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Date Will you go bust during this December-08 recession?

Les Glassock of Les Glassock & Associates takes a detailed look at viability predictors for dealers and assesses the chances for • Is Insolvency rising in the UK? Ford, GM and the UK’s largest dealer groups. • Should a UK dealer predict the probability of insolvency for his business and any key credit The Big Three US car makers customers? are inching their way to- • Where can you get a free insol- wards a multi-billion $ slice vency prediction? of the $700BN bank bailout • If Ford and GM don’t get a package from the US Con- large enough bail-out from the gress. Here in the UK, Inch- US Congress, how will it im- pact on Volvo, Saab and their cape, Lookers and Pen- UK dealer networks? dragon have seen their

• What is the impact of the share price plummet to lev- Rick Wagoner, GM CEO, 2008 slashing of share prices for els where they are all vul- The hardest hit will be small and medium sized the main UK dealer groups: nerable . But should they businesses in the property, retail and leisure Inchcape, Lookers, Pendragon have seen it coming? Can segments. Although the numbers are lower, and Penske Automotive insolvencies in the automotive retail sector are Group—the owners of Sytner? you foresee financial dis- as bad as the national pattern. Comparing Q3 Will any of them go bust? tress? ‘07 with ‘08, company liquidations have more than doubled and Other Insolvencies are up

Insolvency prediction has long been confined 52%. to academic statisticians and accountants. But, with personal computers available to every The immediate causes are that many inde- business, viability prediction models are now pendent dealerships have found it impossible Contents practical and available to all. This recession to renew their credit lines at a reasonable cost, may be the time when prediction ratios join the if at all. But the roots of the problem are often mainstream. much deeper: poor absorption levels, high The why and how of predicting 2 gearing and over-dependence on a market financial distress UK Insolvencies segment or that is under severe stress, The limits of distress prediction 3 According to the UK Insol- models vency Service, the number of Predictions for Ford and GM 4 Company Liquidations jumped by over 10% in Quarter 3, 2008 and is running at just Implications for UK dealers 5 below 14,000 for the rolling 12 months. Added to this are 4,600 ‘other insolvencies’, Predictions for UK Quoted 6 which brings the total nearer Dealer Groups to 18,500. The ‘other insol- About Us 7 vencies’ are up 65% on the same period last year. If the trend continues, we are on course for a 40% rise in busi-

ness failures in 2009. Page 2 Can you predict financial distress?

UK Insolvency in Q3 2008 Why and how of predicting finan- cial distress ? Figures from the UK Government's Insolvency The why is simple: the break-up value of most Service showed liquidations dealers is much lower than the going-concern are rising at their fastest rate value. The shareholders receive much less value when a company is in recognized financial dis- for 18 years, with insolvencies tress than otherwise. between July and September up 26.3pc on last year and All going concerns face credit default risk: they 10.5pc on the previous three extend credit and might not get paid. In fact, months. It was the first time the number of dealer closures is heading to- the figure has topped 4,000 wards 400 in 2008, so for some dealers closure is inevitable. Using a bankruptcy prediction since 2002. model may help reduce the risks. While the total is little over them as well. half the level reached in the Modern bankruptcy prediction is based on large depths of the early 1990s scale analysis of business data using complex Most accountants know about the basics of recession, the steep rise in maths - multiple discriminate analysis (MDA) viability, credit scoring or bankruptcy prediction and probability statistics. the number of firms in models. So, your first port of call might be to administration suggests there ask your accountant to create a simple In simple terms, the data on two groups of spreadsheet for you. The calculations are is more pain to come. businesses is assembled—those that survived widely available for all of the models discussed Administrations numbered and those that failed. Computer pro- 1,007 in the quarter, a 51pc grammes analyse the financial ratios Distress Prediction Free on the Net increase on this time last year and trends of all the businesses in the sample to find which ratios predict and already 12pc higher than Free Excel sheet: bankruptcy. http://www.jaxworks.com/download.htm the whole of 2007. and download Free Excel Dashboard Workbook Small businesses in particular So far, around 11 different financial ratios have been identified which are are bearing the brunt of the Free trial entering your own data online: used in four bankruptcy prediction crisis, with 280 going bust http://www.bankruptcyaction.com/bankpred2.htm every week, according to the models. The 11 ratios are given be- low. http://www.cellspark.com/zscore.html Federation of Small Businesses. Each model is named after the individual who here. Motor retail experts at Grant invented it or the underpinning statistical Thornton predict that more method: Altman, Springate, Fulmer and Logit. If you want a free sample spreadsheet go to than 1,000 franchised outlets More on each of them can be found later in this the Jaxworks site and download one there. will close in 2009. paper. Simple examples, where you just enter your data are available on the Internet free. (see DIY Distress Prediction inset box).

