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IFRS 19 pensions “Voodoo accounting” – ThyssenKrupp edition
ThyssenKrupp issued their quarterly earnings today. Together with Lufthansa, Thyssen has one of the largest “pension holes” in the DAX index.
As we all know, from 2013, IFRS 19 requires to fully reflect pension liabilities “on balance”. Interestingly, in their Investor presentation, IFRS equity is not mentioned at all.
So one really has to go into the interim report to look what happened.
And again, at a first glance it doesn’t look so spectacular:
Shareholders Equity end of March is around 2.8 bn EUR, 0.77 bn less than stated for September 2012, in line with the losses. However when we look into the developement of the equity position of page 32 of the report, we can see that closing shareholders equity has actually been 7.6 bn in September 2012.
In contrast to Lufthansa, they hide their restatement in an “insignificant drop” of retained earning from March 2012 to September 2012 in an amount of ~4.2 bn EUR. Lufthansa had spread their restatement over 2 years. So there seems to be quite some leeway how to do this.
So to sum it up: Thyssen Krupp has lost ~ 4.8 bn of equity or -63% and management doesn’t even bother to disclose this to shareholders in their presentation. Well, who cares about equity anyway ?
One final remark: Thyssenkrupp uses 3,6% to discount the liabilities, which is quite high. Many other companies use 3.2% for EUR or less. As a proxy, one would multiply the difference times 15-20 in order to see what to add in percentage points to the pension liabilities.
So to scale this, we would for instance multiply 0.4%*15= 6%. With total pension liabilities of 8 bn EUR, we would need to deduct a further 500 mn EUR from equity in order to compare them with more conservative companies.
In any case, I think Thyssen will need to raise some equity capital pretty soon.
Voodoo IFRS Accounting: Lufthansa AG pension liabilities Q1 2013
Lufthansa AG, the large German airline company has a serious problem with pension liabilities. Some people even call it the “flying pension plan”. In the past, under IFRS, they could defer the recognition of higher pension liabilities over a very long-term via the so-called “corridor” method.
However in 2013, IFRS 19 changed this. Now, pension liabilities have to be fully recognized in equity via OCI (other comprehensive income).
This is what Lufthansa wrote in their 2012 annual report:
Change in accounting standard IAS 19 will lead to higher pension provisions
The Group runs defined benefit pension plans for staff in Germany and abroad, which are funded by external plan assets and by pension provisions for obligations in excess of these assets.
In the context of these defined benefit pension plans, the amendments to the accounting standard IAS 19, Employee Benefits, applicable as of 1 January 2013, mean that actuarial gains and losses from the revaluation of pension obligations and the corresponding plan assets are recognised immediately and in full in equity, without effect on profit and loss. One important effect of this retroactive application of the standard
will be that the balance of actuarial losses previously carried off- balance-sheet will be offset against equity at one stroke as of
1 January 2013. After accounting for taxes, this will reduce Group equity by EUR 3.5bn. The change in the accounting standard does not result in higher pension payments, however, nor does it establish an obligation to make additional contributions to fund assets.
When I read their Q1 2013 report, I was however really puzzled:
On the very first page the show that the equity ratio remained relatively constant (15.4% against 17.7% at year end). Based on the information above (3.5 bn pension off-balance sheet liability) and 8 bn equity, the equity ratio should have been dropping by almost a half.
Further on, they write the following in the quarterly report:
The revised version of IAS 19 Employee Benefits (revised in 2011, IAS 19R), application of which has been mandatory from 1 January 2013, had a substantial influence on the presentation of the assets and financial position in this interim report.
The revision caused pension obligations and other provisions under partial retirement and similar programmes to go up by a total of EUR 3.8bn as of 1 January 2013 compared with the financial statements for 2012.
On the same page the reiterate the almost unchanged equity:
Shareholders’ equity (including minority interests) fell by EUR 262m (– 5.4 per cent) to EUR 4.6bn as of the reporting date. The decline
is largely due to the negative after-tax result of EUR – 455m, offset by an increase of EUR 166m in neutral reserves from positive changes
in the market value of financial instruments. The equity ratio of 15.4 per cent was lower than at year-end 2012 (16.9 per cent).
So wtf happened ? How can you increase liabilities by 3.8 bn and equity remains unchanged ? Even if we look at my “beloved” OCI statement (page 23) we can see that OCI statement, we can see that OCI is in fact POSITIVE ?
Dark Side of IFRS Accounting: Restatements
Before it gets to exciting, let us introduce to an instrument from the “Dark side” of IFRS accounting: The so-called “Accounting Restatements”.
Definition:
An Accounting restatement means, that already “closed” accounting periods will be “opened up again” and the P/L will be retroactively changed. Usually this is done, when real errors (or fraud) are detected and the auditors force the restatements. In some special cases however, very creative CFOs use this tool to shift losses into the past and bury them in the hard to read (and understand) part of the accounts.
How to detect ?
Well you can either try to understand the “change in equity” portion of the balance sheet. Which is quite hard sometimes. Or you perform a quite simple check:
Just look at the equity of the last report (here annual report 2012) against the value of the current report. And surprise surprise:
In the annual report 2012 (which was only issued a few weeks ago), equity for 31.12.2012 was stated at 8.2 bn EUR. In the quarterly report issued now, equity for 31.12.2012 now suddenly has shrinked by 3.4 bn to 4.8 bn.
So just to summarize this:
Between issuing the annual report 2012 in Mid mArch and the quarterly report which was issued in the beginning of May, Lufthansa decided to change their accounts retroactively for a fact which was already well known since quite a long time.
This is not illegal,but in my opinion they could have explained that better that they used a restatement to book this retroactively.
Why did they do it ?
The reason is relatively clear in my opinion: In order to not put a spotlight on the fact that now almost 50% of the equity have disappeared. The strategy so far looks quite succesful:
The stock even outperformed the DAX.
What to do ?
