Carlin, Tyrone M --- "The grapes of wrath? (Company disclosure  shares)" [2007] MonashBusRw 9; (2007) 3(1) Monash Business Review 44

The grapes of wrath?
(Company disclosure – shares)

Tyrone M Carlin

The lacuna between Evans & Tate’s financial reality and the prosperous image it promulgated over 2005 is deeply troubling and raises powerful questions about Australia’s continuous disclosure regime, writes Tyrone M. Carlin.

The much-awaited Evans & Tate shareholder update on 29 June 2005 was dynamite for all the wrong reasons. Despite previous statements that everything was wine and roses, it wasn’t, and the company was expecting a loss for the year to 30 June 2005. Things quickly got worse and by 16 August the projected loss had ballooned to the point where there weren’t enough funds to pay dividends. Importantly, this didn’t transpire in an institutional void, but rather in an environment of rigorous and persistent legal regulation and obligation. So how did it happen? The answer lies in the records which show that the company’s financial communications with capital markets and the media were at odds with its financial reality.

To give some context to the situation, let’s look at the recent financial history of Evans & Tate. In the financial year following its IPO on the ASX in 1999, Evans & Tate reported earnings after tax of $2.376 million on gross revenue of $19.718m. Thereafter the company grew rapidly and in the financial year ending 30 June 2004 reported gross revenue of $101.643m and after-tax earnings of $7.624m.

Good news stories continued to flow and in late February, CEO and Executive Chairman Franklin Tate stated the company’s first half results revealed a “continuing solid foundation on which to build for increased profit growth for the full 2004/05 year”. He also reassured all who would listen that the international grape oversupply problems had been “pretty well sorted out and the notion that the industry has too much intake is overdone to hell… while there are some pockets where supply has eclipsed demand, I think the reaction has been way out of whack”.

Everything looked good and all was fine… Well, sort of. A week later, competitor McGuigan Simeon announced a profit warning and a Macquarie Bank study was released claiming that bulk wine prices were falling and many producers would be forced to sell stock below cost. Over at Evans & Tate there was no indication of any such problems; in fact the company issued a trading update to the ASX on 19 May emphasising strong sales despite speculation that the banks were circling and administrators had been appointed. However, the ruse was collapsing and soon after, the sorry duty of requesting a temporary halt of securities trading on the ASX fell to Company Secretary Sue Symons. A loss was expected.

Given that the balance sheet at 31 December 2004 showed retained earnings of $14.25m, and that in the financial year ended 30 June 2005 the company paid $4m (in cash) dividends, it stands to reason the loss expected would been no more than $10m. Indeed, the company’s own estimate was $4.8m to $7.5m, after allowing for inventory write-downs in the range of $8m to $10m and intangible write-downs of $4.3m.

History records the company ultimately wrote off approximately $40m in inventories, almost $7m in intangibles and raised provisions to the tune of $7m. The precise value of the sum of these adjustments was in fact $53.255m. This is striking for two key reasons. First, that it should follow so hard on the heels of a series of strident statements that the company was in sound financial health. Second, in making claims about its financial health, the company had consistently promoted the view that full year earnings for 2005 would be higher than those reported for the 2004 financial year. Yet an inspection of the financial statements shows that reported before-tax earnings for the 2005 year amounted to a loss of $49.783m, which, after subtracting the adjustments noted above, would only have translated into a before-tax profit of approximately $3.5m (as against the previous year’s $7.71m).

The stark contrast between the nature of the claims made by the company in relation to its financial circumstances up to and including 29 June and those which emerged from 16 August until the filing of the final financial accounts for the 2005 financial year, raises serious questions about the degree to which the directors of the company who caused such communications to transpire could reasonably have believed their content.

The capacity of the company to operate profitably rested heavily on the performance and value of two highly vulnerable key asset classes – inventories and intangibles which represented 65 per cent of total assets in both 2004 and 2005. To illustrate the magnitude of this risk, assume that the after-tax earnings of the company for the year ended 30 June 2005 would have been at least as large as they had been in the previous financial year, but for the impact of ‘one-off adjustments’, say, $8m. Recall that the company’s total retained earnings as at 31 December 2004 had stood at $14.125m. Assuming all such ‘one-off’ write-down events to be deductible for taxation purposes, the before-tax value of ‘one-off’ write-downs necessary to negate current period earnings and exhaust pre-existing retained earnings would therefore have stood in the range of $32m – approximately 17.5 per cent of the pre-write-down valuation assigned to the inventories and intangible assets.

Assessing the reasonableness of company statements is difficult. One way, however, is to examine the gross profit on each case of wine which shows that prices declined substantially and consistently in the period after the company went public, from $144 per case equivalent ($12 per bottle) to only $58 per case equivalent (a mere $4.83 per bottle) in 2005. Over the same period, gross margins declined from 52 per cent to 32 per cent. Further, close competitors had publicly acknowledged difficulties with inventories in the period, yet Evans & Tate purported to be navigating the tempest unscathed. The hard reality was that a combination of unfavourable exchange rates, intensifying international competition, slack domestic demand and a fundamental reconfiguration of the power balance between wine producers and retailers in favour of the retailers came to bear.

The record shows that the company made a series of communications with capital markets yet their content and timbre proved to be at odds with reality. This in turn begs the troubling question, is it fair to look only to the disclosures which took place between February and late June 2005 in this sceptical light – or could the same spotlight of enquiry be turned onto the (audited) annual and semi-annual accounts which preceded this period?

In 2005, the collective market capitalisation of stocks listed on the Australian Stock Exchange (ASX) stood at around $1.1 trillion. Almost 1,900 companies were listed on the exchange and approximately 100,000 equity transactions worth some $3.5 billion took place each trading day. The enormous flow of value through equity capital markets such as the ASX underlines the importance of effective oversight and regulation and, in particular, in the facilitation of informed markets.

Cheers?

It goes without saying that the apparent disparity between the firm’s underlying operational and financial reality and the image of the organisation promulgated in its various financial reports and press releases is deeply troubling. On reflection, however, the shadow cast by this episode ought to be placed in the context of a much more perfidious matter – the silence of regulatory, standard-setting and professional bodies.

Good governance flows from the recognition and defence of principle. Thus, while this analysis could be taken as an isolated forensic review of an instance of asset misevaluation, its contribution is more readily understood when set against other recently marshalled evidence on substantial deviations, in financial statements and associated disclosures, from the ideal of presenting the hard economic substratum of firms to which they relate.

Tacitus, writing on the subject of the great fire of Rome, reported that Nero stood on a private balcony, a safe distance from the conflagration, and extemporised verses comparing what he saw before him to the fall of Troy, while accompanying his oration with a lyre. In light of the growing body of evidence suggesting that there are matters of fundamental principle about which we should have great concern, one cannot help but wonder what his impression of contemporary trends in the regulation of financial reporting and continuous disclosure would be were he here to witness them.

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Cite this article as

Carlin, Tyrone M. 'The grapes of wrath?'. Monash Business Review. 2007.; Monash University ePress: Victoria, Australia. http://www.epress.monash.edu.au/. : 44–46. DOI:10.2104/mbr07009

About the author

Tyrone M Carlin

Tyrone M Carlin is a Professor at the Macquarie Graduate School of Management.