Compare, Select & Save on health cover with iSelect

What Is The Story With ABC Child Care Centres?

By Sandy Naidu | March 25, 2008

Eddy Groves is a classic rags to riches story. Eddy had an entrepreneurial streak right from a young age. At the age of 19, Eddy started his business career as a distributor for Paul’s milk. After some initial hardships, his milk distribution took off and Eddy was looking to diversify his business interests. He was clear about what his next business venture has to be - it has to be something that was recession proof. After lots of brainstorming he and his wife decided on childcare (a true recession proof business). In 1988 they set up their first child care centre in Brisbane and that was the beginning of ‘ABC Learning Centres’.



The Growth Phase



Eddy expanded his child care business all over the country.

They were growing fast….In 2001 ABC Learning Centres listed on ASX. In 2006, Eddy was in the BRW’s list of Australia’s under 40 millionaires. He expaned his company aggressively - By the end of 2007, the company ran around 1095 child care centres in Australia, around 1000 in US and 110 plus in UK and around 110 in New Zealand. He had a flourishing global empire - atleast thats how it looked. The company expanded in US mainly through acquisitions. The acquisitions was funded through debt. ABC was the largest listed child care company in the world.

Apart from the centres, Eddy also owns the largest Paul’s distribution network in Queensland. In 1999 Eddy took over the franchise for the then-struggling Brisbane Bullets NBL team. Under his management the team reached the finals in 2003/4 season.



The Disastrous Report



On Feb 25 2008, the company announced its half yearly result - a 42% drop in its net profit. A closer look at the results showed that the company was burning cash fast, costs were rising faster than income. There were also a few discrepancies in the way the results were reported - the accounting statements were not all very transparent. Prior to the announcement the share price was around 4 dollars.



On A Side Note



The directors of the company including Eddy Groves funded most of their stock in ABC through margin lending facilities. Eddy Groves’ margin lending facility was with Citibank. Margin lending facility is where the lender lends you money to buy stock in a company. The money that you borrow is secured by the underlying security. You will have to pay interest for the amount you borrowed (nothing different to other borrowings). Margin lending however comes with margin calls - When the value of the underlying security falls below a certain value, the lender can exercise a margin call - You then have to meet the margin call either by providing additional cash or by providing additional security or by selling a part of the underlying security - Usually you will have very limited time to act from the time you are issued the margin call - If you fail to provide the necessary funds, the lender will sell the underlying security. So in ABC’s case, once its share price falls below a certain price, Citibank Margin Lending Department will issue a margin call. Eddy Groves has to meet the margin call requirements in a specific time or risk losing the shares. Btw the current regulations in share trading does not require the directors to disclose their margin lending arrangements.



Going Back To The Earnings Report



As mentioned earlier, the income was low but the cost of funding was on the rise. Added to this not everything on the report was clear and obvious. As per the ABC’s agreements with its banks, it has to have a particular figure for earnings to funding costs. Due to rising funding costs, this figure seems to have been breached. This was the conclusion of the analysts scanning through the half-yearly reports. This explosive piece of breach information hit the market and spread like wild fire.



Again On A Side Note



We need to now understand what short selling is because it played an important role in the ABC crash. Some Fund managers own ABC stock either in their super funds or mutual funds. Once the stock is bought the stock is sitting idle in their vaults. Hedge fund dealers are the dealers who trade in risky deals. These hedge fund managers approach the managers who are holdings ABC stock (which is sitting idle in their vaults) and loan it from them with the aim of short selling the stock. So the regular fund managers lend them the stock in return for some money. The hedge dealers don’t own the stock, they are just borrowing to short sell (means sell the stock which you don’t own).


So why would you short sell? Good question. Lets say the hedge dealers sells the stock he borrowed for 5 dollars. He is hoping that the price for that stock in the near future will fall below 5 dollars. So once it does, he can buy the stock back below 5 dollars (say the stock is 4 dollars now). This newly bought stock will be given back to the original fund manager he borrowed the stock from. So he hopes that the profit margin of 1 dollar (5 minus 4) will cover his borrowing expenses plus will leave a profit in his pockets. Hence the more the drop in the price of the stock, more the profit.



Going Back To The Earnings Report



The hedge fund dealers got active…They started borrowing stock to short sell….The news about ABC’s breach of financial agreements spread…The fact that it had huge debt in its books did not work in its favour either. The short selling further kept pushing the price down….And the more the price went down the more active the short sellers became…The price crashed and fell to a low of 1.15.



Margin Calls



Once the price fell below the agreed level, Citibank Margin Lending department issued the margin calls. Meanwhile Eddy rushed to US to sell his child cares centres in US…With the sale proceeds he reduced the debt. Eddy for some reason did not seem to have responded to the margin calls…As per the agreement there is a short time frame within which he has to respond to the calls (ususally 24 hours)…He seems to have missed this…Citibank Margin Lending department promptly sold his shares at the end of the time frame. The same story with Eddy’s wife’s shares as well…

Selling of such large quantities of the directors shares caused a further drop in the price of the stock.

By second week of March 2008, Eddy reported that he owned no stock in the company he founded.

Short selling is supposed to increase liquidity in the market. This part I understand….But I don’t understand the motives of the fund managers who are lending the stock to short sellers…These stocks are part of super funds and other mutual funds….This is the money of mum and dad investors…By lending the stock (so that it can fall in value), in whose interests are these fund managers acting? All the funds which owned ABC stock are going to report to their investors about how the earrings fell because of the drop in ABC stock…But the price would probably not have fallen to this extent had they not lent the stock in the first place…

Not all blame goes to short sellers alone - Had the stock’s fundamentals been good, short sellers would have stayed away from the stock…Usually short sellers only go after stocks which are fundamentally not strong or which not being very transparent with their earnings. Advocates of short selling say that short sellers are only speeding up the process of price falls in such stocks.

ASIC is investigating claims that short sellers spread false rumours so that the price can drop (and they profit). Spreading false rumours with the intention making profits is against the corporations law.

Maybe the regulators should also make it mandatory for directors to disclose the margin lending arrangements of directors.

What a disastrous month it has been for Eddy and his shareholders….It will be interesting to see what happens next.

Related Posts:

Topics: Financial Topics, Shares |

Comments

« Green Loans | Home | Types Of Super Contributions »