Business Page – December 14, 2003

Returns on Gross Assets and Shareholders Funds

Introduction

The Directors of Demerara Distillers Limited approved the unaudited half-year financial statements of the group on October 24, 2003, some fifteen weeks after the end of the period and just seven days before the statutory deadline set under the Securities Industry Act for reporting to shareholders and the Securities Council. Are the directors and shareholders comfortable with the pattern of late reporting to shareholders and the fact that for the past two years the company held its annual general meeting outside of the statutory deadline?

This analysis was submitted for publication on November 23, 2003, but was delayed due to an exchange of correspondence between the Editor-in-Chief of this newspaper, Mr David de Caires, and Mr Yesu Persaud, the company's Executive Chairman pursuant to a prior commitment by the newspaper to allow Banks DIH and DDL an opportunity to provide answers in advance to any questions raised in Business Page on those two companies. After the article was submitted, Mr de Caires had expressed some discomfort with certain issues raised by the article and requested that questions be prepared by this columnist (who is also a DDL shareholder) for submission to the company. These questions along with the responses received are incorporated in this article under the sections to which they relate.

Readers should note that the results for the half-year are unaudited and cannot therefore be regarded with the same degree of reliability as audited financial statements. Only consolidated financial statements have been published, and shareholders are unable to assess the performance of the company which is the only public entity in the group. While 'IAS 34 - Interim Financial Reporting' neither requires nor prohibits the presentation of the accounts of the company, these would surely have been helpful in assessing its own performance separate from the group as a whole.

The directors have stated that the report complied with IAS 34, but missing information on segment revenue and results, material events subsequent to the interim statement date, changes in contingent assets and liabilities and, very critically, related party transactions suggest a failure to comply with the Standard. A significant number of accounting notes would be required to facilitate a better understanding of the company and the group's performance during the interim period and condition at June 30, 2003.

While the report's financial information exceeds the requirement of the provisions of the Securities Industry Act (SIA) in respect of financial information, it does not provide any information on the interest of directors in subsidiaries as required by the SIA. This is considered particularly important in the context of the directors' continuing failure to respond to questions raised by this columnist about the share transaction in Solutions 2000 Inc, involving two of DDL's directors including its Managing Director Mr Komal Samaroo, FCCA, ACIS, AA.

The group

DDL is a mix of domestic as well as international companies of which only the parent company is a public company. Consequently, financial information on significant portions of the group such as the European and US subsidiaries is not accessible to the shareholders of the parent company. The Chairman side-stepped without any explanation the request by Mr de Caires for copies of the financial statements of all the subsidiaries, information in which all shareholders would have a legitimate interest.

The group network is quite diverse, straddling continents and currencies, and also regulatory obligations. For example, in the state of Florida in which DD USA Inc has been incorporated, it is not mandatory that the financial statements of private companies be audited. Neither the Florida state authorities nor the international credit-rating agency Dun & Bradstreet appears to have much by way of financial information on this subsidiary. The Public Officers/Director details of DDL USA Inc. indicate that the persons holding office are: Yesu Persaud, Komal Samaroo, Loris Nathoo and Paula Lye.

Readers will recall that in our analysis of the group's 2002 Annual Report, we questioned the very substantial write-off of G$57M of 'opening losses' against reserves rather than through the Income Statement which most accountants would find the more acceptable treatment.

We had also questioned the treatment of the DDL's 19% shareholding in Diamond Fire and General Insurance Company Limited (DFGI). Under 'IAS 28: Accounting for Investments in Associates,' an investment should be treated as an associate if the investor has the "power to participate in the financial and operating policy decisions of the investee." IAS 27 which deals with accounting for subsidiaries requires an investment to be treated as a subsidiary where the investor has "the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities."

Conditions of participation, or more probably control, almost certainly exist and for the purpose of accounting treatment, override the fact that the shareholding is less than 20 per cent. Surely the fact that DDL's Chairman, its Managing Director and its Corporate Secretary are on the board constitutes almost irrefutable evidence of the 'power to participate in the financial and operating policy decisions.' We are confident that DDL benefits from the services of DFGI and can influence the cost of those benefits through its board members.

