Category Archives: Comment

Sexing up the statistics. Who needs facts?

Female CEOs

Want Higher Profits? Hire a Female CEO, CFO” The article headline caught my eye. Aren’t we all looking for a magic ingredient that can guarantee financial success? I think that women are disadvantaged and undervalued in business. And this doesn’t have to be the case. The last CEO I appointed was a woman – in a male-dominated industry – and the last board I chaired had a majority of female directors. So, I read this article with great anticipation.

The article is based on a research report1 by S&P Global, entitled even more eye-catchingly: “When Women Lead, Firms Win”. This is shown by the statistic that: “In the 24 months post appointment, female CEOs saw a 20% increase in stock price momentum…”

So, your investment strategy should be to buy stocks with newly appointed female managers! Ah no, the report rebukes you for drawing this obvious conclusion; “…we admonish the reader to interpret the results as a descriptive analysis, relevant from a governance standpoint, but not providing evidence of a predictive trading signal.” Maybe they don’t quite have the confidence in their own research?

The study goes on to suggest that one driver of female-led out-performance is that females are held to a higher standard than males, so like-for-like female executives are better: “…females in C-suite positions are consequently more talented.”

Naturally, I wanted this all to be true. But something about the scale of the claim and the certainty didn’t ring true. I wondered if the statistics were that definitive? Had those headlines been sexed up?

The research study

The study2 is a large one, based on the Russell 3000, a benchmark for the whole US stock market, over the last 17 years and encompassing over 5,800 new executive appointments, of whom 90% were male. It looks for changes in company performance in the two years3 post a female executive appointment4.

In summary, the results seem to show that;

  1. The sex of a newly appointed CEO does not have any effect on the market capitalisation of a business.
  2. New female CEO’s have a better record than males in improving the valuation5 of a company over their first two years.
  3. There is no significant difference by sex for new CEOs in levels of capital expenditure, profitability6, or 12 month share price momentum. However, new female CEO’s companies have greater share price momentum over 6 months.
  4. Companies with new female CEOs appear to reduce the level of their balance sheet accruals compared to those with new male CEOs (However, given that female CEOs on average inherit significantly higher accruals than their male equivalents, this is quite likely to be a case of reversion to the mean).
  5. Companies with new female CEOs increased leverage more than those with new male CEOs7.

What conclusions does the research make?

Sadly, the research makes the most basic of statistical errors. Correlation does not imply causation8. The fact that two sets of data appear to move together does not prove that one causes the other. This is particularly pertinent where both different results are cherry-picked to highlight those that fit the argument, and there is not a robust hypothesis tested to explain the mechanism involved.

The research’s headline claim is that female CEOs deliver a 20% increase in share price momentum. However, this is only true looking at the 6 month momentum. Even then, this result is statistically ‘significant’ at only the 90% level, well below the standard test of a 95% chance of it not a being random event. The 12 month momentum shows improvement of less than half the 20%, and is not significant at any level.

The next major claim in this research is that new female CEOs improve their company valuation (ie reduce the book/market value ratio) over their first two years versus those of new male CEOs. However, the research finds no evidence of a significant gender-related improvement in market capitalisation, share price momentum or profitability, and so it’s not clear where this rating improvement derives from. One answer could be in the finding that new female CEOs increase leverage, which can assist in improving company valuations, whilst raising financing risk.

Confusingly, the graph of average residual returns in the research appears to show that new female CEOs companies are generally under-performing against equivalent males. This finding, whilst unlikely to be statistically significant, seems to undermine the central conclusion.

Ave res returns graph

So where did those headlines come from?

Contrary to the article headline, the research does not claim that female CEOs deliver higher profits. However, the research itself is also guilty of wish-fulfilment and outcome-seeking. There is no evidence that “When women lead, firms win”. In fact, the predominant evidence is that the sex of a new CEO is not a significant factor in company success. This is as you would expect. If sex were a dominant factor, life would be so much easier for Nomination Committees. Business – as with everything in life – is so complex that no one factor about a person is likely to have an overwhelming predictive effect on a company’s performance.

The research’s major claim is that new female CEOs see a 20% increase in stock price momentum. However, the report’s own data doesn’t support this conclusion9, nor would this be a robust long-term performance indicator in the absence of any improvement in either profitability or market capitalisation10.

Is it still possible that the average new female CEO is better than their male equivalent?

It is certainly possible than new female executives are better than equivalent males, and it is possible that female CEOs drive superior company performance. It is possible that the data on financial performance is so noisy that it would not be evident statistically. However, at this stage, there is no robust evidence for this.

It is also possible that females are discriminated against so that they have to be superior in ability or experience to male equivalents in order to get promoted to senior roles. The research uses a crude analysis11 of executive biographies to conclude that females are ‘more talented’ than male equivalents. The research here fails to distinguish between ability and experience. There is no reason to believe that females are innately better executives than males, but they may well suffer discrimination. As a result, women may find they need more experience or more talent, compared to a male candidate, to get the top job. Also, in having and caring for children they may well end up with less management experience than similarly aged male executives. All of this suggests that females deserve some positive discrimination in appointing them with less experience than their male equivalents might have.


This is one of many pieces of research12 that appear to be aimed at proving that females outperform males in senior roles. Studies like this should be invaluable sources of understanding about how business works, how prejudice harms decision-making and how business can create value. However, wish-fulfilment, the selective use and hyping of inconclusive statistics helps no-one, merely pandering to media and political prejudice against business.

I think females are discriminated against and constitute vast under-utilised talent. The fact that we can’t prove it doesn’t mean it isn’t true. We need to work hard to counter prejudice and promote women.  We don’t need sexed up headlines to tell us that this is the right thing to do.


Simon Laffin



2 The statistics are difficult to interpret, particularly how exactly the performance measures are calculated and presented, with little explanation or definition provided. I have interpreted them to the best of my ability in their absence.

3 Two years appears to be a random time frame.

4 The research also looks at new CFO performance, but for simplicity I have focussed on the CEO analysis. If sex were a significant indicator of executive success, you would expect to see that primarily in CEO performance.

5 Defined by market capitalisation divided by accounting book value

6 Defined as Gross profit or EBITDA as % of book assets

7 Interestingly, this is counter to many commentators’ claims that females are more risk-averse and would be more conservative in running companies, particularly in financial services.

8 See for example for more explanation:

9 The research claims that; “These results are economically and statistically significant.” However, this would only be true if the research had started out with a hypothesis that female CEOs improved stock price momentum and then found that the data supported that. In fact, it looks as if the researcher selected seven measures of performance and alighted on the only two that gave him the answer he was looking for. It has two measure of stock price momentum and he has selected the one with a result that fits its conclusion. Test of statistical significance are based upon the likelihood of something happening against a random event. If you choose a measure because you like its outcome, you cannot rank it against a random event, precisely because you selected it. Statistical significance doesn’t work on a ‘pick and mix’ basis.

10 The research does not provide a hypothesis as to how share price momentum is boosted despite there being no improvement in either market capitalisation or profitability.

11 It looked for words in biographies of male executives in companies with ‘positive excess returns’ and then judged the quality of female CEOs by counting the occurrence of these same words in their biographies.

12 The research claims; “The analysis presented herein is one of the most comprehensive examinations, by breadth and time horizon, of gender diversity, to-date.”

Response to consultation on Market Study on Statutory Audit Services

CMA report coverI am responding to the request from the Government for views on the recommendations by the Competition and Markets Authority on the market for Statutory Audit Services. This submission is made in a purely personal capacity.

Over the last 25 years, I have been chairman or director of ten different companies, from small privately owned to FTSE100, participating in over 200 audit committee meetings. I have never worked for an auditing firm, big or small. I am now a non-executive director/Chairman of the Audit Committee at Watkins Jones plc and Chairman of the Audit Committee of Dentsu Aegis Network, as well as a private investor.

Introductory Comments

There needs to be a clearer understanding that audit is a regulated statutory service. As such companies and stakeholders should rely on the regulator to ensure high quality standards. Failings in the quality of audits are primarily the responsibility of the audit firms and their regulator, not company audit committees. Audit committees should be responding to issues that they see in the conduct of their own audits, and should be allowed to select their auditor based on their own criteria. If shareholders are unhappy with this, then they have the power to influence boards and ultimately vote directors out if necessary.

