Any investment which loses more than 95% of its value can only be described as a disaster. However, the lessons learned from this disaster are so powerful I would have to describe Ted Baker as a gift, albeit a painful one.
- Ted Baker produced consistent, rapid growth for many years
- Ted’s growth was largely funded by banks and landlords rather than shareholders
- External funding was used to drive growth because of Ted’s weak profitability
- Even before the pandemic, Ted had more debt and leases than it could comfortably afford.
“A quintessentially British brand, Ted Baker is famed for its quirky yet commercial fashion offering, high quality design detailing and distinctive use of pattern and colour.”tedbakerplc.com
2164p on 07/08/2018
72p on 07/07/2020
1 year 11 months
Ted Baker has been by far my worst investment since I switched from deep value to defensive value investing almost a decade ago. Within two short years, Ted went from consistent growth to a suspended dividend and a significant rights issue (technically it was an equity raise rather than a rights issue, but let’s not split hairs).
On the surface this collapse was surprising because, until recently, Ted Baker had what appeared to be an exceptionally impressive track record of success.
For example, when Ted joined my model portfolio in 2018 it had a ten-year Growth Rate of 19% and Growth Quality of 100%, which means it had grown very rapidly and extremely consistently over the previous decade. On top of that it had a ten-year average net return on capital employed (net ROCE) of 22%, compared to about 10% for the average company.
Those are exactly the sort of stats I’m looking for, and when I invested in Ted I thought it was a high quality retailer that was still in the relatively early stages of building a truly global footprint.
But I was wrong. Even before the pandemic, Ted ran into a series of serious problems culminating in two changes of leadership, a suspended dividend and a large dose of new equity capital raised from institutional investors, which had the inevitable side effect of massively diluting the holdings of existing shareholders.
So my investment in Ted was a disaster, but it was also a gift.
It was a gift because I now understand the importance of taking lease liabilities into account, especially when you’re looking for high quality companies producing consistent and, more importantly, sustainable growth.
Buying what appeared to be a highly profitable business growing quickly and consistently
Ted Baker started life in 1988 as a single store in Glasgow selling men’s shirts. The company was founded by Ray Kelvin who entered the clothing industry as a schoolboy, working in his uncle’s menswear shop. The founding premise of Ted Baker was that it would be a quirky, fun, brand-focused clothing business.
The company expanded gradually, adding new stores through the early 1990s. In the mid-90s Ted launched of a series of iconic “acid house” shirts that became immensely popular, with queues stretching outside the company’s stores and down the street. By 1997 revenues were up to £14 million and Kelvin decided to take Ted onto the London Stock Exchange.
By 2002 Ted had expanded to 18 stores and revenues of £70 million, up almost five-fold just five years after becoming a public company. Ted blasted through the dot-com downturn as if it wasn’t there, and by the time the credit crunch appeared in 2008 Ted’s revenues had more than doubled again to over £140 million.
After pausing briefly in The Great Recession, Ted rocketed back into growth mode and doubled revenues again by 2014. By 2017, 20 years after it joined the stock market with less than ten stores and revenues of £14 million, Ted had grown more than ten-fold to 114 stores, over 300 department store concessions and revenues exceeding £400 million.
Those are some seriously dramatic results and that is the successful track record I bought into in 2018.
However, soon after joining the portfolio Ted began to run into serious problems.
The pre-pandemic slowdown in 2018 and 2019 hit Ted Baker surprisingly hard
The first sign of trouble came in February 2019, when the company revised down its expectations and announced a £5 million write down on the value of clothing stock. In the grand scheme of things that didn’t seem too serious, and when the 2019 results were announced in March they were okay, with the dividend held more or less flat.
In April 2019 the company’s founder left amid a “hugging” scandal and Ted’s long-time CFO took over as CEO.
In June 2019 the company said trading conditions had been “extremely difficult”, with consumer uncertainty driving “elevated levels of promotional activity” across the globe. Revenues at that point were ahead of the prior year, but pre-tax profits were expected to be around £50 million, some £10 million down on 2019 and £20 million down on 2018. Ted’s shares fell 40% following the announcement, which seemed excessive to me.
In October 2019 the company announced an unexpected loss in the first half and a dividend cut of more than 50%. The market reacted with a further 30% price decline, taking the full decline from mid-2019 to about 70%.
Management said the loss was mostly down to “unprecedented and sustains levels of promotional activity” (i.e. discounting) and structural challenges facing high street department stores, where Ted sells much of its wholesale stock through in-store concessions.
There were also one-off costs, primarily from restructuring its Asia business and from the acquisition of its global footwear licensee. But despite making a loss and halving the dividend, management were generally quite upbeat. Despite the obvious problems, management’s focus still seemed to be on growth and expansion, with the negative trading environment merely a small obstacle to be navigated around.
In December 2019, shortly after the arrival of a new CFO, the company announced that clothing inventory on the balance sheet was overvalued by as much as £25 million. 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 the CEO and Chairman resigned.