One interpretation of this is that the capital market is so efficient and this has all been priced in already. The other interpretation would be that Lufthansa is trying to bury bad news into past results and this opens up a nice short selling opportunity if reality finally catches up with investors.
I tend two favour the second interpretation.
For a cpaital intensive busienss like airlines with no real moats, the book value (or replacement value) is not a bad proxy for the value of an airline. Lufthansa now “jumped” from around 0.8 times book to 1.6 times book.
| Name | P/B |
|---|---|
| DEUTSCHE LUFTHANSA-REG | 1.61 |
| GARUDA INDONESIA PERSERO TBK | 1.31 |
| INTL CONSOLIDATED AIRLINE-DI | 1.31 |
| MALAYSIAN AIRLINE SYSTEM BHD | 1.25 |
| SINGAPORE AIRLINES LTD | 1.01 |
| AEROFLOT-RUSSIAN AIRLINES | 1.00 |
| THAI AIRWAYS INTERNATIONAL | 0.97 |
| CATHAY PACIFIC AIRWAYS | 0.96 |
| AIR NEW ZEALAND LTD | 0.93 |
| AER LINGUS GROUP PLC | 0.89 |
| QANTAS AIRWAYS LTD | 0.68 |
| AIR FRANCE-KLM | 0.63 |
| SAS AB | 0.44 |
| DELTA AIR LINES INC | na |
| Avg | 1.00 |
Funny enough, the average of those 13 airline companies for P/B is exactly 1.0 but that is a coincidence. On the other hand, I don’t see a compelling reason why Lufthansa should trade signifcantly above book value.
Going forward, Lufthansa will be on my “short watch list”. I am tempted to bet that most analysts didn’t really understand what Lufthansa has done and P/B will most likely go towards the industry average.
Total Produce (IE00B1HDWM43) 2012 preliminary results – Disappointing
Total Produce is one of the core holdings since the beginnings of this blog. In the beginning, we analysed the stock mostly in German, nevertheless, we finally settled after some back and forth on a fair value range of 0.69-0.83 EUR per share based on a free cash flow analysis, assuming ~8 cent of “adjusted” free cash flow per share (adjusting esp. for minorities.
One of the issues with Total Produce were back then Balance sheet quality (lots of goodwill, leverage) and only average return on equity, which however was set off by a very cheap price, significantly below book value
In between 2 things happened:
1. The price of the stock increased nicely to around 0.61 EUR. resulting in an overall performance of +55% incl. Dividends.
2. The quality of earnings however deteriorated in my opinion.
I think I have to explain point 2 a little bit in more detail. If you read the 2012 premliminary results, everything looks great:
Revenue (1) up 11.2% to €2.8 billion
•
Adjusted EBITDA(1) up 17.8% to €70.4m
•
Adjusted EBITA (1) up 21.4% to €54.6m
•
Adjusted profit before tax (1) up 19.1% to €47.3m
•
Adjusted EPS (1) up 12.0% to 8.11 cent
•
Final dividend up 12.0% to 1.512 cent; total 2012 dividend up 10.0% to 2.079 cent
(1)
Key performance indicators are defined overleaf
So everything is up double digits, where is the problem ? Well, the problem could be the use of the word “adjusted” in most of the items presented.
If one flips to the next page of the report, we can already see that “unadjusted” EPS declined by -7.5% from 7.11 pence to 6.58 pence per share.
Where does that come from ?
The “explanation” reads as follows:
Adjusted earnings per share excludes acquisition related intangible asset amortization charges, acquisition related costs, exceptional items and related tax on such items.
On the one hand, one could say OK, acquisitions are not part of the operating business, let’s ignore that. However, Total produce does a lot of acquisitions, year after year. Most of their growth actually comes from acquisitions, organic growth seems to be quite limited.
Total Produce, year after year reports those “adjusted” earnings, whereas the “regular earnings” are always lower. Let’s look at the past 4 years:
| 2012 | 2011 | 2010 | 2009 | Avg | |
|---|---|---|---|---|---|
| “adjusted ” EPS | 8.11 | 7.24 | 6.84 | 6.47 | |
| EPS | 6.58 | 7.11 | 5.25 | 3.7 | |
| EPS/Adj. EPS | 81.1% | 98.2% | 76.8% | 57.2% | 78.3% |
So not surprisingly, we only see “upside” adjustments, on average the “real” EPS is only ~78% of the adjusted EPS.
But it gets worse. In my opinion, one of the most “underused” pieces of information about the quality of a companies’ accounts is the Comprehensive Income statment.
“Modern” IFRS accounting allows quite a lot of items to be booked directly into equity as those items are considered sort of non-operating as well. Usual suspects in this category are:
- pension revaluation
- fx effects of foreign subsidiaries
- revaluation of fixed assets
In my opinion, one has to look at all those items because all of them influence the value of the equity position. Let’s look again at the last 4 years:
| 2012 | 2011 | 2010 | 2009 | |
|---|---|---|---|---|
| EPS | 6.58 | 7.11 | 5.25 | 3.7 |
| EPS “Comprehensive” | 5.15 | 4.21 | 5.39 | 7.34 |
2009 looks better based on comprehensive income, however especially 2011 and 2012 look bad from that perspective. This is mostly the result of pension charges. interestingly, in 2009, they booked a 3 mn EUR pension gain into comprehensive income, since then, Total Produce however had to book in total 30 mn EUR negative charge through comprehensive income.^The discount rates used to discount the liabilities at the end of 2012 are still relatively high at ~4.2% both for EUR and UK. So there will be more charges coming.
Many analysts will tell you that comprehensive income doesn’t matter, because it is not operational, but I have a different view. With regard to pension for instance, an increase in pension liabilities means that you will have higher cash outflows in the future and the shareholder will get less.
Free Cashflow
For 2012, Total Produce reports ~41 mn EUR Free cashflow. That’s about 12.5 pence per share or ~50% higher than in our base case scenario. Again, this has to be taken with a “grain of salt”.
