Cooking the Books

Even though I am not on air at present, I cannot resist the temptation to comment on this disgrace...

Customers are furious, and staff are in fear of losing their jobs after one of Australia’s oldest and proudest retail firms was placed into the hands of administrators this week. Angus and Robertson was established in 1886 and has been an iconic part of Australian life ever since, but all that now hangs precariously in the balance as the accountants and lawyers attempt to breath life into the firm’s struggling owner, the Red Retail Group, which also controls Borders Australia. Perhaps it will be possible for the administrators to trade through the difficulties and restructure the business so that it might return to prosperity in the future, but that’s little consolation to those angry customers or those fearful employees who will now to some degree be made to pay for the mistakes of others.

That anger has been manifested most prominently by the response from customers who have been told that the gift cards they may have received for Christmas aren’t really a gift at all. Customers have been told that gift vouchers will be honored only if they are matched by an equal or greater amount of cash. In other words, if you have a Borders or Angus and Robertson gift card for $20, you can combine it with $20 cash to buy a $40 book. This grab for cash has been seen by customers as greedy, unfair and unjust. After all, they or someone they know has already paid cash to the face value of the voucher on the expectation that it will be exchanged for merchandise. It’s as if I have paid in advance for a hotel room, only to be told when I check in that I must pay again because the hotel has run out of money. It’s not my fault, and it shouldn’t be my problem. But unfortunately, gift cards are not what they appear to be.

It turns out that they are unsecured financial instruments, as determined by a Federal Government ruling, which means that they are not subject to consumer law. Instead they are governed by securities and investment law, effectively meaning that a gift card is worth less than an I. O. U. Under securities law, people who hold gift vouchers are no longer customers when a company goes broke. Instead, they become unsecured creditors and must line up behind the bankers and the lawyers before they can expect to get even one cent. In that context, the Red Group offer to redeem gift cards when presented along with a matching amount of cash could be viewed as a generous method of ensuring that customers still get value, while the company offloads some of its stock and makes a few more dollars all at the same time. But, of course, that’s not the way customers are seeing it at all. Instead, customers are outraged. And I don’t blame them… if anything, they’ve been dudded by the regulations as well as by the company.

More importantly, the damage to whatever remains of the company’s goodwill could well have a material impact on its chances for survival. By angering customers, the administrators are likely to drive them away, an outcome in which there are no winners.
If the business is to survive, it should go without saying that it will need to keep its customers happy, and hopefully even attract some new ones too. But that really just begins to touch upon the heart of the problem. Why is the company in trouble in the first place? Falling retail sales. Why are sales falling? If more people are turning to on-line sales, why are they doing that? Is it, as the company claims, a result of import restrictions and tax exemptions for on-line purchases? Or is there something else going on? The truth is that Red Group’s goodwill was already taking a beating before this debacle arrived. Comments posted on-line on the Sydney Morning Herald website have reflected customer views that Borders prices are not only more expensive than on-line competitors, but they are more expensive than bricks and mortar competitors such as K-Mart and Big W. One reader even complained that prices are higher than recommended retail.

Of course, if Amazon and E-bay can be successful, surely there’s nothing stopping Borders and Angus and Robertson from running their own on-line operation, and in fact that’s exactly what they do. So, problem solved, or so you would think. But actually, no. Even on the bold new frontier of the cyber world, Red Group retailers have been accused of failing to match the customer service of dedicated on-line operators. Prices are still not competitive, but far more importantly, deliveries are reportedly slow. While there is some substance to the claim that import restrictions disadvantage local operators, and the G. S. T. rules favour the off shore operators, that is only a part of the story. A small part, in fact, but also a clue to some of the components of a much bigger picture.

An alternative view of the downfall of the Red Group has been given by author Di Morrissey, who told John Laws on 2SM that in her view the company ran into trouble because it was badly managed. She acknowledged that there had been a downturn in book sales in traditional stores, but claimed that the decline was broadly in line with the overall retail sector. And it’s true… retail sales figures across the board have been in the doldrums ever since the Global Financial Crisis. Consumers are exhibiting a new pattern of behaviour, less likely to spend recklessly, and when they do spend they are looking for bargains more aggressively than ever. Why should it be any different with books? Consumers have become more frugal across the board, so if any business is going to persuade them to part with their hard earned dollars it will be the one offering the best value and the best service.