The speed and extent of Ted Baker’s collapse was almost shocking. However, rather than panic-selling in an attempt to avoid further losses, my immediate reaction was to open up the wound of my mistake and examine it as closely as possible in order to a) understand why Ted had fallen apart so quickly and b) avoid similar situations in future.
What I found was a small number of interrelated factors which together were the cause of Ted Baker’s impressively rapid rise as well as its (un)impressively rapid decline.
Problem 1) Weak profitability once lease liabilities were taken into account
Whilst Ted Baker was busy falling apart, another holding in the model portfolio was having similar problems.
That company was The Restaurant Group and its history was eerily similar to Ted’s. In other words, on the surface it looked like a quality company producing high returns on capital employed along with rapid and consistent growth, but when the economy slowed in 2018/2019 it quickly found itself in very serious financial trouble.
As I looked at these two companies it dawned on me that they were both property-heavy businesses, dependent on rented stores or restaurants. And yet despite this dependence on property, there was no mention on either company’s balance sheet of rented properties as an asset or their related rent obligations as a liability.
I was aware that some investors adjusted the calculation of capital employed to take account of lease liabilities, but I didn’t. Like most investors, I just calculated capital employed from the balance sheet using equity capital and debt capital, but not leased capital.
So I crunched the numbers and it very soon became clear that these companies weren’t highly profitable after all. In fact, once their very large rental obligations (also known as operating lease liabilities) were correctly added to capital employed, their returns on capital employed declined from very high levels of around 20% to unacceptably weak levels of less than 10%.
If you want the full details on lease liabilities then please read my article The Hidden Debt of Lease Obligations, and my post-sale review of The Restaurant Group, which I should have called The Three Most Important Things in Retail Investing are Leases, Leases and Leases.
I’ll summarise my findings on lease liabilities here:
Lease liabilities are essentially no different from borrowings. If you wanted to open a retail store you would need to either build, buy or rent that store. In the first two cases you would probably get a loan and pay it off over a number of years. If you decide to rent the store then you’ll sign an agreement to pay the landlord for the period of the lease, which would also typically be a number of years.
In all three cases you have:
- No significant up-front cash outlay as the property is funded by (and effectively owned by) your bank or landlord and
- a contractual obligation to pay out an agreed amount every month (or quarter, or year) to either your bank or landlord.
In other words, you have a debt to your bank or your landlord, regardless of whether you buy or rent, so why should a purchased property and its related mortgage be on the balance sheet while a leased property and its related lease liability are entirely absent?
The answer is that lease liabilities should be on the balance sheet as a form of debt and a source of capital, and thanks to IFRS 16 (PDF) this is now an accounting standard.
However, that wasn’t the case when I bought Ted Baker, and not taking account of lease liabilities was the single biggest mistake I made with this investment.
Fortunately it’s an easy mistake to fix and lease liabilities have been integrated into my investment spreadsheet and checklist since late 2019.
So Ted Baker’s return on capital employed was weak once leased capital was taken into account, but why does that matter?
It matters because companies with weak returns on lease-adjusted capital employed typically have little or no competitive advantage. If they did have meaningful competitive strengths then in almost all cases they would use them to generate more profit.
So I now think Ted Baker had no material competitive advantages, and that matters because competitively weak companies are highly exposed to tough competitors and tough economic conditions.
They may sail through one or two recessions if their customers aren’t hurt by the downturns, but when they do eventually face a major challenge, whether it’s the shift to online retailing, a highly promotional environment or a global pandemic, weak companies and their shareholders usually suffer the most.
In contrast, strong companies with consistently high returns on lease adjusted capital employed usually benefit at the expense of their weaker peers, either by taking market share or acquiring them at fire sale prices.
Problem 2) Rapid growth driven by rapidly increasing debt and lease liabilities
Growth doesn’t happen out of thin air. It needs to be funded, whether that’s to increase stock, fit out of a new store or build a new distribution centre. These new assets cost money and that money has to come from somewhere, and that somewhere is typically either:
- shareholders (providing equity capital)
- lenders (providing debt capital) or
- landlords (providing leased capital).
Ideally, growth assets will be funded with shareholder equity because it’s the lowest risk form of funding. It’s low risk because dividends are optional and equity capital has no set repayment date, so it has far more flexible repayment terms than debt or leases, both of which have relatively fixed repayments in terms of how much and when.
Equity can be raised through rights issues, but the easiest way to raise additional equity capital is to retain some of the earnings generated by the company each year.
However, if a company has weak returns on capital then it has little in the way of earnings to retain in the first place, and therefore little to invest in additional assets to drive growth.
For example, in most cases a company producing returns on capital of 5% cannot sustainably self-fund capital employed growth of more than 5%. Since capital employed growth is the foundation of revenue, earnings and dividend growth, this is a problem. And if that same company pays out half its earnings as a dividend then its retained earnings will be equal to just 2.5% of its capital base, and therefore that will be its sustainable self-funded growth ceiling.