Again, as in the first post about Total Produce, I would eliminate the working capital movement, especially as the improvement only came from higher payables and not a reduction of inventory or receivables.
If we do a quick “proxy” calc I would calculate the following Free Cash flow:
+ 38 mn EUR OpCF
- 13.5 maintanance capex (depreciation)
- 1.1 “net minority dividends
= 23.4 mn EUR or ~7.8 cents per share.
This is only slightly below the initial assumption of 8 cents per share but does not include the various payments for the acquisitions.
The problem I do have is that most of the free cash flow is now used for acquisitions, where I am not sure how “value added” that part is.
Summary:
In my opinion, Total Produce’s earnings quality deteriorated significantly. The “adjusted” numbers should be ignored, based on comprehensive income the company only earned ~5.15 pence for the shareholder and this is based on quite optimistic assumptions for the pension liabilities.
The company is using the majority of its free cash flow for acquisitions, where due to all those special effects, it is not clear to me if they earn really enough return. The priority seems to be to increase the size of the company. In my initial thesis, I was giving them extra credit for buying back shares but this seems to be no priority any more. Total value creation suffers quite significantly because of all the related expenses etd.
So I do not see much upside from here as the stock is now already close to my (slightly reduced) value range.
As a result, I will in a first step reduce my Total Produce position by 50%. I assume to have executed this end of last week at an average price of 0.61 EUR per share.
The other 50% are “on probation” so to say, I will look at the annual report and maybe 6M numbers in order to decide finally (or something better comes up).
Operating Cash Flow and interest expenses – (ThyssenKrupp vs. Kabel Deutschland, IFRS vs. US GAAP)
In my recent post to Kabel Deutschland, I made the following remark:
Interestingly, the “operating cashflow” does not include interest charges. In my opinion, interest charges are operating, as they have to be paid regularly and there is no discretion like dividends. So in my view Kabel Deutschland currently runs free cashflow negative and dividends are paid out from the increase in debt.
After some discussions, I was less sure about this myself so I thought it might be a good thing to look at this more closely.
Before jumping into “definitions” of how to calculate and report different cash flow definitions, one should take one step back and ask oneself:
What is “free Cash Flow” supposed to mean anyway ?
The current mantra for most “sophisticated” investors is that you should more or less forget earnings and concentrate on “free Cash flow” as this is the most important metric for determining the value of any (non financial) company.
“Free Cash Flow” in plain English should quantify the amount of money which is generated by a company over a certain period of time (usually 1 year) which can be used in a discretionary fashion to either grow the company, pay dividends, buy back shares etc.
In order to calculate this number, you normally start with operating cash flow, which in theory should contain all cashflows to operate the business on a going concern basis and then deduct cash out for normal Capex, i.e. investments required to ensure the “status quo” of the company.
Further one has to distinguish between two perspectives when deciding how to calculate Free Cash flow:
Free Cash flow to the firm vs. Free cashflow to equity
The single most difference between Firm/equity perspective is that in the “firm perspective” one assumes that the financing structure is discretionary. One wants to evaluate the whole value of the firm based on the firm wide discretionary cashflow.
However, with free cash flow to equity, I have to take the current financing structure as given and one has to calculate how much of discretionary cash flow is left for the shareholder. This of course implies, that interest charges are not discretionary for a shareholder but have to be subtracted from Free cash flow to equity.
This is especially important for highly leveraged companies where interest expenses can “eat away” a lot of discretionary cashflow.
The problem:
So far so good, where is the problem ? The problem is that different companies report cashflow differently.
Let’s look at Thyssenkrupp for instance:
They start with Net income and adjust for depreciation etc. but not for interest expense. Interest expense ist therefore shown within Operating Cashflow (net finance expense was 168mn, maybe they didn’t bother with -1.3 bn operating cashflow.
Now let’s look at the 9M Kabel Deutschland Cashflow report:
We can see that other than Thyssen Krupp, Kabel Deutschland adds back interest expense to Operating CF.
Later on, we can see interest expense under Financing Cashflow:
Accounting view
Under US GAAP it is clear: Interest expense belongs to the Operating cashflow statement. Under IFRS however a company can can choose between Operating and Investing Cashflow (see here, 7.15)
So we can see, there is nothing explictly wrong with Kabel Deutschland from a reporting point of view, they just have chosen to report interest expenses under Financing cashflow.
There is an interesting paper to be found here which makes the following observations:
We find that firms with greater likelihood of financial distress and a greater probability of default make OCF-increasing classification choices. We further show that firms accessing equity markets more frequently and those with greater contracting concerns are also more likely to make OCF-increasing classification choices. Firms with negative OCF are less likely to make OCF-increasing classification choices.
So that is no surprise that a PE “boot strapped” company like Kabel wants to show higher OCF and FCF and opts for Financing Cashflow.
What to do & Summary?
In my opinion, you have to make sure first that you compare apples to apples if you look at two different companies and compare free cashflows. Make sure that you treat this consistently. I am not sure if all the US investors which hold the largest stakes in Kabel know about this small but important reporting difference.
Secondly, I personally think that interest expenses always should be deducted from Operating Expenses and therefore Free Cash Flow in any equity valuation exercise.
Imagine for instance a company which rents its building against a company which takes out a loan to buy the exact same building. In the first building, you would subtract the rent clearly from operating profit, so why would you not subtract the interest on the mortgage for the second company ?
Hess AG (DEDE000A0N3EJ6) busted German IPO stock – Could the fraud have been easily detected ?
Just yesterday, Hess AG, a company which IPOed on the German stock exchange on October 25th 2012, announced that they fired both, their CEO and CFO because of alleged balance sheet manipulations.
The stock price directly crashed some 60% to 6 EUR (IPO price 15,50 EUR):
In some follow up news, the company reported that sales might have been inflated and the financial position might not be as good as stated in the IPO prospectus.
As a value investor, one wouldn’t invest in IPOs anyway.