So how do you get a viability prediction for your business? If you want a professional Viability Prediction there are lots of proprietary software pro- A viability prediction for your own company is a good starting point, but a small grammes on the market. These range from the dealer may be highly exposed to one or two large fleet or service customers. If most sophisticated, such as RiskAnalyst (Moody the fall of a few large customers could be risky for you, it’s sensible to assess KMV), to easy to use software for under £50,

Predictor Ratios closely linked to bankruptcy or survival 3. Earnings Per Share: A profitability ratio, for quoted compa- One recent study suggested that these 11 nies ratios are the best predictors of future fi- 4. Total debt to total capital: Solvency ratio that indicates nancial distress for companies the level of financial distress and vulnerability to recession, in- 1. Working capital ratio: This is a liquidity ratio - measures terest rate rises, etc. 5. Total debt to total assets: As 4 above the ability of a company to meet its short term commitments 6. Cash flow per share: Indication of cash flow and sustain- without having to cease operations or liquidate long term as- ability of the dividend payout sets. 7. Logarithm of tangible asset turnover: Activity ratio indi- 2. Gross Profit Margin: essential for long run survival and Page 3 Can you predict financial distress?

payment history with you. Good credit scoring models generally add this informa- such as Credit Controller (Markitsoft). But, tion into their predictions. before spending any cash, check with your own credit controller. You may already be Another issue is whether a model has been tested in different countries. Car retail- using a viability predictor in your credit scor- ing is different in the USA than it is in the UK. Very few models have been tested ing of accounts. If you are just input your across the same industry in different markets. Most have only been tested across own financial statements and look at the different industries in the same market! score you give yourself. Finally, we’ve all learnt, that governments can help or harm the chances of busi- Some practical limits of financial ness success by their economic management. While, professional ratings agency’s distress prediction models take this into account, they are often left out of the models developed by account- ants. All distress prediction models have limitations and are a supplement to, and not a substitute for, good judgement. Ford and GM First, of all, insolvency can be calculated in at least two ways. One is ’cash flow insolvency. It comes as no surprise that US car makers are in financial trouble. Ford made This means that you run out of cash and can’t operating losses of almost $29BN between 1999 and 2007. By the third Quarter of pay your creditors. A second type is ‘negative 2008 the loss deepened by another $8.7BN net worth’’. In this situation, your debts ex- and the entire shareholders equity in the firm ceed the value of your assets. In this situa- was minus $2BN. It has negative net present tion, even if you sold everything, the firm is value: it’s technically bankrupt. insolvent because it cannot repay all of its debts. Not all models measure both of these. So to is GM, but to an even greater extent. For example, Ford and GM do not have cash By September 2008 shareholders funds - the flow insolvency - yet! But, they do have equity in the business - were minus $6BN. debts greater than their asset value. Since 2005 GM has accumulated net losses of $51BN and wiped out equity which took over Another important point: size matters in the a century to build. retail business. In the case of Pendragon, its very size and importance to its creditors and Before the U.S. economy crashed this year, suppliers ensures that they support it in more the Big 3 were already losing money as they ways than a smaller business. Either your struggled to restructure and bring production model - or your evaluation - should always capacity, the workforce and wages in line take size of turnover into account for a car with demand and to shift their line up toward retail business. more fuel-efficient vehicles and away from the pickups and 4X4’s that brought them Models are not as accurate at predicting five huge profits in the 1990s. years ahead as they are two years ahead. Although it’s the most widespread, Altman’s After years of losing money, both GM and Z-Score is more accurate in predicting busi- Ford are still able to use their cash flow to ness failure one or two years ahead, rather ensure that creditors are paid. The main than four or five. The more complex profes- problem is that even these funds are ex- sional models are often more accurate over haustible. longer time periods By the end of Q3 2008 Ford had around The statistical models omit ‘qualitative’ infor- $18BN left and GM about $16BN. Ford estimates that it has enough cash to last mation, such as CCJ records and a customer’s through to 2010, GM doesn’t. It thinks it could run out of cash early in 2009.

