Month: October 2019

Can we trust these numbers?

October 31, 2019 / / 0 Comments

A 2015 study published in the Journal of Accounting and Economics (Dichev, Graham, Harvey & Rajgopal) revealed that chief financial officers (CFOs) believe that 20% of firms intentionally distort reported profits. They estimated that CFOs, along with other executives, ‘low ball’ earnings (deliberately reduce reported profits) approximately 33% of the time and 67% manipulate earnings upwards when they elect to ‘cook the books’. That is very disturbing for those of us who analyze annual financial statements and rely on them for investment decision making. In fact, it should be worrying for all of us since we should be saving monthly and investing in unit trusts, retirement annuities and those sorts of things.

So how do CFOs manage to manipulate profits upwards or downwards quarterly, biannually and/or annually? Surely, the auditors would detect this? Unfortunately, accounting standards have become so complex that very few people understand them all. I pull my hair out at times, the few strands I have left, at the illogicality and complexity of certain accounting standards. I often joke in the classroom about a conspiracy theory about why accounting has become so opaque and intricate. There is a global body called the International Federation of Accountants (IFAC) head quartered in New York that issues accounting standards that its member bodies in 130 countries need to comply with. These accounting standards are either called International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS). IAS are the older statements and IFRS’ are slowly replacing these. The only people who really understand these standards are accounting university lecturers (their students are mostly baffled by these lengthy documents), the audit firms (hopefully), CFOs, global accounting institutes and IFAC itself. So my conspiracy theory is that these accounting standards have been issued so that auditors and consultants can charge a fortune to interpret them. Please forgive my wondering mind.

Please indulge me as I discuss how sometimes accounting standards are removed from economic reality and are really difficult to understand. IFAC introduced IFRS 16 Leases which is effective for all financial years commencing on or after 1 January 2019. IFRS 16 deals with the accounting for leases which are more than 12 months in duration  and cover assets which have a value of more than $5,000. I know some of you may be switching off at this stage but hang in there. Let me illustrate with a relatively simple, hypothetical lease agreement of office space:

  • Occupation date of 1 January 2019
  • Five year duration, lease terminating on 31 December 2023
  • Annual rental of R1,000,000 payable annually in arrear (in our collective dreams would landlords offer us terms such as these but this is a hypothetical example)
  • Annual escalation in rental of 5% from 2020

Now we would think this is a pretty simple transaction to account for. The rental payments due are set out below (hope I got the maths right) and the related accounting would surely be as simple as this:

Well, IFAC and its members decided that this accounting was too simple and allege that lease obligations are in fact interest-bearing debt instruments. All leases (except those of less than 12 months duration and low value items) need to be capitalized on the balance sheet (forgive me but I can’t get around to calling this a statement of financial position). From 2019 onwards, all companies that adopt IFRS need to present value future lease payments using their incremental borrowing rates (effectively the rate that their bankers would lend money to them in order to enter into the lease). Without getting too complicated, companies need to recognize a right-of-use asset and a corresponding lease liability (being the NPV of future lease payments) at the inception of the lease. The right-of-use asset is then to be ‘depreciated’ over the period of the lease and the lease liability is to be extinguished by the lease payments after adding hypothetical interest. Seems like the right thing to do? Assuming that a hypothetical company above entered into the above mentioned lease agreement and had an incremental borrowing rate of 10%, the net present value of the future lease payments would be R4,150,591. The accounting would go something like this:

You pay R1,000,000 in 2019 to use the office space but record an expense of R1,245,177.  In 2023, the actual lease payments amount to R1,215,506 yet the total expense recognized in the income statement will be R940,619. That makes sense (forgive my attempt at sarcasm). I have attached the Excel workings in case some of you wish to indulge in the deep dark world of IFRS workings. The balance sheets make even more sense (sic).


Pick n Pay recently released its results for the 6 months ended September 2019. Imagine the shock and horror when the CEO and CFO announced that interest-bearing debt had risen from R1.3 billion at February 2019 to R15.9 billion at the end of September thanks to their adoption of IFRS 16. So perhaps you have been enlightened about how these accounting scandals occur. The recipe is simple. Make the accounting rules very complicated and ensure that they require significant judgment by users in following them. Then add a human being (obviously an ethical one) to be the implementer of these rules and add the pressure of having to satisfy the market’s unrelenting appetite for increasing profits. Ensure that these results are then audited by 1st year clerks. The result is a world of pain for financial analysts.

