End of a fairytaleSeptember 6, 2008The rise of Eddy Groves to...

End of a fairytale

September 6, 2008

The rise of Eddy Groves to the big league was meteoric - and his fall has been just as swift and spectacular,.

"I like to have a punt - blackjack," said the boss of ABC Learning Centres, Eddy Groves. "I was one of the original regulars at Jupiters [Casino] . . . I'm the only one still going."

It was 1999, he'd just acquired the loss-making Brisbane Bullets, giving Groves a celebrity profile that exceeded his already considerable wealth but not his ambitions.

Groves's growing child-care business had already eclipsed the lucrative milk run which brought his quick elevation to Brisbane's moneyed elite. He had the mansion - complete with its own basketball court - and now his own team. Life was good.

Even then, Groves conceded to local papers he was worried about coming across as a spiv - but not enough to hide an abundant confidence and drive. "The key to business is to never lie to yourself," he said.

"When I go into something I ask myself: `Eddy, can I make this work?' If the figures really add up, I go for it. If not, I walk away.

"I don't think I've ever done anything in business that I've lost money on."

Over the next eight years the snakeskin boot-wearing maverick would complete his stellar trajectory from a single child-care centre in Brisbane to a multibillion-dollar global empire with thousands of centres.

Times have changed. Two months ago Groves was forced to hand in the licence for his beloved Brisbane Bullets, killing off the basketball franchise which won the NBL title last year. He failed to find a buyer for the loss-making team that was now beyond his means.

It would be safe to bet he won't have been frequenting any casinos lately, either. Eddy's got a much bigger gamble on his hands - and its outcome could reshape the child-care industry.

Groves's fairytale run came to an end on February 25 when ABC Learning released its half-yearly results to the market. It wasn't immediately obvious, but this was when the ABC success story imploded.

At the analyst and investor conference call after the release of the results, it became apparent something was seriously amiss.

Groves, the man who usually had all the answers, could do little to dispel the confusion about the result, the state of ABC's finances, or if margin loans on his stock would force a sale of his significant stake in the child-care empire.

In simple terms, it was a mess. "There were alarm bells all over the place," said one of the many investors who have since dumped the stock. "Eddy had a shocker," he said.

There was reason for Eddy to be nervous. Margin calls would soon wipe out his stake in the company, and the share price was plunging amid allegations ABC was in breach of its bank debt covenants, but he still tried to weave his usual magic the following day as its share price plunged.

"I am just so shocked when you look at the assets this company has. It is extraordinary what fear can do and what momentum can do," he told reporters.

"I think it's probably people that have not understood the result, I think there's been some mischief in the stock."

This tune would change dramatically as the disaster befalling the company slowly emerged. Groves appears to have had some inkling of what was to come.

Just before Christmas he sold all of his waterfront property on the Gold Coast, in what looks like a last-ditch attempt to pay down his margin loans as disaster loomed. He pocketed $11 million from the sale of his three Gold Coast waterfront properties. There was also the $2.1 million he received from the sale of a three-bedroom beach house to Harvey Norman executive, Katie Page, for $600,000 less than what he paid for the property three years previously.

The big bet failed on that disastrous week in February. ABC's bankers were already baying for blood, triggering a fire sale of assets beginning the day after was attesting to ABC's health. Institutional shareholders had been pushing for ABC to replace longtime auditor, Pitcher Partners, with a "Big 4" firm since early 2007, but it was the muscle of the banking syndicate, providing more than $1.48 billion worth of debt, that forced ABC's board into appointing Ernst & Young in July 2007. The new auditors were given a mandate to run a fine-tooth comb over the company's accounting practices.

With new auditors on board, the banks decided against the option of sending their own people in to check its accounts.

It's a decision they would come to regret that fateful Monday in February as the implications of the half yearly results hit home.

The top line figure - first half earnings dropped 42 per cent to $37.1 million - was bad. But what most observers missed amid the panic over margin loans, debt covenants, and the shock drop in earnings, was a single entry deep within ABC's financial statement.

