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Innopac Holdings Ltd - When did it last make a cash profit?

16/3/2014 – It appears we can still learn lessons from the way the US energy trading house Enron managed its accounts in the 1990s, before it went bust in 2001.

Professor Bala G Dharan and William R Bufkins - the authors of a chapter entitled 'Red Flags in Enron's Reporting of Revenues and Key Financial Measures', in the 2004 book, "Enron: Corporate Fiascos and Their Implications" - explain how the Enron scandal could have been identified well before the company imploded.

They pointed out that Enron's primary financial objective was to grow revenues, not profits, because it was revenue which would rank it higher in the Fortune 500.

Therefore, Enron manipulated its revenue to grow by 750% in less than four years – from US$13.3 bln in 1996 to US$100.8 bln in 2000.

This spectacular revenue growth took it to 7th place in the Fortune 500 in April 2001.

How did Enron grow so much, so quick?

According to Prof. Bala and Mr Bufkins, the key to such growth was two revenue accounting techniques of Enron - 'Merchant Model' and 'Mark-to-Market'.

With the help of the 'Merchant Model', Enron reported the entire value of each trade on its portal, Enron Online, rather than reporting as revenues only its trading and brokerage fees.

In simple terms, it is same as a stock broker which books the entire value of each transaction as revenue, instead of considering as revenue its brokerage fees only.

In reality, say Prof. Bala and Mr Bufkins, big broking firms like Goldman Sachs and Merrill Lynch book only brokerage fees as revenue:

"To understand the merchant model, consider a retailer, such as Wal-Mart, who buys products from manufacturers, takes possession of the goods, and takes the risks of selling the goods as well as the risks of collecting from the end-user. Because of the risks taken, the merchant is allowed to report the entire selling price of the products as revenues and the cost of purchases as 'cost of goods sold'.

By contrast, an 'agent' is someone who provides a service to the customer (such as facilitating the purchase of an airline ticket), but does not really take up the risks of possession and risks of collection. Under the agent model, the service provider is allowed to report the trading fee, brokerage fee, etc as revenue, but not the entire value of transaction."

So, it's pretty clear – Enron was booking revenue like a 'merchant', although it was just an 'agent'.

The other accounting technique of Enron, 'Mark-to-Market' or MTM, helped it book the present value of all future contracts as revenue.

Prof. Bala and Mr Bufkins estimate that an adjustment for both MTM accounting and merchant accounting would have pushed down Enron's revenue to just US$6.3 bln in 2000, instead of the reported US$100.8 bln.

This way Enron managed to grow its revenue, walk up the Fortune 500 rankings, and create an illusion in the minds of the investing public that its innovations were raking in the dollars.

And profitability?

Prof. Bala and Mr Bufkins point out that investors and analysts were happy witnessing 10%-15% annual growth in Enron's profit, and didn't bother to look at the bigger picture.

Enron's net income as a percentage of revenue dropped consistently from 4.4% in 1996 to just 1% in 2000.

In fact, Enron's books were ferociously bleeding throughout – it lost about US$6 bln in cash from operations from 1996 to 2000.

To make up for such tremendous cash outflow, Enron devised another manipulative way to sell its investments to related companies so that high debt on those private entities didn't reflect in Enron's books.

According to another website, "Enron's operating cash flow shows large inflows from sales of 'merchant assets' ie, investments held for trading. If we exclude all cash changes related to merchant assets for the years 1998 to 2000, cash flow greatly reduces, and if we then take off capital expenditures it's negative".

Investor Central. Asian insights for global investors. We ask the tough questions of Asian companies which global investors need answers to.

Question
Question

1. What justifies Innopac's revenue accounting?

According to Innopac Holdings Ltd's Annual Report for 2012 (page 31), its business is:

'…those of investment, investment holding and provision of management services to related companies.'

As a result, Innopac has a significant portfolio of 'investments held for trading'.

Going back to the 2012 Annual Report, "Investment held for trading are mainly marketable securities held with securities trading companies which are subsidiaries of well-established banks".

Now, here's the thing:

Just like Enron's 'Merchant Model', almost all of Innopac's revenue appear to be made up of 'sale of investments held for trading'.



