Tesco is in news a lot lately for all the wrong reasons: financial shenanigans from early recognition of commercial income and delayed recognition of related expenses.  What is also coming out now is how much Tesco in the past used off-balance sheet financing (special purpose vehicles (SPVs) and sale and leaseback arrangements) to artificially reduce its debt - i.e. hide its true debt picture from investors - even though it was either required to make guaranteed lease payments or buy properties back.

Background

Between 2009 and 2013, Goldman Sachs helped Tesco execute a sale and leaseback plan which used 6 SPVs to issue around £4bn worth of property bonds. Analysts think the effect of this off-balance sheet financing has been to artificially reduce Tesco’s net debt by around £2bn.

Between 2009 and 2013, 6 SPVs — Tesco Property Finance 1 through 6 — issued around £3.6bn of 30 year bonds to investors. These SPVs are not Tesco subsidiaries, although Tesco is contractually obliged to cover interest and principal payments.

Structure

For each transaction, Tesco established limited partnership to which it sold package of properties, which it leased back for 30 years with annual rent increases linked to the retail price index (RPI). 

Purchase was financed by issue of 30-year bonds by SPV, which loaned proceeds to partnership. 

Bonds and partnership loan have identical, back- to-back terms, with same fixed interest rate and repayment schedules. 

To solve cashflow mismatch between RPI-linked rents paid by Tesco to partnership, and fixed payments due on bonds, partnership and SPV, and SPV and Tesco entered into back-to-back swap arrangements. Netting off various swap and other payments, Tesco receives amounts equal to rental income and pays to SPV amounts equal to interest and principal repayments on bonds. 

Rent payments are completely circular: Tesco pays rent out of one pocket to partnership and receives it back (via SPV) in another. In simple terms, Tesco receives bond proceeds and repays interest and principal; bond investors look to Tesco as source of all bond payments, while underlying property leases are, in effect, irrelevant.

These bonds don’t appear on Tesco’s balance sheet, being treated as regular operating leases instead. But even here, disclosure is limited. While leases have 30-year term, Tesco has break option after 10 years if it buys back the properties – so it only has to disclose minimum future lease payments up until that point. And because Tesco only has option to buy back properties — and is not required to do so — cost of buying back properties is not treated as an obligation either. 

Tesco has choice between 2 obligations: (1) Buying back properties or (2) paying rent.  Yet Tesco's off-balance sheet financing allowed it to avoid recording either obligation by saying both are options.  There is only one true option, to recognize the lower of the 2 values at your liability exposure.  Tesco failed this test.

From 2010, Tesco had regular wording buried in its annual report setting out the above — until this year, when it added:  "
Current market value of these properties is £5.4bn (2013: £5.2bn) and total lease rentals, if they were to be incurred following option exercise date, would be £4.2bn (2013: £4.1bn) using current rent values.  

Discounting £4.2bn back to present value increases Tesco’s total debt by £2bn.

How many times until leaders learn off-balance sheet financing is a paper allocation exercise which simply serves to mask the true transparent situation of the company.  Rarely is it really off-balance in the send the liability does not belong to the company itself in the end.

Ultimately, when leadership of a company becomes more focused on managing numbers, they lose focus on managing to take care of customers.  Result is a company in double whammy trouble:  The business suffers as it loses touch with satisfying customer's needs who defect to competitors and the financial situation turns out to be worse than everyone saw on paper.

Sources:
http://ftalphaville.ft.com/2014/09/22/1979462/tescos-off-balance-sheet-wheeze-courtesy-of-goldman-sachs/
http://discount-investing.com/2014/08/26/tescos-hidden-debt/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Anticipating when players will move on is essential part of recording revenue in mobile-game industry, where sale of “virtual durable goods,” such as cows and tractors in “FarmVille” or cannons and dark barracks in “Clash of Clans” is major source of income.  When game companies change assumptions it can skew short-term results.  

Virtual goods for single use, e.g. potions and spells, are accounted for as one-time sale.

Virtual durable goods are continually available to the player. E.g. superhero character or tractor, depending on game.  These are accounted for like services or club memberships. Companies book part of payment upfront, but defer rest until end of average period in which item will be used—whether 4 days or 14 months.

