Do Your Own Research

Insightful analyst, fund manager and accountant lan Robertson shares his tips to help investors understand what questions to ask when making investment decisions.

November 21, 2023

Size of a cow! – Victoria PLC and how to keep things in perspective

Sometimes it can be difficult to tell the difference between something small close up and something big far away.

The share price fall for Victoria PLC in recent months has been an excellent example of this. A small but admittedly dramatic issue (a qualified audit) has triggered a cascade of other concerns to come in from the sidelines, whilst something possibly far greater (and more complex) is barely mentioned.

In this blog, rather than viewing events through the ‘underlying’ perspective that management presents, I assemble a ‘normalised’ perspective that institutional investors may be more likely to use.

Small – near

Qualified audit is not a death sentence (sic)

In April 2023, Victoria provided a trading update and stated that it intended to publish its results in July.  At the start of August, it provided a trading update and stated that it intended to release its full-year results on 15 August.  On 15 August, however, Victoria announced that its auditors had requested more time to complete the audit, and provided a set of key figures. On 14 September, Victoria published audited figures that, along with some background information, disclosed the fact that the management had imposed a limitation of scope upon the auditors with regard to work on Hanover Flooring Limited, ensuring that the audit opinion would be qualified. On 25 September, Victoria announced that it had posted its Annual Report and Accounts on its website. There was slightly more detail on the nature of issue, but it was far from closed – and the share price has fallen by 47%, £344m in market capitalisation terms, since then.

Hanover Flooring Limited was the corporate shell into which Victoria placed a set of business operations and assets purchased from a business partnership back in January 2021.  Some elements of it were relatively well established; others appear to have been little more than months old. The business seems to have been growing rapidly and a substantial proportion of its work was with small enterprises and traders. There appears to have been some overlap and crossover between individual and partnership business (and perhaps other) interests with respect to who was selling what, to whom, and where cash was going.

This was recognised in the deal structure and the Asset Purchase Agreement.  Although purchases of business assets are common, it is noteworthy that in this case the structure would also serve to insulate Victoria from a variety of possible issues and liabilities.  There were, apparently, procedures in place to deal with the bank account issues and for retention of deferred payments.  There is, perhaps, something of a clue that Hanover was not a normal deal in that Victoria only paid £1m initial payment on a £25m potential consideration acquisition.

Where the matter was clearly not dealt with sufficiently was in the systems and processes that Victoria put in place.

Grant Thornton identified a number of issues at Hanover in its FY23 audit. Significant sums went through the vendor’s bank account over the two years following the purchase and it was not possible to reconcile takings to invoices for an amount of £400,000.  Furthermore, Hanover had not registered as a high-value dealer, where businesses taking cash payments in excess of €10,000 in exchange for goods have to register with HMRC as part of the UK’s money laundering regulations.

Advised of the issues, Victoria’s management appointed Big Four advisers to investigate and help.  Grant Thornton then considered the work done and undertook some more checks, but was unable to satisfy itself that the revised figures were correct and complete.  This extra work included whether other subsidiaries might also be affected. Grant Thornton asked management for the opportunity to undertake more work with regard to Hanover in order to satisfy themselves that the accounts were true and fair, and therefore to be able provide an unqualified audit opinion.

Victoria management has pointed to the need to get audited results published for debt holders, amongst other reasons, for its highly unusual decision to impose a limitation of scope upon Grant Thornton.  Inevitably, some investors and commentators have taken it as a sign that management is trying to cover something up.

But what were the auditors going to find?  If you think about it, nothing much, even if it is/was there.  We are talking about historical cash transactions and inadequate record keeping.

The Hanover figures may well have been wrong, perhaps by more than a material amount, and Victoria should have been more aware of the issues. But the gap has been closed and hopefully some lessons learnt.

Hanover is a business that takes in carpet and sells it on; hardly a business suited to the purposes of money laundering and significant malfeasance.  Furthermore, with a contingent consideration deal based around a multiple of earnings, it is hard to see Hanover’s management, which includes one of the vendors, seeing much to be gained personally from allowing the business to operate beyond Victoria’s records.

It is, after all, as management is understandably keen to point out, a business that accounts for less than 1.25% of Victoria PLC’s revenues. And whilst there is a distinct prospect of a fine(s), typical fines for acts of omission are in the range of £1,000-£20,000 pounds.

It would appear that the cognisant wrongdoing, if any, lay beyond Victoria PLC. If there is something grave to investigate here, it’s probably more for HMRC than Grant Thornton.

That said, it is difficult to argue that Victoria has dealt with Hanover and its audit fallout well.  Management was perhaps naïve as to what exactly it was getting itself into with the Karim family and their enterprises, and maybe the auditors were too.

