FAKE PROFITS

The following article first appeared in its original form in the 30 June 2012 investment newsletter of Lighthouse Advisors. Those who wish to investigate the companies discussed should refer to the individual companies’ announcements and the external reports cited for relevant information.

No part of this foreword or the article below is to be construed as investment advice. The article is reproduced for informational purposes only, and the author accepts no responsibility for any inferences drawn or actions taken as a result of the article. Any opinions expressed therein are the personal views of the author and do not constitute a professional opinion for any purposes whatsoever. At the time of this writing, Lighthouse Advisors is a “long-only” fund manager and holds no long or short interest in any of the companies discussed.

Benjamin Koh

Investment Manager

Lighthouse Advisors

14 August 2012

Benjamin Koh, Investment Manager, Lighthouse Advisors

Profits are what businesses are supposed to be about. Shareholders start, build and continue to own businesses, in order to make profits. But all companies are not equal.

Profit margins differ among industries and to a lesser extent among companies in the same industry. If margins are too low, the company is reliant on debt to expand. If margins are too high, it attracts competition.

Importantly, if the profits are real, the company can pay cash dividends.

While some shareholders may prefer that a company reinvest its earnings to create future wealth for shareholders, the sad reality, as noted by Benjamin Graham in The Intelligent Investor, is that few companies are able to reinvest such profits to earn the same rate of return as the existing business.

Besides assuring shareholders of a minimum return on their investment, a cash dividend also serves as useful, albeit partial, proof that the company’s reported earnings are real.

If the profits are real, the margins will also be similar to that of competitors – after all, with the same capital inputs, the same workforce, the same customers, and the same selling price, the profits must also be the same. Few companies are so unique that they have no competitors and can set any price they wish.

So what happens if the profits are fake?

Generally, if the profits are fake, it is because the reported profit margin is too high. This can be detected in a peer comparison with the company’s direct competitors, or similar businesses operating elsewhere in the world. Given today’s globalized economy, very few companies will leave a region alone if it is seen that a peer is making good profits there. Thus, excess profits are unlikely to persist, and over time profit margins go back to normal i.e. there is reversion to the mean.

Because profits and losses from the income statement are reflected in the balance sheet, fake profits will also show up on the balance sheet, often in the form of imaginary cash balances.

The problem here is that cash is a transparent and easily auditable item, which makes it a prime focus of auditors. Blatant fraudsters may of course collude with bank officials to produce fake statements to fool the auditors.

However, even if the auditors are fooled, as cash apparently builds up on the balance sheet, it becomes increasingly more difficult to fend off minority shareholder demands for cash dividends, or at least a repayment of outstanding debt.

One way to avoid having to show the cash to the auditors is to not collect it in the first place. This then causes the trade receivables account to swell. This topic was discussed 3 years ago in the June 2009 newsletter, so it will not be discussed further here.

If one does pretend to collect the cash, then the logical progression is to use up the fake cash on items which are harder to evaluate than cash. Popular choices include inventory, machinery, supplier prepayments, intangible assets and even other companies.

Inventory, specifically finished goods, can be a useful place to dump fake earnings, as finished goods comprise a mix of different costs such as raw materials, capital and labour. This creates more work for auditors, who are not interested in dissecting the business to figure out the true cost of finished goods. In a retail business, the stock is also scattered across hundreds if not thousands of stores. So a retail company can dump fake earnings here and be fairly confident that the auditors are not going to do a thorough stock-take.

For example, Ports Design, a luxury apparel brand, has reported very high profit margins for the past 10 years. One would expect that Ports would then be sitting on a huge cash hoard. Instead, Ports has opted to plow much of its earnings back into inventory, to the extent that since the end of 2009, its inventory holdings have represented more than 18 months of sales.

But apparel, by its nature, goes in and out of fashion. Therefore, stock cannot normally be kept from season to season. It must be sold before the end of the season, lest it becomes unfashionable and hence un-saleable. Keeping stock beyond the season essentially means keeping it for one full year, until the next season. This is suicide in the fashion business, but Ports seems determined to commit it.

A comparison with luxury brand owners around the world, such as Hugo Boss, Burberry, Hermes, LVMH, and Prada, shows some red flags.

First, none of these brands, which are arguably far better known than Ports, have margins in common with Ports. Their gross margins in the last 3 years are similar to each other at about 60-70%, but materially lower than the 80% reported by Ports.

Second, none of these brands keep as much stock as Ports. The norm seems to be 5-8 months of sales, with the longest being LVMH at about 10 months. LVMH at least has the excuse of having a significant leather goods business, and bag fashion changes more slowly than apparel, so higher stock levels could be acceptable. Ports, however, has no leather goods division.

So while there is no “smoking gun” evidence that Ports is making up their profits, it seems highly likely that their inventory levels are overstated. Their inventory may well be overvalued, or some of it may simply be nonexistent. Either that, or their products are truly timeless classics which can be safely hoarded in stores and warehouses, and sold years later at full price. This seems unlikely.

Another dumping ground for fake earnings is plant, property and equipment (PPE). Auditors are seldom experts at valuing industrial equipment. As long as the cash payment matches the invoice, they may well accept the purchases at face value.

But companies may overpay for equipment in order to “use up” fake profits. A related party (whether disclosed or not) can act as a purchasing agent to buy equipment and mark it up for resale to the company. The equipment supplier gets their normal price, while the agent absorbs the difference i.e. the fake cash. Thus, the company is able to remove the fake cash from its accounts.

How would one detect such shenanigans? One way is to track the amount of PPE required to generate the reported sales.

Industrial operations tend to scale linearly. Short of a massive technological leap, to get 10 times the output you need 10 times the machinery. Thus, for an industrial company, the amount of PPE on the balance sheet should correlate very closely to the level of sales. If it does not, something odd may be going on.

The final example will cover the use of fake profits in acquisitions. For this we can thank Anonymous Analytics for their exposé on Huabao International.

Huabao is a producer of fragrances. It claims to be the market leader in supplying to China’s tobacco industry. Its gross profit margins have been most impressive, averaging 70-80% in the past 5 years. These are materially higher than the international flavours giants Symrise, Givaudan, and International Flavours and Fragrances, who post 40-50% gross margins.

Anonymous’ report, titled Smoke and Mirrors, was published on 24 April 2012. The 44-page report delves into the inner workings of Huabao and offers convincing evidence that in several of its acquisitions, Huabao overpaid substantially.

A full discussion of Anonymous’ findings would be too involved; interested readers should refer directly to the report. However, the point (among others) that Anonymous makes is that in terms of price/earnings ratios, when Huabao bought businesses from its owner-chairwoman i.e. in related party transactions, it consistently paid much more than for acquisitions from third parties. This is similar to the case of overpaying for PPE in order to use up fake cash, except that entire companies are involved.

In summary, investors who study financial statements should check for internal consistency. Profits from the income statement will appear in the balance sheet – and if some items show unusual patterns, it may be a warning that all is not well. Losses avoided by skipping companies with suspicious financial statements may well prove more important than the profits foregone by missing out on winners.

Previous article by Benjamin Koh: "Can cash be faked?"