The parent has pursued a strategy of establishing new subsidiaries, some of which, such as a trading operation in Trinidad and Tobago, are questionable on business model grounds. The company must therefore find ways to disclose financial information about those entities in a manner which its shareholders will be able to understand and accept. Regrettably, that is not the case at the moment.

Profitability

The group's net profit for the period is 6% higher than for the corresponding period last year, while revenue has increased by 3.3 per cent. The real improvement, however, derives from the significant turnaround of fortunes of the group's investment in BEV Processors Inc, which contributed $30M to income compared with a loss of $3M for the same period last year, and a $19M loss for the full year. For group companies only, i.e. without BEV Processors, the after-tax profit for the period has actually declined by 2.6% from $375M to $365M.

The gross profit margin has declined marginally from 37% to 36 per cent, but earnings per share (EPS) which take into account the results of BEV Processors Inc have increased from $0.48 to $0.51. EPS express the earnings of the group in relation to the number of shares outstanding, and by extension the returns to the shareholders. Other profitability indicators, such as return on assets and return on equity, declined in comparison to the same period and indeed for full-year 2002. EPS are only of limited value and are of no greater significance than other indicators of management performance, such as returns on assets and equity, both of which have continued the downward trend which began some ten years ago.

The report does not include any provision for dividends, but subsequent to the report's issue, the company announced a dividend of $0.1 per share which would require cash resources of $77M, which can only be obtained by adding to already substantial short-term bank borrowings, since enough free cash flow does not appear to be available. The combined effect of the difficult conditions which the Chairman laments with troubling frequency, deteriorating cash position and the absence of any overt policy on dividends may account for the decline in the company's share price since the beginning of the year, and its shaky performance since the advent of the Stock Exchange earlier this year. Indeed, the declaration of a dividend in the current illiquid financial situation must have been approved by the directors only after the most careful consideration of the likely effects of the reaction of shareholders to the non-payment of dividends and the impact on share prices.

With 770M shares in the hands of shareholders and with shares trading at $6.50, the market capitalisation of the company suggests either that the company's assets are considerably overvalued or its shares undervalued. A close examination of the balance sheet (see below) indicates possible problems with inventories, which account for 41% of the group's total assets. It would, however, take a much more detailed technical analysis to arrive at any firm conclusion about what might be considered a realistic price for the company's shares, if one were to suggest that the Stock Exchange price is distorted by market imperfections and the availability and quality of information. Only 490.4k or 0.06% of the company's shares have traded since the advent of the local Stock Exchange.

The price earnings ratio is now approximately 13, which means that excluding dividends, it would take 13 years to recover one's investment in the company's shares at the current price. While this would not normally cause concern, in an unstable economy with a depreciating currency, shareholders would be justifiably uneasy about the earnings of the group, the performance of their investments and the limited returns in the form of dividends.

Note: The Stock Exchange began active trading only in July 2003, and the table above shows trading prices from July 19 to November 20, 2003. At December 31, 2002, some pension funds and insurance companies valued their DDL investments at $8. Indeed the NIS's annual report for 2001 valued its DDL holdings at $9 per share.

Balance sheet

The balance sheet which is the equivalent of a personal statement of affairs confirms the company's continuing difficulties as evidenced most tellingly by one of its loans according to the Federal Deposit Insurance Corporation (FDIC) being classified as non-performing. While the group's working capital has improved by close to $200M, the increase is entirely accounted for in inventories, which is the least liquid of circulating assets. The total cash and bank balances of the group at June 30 was just $34M, down from $264M six months ago. In June 2002, the company had a net overdraft position of $278M, increasing to $496M at December 2002, and now standing at $615M - a clear indication that the company is unable to generate the desired level of operating cash flows to justify its large asset base, while supporting an investment and expansion strategy which defies logic and business sense having regard to the quality of the returns on this investment over the past several years.