But the loose thread has been pulled. Bears and commentators have uncovered some ‘nasties’. However, in a business like this, growing rapidly and trading with entrepreneurs and sole traders, there are always likely to be things to ask questions about. And we note that many of the points raised (and even some taken up by the media) are, whilst entertaining, spurious – and in the context of AIM scandals, public and not so public, they barely move the dial.

Big – far away

Interest charge is not going down

Victoria has taken on a substantial amount of debt, having made heavy investments in recent years in acquisitions and restructuring.

As at 1 April 2023, net debt was £959m on a pre-IFRS 16 (pre-leases) basis and £1,132m on an IFRS 16 basis (post-leases). However, if we – as the company urges – take the view that, contrary to the accounting standards, the preferred equity is not debt, then net debt at the year-end (pre-leases) was £678m.  Whichever way you look at it, it is a substantial sum in comparison to the current market capitalisation of c.£384m.

Victoria’s debt at the year-end fell mainly into three distinct piles: the senior secured notes (£656m); the preferred equity (£255m); and other debt instruments and unsecured loans, which amounted to £113m at the year-end, up from £32m the year before.

Senior debt rate rise lies beyond the horizon

The €750m of senior secured notes, as at 1 April 2023, is made up of €500m of 3.625% notes due in August 2026 and €250m of 3.75% notes due in March 2028.

But much has changed since this debt was first issued in 2021.  Euribor rates were negative 0.5% in 2021 and are now at around 4%, although the forward curves suggest around 2.7% for 2026.  Adding 3.2% to the current 3.625% and 3.75% gives us 6.825% and 6.95% as starting points. A substantial uplift.  For FY23 this would equate to about £20m, or over a quarter of underlying PBT.

However, with current market earnings estimates running only to March 2026, the reality of the refinancing and the higher interest rates lies beyond the horizon.

Preferred equity – can you choose to ignore it?

The liability on the preference equity of £255m, as at 1 April, has evolved from an initial £225m of preferred equity issued across 2020 and 2021, which carries an 8.35% dividend if paid in cash and 8.85% if paid in kind.

Excluding the preferred equity in line with the basis used by its banks, this equates to a net debt/underlying EBITDA ratio of 3.4x.  Management has historically been comfortable with ratios of 3x to 3.5x, whilst UK small-cap investors usually get jittery at any number that starts with a 3.

Management now regards the current level (3.4x) as too high given the interest rate environment and wider economic uncertainty, and it is looking to focus on cash generation ahead of the senior secured debt refinancings in 2026 and 2028.  Management has stated that the repurchase of preference shares and the buying back of bonds are likely actions.  Progress towards 3x and below on some or any measure is clearly going to be welcomed.

It is worth remembering that to the debt holders neither form of equity has any prior claim, so the inclusion of preferred shares in debt is unwarranted for them.  To the common equity holders, the preference equity holders have greater protections than they do; standing in front in the queue, they look more like debt holders than fellow equity holders. When the preferred equity is treated in line with accounting standards and included in the overall debt figure, the net debt to EBITDA ratio moves from 3.4x to 5.4x.

These preference shares are a cost to ordinary equity holders in the income statement. But because this is a non-cash cost, and management run counter to the accounting standards on their view of what debt is, this £27m (FY23) is adjusted out of the underlying figures.

Taking an investor’s perspective – looking at normal not underlying

In order to see just how significant these debt issues are, the simplest thing is to create illustrative normalised earnings figures.  The sort of thing a small-cap investor might do rather than relying on the underlying figures presented by the company in its spiel and by brokers’ analysts in their notes.

We have based our illustrative figures starting from the market estimates for EBITDA of £220-230m for the next few years.  For all the noise and external commentary, management is not making outlandish claims about the tough markets and challenges that lie ahead.

In calculating these illustrative earnings figures, it would be unfair not to recognise that Victoria is anticipating paying down its debt (or preferred equity) – so we factor this significant debt reduction into our calculations of the ‘normal’ interest charge.

We believe that Victoria needs to spend somewhere in the region of £60m on capex each year.  We also know that we must charge some of the provided for costs of restructuring from FY23 and set these against the funds not received at the end of FY23 from the Balta property disposal – £24m and £27m, respectively – to get to the right cash starting point.

Near-zero base rates are for the history books, not for forecasts

No one is predicting a return to near-zero interest rates in the short to medium term, so it makes sense to view the current low interest rate on the secured debt as abnormal.  We therefore add the extra interest costs (post tax) for the purposes of our illustrative normalised earnings calculation, applying what some might see as a generous rate of 7%.