The CMA Report is heavily UK-centric, failing to take full account that the Big 4 have international arms and associates and that most FTSE350 companies are international. It does however recognise that the dominance of the big 4 firms is an issue that must be tackled globally, or at least on a European basis. It is not tenable to argue that the global oligopoly of the Big 4 can be successfully challenged by measures that affect UK-based firms only.

The CMA report provides no analysis as to why the market has become so concentrated (although its predecessor body contributed significantly by allowing the merger of Coopers & Lybrand and Price Waterhouse in 1998). As a result, the report sheds no light on what will happen if the joint audit proposal is implemented, diverting significantly more revenue to non-big 4 players. How will they react? Will this artificial subsidy turn the non-big 4 into real challengers? The answer is that no-one knows. This is a poor basis for a major change to affect virtually all our 350 largest companies. The CMA should have recommended that this proposal be trialled first to learn what happens rather than rush to rollout a significant untried policy measure.

The most effective and fastest way to increase competition in this market would be to increase competition within the big four by ensuring that each of the big four can always compete for an individual audit. This is not currently the case as often a company already uses one or more of the big 4 to provide tax, advisory or internal audit services. The CMA recommendation to require some form of split between the audit and non-audit services of the big 4 is therefore the strongest recommendation and the one most likely to provide more choice in the short term. The government should also lobby internationally for other countries to require a similar split.

Arguably, the best opportunity for non-big four firms to increase their competition against the big 4 would be by investing in their non-audit work. Developing a strong tax practice or due diligence team is likely to be easier than trying to compete for audit work, particularly as the latter tends to require a strong international network.

Detailed responses to questions posed by the Government

  1. Do you agree that the new regulator should be given broad powers to mandate standards for the appointment and oversight of auditors, to monitor compliance and take remedial action? What should those powers look like and how do you think those powers would sit with the proposals in Sir John Kingman’s review of the Financial Reporting Council?

The CMA has not provided any guidance as to what form the ‘standards’ for the appointment and oversight of auditors would be, and therefore there is no basis for this being new powers for a regulator. UK corporate governance hinges on boards, and particularly non-executive directors, exercising their fiduciary duty to operate the company on behalf of members and other stakeholders. There is no evidence in the report of widespread failure by boards to do this. Nor is there any analysis of why individual auditing failures have emerged. Regulation of statutory audit is not the role of boards, who have in fact been let down by the failure of the regulators themselves to do their job. It is therefore somewhat ironic to have regulators trying to increase their own powers to regulate boards with regard to audit quality.

  1. What comments do you have on the ways the regulator should exercise these new powers?

These new powers are not justified by any evidence and so should not be conferred on a regulator.

  1. How should the regulator engage shareholders in monitoring compliance and taking remedial action?

Shareholders should be engaging with boards directly themselves.

  1. What would be the most cost-effective option for enabling greater regulatory oversight of audit committees? Please provide evidence where possible.

The case has not been made for greater regulatory oversight other than by shareholders themselves engaging with individual companies.

  1. Do you agree with the CMA’s joint audit proposal as developed since its interim study in December?

The CMA’s joint audit proposal does not have an evidential basis. Joint audits are voluntarily used by a few companies, but are mandatory only in France. The actual evidence shows very mixed results. For example the Lesage, Ratzinger-Sakel, Kettunen study, ‘Struggle over joint audit: on behalf of public interest?’ concludes that;

“we do not observe a higher quality associated with joint audit, neither on the Danish sample (main analysis) nor on the matched FRA/GER [France/Germany] sample.”

The CMA admits that the effect on quality ‘should be at worst neutral.’ (Final Summary Report. P10). This is hardly a ringing endorsement for a major proposal to improve audit competition and quality.

The CMA’s main objective is to increase revenue for non-big Four firms. It is akin to them mandating that shoppers must purchase half their groceries from an independent convenience store, rather than a supermarket. This proposal would by definition lead to the non-big four firms getting more audits, but is by way of a large subsidy to them rather than through increased competition. There is no guarantee – and no evidence identified – that this will improve the quality of non-big four audits, as opposed to swell their partners’ incomes.

This proposal would be a very substantial change to UK audits and incur considerable extra costs. An incumbent big Four firm is very unlikely to reduce its fees in order to fund a smaller competitor duplicating some of its work. Companies will have two sets of auditors reviewing the same accounts, slowing the process and consuming management time. It would take a long time for the non-big 4 to grow their headcount to cope with even 30% of the audit work of the FTSE 350. The CMA interestingly has made no attempt to model out how much this work would be, how long it would take for the non-big 4 to be in a position to resource this, nor whether such pace of expansion required is feasible.

The CMA has failed to show any evidence that this proposal is likely to be either successful or proportionate. In the absence of this evidential basis, the most that should be proposed is a trial for certain companies or sectors to see if joint audits do have the benefits claimed. This should be followed by a very gradual roll-out if it deemed successful. This would also give more time for the non-big 4 to resource up.

  1. Do you agree with the CMA’s proposed exemptions to the joint audit proposals? How should the regulator decide whether a company should qualify for the proposed exemption for complex companies?

Whilst I believe that the joint audit proposal is a costly and disproportionate measure, I do not see the argument to exempt complex companies. This measure would be most cost/benefit effective if applied precisely to the largest companies and largest audits, as they would transfer most revenue to non-big 4 companies per audit affected. The more complex the audit, the more the learning should be transferred to smaller firms.

  1. Do you agree that challenger firms currently have capacity to provide joint audit services to the FTSE350? If a staged approach were needed, how should the regulator make it work most effectively? If not immediately, how quickly could challenger firms build sufficient capacity for joint audit to be practised across the whole of the FTSE350?

Obviously non-big 4 firms would need both to recruit new staff and to improve the overall quality of the staff that they currently have. Inevitably this would require large scale recruitment by them from big four firms. It might well mean that non-big four firms would also have to resign from smaller audits in order to resource the new audits gained. The main results are likely to be inflation in pay for auditors and partners, with a modest growth in non-big 4 headcount. Audit quality is likely to suffer as big four firms lose staff and non-big 4 firms struggle to upscale. Accordingly, the Government would be taking a major risk in mandating a large scale roll out of this proposal.

As suggested above, a pilot scheme involving a relatively small set of large companies would be the optimum next step to see if the remedy works without causing widespread disruption.

  1. Do you agree with the CMA’s recommendation that the liability regime would not need to be amended if the joint audit proposal were implemented?

If both firms were jointly and severally liable, they would need to review each others’ work. It seems unlikely that they could place reliance on the other’s review. This would reinforce the duplication of effort and increased costs of this proposal.

  1. Do you have any suggestions for how a joint audit could be carried out most efficiently?

A joint audit is inherently inefficient, particularly when its main purpose is to give more work to smaller players in the market.

  1. The academic literature cited in the CMA’s report suggests the joint audit proposal would lead to an increased cost of 25-50%. Do you agree with this estimate?

This sounds plausible.

  1. Do you agree with the CMA’s assessment of the alternatives to joint audit, including shared audit?

No comment.

  1. How strongly will the CMA’s proposals improve competition in the wider audit market, and are there any additional measures needed to ensure that those impacts are maximised?

The CMA’s proposals will cause significant dislocation in the audit industry as non-big 4 firms try to grow to meet the increased number of audits required, poaching staff from the big 4. Overall audit quality is likely to therefore decrease, not helped by the inefficiency of having two auditors.

  1. Do you agree with the CMA’s proposals for peer review? How should the regulator select which companies to review?

The CMA argues that there should be a non-big 4 peer review for audits that are too complex for a non-big 4 firm to jointly auditor. This seems illogical, especially as the inexperienced non-big 4 firm will have no liability for the outcome. How different is this from a regulator’s Audit Quality Review (AQR)? What value would the peer review have? The peer reviews would report only to the regulator, but if they are not shared with either the auditor or the Audit Committee, how can the regulator get a balanced view of the value of said peer review?

  1. Are any further measures needed to ensure that the statutory audit market remains open to wider competition in the long term?

It is likely that forcing a split between audit and other services would be the most effective and low risk measure to improve competition. This would enable companies to have a fuller choice between the big 4, reducing the times that one or more is ruled out through a conflict of interests.