cating ability to use assets effectively 8. Logarithm of market value of common stock: Indicates how the financial markets perceive quoted firms. Shows the degree to which markets anticipate results in the financial state- ments 9. Logarithm of cash turnover: 10. Logarithm of stock turn 11. Logarithm of debtor days The last three above are all efficiency indicators similar to 7. above, but emphasise working capital efficiency. Page 4 Can you predict financial distress?

Both firms have already sold off as much as anyone there listen to their story? they can, so there are few immediate opportu- nities to raise cash; hence, they and Chrysler What are the bankruptcy predic- went cap in hand to ask the US government to tions for GM and Ford? give them a credit line. The table below gives the results for both Ford The question that faces the US Congress is and GM based on three out of four models. why might the latest plan dreamt up work, when all their plans of the last two decades Altman’s model produces a number called a ‘Z have not? We wait to see if both Congress and Score’. His team have produced different target the Senate can be convinced. Z-Scores for different types of business. Public General Motors CEO Rick Wagoner, companies have to achieve the highest num- Chrysler CEO Robert Nardelli, and At the back of everyone’s mind is the risk to Ford CEO Alan Mulally, at the Sen- ber, Followed by Private Companies and then the already weak US economy if Ford or GM Non-Manufacturing firms, such as service and were to fall. retail businesses. The Z-Score for Ford, al- though higher than GM, is still way below the They employ over 239,000 staff. One predic- target of 2.99. tion is that, if either Ford or GM went bust, it would remove 2.5 MN jobs to begin with and Springate’s cut-off score is 0.862 for any busi- only 1.5MN would be added back in a recov- ness. Once again, both Ford and GM are a long ery. There would be an economic loss of way below the target. $380BN. Finally, the Logit model gives a bankruptcy One challenge for both firms is their negative probability % score. The target is to be less Ford Share Price: net worth. One condition for a US government than 25%. In both cases, Ford and GM score May 1998—May 2008 loan is they must have positive net present 100%, which means that the model calculates value. In the case of GM this could mean that they are certain to go bust in their current debt holders convert their loans into equity— shape. probably at a deep discount. The losers are all the current shareholders whose investment The final model (not shown) cannot compute would be worthless. For Ford, it’s the families companies without equity. So, both GM and ’super voting’ shares that are at risk. These Ford are already assumed to have ceased! would almost certainly be heavily diluted—or removed—as a condition. No wonder Ford is What are the implications of trying its hardest to keep any help at arms length. bankruptcy at Ford or GM? GM Share Price: In the case of a collapse at Ford, keep two May 1998—May 2008 I’m certainly not a US citizen, but it strikes me factors in mind: that Ford, Chrysler and GM are all staffed with accountants capable of detailed distress prediction. If they aren’t, the banks remains profitable. It con- that lent to them certainly are. If that is the case, doesn’t it seem opportunistic tributed $1.3BN up to September 2008, to go cap in hand to the tax-payer for a loan at this time. Surely, they knew just ahead of Ford South America. Ford is what was coming? If the recession wasn’t as deep in the US right now, would also profitable in the Asia-Pacific region. This pattern has held since Target Ford GM 2004, except for Ford Europe, Z Score: If Publicly Held 2.99 0.74 0.25 who made a loss in that year.

