Wednesday, October 17, 2007

Keystone Co-Op #3: Dissecting the Debacle

posted by deep throat

Having attended the Co-Op's annual member meeting on Sunday, I have to say that it was heartening to see that the severity of the organization's financial distress has finally begun to penetrate the outer-most layers of the membership. While this dawning realization does not diminish the serious financial issues, at least more members are getting a clue.

I am still in the process of sorting through the historical financial statements, and the very poor disclosure has substantially hampered my efforts. I've got plenty of questions about where the Co-Op is classifying its rent expense, where its liability in back rent payments to the University shows up on the balance sheet, what its debt covenants are, which ones the Co-Op has violated and the ensuing penalties, specific detail on payroll expense, sales/marketing expense, and interest expense, among others. Let's hope the audited financial statements for fiscal year 2007, which should be available after 11/10/2007, will provide a much clear picture of what's going on with the Co-Op.

There has been some disagreement on this blog about just how profitable or unprofitable the Co-Op is. On the one hand, the Co-Op reported net income of $809,299 in fiscal 2006 from continuing operations, which basically means the 55th Street and 53rd Street stores. The audited financial statements did not disclose net income by individual store, so I cannot find any evidence of the $1 million in profits that has been mentioned on the blog before. (If anyone does have knowledge of where I can find these numbers in the audited financial statements, then please point me in the right direction!)

Now, any credit or equity analyst worth his/her salt can tell you that net income is easily manipulated through the various accounting rules. For example, the Co-Op has classified the 47th Street store as a "discontinued operation" back in fiscal 2005, so the on-going and significant rent obligation on that space is not part of the calculation to arrive at last year's $809,299 profit. Unfortunately, just because the Co-Op has discontinued operations doesn't mean it can also discontinue rent payments to Certified. If you disregard the discontinued operations and solely focus the continuing operations of the Co-Op (the 55th Street store), yes it is profitable. However, I would argue that it is simplistic to look at the 55th Street store in isolation. The money-suck originating from the 47th Street store has been sitting in discontinued operations from FY 2005 through FY 2007, and the first three months of FY 2008 – and it doesn't look like this will change any time soon based on President Poueymirou's comments at the Annual Meeting. For this reason, it would be irresponsible to ignore the discontinued operations sink hole when evaluating the financial health of the Co-Op. If you count all the on-going obligations associated with discontinued operations, then the Co-Op is clearly in the red. Obviously, the $809,299 in earnings last year is just a profit on paper – otherwise, it would show up as cash on the balance sheet, as a positive contribution to retained earnings (which drives membership equity toward positive numbers), and the Co-Op should be issuing a nice dividend check to its members.

One key number that seemed to bring the situation home to members at the annual meeting is the Co-Op's negative shareholders equity. For those who aren't accountants, shareholders equity (membership equity, in the case of the Co-Op) can also be thought of as the Co-Op's net worth, or tangible book value. Technically, it is calculated by taking total assets minus total liabilities -- $4,823, 219 in assets - $6,496,066 in liabilities, which leaves -$1,672,847 in membership equity (based on the FY 2006 balance sheet). In this case, since it is negative, that essentially means that the value of the Co-Op's assets have fallen below the value of the liabilities used to obtain those assets. This is analogous to the situation that some homeowners find themselves in, after having bought their homes at the top of the market and taken out big mortgages to finance the deal, but now struggling to pay on a mortgage that exceeds the market value of their home as the housing market dips. Based on the Co-Op's operating performance over the last few years, I am expecting membership equity has slipped further into the red in FY 2007.

Because it's so easy to manipulate the calculation of net income, I prefer to look at the statement of cash flows, where it is generally harder to sweep ugly things under the rug and you can get a better picture of what cash is coming in and going out. Leeway in accounting rules can create paper profits (and provide false reassurance), but its only cash that counts when the music stops because that's how you pay off your obligations and secure what you need to continue operating. The Co-Op generated $296,000 in cash from operations in fiscal 2006 – which is considerably smaller than the $809,299 in profits from continuing operations. This is a major red flag to me. In well-managed entities, cash flow from operations typically exceeds net income, and importantly, growth in cash flow exceeds growth in net income. Since I have not yet received 2003-2004 or 2007 financial statements, I can't comment on the growth trend, but clearly, cash flow from operations is trailing net income in absolute numbers.

Humor me with one last calculation that can provide insight into the financial health of this organization – the cash burn rate. The Co-Op burned through $13,016 each month of fiscal 2006 ($295,971 cash flow from operations - $77,159 in capital expenditure - $375,000 in debt paid off during the year/12 months) = -$13,016). Ideally, this number should be positive, which would indicate the entity is generating net cash and can shoulder investments necessary to improve the business. But, in the Co-Op's case, it's in negative territory, which means the entity is spending $13,016 more than it is generating in cash. In general, unless this condition is corrected, the Co-Op will not be able to pay debts when due, including the upcoming $529,711 portion of long-term debt that must be paid in fiscal 2008.

Since the Co-Op is already insolvent, a discussion of the nuts and bolts of bankruptcy might be helpful in the next installment.


Elizabeth Fama said...

Nothing looks good in these numbers. I tried to put myself in James's shoes and find something positive to say, and here it is: if the 55th Street Co-Op could unburden itself of the 47th Street store, maybe the business would be salvageable, financially.

But it's impossible to say even that yet, without further information, because (correct me if I'm wrong) it's not clear HOW MUCH of the rent they're actually paying at 47th Street, and WHERE they put it on the balance sheet.

Certified must be getting SOMETHING in rent from the Co-Op, or it would force the Co-Op into bankruptcy. Or maybe not, since we're starting to see that there's nothing there to seize, and lots of other creditors. Maybe Certified figures a partial payment of rent on an empty store is better than no rent on an empty store.

And beyond whether the Co-Op is salvageable financially, there would still have to be a lot of changes in food quality, cleanliness, and service to make it a place I'd ever shop again.

I wish I understood accounting more. Although I appreciate your explanations in these posts, I'm still a bit lost.

Famac said...

Sometimes I wonder whether Certified isn't trying very hard to find a tenant for 47th Street.

Perhaps they plan take over the Co-Op space once the towel is finally thrown in.

Wasn't there a store called Certified in the space now occupied by the bakery and UM?

deep throat said...

Elizabeth is correct about the rent situation on 47th Street. Though the Co-Op owes $90,000 per month to Certified on that space, it is not clear whether the Co-Op has been able to keep up on those payments, or some portion thereof. And, if there is back-rent due, where is it sitting on the balance sheet? I've noted that there is $960,000 lumped into "other current liabilities" as of the end of FY 2006. Maybe this contains some of the back rent that the Co-Op hasn't been able to pay. However, I doubt the FY 2006 numbers have captured an accurate picture of how much the Co-Op owes its landlords based on President Poueymirou's comments at the annual meeting. He pointed out that the Co-Op's main creditors in that year were vendors (which likely includes Certified). In FY 2007, he contends the mix of creditors has changed (even though the absolute level of debt hasn't shifted materially) such that half is owed to vendors and the other half is owed to landlords (Certified and the University?).

Then, there is the on-going lease commitment on 47th Street that the Co-Op is locked into through FY 2023. That's another 16 years of $1 million in annual rent. There is absolutely no evidence of this liability on the balance sheet because the financial statements only require the Co-Op to recognize a single year's rent expense in each fiscal year.

Yes, it does seem to me that there's a viable business in the 55th Street store. But, whether the new general manager can revive that business and churn out enough profits to satisfy the Co-Op's creditors in a timely manner remains to be seen. In situations of financial distress, time is really the name of the game. The entity will try to bargain for enough time to shed the sink holes and polish up the remaining healthy businesses.

Based on Treasurer Lowenthal's financial report at the annual meeting, it looks like even the 55th Street store has trailed industry benchmarks for the last few years. For example, revenue growth from that store has essentially been flat from FY 2003 through FY 2007. (This was shown in bar chart form, so I don't have actual figures yet).

Just for perspective, supermarket sales typically grow in line with GDP -- unless there have been some changes in the local trading area, like an increase in population. So, we would expect the Co-Op's sales to grow about 2% a year, and we'd throw in another 1% in food inflation (though we expect food inflation to be higher this calendar year thanks to higher feed prices and a worldwide surge in demand for dairy). So, in the absence of any big change in population or nearby competitors, we should be seeing the 55th Street store rack up sales growth in the neighborhood of 3% annually. At the very least, I would have expected to see some modest bump in 55th Street sales in FY 2005 when the 47th Street store closed and shoppers would have shifted to the original location.

We've heard from Neo, the Peapod Guy, that Peapod's business in Hyde Park has increased significantly. So, I would surmise that Peapod is grabbing more share of the Hyde Park stomach.

Elizabeth raises some really good questions about why Certified would put up with this situation or why it hasn't forced the Co-Op into bankruptcy. From what I can tell, there are a lot of intertwining relationships between the two entities. The Co-Op owns some of Certified's common stock, but it also owes Certified over $1 million in notes payable (long-term debt) at the end of FY 2005. Please keep in mind that this LT debt is separate from the $1 million in annual rent the Co-Op owes Certified on 47th Street.

It is sort of a neat little cycle: The Co-Op sells Certified's products, and then sends most of its profits back to Certified in the form of rent, repayment on debt, and payment for inventory.

Certified may have come to the conclusion that it is better off working out some sort of more lenient repayment plan with the Co-Op, than kicking it to the ground.

Then there is also a brothers-in-arms dynamic because Certified itself is a co-operative organization (which is why the Co-Op owns shares). Certified may be willing to cut the Co-Op some more slack in the name of solidarity, even if it takes longer to receive payment.

Elizabeth, if it makes you feel any better, I'm also lost with the Co-Op's murky financials. And I pick apart financial statements to diagnose companies for a living. This is some of the worst disclosure I've ever run across. The Co-Op is not a privately-held entity where financial conditions can be kept quiet -- it is accountable to its 22,000 members who have an ownership stake in the business.

Peter Rossi said...

Doesn't it stand to reason that the Co-op is paying (at least in part) the rent to Certified and stiffing the University on the rent for 55th street?

Never give a sucker an even break -- W.C. Fields

Beth makes the most important point. We CAN have a high quality store instead of this mess. What could the Co-op do to bring customers back after more than 10 years of mis-management, rotten food and poor customer service?

Otto said...

"At the very least, I would have expected to see some modest bump in 55th Street sales in FY 2005 when the 47th Street store closed and shoppers would have shifted to the original location."

That's rather a long walk.