"Simplicity is the Ultimate Sophistication " Quote from Leonardo da Vinci
Simplicity is the Ultimate Sophistication
Forensic Accounting Part II
Cash should be a very straightforward item on a company’s financials. However, as investors, we ask ourselves seemingly basic questions about it. For example, what is cash? Where is it held by a firm? Where is it being invested? And is it readily accessible to the company and investors?
To better understand the true underlying health of companies in Asia, we need to investigate several broad areas of financial reporting. Besides being able to grasp the nuances of cash and free cash flow, it is vital to analyze the tendency of some Asian companies to revalue assets (such as land), decipher the implications of such moves for investors and explore the intricacies of things like related party transactions.
In our October 2013 issue of Asia Insight: The Science of Forensic Accounting
, we outlined techniques sometimes used by management teams to boost earnings and paint misleading portraits of a company’s performance. In this issue, we focus more on items that impact a company’s balance sheet. As fundamental investors, we look to a firm’s accounting procedures as a window into not only its profitability and efficiency, but also its governance.
Cash: What is It?
Why is it important to ask “what is it?” when a firm references its cash? Let’s use net debt (total debt minus cash and cash equivalents) as an example since it is a common, but frequently misleading, metric used in evaluating leverage. One Asian hotel company, for example, categorizes its entire investment portfolio in “cash equivalents” in its computation of net debt. When you look at the portfolio composition, though, it hardly screams cash. Its so-called “cash balance” is actually made up of Chinese property bonds, European financial bonds and bank stocks. This company’s low net debt and sizeable (albeit misleading) cash balance would have been adversely affected during the Global Financial Crisis. Net debt would have skyrocketed because the “cash” balance would have dwindled as the value of stocks and bonds collapsed. To make matters worse, because bonds and equities are often pledged as collateral against bank loans, investors in a company like this cannot access these assets in times of need. This is a harsh reality associated with the “net debt” approach to analysis and precisely why we need to understand a firm’s exact cash composition.
Cash: Where is it?
Understanding where cash sits is essential, especially in relation to a company’s debt. Let’s consider one Southeast Asian conglomerate that is a typical holding company—it has no standalone operations and only owns stakes in its subsidiaries. The company’s statements show about US$1.7 billion of debt and roughly US$2.2 billion in cash, but in reality, less than US$600 million in cash actually sits at the holding company level. The rest of the cash is consolidated from its subsidiaries, which also have debt of their own. In a distressed scenario, each of the subsidiaries would use the cash to support operations and repay debt at its subsidiary level, leaving much less cash at the parent than it initially appears. The US$1.6 billion difference in cash changes the parent’s risk profile when considering its financial health as well as its willingness and ability to repay debt. It is critical as investors to understand the corporate structure, scrutinize where the assets are and where the cash sits.
Cash: Is it tied up?
We also ask ourselves if cash is restricted or encumbered. A Chinese property company, for example, may get a deposit from an apartment buyer. It would hold the customer’s cash until it delivered the unit to the buyer, but typically the firm would be restricted from spending the cash. Cash can also be encumbered by debt facilities. This can be to a bondholders benefit or detriment, but in most cases it is bad for an equity investor.
One example where bondholders benefit while shareholders suffer is in the case of an Indonesian coal company that issued bonds stipulating minimum cash levels with a strict waterfall that restricts the flow of cash. Operations and debt repayment are prioritized, while dividend payments are restricted. Revenues come in from three different sources, and there are over 20 approved uses of cash before the company has discretion over it and can pay a dividend.
Bondholders may suffer in a case where bank loans that are more senior to bonds in the capital structure require a certain amount of cash to be held in an account and segregated for the benefit of banks. For equity investors, in times of financial distress, recourse to cash will be even more limited when it is restricted or encumbered, although they may benefit in good times from the additional discipline these limitations place on management.
Free cash flow: Why does it matter?
Like cash, free cash flow is another simple metric that is important to understand. It is the cash a company generates after using funds to pay for expenses, interest, taxes, capital expenditures and working capital. Free cash flow (FCF) represents the flow of real cash, stripping away accounting assumptions in earnings. FCF is one of the more credible indicators of a company’s earnings quality and signals how much money a business is actually generating. It is significant for investors because companies can use this money to pay dividends, buy back shares or repay debt.
Working capital—the cash used in the day-to-day operations of a firm—is an underappreciated driver of FCF. It can tell us about the quality and financial health of a company’s operations. An increase in receivables, for instance, can be indicative of a deceptive practice known as channel stuffing, which inflates sales and earnings figures in the short term by sending out goods for distribution that will inevitably be returned to the company. A dollar spent on inventory is one less dollar in cash. Large inventory purchases (or increases in trade receivables) can drain cash and liquidity prior to a default. One Hong Kong retailer, for example, appeared to have a high cash balance. But it recorded almost a 30% increase in receivables and inventory the year before financial distress in a period when sales grew by less than 10%. This increase in working capital led to a drop in cash, just when the company and investors needed it the most.