Springate Analysis 0.862 0.37 -0.05 Its consistent loss makers Logit Analysis <25% 100% 100%

If Ford goes bust expect: If GM is bankrupted expect: Volvo to be sold off Saab to be sold off or closed down as a The European operations to be up for sale separate brand The UK network to be down-sized until it’s prof- GM bondholders to convert loans into itable equity and existing shareholders to The Ford family control eliminated or diluted. lose their investment LGA White Paper © Page 5

are, or have been, PAG/Volvo and North these manufacturers should consider that in America. any event, they may downsize their networks in 2009. It’s likely then that Ford’s own brand interna- tional operations would find a buyer more Euro-zone unemployment is expected to rise by readily than the rest. They are profitable and 2 million in 2009 with large job losses in Spain, their attractive small car line-up might make France and Germany. The car market is ex- sense as an acquisition for someone with a pected to contract by 20%. stronger balance sheet, such as BMW, Daim- Pendragon Share Price: ler or . On these forecasts, dealer numbers are likely Nov 1998 - Nov 2008 to fall across the board. If one of the Big 3 The Financial Times reported on Monday collapse, their networks would bear the brunt 1/12/08 that both U.S. carmakers, General in 2009. Motors and Ford, had approached the Swed- ish government about aid for, respectively, With only a few months to consider an alterna- Saab and Volvo, ahead of the possible sale of tive, every dealer would benefit from a full risk assessment—including a distress prediction for themselves!

UK Quoted Dealer Groups Inchcape Share Price: Nov 1998 - Nov 2008 Arguably some of the UK retail consolidators have been the vic- tims of events beyond their imme- diate control. Both Penske () and Inchcape have modest gearing, diversified well interna- tionally and fund their working capital prudently. Yet even they have seen a share price collapse.

the . But not every business may have been as pru- dent. - whose shares languish Lookers Share Price: For both these brands their global networks below 5p at the time of writing - may have Nov 1998 - Nov 2008 could experience considerable down-sizing harmed themselves in their rush for expansion. and network refranchising. Funding its working capital almost entirely from creditors plus high levels of debt, that regularly In the case of GM, the future for its European has to be ‘rolled over’, ensured its vulnerability operations is more doubtful. GM Europe has to a credit squeeze. Shareholders may have been losing money since 2004. GM Latin failed to recognize its below par trading per- America, Mid-East, Africa and Asia-Pacific formance, and inability to ’digest’ its acquisi- have at least been profit making since 2006. tions, because it was masked by high gearing If GM survives it will probably slash some which provided exceptional shareholder re- domestic brands. Saab is expected to be a turns. Lookers followed a similar path after casualty as its US sales have crumbled by 2004, seeking to grow by acquisition funded by 30% this year and it may be sold. debt . Penske (Sytner Group) Share Dealers with significant exposure to either of Price: The different business paths taken by these Nov 1998 - Nov 2008

Vauxhall under threat of closure The UK GM network to be down-sized until it’s profitable

II they get a bail-out in both cases, little will happen quickly, because the US government

will keep it all afloat! Vauxhall cars in stock at Ellesmere Port, 2008- Page 6 Can you predict financial distress?