ABC reported for the first time that its revenues included $73.3 million worth of "fees paid by child-care developers" which apparently "support centres during occupancy growth". Including liquidated damages, the total fees paid by "developers" came to $110 million - more than 20 per cent of its Australian revenues for the period.

In the context of a $37 million profit it was significant, especially since no one knows what expenses were recorded against these fees. That the developer payments pumped up ABC's revenues and earnings was bad enough, but it also revealed another shocking truth - ABC's Australian business was underperforming dismally.

ABC's abysmal disclosure did not help. In the six months that have followed, the markets are still trying to grasp what is really going on at the child-care empire amid conflicting statements from the company which have shredded whatever remained of its credibility. "Nothing they have said makes any sense under any sort of scrutiny," was the scathing assessment of another institutional investor.

ABC's new chairman, David Ryan - appointed after a purge of directors from the company with a mandate to fix up the mess - admitted to the disclosure issue in April. The purge included its prominent chairman Sallyanne Atkinson and the former federal children's affairs minister Larry Anthony and the Austock chief Bill Bessemer. It was a rare concession to institutional shareholders who demanded scalps.

"We had a breakdown in management accountability over a relatively short period," Ryan said later in an interview with The Australian. He admitted there had been an "inconsistency of presentations" and "that confused the hell out of everybody."

Everybody is still as confused as hell, apparently, including the auditors who have forced ABC into an indefinite trading halt while they try and clean up the company's financial statements.

It's not a good look for Ryan, who was on the audit committee which presided over this mess. In the six months following ABC's interim results, expectations of a $164 million profit have been slashed in a series of downgrades to a loss that is now expected to exceed $437 million.

The company's woeful disclosure during this period grabbed the attention of the litigation funder IMF, which is preparing a shareholder class action that could test the $144.5 million record payout by Aristocrat Leisure last month. The case is expected to focus on ABC's materially misstated earnings over previous years and bullish forecasts which "had no reasonable basis". The Australian Securities and Investments Commission is also expected to act.

Lack of disclosure was a major issue for ABC right from the start, but a lack of proper scrutiny may have been as well. Located on the outer fringes of Brisbane, ABC was largely out of mind, out of sight - as long as it kept on reporting record results, at least.

And as the only listed child-care operator of any real scale on the Australian sharemarket, it was usually in the odds and ends basket for analysts covering other industries. Its uniqueness also meant there was nothing else against which to compare the company from a performance standpoint, and for warning signs.

One area under a lot of scrutiny now are the developer payments, and who was ultimately paying for it. It was, of course, none other than ABC itself.

The fact that there were question marks over ABC's relationship with some of these developers (see related report) only adds to the controversy. ABC has said it will swap to a new model when the agreement covering these payments expires on June 30 next year.

The current system works like this: a developer buys the land and builds a child-care centre. On most occasions, the land would be sold off to a listed real estate trust which would have a long-term lease from the centre's operator, ABC Learning.

ABC then buys the business, but receives payments from the developers akin to "rental guarantees" paid to property investors. In basic terms, loss-making centres are subsidised by developers until they hit certain occupancy levels.

This would only make sense for developers, of course, if they could factor these subsidies into the sale price ABC would pay for the centres. These inflated costs would show up on ABC's balance sheet as an asset, or to be specific, a child-care licence.

These "intangible" assets (there is no physical asset to back up its value) accounts for most of the $3 billion worth of intangible assets reported on the half-year balance sheet. That compares with ABC's current market value of less than $300 million.

The intangible assets underpinned ABC's semblance of rude health, and a fall in their value would trigger the debt covenants underpinning ABC's massive loans.

ABC is expected to announce massive write-downs of these assets in its full-year results, but breach of the debt covenants is no longer an issue in practice. ABC has effectively been under the control of its banks since February.

All in all, ABC's simple success story of earnings built on fat Federal Government subsidies and a steady flow of child-care service fees has been blown out of the water.

For those who missed it, the story went something like this.