The Hess AG IPO was priced at levels which one could only assume as “optimistic”, with a trailing P/E ratio of ~50. The price was justified with the supposed “growth” the company was showing in the past and the “story” of the “LED” based business model.
As usual, all parties involved in the IPO (Banks: Landesbank BaWü, Kempen, MM Warburg) will claim that they knew nothing and that you cannot protect against fraudulent management.
The auditors of course will claim the same, in the IPO prospectus they stated explicitly (in German) the follow:
Nicht Gegenstand unseres Auftrags ist die Pr¨ufung der Ausgangszahlen, einschließlich ihrer Anpassung an die Rechnungslegungsgrunds¨atze, Ausweis-,
Bilanzierungs- und Bewertungsmethoden der Gesellschaft sowie der in den Pro-Forma-Erl¨auterungen dargestellten Pro-Forma-Annahmen.
This says they explicitly didn’t check the underlying figures.
The big question of course is: Were there any red flags in the presented numbers ?
How do you “fake” sales anyway ? Well, this is quite simple. You have to organize some kind of “strawman” first, then sell the stuff to him/her and book the proceeds against receivebales. So whenever one sees a large increase in receivables, one should be extremely cautious.
In the case of Hess AG, one does not need to be a Rocket scientist to “smell the rat”. I have extracted the following working capital items from the balance sheet (page 64):
| 6M 2012 | 2011 | 2010 | 2009 | |
|---|---|---|---|---|
| Inventories | 17.3 | 14.8 | 11.7 | 9.6 |
| receivables | 24.1 | 22 | 11.5 | 8.5 |
| Payables | 9.8 | 4 | 2.2 | 1.3 |
| Net Working cap | 32.8 | 21 | 16.8 | |
| “Sales” | 68.3 | 55.7 | 52.4 | |
| Inv/sales | 21.7% | 21.0% | 18.3% | |
| Rec/Sales | 32.2% | 20.6% | 16.2% | |
| Payables/Sales | 5.9% | 3.9% | 2.5% | |
| NetWC/Sales | 48.0% | 37.7% | 32.1% |
So it is pretty easy to see, that receivables compared to sales almost doubled over 2 years. The increase in receivables almost exactly mirrors the actual increase in sales. It looks like that almost all the sales increase were actually generated by sales against receivables.
The next item to check is of course the cash flow statement. Here however we see something strange:
| 6M 2012 | 2011 | 2010 | 2009 | Total | |
|---|---|---|---|---|---|
| Op CF | 3.4 | -4.6 | -1.4 | 3.6 | 1.0 |
| inv CF | -7.3 | -7.9 | -1.5 | -6.9 | -23.6 |
| Fin CF | 6.2 | 14.2 | 2.3 | 2.6 | 25.3 |
At first it looks that in total, operating CF over the last 3 1/2 years was positive and the company did just invest a lot. But how did they manage the Turnaround ?
In the IPO prospectus they say the following (page 89) about the operating cashflow:
Operativer Cashflow
Vergleich der Halbjahre endend zum 30. Juni 2012 und 2011
Der operative Cashflow erh¨ohte sich von TEUR -3.133 im ersten Halbjahr 2011 um TEUR 6.494 auf TEUR 3.361 im ersten Halbjahr 2012. Wesentliche den operativen Cashflow bestimmende Faktoren waren ein erheblicher Mittelzufluss aus der Position „Veränderungen der Forderungen aus Lieferungen und Leistungen und sonstigen Forderungen und Vermögenswerte’’ in Höhe von TEUR 8.130 gegenüber einem Mittelabfluss im ersten Halbjahr 2011 in Höhe von TEUR 638, der Rückgang des Mittelabflusses aus der Veränderung der Vorräte in Höhe von nur TEUR -652 gegen¨uber TEUR -3.043 im ersten Halbjahr 2011 sowie eine deutliche Erhöhung der Position Abschreibungen in Höhe von TEUR 2.086 gegen¨uber TEUR 1.255 im ersten Halbjahr 2011. Gegenl¨aufig verhielt sich die die Position „Veränderungen der Verbindlichkeiten aus Lieferungen und Leistungen und sonstiger Verbindlichkeiten’’, die zu einem deutlich erh¨ohten Mittelabfluss in Höhe von TEUR -7.976 im ersten Halbjahr 2012 gegen¨uber TEUR -1.719 im ersten Halbjahr 2011 f¨uhrte.
This statement clearly shows that there is something very fishy going on. In the table I extracted above, we can clearly see that there was a NEGATIVE effect from receivables and inventories in the first half year and an unexplained very POSITIVE effect from payable. So why do they state the exact OPPOSITE in their explanation of the cash flow statement ?
Explanation 1: They just mixed up the vocabulary (which would be already a reason to fire the CFO)
Explanation 2: They included other balance sheet item here in order to obscure the fact that they have inflated sales.
Explanation 3: The 6m 2012 cashflow statement is just fabricated and does not fit together with the (fabricated balance sheet)
Just for fun, let’s compare the balance sheet positions with the entries in the operating cashflow statement:
| OP CF statement | Balance sheet | calculated Op CF | Delta stated | ||
|---|---|---|---|---|---|
| 6 M 2012 | 30.06.2012 | 31.12.2011 | |||
| Change in inventory | -0.7 | 17.3 | 14.8 | -2.5 | -1.8 |
| Change in receivables | 8.1 | 24.1 | 22 | -2.1 | -10.2 |
| Change in short term payables | -8.0 | 9.8 | 4 | 5.8 | 13.8 |
We can clearly see that the 6m “flow” numbers have absolutely nothing to do with the delta of the respective balance sheet numbers.
At that point in time one could already stop and conclude that there is either total incompetency or already fraud. Even taking into account all the other short term balance sheet figures, one never gets to the stated cash flow numbers.
In my experience, strongly rising receivables combined with an incomprehensible or even wrong operating cashflow calculation are a very reliable “red flag”.
