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‘Casino: Heads They Lose, Tails They Lose’

Casino is anything but a boring supermarket story. Faced with increasing price competition in its native France a number of years ago, Casino decided to lever its balance sheet to acquire assets in emerging market countries, namely Brazil, Thailand, Columbia and Vietnam. Whilst this initially bought the company top-line growth, the combination of Euro denominated debt with emerging market earnings has now become problematic given the deterioration in emerging market macro conditions, currency headwinds, and increasing competition in local markets. Moreover, a deeper examination of its accounting practices and complex holding company structures presents further questions around the ability of Casino and in particularly Rallye - the holding company of CEO Jean-Charles Naouri - to sustainably service its debt.

Casino has been set up as an incredibly complex company. It ultimately has around 55 subsidiaries, which it fully consolidates. Some of these have holding companies between themselves and the parent, some have cross ownerships in other subsidiaries, and in some cases the parent has direct ownership stakes in the subsidiary in addition to stakes held through aforementioned holding companies. This makes the process of determining Casino’s actual proportional ownership of the earnings of its subsidiaries a difficult task. This is, however, a process that becomes critical in understanding the true leverage story behind Casino, given that it holds a large majority of its debt at the parent level, while in its published reports it is fully consolidating 100% of the EBITDA of subsidiaries that it only has fractional stakes in – for example, Casino reports 100% of earnings from its LATAM electronics business Via Varejo, despite only owning 14% of the company. Casino is able to do this by demonstrating that it has significant control over the subsidiary (typically through obtaining seats on the board). Whilst the company asserts its reporting is IFRS compliant, it is our view that this understates group leverage. When restating the financial accounts on a proportional basis, Casino retains around half of the EBITDA it reports, and more than 90% of the net debt. Net debt is increased further after adjusting for a number of equity-like debt securities that Casino does not include in their net debt figure - deeply subordinated bonds and convertibles which require their coupon payments are covered before dividends are distributed. After making these adjustments we calculate a leverage ratio that is more than double that shown in Casino’s reported accounts. Also troubling is the fact that with Casino shifting to an emerging markets focused business, cash balances sitting in emerging market currencies have been subject to FX erosion over the course of the year, particularly cash balances in Brazilian Real. With the majority of debt having been raised in Euros, this adds further pressure to net debt levels. Problems are then further compounded when taking into account the performance of their emerging markets subsidiaries, which have largely seen year on year declines in operating profit. The Casino group reported in its H1 2015 presentation that, due to insufficient free cash flow generation, it had moved to funding its dividend through debt.

Source: Casino H1 2015 Investor Presentation1

Typically, good corporate governance would dictate that Casino should cut their dividend to stabilise net debt while they focus on alleviating operational issues. Looking at the holding company structure above Casino gives us an idea of why the management may be reluctant to take this option.

Source: Companies’ 2015 interim results & 2014 annual reports

Similar to our previous blog on Banco Espirito Santo2, the holding company structure at Casino adds to the troubling picture of inappropriate levels of leverage. The common denominator running through the organisational chart above is Jean-Charles Naouri, current CEO of Casino, and Chairman of the Board of Rallye, Casino’s majority shareholder. Rallye currently has an additional 2.8bn net debt which Naouri has borrowed against Casino shares worth 2.1bn at current market prices. Rallye has other additional assets of around 0.3bn, bringing total assets to 2.4bn – this implies that the company is currently trading with a negative equity value. Crucially, all of its income is essentially derived from Casino dividends. If Casino were to cease paying dividends, how would Rallye service its debt? It also seems such relationships continue further up the chain, with more net debt being added at each stage on limited to no additional income generation.

The credit markets began to take notice of this increasingly precarious pyramid of leverage, as Casino’s CDS rose to record levels, breaking through those seen during the financial crisis. Interestingly, Casino had up to this point retained its investment grade status of BBB- (one notch away from junk status), despite breaking through junk-rated Tesco’s CDS levels. Such a move to junk would be particularly painful for Casino, not just because of the increased cost of refinancing, but also due to the fact that its outstanding bonds have a 125bps step up in their coupon should this happen. We calculate that the effect on Casino of such a credit rating downgrade would be to instantly increase the group’s annual interest costs by c.30%.