four major dealer groups may explain why, at Pendragon paid £230.6MN to acquire C.D. the time of writing, two, Inchcape and Penske, Bramall. Tony Bramall already owns over are being given ‘buy their shares’ signals by 20% of Lookers and with a market capitaliza- financial analysts on Reuters, while Lookers is tion of under £60MN, he could probably af- given ‘hold’ and Pendragon shareholders are ford to take a controlling stake. Lookers are advised to sell. Underlying these signals may still paying a dividend so investors will be be the analysts assessment of their probability inclined to wait. In fact punters who believe of independent survival. the company will survive will enjoy a divi- dend yield of 10%+ if they bought at the What are the bankruptcy predic- time of writing (SP £0.30) Lookers have tions for the UK dealer groups? modest cash reserves, but also modest debt which is to be repaid in instalments up to The scores for four major groups are given in 2010. The business should generate £30MN the traffic light colour-coded table below. cash which should sustain its debt repay- “It looks as if billionaire ments through 2009. ‘value investor’ Jack On the Altman Z-Score for PLC’s, all except Penske miss the target, but no one is in the Pendragon is more likely to be downsized Petchey is betting on danger zone, although Lookers is closest to it. than fail completely and its senior directors both Pendragon and On the Z-Score for Non-Manufacturing - they replaced. all miss the target, but only Lookers is in the Lookers pulling danger zone. On the Springate Analysis, again It is shrinking its operations base in line with the market and shedding staff in high num- through. Lookers is the only business under target. On the Logit Analysis, everyone except Penske is bers. This should ensure that it at least His investment in the danger zone. breaks-even in 2009. The 13% stake built up by ‘value investor’ Jack Petchey in April 2008 vehicle , Trefick Ltd, Taking the combined results, Penske is the may signal to others that recovery is possible owns 4.5% of Lookers strongest business, followed by Inchcape, then in the medium term. Petchey has been as- Pendragon, with Lookers behind the rest of the tute in his investments in auto retail firms and he has 13% of field. when their share price was low. Pendragon. Will one of the large UK dealer Even with profits at zero in 2009, it should generate positive cash through reductions in groups go bust? Probably not! working capital. Even if these are all used up in exceptional redundancy and closure costs, Notwithstanding the scores below, outright there should be enough to repay £40MN of bankruptcy is unlikely at either of the two most bank lending in 2009. vulnerable businesses. Not because of the fi- nancial ratios, but because other, qualitative But Pendragon faces significant downside factors may protect them. risks: its dividend is frozen, which will hold its share price down at current levels and Lookers is backed by Tony Bramall, whose fi- ensure it remains vulnerable to take-over. nancial pockets were deepened considerably by Trevor Finn at arch rival Pendragon. In 2004 Target Inchcape Pendragon Lookers Penske Z Score: If Publicly Held 2.99 2.47 2.66 2.16 3.42 Z Score: Non-Manufacturing 2.6 2.18 1.46 0.76 1.78 Springate Analysis 0.862 1.02 1.16 0.83 1.40 Logit Analysis <25% 89% 95% 97% 66%

Who’s Who in Bankruptcy Prediction? Ed Altman (1968) is the dean of insolvency predictors. He was the first person to successfully use MDA to develop a prediction model with a high degree of accuracy. Using a sample of 66 companies, 33 failed and 33 successful, Altman's model achieved a bankruptcy prediction accuracy rate of 95.0%. Through continuing research Altman was able to refine his model to predict bank- ruptcy for public and private companies and for non-manufacturing businesses. It is now in common use by banks and investment analysts. In Canada, Gordon Springate , following similar procedures to Altman in the U.S, managed to get the total number of ratios down to 4 and still predict bankruptcy with an accuracy of between 83% - 92%, depending on the size of the firm. Christine Zavgren developed Logit analysis to predict bankruptcy. Due to its use sophisticated probability statistics her model is considered very robust. John Fulmer uses a similar statistical approach to Zavgren in his ‘H-Factor’ Model L. Glassock & Associates Will you go bust during this recession?

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Cont’d from page 6 You can find many more white papers in the ‘News’ section of our website at: http://lga-consultants.com/. These include: The investment by Petchey could be an each way bet: Either the shares Motor Trade Economics Chapters 1 - 6 February 2008 price will improve or a bidder will need The Credit Crunch & the UK motor Trade May 2008 to pay a premium to get control. He’ll Ford Motor Company: what’s it worth? June 2008 make a profit Oil Prices and the UK Car Market July2008 China and India in the premium and luxury car market August 2008 From its 2007 Annual Report, it has The Financial Crisis: How deep will it be? significant loan repayments to make in How long will it last? November 2008 2010—at least £120MN. On top of Predicting Financial Distress: Will you go bust in this recession? December 2008 that, its £350MN revolving credit facil- ity is up for renewal in the same year. Lingering in the background are £185MN of unsecured bank borrowings that need constant renewal. It is this crushing level of debt that is most likely to bring the business to a halt for the current managers. Shotover Edge, While independent dealers and smaller Shotover Hill, groups might be unphased if Pen- Old Road, Headington, dragon imploded, although sad for the Oxford, OX3 8TA, staff, manufacturers might have more concern. BMW have already severed their connection, but brands whose T: 0044 (0) 1865 76 16 27 network footprints have been re- written by Pendragon’s spate of site F: 0044 (0) 1865 76 16 27 closures, may be reassessing the risk M: 077 68 93 28 71 posed by the existing management. Email: [email protected]

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