Summary:
Although it sounds like “Monday morning quarterbacking”, a relatively superficial analysis of HEss AG’s IPO prospectus would have discovered some serious issues with receivables and operating cash flows. Whe someone starts to doctor around with fake sales, one usually gets negative operating cashflows. If the cashflow statement then looks incomprehensible or wrong, actual fraud is quite likely.
In cases like Hess, “red flags” in that magnitude could even be a very good indicator for an interesting short opportunity. In cases like Reply, where the inconsistencies are on a smaller scale, it is rather a hint to stay away from investing.
Edit: If someone thinks that Hess is now a good investment, because it is so “cheap”, then forget it. Eevn if there is some “sound” business left in the company, first of all there is no proof that they ever earned money and secondly I will assume that there will be quite some legal action on that one.
Reply SpA part 3 – Strange cashflow –> RED FLAG ALERT
In the last two posts (part 1, part 2) about Reply, I mentioned that there was some questionable provisioning for overdue receivables and that free cash flow generation in general looks relatively weak.
So let’s look at a further example, if and how reliable Reply’s accounting is.
In 2009, Reply made an interesting deal, as stated in the 2009 annual report:
Acquisition of Motorola Research centre
In February 2009 Reply Group, through the subsidiary company Santer Reply S.p.A., finalized the acquisition of the Motorola research centre based in Turin.
The acquisition, accountable as a “net asset acquisition” was purchased by Reply for a symbolic amount of 1 Euro and comprised 339 employees, 20.6 million Euros in cash, 2.9 million Euros of assets and liabilities for 23.5 million Euros. Reply has committed to the operation on the basis of the research perspectives outlined at the time of acquisition and the agreements defined with the public administrations (Region and Ministry of Development).Such agreements foresee that the Piedmont Region finance through a free grant a maximum of 10 million Euros on the condition that the Research centre carries out projects within the research and development of Machine to Machine (“M2M”) and that proof can be provided. Furthermore, the Ministero dello Sviluppo Economico (S.M.E.) has made a commitment to grant the Research centre a loan for a maximum of 15 million Euros of which 10 million a free grant for research and development projects similar to those agreed with the Piedmont Region.
In the last months the Board of directors of Reply Group and Santer Reply S.p.A have outlined and defined organizational strategies of the course of business of the Centre. More specifically costs related to research projects have been quantified and the financial resources necessary for such research projects and means of disbursement have been defined by the Public Administrations.
So they “bought” a company for 1 EUR which had 20.6 mn in cash. In theory, we should see this as a positive investing cashflow in the CF statement. Lets look at the 2009 statement:
Strangely, the stated “payments for the acquisition of subsidiaries net of cash received” is negative !! We know that they only paid 1 EUR, received 20 mn and didn’t do other big acquisitions in 2009.
I do not know where they actually booked the acquired 20 mn EUR liquidity, but this is very very strange.
The second part of the puzzle are the Government grants out of this deal.
In their notes, they state the following:
Government grants
Government grants are recognized in the financial statements when there is reasonable assurance that the company concerned will comply with the conditions for receiving such grants and that the grants themselves will be received. Government grants are recognized as income over the periods necessary to match them with the related costs which they are intended to compensate.
So what in theory should happen is the following:
-when they receive the money, the book a liability against the money (P&L neutral)
- then over time they reduce the liability by booking this release as profit
Based on Note 29, Reply booked already such a provision of ~23 mn EUR at the end of 2009, from where they used half of it again. I am not sure why,but again, where is the corresponding asset ? I would assume somewhere in other receivables (as they may not have received the Government money in 2009).
If one of the readers really understands what is going on here, then please help me.
In 2010, the provisioning continues, it looks like the increase and use those provisions as they like to:
This might explain why the very unusual and unexplained line item “changes in other assets and liabilities” makes up 2/3 of Reply’s 2010 operating cashflow.
in 2011, the provision is still significant:
So what does that mean ?
In my opinion, there is poor visibility in the accounts and especially in the cash flow statements. We know now, that the Motorola transaction netted them around 40 mn EUR net cash, but didn’t show up in the investment cashflow. As it didn’t show up in financing cashflow neither, it has to be moved into operating cash.
As operating cash in total from 2009-2011 was only 55 mn EUR, basically a large amount of the operating cashflow in this period seems to be non-operating and coming from the acquired Motorola Research center.
At this point it is time to stop and summarize:
- at least to me, the accounting and cashflow treatment of the Motorola acquisition is not transparent
- together with the weak cash flow generation, large goodwill position and a large number of acquisitions this is A BIG RED FLAG
Maybe I am just not clever enough, but my philosophy to avoid companies with large intangibles and non-transparent accounting makes me stop here and not further investigate the company.
Dart Group – Follow up on fuel hedging and comprehensive income
As proposed in the last Dart Group post, I wanted to take a better look at the impacts on fuel hedging.
Quick summary (or spoiler): During writing the post, I got less and less sure of what to do with the fuel hedges, so the post got very long without a satisfying end. If you are not interested in the process and accounting details, the result is: I am not sure.
Let us start with a “accounting refresher” first.
Accounting for Cash flow hedges
Dart Group uses “cash flow hedges” for their fuel hedges. What does that mean ? Normally, any derivative financial instrument would be considered a “trading instrument” and would have to be marked-to-market directly through P&L.
If a company however wants to hedge a future cashflow (doesn’t matter if in- or outflow) one can apply a technique called “cash flow hedging” which requires basically two things
1) one is able to predict future cashflows with a reasonable accuracy
2) one uses a heging instrument which is “efficient” i.e. tracks the value of the hedged
If one achieves “cash flow hedging” treatment, then the hedge will treated in the balance sheet (under iFRS) the following way:
A) the value changes in the derivatives can be recorded under “OCI” (other comprehensive income)
b) in the future, when the cashflow actually happens, the corresponding hedging gain or loss will then be added or subtracted from the then realised spot price
This is what Dart Group is doing with its fuel hedging and as Wexboy commented fully aligned with accounting standards.