Source: Bloomberg

Two months after we had made these discoveries, Casino announced a deleveraging plan with intentions to dispose of its operations in Vietnam as well as real estate in Columbia and Thailand, and subsequently came under attack by the activist short seller, Muddy Waters. In a research note published on their website3, Muddy Waters called Casino ‘one of the most overvalued and misunderstood companies we have ever come across’. The Muddy Waters article and subsequent media coverage brought a number of our key concerns to the attention of the public, and we anticipated that Casino’s response would bring some clarity to questions we believe analysts and shareholders of the company should be asking. Unfortunately this was not the case - at a very minimum, we (and, we expect, many other market participants) were expecting Casino to clarify that the French business was not in terminal decline excluding intercompany property transactions which they have allegedly used to inflate EBITDA.The general defence provided by the company was to simply state that the company reports in compliance with IFRS, rather than to provide any specific clarity around the accounting practices and figures in question. Whilst Casino have stated they are acting within the boundaries of accounting law, in our opinion the information they are presenting is potentially misleading. A follow up by Muddy Waters contained the revelation that S&P had made two material arithmetic errors in their leverage calculation for Casino – ‘overstating the proportional EBITDA contribution from Via Varejo by €164million, and overstating proportional cash by €2.6 billion (thereby understating net debt)’4. Two days after the publication, and less than one month after having affirmed its investment grade rating, S&P placed Casino on negative watch stating that it may lower long-term ratings ‘by no more than two notches’5. A maximum 90 day countdown timer to this event began on Jan 17th.

Source: Bloomberg

Given the holding company structure above Casino, we believe CEO Jean-Charles Naouri has now been driven towards disposing of Casino assets in order to ensure the company can cover its dividend, which is necessary for his holding company Rallye to sustain its debt. This would appear to be a clear conflict of interest which raises the question of whether maximising Casino shareholder value is currently the main priority. Unfortunately for Casino this means auctioning off what we believe are its best assets as a distressed seller to generate the cash needed – indeed they have recently put all of their operations in Thailand up for sale, in addition to their initial deleveraging plan. The problem with this, however, is that it is only a short term fix. In Thailand and Vietnam, Casino will be selling higher yielding assets to pay down lower yielding debt, and the company will inevitably see dilution to both earnings and cash flow generation. The sale of what we believe to be are the group’s best assets in Thailand and Vietnam will also leave the group with just operations in allegedly inflated France and underperforming Latin America. The dilution in earnings and cash flow could subsequently negatively impact dividend coverage, which could potentially place Casino back at the start of its initial dilemma. For this reason, while some market participants have viewed these assets sales as a step towards recovery for the group, we strongly believe these actions are only kicking the can down the road. Furthermore, we still have not been given any concrete details on the deals with respect to prices, and, importantly, on how Casino will upstream the proceeds of the sales to the group for deleveraging purposes (for example, how much of the proceeds will be lost to tax?). Simply quoting the size of the potential proceeds from planned asset sales, not all of which will be recoverable at the group level, as a percentage of Casino’s current market cap - as analysts defending Casino have done - is meaningless, as it completely disregards the value of the debt that is the root of all problems for Casino. It is our belief that there is more pain to come for Casino, with assets being slowly stripped away as the company slips further and further into a negative leverage spiral.

Casino currently finds itself between the proverbial rock and a hard place. A number of tough choices lie ahead, and we question whether current decisions by management are being made with Casino shareholders’ best interests in mind. Even putting the leverage difficulties aside, pressures on emerging market operations show no sign of easing, and this is without considering the cloud overhead of a potential two notch credit downgrade to junk. With further asset sales and the potential for shareholder value destruction on one side of the coin, and the threat of a holding company default on the other, for Casino shareholders this scenario can best be described as heads they lose, tails they lose.

Oisin O'Leary
Investment Analyst
January 2016

1 http://www.groupe-casino.fr/en/wp-content/uploads/sites/2/2014/01/2015-07-30-VA-RIF-Semestrielle_30-juillet-DIFF.pdf - slide 41
2 http://blog.argonautcapital.co.uk/articles/2014/07/16/the-father-of-debt-the-son-of-liabilities-and-the-holy-spirit/
3 http://www.muddywatersresearch.com/research/co/mw-is-short-groupe-casino/
4 http://www.muddywatersresearch.com/research/co/questions-for-call/
5 http://uk.reuters.com/article/casino-rating-idUKL8N15112C

Argonaut Capital Partners LLP is authorised and regulated in the UK by the Financial Conduct Authority (FCA), FCA Reg. No.: 433809, Registered office: 4th Floor, 115 George Street, Edinburgh, EH2 4JN. Co. Reg. No.: SO300614. This document has been provided for informational purposes only. It does not constitute investment advice. This document is for professional clients & eligible counterparties only as defined by the FCA, with the experience, knowledge & expertise to make educated investment decisions and understand the associated risks. The document therefore should not be relied upon by retail clients. Non-professional clients and non eligible counterparties should seek professional advice before making any investment decisions. It is the individual investors responsibility to ensure that any investments made and it's tax liabilities meet your personal requirements and are compatible with the country in which you reside. Information and opinions expressed in this material are subject to change without notice. They have been obtained or derived from sources believed by Argonaut Capital Partners LLP to be reliable but Argonaut Capital Partners LLP make no representation as to their accuracy or completeness. Fund Partners Limited (formerly IFDS Managers Limited) is the Authorised Corporate Director (ACD) of FP Argonaut Funds and is authorised and regulated by the FCA. Registered office: Cedar House, 3 Cedar Park, Cobham Road, Dorset, BH21 7SB.