If people lose interest in a game and play for shorter periods, it drives faster revenue recognition. Shorter playing period is negative for business, but drives higher revenue.

Game makers base their estimates on historical data, but playing periods can change substantially each year, especially for newest and more popular games as players are fickle. 6 of top 10 revenue generating games in September 20914 were not on last year’s list, according to data tracker App Annie. And a mall percentage of players account for bulk of purchases (as expected using Pareto's 20-80 rule).

Companies making similar games might make different choices in booking sales and costs, which can make it difficult for investors to compare.

Ironically, analysts get around confusion by looking to performance benchmarks that do not follow US GAAP accounting rules.  Analysts at bookings more than revenue. Bookings include all cash paid for any virtual item, consumable or durable, and independently of whether those items have been used or not.   Bookings are realized right away, and people really focused on that metric as measure of health of the business.

Source: http://online.wsj.com/articles/how-mobile-games-makers-account-for-magic-wand-sales-1415670273

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Background

• Suntech Power Holdings was forced to put its Chinese solar unit into bankruptcy in March 2013
• The slide into insolvency began in 2009 when customers linked to the company's founder were not paying their bills and yet the company booked the sales as revenue anyway
• Suntech suffered a €60m (US$720m) fraud resulting in a US$541m bond default

Missed Red Flags

• Suntech was booking revenue from sales to related companies with unbuilt projects in a fledgling industry - solar.
• Suntech guaranteed loans to those related companies. 
• Suntech relied on a former sales agent to secure one guarantee with bonds it never saw or verified actually existed.
  
• Suntech had uncollected bills from related-company projects exceeding sales from those companies by a widening margin. Receivables were US$44.7m in Q1 2011, against US$33.6m in revenue booked from the companies. Sales dried up in later quarters and uncollected bills remained.
  
• Suntech’s vehicle for investing in new solar projects in the credit crisis was Luxembourg-registered Global Solar Fund, run by Javier Romero, who was once Suntech’s external sales agent in Spain. Romero persuaded Shi to commit 258 million euros to Global Solar Fund beginning in 2008, eventually giving Suntech an 86% equity stake.  Shi himself committed €32m for almost 11% of the fund. Suntech wound up with 79% of the fund after giving part of its stake to Romero as an incentive payment.  Global Solar Fund invested in 7 solar projects, mostly in southern Italy. They became the Suntech customers that had difficulty paying their bills. One of them, Solar Puglia II S.ar.L, required the guarantee of a €554.2m bank loan from China Development Bank.  Suntech told the SEC that Global Solar Fund backstopped the guarantee with €560m of German government bonds.  Romero assured Suntech that the bonds could be sold at any time to pay China Development Bank if the project defaulted on its debt, Suntech wrote to the regulator. Trouble was: The German bonds Romero promised as a backstop never existed, Suntech said in December after looking for them for four months.
  
  

How did people miss this?  They did not check the SEC files and correspondences available online.  

The SEC’s first letter to Suntech was in November 2005, and its latest was April 2011. All of its letters were available to the public by mid-June 2011. There were about 38 equity analysts covering Suntech as of July 1, 2011, of whom 31 recommended either holding or buying the stock, data compiled by Bloomberg show.

Source:
"Suntech Unit Bankruptcy Had Roots in Deadbeat Customers", Bloomberg, April 4, 2013
http://www.bloomberg.com/news/2013-04-02/suntech-unit-bankruptcy-had-roots-in-deadbeat-customers.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

S&P estimates China will need more than $8 trillion for refinancing during the five years ending 2017, accounting for half of such needs in the Asia-Pacific region.  

Bloomberg data shows borrowers from Hong Kong and China have sold 7x more bonds to repay existing debt this year than in the first five months of 2012. 

Bright Food Group Co., which has operations from dairy to wine, issued US$500 million of securities maturing May 2018, according to data compiled by Bloomberg. The company will use the funds to repay financing for its acquisition of British cereal maker Weetabix Ltd., Moody’s Investors Service said in a report on May 7.

This is how the beginning of the end begins.  Companies and governments issue new debt to pay off old debt as the cash flows of the underlying asset/investment do not generate sufficient returns to pay off the original debt.  And they never will.  Kicking the can down the road works for a time, that is until the road ends either because runaway inflation prevents governments from continuing to print money or investors balk at rolling over the debt again forcing a bankruptcy restructuring.