For the same period last year, the cash generated from operations declined from $983M to $277M in the current period. The declining cash generation and increasing overdraft situation means that the interest payable by the group continues to climb, a situation that is likely to worsen as the impact of the recent tax charges on bank lending by way of the 'bond device' is felt. The bottom line could be affected by any increase in rates or borrowings, and it is not inconceivable that the company's shareholders will be asked to bear increased debt service charges. In 2002 the company borrowed $1B at the Treasury Bill rate plus 2% and, based on the statements made by the banking community, an increase in the interest rate would seem inevitable.

Expansion programme

Over the past few years the company has undertaken some quite large projects including its move to Diamond, the construction of a new Head Office in Kingston, TOPCO and some of its overseas operations including Europe, where the Chairman has reported that land has been acquired in a "prime" area in Zaandam to build a new warehouse financed by bank borrowings. While it is difficult to understand why one would want to construct a warehouse on prime property, it is the announced massive investment in TOPCO, the acquisition of the majority interest in Solutions 2000 Inc, and the determination to move into the Indian market that cause real and specific concerns. The Chairman did not respond to the request that he indicate the projected payback period for the announced $500M investment in TOPCO, a company which made a total pre-tax profit of $17M in the past two years.

In relation to Solutions 2000, the questions submitted by the Editor-in-Chief referred the Chairman to allegations that certain directors of DDL profited from the acquisition, and questioned its enhancement of shareholder value. He asked the Chairman to identify the directors involved and the steps taken by the Board of Directors of DDL to ensure that there was no conflict of interest. He also enquired about the method used to establish the purchase price and the person(s) who carried out the valuation. He further enquired about the strategic reason for the acquisition, the addition to earnings by Solutions 2000 since the acquisition and any common directorships between DDL and Solutions 2000 at the date of the transaction and currently.

In response the Chairman noted that the acquisition of Solutions 2000 was sanctioned and approved by the Board of Directors and that the acquisition was fully disclosed in the 2000 Annual Report. He added that since the acquisition, cash generated by Solutions 2000 has exceeded the purchase price and that the reason for the acquisition was also stated in the 2000 Annual Report.

It is rather disingenuous to consider as 'full,' disclosure which did not state that some Directors of DDL also had significant ownership interests in Solutions 2000, or to leave the reader to find out that the net assets acquired represented less than 25% of the purchase consideration. The Chairman's response about "cash generated exceeding the purchase price" is evidence of the confusing manner in which he addresses what should otherwise be direct issues. The 2000 Annual Report commenting on Solutions 2000 states: "The company recorded a 12% improvement in turnover to $72M and generated $12.1M in surplus cash after operating expenses, interest and tax payments." Annual Report 2001: "The pre-tax profit was $9.9M against $1.1 million, an increase of 800% against the preceding year, quite a substantial increase for the Company." Annual Report 2002: "Turnover was $94.8M compared to $94.6M in 2001, however profits before taxes declined to $4.6M compared with $9.9M in 2001."

It may be considered hindsight, but the goodwill paid for the investment can hardly be justified. In addition, the fact that the group is still to post its 2002 Annual Report or the 2003 half-yearly report on its website raises doubts about the IT culture in the organisation.

The report gave no indication of the money spent so far on the 50% Joint Venture - Demerara Distillers India - announced by the Chairman, Mr Yesu Persaud CCH, earlier this year. This investment, which took many shareholders by complete surprise, raises serious concern, particularly given the disappearance of a similar venture glowingly touted by the Chairman in the 1993 annual report when he said: "There is a large market for spirits and DDL has entered into a Joint Venture with Tungabhadra Machinery and Tools Limited to build and operate a distillery in India to supply from its base in the State of Maharastra, the Indian market, the Pacific Basin and the former Soviet Block (sic) and Africa." Then in the 1994 annual report: "We also have a partnership in India - the building of a distillery - which has not fully gotten off the ground because of certain logistical problems. These will shortly be overcome."

