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.

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.

The India government is taking an interesting approach to try and attract more much-needed foreign investment.  The India finance ministry, while trying to attract foreign direct investment,  is initiating some rather interesting tax collection actions against some very well known MNCs.  And of course this news is being read around the world outside India.  Some examples:

• India's Finance Ministry wants Vodafone, as the buyer, to pay the capital gains tax for Hutchinson Whampoa, the seller, after Vodafone bought out Essar via the Mauritius legal entity.
• Royal Dutch Shell used a unit in the Netherlands to invest into Shell India via a share purchase of Share India.  The India Finance Ministry is claiming Shell should have paid a higher price (18x) for those shares, and thus higher taxes on the share purchase.

India Taking Transfer Pricing Scrutiny to a New Level

India is right to scrutinize MNCs and their transfer pricing.  India audits companies with back offices in India to ensure the parent companies and other subsidiaries outside India are paying their Indian subsidiaries at arm's length, with a rate equivalent to what they would pay a third party for similar services.  Parent companies and their subsidiaries pay subsidiaries on a cost-plus basis to guarantee the subsidiary a certain profit over the cost of the labor and parts that go into the subsidiary's business.  India is trying to take transfer pricing to a new level:

• India wants to switch to a system where MNCs assign a portion of their total global profits to their Indian subsidiaries.   India obviously wants more tax revenue, but MNCs have options and will invest elsewhere.
• Indian tax authorities claim when a MNC run expensive marketing campaigns in India, they are transferring intangible value to the brand world-wide and the Indian subsidiaries should be taxed for that. LG Electronics has been fighting such a case for years. A Delhi tax tribunal upheld the tax authority's view last month.

Source: "India to Foreign Firms: Pay More Taxes", The Wall Street Journal, February 25, 2013.
http://online.wsj.com/article/SB10001424127887323864304578317821999568656.html?mod=WSJASIA_hps_LEFTTopWhatNews

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.

Summary:

• Perpetual bonds have no formal maturity and pay interest until the bond is bought back by the issuer
• Caveat Emptor: Perpetual bonds are much riskier than the name implies

What are Perpetual Bonds?

Perpetual bonds are bonds issued which pay an interest rate (usually annually) with no formal maturity and the issuer will usually have a call option to buy back the bond under specific circumstances.  A perpetual bond can theoretically last forever, with investors never being repaid their principal but instead forever collecting an interest payment.

What are the Risks of Perpetual Bonds?

Perpetual bonds are much riskier than the name "perpetual" implies. 

• Seniority: Perpetual bond debt can be subordinate to other company debt.  This means perpetual bond investors are at the back of the creditor line behind all the other debt holders if a perpetual bond issuer defaults.  An investor should make sure they understand whether their perpetual bond is senior or subordinate debt.
  
• Interest Rates: Perpetual bonds are very sensitive to interest rate movements since the cash flows are far in the future. When interest rates rise, their attractiveness falls since it is paying an interest rate less than an investor could currently get.  This means the perpetual bond price falls to a price which matched the current available yield.  
  
• Interest Rate Reset:  This feature means the interest coupon rate will be adjusted periodically as interest rates rise after the initial interest coupon rate.  f this feature is part the perpetual bond, keep in mind the interest rate does not normally reset regularly, but rather once every few years, sometimes once every 5 years.
• Interest Rate Step-Up:  This feature means the interest coupon rate will be adjusted for interest rate increases, and by an extra set percentage (called step-up margin) on top of adjustments for interest rate increases as interest rates rise after the initial interest coupon rate. If this feature is part the perpetual bond, keep in mind the interest rate does not normally reset regularly, but rather once every few years, sometimes after 10 years.

If Institutional Investors Will Not Touch Them, Whey Should You?

Institutional investors normally avoid buy perpetual bonds because the risks are too high compared to the interest they pay.  When institutional investors are not buying, bank push perpetual bonds on their private bank clients to buy.

