Bosses may have differing views on EU membership, but few would have relished the prospect of another prolonged stalemate on the issue, even if the shape of our future trading arrangements with the EU27 is still open to negotiation.
The Brexit saga has drawn attention away from issues that might normally have been front row and centre. Just consider the roll call of accounting/audit failures through 2019: Eddie Stobart Logistics (ESL) and Thomas Cook came unstuck partly due to accounting irregularities, while respective inventory overstatements and multi-year accounting errors came to light last month for Ted Baker (TED) and M&C Saatchi (SAA) – to name but a few.
The year culminated in an attack on NMC Health (NMC) by Muddy Waters Research, which has cast doubt on the Abu Dhabi-based healthcare chain’s ascribed asset values, along with its cash balances, reported profits and debt levels.
The short seller had taken aim at the UK market four months earlier with a tilt at litigation finance specialist Burford Capital (BUR). The problems besetting the UK audit industry wouldn’t have gone unnoticed by Carson Block and his team at Muddy Waters, so they will be looking at the relationship between the NMC directors and the group’s external auditor, Ernst & Young LLP.
James Montier, the author of The Little Book of Behavioural Investing, has developed criteria that could help to tell if a company is manipulating its accounts. It is based on a range of accounting measures, from the divergence between net profit and cash flow to the rate of asset growth. Once applied, the resultant 0-6 ‘C-Score’,provides an indication as to whether earnings are being doctored – the higher the score, the greater the likelihood.
In the case of NMC, the transition from inventory to sales through to cash isn’t as enlightening as it could be because of the long credit period offered to customers in the UAE, typically 90-120 days, whereas trade payables are normally settled within 50-60 days of the date of purchase.
NMC makes the point that a “significant amount” of accounts receivable is neither past due nor impaired, but the arrangement is problematic from a working capital perspective and it makes it more difficult to assess how efficiently profits are being transformed into cash flows.
Nevertheless, based on the year-end accounts for 2015-18, receivables days, though high relative to other industries, have been pulling back, while inventory turn is increasing. And nothing appears to have been swept under the carpet by creative classifications within current assets.
The group’s ability to transform profits into cash flow is sound enough at the operating level, but rather less so in terms of net cash flows and earnings. And although there is no evidence to suggest that profits have been inflated by a reduction in depreciation charges relative to gross assets, it is the sheer rate of asset growth that may have invited scrutiny from Muddy Waters. Companies that pursue a highly acquisitive strategy have greater scope to distort the reporting of profits. NMC closed 18 deals through 2018, only seven of which were given full or specific audit scope in the full-year accounts based on materiality and related risks.
Recourse to the C-Score may have limited value given that the Muddy Waters critique centres on possible overpayment for assets, along with the questions over reported cash and debt levels (NMC has refuted recent speculation over off-balance-sheet financing). It is the preserve of auditors to judge whether companies have acted prudently, but even if the red lights aren’t exactly flashing when you employ the criteria laid out by James Montier, you would still be justified in digging a little deeper into NMC’s dealmaking. An independent third-party review is being launched into the charges against NMC. Carson Block’s hedge fund has dismissed the validity of such an approach, but it is hardly a disinterested party in all of this.
Ultimately, it boils down to questions over corporate governance and the control wielded by a small group of UAE-based billionaires. But even if it can be proved that NMC has systematically overpaid for assets, who can say where poor dealmaking ends, and malfeasance begins? Unfortunately, for minority holders, the consequences are much the same anyway.