We could argue whether Innopac is a 'Merchant' or acting as an 'agent'.

Those in favor of Innopac being a 'Merchant' can argue that it is not just "passing through" investments between third parties and earning a commission.

By buying and selling securities, it takes on the risk that the security will go up or down.

But others might take a view that Innopac is just investing and trading the funds of its shareholders, exactly like an 'agent'.

In light of such conflicting opinions, it seems appropriate to take a look at the revenue-accounting style of similar 'investment holding' companies in Singapore.

For example, Hotung Investment Holdings Ltd.

According to pages 44 & 64 of Hotung's 2012 annual report, its auditor, KPMG, has booked only the gain/loss from sale of investments as the company's revenue.

In other words, KPMG doesn't find it appropriate to book entire sale proceeds of investments as the revenue for the company.

Just imagine how conveniently a company can grow its revenue with such a controversial revenue accounting technique.

In fact, Innopac can rake in full year revenue just by trading its investment portfolio for a few days, or maybe even just a few hours, in a year.

Just look at the extraordinary growth in Innopac's revenue from 'sale of investments held for trading' in 2009 (590% YoY) and in 2012 (83.6% YoY).

No wonder Innopac's total revenue has grown from S$7.7 mln in 2006 to S$24.6 mln in 2012, despite a drastic drop in its revenue from 'rendering of services' during the period.

Innopac's revenue from the sale of 'investments held for trading' has surged about 400% in the past 6 years.

Here is some more information on the financials of Innopac:



Just like Prof. Bala and Mr Bufkins explained in the context of Enron, the cost of sales on Innopac's books, too, nearly matches the revenue.

The above table also shows the sale and purchase of 'investments held for trading' on Innopac's books.

Innopac didn't share the sale and purchase details of its 'investments held for trading' portfolio, until 2011 (we only got to know 2010 details from the Annual Report 2011).

Therefore, we don't know what the value of its 'investments held for trading' was in 2006, 2007, 2008 and 2009.

And this is the reason why we cannot calculate the changes in 'investments held for trading', which were recorded in the operating cash flow of the company in all the above mentioned years.

In other words, we cannot conclude how much of the cash flow is the purchase and sale of assets, and how much of a profit it made on these transactions.

Unfortunately, we don't know what is inside the 'investment held for trading' portfolio of Innopac.

So that leaves us wondering how much of Innopac’s revenue was actually contributed by the value of its assets all these years.

There are many more questions that need to be asked, some speculative in nature.

We are not making any allegations because significant pieces of evidence are lacking, so you should read this article in that light.

Question
Question

2. Did it ever make cash profits?

Now, let us shift focus to the profitability of Innopac.

Innopac's profits come from fair value gains on 'investments held for trading' or other accounting gains.

And the salient feature of such gains is: they don't generate cash.

This is how Innopac did it:



Apparently, Innopac couldn't have posted profits in any of the years without fair value gains.

In one of the deals, which we have already reported in an earlier story, it bought net liabilities of Mega Highlights Sdn Bhd and Mega Commercial Vehicles Sdn Bhd for a cash consideration of S$2 mln.

And later, it sold those liabilities for RM1 (as good as free) to an "unrelated party".

By doing so, Innopac booked a S$7.9 mln accounting gain in 2007 and another S$0.8 mln accounting gain in 2012.

So, Innopac's statements were reflecting profits even though it lost almost S$2 mln cash and another S$29,000 on the books of Mega Commercial at the time of sale.

While Innopac's gains were non-cash in nature, its losses were for real as is obvious from relentless cash loss on operations in the past five years.

Any reasonable mind would wonder how Innopac was able to sustain itself despite about S$30 mln cash lost in operations over that time.

The answer is very simple: it tapped capital markets.

(Total number of questions in the full story: 12)

We have sent these questions to the company (info@innopacific.com) and its IR agency (janice@august.com.sg, lily@august.com.sg) to invite them for an on-camera interview, and/or seek their written response.

Our email to Innopac's former auditor Mr Yeo Ek Khuan (ekkhuan@bdo.com.sg) bounced back.

We have also emailed its current auditor Mr Chris Johnson (chrisjohnson@moorestephens.com.sg).

So far, we have not had a reply (which is why you are seeing this message).


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