  1. What factors do you think the regulator should take into account when considering action in the case of a distressed statutory audit practice?

As the CMA recommends, the regulator should take a close interest in the viability of the big 4 and act early in the unlikely event that one appears to be failing.

  1. What powers of intervention do you think the regulator should have in those circumstances, and what should be their duties in exercising them?

No comment.

  1. Do you agree with the CMA’s analysis of the impacts on audit quality that arise from the tensions it identifies between audit and non-audit services?

I have not seen any evidence that audit quality is affected by ‘tension’ between audit and non-audit services. There are in fact benefits from the cross-fertilisation between audit and non-audit in sharing knowledge and career development. However, the overwhelming argument is to split them organisationally to increase effective choice for audit clients.

  1. What are your views on the manner and design of the operational split recommended by the CMA? What are your views on the overall market impact of such measures?

The proposals for an operational split seem sensible.

  1. Are there alternative or additional measures which would meet these concerns more effectively or produce a better market outcome?

No comment.

  1. Do you agree with the CMA’s proposal to keep a full structural separation in reserve as a future measure?


  1. What implementation considerations should Government take into account when considering the operational split recommendations? Please provide reasoning and evidence where possible.

No comment.

  1. Do you agree with the CMA’s other possible measures? How would these suggestions interact with the main recommendations? How would these additional proposals impact on the market?

Limiting notice periods and non-compete clauses for big 4 firms seems sensible. The other proposals appear somewhat peripheral. Moving audits to a fixed term of seven years would be unnecessarily intrusive, but there could be a requirement for a tender every seven years. This however should not be expected to have an impact on big 4 market share.

  1. Do you agree with the CMA’s suggestions regarding renumeration deferral and clawback?

Having the opportunity to clawback auditor remuneration for serious failings discovered later seems sensible and in line with modern corporate governance.

  1. How would a deferral and clawback mechanism work under a Limited Liability Partnership structure?

No comment.

  1. Do you agree that liberalising the ownership rules for audit firms would reduce barriers for challengers and entrants to the market?

It is difficult to be sure how this would work in practice, but it would be worth trialling for a few smaller firms to see how it works.

  1. Do you agree with the CMA’s suggestions regarding technology licensing?

It might work, but you might find a low take up by smaller firms.

  1. Do you agree with the CMA’s suggestions to provide additional information for shareholders? Do you have any observations on the impact of the Public Company Accounting Oversight Board’s database on the US audit market?

This seems harmless, but I’m not sure that there will be significant benefit.

  1. Do you agree with the CMA’s suggestions regarding notice periods and non- compete clauses? Do you agree that the regulator should consider whether Big Four firms should be required to limit notice periods to 6 months?


  1. Do you agree with the CMA’s suggestions regarding tendering and rotation periods?

Moving audits to a fixed term of seven years would be disproportionate, but the requirement for a tender could be set at seven years. This however should not be expected to have an impact on big 4 market share.

  1. Do you have other proposals for measures to increase competition and choice in the audit market that the CMA has not considered? Please specify whether these would be alternatives or additional to some or all of the CMA’s proposals, and whether these could be taken forward prior to primary legislation.

The Big 4 could be required to initiate a certain level of secondments of staff into non-big 4 players, in order to boost the latter’s capabilities.

  1. What actions could audit firms take on a voluntary basis to address some or all of the CMA’s concerns?

They could initiate an operational split between audit and non-audit services. They could also have a code of conduct to facilitate movement of staff into smaller players.

  1. Is there anything else the Government should consider in deciding how to take forward the CMA’s findings and recommendations?

The Government has a major role in lobbying for international action to increase competition and quality, as these proposals cannot work if implemented solely in the UK.



Simon Laffin                                                                                                28 August 2019

The audit punch-bag: Where is the voice of industry?

Punchbag auditStorm clouds are gathering over the audit market. Government, politicians, media and regulators are all queueing up to condemn companies and auditors over the few, but well-publicised, failures of certain companies. Lack of knowledge about the audit process is no bar to these opinion-formers. Meanwhile industry bodies are supine in defending business and signally failing to provide the missing knowledge as to what actually happens and what went wrong.

Having attended some 200 Audit committee meetings across 10 companies of all sizes and ownerships over the last 25 years, I have seen how audits actually work for companies and shareholders.

Is there a fundamental problem with the audit process?

There are hundreds of thousands of audits completed every year in the UK. There has been a handful of, admittedly large, company failures in recent years. There are even fewer cases where an auditor has been found culpable, remembering that it is not an auditor’s job to stop a company failing. There certainly have been issues in auditing, like any business, but it is not legitimate to conclude that the system is fundamentally flawed based on a few examples.

Has greater regulation helped in the past?

In 1998, I along with many other Finance Directors pleaded with the then competition regulator, the Monopolies and Mergers Commission, not to allow the merger of Coopers & Lybrand with Price Waterhouse. This, coming soon after the demise of Arthur Anderson, would mean that we would be left with only four global auditing firms. Industry was ignored, as the regulator knew better and convinced itself that competition would be maintained. Move forward 20 years, and the current regulator, the Competition and Markets Authority, is without a single blush of shame, looking at whether the Big Four are too concentrated. Industry told them 20 years ago that this was a bad thing. What chance that the regulator will listen to industry this time?

The European Union decided in 2014 that the answer would be compulsory tenders and controls on non-audit work. This hasn’t increased competition between auditors and especially non-Big Four, who haven’t won more work. It has created an industry in pitching for new audits, which itself disadvantages the smaller players who cannot afford such expense and who are increasingly not bothering to pitch for larger company work. Moreover, the banning of a company’s auditors from doing non-audit work has actually reduced choice where other Big Four firms are already providing tax, advisory or internal audit services. The choice can end up between two firms, one of whom might then be ruled ineligible as a long-standing incumbent.

In the UK, audit quality is monitored by the Audit Quality Review team, part of the Financial Reporting Council. It reviews about 25 audits for each of the Big Four and a handful each for another four firms. The reviews are effectively an audit on the audit. Although the AQR says that it contacts each Audit Committee Chair at the start and sometimes at the end of each review, there is no evidence in the reports that any weight is attached to their views. For example, the typical Audit Committee concerns; responsiveness, clarity on technical issues and speed are not mentioned in these reports. It is clear that the regulator feels it knows best what makes a good audit.

In short, the evidence is that greater regulation and intervention have proved at best ineffective, largely counter-productive and have actually reduced competition in the audit market.

Is new regulation going to help?

The Government has asked the Kingman inquiry and the CMA to look at aspects of the audit process. There are two key themes; increasing competition in the audit market and looking at a regulator taking over the responsibility for appointing a company’s auditors.

Increasing competition in the audit market

Commentators often wonder why so many companies, especially large ones, principally use the Big Four. The answer is simple. Multinational companies need to be sure that they will get a high-quality audit in all their countries, and the Big Four have the best international networks. Coordinating different auditors in different countries with different technical outlooks and rules is an unwanted significant additional complexity for companies.

There are high quality people in all audit firms, but, from my experience, there is significantly less quality in depth in the non-Big 4. They don’t have the resources, attractiveness and career development that the largest players do. If the objective is higher quality audits, forcing companies to employ less well-suited auditors is a strange response.

Breaking up the Big Four would be very problematic. These are international alliances of companies, so breaking up the UK firms wouldn’t solve the issue the international issue. It is very difficult to imagine that a coordinated multilateral effort could successfully break up the alliances across the world. The Government could encourage or subsidise the non-Big Four to merge, invest, grow their expertise and better develop international partnerships, but this feels pretty tricky. The most plausible change would be to force UK firms to divest all their non-audit work. The auditors worry that this would make audit firms less attractive as employers, and that this would damage audit quality. They may well be right, but industries also have a habit of accommodating such change, not least by increasing salaries.

A regulator appointing auditors

Some believe that companies select auditors who are more malleable to management. However, I can find no suggestion that some auditors are too lenient in any of the AQR reviews of audits, nor indeed any other evidence of this anywhere else. My experience from seven tenders that I have participated in, is that auditors are chosen largely on how sharp, commercially-aware and technically-competent the lead partner and top team are. Never has an auditor even implied that they would allow management more leeway than others. Moreover, if this were the case, then our whole governance structure with independent non-executives and audit committees would be failing. The answer then would be in governance change, rather in imposing audit appointments.