ABC cashed in on unprecedented demand for child care as more women re-entered the workforce. The company's competitive edge was an aggressive acquisition strategy that would beat the competition with economies of scale and a brutally simple business school methodology - buy market share and rationalise local markets to boost occupancy.

Price sensitivity on the part of customers is offset by government largesse. This year, the Government is expected to hand out more than $2.75 billion in child-care benefits and related tax rebates - ABC will be the largest beneficiary by far, accounting for around 15 per cent of long day-care placements in Australia.

This includes a lift in the child-care rebate from 30 to 50 per cent on July 1 this year. ABC pipped in with an 11 per cent fee increase the week before. The story delivered handsomely for investors. $1 invested in the float in 2001 would have returned more than $22 at its peak in December 2006.

At its heart, the business is about bums on highchairs. Child care is a business with high fixed costs, so, like a hotel, occupancy is everything.

Your occupancy does not determine how profitable you are, it determines whether you are running at a profit or a loss.

A recent industry report from market researcher IBISWorld, says: "Generally, long day-care centres require occupancy rates of at least 70 per cent to be profitable."

In this context, the "developer revenues" appear to play a very important role in the ABC success story.

So did ABC's decision in 2004 to stop reporting how many children were actually enrolled in its day-care centres.

Investors and analysts could not determine the occupancy levels of ABC centres, and the developer payments effectively hid any shortfalls from child-care service fees.

While ABC has promised to clean up the mess and make its disclosure a lot more transparent, it will take a lot more to get back investor confidence. The problem is that no one's sure what exactly the company's worth in light of the latest revelations.

Nothing is being taken for granted, not even the viability of the Australian child-care business which launched the empire and now - heavily laden with debt - is one of the few assets that will be left after the asset sales are completed.

Shares last traded at 54c, but Clime Asset Management's Roger Montgomery, a long-time ABC sceptic, the stock may be worth as little as 19c.

In a worse-case scenario, he says the company is "potentially insolvent".

"You've got so much debt there that selling the assets may not pay down all the debt," Montgomery says.

No one is expecting the fire sale to go that far, but it isn't a good sign that the banking syndicate took out a $1.25 billion fixed and floating charge last month against ABC's assets.

To be fair, ABC's failures cannot all be put down to these previously undisclosed transactions.

The company's 2006 expansion into Britain and the US was well publicised and was already triggering rumblings of concern over the massive debt, and the management oversight needed to make it work.

Borrowings exploded from $380 million to $1.8 billion during the 2007 financial year - this doesn't include another $1 billion from capital raisings.

ABC expanded into the two markets most affected by the credit crunch and it is now being crippled by the massive debt used to enter those markets.

It may take some time to divine the ultimate future of ABC, assuming it has one, but the big question is: how has Groves survived such a debacle?

He has claimed in the press to still have the support of ABC's remaining shareholders, but declined interview requests by the Herald.

The assessment from former institutional investors is that he may know how to manage a child-care centre but "the business of child-care centres is where he has fallen short".

Some ABC watchers predicted that in the long term - assuming it survives - ABC will probably ditch Groves for someone more palatable to the markets.

It may not be an option in the short term given the mess that needs to be cleaned up at ABC and the loss of senior executives so far this year.

As for why Groves is sticking around, a potential turnaround is the only thing that might revive his tattered corporate reputation. There is also the point that ABC is about all he has left.

His houses are gone and so is the milk delivery business which provided his initial fortune. Eddy's privately held Quantum Food Services sold its milk and food distribution operations business in September 2006.

Groves is relying on his current ABC salary, most of which will be received in share options priced at more than double today's levels, to restore his fortunes. At least he still owns the 5 million shares in Austock he controversially acquired while the company had ABC as a major client.

One thing Groves doesn't appear to have lost is his confidence and salesmanship.

"This is all about a rebirth and takes us back down a pathway that we can go down," he said last month.

"It's a very good company. We made a mistake in a year out of 20 years. I don't think that's too bad. I am not saying that lightly. I am disappointed with what we did but we need to change that around and I know we can."