The contention is that, with prudent management, a good business can withstand the challenges of an economic downturn. The fact is that while all bookstores have experienced challenging conditions, not all of them are going broke. No doubt the management at Red Group is keen to find excuses and explanations such as the fall in sales and the rise in competition, but they are hardly going to blame themselves are they? So is there something wrong with the way the group has been run? Well, funny you should ask that, because it brings us to the real roots of the problem. And it’s not just Red Group that suffers from the afflictions which have landed them in the hands of the administrators.

So, just what is the Red Retail Group, and why has it run off the rails? The Red Retail Group is comprised of Angus & Robertson, along with Borders Australia, Whitcoulls New Zealand, Calendar Club, and Supanews Newsagencies. In turn, the group is owned by a so-called investment company by the name of Pacific Equity Partners. PEP is a private equity firm, which means that neither it, nor any of the companies it operates, is a publicly listed company. So far, the only explanations to have been forthcoming from management have identified a decline in profitability, blamed on a combination of increased competition from on-line sales and the increasing popularity of electronic books. On the face of it, that’s an explanation which seems to make sense. On-line retailing has experienced significant growth across the board, but it has been especially successful for books, which don’t need to be tried on for size, and which can be easily warehoused and shipped without spoilage. So-called E-books too have proven to be popular, and will only become more so as devices such as the i-pad proliferate the market. But what the management has been less vocal about is the nature of their investment and the magnitude of their debt.

Red Retail Group has reported a net loss of $43.6 million on turnover of about $580 million. Debt is said to be in excess of $130 million. On the face of it, that seems like a very large number, but does the debt explain the group’s difficulties? Well, even if an outrageous interest rate of 10% was applied it would only account for $13 million of the net loss, so it would be unreasonable to suggest that the level of debt alone is the cause of this particular disease. However, it is a symptom. While it is generally accepted that debt financing is a legitimate method of funding business activities, it is predicated on the purpose of the borrowing. The principle is that debt funding can be used to finance capital works which will be productive, it can finance stock which will be sold at a profit, and it can be used to finance the acquisition of an appreciating asset. But has anybody stopped to consider the purpose of this particular debt?

Pacific Equity Partners is not a bookselling or publishing firm. Its managers are not “book people”. They are “money people”. Pacific Equity Partners is a private equity investment company run by merchant bankers and lawyers. While you might think that a private equity firm might be in the business of simply managing the money of its wealthy clients by finding worthwhile investments for them, PEP does not exist to acquire and operate robust businesses. It exists to acquire under valued or underperforming businesses, restructure or reshape them, and then sell them to someone else, usually through a public offering and floatation on the share market. The vultures strip the carcass bare, and then fling the remains to the Wall Street wolves. Or in this case Bridge Street in Sydney, but that just doesn’t have the same ring to it.

In order to achieve this, a private equity operator will usually seek to cut costs by restructuring a company, reducing staff, and gouging suppliers. They will then seek to maximize returns either by driving up volume with aggressive marketing and sometimes discounting, or alternatively by increasing margins by pushing prices up. Note that none of these strategies are in fact sustainable over the long term, and therefore none of these strategies are conducive to building a robust business which will thrive in the good times and survive in the down times. But that is not important to the private equity operator, because his goal is to artificially inflate the perceived value of the asset so that it can be sold to unsuspecting punters at the highest possible price, lining the pockets of the private equity operators and their wealthy clients. They have absolutely no stake whatsoever in the long term viability of any such business, and they care even less about the customers who keep that business alive.

The point is that one of the factors, and perhaps the most significant one, contributing to the demise of the Red Retail Group is this agenda to plunder the company of its value in order to enrich the bankers, the wankers, and the lawyers, at the expense of job security and income security for employees and without any regard for actually serving the customers. That’s because in their view, the people buying books at Borders are not their customers. Their real customers are themselves and their financial backers. Of course the glaring weakness in this whole business model is that it relies on UNNECESSARY debt to finance it. The whole trouble is that these modern day buccaneers have not simply reached into their own back pockets to purchase what is an otherwise perfectly good company. They have borrowed the money to buy the company, and it is the company which must shoulder the burden of that debt, even though the company did not require the funds for operational purposes. In short, the company is made to suffer for the benefit of the privateers.