However my argument was that you shouldn’t ignore those movements in OCI but try to understand them and make adjustments if necessary. In order to understand this better, we have unfortunately step beck a little bit and ask the following question:
What is a hedge anyway and when is a hedge a speculation ?
In the case of Dart and airlines in general, this question is quite difficult to answer. In an ideal world as a company, you would like to pass on all your changes in costs directly to your customers and just earn a fixed fee on your products. As we all know, prices on tickets are relatively volatile, however many clients prefer to fix a price well before they start a trip in order to be able to control their budget.
An airline could also, if they were really really good speculators, create a big competitive advantage if they for example could hedge their fuel at low prices while the competitors have to buy much more expensive fuel on the spot markets if prices are rising. However, this is clearly speculation, not hedging as it could go the other way as well.
accounting wise however, one does not distinguish between “economic” hedging and what I call speculation.
So let’s look at Dart Group.
First step: READ THE ANNUAL REPORT
Before one starts to speculate how and what Dart is hedging, it makes sense to look at the annual report to find out what they are actually saying.
On Page 21 of the 2011 report they give us the following information:
| 2011 | 2010 | |
|---|---|---|
| Average hedged Price per ton $ | 870 | 786 |
| Percentage of estimated annual fuel requirement hedged for the next financial year | 91% | 90% |
So we know now, that they have hedged ~90% of ALL fuel requirements according to this and we know the price.-
On page 67 we can look at fuel costs (in GBP):
| 2011 | 2010 | |
|---|---|---|
| Fuel Cost | 122.8 | 95.3 |
On page 57 we can see the fair values of the fuel hedges, both an the asset and liability side:
| 2011 | 2010 | |
|---|---|---|
| Fair value Assets Forward jet fuel contracts | 55.9 | 16.4 |
| Fair value Liabilities Forward jet fuel contracts | -17.8 | -8.7 |
| calc net Fair Value | 38.1 | 7.7 |
| Delta yoy | 30.4 |
On page 58 we can see that in 2011, none of the fair value movements have been recorded in equity, we can also look at the total fair value movement of the ALL hedges (including currency) which were
| 2011 | 2010 | |
|---|---|---|
| Fair value Assets all hedges | 59.4 | 21.7 |
| Fair value Liabilities Forwardalll hedges | -24.7 | -9.7 |
| calc net Fair Vlaue | 34.7 | 12 |
| Delta yoy | 22.7 |
So basically, fuel hedges increased by ~ 30 mn GBP in vALue, FX hedges lost ~ 8 mn GBP
On page 61 they give us another interesting piece of information:
| 2011 | 2010 | |
|---|---|---|
| Impact on Profit and Loss 10% change in jet fuel prices | 3.8 | 0.8 |
| 2011 | 2010 | |
|---|---|---|
| Profit for the year | 17.3 | 15.6 |
| Exchange differences on translating foreign operations | 0 | 0 |
| Effective portion of fair value movements in cash flow hedges | 23 | 10.6 |
| Net change in fair value of effective cash flow hedges transferred to profit | -1.8 | 0.1 |
| Taxation on components of other comprehensive income | -5.2 | -3 |
| Other comprehensive income and expense for the period, net of taxation | 16 | 7.7 |
| Total comprehensive income for the period all attributable to owners of the parent | 33.3 | 23.3 |
One important final piece of information:
Prepayments or “deferred income” stood a 177 mn GBP against trailing sales of 540 mn GBP.
So how to interpret those numbers ?
A) as the hedges seem to qualify almost completely as “cashflow hedge”, we can assume that they use “traditional hedges” like forwards or (tight) collars to hedge
B) IMPORTANT: Dart Group “hedges” 90% of next years fuel prices, but only 177/540 = 32% of (trailing) sales are prepaid. So one could argue that in order to “truly” hedge, Dart should only hedge a third of next year’s fuel consumption as for the rest, the final sale price of the tickets is still variable.
If the competitors don’t hedge, than Dart would have locked in potentially different fuel prices than the competition for 60% of next years fuel consumption and therefore run the risk of being uncompetitive if fuel prices fall.
So coming back to the initial question: What are we going to do with the change in value in OCI for dart Group ?
I have to say I am not sure anymore. I am oK with “ignoring” the part that is covered by deferred income but I honestly don’t know what to do with the part which is “speculation”.
I have quickly checked Ryanair’s latest statements and Easyjets last annual report.
While Ryanair similar to Dart seems to hedge 90% of next years fuel cost, Easyjet only hedges 65-85% of next years fuel charges and 45-65% of the costs in 2 years time.
Ryanair interestingly said that increasing fuel prices were responsible for a 29% profit decline. That sounds strange as they were supposed to be 90% hedged. Interestingly, fuel prices for Jet fuel decreased strongly in Q2, so the problem for Ryanair seem to have been locking in high fuel costs whereas some competitors were able to buy cheaper fuel in the spot market and compete better on ticket prices.
Bloomberg even compiles hedging ratios across companies:
Jet Fuel Hedging Positions for Europe-Based Airlines (Table)
2012-07-30 07:46:25.103 GMT(Updates with Ryanair.)
By Rupert Rowling
July 30 (Bloomberg) — The following table shows the amount
of jet fuel consumption hedged by European airlines to guard
against price fluctuations.
