Rotten Food Group

If you're surprised by Retail Food Group's implosion then this article is for you.

Fairfax's expose of Retail Food Group (ASX: RFG) didn't mince words, with talk of  ‘hundreds of franchisees' being 'financially devastated' as well as ' systemic wage fraud' and ‘ghost stores'.

But while Fairfax's analysis came as a surprise to the market, it shouldn't have. Red flags have been flapping around Retail Food Group for years.

Our concern was building when we wrote up Retail Food Group's 2016 final result and it reached a crescendo in Shutting shop on Retail Food Group, in which we recommended selling at $6.93. The stock has since fallen by 80%.

Truth is, it didn't take rocket science to see that all was not well at Retail Food Group. 

We're not trying to say we predicted its collapse – identifying risks and predicting disaster are entirely different things – but we noticed enough to get us a long way from the volcano in case it ever erupted. Here's what we saw.

Rotten core

Franchise businesses involve a symbiotic relationship between franchisee and franchisor. This means that in order for Retail Food Group to succeed, the majority of its franchisees also had to succeed. 

It follows that the timeliness according to which franchisees pay Retail Food Group gives important clues about the underlying health of the business.

As part of a routine check of receivables, we noticed that 'more than half the company's receivables are past 90 days due'. As we said at the time, 'that's a big red flag', which shows a high level of stress at the company's core.

Confusing accounting

We also found RFG's accounts very confusing and, as Warren Buffett's says, if you don't understand it, it's because management doesn't want you to understand it. If that's the case, there's usually something wrong.

Our main concern, noted in Retail Food Group: Result 2016, was over the treatment of RFG's ‘national marketing funds'.

As part of its operations, RFG charges its franchisees a few percent of their revenue which it uses to promote its brands. It then puts this money into a fund which sits as an asset on its balance sheet.

Much to its franchisee's dismay, RFG was spending less on marketing than it was receiving from its franchisees, but it was also spending it on things completely unrelated to marketing.

We noted at the time: 'A large chunk of it was used to subsidise Michel's Patisserie franchisees during a supply disruption. Again, that looks like a normal business expense to us – at the very least it will reduce the funds available for marketing expenditure.'

At best this was highly questionable accounting but at worse it was something much more sinister. The lesson is that when you discover one cockroach its best to assume there are more in the kitchen.

Risky roll-ups

On top of that, Retail Food Group was 11 years, and 15 acquisitions, into a debt-funded, roll-up strategy.

If we've learned anything from ABC Learning, and all the other roll-ups that have since unravelled, it's that their risks intensify with time. That's because the number of suitably priced and strategically sensible targets is not unlimited, yet the roll-up must continually acquire ever larger businesses to appease the growth desires of its shareholders.

There comes a point where the risks are too great and Retail Food Group had reached it.

We were also concerned about the reduction of 'skin in the game' as Retail Food Group's founding chief executive departed. But, in fairness, a bigger concern that we failed to acknowledge, was whether problems were being swept under the rug so that the departing chief executive could go out with a bang.

You can think of this as the 'General Electric' risk, as it was only after Jeff Immelt departed that we've learned of his two corporate jets.

Get out quick

It's important to remember that when the red flags start adding up the downside risk multiplies, as when a risk becomes a reality it brings many second and n'th order effects.

RFG has been a perfect example of this as its questionable accounting lost investors' trust. The poor health of its franchises hurt its earnings. The lower share price increased its cost of capital and, coupled with its high debt load, it has raised the probability of an emergency capital raising or, at worse, administration.

The lesson here is that when the red flags start piling up its best to quickly head for the exits.

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