Revaluation of assets
Companies sometimes revalue assets on their balance sheet when the value of those assets no longer reflects economic reality. We are most interested in revaluations that “write up” (increase) the value of the assets. Why does this matter? Let us say the value of land bought 10 years ago for US$1 million has appreciated to US$10 million. The firm’s management may argue that it needs to revalue the land to reflect current economic reality as investors will likely underestimate the value of the company with assets stated so low. Also, lenders might be inclined to curb loans because at first glance the balance sheet appears weak. Hence, management may feel inclined to “write up” the company’s assets to their current market value.
But revaluing illiquid assets such as land on an ongoing basis is a bad practice. First, it is not in keeping with conservatism inherent in accounting standards and tends to create mistrust in a company’s management. The conservatism philosophy in accounting requires management to write down assets when they are impaired permanently, but rarely allows writing up of assets. Second, prices of assets that are not determined in an open, liquid market are subjective. In other words, there is no reliable pricing mechanism. Another negative effect is that it adds volatility to the balance sheet and makes it difficult to determine the true earnings power of the company. This is important for investors because the market cap of a firm is ultimately a reflection of its true earnings power.
Over the years, we have seen some companies aggressively revaluing assets. One company in particular was extending sales growth assumptions 30 years into the future and using those assumptions to “fair value” its fruit plantations. The land values they provided were not based on how much the property was actually worth from comparable property sales. Instead, the firm was discounting future revenues spread over the next 30 years that were subject to unknowable factors such as crop yield and fluctuations in agricultural pricing. Moreover, these revaluations had been “baked” into the financial statements for several reporting periods, so it became very difficult to distinguish between real and estimated sales growth. In this particular case, these revaluations were material, sometimes accounting for about half of reported earnings.1 In our investment process, we consider this level of revaluation to be a red flag.
Related party transactions: Are they about efficiency or nepotism?
What motivates a company to award business to affiliates or other related parties? Are affiliates winning business because they are the best-suited vendor in terms of pricing and quality? Nepotism is an obvious theme in related party transactions but it is a poor basis for doing business and often indicates a lack of transparency. Related party transactions may be legitimate but they should raise red flags. An Indonesian company we once visited was paying too much for distributing the candies and cookies it sold. The company it contracted with for distribution was controlled by the founding family. In situations like this, the listed company could sell its products to the distributor too cheaply and allow the distributor to enjoy super-sized profits. As minority shareholders, we take exception to these relationships because they typically place the interests of majority shareholders ahead of ours.
One way some companies in Asia operate is through the so-called “PPCC” model, where they “Privatize Profits and Commonize Costs.” Simply put, a controlling shareholder tries to maximize his personal profit while bearing as little of the cost as possible. We saw this in an Indian consumer durables company through a royalty agreement. The brand was owned by its majority shareholder, but the listed company assumed the cost of building the brand while technically not owning it. Moreover, the company paid royalties for the privilege of using its “own brand.” In this case, the majority shareholder listened to the concerns of minority shareholders and eventually transferred the brand ownership to the company.
Another related party arrangement that raises red flags is compensation structures that provide subsidiary managers with stock options from the parent company. Such structures, in fact, inadvertently shift the interest of management away from the subsidiary and towards the parent company, creating a conflict of interest. We follow a number of companies that are listed subsidiaries of multinational corporations and conduct regular business with their parent companies. As part of our investing process, we try to gauge whether companies and their subsidiaries conduct arm’s length transactions that are competitively priced at standard market rates.
Given all these potential difficulties, should we then avoid companies with substantial related party business? The realities of doing business in Asia imply that these kinds of affiliations often have historical context or are often industry norms, either for economies of scale or regulatory purposes. In India, for instance, several telecommunications service providers band together to jointly own a subsidiary tower company. In this situation, the majority of revenues of the subsidiary firms come from the services provided to its parent companies. In an industry like this, a shared service model makes sense in order to manage the high fixed costs associated with the infrastructure. In fact, this is somewhat of an industry evolution. The telecommunications service providers realized that by moving the towers to a separate company they could share the towers and reduce capital expenditure and operating costs.
All of these issues—questions around cash; revaluation, or “writing up” of assets; and related party transactions—can be abused by management to capture economic value, reduce transparency and potentially put the business and shareholders at risk. Even a simple matter, like how much cash a company has, can in fact be quite complicated. As specialists in Asia, we know that each market is different, and forensic accounting provides us with a tool to help uncover high quality investments across the region.
Satya Patel and Sudarshan Murthy, CFA
1 By measure of EBITDA: earnings before interest, taxes, depreciation and amortization.
The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein.
The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information.