Data is compiled mainly from company statements and is
updated as it becomes available. Hedges are for prices per
metric ton of jet fuel, unless otherwise stated.*T
Company/ Percent Hedging Period Price
Disclosure Date Hedged
————— —— ————– —–Ryanair Holdings Plc
7/30/12 90% July to Sept. 2012 $840
7/30/12 90% Oct. to Dec. 2012 $990
7/30/12 90% Jan. to March 2013 $998
7/30/12 90% April to June 2013 $985
7/30/12 90% July to Sept. 2013 $1,025
7/30/12 90% Oct. to Dec. 2013 $1,005
7/30/12 90% 2013 $1,000
7/30/12 50% Jan. to June 2014 $940EasyJet Plc
7/25/12 85% Three Months to Sept. 2012 $983
7/25/12 79% Year to Sept. 2012 $964
7/25/12 77% Year to Sept. 2013 $985Air Berlin Plc
5/15/12 82% April to June 2012 Not Given
5/15/12 92% July to Sept. 2012 Not Given
5/15/12 61% Oct. to Dec. 2012 Not GivenInternational Consolidated Airlines Group SA*
5/11/12 80% April to June 2012 Not Given
5/11/12 69% July to Sept. 2012 Not Given
5/11/12 55% Oct. to Dec. 2012 Not Given
5/11/12 55% 12-month forward Not GivenVueling Airlines SA
5/10/12 76% 2012 $1,023
5/10/12 71% April to June 2012 $1,008
5/10/12 83% July to Sept. 2012 $1,035
5/10/12 74% Oct. to Dec. 2012 $1,042
5/10/12 28% 2013 $1,027Air France-KLM Group
5/4/12 60% April to June 2012 $1,081
5/4/12 53% July to Sept. 2012 $1,081
5/4/12 50% Oct. to Dec. 2012 $1,078SAS Group
5/3/12 50% April to June 2012 Not Given
5/3/12 49% July to Sept. 2012 Not Given
5/3/12 48% Oct. to Dec. 2012 Not Given
5/3/12 50% Jan. to March 2013 Not GivenAer Lingus Group Plc**
3/29/12 62% 2012 $972
3/29/12 7% 2013 $991Deutsche Lufthansa AG
3/15/12 74% 2012 $107/barrel
(Brent crude)NOTES:
*Hedging breakeven for 2012 at $1,003 a ton, according to May 11
presentation.
**Aer Lingus figures as of Dec. 31
Summary:
To be honest, I am not sure what to do with the fair value movements in OCI. To simply ignore them and assume mean reversion would be very naive. The extent of the movements is just too large. However the impact of the fuel hedging is difficult to estimate as it depends on the behaviour of the competitors.
In general, a positive movement in fair value should be positive for the company and vice versa. nevertheless, the whole fuel hedging issue exposes Dart to quite substantial business risk, especially for the part which is not covered by deferred income.
However, this exercise made it clear to me that running airlines is a quite difficult business, especially in times of volatile fuel prices.
For the time being, I will stick with my half position and try to learn more about it.
One technical remark with regard to hedging:
In the “good old times”, fuel hedging could be done without cash collateral. A bank would happily “step in between” the airline and the futures market and only require cash at settlement of the contract.
As one of the consequences of the finanical crisis, every bank now requires cash collateral on a short term basis from the airlines for the fuel hedging contracts. For the airlines this means a significant increase in reuqired working capital. Lufthansa et al are lobbying strongly against this, but especially for smaller carriers this is a problem.
As a proxy I would use 25% of the notional as working capital requirement for fuel hedges. For Dart this would mean that 25% of around 150 mn GP or 40 mn GBP of Dart’s liquidity should be considered as “locked” for fuel hedging cash collateral.
Why comprehensive income matters – Dart Group Plc
I have mentioned a couple of times that in my opinion, the so-called “comprehensive income” is a much better indicator for shareholder wealth created than net income or earnings per share.
In my experience, almost no one cares to look at what happens after the net income line. Usually, comprehensive income is stated on a separate page anyway.
A good example to turn this into an interesting practical exercise is the most recent preliminary annual report from Dart Group, one of my Portfolio holdings
The first thought is of course “Yippie yeah”, a really significant earnings increase, P&E of 4 etc etc.
Richard Beddard at the excellent Interactive Investor blog even says the following:
The highest earnings yield ever calculated by the Human Screen is 35%. It’s so high, he’s wondering if air line and road-haulier Dart has bust his value yard-stick.
Highlights
Adjusted operating profit up 9%
Adjusted return on tangible assets: 4%
Net profit of £23m compared to net cash flow of £95m (£48m after net capital expenditure)
Net cash after approximate capitalised lease obligations of £125m is £34m, 5% of tangible assets
Per-share dividend up 7%
Not so fast. I guess that Richard stopped at page 9 of the interim report and didn’t bother to read that strange stuff at page 10 which looks as follows:
So we have additional items which significantly decreased shareholders equity but didn’t need to be recorded in normal earnings but comprehensive income. In this case we are looking at fuel hedges.
Items which can be recorded in comprehensive income are:
- Unrealized holding gains and losses on available for sale securities ( a trick often used by banks and other financials)
- Effective portion of gain or loss on derivative instruments (cash-flow hedge);
- Foreign currency translation adjustments (i.e. change in value of a foreign subsidiaries net asset value)
- Minimum pension liability adjustments.
Normally people would argue that those items are “non operating” and therefore not or less relevant. However, as it affects shareholder value, in my opinion it is very important to look at those item to determine real value creation for the shareholder.
Coming back to Dart Group: The fuel hedging is an essential part of the business model. Fuel costs are around 20% of sales and cannot be passed directly too customers, especially for the prepaid part. I will have a separate post on how to interpret the fuel hedges but for now the important point is:
The result of the fuel hedges should be treated as part of the normal business of Dart Group.
Therefore real 2011/2012 earnings for Dart are rather around 9 pence per share and not the 16 pence recorded in the income statement. Still cheap (PE of 9) but not “busting any value yardstick”.
Summary:
Any value investor interested in the total value creation of a company for shareholders should include all items of the comprehensive income statement into his valuation. Many companies are very good in shifting all unpleasant stuff into this section. Especially for financial companies, recorded earnings are more or less meaningless without the items in comprehensive income. Also fuel hedges for airlines or other fuel cost eexposed companies should be viewed as relevant.
Game Over Bei Sino Forest – Gedanken zu Shortselling & Auswirkungen auf Value Investoren
Letzte Woche hatte die Kanadische Börsenaufsicht quasi “den Stecker gezogen” bei Sino Forest.
