GBP3.7 billion. This equates to an operating profit margin of just over 4%. If the accounting benefit of inventory provisions unwinds in future this might cost one percentage point of margin. With no operating cost offsets this would fall to the bottom line and reduce operating profit margin to 3% – that’s a 25% decline in earnings. At two percentage points earnings would halve. And this is all based on a stable business, not deterioration like we are seeing in the UK brick-and-mortar retail space.
Fall to come
Sports Direct share price (GBp/share)
Management can’t defy gravity forever and ultimately reported margins will fall back to earth and severely impair the profitability of the firm. We think that when the economic reality is revealed the stock is likely to keep tumbling towards zero the way it has for much of the past couple years. As it does the Montaka funds will benefit financially from our short position in Sports Direct.
Montaka is short Sports Direct
Christopher Demasi is a Portfolio Manager with Montaka Global Investments.
To learn more about Montaka, please call +612 7202 0100.