That was the last mention of that Joint Venture, the financial consequences of which have never been published causing the Editor-in-Chief to ask the following questions: How much was spent on the first Joint Venture in India and what was the projected payback period? Why did it fail? Who negotiated that JV and who were DDL's representatives on the JV Board/governing council? How were the initial investment and subsequent failure accounted for in the financial statements? What is the reason for going into the new venture and what is different this time? What is the estimated payback period? How much is DDL required to contribute to this investment and over what period, and finally who are DDL's representatives on the JV Board?

In his response the Chairman said, "The first Joint Venture in Andhra Pradesh was never formalized because no alcoholic products were permitted in this state which was referred to as the 'Dry State'. No investment was actually made. It took ten (10) years to see a change in the Laws of the State making the production, sale and distribution of alcoholic products less burdensome and DDL, India was launched in January 2003. Actual production and sales started in the second half of the year. DDL's investment is expected to be less that US$1Mn. Over the last couple of years, some of the largest Spirit producers in the World like Bacardi, Pernod Richard, Diego, Allied Distillers and US companies have entered this market as they see great potential since the decision was taken to open up this market as a result of WTO pressures. Bacardi has had an early start as well as the others and there is some catching up to do."

The Chairman's response which creates some confusion as to whether the first Joint Venture was in Maharastra which is in western India or Andhra Pradesh which is in south-east India, not only fails to answer many of the questions, but raises others as well. It surely stretches credulity that neither the company nor its JV partner would have been aware that the state was a "Dry State" and would have contemplated building a distillery. The statements in 1993 and 1994 annual reports appear to imply that some degree of negotiations must have occurred, presumably after proper market and other studies had been completed and legal advice taken, and that some kind of agreement had been sealed. Could these have been achieved with no expenses incurred on the investment? In addition it is difficult to comprehend how other companies could have entered the market "over the last couple of years" when by my arithmetic the law was only changed in 2003. And how alert have DDL and its partner been to allow more recent interests to be way ahead when DDL already had a joint venture agreement since 1993?

It is worth pointing out that the Chairman did not respond to the questions about the identity of the directors and the estimated payback period of the investment.

Because of the disparate investments and a couple of references to plans in successive annual reports, the Chairman's attention was drawn to a reference to a strategic plan and restructuring, and he was asked about the significant investment and borrowing decisions, to identify the consultant(s) who authored the plan, the investments planned and their value. He was also asked to comment on the several billion dollars spent on the expansion programme over the past few years, the specifics of the expansion and to indicate approximately what percentage is complete and how much more money will be required for its completion.

In what can best be described as a casual and incomplete response, the Chairman noted that, "The 2000 Annual Report outlined the company's expansion plan and the associated costs." Readers will realise that the response only addressed the question of the expansion and completely ignored the specific questions regarding the strategic plan, related investments and TOPCO, all matters of critical importance to shareholders.

Inventory

In contrast to cash resources which have declined quite significantly, inventory moves in the opposite direction but with equally costly consequences. The report gives no breakdown of the closing inventory (which at June 30 stood at $4.7B), but the 2002 audited statements suggest that work in progress is quite negligible (0.18%), particularly for a manufacturing entity with a long production cycle. What is hard to understand is that a company can have more "Spares, containers, goods-in-transit and miscellaneous stocks" than "Finished stocks and work-in-progress" combined. Yet that is the situation at December 31, 2002, when it had $1,593M of finished goods and $1,653M of spares, containers and goods-in-transit. The relationship of these two categories of inventory for the remainder of the group appears more logical with Finished Goods of $1,186M and the other items valued at only $53M.

In the questions posed to Mr Persaud, it was noted that the level of inventory seems unacceptably high, especially with respect to items other than finished goods, and he was asked about the economic logic of such a strategy. He was also asked to provide by category the value of items other than finished goods at June 30, 2003.

