ABC Learning Centres scrip recovered somewhat yesterday after the company issued an announcement noting that it was not in breach of any of its banking covenants under its $1.43 billion syndicated facility. ABC claimed that while there was a covenant pertaining to “shareholders funds”, the clause required that shareholders funds not dip below $2 billion, with “shareholders funds” as being “total assets less total liabilities of the ABC Group on a consolidated basis plus the aggregate value of all notes.” At last count, ABC had net assets of $2.2 billion, plus the $600 million in notes and therefore in a technical sense, was not in breach.

ABC is awfully fortunate that the covenant didn’t relate to market capitalisation. At ABC’s closing price last night, it has a capitalisation of around $880 million – well below its apparent $2.2 billion in net assets (ABC has now been voluntarily suspended until Friday). That basically means that the sharemarket thinks ABC’s assets are only worth around $3.1 billion – as opposed to the $4.5 billion suggested by ABC.

Is the world’s largest Childcare operator playing some accounting games? The problem with ABC’s balance sheet is that the vast majority of its assets are intangible childcare licences. The actual value of these licences is dependent on how much cash they can generate. However, in the wonderful land of accounting, the value of the licences is determined by how much ABC paid for them or how much ABC thinks they’re worth. Therefore, the only thing stopping ABC from breaching its banking covenant by hundreds of millions of dollars is an accounting valuation placed on an asset by ABC itself. Crikey contacted ABC last night for an explanation as to how the company placed a value on its childcare licenses but an ABC spokesperson failed to reply.

Another example of accounting chicanery was the decision by ABC to book $51.1 million revenue from a “discount on [its] Leapfrog acquisition”. In essence, ABC is claiming that the value of the assets it acquired in its acquisition of Leapfrog was $51.1 million less than the amount it paid. Therefore, because Leapfrog was a “bargain”, the discount should flow straight to ABC’s bottom line as profit.

While that makes sense, the problem is that when companies purchase assets for more than their book value, they don’t expense the excess – rather, it is capitalized as ‘goodwill’ and called an asset. Therefore, there is one rule where profit will be boosted, and another where profit will be reduced.

In its 2007 Annual Report, ABC noted that it had accumulated goodwill from acquisitions of $271 million (the vast majority of which was due to its recent US and UK acquisitions). Therefore, if ABC treated goodwill in the same manner as it treats its “discount on acquisition” – it would come even closer to breaching its banking covenants.

In a sense, by overpaying for US and UK assets, ABC has been able to claim it has a higher level of assets and that its “shareholders funds” are above the mandated threshold.

Yesterday Groves said “I’m just so shocked when you look at the assets this company has and look at the value of those assets on a global basis. It is just quite extraordinary what fear can do and this momentum can do.” Sadly for Fast Eddy, the problem seems to be that traders are very much looking at ABC’s assets – and they don’t like what they see.

Was Fast Eddy margin called yesterday? ABC this morning announced that directors Martin Kemp and David Ryan were forced to offload part and all of their shareholding respectively in ABC Learning yesterday.

Kemp (who was the largest individual holder of ABC shares after Groves and Le Neve) was already “margin-called” on Christmas Eve when he was forced to offload 600,000 shares at $4.99 each. Yesterday, poor old Martin was absolutely decimated, with his margin lender flogging off 7.6 million shares – 5.6 million of which were sold at only $1.66 per share. Kemp’s stake in ABC has dropped from more than $80 million to around $5 million – before whatever debt he still has is even considered.

Ryan’s stake in ABC was offloaded with his 249,101 shares dumped at an average price of $1.90 per share. Even though Ryan picked up most of his shares for the “discounted” rate of $3.22 in 2005 he still managed to lose around $300,000, proving that it doesn’t pay to be an ABC director.

Despite wide speculation, ABC made no announcement that Groves’ sold any of his holding. If that is the case, Groves has pulled off a remarkable save, given that the ABC founder has been a prolific purchaser of ABC shares in the past two years. Since May 2006, has spent $32,638,100 acquiring 4.7 million ABS shares in the past 20 months. Those shares were worth only $5.4 million at one point yesterday morning.

In fact, Groves’ entire ABS shareholding fell to only $23.2 million yesterday (this compares to 2006 when BRW valued Groves’ wealth at $325 million).

While Groves was until recently asset rich, ABS was never a large dividend payer and it would be fair to suggest he would have used margin to acquire a fair number of his recent purchases. If Groves had used a loan-to-valuation ratio of 50% to fund his recent acquisitions (which is reasonably conservative) he would be well into margin loan territory. When ABS shares were $1.15, it is highly feasible that Groves’ entire holding of ABC (net of debt) would have been close to zero. Groves may have topped up his account with other funds, or had a very understanding margin lender.

King, Adams, Scott, Coe, Kemp and possibly Groves – the great shake-up of 2008 has now claimed some of the market’s highest fliers. The market can be a very unforgiving beast.

Peter Fray

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