So why do executives misstate profits or losses? The research referred to at the start of this blog revealed that the motivations to misrepresent economic performance included:

  1. To influence the share price, if the company was a listed entity
  2. Because of pressure to meet earnings targets due to both internal and external expectations
  3. To improve executive compensation (ouch, eina, bliksem)
  4. To avoid adverse career consequences if poor performance is reported
  5. To avoid a breach of debt covenants in place with the bankers

So how do we mere mortals detect these incidents of accounting manipulation? We can learn from past experience, as painful as that it. When financial statements become unfathomable due to descriptions of items called brand income for a furniture retailer (think Steinhoff), be scared. When the group changes its financial year-end every 18 months (think Steinhoff), be terrified. When the group keeps acquiring every moving target beyond our beautiful shores (think Steinhoff), be alert. When the group revalues its sugar cane plantations without providing the underlying assumptions (think Tongaat) and records these upward adjustments as profits before a sliver of sugar cane has been harvested, be sceptical. Other warning signs could include:

  • Profits and cash flows do not correlate (profits are up but cash generated is consistently much lower or even negative)
  • Financial results are unrelated to industry norms or economic conditions (eg. revenue growth of 25% whilst the rest of the economy is bleeding)
  • The group consistently meets or beats market expectations re financial results
  • Frequent once-off items such as restructuring costs, impairments and gains on disposal of assets
  • Earnings results are just too smooth such as General Electric which under Jack Welch’s leadership, delivered 100 consecutive quarters of earnings growth. That is surely a statistical impossibility.

Be grateful if you never invested in Steinhoff or Tongaat. All the best from BeechieB.

Simple lease accounting example

A house of cards or a viable real estate business model?

October 16, 2019 / / 1 Comment

Imagine this story. A kid grows up on a kibbutz in Israel where the sense of community is indoctrinated from a young age. The boy leaves school and goes to the Israeli army for 5 years before moving to New York. The young man enrolls at university and drops out to start three ‘failed’ businesses in rapid succession. The one failed start-up called Krawlers, which made baby clothes with pad inserts to make crawling more comfortable, was innovative but failed to gain much traction. Fast forward to 2010 and a co-sharing workspace company is founded in New York. Ten years later the group had 528 co-sharing offices in 111 cities globally and was valued at $47 billion pre the IPO. That’s the story of Adam Neumann and WeWork. An extraordinary tale of ambition and rapid scaling of a business model (which is hardly unique or disrupting).

How did WeWork manage to grow so rapidly over ten years? The playbook follows many other unicorns (private companies worth more than US$1 billion). First, you need to define a potential market for your goods or services that is ready for disruption (co-sharing office space) and ensure that this is really big. WeWork in its draft IPO 2019 prospectus defined the potential market as offices in 280 cities globally and the potential demand for its services as US$3 trillion (that’s US$3,000,000,000,000). Secondly, ensure that the founder and CEO is larger than life, a little crass and super arrogant (watch some Youtube videos of Neumann and you will notice a messiah like character with long hair and who has every answer and fact on the tips of his fingers). Thirdly, create a vision that is going to change the world as we know it. WeWork did this brilliantly by enunciating in its prospectus that its mission is to “…elevate the world’s consciousness…”. To scale a business such a WeWork you need serious money. That’s step 4. Neumann managed to convince numerous investors to invest billions into enabling WeWork to fulfill its mission. At last count, Softbank alone has invested ±US$10.6 billion in WeWork. Step 5 involves growing without consequences (worry about profitability later since profitability and growth are conflicting goals). Add in a bit of fun in the workplace like free beer on tap and compulsory tequila down downs after announcing retrenchments. Seems to be a winning strategy?

So what is WeWork’s business model in a nutshell? It’s quite simple actually. Lease office space in suitable locations on a long-term basis. Renovate the office space to attract millennials, centennials and some major corporates. Rent office space on a short-term, flexible basis to credit worthy tenants (WeWork’s average tenant lease term is apparently 15 months). Provide extraordinary service (coffee, refreshments, boardroom facilities etc.). I know the business model since I lease space in a co-sharing environment. It makes economical sense for me. I don’t have to commit for more than 12 months at a time. I don’t have to invest in office furniture, printers and shredders and have access to really interesting meeting rooms (one in particular has no chairs and I can write on the wall during meetings). I also get to hear some pretty interesting conversations during the day. Some humans cannot resist talking loudly whilst sharing intimate details of their existence.

WeWork in its prospectus strongly disagrees with my assessment of their business model. I had to read the entire prospectus, which by the way is 383 pages long, in case I missed a valuable life lesson. Some excerpts from this document…

“..we pioneer a space-as-a-service membership model…”

“…we are changing the way people work globally…we have disrupted the largest asset class in the world – real estate…”

“…technology is the foundation of our global platform…”

Reviewing WeWork’s historical financial performance and position is horrifying (refer attached for my Excel workings WeWork (Oct 2019). The business is losing money hand over fist. It reported revenue of US$1.8 billion in the financial year ended 31 December 2018 (FY2018) and seems on track to breach the US$3 billion mark in FY2019. Unfortunately, revenue growth has come at a huge cost namely; operating expenses of US2.7 billion in FY2018.

So why did potential investors baulk at WeWork’s proposed IPO valuation? I think there were four main reasons:

  1. The market has become weary of fast growing businesses which incur enormous losses with no regard for return on capital or cost containment. Think Uber, think WeWork.
  2. The market expects some degree of corporate governance and ‘doing the right things’. WeWork’s governance is shocking to say the least. Neumann has no employment contract with WeWork yet is the CEO. He had special voting rights to enable him to potentially control the company forever. Some of the executive titles are bizarre (apologies but I am ‘old school’). Neumann’s wife Rebekah (who is Gwyneth Paltrow’s cousin) was the Chief Brand and Impact Officer of WeWork. The co-founder of WeWork, Miguel McKelvey, is the Chief Culture Officer. Adam Neumann in the past acquired properties and then leased them to WeWork. In FY2018, WeWork paid rent to Neumann’s entities of US$11.6 million. Neumann has on numerous occasions in the past obtained low interest loans from WeWork. It came as no surprise that the WeWork prospectus revealed that the company “…may elect not to comply with certain corporate governance standards, such as the requirement that our board of directors have a compensation committee and nominating and corporate governance committee composed entirely of independent directors…”. Oh my goodness, does that mean the Neumann could sit on the compensation committee which decided on his salary and benefits?
  3. Property companies are subject to the vagaries of the economy. In good times, buildings are full and all is swell. In bad times, occupancies drop and some property companies go out of business. WeWork is not exempt from these market forces. In fact, its business model is even riskier. WeWork leases property from landlords for on average 15 years and then leases them to its tenants for an average of 15 months. That mismatch is cause for great concern in recessionary times. WeWork burnt US$2.5 billion of cash in the first 6 months of 2019 in its growth trajectory. To continue this, it will need to continue borrowing or stop expanding. Imagine the happy ending when the banks stop lending to WeWork and the USA economy enters a recessionary phase.
  4. The market has become less enamored with white male dominated unicorns who have faint regard for ‘rules’ that the rest of us have to abide by. There seems to be a lack of moral compass by some of these billionaire CEOs. Adam Neumann reportedly hired a private jet to transport him and his friends to Israel for a jaunt recently. The jet owner ordered the plane to return home immediately after the staff discovered enough dope on board to elevate the potential indiscretion from casual use to industrial dealing.

Take care out there. Regards from BeechieB.

 

 

Gini out of the bottle…

October 2, 2019 / / 19 Comments

Let’s go where angels fear to tread and talk about executive compensation. Back in the early 2000’s listed companies in South Africa started disclosing the remuneration earned by their directors. At the time, I publicly stated that this was a very bad idea. My contention was that once executive remuneration became public knowledge, the average chief executive officers (CEOs) salaries would rise towards the level of the most highly paid executives. Previously, this information was not in the public domain and it was very hard for CEOs and other executives to claim that they were underpaid relative to their peers.

Executive compensation is a very emotive topic globally as it highlights income inequality. Statisticians calculate relative income inequality using the Gini coefficient. A Gini coefficient of 0 represents perfect income equality whereas a coefficient of 1 represents the maximum inequality. South Africa tops the world rankings in Gini coefficients at around 0.63 according to the World Bank. Interestingly, Ukraine has the lowest Gini coefficient at around 0.25. I find that odd since Ukraine is known to be a poor European country. Perhaps most Ukranians are relatively poor so everyone is pretty much in the same boat?

Getting back to South Africa, income inequality is a sensitive and emotive issue for those in employment. Unfortunately, many South Africans are unemployed. Stats SA in its Q1 2019 quarterly labour force survey revealed that the unemployment rate had increased to 27.6%, or 38% if one includes discouraged workers (unemployed people who did not actively seek employment). This is tragic and hopefully, our government, and business generally, takes on the  challenge to create jobs and uplift its citizens. Anyway, I am digressing.

