Ted Baker’s collapse is a lesson in the dangers of too much growth

Ted Baker was by far my most disappointing investment in 2019.

As outlined in my recent annual performance review, Ted Baker’s share price fell by about 74% during 2019, contributing -2.7% to the UK Value Investor model portfolio‘s overall 2019 return.

Normally I don’t like to comment on the short-term ups and downs of specific holdings, but Ted Baker recently suspended its dividend and for me that’s more than enough reason to carry out a full mid-term review.

The eagle-eyed among you will know that this review comes only a few months after a similar mid-term review of Xaar. That, of course, is not ideal, but we are where we are and the best path forward is to review the situation, to learn, to evolve and to try to avoid similar situations in future.

And in case you’re interested in the history of this investment, you can read a 2018 review of Ted Baker which I wrote shortly before investing in the company.

Ted Baker’s horrible 2019

Ted Baker has, in short, had a horrible year. Here’s a quick review of the major events:

As a quick aside, I should point out that I’ll be largely ignoring the “hugging scandal” surrounding the resignation of founder and CEO Ray Kelvin in early 2019, as I don’t think it’s responsible for much, if any, of Ted Baker’s current problems.

February 2019: The first sign of trouble appeared when Ted Baker revised down its expectations for FY 2019, including a £5 million write down on the value of clothing stock.

In the grand scheme of things that didn’t seem too serious, and in the end Ted’s annual results for the previous year were okay, with the dividend held more or less flat.

June 2019: The first announcement of more serious problems appeared. The company said trading conditions had been “extremely difficult”, with consumer uncertainty driving “elevated levels of promotional activity” across Ted’s global markets.

However, revenues at that point were ahead of the prior year and pre-tax profits were expected to be around £50 million, only £10 million down on 2019 and £20 million down on 2018 (so not great, but not a total disaster either).

The market’s reaction seemed excessive (to me at least), with Ted Baker’s share price falling 40% or so following the announcement.

August 2019: The company announced some positive news with new license deals in childrenswear and a new geographic license partner for Japan.

October 2019: The company announced an unexpected loss in the first half of FY 2020 and a dividend cut of more than 50%. The market reacted with a further 30% price decline, taking the total decline from early-2019 to about 70%. 

The unexpected loss was mostly put down to “unprecedented and sustained levels of promotional activity” (i.e. discounting) and challenges facing high street department stores through which Ted sells much of its wholesale stock.

There were also one-off costs, primarily from the restructuring of its Asian business and from the acquisition of its global footwear licensee.

But despite making a loss and halving the dividend, the interim results were otherwise quite upbeat. My impression from reading the results was that management’s focus was still very much on growth and expansion, with the negative trading environment merely a small obstacle to be navigated around.

December 2019: Shortly after a new CFO arrived, the company announced that clothing stock on the balance sheet was overvalued by as much as £25 million (perhaps the arrival of a new CFO and the disclosure of balance sheet problems was not entirely coincidental?)

A week later, a trading updated said results were behind expectations and that it was “appropriate to take a more cautious outlook”. That was a serious understatement because, at the same time, the dividend was suspended and both the CEO and Chairman resigned.

So Ted Baker fell apart rapidly and dramatically, leaving me with these key questions:

1. What was the underlying cause of Ted Baker’s problems?
2. What practical lessons can be learned?
3. Does Ted Baker still deserve a place in the model portfolio?

Q1: What was the underlying cause of Ted Baker’s problems?

The easiest way to answer that is to walk you through the steps I’ve taken in recent weeks as part of my review of the Ted Baker business. The first thing I did was to enter Ted’s financial data into the latest version of my Company Review Spreadsheet.

This is an important step because I’ve made several improvements to the spreadsheet since Ted joined the model portfolio in mid-2018. These improvements show that Ted probably wouldn’t have made it into the model portfolio at all if they’d been in place in 2018.

I’ll list each of the issues which the updated spreadsheet highlights:

Rapidly increasing debts

The old spreadsheet only took a snapshot of a company’s debt position as it stands today. The latest spreadsheet shows a company’s borrowing history over the last ten years.

This immediately makes it obvious that Ted had rapidly increased its debts each year, from nothing in 2011 to £129 million at the time of purchase. 