On what basis would a regulator appoint an auditor to an individual company? Would they use sector expertise? This would inevitably lead to a greater concentration of audits as it would be self-reinforcing. Would it be a cab-rank principle like barristers? But this couldn’t cope with companies needing sector-expertise or international coverage. How would allocating audits on a ‘buggins’ turn basis contribute to effective competition between auditors? If a company were allocated a poor performing audit partner, what recourse could it have when the audit is imposed on them? And how would this enhance competition?

An audit does much more than simply agree a profit number. A good audit works closely with management in order to get under the skin of a business and use that knowledge to make judgements, challenge assumptions, identify risks and suggest improvements in processes. The Audit Committee, in consultation with management, is in a good position to assess an auditor’s success in achieving this. How would a regulator be better placed to make this call for an individual audit, along with thousands of other appointments that it would have to make?

There is a problem, but how do we get to a solution?

There are issues with the quality of some audits, but there is no evidence that this is widespread. In fact, the continued repetition of Carillion and BHS as evidence actually suggests that there are relatively few known examples. Clearly there were issues to investigate at Carillion, BHS, Patisserie Valerie, and Conviviality, but no-one is really trying to understand how the audit process contributed to those failures. The media, government, Select Committees and regulators have focussed on allocating blame to individuals. This is not the same as understanding what happened. In fact, searching for blame is pretty much guaranteed to block thoughtful impartial analysis.

It does make sense not to allow any company to become too important to an audit firm. It may well be helpful to separate out completely non-audit work from all audit firms. But making auditors more nervous and cautious about signing off a company’s going concern statement won’t save companies from going bust. In fact, it is likely to increase it, as companies that could perhaps have been saved, have to through in the towel after being unable to get their accounts signed off as a going concern.

The current pressure to increase audit regulation is likely, on past experience, to be counter-productive. It may buy some good headlines for a beleaguered government, but responsible regulation has to be built on evidence, clear thinking and understanding of all the consequences (whether intended or not). It also requires the humility that would come from accepting the failures of past measures and decisions.

The likelihood is that we will end up with more regulation proposed by the ‘great and the good’, few of whom have actual experience of company audits, based on little evidence, but genuflecting to politicians with little or no understanding of business.

And where is the voice of business? The trade bodies remain craven to the government and fearful of a political backlash. The accountancy bodies, dominated by auditors, keep their heads down. It is no wonder that companies are likely to end up being the punch bag for yet more political games.


Carillion – a salutary reminder on due diligence

Carillion Annual Report cover

Carillion has entered the pantheon of cursed companies following its recent failure. Politicians and the media have worked themselves in another fit of righteous indignation about greedy management and incompetent boards. The search is out for people to blame, shame and even prosecute. Regulators, sensing the flow of the political wind, are climbing on the bandwagon and looking for blood.

Non-executive directors are reasonably enough feeling nervous. They are at the centre of corporate crises such as this. Already some Carillion directors have had to resign from other roles and the non-execs will be contemplating an enormous black mark on their CV’s. Being a non-exec in this form of collapse can be terminal for any career.

Do your due diligence

One lesson for non-executives is to do careful due diligence before you contemplate joining a board. Another lesson is that non-executives need to be sceptical of what they are told around a board room table, applying due diligence principles to what they see and read.

Most candidates take the financial health of a company, especially a well-known or large one, for granted. This is a dangerous assumption. Two companies that I joined as a non-exec proved to have potentially fatal toxic derivatives. Carillion recruited two new non-execs onto its Audit Committee in the couple of months before going bust.

Read the Annual Report

Although full of guff and regulatory noise, the Annual Report generally should tip you off to issues. In my experience with the toxic derivatives, they were indeed listed in the Annual Reports, but were so surrounded by reassuring jargon that it took several interrogations of the CFOs to confirm their real nature. In fact, the words in the Annual Report are very unlikely to warn you. Despite the regulators attempts to ensure that reports are balanced and fair, they are still largely promotional documents.

I am not attempting here a technical analysis of the Carillion Annual Report. Nor do I wish to criticise the directors (there are many others only too keen to do that). My objective here is to use 20:20 hindsight to look at whether there were clues even in the 2016 Annual Report that could at least have raised questions in non-execs minds, and to offer these as lessons for other non-execs doing due diligence.

The words

Virtually all the text is confident and devoid of doubt, as is pretty standard for most annual reports. However, amongst all the good news, there was one clue: “In 2016, we made good progress in a number of our markets, while managing and mitigating the effects of more difficult trading conditions in others.” Given companies natural reluctance to air their problems, a reader should highlight any cautionary statement like this. The Board will have had a very good reason to include such a comment.

Overall however, you wouldn’t have got much balanced information from the words. Most of the clues lie in the numbers, particularly those that are not discussed in the text.


There had been two years of decline in ‘secured and profitable’ orders from £18.6bn to £16.0bn, which possibly was an early sign of slowing growth. Of this £12.2bn was support services. Given that support services annual revenue was £2.7bn, the ‘order book’ looks as if it is adding up all future contracted service revenues. This is therefore not as impressive as it looks. Furthermore, the reader should ask if this future revenue is actually all unconditional or subject to performance conditions.


Underlying operating margin had fallen for two successive years from 5.6% to 4.9%. This should have been of concern. However, given the revenue growth, the business recorded two years of underlying EPS growth from 33.7p to 35.3p. The question therefore is whether Carillion was buying less profitable business, just to keep its growth going.

Long term contracts can be inherently volatile. Costs are generally booked as incurred and revenue – and hence profit – are, broadly speaking, booked on a pro rata staged basis. This is calculated using % contract costs incurred so far against forecast total contract costs times the full contract revenue. If individual contract costs run to plan, there is little problem, but if costs start to escalate, then there can be a big swing from pro-rata profit to whole contract loss. There isn’t much discussion of this in the Annual Report, other than noting the accounting policy and that the Audit Committee had reviewed the accounting and found it ‘reasonable’. There is no way of knowing whether the Committee deliberately used such a mild word to suggest that they were not very enthusiastic about the accounting or whether this was a synonym for ‘true and fair’. Either way, a reader might have queried it. For all the length of the new external auditor’s report, it simply lists all the work they did, without drawing a specific conclusion on this issue.

There was a big increase in non-operating costs from £5m to £40m, excluded from ‘underlying profit’. These were largely redundancy and closure costs. Costs excluded from underlying are always of interest.

Net debt and cash flow

On the one hand, the company seemed happy with its cash flow and debt;

“Cash flow from operations represented 117 per cent of profit from operations.”

“The Group continues to have substantial liquidity with some £1.5 billion of available funding…The vast majority of the Group’s £1.5 billion of funding matures in November 2020 and beyond.”

On the other hand, there is a clue that they are not as happy as they appear to be;

“We will also begin reducing average net borrowing by stepping up our ongoing cost reduction programmes and our focus on managing working capital.”

The year-end net debt ratio to EBITDAR rose from 0.6x to 0.8x. But average net debt was 2.7x bigger than the year-end debt, implying an average net debt to EBITDAR of 2.2x, a very different picture. There is no explanation in the annual report why year-end net debt is so much lower than the average. Maybe there was a consistent big seasonal swing, but this seems unlikely in this industry. In its absence, a sceptical reader might draw the conclusion that the year-end balance sheet was being managed aggressively.

There is evidence of working capital issues as the construction contracts receivables increased by 60% to £615m, perhaps indicative of cash flow problems with such contracts. Other receivables and prepayments also rose by 36% to £750m. Finally, Carillion was having a little trouble in getting paid, with trade receivables that were over 3 months old more than doubled from £25m to £55m. Carillion had managed its working capital by lengthening many payment terms to 120 days. As a result, its trade payables were rising and suppliers were being encouraged to use an Early Payment Facility, whereby they would borrow against their receivable from Carillion to keep their own business going despite such slow payments.

The group’s net debt was growing. Both year-end and average net debt rose by just under £50m, although £68m was due to foreign exchange offset by £34m from selling shares in PPP joint ventures. The report was a little dismissive of the foreign exchange loss, half of which was ascribed to a US dollar private placement debt. This latter was apparently fully hedged, but it is not clear where the corresponding hedging benefit appeared.