This is a major problem for companies like Ted Baker or The Restaurant Group, which consistently produced returns on lease-adjusted capital employed of around 8% and 5% respectively. They both also paid out dividends, so their self-fundable growth rates from retained earnings were even lower than that.
But if Ted Baker was retaining earnings equal to less than 8% of its capital base each year, how did it manage to grow by more than 20% per year for so many years?
The answer is that Ted used external funding from banks and landlords to massively increase its growth rate.
For example, in 2016, Ted produced earnings of £44 million using £173 million of equity capital, £98 million of debt capital and £258 million of leased capital. Ted’s return on total capital employed was therefore 8%. About half of the earnings were paid out as a dividend, so retained earnings were about 4% of its capital base.
If Ted had only raised additional capital by retaining earnings then it would have grown by about 4% between 2015 and 2016. But that’s not what happened.
Instead, Ted’s debts that year went up by almost 400% (from £26m to £98m) while its lease liabilities went up by about 50% (from £171m to £258m). This rapid increase in debt and leases helped Ted’s capital base grow more than 50% that year, far faster than its sustainable self-fundable growth rate of 4%.
This is the magic of using other people’s money. If you take on lots of debt and lease liabilities you can grow a company much faster than you could using the “boring” but sustainable method of self-funding growth with retained earnings.
The risk, of course, is that when things turn bad the company won’t be able to meet its relatively inflexible debt and lease obligations. At the very least, excessive debts and leases may force a company to suspend its dividend and/or carry out a rights issue, and that’s pretty much what Ted had to do.
Problem 3) Excessive debt and lease liabilities
This follows on from the problem of using debt and leases to turbo boost the growth rate of an otherwise ho-hum company. This can work for a surprisingly long time, as long as things don’t spiral out of control. I think through most of Ted’s history it used leases that were either too expensive or too long, but at least it didn’t make the mistake of having lots of debt as well.
Eventually though, management succumbed to the magic money tree of borrowed funds, as debts increased rapidly from zero in 2012 to almost £140 million in 2019. When combined with Ted’s lease liabilities, that left it with financial liabilities of almost £350 million, about 15-times its ten-year average earnings.
My preference is for cyclical companies like retailers to keep debts and leases to less than four-times earnings, or five at the very most, so Ted was wildly overleveraged by thost standards.
Rule of thumb
In summary then:
- Ted Baker produced weak returns on capital, leaving it with a mid-single digit self-fundable growth rate.
- Management chose to increase its growth rate by using large amounts of lease capital and, more recently, debt capital.
- That worked for a long time, but eventually Ted found itself in a market characterised by heavy discounting, and this left it unable to afford its excessive lease and debt liabilities.
- Ted had little choice but to suspend its dividend and raise additional low risk equity capital via an equity raise, offering new shares at rock bottom prices which massively diluted the holdings of existing shareholders.
How to make sure this doesn’t (or is very unlikely to) happen again
Investing in Ted Baker was a mistake caused by a lack of understanding of the importance of lease liabilities.
- Measure lease liabilities going back ten years
- Include lease liabilities in the calculation of return on capital employed (ROCE)
- Add lease liabilities to my Debt Ratio (ratio of debts and leases to average earnings)
- Measure debts over the last ten years so any trend of increasing debt is visible
- Add lease liabilities to my Growth Quality score because companies using lots of external growth funding have less sustainable growth
With these changes in place I have a much better understanding of the strengths and weakness of retailers and other property-heavy businesses, and hopefully that will be enough to stop me from making the same mistake again.
As for the model portfolio’s remaining retailers, most are highly profitable and have relatively strong balance sheets, even when lease liabilities are taken into account.
Selling Ted Baker because it isn’t a “special” business
I like to own high quality businesses, or as I prefer to call them, special businesses.
- Generate consistently high returns on lease-adjusted capital employed over long-periods of time.
- Retain some of those impressive returns to drive relatively consistent growth, without using dangerous levels of debt or lease liabilities.
- Are usually market leaders.
- Have entrenched competitive strengths.
- Are built around a highly focused core business.
- Usually grow by tightening their grip on their core market and by moving into closely related adjacent markets.
I’m now of the opinion that Ted Baker does not have any material competitive strengths and is therefore unlikely to be a special company. I think it was a so-so company which grew too rapidly using too much external funding from debt and leases.
Selling Ted Baker
The only reason I held onto Ted in recent months was to see what the new CEO’s turnaround plan would be, and whether that tied in with my thoughts about Ted’s weak returns and excessive use of external funding.
That turnaround plan has now been announced, and it focuses on capital-light growth with Ted becoming an online-first rather than store-first retailer, with efficiency and cost reduction used to drive higher returns on less capital in the future.
This closely matches my view that Ted’s stores were too lavish and cost too much money for too little return, and that the number one goal going forward has to be an increased focus on return on capital rather than growth.
With the turnaround plan in place I think there is little left to be learned from this investment, so I think now is an appropriate time to sell up and move on.
So I sold my Ted Baker shares earlier this week, and the meagre proceeds will be reinvested into a new holding in the next month or so.