How Eddy Groves left himself exposed

It’s understandable that the CEO of ABC Learning Centres, Eddy Groves, is looking for someone to blame for the mess he and his company got into, but if he wants to rebuild his company’s credibility, lashing out at Citigroup won’t do it.

That was evident in the market yesterday when the stock fell 18% despite the promise in his interview with Business Spectator yesterday to “have little or no debt in the next three or four months” as a result of this week’s sale of 60% of its US childcare centres and further asset sales.

Very few promises are believed these days and with the market in a bear phase and normal long trading profits hard to come by, all investors, not just hedge funds, are looking for shorting opportunities to give themselves an edge.

It means the market is utterly merciless, and any lack of credibility or surplus of debt is brutally punished by the howling mob. Eddy Groves had both of these things.

But fault lies with Citigroup in this story as well, in my view.

ABC Learning Centres issued its half-year results and earnings forecast at 4.30pm on Monday, 25 February. Like all ABC Learning analysts, Citigroup’s Jenny Owen then had to work through the evening on the numbers. She produced a report at 1.45am, next morning. Like all the analyst reports that night, it was generally negative about the result.

Owen would have then got back to work at 7.30am on Tuesday, as usual, for the morning meeting, at which she would have briefed the firm’s dealers on her research – including the explosive suggestion that the company was in breach of one of its loan covenants.

Here is the section on loan covenants in full:

“Three main covenants are in place with ABC’s bank facility; the company confirmed that the covenants are unchanged from those outlined in May 2007 at the time of the $600m convertible note issue.

1. Shareholders funds >$2bn. Shareholders funds ended 1H08 at $2.23bn, within covenant.

2. (EBITDA + Leases)/(Interest Expense + Leases) = Funding Cost Ratio, must be >=1.75 over PCP year. This appears to have been breached, although there may be inclusions/exclusions which ABC can claim to achieve the 1.75. On the basis of the earnings report for 1H08e, we calculate this ratio at 1.53 times. We will seek clarity on this ratio from ABC.

3. Debt/ (“runrate” EBITDA + Leases) = Gearing Ratio, must be <=3.5 over PCP year. Gearing ratio appears to have been 2.75 at end 1H08, within covenant.”

Jenny Owen is a good analyst, who takes her responsibilities and independence seriously. If she calculated the EBITDA to funding cost ratio to be 1.53 times instead of the required 1.75 times, she would have felt obliged to report this to the firm’s dealers.

Which she did at the morning meeting of Tuesday, 26 February.

Should she have waited until she spoke to the company to “seek clarity” before publishing her calculation of that ratio? With the benefit of hindsight, she probably should have.

But then again, ABC Learning should not have put out its results at 4.30pm, so that the analysts were working this stuff out at midnight and couldn’t ring anyone before publishing. It was an example of Groves leaving himself vulnerable, and not understanding how the market works.

Citigroup dealers would have left the morning meeting that Tuesday knowing they had a good story to tell that would get them a lot of “tickets” (trades) that day.

But it wasn’t just them. Something as explosive as Owen’s calculations on the company’s loan covenants found its way into other morning meetings as well.

Groves himself first heard about it at a breakfast briefing of analysts and fund managers in Melbourne that same Tuesday morning. He denied it, but everyone at that breakfast knew what was going to go down in ABC shares that day.

So in that crucial hour between 9am and the market opening at 10am, dealers in broking houses across the land hit the phones to their clients with a very negative story on ABC Learning and offering to transact a sale.

I know of one fund manager (not a hedge fund) who was rung during that period (not by a Citigroup dealer) and asked: “Do you have any ABC?” The answer was no, but after the hearing the story the fund manager said: “OK, you better short me 100,000.”

The dealer was then instantly able to lend him 100,000 ABC to sell, and the trade was done. Next client…

When the market opened there was a colossal weight of offered stock, so the price went into free-fall, dropping from the previous close of $3.74 to as low as $1.15.

The company put out a brief statement at 11.30am denying that it was in breach of any of its covenants. But it did not go into any detail, and it was too late – the damage had been done.

The collapse in ABC Learning’s price immediately caused a light to go on and bells to ring at margin lenders that had an exposure to ABC Learning, including in another part of the Citigroup empire that had lent to Eddy Groves.

Groves and his estranged wife got a margin call that day. When that happens the client has 24 hours to do one of three things – provide more collateral, provide cash, or give the margin lender a sell order.

It seems Groves did none of those things. This, perhaps, is the key problem with CEOs having big margin loan positions. If their stock is falling and the company is in crisis, they will be distracted by the crisis and might miss the call.

That’s almost certainly what happened that day. Perhaps Groves was in such a funk watching his share price collapse he didn’t get the message to call his lender. Or perhaps he thought it was all a bad dream, from which he would awake within the 24 hours.

And then as we learnt in our interview yesterday, he received an email at 11pm Tuesday night from Morgan Stanley offering cash for the US child care centres, and Groves grabbed this as a drowning man grabs a floating plank. Further distraction.

The margin call was neglected, so next day, while Groves was preparing to fly to the US to meet Morgan Stanley, the collateral stock was sold by Citigroup’s margin lending department.

Citigroup is not commenting on these matters, but in my view there is no chance that it would have sold the stock without clearly issuing the margin call and then acting within its rights under the loan contract.

The fact that it was Citigroup’s own research that triggered the call would have been totally unknown to the loan officers, and anyway, was irrelevant to them; their job was to enforce a contract.

So the old saying probably applies; when it’s a choice between a conspiracy and cock-up, always go for the cock-up.

When she calculated ABC Learning’s EBITDA to loan cover ratio, probably close to midnight, Jenny Owen had a difficult choice. But with no one to phone at that time she obviously decided to go with her responsibility to colleagues and tell them what she found, with the idea of asking the company as soon as possible.

By the way, the company has still not clarified in detail the position with loan covenants beyond that brief statement on 26 February and yesterday’s promise to have “little or no debt” in our interview yesterday.

This is a market that gorges on rumour and then spits out the bones.

Eddy Groves will come back to Australia a wiser CEO, and will never put out a complex, negative profit result late in the afternoon again.


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