The Hindenburg diet

Good morning! What are the ingredients that go into cooking the books? You may have got a whiff of certain staples thanks to Hindenburg Research’s allegations against the Adani Group, but turns out there are red flags that aren’t limited to unrealistic growth. Today’s story is a ready reckoner on how to read between the lines of company financials. Think related party transactions and a lack of institutional investors. And that’s just the start.

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If something is too good to be true, it rarely is.

An Indore-based company in the business of sustainability advisory and carbon credits had issued its initial public offering (IPO) in March 2021 to raise ₹18.60 crore. It had reported a net profit of ₹4.51 crore in the financial year ending March 2020. The company had a strong debut on the BSE Small and Medium Enterprises (SME) exchange, with the stock getting listed at a 37% premium over its issue price.

What unfolded next is the stuff of corporate dreams.

The company’s net profit for the financial year ending March 2021 jumped fourfold to ₹18.69 crore. That went up to ₹383.36 crore in FY22—a jump of 1,951% from the previous year, perhaps thanks to the carbon credit market catching investors’ attention (carbon credit is a tradable certificate that allows firms to emit a certain amount of carbon emissions). The stock soon ballooned 8,900% in a matter of nine months, hitting its all-time high of ₹3,150 on January 24, 2022.

The company is EKI Energy. But as we established at the outset, this was all too good to be true.

EKI Energy’s auditor, Walker Chandiok & Co LLP, had reported "material weaknesses" in its financials. The sore point was revenue recognition. Per the auditor’s report, EKI Energy had overstated its revenues and profits. The company’s stock, which was already on a downward spiral, extended loss. The profits for nine months in the financial year ending March 2023 was ₹240 crore. Quarterly profits for the December quarter fell a whopping 76.34% year-on-year.

EKI Energy issued clarifications (pdf) against the auditor's statement, but failed to convince investors. Little wonder then that there are concerns over EKI's financial accounting practices. But nothing has been proven yet.

“If you read its financials, the company’s cash deposits have been low even as profits grew substantially. Capex [capital expenditure] too is low. It raises questions on the company’s financial reporting and working capital management,” a stock analyst tells The Intersection on condition of anonymity. The mystery here is if the company made so much surplus, where did it all go.

Numbers tell a story. They scream if something does not add up, but only savvy investors have the skills to hear said scream. Consider the debate around adjusted Ebitda (Earnings Before Interest, Taxes, Depreciation, and Amortisation) in the case of new-age companies, which are now using this accounting metric to show profitability. Paytm reported its first-ever quarterly profits—read: adjusted Ebitda, or Ebitda before employee stock option (Esop) costs—at ₹31 crore in the third quarter of FY23, up from a loss of ₹393 crore in the year-ago period.

Why single this out? Because adjusted Ebitda is about excluding one-off expenses, or expenses unrelated to the business. New-age companies justify excluding Esop costs from Ebitda since it is a non-cash item. But it comprises a major part of their businesses.

Not all analysts are impressed with this accounting hack.

“Ebitda does not always capture the full picture of profitability. Managers may make purposeful mistakes in estimates. The value of Esops can be overestimated or underestimated. Companies should hire independent agencies to validate their valuations,” says Hemant Kumar Manuj, associate professor and chairperson, Finance & Economics at S. P. Jain Institute of Management and Research. “With respect to new-age companies, it would have been better had they produced independent valuations. They have not done so.”

2Point2 Capital co-founder Amit Mantri also considers adjusted Ebitda a problematic barometer. “These metrics allow companies to claim profitability with accounting jugglery. Best to avoid looking at such metrics,” he says.

On that note, here’s how to spot some accounting red flags.

Spectacular Unrealistic growth 

US-based quantitative analyst Harry Markopolos spent decades trying to alert the US Securities and Exchange Commission (SEC) and Wall Street about the largest Ponzi scheme in history. That Ponzi scheme was the Bernie Madoff investment scandal, operated by the eponymous and most influential market makers in the US.

(If you don’t know about Bernie Madoff already, the Netflix docuseries Madoff: The Monster of Wall Street is a good place to start).

The extent of Madoff’s securities and stock fraud was laid bare only because of the 2008 financial crisis. But here’s what Harry Markopolos, who’d sniffed a rat much prior, has to say about red flags:

“Focus on the manager or the company that is head and shoulders above the rest. Whenever somebody has outstanding performance, Wall Street assumes genius. I assume fraud until genius is proven. Look for the outperformance and investigate there.”

For example, if a company is commanding a much higher margin compared to an industry leader, that means the margins are either unsustainable or unreal.

Let’s take an example of a mid-sized jewellery company that was referred to as ‘the next Titan’. Let us call this company JewelCo.

“In a difficult environment for the jewellery industry, JewelCo was growing faster than Titan and had better margins despite being a substantially weaker brand in the organised jewellery space. The stock went up 14x in a four-year period as investors bought into the “next-Titan” pitch,” 2Point2 Capital’s Amit Mantri, observed in a 2020 note.