However, the group claimed to have ‘a strong funding position’. £1.4bn of funding was available at Dec 2016 (of which £0.7m was undrawn), plus additional funding then secured the following month, gave a total of £1.5bn. The only mention of any debt covenants in the report is in the going concern section, where the board confirms ‘comfort that funding covenants will continue to be met’. In retrospect, a reader might have wished for the details  of those covenants.

The Group therefore continues to have substantial funding…over the medium term’, with only £85m of facilities maturing in 2017. When Carillion went bust, with a reported only £29m in cash, you would have assumed that it had at least £1.4m in debt facilities. It looks as if failure to meet the undisclosed covenant conditions caused facilities to be withdrawn, triggering the eventual liquidation.


Net promoter score (a measure of customer satisfaction) fell dramatically from +36 to +22, which the company ascribed to ‘challenges of mobilising new contracts’, although there was no evidence that new contracts were growing in number. Anecdotal reports suggested that there was a growing unhappiness with customers and a few high-profile disputes had surfaced.

Segmental profitability

“…the wider outlook for volumes and margins across the (Middle East) region is expected to remain challenging…”

Middle East construction services revenue grew by 19% to £428m, but at a tiny net margin of 1.9%. The commentary recognises the low margin, but point to a further £15bn of contract opportunities, without discussing whether these would be at a higher margin. The segmental analysis reveals year-end net assets employed of £206m, which with an operating profit of £8m, suggest a return on capital of only 3.9%. This assumes of course that the year-end net assets are representative, yet we know that the group’s average net debt is 2.7x higher, so the real return on capital was likely to be lower. It wouldn’t have taken much of a cost overrun for this return to be wiped out. There is no discussion of segmental capital returns in the Annual Report.

Other construction services also grew fast by 21% but at a net margin of only 2.1%, down from 2.9% the previous year. A margin target margin is given here as 2.5% to 3.0%. The Company is able to claim that it satisfies this target by adding in joint ventures where the £9.0m profit share exceeds its £8.9m revenue share. There is nothing like a 100% net margin joint venture to improve reported performance. Mention is made of ‘managing risks in order to deliver our target margins and cash flows’, although there is no further discussion of cash flows. The segmental reporting reveals year-end net assets of £190m. With a profit of £32m, this suggests a decent return on capital of 17%, although this is probably flattered by year-end working capital being below the average.

Recent acquisitions were underperforming. There isn’t any reference to this in the commentary, but buried in the financial review is £15.6m of non-recurring credit. This would seem to be good news, but is in fact a reduction in consideration to be paid for two acquisitions whose EBITDA is ‘lower than the stretching targets agreed’. ‘Nevertheless, these businesses have performed well…’. The report does not define what it means by ‘well’.

The pension scheme

£47m cash pa was being put into the defined benefit pension scheme, whose IAS9 deficit had ballooned to £805m from £394m the previous year. The deficit payments look light, being based on a 15-year recovery period, as a rule of thumb is more like a 10-year period. This was a warning sign that cash payments would be likely to rise significantly at the next triennial valuation (due in 2017). The absurdity of pension accounting rules is that the P&L was actually being charged only £6m (the rest effectively goes through reserves). Unlike many companies that have closed their increasingly expensive defined benefit pension schemes, Carillion kept theirs open for employees when necessary ‘to meet the requirements of work winning’. A reader might ask whether the costs and risks of this were fully built into those contracts.

Goodwill & deferred tax

Carillion had a lot of goodwill on its balance sheet – £1.6bn compared to £0.1bn of fixed assets. The rules say that goodwill has to be justified on whether it can be backed by prospective profit flows. This is a potential double whammy. The reader should note that if performance falters, large potential write-offs in goodwill become necessary, exacerbating the financial pain.

A similar problem exists with deferred tax assets, which were £164m. These can only exist where you are forecasting sufficient forward profits to justify them. Poor performance can lead to these being run down quickly.

Corporate Governance

Carillion appears to have been exemplary in its corporate governance, as described in the annual report. The board fully complied with the governance code. Employee engagement rose from 68% to 73%; employee volunteering increased from 18% to 30%; and the gender balance improved, with 38% of employees being female. The board had an external review of its effectiveness and 29% of the board were female. The previous Remuneration Committee was approved by 80.6% of the votes.

Regulators might note this. If Carillion obeyed all the rules, then maybe the rules are not really the be all and end all to company performance after all. Perhaps Regulators could focus on understanding why companies fail, rather than grandstanding the latest governance flavour of the month.


The Annual Report boasts that; ‘Rigorous risk management processes that identify, manage and mitigate risk are fundamental to the success of our centralised operating model.

However, this rigorous process did not identify liquidity as one of the top ten Group risks (although the pension liability was regarded as high impact/high risk). The top risk was winning new work, but it didn’t mention the risk that new work might be loss-making or cash consuming.

The new requirement for a Viability Statement was intended to highlight precisely such looming cash crises as Carillion, but stakeholders were reassured;

“On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.”

 In fact, there was insufficient information in the Annual Report to give a reader comfort on liquidity and viability. Perhaps the regulators need to study this again.



There are many cautionary lessons here for a non-exec in using an annual report as part of their due diligence on any company;

  1. Pay limited attention to the words, except where there is any hint of caution or bad news. Accept that boards will naturally enough always accentuate the positive in writing about their business, but apply scepticism yourself.
  2. Always question whether numbers are unconditional. Future revenue and pipeline numbers are unlikely to be guaranteed. Banking facilities can often be withdrawn.
  3. Watch out for specialised accounting, such as long-term contracts. Some rules say that profit must be booked before it becomes unconditional. Do not assume that the accounting rules are designed to protect the investor.
  4. Take a close look at non-underlying costs. They may well be genuinely one-off or technical, but they may still be important.
  5. Cash is king. Businesses don’t go bust because they make a loss, but because they run out of cash, sometimes even when profitable.
  6. To understand the usefulness of borrowing facilities requires you to know not just the amount and maturity but also any conditions under which facilities might be withdrawn. This includes covenants, but there may also be other conditions too.
  7. Study working capital seriously. It is the most likely source of cash problems in a profitable business. If the company is making strenuous efforts to manage working capital, it may be under strain.
  8. Year-end quoted cash numbers are of limited value. Focus on the average balances and try to find out the peak numbers too.
  9. If there is evidence of general or growing customer discontent, treat this as potentially serious.
  10. Segmental profitability matters, but you will probably need to look at the numbers rather than rely on the commentary. Try to understand revenue trend, net margins, net capital employed and cash flows by segment. Check that the business is growing the high margin/return segments.
  11. Underperforming acquisitions are an amber light. Businesses under pressure may seek to alleviate this by acquiring other companies.
  12. Defined benefit pension schemes are now commonly in deficit, not because company contributions have fallen, but because monetary policy has led to very low interest/discount rates. However, higher cash contributions will follow and these are not reflected in profit.
  13. Good corporate governance is very important, but more important is high quality, experienced directors doing a diligent job in the board room. Box ticking governance codes in reality provides little reassurance on company performance.
  14. Risks and mitigations disclosed in the annual report are generally fairly meaningless, and provide no real reassurance. As in Carillion’s case, it’s often the risks that are not mentioned that prove fatal.


Simon Laffin


NB. All quotes are from 2016 Carillion Annual Report

“Marking our homework” – Why executives resent non-execs

Management scribbles001


It won’t be long into your first non-executive job when you start to feel as if the executives resent you. It’s okay. You haven’t become paranoid. They really do resent you. Why?




Being an executive director is a tough job. You work all the hours that the Working Time directive allows, then you opt out and work some more. The market is very tough and competitive, and you end up making numerous difficult decisions. You do this for a couple of months and try to summarise what’s happened and why for the Board. Then a few part-time directors waft in and criticise the papers, ask stupid questions and lecture you about governance. What’s not to hate about that?


But being a non-executive director is also a tough role. You are invited to join the board of a company about which you probably know little and possibly in a sector of which you know nothing. You may get a cursory induction programme and then it’s straight into a board meeting. The performance information may be either perfunctory or so detailed that you can’t get any sort of meaningful overview. Management may be defensive, resentful and resistant to questions. You ask yourself, how can I add value to this board?