In his response the Chairman asked simply, "The statement that the Inventory seems unacceptably high is made on what basis? The Inventory besides finished bottled stock comprises mainly of barrelled rums being aged. The chairman in the 2000 Annual Report made specific mention of the company's plans in this regard. As you are fully aware the company sells rums aged to up-to 25 years. These rums have got to be put aside now to meet current growth in sales."

The response supports our expectation that the value of work-in-progress and finished goods, which are the source of the company's profits, should logically significantly exceed its containers and other miscellaneous items. The numbers, however, which the Chairman confirms, suggest otherwise. Even having regard to the nature of some of the company's products, its level of inventory, which amounts to more than nine months of sales, is excessive, and clearly warrants a special investigation as it reflects substantial overstocking or high levels of obsolete stock, or indeed both. Even if the company was in alcoholic beverages only, there should be no more than about five months' inventory on hand. In the past year, inventory has moved from $4.1B at June 2002 to $4.5B at December 31 and reaching a record level of $4.7B at the reporting date.

Deferred expenditure

Expenditure incurred by the company, but optimistically deferred to future years, now stands at $250M, up by $42M over the past year. What is particularly troubling both about the nature and level of this item is that it is largely (82%) in respect of the subsidiaries, which account for a mere 15% of the total assets of the group and an even less respectable 11% of net profit. Expressed another way, deferred expenditure represents 2 1/2 years of 2002 profits of the subsidiaries. Such a policy, which has led to disaster elsewhere, should therefore be pursued with extreme caution, given that the US subsidiary alone had a loss adjustment of $57M in 2002, which was questioned in this column earlier for want of an explanation and which regrettably has not been forthcoming.

The following questions were put to the Chairman: There appears to be a policy of significant expense deferral under certain circumstances. What is the basis for this? How much of the total deferred expenditure relates to the US and how much to Europe? Who were the trademarks acquired from? Are there any payments to or on behalf of related parties charged to these subsidiaries' financial statements? If so please identify the persons and the amounts.

The Chairman responded as follows: "There are companies in the world that were using the Trademarks and we had to buy them back from these companies. This has been the case in Spain, Finland, Germany and USA. The cost of registration is very expensive and to date we have only registered in 60 countries but over a period of time we would register in all the countries. Amounts spent on brand development such as trademark protection is deferred and written off over ten years. No payments were made to any related parties."

The response seems inconsistent with the level of deferrals recorded in the financials, since the 2001 annual report indicated that "$70M was spent on registration and protection of the El Dorado brand." However, the balance sheet at December 2001 shows 'Deferred Expenditure' for the company and group as $37.9M and $53.4M respectively, and for both group and company at December 2000 at $7.1M.

Despite the Chairman's explanation, the concern must be whether the profitability of the product in every country is sufficient to justify the reported high cost of registration. Over the previous two years the group spent close to $200M on trademarks/registration - an exceptionally large amount. In addition, having experienced a situation in the USA eight years ago when a trademark had to be acquired at a high cost, why did the directors not take earlier action to protect the trademark of one of the world's best-known rums? And what steps did they take to ascertain and possibly take legal action against what was in effect the theft of its property?

Loans

Loans constitute another area of concern, particularly because of the company's failure to disclose information which would enable an appreciation of the company's currency exposure. Of the loan of $1B borrowed in 2002, $921M was drawn down in the latter half of last year, while over the twelve-month period July 2002 to June 2003, total loans have increased by approximately $485M - 79% of which was spent on capital expenditure. A report in the Miami Herald about a significant loan buy-back in which the company was involved some time last year prompted the following questions:

Which of the loans listed in the audited financial statements for 2001 and 2002 are foreign currency loans, and what is the extent of the company's exposure in foreign currency loans at June 30, 2003? Was there a loan buy-back in 2002 of a non-performing loan? Why was it in this category? Why was the transaction not in the notes to the financial statements? Was there a gain or loss on the transaction and how was it accounted for? How was the transaction financed? From whom was a loan of $1B obtained in 2002?

The Chairman responded as follows:

"The foreign currency loans are clearly stated in the Annual Report of 2002. No new foreign currency loans were taken as 30th June, 2003."