"Perpetual bonds are favored by individual investors, some of whom are thirsty for yields and focus on short-term investments. Managers of large bond funds usually shun the instruments because perpetual bondholders rank low in a company’s capital structure and would be the last to recover their capital if the issuer defaults."

When will an Issuer Buy Back a Perpetual Bond?

The interest rate reset and step up may create an incentive for the issuer to buy back their perpetual bonds, because as interest rates rise, there becomes a point when interest rate payments become too expensive for the issuer to continue and will refinance.  Investors in perpetual bond issuers will then get their principal back.

If a perpetual bond has no interest rate reset or step-up features, or the interest coupon rate increases are not enough to incentivize an issuer to buy back the perpetual bond, turn and run away from it as fast as you can.  Investors will probably be left holding a long-maturity bond which declines significantly in value when interest rates rise.

Sources: 

• "Perpetual Bonds", South China Morning Post, February 25, 2013.
  http://www.scmp.com/business/money/markets-investing/article/1156330/perpetual-bonds
• "Investors Get a ‘Perpetual’ Headache", The Wall Street Journal, January 21, 2013.
  http://blogs.wsj.com/deals/2013/01/21/investors-get-a-perpetual-headache/

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.

Like nature always finding a way, Chinese people are adept at finding and exploiting any loopholes to circumvent the government's bureaucracy and regulations.  Case in point is China's financial system.  Large Chinese banks controlled directly and indirectly by the government provide loans to mostly large companies leaving small and mid-size companies starving for capital.  Chinese regulators also control the level of interest a bank must pay to depositors, and the lending rate to borrowers.  This spread is always in the bank's favor at the expense of consumers, and currently savings rates are negative when adjusted for inflation.  When Chinese regulations instruct banks to stop or lower lending to certain sectors like real estate developers or small and mid-sized companies, nature finds a way.  Enter under and sometimes un-regulated Trust companies and wealth management products.  Trust companies pool together large amounts on money from individuals by offering to pay interest rates much higher than what a bank would pay a depositor in interest.  Often using wealth management products, the capital raised is then lent out to high risk borrowers and high interest rates.  

The main borrowers from trust companies are those which have difficulty obtaining funding from banks and the bond market: local government financing vehicles with unprofitable projects, property developers, and firms in industries with large amounts excess capacity brought on by the previous lending boom, such as steelmakers and cement producers.  Hardly an ideal concentration of risk in a lending portfolio.

At what point does this game of musical chairs end?  And when it does, will it end badly?  Defaults are already regularly occurring. Some of the defaults are the result of outright fraud.  A large portion of trust loans extended over the past couple of years will mature this year. 

The structure of mainland financial markets has changed recently with large amounts of new lending occurring outside the traditional banking system and instead via a shadow financial system of wealth management products and company-to-company loans, while the corporate bond market has taken off.  This shadow lending system is so large now, that were the Chinese government to shut it down, the economy would collapse - that is how big this lending has become.  A big problem is no one is really sure how big this shadow financing system has become, which means no one has a good idea what the risks really are.

Some trust products are outright ponzi schemes in the early years when the project invested in requires several years to get off the ground and generate returns.  In such cases, later investors are used pay interest to earlier investors until the project generates cash flows.  If these cash flows never happen, game over.   

Sources:
(1) "The black hole that is wealth management products", South China Morning Post, February 14, 2013
http://www.scmp.com/business/banking-finance/article/1149718/black-hole-wealth-management-products
(2) "New dangers lurk in trust firms' rush to finance", South China Morning Post, February 18, 2013
http://www.scmp.com/business/banking-finance/article/1152695/new-dangers-lurk-trust-firms-rush-finance
(3) "Beijing can't afford to rein in the shadow financing system", South China Morning Post, January 24, 2013
http://www.scmp.com/business/article/1134686/beijing-cant-afford-rein-shadow-financing-system

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.