They are distinctly two different companies, although both are leaders in their field. Singapore’s Olam International Limited deals in agricultural products and food ingredients. US-based HP is immersed in the digital world of bits and bytes, including personal computers, printers and enterprise software.
Last week, though, both Olam and HP were united in facing a firestorm related to alleged accounting irregularities. As their stock price plunged, top executives, including the CFO, sought to explain, clarify and assign blame. “The board relied on audited financials, audited by Deloitte, not a Brand X accounting firm, but Deloitte,” said HP CEO Meg Whitman.
For its part, Olam has sued short-seller Carson Block, founder of self-styled research firm Muddy Waters, for libel, slander and malicious falsehood. “If you look at [Olam’s] historical financial statements,” Block told an investment conference in London, “literally two-thirds of the accounts in the cash-flow statements were reclassified by the time you got the audited numbers.” He predicted that the company will collapse under the weight of its debts.
HP’s accounting controversy relates to its subsidiary Autonomy, which it acquired for US$11 billion in October last year. It has accused “some former members of Autonomy’s management team” of orchestrating “accounting improprieties, misrepresentations and disclosure failures to inflate the underlying financial metrics of the company.” HP has written off US$8.8 billion on its books in relation to the acquisition and said it may sue “various parties . . . to recoup what it can for its shareholders.”
It’s unclear whether those parties will include external auditor Deloitte or KPMG, which was engaged by HP to conduct due diligence on Autonomy prior to the takeover. Understandably, the quality of the audit and due diligence work has come under question – Ernst & Young is Olam’s auditor. Both Deloitte and KPMG have denied knowing about the alleged accounting shenanigans at Autonomy, while Ernst & Young says it stands by its audit of Olam.
Biology of profits
In truth, Muddy Waters has yet to release a report on Olam in the same way that it did with Canada-listed timber company Sino-Forest last year (to devastating effect – Ontario authorities charged key executives with fraud and the company, which operates in China, filed for bankruptcy in March). Muddy Waters claims to have done exhaustive research on Olam, but has not said that it would publish a report.
What it has done so far is an 18-slide presentation on Olam by Block on 19 November at the Ira Sohn Investment Conference in London, and an open letter to Olam by Muddy Waters the next day. Incidentally, John Armitage, founder of Europe’s Egerton Capital, also spoke at the London conference and mentioned that the hedge fund also had a short position on Olam. “It has been very profitable,” he is said to have told the participants.
In London, Block said he was shorting Olam because of its “unsustainable” business model, “highly leveraged” financial position and “aggressive” accounting practices. He pointed specifically to Olam’s valuation of the “biological gains” it is making from assets such as orchards and farms. “It’s a leap of faith to think the company is being honest with its valuation,” Block said, one reason why he believes the company will eventually collapse.
According to a Wall Street Journal analysis, Olam’s reported biological gains came to S$111 million (US$90 million) for the fiscal year ending 30 June 2012, equivalent to about 30% of net profit of S$371 million (revenue sales: S$17.1 billion). That’s a net gain from the change in the fair value of biological assets of 38% compared with the previous year.
Olam purchased almond orchards in Australia three years ago and operates a number of dairy farms, but the 23-year-old company’s core business is still in trading – it is a major global player in cocoa, coffee, cashew, sesame, rice, cotton, and wood products. In media reports, the company is described as accounting for 90% of global trade in peanuts and as the world’s second-largest rice trader.
Muddy Waters was expected to publish a report on Olam on 20 November, but an open letter appeared instead on its website. “Olam halted its stock, scheduled two conference calls, discussed buying back shares, and issued statements that included saying it is not a ‘fly-by-night’ company,” said the letter, which suggested sarcastically that Olam is better off working on plans “to reign [sic] in your CapEx and de-leverage.”
Muddy Waters appeared surprised at the speed and ferocity of Olam’s response. Perhaps taking lessons from the dithering at Sino-Forest and other previous Muddy Waters targets, Olam CEO Sunny Verghese went on the offensive the day after Block’s talk. In a 20 November conference call with analysts, he accused Block of working with unnamed groups that have built significant short positions in Olam.
“We see a pattern in the way Muddy Waters and whoever they are working in concert with have taken a view on Olam having built a very significant short position and then coming up with this kind of report and using very aggressive and very big statements about Olam,” Bloomberg quoted Verghese as saying. “It is quite apparent that the objective was to create panic amongst our shareholders.” Olam's Singapore stock price fell 7% the day after Block's London presentation, but closed at S$1.66 per share on 23 November, paring the losses to 4.5%.
After announcing that it was suing Block and Muddy Waters, Olam published a detailed rebuttal on 23 November of the Muddy Waters attack. “The Company is in a sound financial position and has built a strong, unique and well differentiated competitive position in its industry and has a reputation and track record for transparency and good governance,” it declared.
The accounting of its biological assets is entirely in keeping with the mandatory requirements of Singapore Financial Reporting Standard 41 (Agriculture), said Olam. “Negative goodwill, which arises as a result of purchase of assets at a discount to their fair value, is recognised in the profit and loss statement after due verification by the Company’s auditors, Ernst & Young LLP,” it added.