The pay ratio (comparison between what the CEO earns versus the average salary of all employees in a company/group) has been rising globally over the past decades, particularly in the USA.

The average CEO of a listed company in the USA earns more than 300 times that of the average worker according to Bloomberg! PWC publishes a research report into remuneration trends and practices  called the ‘executive directors report’. The pay ratio in South Africa currently varies between 12.8 and 66.9 times per PWC. Well I guess that’s below the USA stats but it is still a very large gap. Eskom’s pay ratio is one of the lowest at around 11 times – the Eskom CEO earned R8.6 million in the financial year ended March 2019 whilst the average employee’s salary was an astonishing R785 600.

PWC further reported that the median (the midpoint in a range as opposed to an arithmetical average) total guaranteed package earned by CEOs of JSE listed companies was R5.5 million in 2018. Thats not too shabby but also does not seem out of kilter. There are currently 365 listed companies on the JSE and the range of CEO pay varies mainly according to the size of the group. Which reminds me of a true story some years ago. I was lecturing (an outdated concept these days at business schools) to MBA students at Wits Business School on the topic of mergers & acquisitions (M&A). I invited a friend of mine to address the class on his experience in M&A. Anyway, Terry gave a rock star performance and entertained the class. At the end of his presentation, he asked the class for their takeouts from the session. The MBA students made me proud by identifying all the good stuff one should know about M&A. Terry admonished them and said that M&A was actually all about executive pay – the bigger the group you manage, the more you get paid! I can still recall the laughter that followed that statement. But perhaps there is some truth in that.

Executive compensation becomes even more contentious when things start to go wrong in corporates. Some examples:

  • Markus Jooste, the ex-CEO of Steinhoff received compensation of R578 million, including the fair value of share options, over the financial years (FY) ended 2012 to 2016. Steinhoff has subsequently been devastated by accounting irregularities and its market value has declined by more than R250 billion. No wonder Steinhoff has instituted a civil claim against Jooste to repay R858 million, being the salary, bonuses and the value of share options he earned over the period 2009 to 2017.
  • Peter Staude, the retired CEO of Tongaat Hullet, reportedly earned compensation of around R176 million over the decade prior to his retirement in 2018. The subsequent revelation of accounting funnies has destroyed over R8 billion of shareholder value;
  •  Steve Cornell and Bongani Nqwababa, the joint CEOs of Sasol, collectively earned R72 million in FY2018 despite the massive cost overruns and project delays in the Lake Charles project! (Note to self, never invest in a company which has joint CEOs)
  • Ian Moir, the CEO of Woolworths, earned R146 million over the past 5 financial years despite the disastrous acquisition of David Jones in Australia.

I have compiled and updated a case study on Woolworths’ acquisition of David Jones in 2014 and what subsequently transpired on numerous occasions over the years. In short, Woolworths’ market value on the JSE was just under R66 billion in June 2014. It completed the acquisition of David Jones for AUD2.1 billion (±R21 billon at the time) in August 2014 and raised a further R9.9 billion from its shareholders to partially pay for the acquisition. With insight, Woolworths swallowed a lemon as David Jones has significantly underperformed post acquisition. But that’s a series of blogs on it own. Woolworths’ shareholders have taken a beating over the past 5 years – best illustrated in the graph below.

Executive compensation is public knowledge, so let’s compare the CEO remuneration of some of South Africa’s banking groups:

  • Gerrie Fourie, CEO of Capitec, earned R95 million in total in FY2019 – that’s a whopping R286,145 a day assuming that he did not work on public holidays and was granted 21 days annual leave
  • Sim Tshabala, CEO of Standard Bank, earned R59 million in FY2018
  • The CEO of Nedbank, Mike Brown, earned R53 million last year
  • Alan Pullinger, CEO of Firstrand, earned R45 million in FY2018
  • Maria Ramos, ex-CEO of ABSA, lagged the pack at R30 million of remuneration

I have interacted with three of the above individuals in a business context over the past 25 years. I can assure you that they are good people who are incredibly competent. However, I think executive compensation levels are out of kilter with what is happening on the ground for most South Africans. We have far too many unemployed people.  We have far too many people reliant on inferior quality healthcare and education. It’s just my opinion.

Take care and be grateful.

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