Executives often say they feel that non-execs come to board meetings ‘to mark their homework’. This is very difficult to avoid. Execs usually work very hard and in their heart of hearts, really want the non-execs to turn up and applaud them. There are few things more irritating than having a non-exec appear and come up with a good idea or question the execs hadn’t thought of. Even if it’s helpful, human nature means that you may resent it.

Here are some suggestions to help harmonious board discussions.

For the executive:

  1. Remind yourself that the non-exec is trying to understand your position and making sure that you have thought of all the angles.
  2. Don’t react immediately, but let the board discussion continue. The initial comment, even if naïve, may lead to a useful discussion.
  3. Remember that you are paying the non-exec to be there. Whether you like it or not, you might as well listen to something you’ve paid for!
  4. Pause a while, as what may seem initially as a strange comment from a non-exec may turn out to give a new insight or angle into a common issue. They won’t necessarily use the same jargon as you, but may still understand the problem.
  5. If the non-execs are well chosen and sensible, remember that their comments are likely to be, or at least intended to be, helpful.
  6. Avoid being defensive at all costs, and watch out for sounding defensive.


For the non-executive:

  1. Avoid stating the obvious or asking a question implying that executives don’t know their job.
  2. It is tempting to review paperwork and point out errors. If this is necessary, do it privately outside meetings, rather than in board discussions.
  3. I think that it is good practice to ask questions that arise from reading advance paperwork directly of executives before the day of the meeting. This can be in person, by telephone or email.
  4. Questions should generally be asked in board meetings only when they have just occurred to you or will elicit an answer that you would like everyone to hear. If the latter, you could also warn executives in advance that you intend to ask the question and give them time to prepare a good response. This will make them much less defensive as they won’t feel that you are trying to catch them out.
  5. Keep interventions and questions short. The longer you go on, the more pent up anger may build in others.
  6. Don’t confuse asking a question with making a speech. There’s a time for both, but not at the same time.
  7. Try to put important questions or points early in the discussion, rather than dropping them in like a depth charge, just as the Chairman is drawing the discussion to a close.
  8. Use cautious language, with plenty of conditional tenses and get-outs (“I was wondering if…” ,“Perhaps this might be an issue…”)
  9. Offer to meet separately (”offline”) if the discussion goes on for a long time or has generated some unwelcome heat.
  10. Remember that when you leave this meeting, you can go onto other things, but the executives are stuck dealing with the same issues full time until the next board meeting.


I have been in executive and non-executive roles on quite a few boards, and even temporarily moved from non-executive to executive on some boards, so I have seen these issues from both sides. I am grateful (and would like to apologise) to all my boards for allowing me to make all the mistakes listed here, and now to write from bitter experience!


Board meetings can very sensitive affairs. A good one informs all participants and pools their knowledge and experience to come up with good decisions. A poor meeting just stokes resentment between the various participants. Directors should remind themselves that it’s not an aural exam and board papers are intended to be the genesis for a two-way discussion. There is no marking of papers required!


Sir Ken Morrison – a retail giant, but still human

mrw-high-wycombeSad news came last week with the death of Sir Ken Morrison. It made me reflect on his tremendous lifetime achievements. His career is sometimes viewed as 50 years of success, until at 73 he led the 2004 Safeway acquisition followed by four difficult years until retirement. He built up a leading supermarket chain making £320m pa. Few people will, or can ever, achieve such a feat. The last four years should never lessen that achievement, but inevitably the latter attracts more interest, as it is the story of how things went wrong and why, even when led by someone as talented and experienced as Sir Ken.

I met Sir Ken quite a few times during the Safeway take-over, as I was the CFO. He was always very polite and proper, even warm. However, he never let that Yorkshire reserve go, so you were never sure whether you were seeing what he was really thinking. He always seemed to agree with you, even when you expected to disagree. Eventually, I realised that this was how he handled situations with people he wasn’t comfortable with; his close associates and subordinates. He would listen carefully and politely to what people said, nodding and smiling, but saying very little. You would think that he was agreeing, but in fact quite often you would hear later that he completely disagreed.

It is well-known he despised consultants, analysts and non-executive directors in equal measure, but he knew every one of his 100 store managers, how his business ran and, above all, what his customers wanted. When you met him, you knew you were in the presence of a retail giant.

So why did it all go so wrong? Why did the £600m combined profits of Safeway and Morrisons, not to mention another £300 odd of synergies, dissolve into a £300m loss two years later? To be fair, by the way, by the time Sir Ken retired in 2008, profit had recovered to over £600m, which is incidentally more than twice the profit today.


The Morrison success story was built on a simple concept

We all know that simple businesses have the best chance of success. Morrisons was a chain of near-identical stores built largely in downmarket demographic areas in the midlands and northern England. Sir Ken loved simplicity and wanted all stores to be very similar to adhere to that principle. Morrisons offered great ‘everyday value’ with low base prices and around 1,000 promotions, largely multi-buys (perfect for growing families), with many service counters offering variety and a ‘good honest quality’ feel. Little went to waste, as food near its sell by date would be used in the customer and staff restaurants or recycled in a service counter (eg prime meat as mince).

Sir Ken didn’t believe in complex systems. He told me once that he designed their ordering system one day in a store canteen. He described what he meant. I said but that’s just a stock & order card. Yes, he agreed, and that’s all the system is. But how does this do forward ordering, I asked. Ah, he replied, we are just trialling a system now. This was in 2003, some 10 years after the other majors, including Safeway, had automated re-ordering.


Sir Ken dreamt of growing faster

The Safeway takeover started when Safeway approached Sir Ken. Safeway had struggled as No4 in the UK grocery market, and had tried a number of strategies without any lasting success. Eventually the board concluded that scale was the major issue. A couple of attempts to merge with Asda failed, and it was considered highly unlikely that the competition authorities would allow such a merger of No3 and No4 anyway. That left Morrisons. I had presented a number of competitor analyses to the Board over the years and every one concluded how well Morrisons performed. The answer was obvious, to put the two businesses together to rival Sainsbury and Tesco in size.

Sir Ken, however, had less lofty ambitions. He wanted to grow faster and coveted the Safeway superstores and hypermarkets. He was initially very cautious, not wanting to threaten what he had created so far, and took many months to agree to explore the idea. Sir Ken told us, at the time, that it was his fellow executive directors that were more ambitious. It was they who were urging him to go for a takeover and who were so confident of making it a success.


Simplicity has its own challenges

Morrisons was a simple business run in an efficient uncomplicated way. Reordering was manual. Ranges were near identical in all stores, each with very similar layouts. Sir Ken made almost all the decisions in a Thursday morning weekly meeting in his office. He didn’t need complex processes. He claimed that new store development decisions were made by counting chimney pots, ie driving round the neighbourhood for a while, at a time when the other chains were using sophisticated geographical databases. He spent a lot of time visiting stores and fixing problems there and then.

Sir Ken didn’t believe in sophisticated management. He had confidence in his own judgement on decisions. He didn’t need strong management around him. He needed people who would implement his decisions. As a result, his colleagues on the board were not the strongest, and there was very little middle management. This made for a simple lean structure, but also contained the seeds of future problems. It was not a structure that could cope easily with complexity or a heterogeneous store portfolio and customer base.


Safeway was a complex business

 Morrisons acquired a difficult situation when it acquired Safeway;

  1. Safeway was a much bigger business than Morrisons, with 500 stores and a turnover of nearly £9bn, against 120 stores and less than half the turnover.
  2. Safeway was a much more heterogeneous business. Almost all Morrisons stores were bigger than 2,400 sq m, barely the average size of the Safeway stores. Safeway was a multi-format business, with five formats (hypermarkets, superstores, supermarkets, convenience stores and BP petrol stations), where Morrisons had one.
  3. Safeway had a very diverse customer base with slightly upmarket demographics, across all UK regions including Scotland, whereas Morrisons had a more homogeneous, downmarket customer base principally in the midlands and northern England.
  4. Safeway had built itself complex logistics and IT systems, while Morrisons had experience only of relatively simple IT and two regional distribution depots.
  5. All Safeway formats were profitable, so selling off small stores, as Morrisons did, wouldn’t improve profitability, even if it reduced complexity.

This complexity was one reason why Safeway had struggled over the previous decade. Itself the product of a takeover, by the Argyll Group (Presto supermarkets) in 1988 of the UK arm of US Safeway, initially this new group had performed very well until the downturn in 1993. Under Sir Alastair Grant, Argyll managed to merge the range excellence and customer service of Safeway with the canny northern financial and cost management of Argyll. Safeway Group, as it became, flourished with a management and culture that was roughly a third Safeway, a third Argyll and a third new recruits from other businesses.

However, the synergies of the merger hid for a while the longer term problems of lack of scale and complexity/heterogeneity of the resulting business. This became evident in the mid 1990s, when not even the advice of McKinsey, which ironically also played a lead role in the contemporaneous turn around of Asda, seemed able to lift Safeway’s stagnating profit. Later a new CEO, the glamorous Argentinian Carlos Criado-Perez, similarly struggled.

Carlos added significant extra complexity himself. His vision was for a Safeway that had a warmer, Mediterranean feel, where; cream replaced white colour; real pizza ovens provided theatre and ambience; large fish counters established food credibility; overflowing ‘misted’ produce counters literally dripped fresh food allure; and block colour merchandising made grocery lines impactful. He also understood that Safeway couldn’t offer lower prices than Tesco or Asda (not least because of lesser scale buying), and complained that Tesco immediately matched any significant Safeway promotion. To counter this, he devised a rolling series of deep promotions across different sets of geographically disparate stores. Whilst very complex, these promotions proved impossible for any competitor to match effectively.

The promotions then developed into a portfolio of transaction-driving (ie loss-making promotions exciting enough to draw in new customers) and basket-driving (ie an existing customer would buy additional products on promotion). In business school jargon, this was an extreme, local form of high-low pricing.

Carlos believed that a No4 player had to be high-low, i.e. promotional, because it would lack scale benefits of larger players. However, the extreme nature of the Safeway version was intended to be temporary. It was a holding action while the new formats were being developed and would generate customer trial when the formats were refitted and rolled out. However, it later became clear that not only did the new formats not bring significant additional sustained revenue, but they brought permanent extra costs. In the end, this failure bequeathed extra complexity for the incoming Morrisons team.


Safeway customers didn’t shop at Morrisons

 Safeway, in the run up to the takeover, did some research that showed that in areas where there were both Safeway and Morrisons stores, Safeway customers tended to be Morrison-rejectors. The Safeway customers would also shop at Tesco or Sainsbury, but rarely Morrisons. Morrisons dismissed this evidence, but it would come back to haunt them.

Almost all grocery customers have a choice of where to shop. Indeed, maintaining this was at the heart of the later competition inquiry into and remedies for the takeover. Safeway attracted customers who liked strong, largely price-led (ie not multi-buy) promotions. They appreciated a wide range with upmarket lines tailored to their demographics. These were the key factors why Safeway customers were choosing to go there, rather than to Morrisons and, to a lesser extent, Sainsbury and Tesco.

It was therefore quite a brave decision by the incoming Morrisons management to stop the price promotions, replacing them largely with multibuys. They then reduced range, especially on fresh lines, and put in a more generic downmarket product range. As the Trading Director asked us: “Why do you stock balsamic vinegar?” We explained that it is regarded as an essential in Sutton and Reigate, southern towns of which she knew little. In another example, they replaced freshly squeezed orange juice at £2 a litre and a 45% gross margin, with Morrisons entry-level orange at 40p and a 30% gross margin. If customers wanted that type of juice, they were already shopping at Lidl and Aldi, but if they wanted upmarket orange juice they now had to go to Tesco, Sainsbury and Waitrose.

And they did. Post takeover Safeway suffered a dramatic loss of customers, who fed revivals at all its rivals. The transaction loss was somewhat offset by an influx of very price sensitive customers who did want the lower ‘everyday’ prices of the new range. However, these customers often could not afford to spend very much money, targeting only cheaper, lower margin lines.

This represented a victory for simplicity and less fresh food wastage, but it was a somewhat pyrrhic one as customer numbers dwindled.


Morrisons wanted to purge Safeway

There was to be no merger of management. Initially Morrisons agreed to ‘best man for the job’, but the reality was different. Safeway’s head office, west of London, was closed progressively and employees could either take redundancy or apply for a job in Morrisons head office in Bradford. Few took the latter, fearing for their long-term future. As a result, Morrison lost the people who knew how to manage the complex Safeway business.

Morrison simplified the supply chain by disposing of the automated replenishment system, explaining to store managers that they would have to go back to writing their own forecasts again. The core multimillion-pound ERP system that Safeway had just finished installing was cancelled (a consultant later told me that he loved Morrisons. Why, I asked. Because, he said, it was the only company that had, as Safeway, paid him to install an ERP system, then paid him to remove it after the takeover and then paid him a third time to reinstall it later when they realised their mistake).

Morrisons rejected Safeway’s promotional strategy. They disliked, with some justice, that supplier funding for the promotions tended to come in as lump sum monies at the year-end, with other volume and activity-related rebates. The year-end sum was around £600m, twice the annual profit, so you can understand why this disturbed them so much. Controlling such an accrual was a very tricky task for the finance team, but Morrisons management went further and said that they didn’t believe the (externally audited) sums were real and that they didn’t approve of collecting them. They were men and women of their word. They stopped trying to collect these monies and then fired the finance team and the buyers, who knew where the money was.

There is an established principal for a retailer when it moves from high:low to everyday low price (ie reduce promotions). You add up promotional funding and then tell suppliers that you want that same money now taken directly off invoiced cost prices. However Morrisons management lost control of the funding sums, and lost the people who could have retrieved the situation when they realised their error. They then did the only thing they could do, and blamed Safeway for fiddling the numbers. In fact, one supplier told me that all his Christmases had come at once. Morrisons had apparently forgotten that he owned them a couple of million pounds and he was able to reverse his accrual to the direct benefit of his bonus. He was not alone.

This was not an error of strategy, as reducing the promotional weight was very sensible, but one of execution by the people Sir Ken had charged with managing the integration.


Simplicity plus complexity results in more complexity

Sir Ken had built a brilliant model. His was a simple, homogeneous business with a thin management structure under his clear management. However, this also limited its growth. Morrisons didn’t want to develop new stores that were significantly smaller or larger or in different demographics. There was a limit to how many stores Morrisons could run with this model, not least as Sir Ken couldn’t know and visit each one regularly. There was a limit to its scaleability.

Safeway had been complex partly because it struggled with a variegated store portfolio. It wasn’t possible to simplify the combined business just by imposing the Morrison model. In so far as this happened, the result was then not what the Safeway necessarily customer wanted.

The Safeway acquisition didn’t cause these problems for Sir Ken, but it revealed them in spectacular fashion. Trying to impose Morrison simplicity on Safeway customers and processes was like trying to herd cats into one of Ken’s cowsheds.


Maybe managing Safeway was just too tough for anyone

We can analyse the Safeway acquisition with 20:20 hindsight, but maybe this was a business that was too difficult for anyone to manage successfully. Two successive CEO’s at Safeway struggled and Morrisons then laboured. Grocery retailing is a tough business and scale takes a toll on the smaller players.


Sir Ken – a retail giant of his time

You have to admire the entrepreneurial and retail genius of Sir Ken Morrison. Maybe in another time, he would have retired with Morrison as a growing successful fifth player. Perhaps he cursed the day that David Webster, Safeway Chairman, darkened his door with a siren call to merge. However no one is perfect and Sir Ken is not, and won’t be, the last entrepreneur to be seduced by a tempting corporate acquisition.

The best tribute to him is to learn from the experience:

  • To appreciate the value of strong independently minded executives and a few challenging non-executives:
  • To move with the times, embracing change and new methods. The development of IT and the digital economy simply cannot be ignored.
  • To balance the huge benefits of simplicity with the necessary complexity of the business you actually have, rather than the one you wished you had.
  • To evaluate acquisitions, without understating the risks of upsetting customers, losing key staff, setting the right inclusive culture and understanding the different business models.








Tesco and Booker – The Great British Food Merger?


I was just leaving the room on Friday, when I thought I heard on the radio that Tesco was merging with Booker. I smiled as I’d clearly misheard. When I realised it was true, my mind drifted back to the past.

The UK grocery chain, Safeway, used to own both a cash & carry and a delivered wholesale chain. I was a non-executive director of both these, as well as finance director at Safeway itself. So I have direct experience of managing both wholesale and retail in one group. This made me a bit surprised that Tesco is so keen to try the same thing.

What does it tell us about Tesco?

Tesco has struggled with both accounting scandals and weak grocery sales growth in recent years. The former revealed a poor culture in the business, but the latter will have been the more significant issue weighing with the board. Grocery has become more centred on internet/home delivery and convenience stores. The former is lower margin, as customers are not prepared to pay the full picking and delivery costs. Convenience stores are less profitable as they have higher costs than larger stores. Meanwhile the grocery market has been stagnating, not helped by low sales inflation.

Supermarket non-food has not produced much growth in the economic downturn and is also affected by the growth in online retailing. So Tesco has been in search of growth from somewhere outside grocery retailing.

The fact that Tesco has not bought a general retailer tells us that it doesn’t have much faith in non-food retailing for growth. As with its own non-food offering, general retailing has been struggling. The obvious partner for Tesco, M&S, was probably considered too expensive and too difficult. Sainsbury has already secured the leading bricks/online combo retailer, Argos.

Tesco has been eyeing the catering market for some time as a growth opportunity. It took however a misstep by buying Giraffe and Harris + Hoole – too small and with too much complexity to move the needle.

This also tells us that the strategy to grow Tesco internationally is being put more on the back burner. After the expensive debacle of launching in the US, Tesco feels suitably cautious.

Tesco now is trying to buy a cash and carry and delivered wholesale business. This will bring it exposure to catering (£1.9bn Booker revenue and growing) as well as small grocery retail supply (£3.1bn and flat).

Is it a merger or take-over?

This is a takeover in all but name. Tesco is paying a 15% (24% on a 3 month average basis) premium, and only the talented Charles Wilson, CEO, and the Stewart Gilliland, Chairman, are joining the Tesco board, in neither case as CEO or Chairman. Booker will contribute 14% operating profit in return for 16% of the equity. The premium however looks a little low for a takeover, which would usually be 30-40%. This tells you that Booker is pretty keen for this to happen, possibly an indication of their own concerns about future growth.

Has anyone else tried running retail & wholesale food?

Tesco may have been inspired by Germany’s Metro Group, that does indeed include a cash & carry and a hypermarket business, Real. However the performance of the Real hypermarkets has been disappointing and Metro sold the Eastern European Real businesses in 2012. There appear to be few synergies between the cash & carry and retail businesses.

The Big Food Group, a merger of Iceland Frozen Foods and Booker, lasted only five years.

Will the merger actually happen?

It looks as if the main block will be the competition authority (CMA). Tesco will explain to them that the only overlap is on retail, as catering is a different market. The CMA will look at the degree to which Tesco will use its ownership of Booker to influence small retailers. Small convenience stores will protest about this, and Tesco will almost certainly have to offer pledges that it will behave itself and not try to influence retail prices. Suppliers would do well to protest, not least as the largest element of the synergies is from ‘procurement’ ie squeezing them. The CMA will need to look hard at the prospect of Tesco getting access to wholesale cost prices. The investigation is likely to look at the market for convenience stores, although this could be broadened out to all grocery retailing, and the market for grocery supplies. This could take a year, potentially even longer, delaying the deal considerably.

The end result of this takeover would undoubtedly be a significantly stronger grip by Tesco on the grocery market. Will the CMA approve it? Logically, it probably shouldn’t allow it, but my three years experience at Safeway spent dealing with the Competition authorities is that bare logic is rarely the determining factor. I’d give this 50:50 at best.

What’s the benefit?

Take-overs are generally justified by synergies. In this case, they are a modest £200m pa after 3 years. It’s always good for an acquirer to focus on a Year 3 target, as after 3 years everyone has forgotten about the synergy target or dismisses it as irrelevant given all that has happened since.

Revenue synergies are given as £25m by year 3. At a marginal profit margin of say 20%, this implies additional revenue of £125m. With a current sales level of £60bn, that’s an uplift of 0.2% after 3 years. Blink and you’ll miss it. This is clearly just a notional number, so they either can’t justify, or they don’t believe in, any significant revenue uplift.

The cost synergies of £175m are the heart of this deal. Given that Tesco seems to have been working on this deal since June, it is very noticeable how lacking in detail these synergies are:

Procurement: Over half the savings are from procurement. This means two things; comparing different cost prices and using the combined volume to demand new lower cost prices from suppliers. On the former, it has been a holy grail for retailers to get access to wholesale prices, and this would appear to offer wholesale prices to Tesco. However, in my personal experience, suppliers are very aware of this issue and have in the past refused to give wholesale prices to retailers. They monitor sales to wholesalers and will stop supply if they see demand suddenly increasing as deliveries are being shipped onward from wholesale to a large retailer.

Tesco talks about ‘full crop procurement’ as a key, if obscure, benefit, but this is likely to be a red herring. This will be about pressurising branded suppliers. Tesco undoubtedly wants very much to get access to Booker’s cost prices, and if it does, it probably will be able to use its huge muscle to exploit this information. On top of this, Tesco will almost certainly be successful in just using its bigger scale to get better deals from suppliers generally.

Other cost savings: £60m odd from logistics seems a lot, especially as no detail is given. However, joint logistics costs are probably around £1.8bn, so this would represent a saving of some 3%, which is frankly not very much synergy! About £17m from other costs is also barely a rounding error, maybe 1.5% of other costs. The big issue will be whether they close the Booker head office and merge all the support functions.

What are the risks?

  1. Distraction: Booker will be the new shiny toy that all Tesco managers will want to play with. It will be very difficult keeping focus on the Tesco brand, only slowly now recovering, when there will be so much focus on another business, the integration and inevitable redundancies.
  2. Cost drift: This is a key reason that supermarket operators don’t run discount chains or cash & carries. When Safeway owned the discount chain, Lo-Cost, the moment anyone from the supermarket business got anywhere near the discount chain, they wanted to add cost. A cash & carry business has to have a very lean cost structure, even more so than a discounter, so Tesco management will have to work very hard indeed not to avoid extra costs creeping into Booker.
  3. Daddy knows best”. The acquirer’s management always tend to think that they are cleverer and more gifted than the acquiree’s. Functions move to the acquirer business and redundancies are concentrated in the acquiree business. This has already happened in the “merger” of the two boards, with only two Booker men surviving.
  4. Retailers think they understand cash & carry and catering. Charles Wilson will have his work cut out keeping Tesco management away from a very different business, of which they know next to nothing.
  5. Internal focus. It is inevitable that on a merger, focus tends to turn inwards as integration teams drive out synergies and managers jockey for position. It would be challenging for the combined group to keep developing the customer offering of both businesses over the next few years.
  6. Not understanding the risks at the start. It would have been more reassuring for the launch presentation to have at least mentioned possible risks!

Conclusion – is this a marriage made in heaven?

We are likely to have a competition inquiry that will last a year before we know if it will happen. If it gets approved, the businesses will then spend a couple of years integrating and settling down. If in this period, Tesco starts to lose out to grocery rivals in its core chain, then the synergies could easily be lost in weaker like-for-like sales growth.

Retail take-overs, as in other sectors, have a very mixed record. Iceland/Booker failed and was unwound. When Morrisons bought Safeway and merged two grocery retail chains, it decimated the combined profits of over £600m operating profit (excluding any synergies). Today Morrisons still only makes just over £300m, half that of the different businesses 13 years ago. A failed takeover generally proves very expensive.

On a £20bn joint market capitalisation, the synergies would be worth some £1.6bn (less tax, using a 10x multiplier), so this is an 8% opportunity. This is pretty much the uplift in Tesco’s share price after the announcement this week.

I suspect that the synergies are well grounded and sufficiently discounted that the target £200m in 3 years will be delivered. However investors need to consider four other questions;

  1. Will it get competition approval?
  2. Will Booker accelerate Tesco’s medium term revenue growth, especially in catering?
  3. Will combining wholesale and retail be disruptive to the two businesses?
  4. Will management distraction damage core performance of either business?

Overall the deal gives immediate one-off consolidation growth to Tesco, justified by cost synergies. But it also raises major risks in competition clearance and execution. This doesn’t feel like a marriage made in heaven, but very much made of convenience.