In order to reflect the economic reality of the suppressed interest payments over the next few years, we can add this less the value of the tax benefit on it, approximately £50m, to whatever calculation of market capitalisation we arrive at having applied an appropriate P/E multiple to our normalised earnings.

Preferred equity – actions speak louder than words – treat as debt and real interest

As noted above, the liability on the preference equity was £255m as at 1 April.  This has evolved from the issuance of £225m of preferred equity issued to Koch Equity Development (£75m in November 2020 and £150m in December 2021), which carries an 8.35% dividend if paid in cash and an 8.85% dividend if paid in kind (i.e. in more preferred equity to add to the liability).

Starting in year five, the dividend increases to three-month SONIA plus a spread of 8.35% (or 8.85%), with the spread increasing by 1% each year.  As at 9 November 2023, three-month SONIA was just under 5.2% but with the forward curve suggesting it will track down by 1%-1.5% over coming years, suggesting that 12% dividends may be in prospect. The preferred equity is redeemable subject to certain terms; it is also convertible and has warrants attached.  The liability associated with the warrants was £26m at the year-end.

It is not difficult to see why investors may have parked preferred equity in the pending pile with the assumption that, if everything else is going OK, this will be OK too. And why they may find it easier to take comfort from management talking about the perpetual nature of the preferred equity than think about a cost of finance of 12%.

However, management is committed to redeeming the preference shares.  In this respect they would appear to be treating preference equity pretty much as debt, and for this reason it makes sense to do likewise.  The repayment of the preference equity will cause its cost, both current and historical, to be incurred in a cash form.

To create an earnings figure more in line with management’s actions, we should include preferred equity dividends as a cost in our illustrative normalised earnings figures. However, in recognition of the fact that they look like being mostly, if not fully, redeemed before the hike in interest and that there is an equity element to their return, we do not apply the full 12% nightmare rate until FY27 – by which time the impact is de minimis.  For the sake of brevity, we will not go into KED conversion options or the warrants here but see it as reasonable to regard these as less preferable outcomes for shareholders given that management, acting on behalf of shareholders, says it will seek to redeem the preference shares.

As we are taking the ‘preferred equity as debt’ path, we model paying the dividend/interest in cash and prioritising the repayment of the preferred equity, which carries the highest charge, ahead of other debt.  With regard to the interest on the £113m of other debt, whilst current rates are low-single figures and could move up, the impact of this is only going to be single figures £m and therefore we have not factored this possible increase in interest costs into our analysis. We accept that this is all far from precise and that for a variety of reasons management may not pay down all the preference shares before moving onto reducing other debt exposures, but we are trying to present things in an understandable and realistic format – without being dragged into the realms of warrants and option values.

Tax – assume normal for normal earnings

With regard to tax paid in our calculations, we have a puzzle as Victoria has not paid much tax in recent years.  Whilst the basic principles of tax are simple, there are too many variables to be certain one way or another – and we don’t regard this as cause for consternation.  But tax has to be paid at some point, and if management is correct on what constitutes underlying profit, then ‘tax charge equals tax paid’ is the best way to think on a long-term basis, and we should use the 25% UK corporation tax rate as a starting point and assume that depreciation and amortisation are equivalent to capital allowances. These are assumptions that would clearly need to be clarified prior to any investment decision.

Normal is a lot less palatable than underlying, but not life or death

The impact on the illustrative earnings figures is quite significant, as can be seen in the tables below, with the illustrative ‘normalised’ EPS being over 40% lower than the illustrative ‘underlying’ EPS. Importantly, even with the possibly somewhat pessimistic assumptions of no top-line recovery and no EBITDA margin progress, the outlook is that, even with a jump in actual interest rates payable on the refinancing of the senior secured debt, on these illustrative figures Victoria looks able to service its debt – suggesting an issue very much more about valuation than solvency.

Victoria plc illustrative forecasts

Most evident is that the mess surrounding Hanover is easy to get excited about but is not the big issue.  The maximum consideration for Hanover was £25m, but both the preferred equity interest cost and senior debt interest uplift in 2026 are on a similar scale – and happen every year.

It is also important to see that although these numbers are looking forward to August 2026 to the refinancing deadline, when we look back two years and nine months that was nine acquisitions ago and Victoria had only just purchased Hanover.  A lot can happen at Victoria PLC in a short time, and it would be wrong to make too many assumptions about interest rates, availability of finance, strategic progress and the actions of others.  After all, debt and interest rates may well be bigger than Hanover, but they may not be the biggest of all the issues either.

Ian Robertson


This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

Any prices quoted in our research are as at the previous day’s close.