Muddy Waters had criticised Olam for taking on S$900 million in new debt while increasing “cumulative investment cash burn by approximately S$2 billion” and “cumulative operating cash burn by approximately S$500 million.” Noting that Olam has received investment money from the Singapore government – state-owned firm Temasek has a 16% stake – Muddy Waters pontificated that “Olam’s mismanagement of the public trust is that much less forgivable.”
In its defence, Olam said its net debt-to-equity ratio stood at 2.03 times as of 30 September 2012, which it described as a “comfortable financial position from which to continue on the growth path.” It assured investors that it has enough liquidity to meet financial obligations and “those that might arise from stress in the capital markets.” No further equity-raising is expected to meet Olam’s fiscal-year 2016 strategic goals, it stressed.
The company’s long-term growth strategy is to build a “well-balanced and diversified business” that is oriented towards food raw materials, which are largely recession-resistant – everyone needs to eat in good times and bad. But the required capital investments are necessarily “front-loaded” and require long gestation, so “the Company was explicit in its communication that positive free cash flow generation is expected to commence only from FY2015.”
“The Company would like to reiterate that its financial statements have been subject to annual audits by E&Y,” said the Olam statement. “E&Y have also stated in their letter to the Board of Directors that ‘the consolidated financial statements issued by Olam were prepared in accordance with SFRS. Our audits were conducted in accordance with Singapore Standard on Auditing . . . We stand by our audit opinion on the consolidated financial statements of Olam.’”
HP and the $8.8 billion debacle
Muddy Waters is not involved in the other scandal du jour, which culminated in HP’s massive write-off. If it had shorted HP, it would have made a handsome profit after the share price crashed by 12% on 20 November, the day the company announced the US$8.8 billion non-cash charge. The stock clawed back some of its losses on 23 November, closing at US$12.44 per share, but that is still 6% below the price before the write-down.
HP is still investigating, but it has given examples of some of the alleged accounting improprieties and misrepresentations carried out by Autonomy before the sale. They include:
- mischaracterising revenue from “negative-margin, low-end hardware sales with little or no associated software content” as IDOL product – IDOL stands for Intelligent Data Operating Layer, Autonomy’s main technology that allows users to search and process text extracted from database, audio, video, and text files or streams. This revenue, which HP estimates comprised 10-15% of Autonomy’s total sales (or about US$100 million), was supposedly accounted for as “license revenue,” resulting in inflated calculations of organic growth and the growth of the IDOL product.
- using licensing transactions with value-added resellers to accelerate revenue recognition or create revenue where no end-use customer existed at the time of sale.
- stripping out future revenue from software subscriptions and booking them at once. The accounting for these revenue streams should have been deferred or recorded as future revenue.
Because of these mischaracterisations, said CFO Cathie Lesjak, Autonomy was able to report gross margins of 40-45% -- and thus justify a high valuation for the company in the sale to HP. She estimates that the more realistic figure is probably 28-30%. According to Fortune magazine, Lesjak had opposed the Autonomy deal, telling the board that it was “too expensive” and “not in the best interest of the company” – to the anger of then CEO Leo Apotheker.
How does all this relate to that humungous US$8.8 billion charge? About US$5 billion is attributable to Autonomy’s machinations, said Lesjak, presumably representing the write-down on the goodwill booked on the US$11 billion HP paid for Autonomy. The rest is due to the drop in HP’s stock price, which has been under pressure even before the Autonomy bombshell over falling demand for PCs and printers, and the controversy around Apotheker’s firing last year.
Denials – and the auditors
Mike Lynch, Autonomy’s founder, strenuously denies HP’s charges. “It is inconceivable how, from US$100 million of revenue that just changes classification, you could possibly have a write-down as big as US$5 billion,” he told the Guardian newspaper. “They’ve had to do a very big write-down and they tried to blame it on the accounting but obviously something else is going on.”
Deloitte declines to discuss its work because of client confidentially, but it “categorically denies that it had any knowledge of any accounting improprieties or misrepresentations in Autonomy’s financial statements.” It adds: “We conducted our audit work in full compliance with regulation and professional standards . . . [and] will cooperate with the relevant authorities with any investigations into these allegations.”
A KPMG spokesman told The AM Law Daily, a lawyers’ publication in the US, that the Big Four firm “performed limited, non-audit work for HP on this matter,” adding that “because of our professional obligations and client confidentiality, we cannot discuss our engagement further without HP’s consent.” PwC, which is conducting the forensic investigation for HP, is not commenting either.
But the facts of the case may eventually be known. HP says it has asked the US Securities and Exchange Commission’s Enforcement Division and the UK’s Serious Fraud Office – Autonomy is based in the UK – to conduct a civil and criminal investigation. Ernst & Young’s audit work at Olam may also come under scrutiny in the courts, if Olam pursues its case against Block and Muddy Waters.
It’s going to be an interesting few months – or likely years -- in financial and auditing circles.
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation