A ramble through the DCC multiverse

Simple question: why does DCC have an overdraft? The answer’s at the end of this post. Skip straight there if you want, or stick around for the journey.

Anyone still reading might not know what DCC does, which is fair enough, because it can sometimes seem like DCC doesn’t either. Activities include off-grid gas marketing, sales of heating oil and biodiesel, distribution of consumer electronics, and the manufacture of medical products. Having floated in 1994, the Dublin-based group has grown via several hundred acquisitions to join the FTSE 100 in 2015 — offering blue-chip investors a unique opportunity to gain combined exposure to heat pumps and unmanned petrol stations, catheters, dietary supplements and professional drones.

Those who do know DCC will usually know it by its cash. As the company says:

Our strategic objective is to build a growing, sustainable and cash-generative business which consistently provides returns on capital well in excess of our cost of capital. This simple strategic objective drives a consistent group-wide focus on continuous value creation, exploration of growth opportunities and a steadfast commitment to sustainable business activities.

A simple strategic objective means DCC can buy a lot of stuff:

Number of deals (right axis) and cash spent (left axis, £mn) © Morgan Stanley

And has consistently generated a lot of cash:

Free cashflow (left axis, £mn) and conversion (right axis, per cent) © Numis Research
Pre-tax return on capital employed including IFRS 16 leases © Numis Research

It helps to know that DCC began life in the mid-1970s as Development Capital Corporation, a venture capital firm for start-ups. Founder Jim Flavin then switched to a decentralised conglomerate structure, gradually selling off all the bits that weren’t energy, technology, food & beverage or healthcare. Flavin stepped down as CEO in 2008 to be succeeded by Tommy Breen, who sold F&B while growing the energy businesses. Current CEO Donal Murphy took over in 2017 and has tended to prefer shopping in the technology and healthcare sectors.

DCC is often held up as an example of how reinvestment into expansion can compound returns. As Numis says in a recent note:

Over the past 28 years, the business has a track record of 14 per annum operating profits growth, with 100 per cent conversion into operating cash flow, with an average 19 per cent pre-tax ROCE alongside low net debt/EBITDA <0.5x.

History lesson over, we can turn back to the overdraft question. Here’s the relevant bit in the 2022 annual report:

Going overdrawn by nearly £68mn while sitting on £1.4bn in cash might look irrational, but among corporates it isn’t that unusual. The vast majority of UK-listed companies don’t use overdraft facilities to manage liquidity but quite a few do. Vodafone does. So do Centrica, Diageo, Next and Rolls-Royce, according to Bloomberg data. In all, more than 50 FTSE All-Share members had bank overdrafts in their most recent financial year, equivalent to just over 9 per cent of the total.

And DCC’s overdraft isn’t particularly big, in relative terms, at approximately 5 per cent of cash. The chart below shows the biggest overdrafts in the FTSE All-Share. (A full-fat logarithmic scale version is available here.)

Given all that, why are we talking about DCC? Several reasons.

Firstly, its overdraft has attracted the attention of some professional short sellers, having first been spotted in DCC’s accounts at the 2021 year end. Secondly, it’s part of what might look like an unnecessarily expensive capital structure for such a profitable company.

DCC’s gross debt at the 2022 year end was £2.2bn, of which about 60 per cent was priced at floating interest rates. In addition to term loans of more than $1.3bn there are sterling- and euro-denominated private placement notes with rates of between 4.04 per cent to 4.98 per cent.

In March 2022 DCC secured a new £800mn floating-rate revolving credit facility, which was double the size of the one it replaced. Extending its credit line came after DCC tapped shareholders for financing twice in recent years: first in 2015, to help buy French LPG distributor Butagaz, then again in 2018 to keep gearing levels low after a shopping spree in 2017.

Every percentage point rise in interest rates cuts DCC’s group EPS by 2 per cent, estimates Morgan Stanley, though there’s the partial counterweight from interest on its cash and equivalents.

Running such a fat balance sheet means acquisition funding is always available in a hurry, DCC told us. The company has been working to reduce the cash on its balance sheet in the name of efficiency and has been “developing access to other funding sources”, which may include the issue of public debt, a spokeswoman added.

The third reason to talk about DCC is happening in Western District Court of New York, where the former owners of an electronics distributor bought by the company are suing for more than $24mn.

Kevin Kelly and Mark Wilkins sold Stampede, an audiovisual equipment specialist, to DCC in 2018. They claim in a lawsuit filed against two DCC subsidiaries, DCC Technology Holdings, Inc and Exertis (UK) Limited (PDF link), that the defendants breached obligations on earn-out payments and that Stampede’s profits were “systematically” manipulated.

DCC management, they allege, insisted that Stampede create a senior vice president of finance role above its own vice-president of finance, and then installed to the job its own man, Denis Tobin, who had previously worked on M&A. The complaint alleges:

Under the SPA [share purchase agreement], adjusted Ebitda was to be determined in accordance with generally accepted accounting principles, “applied and calculated in a manner consistent with the Ebitda calculation” derived from Stampede’s 2017 audited financial statements.

Tobin, however, ignored the SPA and moved quickly to implement significant changes to the earn-out group’s accounting practices (and, consequently, DCC’s calculation of adjusted Ebitda for the purposes of earn-out payments) that differed from the calculations used in Stampede’s 2017 audited financial statements.

As evidenced by their consequences, the purpose of these changes was to improve DCC’s calculation of its return on capital employed, a metric prioritised by senior leadership of DCC PLC.

ROCE targets matter for DCC’s management bonuses, the complaint notes, continuing:

This bonus structure incentivises executives to hide profits that were earned in a particular period on the company’s balance sheet so that they may be released to the income statement in a subsequent period, when needed to achieve the monthly or annual budget.

Towards the end, a “buckets” spreadsheet was maintained to track where the earn-out group balance sheets [sic] various excess reserves had been hidden and where they could be released from in later reporting periods.

On or about March 29, 2021, a DCC representative said they would be using “two sets of books” through the remainder of the earn-out period.

DCC’s motion to dismiss (PDF) hangs on an argument that, under the contract signed, disputes over earn-out payments had to be determined by independent accountants. The arguments of the plaintiffs are “disingenuous” and rely on an “outdated and incorrect legal paradigm . . . in an effort to confuse the court,” the motion says, adding:

It is implausible that DCC would conspire to damage the company it spent $70mn to acquire while continuing to provide it with debt financing.

The plaintiffs argued in response (PDF) that DCC had “breached the foregoing covenants but hopes to escape liability by stretching a narrow accounting clause beyond its breaking point”. The case continues. (Pacer link, requires login.)

A spokeswoman for DCC added:

 The former owners of Stampede have made a number of claims that are designed to increase their earn-out. All of those claims have been rejected in court submissions made by Exertis. We have taken the appropriate measures to ensure all conditions were fairly met in this transaction, but we cannot comment further given the case is ongoing. Since going public in 1994, DCC has completed over 350 other acquisitions without dispute; and earn-out arrangements were part of many of those acquisitions.

Anyway, here’s the answer to question at the top. When asked about the overdraft, DCC said the company has been using cash pooling arrangements to manage its liquidity efficiently.

At all times our businesses units are collecting substantial amounts of cash or paying for product. DCC nets positive and overdrawn cash balances within the pool. This means resources are not spent manually “netting” balances to fund modest working capital requirements in individual business units. We do not incur interest costs on the overdrawn balances as long as the total in the cash pool is ‘net’ positive.

For accounting purposes, DCC must present the pool ‘gross’: it shows overdrawn bank balances separate to (positive) gross cash bank account balances, even if there is a “net” cash balance within the pool. [ . . . ] The overdrawn balance in the cash pool is £65mn, while DCC held £467mn cash balances with the same banks.

Which seems fair enough. Sector peer Bunzl uses a similar cash pool facility. So do aggregates group CRH, caterer Compass and packaging maker Smurfit Kappa.

Whether pooling is the ideal structure for managing liquidity in a net-cash positive decentralised conglomerate is a matter of debate, which accountants are very welcome to take to the comment box. For everyone else, maybe the real answer was the exploration we did along the way.

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