The scandal

In December 2017, Steinhoff International’s share price dropped from ZAR 55.81 to ZAR 4.62, a 92% drop. Most of this drop (61%) happened in one day with company’s market value dropping ZAR 118 billion ($7 billion) on that day. The company began December 2017 valued at ZAR 235 billion and ended the month valued at ZAR 19.5 billion.

Steinhoff International was a multinational furniture company that was started in Germany in 1964 and then merged with a South African company in 1998. Steinhoff moved its headquarters to South Africa and went public on the Johannesburg Stock Exchange in 1998. 

The issue it faced was accounting irregularities that resulted in the CEO resigning on 5 December 2017. Once that happened the stock dropped like a rock and never recovered.

It turns out that the senior management engaged in fictitious and irregular transactions to inflate profit and asset values over a period of years.

In the years since the scandal broke, various parties sued the company to recover their money. People received some payouts in early 2022, but not everything that they lost. The company was gutted and under the control of its creditors, it was liquidated and delisted from the stock exchange in October 2023.

The billionaire who lost it all

What made the Steinhoff fraud even more topical is that in 2015, South African billionaire Christo Wiese sold Pepkor, one of two companies in his retail empire, to Steinhoff for ZAR 59 billion ($5.7 billion).

He was paid in shares and ended up owing 20% of Steinhoff, which effectively became worthless. After filing lawsuits, Wiese recovered ZAR 8 billion ($500 million). He explains that at age 81, he did not want to spend the last years of his life fighting in court for money, so he decided to accept the settlement and enjoy his life. Wiese told Forbes magazine “I have a lot to be grateful for. I love my country, I’ve got a wonderful family, wonderful friends. I just decided to carry on with my life.”

Steinhoff undoubtedly was a big hit to Wiese, destroying the majority of wealth accumulated over his lifetime. In 2017, Forbes magazine valued Wiese’s fortune at $5.6 billion, shortly thereafter he fell off the billionaires list. Following the settlement, he was back on the billionaires list in 2023, with an estimated net worth of $1.1 billion.

Analysis

The first thing that stands out for me is that if you are going to run a multibillion-dollar fraud, make things look okay-ish. Not great, not disasterous, just somewhere between average and below average. Also expand rapidly so it’s hard to evaluate performance in a constantly changing business.

Let’s get into the details.

Funding

A business has three main sources of funding. It can fund itself through equity investment from shareholders – normally a business starts with shareholder money. It can also fund itself from the profits it makes. Finally, when profits are not enough, the company can borrow money from the banks.

In 1999 there were about 671 million shares outstanding in Steinhoff. Every year from then until 2016 the share count increased. By the end of that period, there were 4.1 billion shares outstanding.

In financial terms, this is called dilution because it dilutes your ownership. If you owed 100% of the company in 1999, by 2016 you would have owned 16.4% of the company. You would have gone from total ownership to minority investor.

Dilution is one of the biggest management sins. Companies that do this do not deserve your money. Therefore, this is a BIG red flag and reason enough not to invest. 🚩

But the story gets worse.

In the period from 1999 to 2016, Steinhoff also borrowed money every single year. Over that 18-year period they borrowed ZAR 112 billion. They repaid ZAR 37 billion. 

Also, in that period, the company earned free cash flow of ZAR 50 billion. In addition, all the shares issued raised ZAR 22 billion from shareholders.

In total Steinhoff got ZAR 134 billion (22 billion + 112 billion) from financiers and repaid ZAR 37 billion. Thereafter, it had ZAR 13 billion remaining from free cash flow.

If Steinhoff had returned the remaining free cash flow to financiers, the financiers would have a negative ZAR 84 billion balance (-22 billion - 112 billion + 37 billion + 13 billion = -84 billion).

If over a long period of time a company is not able to generate free cash flow in excess of the financing it took, then it would appear doubtful that the financiers will ever see a return. This is a BIG red flag. 🚩

If you want to see how it should be done - Apple borrowed a lot of money over the past decade, here’s how they performed:

• Apple generated $771 billion in free cash flow.