Ich hatte ja diverse Male darüber berichtet. Was den Fall besonders interessant macht ist die Tatsache, dass wirklich bekannte Investoren sich hier die Finger verbrannt haben.
John Paulson, bei dem es dieses Jahr eh nicht gut läuft ist ja immerhin direkt nach dem Muddy Waters Bericht ausgestiegen.
Daraufhin meinte z.B. die große Fondsgesellschaft Wellington und ein Australischer Milliardär namens Chandler, dass sie schlauer sind und hatten trotz der recht begründeten Vorfälle erst richtig aufgestockt.
Interessant auch die bei Zerohedge veröffentlichte Liste der Analysten Ratings, wo doch auch einige namhafte Analysten noch sehr positiv gestimmt waren:
Kommen wir nun zu den Shortsellern. Den Stein ins Rollen gebracht hat ja Carson Block von Muddy Waters mit einem Bericht vom 2. Juni.
Bis dahin gab es keine Anzeichen. Die “Beteiligten” bei Sino Forest sind alles Top Adressen. Wirtschaftsprüfer ist Ernst & Young, einer der Big 4, die Gesellschaft hatte ein Rating von S&P und Pöyry, eine namhafte international Agrar-Beratung hat die (Phantom-) Wälder bewertet und ein Aufsichtsrat ist immerhin auch Aufsichtsratchef bei Glencore.
Wenn das Ganze mal vorbei ist, werden alle Beteiligten wohl sagen, dass sie nichts dafür konnten und vom Management von Sino Forest betrogen worden sind. Vielleicht ist das auch so. Allerdings haben alle eines gemeinsam: Solange der Betrug lief, haben alle kassiert. Die Prüfer, die Berater, die Investmentbanker und auch der Aufsichtsrat. Solange die Gebühren fliessen, hat auch keiner ein Interesse unangenehme Fragen zu stellen.
Echte Konsequenzen hat das auch in den wenigsten Fällen. Bei den Chinesischen Firmen ist noch die Besonderheit, dass der lokale CEO in China nichts befürchten muss, für einen Betrug im Ausland wird meines Wissens in China niemand belangt.
Interessant ist es auch, wenn man mal die Motivation der Anleger nachvollzieht. Jemand der die Aktie gekauft hat, will ganz sicher auch nichts von Betrug wissen, sondern am liebsten seine Aktie mit einem dicken Gewinn an einen anderen (Nichstahnenden) weiter verkaufen.
Der einzige, der wirklich Interesse an der Aufdeckung eines Betrugs hat, ist nur der Shortseller. Er allein profitiert, wenn er einen Betrug aufdeckt und seine leer verkauften Aktien billig zurückkauft.
Für viele ist das “verwerflich”, weil er ja so quasi am “Leid der Betrogenen” verdient. Auf den ersten Blick stimmt das ja, aber auf den 2ten Blick sollte man sich vielleicht fragen:
- verhindert er denn nicht, dass noch weitere Leute betrogen werden ?
- was ist mit denen, die vorher die Aktie gepushed haben und ahnungslose Anleger durch Kaufempfehlungen zum Kauf verleitet haben ?
- sind da nicht auch viele Anleger, die bewusst zocken obwohl sie etwas vermuten ? Ist man schuldig wenn man weiss das es Betrug ist und seine aktien noch schnell an einen weiter verkauft der das nicht weiss ?
Shortseller sind immer die einfachsten Ziele wenn die Aktien fallen. Ganz besonders Bank CEOs sind ganz schnell bei der Hand, den bösen “Shorties” die Schuld zu geben. Von der Politik wird das auch immer dankend aufgenommen, Hauptsache man hat einen Schuldigen. Relaitv typisch auch die Forderung des Deutschen Wirtschaftsministers Rösler, der anscheinend innerhalb weniger Wochen vom Gesundheitsexperten zum Finanzmarktspezialisten mutiert ist.
Stabilität in den Finanzmärkten erzielt man m.E. nicht mit dem Verbot von Short Selling, ganz im Gegenteil. Das Problem sind ja die vorhergehenden Blasen. Wie wir am Fall von Sino Forest sehen, sind die Interessenlagen so gestrickt, dass trotz aller Kontrollen nur ein Shortseller eine echte Motivation hat, eine Überbewertung oder einen Betrug aufzudecken.
Zwischenfazit: Selbstverständlich sind auch Shortseller keine “edlen Ritter”, sie sind aber m.E. einfach nur Kapitalmarktteilnehmer wie viele andere, mit einer sehr sehr wichtigen Funktion. Ein Verbot von Short Selling würde vermutlich eher das Gegenteil von Stabilität bringen, weil sich dann der Blasenbildung kaum jemand entgegen setzen würde.
Für den Privatinvestor gilt meiner Meinung nach Folgendes:
- man darf sich keinesfalls auf bekannte Namen verlassen, egal ob auf Investorenseite, Analyse, Rating oder Wirtschaftsprüfer
- wenn etwas zu gut ist um wahr zu sein (3er KGV, riesiges Wachstum, Berge von Cash etc.) ist es meistens nicht wahr
- wenn man etwas nicht versteht und es nicht wirklich erklärt werden kann, ist die Gefahr groß, dass es nicht wahr ist
- schon leiseste Anzeichen von Unsauberkeiten im Accounting können jede “Margin of Safety” in einem Investment zu nichte mache
- als Value Investor kann man die Analysen von bekannten Short Sellern nutzen, um zu erkennen ob es prinzipielle Probleme in einem Unternehmen, Sektor oder Land gibt, die eine Margin of Safety gefährden.
- als Konsequenz sind für mich z.B. China Werte mit Auslandslisting grundsätzlich uninvestierbar, ganz egal wie billig die Werte optisch sein mögen
Fazit: Short Seller haben meines Erachtens eine sehr wichtige Funktion. Als Valueinvestor kann man deren Analysen gut verwenden um die “Margin of Safety” in den eigenen Investments kritisch zu hinterfragen