Spiralling debt is not a good sign as it may indicate that a company is fuelling rapid growth with rapidly increasing debts, and that is a potentially explosive cocktail.

High debts relative to average earnings

When Ted joined the model portfolio I used a Debt Ratio which was the ratio of total borrowings to five-year average earnings.

Using average earnings provides a more stable value to compare debts to, but eventually I decided that fast-growing companies should be more cautious with their borrowings, so I changed the Debt Ratio to use ten-year average earnings instead of the five-year average.

In a fast-growing company like Ted Baker (its growth rate over the previous ten years was approaching 20% per year), ten-year average earnings will be substantially lower than five-year average earnings, which means the ratio of today’s borrowings to ten-year average earnings will be much higher than the ratio to five-year average earnings.

As a result of this change, Ted’s Debt Ratio increased from a benign 3.0 using the old ratio to a slightly too high 4.4 using the new ratio.

Here are my rules of thumb for the Debt Ratio:

With an updated Debt Ratio of 4.4, Ted Baker fails this test. This alone would have been enough to make me avoid Ted.

Mediocre returns on lease-adjusted capital employed

Adjusting capital employed to take account of lease liabilities (e.g. leased retail stores) is something I have only recently started to do. And Ted Baker is a good example of why it’s such an important adjustment to make. 

Without taking store leases (which are effectively a form of debt owed to the landlord) into account, Ted had net returns on capital employed (net ROCE) averaging 22%, which is exceptionally high compared to the market average of around 10%. 

The updated spreadsheet takes leases into account, and for Ted those lease obligations add up to almost £300 million. Adjusting for this additional capital gives the company an average net return on lease-adjusted capital employed (net ROLACE) of just 8.4%. That is simply too low:

8% isn’t a horrendously low return on capital employed, but it’s a lot less than 22% and it breaks my rule of thumb for returns on capital employed.

In reality this is a rule of thumb so there’s some wiggle room, but Ted’s relatively low return on capital employed would have been a legitimate reason to not invest.

Incrementally improving your investment process is a good idea

The first point I want to make then, is that improvements to my Company Review Spreadsheet in recent months have identified several red flags in Ted’s otherwise impressive track record.

The company had rapidly increased its debts to the point where they were somewhat excessive, and it had weak returns once leased capital was taken into account.

However, none of those red flags are dramatically bad, and none seemed to identify an underlying cause.

Yes, Ted Baker’s debts had increased rapidly each year, but why?

And while weak returns on capital employed indicate a weak competitive position, it seemed a bit of a stretch to say that simple competitive weakness lay behind Ted’s recent collapse.

I thought there had to be a better explanation of what had gone wrong; preferably one which would help me identify and avoid similar situations in future.

After looking at the problem from various angles, I eventually settled on a simple but somewhat counter-intuitive idea which I think highlights the fundamental problem at Ted Baker.

Not all growth is good, and too much growth can be very dangerous

One of Ted Baker’s most attractive features in mid-2018 was its impressive track record of rapid and consistent growth.

However, I now realise that Ted’s consistently high growth rate (18%) and consistently low return on capital employed (8%) was a potentially explosive combination.

Here’s why:

Imagine you have a savings account containing £100. That is your capital. The account has an interest rate of 10%. That’s your return on capital. If you don’t put any additional funds into that account then the most it can possibly grow by, even if you reinvest all interest back into the account, is 10%. 

If you want the capital in that account to grow faster than 10% then you’ll have to put in some additional cash.

That cash may come out of your own pocket or you may decide to borrow it, but either way, there is no magic money tree and growth beyond the rate of return on capital employed has to be funded from somewhere.

In other words:

• The rate of return on capital employed puts a natural limit on self-funded growth

What does this have to do with Ted Baker?

The answer is quite a lot. Ted had returns on capital employed of 8%, paid about half of that out as a dividend, and yet managed to grow its capital employed (and revenues, earnings and dividends) by about 18%, year after year.

So where exactly was that additional capital coming from, because it certainly wasn’t coming just from retained earnings?