Source:
"China Corporate Debt to Overtake U.S. Within Two Years, S&P Says", Bloomberg, May 15m 2013
http://www.bloomberg.com/news/2013-05-15/china-corporate-debt-to-overtake-u-s-within-two-years-s-p-says.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

A recent settlement between the U.S. SEC and a husband-and-wife team that ran a Chinese maker of pollution control equipment provides another shining example of how due diligence was not "do" diligence.

In this case, CEO Zou Dejun and his wife, the chairwoman, Qiu Jianping, ran Rino International, at one time worth about US$500 million on Nasdaq.  It collapsed after short seller Muddy Waters accused it of claiming revenue from nonexistent contracts. More than three years ago, the company raised $100 million from American investors in a stock offering.

The S.E.C. complaint said the company kept two sets of books. The Chinese books, which the S.E.C. said were correct, showed total revenue of $31 million from the first quarter of 2008 through the third quarter of 2010. The United States books, which were used in financial statements, showed revenue of $491 million, or about 15 times as much.

Shocking!  A Chinese company with more than one set of books?  This surely has never happened before in China or anywhere else.  Nod, nod, wink, wink.

The S.E.C. said that days after the 2009 public offering, the couple, who together controlled 65 percent of the company’s stock, used $3.5 million of the money raised to buy a home for their use in Orange County, Calif., then gave conflicting accounts to auditors regarding how the money was used. They eventually signed notes indicating that they had borrowed the money from the company.  So they got caught with their hand in the company cookie jar, and the auditors did not think maybe something else is going on and just took everything else at face value?  Well done to the due diligence team.

The fraud fell apart in November 2010 after the Muddy Waters research Web site, which seeks out stocks to sell short and has exposed a number of Chinese frauds, released a report saying some of the company’s reported revenue came from fraudulent contracts with purchasers.   A few days later the company’s auditors, Frazer Frost, reported that Mr. Zou had admitted that some of the contracts did not exist. The auditors withdrew their previous certifications of the financial results.

Again, well done to the Frazer Frost auditors for the level of rigorousness on this one.  They were clearly more concerned with getting paid than fulfilling their responsibility for investors.

On Nov. 30, the company sent a letter to the S.E.C. saying it intended “to file restated audited financial statements” for 2008 and 2009 “as soon as practicable.” It has made no such filings since, and the company’s Web site is no longer available.

Source:
"Couple Settle Fraud Case Involving Chinese Company", New York Times, May 15, 2013
http://dealbook.nytimes.com/2013/05/15/chinese-couple-settle-s-e-c-fraud-case/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Chinese company ChinaCast Education went public in the U.S. via a reverse-merger in 2007. It was de-listed from Nasdaq in June 2012 after a former executive siphoned off the firm's assets.  All this happened under the watch of a Big 4 accounting firm and Board of Directors.

What went wrong?:

• Same bed different Dreams.  In early 2011, U.S.-listed shares in several Chinese companies started falling on reports of financial fraud, especially firms like ChinaCast which legally dodged U.S. disclosure rules by listing through reverse mergers.  U.S. investors thought the company's performance in the face of this falling share price signaled it was time for ChinaCast to launch a share buyback. Investors were then pleased when Chen announced a plan to repurchase US$ 50 million worth of common shares over 12 months.  Shareholders waited for the buyback to begin, but nothing happened. Frustration ensued and soon the two sides were fighting.   Chen was offered but refused two years compensation in exchange for a voluntary resignation. Chen was then removed by the seven-member board, four of whom backed Sherwood, and replaced Chen with Feng.
• In 2011, American shareholders, the 10 largest of which controlled 55% after the listing, initiated a shakeup of the company's management, ousting then CEO and chairman Hong Konger Chen ZiAng.  Derek Feng Yiyi was installed as the new chairman.
  
• In February 2012, Deloitte attempts to check the books at the company's Shanghai office were blocked by the company's employees.
  
