Commentary on Political Economy

Friday 30 October 2020



Seek attacker's 10 red flags


Short sellers don't always get it right when they attack businesses for allegedly misleading shareholders. But more often than not they find tell-tale signs of hidden problems.

Just days before Blue Orca Capital's Soren Aandahl launched a short-selling attack against online jobs platform Seek, he shared with Chanticleer 10 of his favourite signs of impending corporate trouble.

Many of these red flags have been used to predict fraudulent activity or deception of investors. It should be noted Aandahl's campaign against Seek is not covered in this column because the company is yet to issue an ASX response.

Blue Orca founder Soren Aandahl says he never ceases to be amazed at the ingenuity of accountants. ABC

High profits – poor cash flows: Companies reporting impressive profits, as a general rule, should report equally impressive cash inflows. Watch out if they don’t. Despite growing revenues and reporting 70 per cent-plus profit margins, Rolta India never reported positive free cash flows. It went bankrupt, and its profits proved to be a mirage.

Ballooning receivables: Investors should also watch for rising account receivables, typically measured as DSOs (day sales outstanding). Ballooning receivables indicate that a company is not collecting cash for its sales, which can call into question the authenticity of its revenues and profits. For example, Blue Sky Alternative’s receivables rose to 129 per cent of revenues, an early clue that the asset manager was inflating the value of its unrealised investments.

Inventory turnover: Investors should also pay attention to inventory movement, looking for changes in accounting treatment from year to year or for strange outliers. We first noticed China Metal Recycling, one of the largest and most brazen frauds in Hong Kong history, in part because it claimed to be turning over its scrap metal inventory five to six times faster than its closest competitors.

Non-cash gains: We are always sceptical of companies that achieve earnings targets with the help of one-time, non-cash gains. Often, such non-cash gains are not derived from the superior performance of a healthy business, but from accounting trickery. Sandalwood plantation owner Quintis used this trick, with non-cash gains accounting for 77 per cent to 238 per cent of net profits.

Performance too good to be true: As an investor, Blue Sky claimed to have achieved a 15 per cent internal rate of return (IRR) net of fees since inception, making it one of the best asset managers in the world. Blue Sky’s track record of purported success was based not on the market but on their internal valuation of their own investments. Under scrutiny, this track record fell apart.

Serial capital raising: We always look for companies that continually rely on the capital markets to function. Serial capital raising has become fashionable lately, but investors should remain especially sceptical of companies which claim to generate high paper profits, yet constantly raise debt or issue equity to operate their business.

Is China really so constipated? As investors, we always try and ask simple, stupid questions to sanity-check a company’s claims. For example, Hong Kong-listed China Lumena claimed to sell so much homeopathic laxative that every man, woman and child in China over the age of 14 would have to be taking a dose every two weeks. We asked ourselves, "could China really be so constipated?" Of course not. Lumena was just making up the numbers.

CFO turnover: Investors should beware when CFOs leave frequently or abruptly, especially if such departures take place around the annual audit. L&L Energy, one of our Chinese reverse takeover offer (UTO) shorts, had five CFOs in three years. When one CFO candidate refused, the CEO simply forged her signature.

There are no trees: One of the most famous frauds of the Chinese RTO years was Sino-Forest. Muddy Waters found that Sino-Forest was lying about the amount of timber acreage under its control. It is hard for many investors to deploy investigators or conduct on-site due diligence in far flung regions, but simple asset checks can sometimes reveal the most brazen of schemes.

Serial Acquisitions (part I): Roll-ups should be treated with scepticism. Companies engaging in serial acquisitions give management teams discretion to use accounting tricks to massage earnings. Valeant was a classic example, seducing investors with the appearance of growth which was achieved through debt-fuelled acquisitions. The debt binge comes with a cost, and acquisitions create a unique opportunity for unscrupulous managers to play accounting games.

Serial acquisitions (part II): Sometimes, companies use acquisitions to steal money from shareholders, by secretly buying businesses or assets from undisclosed related parties (usually themselves). One Hong Kong-listed company spent hundreds of millions acquiring empty shell businesses from entities secretly connected to insiders. We discovered that this shadowy network was connected to groups affiliated with male prostitution and brothels in China.

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