Several other red flags were ignored. “JewelCo was reporting 4x employee productivity vs. Titan in the retail segment, which was “too good to be true” given the similar business models of both companies,” Mantri says. “JewelCo was also reporting a high return on capital employed (ROCE) of >30% in the commodity B2B jewellery exports segment. This business had a nine-month receivable cycle, and a large chunk of these receivables has now been written off or are stuck.”

Digital advertising company Brightcom Group is another example. The company’s quarterly net profit rose from ₹144 crore in December 2019 to ₹544 crore by December 2022 even as the digital advertising business slowed down in 2022, both in India and globally. In September 2021, suspecting it was misleading investors, Sebi ordered Brightcom (pdf) to conduct a forensic audit.

The company hid the notice even as it made a preferential allotment of shares around the same time. It was finally disclosed to exchanges on February 28, 2022. Brightcom stock price fell from over ₹100 in April 2022 to below ₹20 now.

(Lack of) institutional investment

If a company has industry-beating growth, look up the investment by domestic and foreign institutional investors. If they’re staying away despite the rise, it’s a sign that they don’t believe in those numbers.

“Sometimes, companies want to showcase higher profits to play to the gallery. They want to ensure that fund managers take note of their performance,” Sunil Damania tells The Intersection. Damania is chief investment officer at MarketsMojo.

A case in point is Mumbai-based IT company Vakrangee. The company posted robust earnings for a long time, but hardly any fund managers invested in it. In 2018, the Ministry of Corporate Affairs (MCA) ordered a probe into the company’s accounts and its shareholding structure.

The company saw its net profit for the September quarter tumble by 99% to ₹1.94 crore from the previous year’s ₹189.80 crore. The company eventually received a clean chit in the following months, but investors weren’t assured. The stock is still languishing around ₹15; it had crossed ₹500 in January 2018.

Related party transactions

Another effective way to figure out malpractices is related party transactions. Listed entities must disclose whether they transact with related parties, i.e. entities that are linked with the company. “If a listed company has links to several offshore entities, that is a red flag,” says MarketsMojo’s Damania.

“We have checks and balances to look at related party transactions. If our analysis suggests that something is fishy, we try to avoid those companies. Our job is to stay away from these companies,” he adds.

Sun Pharma comes to mind. In 2018, global asset manager Macquarie had raised doubts over the company’s corporate governance practices in a note. Of concern were related party transactions and alleged transactions with banned stock market traders.

Eventually, two whistleblower complaints alleged that Sun Pharmaceutical Industries and its wholly-owned subsidiary, Sun Pharmaceutical Laboratories (SPIL), had been diverting funds through Aditya Medisales Limited (AML), its sole distributor in India. Further, it was alleged that transactions with AML were ongoing for several years, but AML was disclosed as a related party of SPIL only in the 2017-18 financial year.

On February 11, 2021, Sebi observed: “Disclosure of related-party transactions with AML (Aditya Medisales Ltd) in the Annual Reports for FY 2015-16 and FY 2016-17 was not made.” The markets regulator added that AML was a related party of Sun Pharma even before the scheme of amalgamation.

Sebi disposed of charges against Sun Pharmaceutical Industries and its promoters and directors for alleged diversion of funds through AML, after all plaintiffs in the case filed settlement pleas.

Of the many allegations against the Adani Group by Hindenburg Research, what stands out are the assertions about Gautam Adani’s older brother Vinod Adani, who allegedly oversees several offshore companies related to the Adani Group.

The Adani Group, however, clarified that Vinod Adani is part of the "promoter group" of various listed entities within it. "This fact has been submitted to Indian regulatory authorities from time to time in various disclosures," the conglomerate said.

One of Vinod Adani’s companies, Endeavour Trade and Investment, was involved as the Adani Group’s acquisition vehicle for its $10.5 billion takeover of Swiss firm Holcim’s stakes in cement companies Ambuja Cements and ACC, according to Ambuja’s public filing. The deal made the Adani Group India’s second largest cement company.

The Supreme Court recently asked Sebi to check whether there’s been a failure to disclose transactions with related parties, and whether there was any manipulation of stock prices in contravention of existing laws.

Inventory levels and other bugs

The Satyam scam is one of India’s worst corporate frauds. In this case, promoters had inflated cash flows.

At the centre of the cesspool was former chairman Ramalinga Raju, who cooked the IT firm's books by creating fake invoices, inflating revenues, hiring ghost employees, and showing non-existent cash and bank balances and interest on fixed deposits, among other manipulations. Such manipulation, albeit to a lesser degree, is still prevalent in many listed companies, analysts say.

“Inventory level is the biggest grey area. The moment you adjust inventory, you can either report profit or loss. So, if a company’s inventory levels and debtors are increasing without a substantial jump in sales turnover, it is a red flag,” says Sunil Damania of Marketsmojo.

A sure shot red flag in the services industry is if a company reports higher revenues and profits, but constant/low manpower or key asset cost. 8K Miles is a case in point. The company, essentially a cloud computing business, reported excellent financial performance between March 2013 and March 2016. The stock rallied exponentially during these years.