We can begin to answer that question by looking back to 2009, when Ted had £62 million of equity capital, no debt capital and £100 million of leased capital (lease liabilities giving it the right to use retail stores, warehouses, and other leased assets). In terms of pence per share, this came to 381.1p of capital employed per share.

By the time Ted joined the model portfolio in 2018, it had added an additional 1,028.5p of capital employed to its balance sheet. This is good because (assuming the rate of return on capital employed remains the same) more capital can be used to fund more stores, warehouses and other assets, and they will produce more earnings which will support more dividends.

So where did this 1,028.5p of additional capital come from?

By my calculation, about 310.7p came from retained earnings (earnings minus dividends). That leaves the bulk of the increase, some 717.8p, coming from a combination of additional debt (from zero in 2009 to £129 million in 2018) and additional lease obligations (from £100 million to £276 million).

Why does this matter?

It matters because the most sustainable form of growth is usually self-funded growth, i.e. growth driven by retained earnings reinvested either into the business, into acquisitions or into share buybacks.

The alternative is externally-funded growth, which involves taking on more debt and lease liabilities or raising equity through rights issues.

Higher debt and lease liabilities are of course a risk, but very rapid growth is also a risk.

High growth brings in lots of new employees, new teams, new systems, new locations and new equipment, and all of this has to go through an expensive learning curve before acceptable profitability can be achieved.

Integrating all that newness can leave companies ignoring the basics of their core business and what attracted customers to them in the first place.

To use a driving analogy, growing too fast like driving too fast. It doesn’t matter how safe the car is. Even the sturdiest Volvo will crash and burn if it’s being driven far too fast down a bumpy, twisty road late at night.

In Ted Baker’s case, I think its long track record of near-20% growth year after year left it with a range of problems, from somewhat excessive debts to weak inventory management and lots of new customers who had little loyalty to the brand. 

Q2: What practical lessons can be learned from Ted Baker’s problems?

My model portfolio holds a range of other general retailers which have yet to suffer significant problems, despite operating in the same weak market as Ted Baker.

One very obvious difference between Ted Baker and holdings such as Burberry and Dunelm is that the latter are companies where all growth over the last decade either was or could have been self funded. 

Yes, they use external funding in the form of debt capital and leased capital, but growth funded by those sources has been dwarfed by growth funded by retained earnings.

Their performance so far in this downturn has been far more robust than Ted’s, although how much of that is down to their preference for self-funded growth is impossible to know.

Either way, I think restraining growth to sensible self-fundable levels has left their businesses significantly less stretched and operationally far more integrated and less fractured than Ted’s.

So for me, the key lesson from Ted Baker’s collapse is that rapid growth is risky, and rapid growth driven primarily by external funding is riskier still.

To help me avoid this situation in future I’m going to add a metric to my investment spreadsheet, with the goal of measuring the sustainability of a company’s growth.

One way to measure the sustainability of a company’s growth

For me, the idea situation is that a company’s growth is funded purely from retained earnings. In practice, growth from retained earnings is likely to be supplemented by increasing debt and lease liabilities, or even rights issues, but these should play a secondary role.

The first thing I need to do then, is compare the total amount of capital employed growth over the last decade to the total amount of earnings that were retained within the business.

If lease-adjusted capital employed growth exceeds retained earnings then, in most cases, additional external funding will have been used to boost growth.

Here’s the calculation:

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additional capital = new capital employed - old capital employed

retained earnings = earnings - dividend

external funding = additional capital - retained earnings

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As we’ve already seen, for Ted this external funding came to 717.8p per share over the ten years to 2018.

But simply saying the company used external funding to drive growth is not enough. What we need to do is compare the amount external funding with some measure of the company’s ability to absorb that funding.

There are lots of factors you could use, and I doubt that any of them are perfect, but I like the idea of comparing the amount of external growth funding with the amount the company earned over the same period. This gives us a growth funding to earnings ratio:

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growth funding ratio = external growth funding / earnings * 100%

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Ted earned 633.9p over the nine years between 2009 and 2018, so its growth funding ratio over that period was:

growth funding ratio = 717.8p / 633.9p * 100% = 113.2%

I think this should be a useful ratio, but how much growth funding is too much?

I don’t have a huge amount of data to go on, but over the last ten years I have invested in two companies which grew rapidly using external funding and then collapsed in a broken and exhausted heap.

Both these companies (Ted Baker and Chemring) had growth funding ratios of more than 100%.

Other relatively high growth companies which I’ve owned and currently own had much lower growth funding ratios and, in the case of companies like Burberry and Dunelm, negative ratios (which means retained earnings were the dominant driver of capital employed growth).

And so from that limited pool of experience I’m going to set my initial rule of thumb:

Feel free to skip the box below as it is potentially quite boring and describes how I’m going to integrate the growth funding ratio into my stock screen.

Q3) Does Ted Baker still deserve a place in the model portfolio?

I’m not a huge fan of immediately selling a company just because it runs into problems or suffers a significant share price decline. I think that too often leads investors to sell at the bottom, when prices are at their lowest and fear is at its highest.

However, I also don’t want to hold onto a company which clearly doesn’t fit with my investment strategy (which can be summarised as investing in above average companies at below average prices), just to avoid locking in losses.

So my first question is:

Is Ted Baker really an above average company?

I will very cautiously say probably (not exactly a ringing endorsement, I admit).

In Ted Baker’s defence, it has produced consistently rapid growth over a very long period of time. Yes, that growth was largely fuelled by external funds, but Ted has been able to sell a lot more clothes to a lot more people on a very consistent basis in what is a very competitive market (retail clothing).

If Ted was below average, or even just mediocre, that would be very difficult.

On the other hand, Ted’s financial numbers are lacking some of the key identifiers of an above average company, primarily an above average rate of return on capital employed (including leases).

Ted’s net ROLACE (net return on lease-adjusted capital employed) has averaged about 8% over the last decade, which is very similar to (and possibly slightly below) the market average rate of return, implying that Ted is a very average company with no significant competitive advantages.

And then we have Ted’s extensive use of external growth funding, in the form of increasing debt and lease liabilities. To me this suggests that management were unconcerned by or unaware of the dangers of excessive externally funded growth.

From this point of view it seems that Ted’s impressive growth could be similar to The Restaurant Group’s impressive growth (before both imploded).

In other words, it’s easy to grow a company very quickly when you can lease lots of new stores each year with very little capital investment up front. The stores are new in their area and people like new things, so they start using the shop (or restaurant).

But if those new customers have little loyalty to the brand, they’ll switch to something else if a competitor opens a new store nearby, or if an existing competitor discounts aggressively, or if the economy slows and they begin to worry about their jobs.

To some extent, I think that’s a reasonable description of Ted’s current position. 

I think Ted Baker has an above average brand and perhaps even above average products, but the way it’s been run this past decade makes it hard to say for sure that it’s an above average business. 

My gut (for what it’s worth) tells me that Ted has the potential to be a truly above average business, more like Burberry, if the company hires a hard nosed CEO who knows how to run an international premium fashion retailer efficiently and effectively, using little or no debt and realistic growth targets.

So on balance I’ll give Ted Baker the benefit of the doubt and say that it probably is an above average business, but only just. And it’s definitely in need of a solid operationally focused CEO.

If I’m right and Ted is an above average company, then my second question is:

Is Ted Baker trading at a below average price?

This one is easier to answer. IF Ted is an above average company and IF it hires a sensible CEO then I think the current price is very low. That’s largely because most investors have jumped ship, either out of fear, disgust or embarrassment, and only the hardy or stubborn remain.

My opinion is that Ted Baker is not broken. It’s the corporate equivalent of a reasonably good car which has been driven down the twisty road of capitalism with too much speed and too little caution. The result is a serious car crash, but one which was the fault of the people behind the wheel rather than the car itself.

I think there’s a good chance that Ted can be repaired and improved, although it will probably take several years.

I would like to see the new CEO focus on improving the company’s operational capabilities, driving all the new stores, warehouses, staff, systems and so on, that the company accumulated over the last decade, up the experience curve and towards acceptable levels of profitability (i.e. above 10% net ROLACE).

In other words, focus on improving the core business until it’s operating like a well oiled machine, and only then focus on growth.

Whether or not that happens, we’ll have to wait and see. For now though, I have no immediate plans to sell Ted.