• In the weeks prior to Derek Feng's appointment as Chen's replacement as Chairman in March 2012, Chen looted the company before shareholders or the Board could do anything to stop him.
• In December 2012, ChinaCast announced all quarterly and annual financial statements from the beginning of 2009 to the end of September 2011 could not be trusted - despite being audited by a Big 4 firm.  The announcement also revealed other problems at the firm, including loss of control of equity in subsidiaries and a great amount of assets that did not exist.

What was Chen able to do:

• Several hundred million yuan was transferred from company accounts without the approval of the board of directors.
• In September 2011, ChinaCast subsidiaries Shuangwei Co. and Yupei Co. each had 100 million yuan in Shanghai's Bund Branch of Huaxia Bank. The money was used as collateral in September 2011,  for loans issued to three other companies unrelated to ChinaCast.
• Company's business license vanished.
• Company's registration seals vanished.
• Company's computer records vanished.
  
• Company's paper files and accounting were shredded.
  
• Loss of control of equity in key subsidiaries.  Ownership of ChinaCast's colleges – Hubei Polytechnic University School of Business, Guangxi Normal University Lijiang College, and Chongqing Normal University's College of Foreign Trade and Business – had been transferred to several people including a former company president Jiang Xiangyuan without board approval.
• Large amount of assets did not actually exist despite being audited by Big 4 firm.

Ned Sherwood, who held 800,000 shares, was the leader of the management reorganization.  He says he never authorized the asset transfers and was later stunned by the financial maneuvering that eventually hollowed out the company.  No disrespect intended, but I am guessing he is not very experienced at doing business in China.  If he was, he would have known a foreigner cannot make any changes to the leadership of a Chinese company without having many trusted people physically on the ground and in key positions such as holding the company chops, controlling bank accounts and having authorized bank signatories, the heads of HR and finance.

Sherwood said he conducted due diligence before buying ChinaCast stock on the Nasdaq exchange.  Really.

Due Diligence should be 'Do' Diligence and not just rolling the dice:

• ChinaCast's former president Jiang Xiangyuan, who was also removed in the shakeup and, according to records obtained by Caixin, may have played a role in the disappearance of funds.  A probe by Feng's management team found Jiang had been convicted in 2001 by the Shanghai Hongkou District Court for misappropriating public funds and given an 18-month suspended sentence.  Jiang's conviction had gone undetected during due diligence long before ChinaCast crumbled.

The key lesson for investors is due diligence can do very little when the shell is in the U.S. and the business is in China. Overseas investors and regulatory agencies will always be at a disadvantage trying to understand what really goes on on the ground in China, or any market for that matter.

Sources: 

• "Shareholders of Looted Firm Sue Auditor in NY Court", Caixin Online, February 20, 2013.
  http://english.caixin.com/2013-02-20/100492666.html
• "Hard Lesson for China-Concept Stock Investors" Caixin Online, May 16, 2012.
  http://english.caixin.com/2012-05-16/100390800.html
  

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Cash is cash, even when management tries to pass it off as non-cash impairment charges.

First, a company pays cash for part or all of an acquisition.  Then it turns out the acquiring company overpaid because either the valuation assumptions were unrealistic or irrationally exuberant, performance failures or even fraud.  In the end, the acquired company turns out to be worth much less then it was purchased for.

Accounting rules state the acquirer must then write down the value of the company it acquired.  Management refers to this loss as "non-cash" because it is technically a non-cash charge at this point in time.  However, it also gives false impression the acquirer did not lose any real cash.   This is completely false and misleading to investors.  When a company acquires something for cash, and then must later write down the value of that asset, the company did lose cash - cash paid out earlier.

When management tries to explain a loss as, "do not worry, it was a non-cash charge", they are either intentionally misleading you or do not understand what really happened.  In either case, put your hand on your wallet and quickly walk away.

It is also misleading when a company acquires another company with stock and subsequently has to write down its value, calling this charge non-cash.  This may technically be non-cash, but management wasted company value that could have been invested in something else.  When cash was used, real cash was lost.  When shares were used, real value was lost.  In either case, management did a poor job and should be held accountable.

Source: "Wrong Way to Admit You Blew Millions of Dollars", Bloomberg, January 25, 2013
http://www.bloomberg.com/news/2013-01-24/wrong-way-to-admit-you-blew-millions-of-dollars.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.