But there were a few concerns. 8K Miles posted a revenue of ₹272 crore in FY16. Surprisingly, the cost of computers was just ₹4 crore, a key asset in the IT industry. When the issue was flagged, the company started reporting higher spends for computers: the amount allocated increased from ₹4 crore in FY16 to ₹540 crore in FY19. Its revenue increased from ₹272 crore to ₹842 crore during the same period. In November 2019, however, its auditor Deloitte resigned, citing inconsistencies in financial disclosures.

The auditor suspected fraud. 8K Miles reported a loss of ₹675 crore in FY20. In 2021, the company changed its name to SecureKloud Technologies.

A recent BSE filing suggests that Suresh Venkatachari and RS Ramani, the promoters of SecureKloud Technologies, have been arrested by the Directorate of Enforcement on March 24, 2023. They are guilty of an offence under the provisions of the Prevention of Money Laundering Act, 2002.

Monish Chatrath, managing partner at MGC Global Risk Advisory LLP, says that companies sometimes create special purpose vehicles (SPVs) to channel funds and hide certain liabilities. “They may make some disclosures in footnotes, which most investors don’t review. They tend to look at SPVs as assets. It is important to get into the details of every unusual action.”

There are many more such cases. GoMechanic, for instance, is the most recent to hit the headlines for fraud. That brings us to the moral of the story: Hype is…well, hype. The devil hides in the numbers.

ICYMI

The house doesn't always win: Especially if your name is Niko Tosa. The Croatian gambler has gained notoriety across casinos worldwide for his genius. What is this “genius”, you wonder? Tosa’s ability to beat the roulette. As this Bloomberg Businessweek story outlines, there is a method to his madness: specifically, placing his bets a few seconds into the spin (with an assist: a specific kind of a table, a perfect wheel, and voila!). Come for Tosa’s gripping backstory—which includes 💰, fake IDs, and an obsessive former British military man—but stay for the fascinating science of roulette.

In the lap of luxury: In late 2022, Bernard Arnault pipped Elon Musk to the world’s richest person title. Not for nothing, given that he has, over decades, built a luxury empire spanning 75 brands. LVMH Möet Hennesy Louis Vuitton, better known as LVMH, is the parent of virtually every luxury label you can think of: from Dior and Sephora to Tiffany’s. How did Arnault, a former engineer, do it? This three-and-a-half-hour aural deep-dive by Acquired has some of the answers. Top it up with Bryan Burrough’s 1999 account of Arnault’s failed bid to acquire the then-troubled Italian luxury family business Gucci.

Balancing act: The last time we heard of a Non-Aligned Movement, it was the mid-20th century, during the height of the Cold War. This “third bloc” mostly comprised newly-independent former colonies. Cut to today, the US-led west is fighting to maintain its geopolitical dominance, while Russia and (especially) China challenge the status quo. Is the time ripe for a new kind of non-aligned movement? This story in The Economist describes how a group of 25 countries are walking the tightrope between the west and China. There is significant dissonance between how the west sees itself and how the rest of the world perceives it. Also, unlike in the 1960s, today’s non-aligned nations, especially India, are also playing the game better, cosying up to each superpower as and when they need something (arms, infrastructure, technology).

Cubicle chronicles: How do you get employees back to work at a time of collective resistance against return-to-office (RTO) policies? For one, even the likes of Amazon, Disney, and Apple aren’t immune to pushback against rigid mandates. Enter behavioural science. The New York Times relays the story of a research company named Information Sciences Institute (ISI) and its struggle to have staff enthused about the office again. ISI has tapped the expertise of behavioural scientist Gleb Tsipursky, whose consulting is a little, shall we say, off-kilter. That’s not a bad thing, because Tsipursky’s recommendations are far more attuned to an increasingly hybrid world. Just what does he advocate? Read on to find out.

A disturbing pattern: The Great Rift Valley in Kenya is a 7,000-km-long ridge system, with steep slopes, green hills, and lakes. It’s also known as the running capital of the world. Kenya’s best runners, including the world’s most decorated marathoner, Eliud Kipchoge, train there—particularly in a small town called Iten. However, between October 2021 and April 2022, two elite athletes in their mid-twenties were found dead in the area. One was Agnes Tirop, who had won the 10,000-metre bronze at the 2017 and 2019 World Athletics Championships. The other was Damaris Mutua, who had won the bronze in the 1,000-metre race at the 2010 Youth Olympics. Both deaths were a result of gender-based violence. This story in The New Yorker details why female running champions are getting killed in Kenya.

The making and unmaking of Rupert Murdoch: An ageing billionaire heads a global media empire. He refuses to give up power, which leaves his children vying to control the company. It may sound like the plot of the hit HBO series Succession, but it’s also the story of News Corp founder Rupert Murdoch. Did you know that as part of his divorce settlement with Jerry Hall, Murdoch barred her from giving story ideas to the show's writers? There are also juicy details in this Vanity Fair story about how sons James and Lachlan competed for the patriarch’s affections and squabbled over Disney’s proposal to buy 21st Century Fox. Murdoch, 92, is also grappling with a $1.6 billion defamation lawsuit from Dominion Voting Systems. We’d argue that the Murdoch dynasty is far more dramatic than the Roys of Succession.