The hedge fund at the heart of Glisten

The unacceptable face of chocolate

The opening page of the chapter on derivatives in my copy of Holmes, Sugden and Gee‘s manual on interpreting company reports starts with the observation that companies enter into derivative contracts mostly to reduce risk.

Then it warns that there is another side of the derivatives business that is:

Sheer speculation: the unacceptable face of capitalism, doubled, and redoubled.

It reprints extracts from an article originally published in the Daily Telegraph in 1995 in which Proctor & Gamble, a giant US manufacturer of consumer goods, alleged Bankers Trust (now part of Deutsche Bank) had ripped it off using derivatives, quite literally. According to P&G bank employees even used the acronym ROF, Rip Off Factor, to describe one method of fleecing clients. Bankers Trust paid P&G $78m in an out of court settlement.

Derivatives have been at the heart of many more famous financial scandals, from Enron to the derivatives of subprime debt that sparked the credit crisis in 2007.

Although derivatives are a generally accepted way of managing risk, the P&G case is relevant because it shows how even a well resourced global company is at a disadvantage when striking derivative contracts with the specialists, and how easy it is to misunderstand their complexities.

So imagine my dismay at finding two whopping great derivatives at the heart of Glisten (GLI), a small company making delicious snacks that ought to be as simple to understand as it gets. Especially as the shares are so cheap.

Ignoring an exceptional charge against profits to account for a decline in the value of its derivative contracts, Glisten’s results don’t look too bad considering it revealed accounting irregularities at its fruit and cereal snacking division in June that have now been resolved.

In accounting terms Glisten’s much less profitable than it was in 2008 but It’s more profitable in cash terms, and debt came down a bit from 38% to 33% of total assets. These are all positive signs, and mean its financial strength as measured by the F_Score is 6 out of 9, normally strong enough to consider for the Thrifty 30 model portfolio.

I estimate its nine year PE ratio (including two years of pro-forma profits from the companies Glisten acquired when it came into being in 2002) to be less than five, well inside bargain territory.

The numbers suggest it’s a good company going cheap.

But I can’t get the derivative contracts out of my head. The company agreed to put a collar on its interest bill. As I understand it, if interest rates rise above a certain level, Glisten’s bank, Barclays, will compensate it. But if interest rates fall, Glisten’s interest rate sticks at 5.43%.

In effect, Glisten paid for certainty about its interest bill, but its paying a high price now rates are low. That’s indicated by a fall in the value of the contracts of £4m which, according to accounting rule IAS 39, the company must deduct from its profits and record in its balance sheet as a liability.

It’s more than enough to wipe-out Glisten’s profit for the year.

The company would prefer us to ignore this charge, as it does not reflect the performance of the business. In a year of higher interest rates, the contracts might become more valuable and add to the company’s profit.

OK, but I can’t ignore its debt. If it had less debt, it wouldn’t be so afraid of high interest rates that it had to buy these contracts. So, to my mind, although the derivatives reduce or ‘hedge’ the risk of fluctuating interest rates that risk was self-inflicted when Glisten borrowed as much as it did.

Neither do these hedges remove the risk that Glisten has borrowed so much, its debt could put the company in jeopardy if profits don’t recover.

The fact that Glisten had to renegotiate its agreements with Barclays when profits fell this year, indicates that borrowings are uncomfortably high. And so does the price it paid to secure the finance.

Not only is it paying 3.61% above LIBOR, as opposed to (mostly) 1.85% above base rate last year, but it also had to issue warrants over 750,000 shares to the bank as a sweetener. Glisten may issue a further 750,000 warrants in lieu of debt repayments in 2010.

It looks as though the company’s walking a financial tightrope. Perhaps Glisten’s low, low share price compensates us for the risk but I can’t say that with confidence.

Also, I’m sceptical about food companies. I’d love to invest in one to diversify. Since food is always going to be in demand, it’s a logical industry to include in a safety-first portfolio. But the respectability of its product seems to have given management teams in various companies the confidence to borrow to the hilt and embark on debt fuelled acquisition sprees. Glisten is the sum of a series of acquisitions since 2002.

That strategy sunk Inter Link Foods and curiously Glisten‘s outgoing chairman, Jeremy Hamer, also chaired Inter Link for a while.

So despite the numbers, and the fact that I’m as partial to a packet of Dormen’s nuts as the next bloke, and more partial to chocolate, I’m not including Glisten in the Thrifty 30.

It will probably recover, but there’s too much to worry about.

Nuts…

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