• Shares outstanding dropped by 39%. Apple did buybacks, they returned $665 billion to shareholders by buying their shares. If you had stayed on as a shareholder, you would own more of the company now than you did 10 years ago, without doing anything.

• Apple borrowed $188 billion in those 10 years and repaid $75 billion.

• In total Apple returned $740 billion ($665 billion + $75 billion) to shareholders and lenders of the company. And they did this from the free cash flow they generated.

• In other words, they made lots more money than they raised from financiers. This is the opposite of Steinhoff.

Returns

The next red flags come from returns.

From 2000 to 2016, the average return-on-assets (ROA) was 5.7%. Inflation in South Africa averages almost 6% and German inflation averages almost 3%. In other words, Steinhoff was barely able to earn a return that beat inflation. This is a red flag. 🚩

But again it gets worse.

Between 2000 and 2005, Steinhoff had an average return-on-equity (ROE) of 20.8%. However, starting in 2006 it dropped to 17% and then continued to drop steadily for the next 11 years. It reached single digits of 9.7% in 2016. The business was clearly deteriorating in those years.  🚩

Return on capital employed (ROCE) is an important measure (we discussed it here). It shows the return that a company can achieve from its operations.

Between 2006 and 2016, Steinhoff had an average ROCE of 9.2%. Steinhoff’s required return is around 12%. The implications of this are terrible.

Think of it this way. If you borrow money from the bank at 12% and then use it to earn 9.2%, every day that you continue, you get poorer. You’re effectively digging a financial hole. Furthermore, rapidly expanding a company that is destroying value makes things worse.

Much as in life, if you’re in a hole, the thing to do is stop digging. But Steinhoff did not stop digging. It continued destroying value over a long period. You get poorer if you stay invested in companies that are destroying value. That is why inadequate returns are a BIG red flag. 🚩

Cash conversion

Cash conversion is the amount of profit that ends up as free cash flow. You want most or all of the profit to end up in free cash flow.

From 1999 to 2016, Steinhoff’s average cash conversion was 44%. This is a very low number. It could indicate that profit is being inflated and never converting into cash. This is a BIG red flag. 🚩

For comparison, over the past decade Apple converted 115% of profit into free cash flow. That is excellent.

Taxes

From 1999 to 2016 Steinhoff had a low tax rate. Its effective tax rate was 10.8%.

This is an extremely low tax rate. It’s the kind of tax rate that you would see in tax havens, but Steinhoff operates mostly in developed countries.

A tax calculation is similar to an income statement, but it uses different rules. In a tax calculation, you can think of gross income as revenue and you can think of deductions as expenses.

There are three ways to have a low tax rate:

1. You have low gross income

2. You have high deductions

3. You are engaged in tax avoidance schemes

The first point catches my attention. A low tax rate can indicate that there is a big difference between revenue (accounting) and gross income (tax). While management might be incentivized to show high revenues for accounting purposes, it would not want to show high gross income for tax purposes, because that would increase the tax bill.

In other words, if they were faking the revenue, they would not use those numbers for tax purposes. That could explain why the tax rate looks so low in relation to accounting profits.

This is definitely an issue that would warrant closer scrutiny.

Conclusion

The main warning signs that we identified were:

• High equity dilution

• Low free cash flow compared to financing cash flows

• Low returns on assets, equity and capital employed

• Low cash conversion rate

• Low effective tax rates

There are plenty of other investment issues with Steinhoff, such as stagnant sales growth, continuous M&A activity and low margins. These things can point to poor operating performance. However, none of them point directly to fraud.

Analysing Steinhoff was an extremely valuable exercise. It showed us where to dig. Perhaps unsurprisingly, everything that we want in a company is the opposite of what we found in Steinhoff. Hopefully that will keep us out of trouble in future.

If you’re looking at a company, here’s a quick analysis you can do (click here).

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