company account, investment strategy, hidden risks

Company reports: it pays to go looking for trouble

15.06.2007

by Tim Bennett

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Ever considered reading a set of accounts backwards? If not, perhaps you should. Faced with digesting a document that can run to hundreds of pages (HSBC’s last set came in at 458), many investors concentrate on the profit and loss account, balance sheet and cash flow statement. But these bits, while a good starting point, tend to paint the picture the firm wants you to see. Anything they would rather no one noticed will be tucked out of harm’s way at the back. Here are a few things to look out for.

1. Hidden debt

Not all firms want you to know exactly how much debt they have. Debt means risk and no one likes their shares to be perceived as risky. Luckily for them, there are several legal tricks they can count on to help hide debt. The main one is the operating lease. Leasing an asset, rather than buying it, can make sense. After all, no one buys a car in Spain for a two-week holiday, they hire one instead. Firms can also avoid the hassle of ownership by renting assets on a long-term basis, but they often end up locked into lease arrangements that can last years. These payments represent a big liability. Granted, cancelling early is an option, but is often expensive.

The balance-sheet ‘creditors’ number excludes these rental commitments, making the firm look less indebted than it is. Instead, information about big, future operating lease obligations tends to appear in a short note at the back of the accounts. So detective work is required. Evidence that the firm rents assets using ‘operating leases’ will appear in the first note, under ‘accounting policies’. If you see that, immediately look to the ‘operating lease commitments’ note much further back.

In note 38 of their 2006 accounts, for example, Sainsbury’s reveal they have signed deals committing them to £6.2bn of payments under operating leases of which the majority will run for more than five years. The FT estimate that in total the retailer rents 40% of its floor space – that’s 25% more than rival Tesco and 75% more than Morrison. Not that you’d know it from the balance sheet. As Sir David Tweedie says, the fact that there is a big operating lease liability ‘missing’ from any balance sheet makes it hard to get a true picture of indebtedness.

2 Hidden risks

If you’ve had a fine for jumping a red light, you’ll probably have cursed, but then noted the payment date and set aside cash to settle it. But what about that time, a few days ago, when you thought you were flashed doing 45 in a 30mph zone? No letter has arrived yet. Maybe you got away with it. Should you set aside a few quid to cover a fine that might never show up? This type of possible, rather than actual, liability is known as ‘contingent’ in the financial world and firms are required to disclose them in a ‘contingent liabilities’ note. Again, you won’t find this vital information about future payouts anywhere on a balance sheet – you’ll have to look to the notes.

Litigation is a fact of life for all firms, but obvious candidates include tobacco firms like British American Tobacco – their note on this extends to several pages. Notes such as this can also reveal vital information about oil and gas firms’ litigation concerning claims for contam¬ination. Financial services firms should tell you about any outstanding claims for misselling anything from endowment mortgage policies to split-capital invest¬ment trusts, with some idea of outcomes. Contingent liabilities can’t be ignored: they can easily become real ones.

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3 Hidden deals

Robert Maxwell used various methods to support the share price of his public company Mirror Group Newspapers. One was to arrange sales of publications from MGN to the private firm, Maxwell Communications Corporation, which he also controlled. The result was an increase in both the sales figure and the value of stock carried in the balance sheet of the listed PLC, something that kept the share price up. None of this is illegal, but it should set off alarm bells.

You can clear things up by looking in the ‘related party transactions’ note, where you will find details of all deals between the company and its own directors or any other ‘connected’ persons or organis¬ations. The longer and harder this note is, the more nervous you should be. Enron’s related party transactions note ran to nearly two pages of opaque waffle the year before it collapsed. More recently, investors who lost out on high-yield deposit notes issued by the recent batch of insolvent Australian property firms (Fincorp, Westpoint and ACR) should have noticed that all of them relied on transactions with related parties. And at the moment, I’d be wary of European property company Medsea Estates (LSE:MEA). Note 26 of its annual report, which covers its related transactions, is both long and complicated.

Case study: Medsea Estates Group Plc

Tony Gatehouse is a director of Medsea Estates Group PLC (the Company) and is the ultimate controlling shareholder of the group.

In November 2003 prior to the Company's admission to AIM in August 2004, Medsea Group S.L. entered into an arrangement with Tojuca Investment S.L. (a company in which Tony Gatehouse and Juan Carlos Rodriguez Martinez each held 35% of the shares) which had purchased an interest in land at Argos Sol in Murcia, Spain. Under this agreement, in return for providing assistance in funding the planning process, Medsea Group S.L. became entitled to commission upon sale of Tojuca Investment's land interest, together with exclusive marketing rights on the development. During 2005, the group earned commission from Tojuca Investment of £342,000 (which was outstanding at 31 December 2006) and as at 31 December 2005 it had loaned Tojuca Investment S.L. £196,000 including accrued interest.

During the current year, the Group loaned an additional £364,000 to Tojuca Investment S.L. The outstanding balance at 31 December 2006 (and the maximum loan value during the year) was > £561,000 > (2005: £196,000) including accrued interest of £24,000 (2005: £2,000) at commercial rates. The loan is wholly repayable within twelve months.

After the year end, following the transfer of the land interest held by Tojuca Investment S.L. to a new company called Residential Argos Sol S.L., the commission of £342,000 due by Tojuca Investment S.L. to the Company was converted into a 12.5% shareholding in Eurobond Investments S.L., which in turn indirectly owns 80% of the share capital of Residential Argos Sol S.L., giving the group an effective interest of 10% in the land originally owned by Tojuca Investment S.L.Additionally, the £364,000 advanced by the Group in 2006 was converted after the year end into a 30% interest in Tojuca Investment S.L. In turn, this has been translated into a further 17.5% shareholding in Eurobond Investments S.L., increasing the Group¹s total shareholding in the company to 30%. This 30% shareholding represents an indirect shareholding of 24% in Residential Argos Sol S.L. and has a market value of £960,000 based on an independent valuation of the land interest. Tony Gatehouse and Juan Carlos Rodriguez artinez each have a shareholding of 20.4% in Eurobond Investments S.L., representing an effective interest of 16.3% in Residential Argos Sol S.L. The balance due by Tojuca Investment S.L. to the Company after the conversion of the £364,000 advance mentioned above amounts to £197,000 and is wholly repayable in 2007.

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