In fact, these corporate hyenas should not be permitted to call themselves “private equity” firms in the first place, because the bulk of the money they use is not equity at all. It’s debt. But of course, calling yourself a “private debt company” just doesn’t have the right kind of sound to it, does it? The amazing thing is that this has all happened before. Does anybody remember the eighties? Gordon Gekko… anybody? Back in those days the smart thing to do was to put together what was known as a “Leveraged Buy Out” or LBO. It was, to all intents and purposes the exact same thing. Anybody who did not have enough money to buy a company simply borrowed somebody else’s money to do it. Then, as now, everything was fine while assets kept appreciating and the market kept rising. Then, as now, everything turned to a particularly lumpy kind of custard when the market took a tumble. You would think that people would learn, but apparently it is enough to get rid of the word “leveraged”, which is after all a dead giveaway about what you’re up to, and simply call the same thing a “private equity investment” instead.

The whole process has been demonstrated over and over again to be something akin to pyramid marketing or the aeroplane game, where it is possible for a handful of shysters to make truckloads of cash relatively quickly, but the dupes who are left holding the bag risk finding nothing left in it for them. But don’t just take my word for it, look at the track record. Texas Pacific Group did it to Myer. They cut staff numbers, destroyed customer service, flogged off the shares at almost $4 each, and today you’d be lucky to sell them for $3.30. And as for Pacific Equity Partners, well they also have runs on the board. One of their most infamous misadventures was the aborted LBO, sorry private equity takeover of Qantas in 2007. Of course, they were just small players in a much larger syndicate run by Macquarie Bank and Texas Pacific Group, but they had a seat at the table ready to push their snouts into the trough.

The attempted takeover of Qantas is a fascinating tale of greed on a grand scale, which, if successful, would have destroyed the company Australians have held dear for so many decades. Even today, I believe, some of the current challenges confronting the airline stem from that debacle. It was only saved because the deal collapsed after institutional shareholders became reluctant to sell out. Shortly after, the Global Financial Crisis ravaged the world and put an end to any possibility that the deal could ever be revived. At the time however, the pirates, sorry the private equity consortium, were offering $5.45 a share. Today Qantas shares closed at $2.54. Just imagine what would have happened to a consortium which had borrowed billions of dollars to pay for a company which subsequently lost more than half its value… It makes you feel sick in the stomach when you think about it. The heritage, the tradition, the pride, all gone on a whim. But far worse than any of that, the jobs of thousands could have been lost.

Sadly, even though Qantas was spared a horrible death, its employees still confront a new world of demands for productivity increases in the face of shrinking wages. In 2006, during the lead up to the private equity bid, Geoff Dixon, then the C. E. O. of Qantas, said “All legacy airlines suffer from the burden of inflated 20th-century cost structures, especially labour costs”. There is no other way to interpret this remark than to believe that it says people are paid too much. That view remains prevalent in the corporate world, with employees considered to be nothing more than an inconvenient expense, rather than a productive asset. Companies are no longer considered to be corporate bodies which serve the interests of their constituent members; rather they serve only their owners… a particularly feudal view of the world.

While it is a sad sight to see a once great Australian icon such as Angus and Robertson at risk of disappearing, or at least falling into disrepute, it is symptomatic of a much deeper flaw in modern business philosophy. It is a philosophy which says that the customer does not come first, that a fair day’s work does not deserve a fair day’s pay, and which falsely assumes that people who are good at managing money are automatically good at managing everything else. It is a corporate philosophy which ultimately must fail, for it cannot be sustained while increasing numbers of stakeholders, employees and consumers, are disenfranchised. It is not possible to run a consumer economy unless you have consumers… or perhaps that’s the whole idea. Perhaps we are entering the era of 21st Century feudalism, where we are all beholden to corporations one way or another, unless we are among the lucky few who actually own them.

So, if you’ve been wondering why Angus and Robertson, Borders, and the others are going down the gurgler, it’s not just because of on-line competition. It’s not just because of the G. S. T. And it’s not just because people are spending less. If that were true, they would all be going broke. No, it’s because the people who are running the business don’t really understand the business. It’s because the people who are running the business are not doing so for the right reasons, with the right motivation, or the right approach to delivering customer service. They have borrowed $130 million and assumed that somebody else will pay. Even the name of the company is surely some sort of joke: why on earth would they call it the Red Retail Group when we all know that red ink means bad news? They don’t care about saving the business, they only care about saving their own bacon.

They’re not in the business of selling books, they’re in the business of cooking them.