Food Empire - Uncle Warning One, Potential Shenanigan?

Rationale

My current interest in Food Empire was due to the disproportionate increase in its account receivables for the last 3 years. Thanks to fellow value investor, donmihaihai, who brought this to my attention by leaving a comment on my earlier article and contributed significantly to my follow up article on its AGM. On his advice, I picked up the book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, by Howard M. Schilit. I am nearing the end and can't wait to finish the last few chapters before re-looking into Food Empire.

Financial Performance, a re-look


A few things to note from the above, especially those highlighed in red:

1. There was a restatement in financial performance in 2004 (due to some accounting changes) and coincidentally, sales started to languish from that year.
2. Net Profit, however, held up pretty well, with a particularly huge jump in 2004.
3. Since 2004, receivable growth had been outpacing sales growth.
4. Cash generated from operations had been lagging behind net profit for all years excluding 2003.
5. Since 2006, there is a huge plunge in the percentage of cash generated from operations with respect to net profit, accounting for around 20+%.
6. Free cash flow reduced drastically since 2006, partly due to the recent acquisitions.
   

The picture becomes clearer with the following graphs:




Interpretations - Potential Implications

Account receivables outpacing sales

The fact that net profit (Pt 2 above) is holding up well usually imply that sales should be comparatively strong but that's not the case (Pt 1). To add to the confusion, account receivables growth outpaced the slowing growth in sales. In fact, account receivables to sales ratio had been increasing almost every year since 2001. My guess is that either Food Empire is more aggressive in recognising revenue or giving a more favourable credit terms to boost sales.

Real hard cash falls short of net profit

Cash from operations (cash flow statement) is a fraction of net income (Pt 4 & 5). This is something rare in other companies in my portfolio. To me, its seems to confirm there's some sort of aggressive accounting here. Its pretty fine when cash flow from operations sometimes dip below net profit, but not all the time! What's alarming for Food Empire is that its cash flow from operations is only 20 odd percent of its reported net profit. It really bring one to wonder the quality of its reported earnings!

The larger number items that cause the reduction in cash flow from operations compared to net profit is usually:

1. Increase in receivables (under working capital changes)
2. Increase in inventories (under working capital changes)

Both of which are not a good sign for a company claiming outstanding financial performance.

Negative Free Cash Flow

Free Cash Flow (FCF) turned negative since 2006, partly due to recent acquisitions, e.g. Petrovskaya Sloboda brand. Negative FCF is not necessary a bad thing, if it's due to huge investment which can imply improved future returns. But for Food Empire, the negative FCF is due to plunging cash from operations and acquisitions (investment), hence another sign of concern.

Changing of reporting currency

With effect from FY 2008, Food Empire begun using USD as the reporting currency. Even though the reported reason for this (quoted from 1Q 2008 quarter report) was to better reflect the Groups' results as majority of its transactions are in US dollars, I would think the underlying reason should be due to the depreciating USD against SGD.

USD transaction had been dominating Food Empire's business for many years, why the change now? Using SGD will paint a even more deteriorating picture, not something pleasant. Already in the published, unaudited FY 2007 results, it was mentioned (quoted):

... Currency fluctuations affected the Group’s results as the vast majority of its transactions are in US dollars while its reporting currency is in Singapore dollars. If the Group’s performance were reported in US dollars, revenue would have increased by 25.5% (unaudited) and profit after tax and minority interests would have risen by 24.8% (unaudited) ...


It seemed to me that the reporting currency would be chosen based one whichever painted a nicer picture. (USD used to be relatively strong right up to 2006, so no incentive to change the reporting currency). I would be please if the good results are due to operational performance, but not due to 'better packaging'.


Comparing with Super Coffeemix, Tsit Wing and Viz Brandz

Super Coffeemix's cash from operations began to dip below net profit since 2006 while that for Tsit Wing was always way above net profit. Food Empire and Super Coffeemix shared one thing in common, both displayed specular growth story (in terms of sales and profit) in the double digits while Tsit Wing languished in the single digits.

However, it might be unfair to compare this way because Food Empire and Super Coffeemix sold to consumers while Tsit Wing sold to retailers, bistros etc. i.e. They operate with different models.

To further quash my doubts, I looked at Viz Brandz. It also sold to consumer (like Super Coffeemix and Food Empire) but had cash flow from operations exceeding net profit. However, it also show signs of preceding the two:

1. FY 2007 sales improved 18% to 137.9m from 117.2m for FY 2006
   
2. FY 2007 profit improved nearly 6 times to 9.213m from 1.627m for FY 2006.
   
3. Cash flow from operations only improved marginally to 11.5m from 12.9m
4. Account receivables jumped 33.7%
   

Seems like the genetics for growth are the same of coffee businesses?

In Conclusion

I would say the numbers Food Empire (possibly Super Coffeemix too) churned out are a cause of concern, but not a red flag yet. Anyway, I would monitor future announcements and results closely, and wait for my chance to quiz the management again in the next AGM or EGM, which ever earlier, and decide my next course of action from there, no hurry... yet.