Note: In fact that information was included in a supplement to the annual report under the Securities Industry Act following questions raised by the Securities Council.

Buy-back of debt 2002

"Prior to closure of Hamilton Bank in the USA, DDL had a revolving working capital line of credit used for the discounting of DDL foreign currency customers debts. In 2001 the Federal Deposit Insurance Corporation (FDIC), closed the operations of Hamilton Bank. At the time of closure DDL had outstanding amounts due to Hamilton Bank. The line of credit is not a loan but is treated as a creditor and is included in the current liabilities of the company. In 2002 the FDIC sought to recover the debts (all debts not only for the amounts due by DDL) owed by Hamilton bank by means of a process allowing persons to buy blocks of debt from the FDIC.

"This was the official process for repaying the debt. DDL settled the debt by means of a normal bank transfer. At that time all the debt owed to the bank was classified as non-performing. The net effect of the settlement resulted in no gain or loss to the company after accounting for all balances both debit and credit with the bank. This was the rationale for arriving at the settlement amount. It is noteworthy that DDL once again has normal banking relations with the Israel Discount Bank who acquired the defunct Hamilton Bank from FDIC. As an international corporate company it is imperative that our credibility is unquestionable. We have banking relations with some of the largest banks in the world, Citibank, ABN Amro, Bank of America, HSBC, etc. We would not have been able to do so had our credibility not been of the highest order."

Loan of $1B obtained in 2002

"This debt was obtained from a bank operating in Guyana, not Demerara Bank Limited."

We do not find the response entirely satisfactory since according to FDIC records, a loan with a balance of US$4,673,156 was purchased for US$3,509,540. Whether it was a loan or line of credit (which is similar to an overdraft) is not the issue, but rather the disclosures required for such a transaction, since interest was payable and some security or guarantee must have been given for the amount advanced.

Additionally, subsequent to receipt of this response an enquiry of the FDIC resulted in the following statement: "Our definition of a non-performing loan is one that is 90 days or more past due." It further continued: "No, not all loans are classified as non-performing loans once the FDIC takes over. Most failed banks do have some good loans at the time of closing." This seems consistent with the definition in our own Financial Institutions Act 1995.

It is of course possible that the FDIC may have made a mistake and classified DDL's facility as non-performing, but it would be illogical and not very good business to sell performing (good) loans at a discount.

In any case, whether the loan was or was not performing is only one of the issues. It is how the gain, if any, is accounted for, as well as how the transaction impacted on the condition and results of the company. It is normal accounting practice for transactions of this nature to be disclosed separately. The situation is even more puzzling when one considers the amount involved, which even for a company of DDL's size, surely cannot be considered insignificant. A wire transfer is not a means of financing, but merely a method of payment. With the transaction not being disclosed it is difficult to validate the assertion that the gain of in excess of US$1.1 Mwas offset by "accounting for all balances both debit and credit." It is also instructive that there is no evidence of any transaction of the magnitude of the amounts of the "line of credit" or repurchase passing through the 2002 cash flow statement. There is also no note in the financials on restrictions on any cash balances, which could only be offset against the "line of credit" if they were securing that facility, or if there was a legal right of set off.

Prior to the preparation of this article a Stabroek News reporter had been told by a senior financial manager of the company who is also a director of the US subsidiary that the gain was off-set by various charges. At best this has to be considered poor accounting, and the two different explanations represent too major an inconsistency to be allowed to pass. This transaction surely requires further explanation in the interest of the company's shareholders.

Conclusion

It is difficult to understand how the directors of a company that consistently wins the world's major international awards for best rum cannot convert this into tangible value, and can be satisfied with such mediocre results. Public companies must be prepared to answer tough questions from both analysts and shareholders, as they are abroad, on issues relating to the principles of good governance, such as late annual general meetings, excessive executive control of policies, questionable accounting practices, combining the roles of CEO and Chairman, cherry-picking of accounting standards, inadequate communication with shareholders, probable conflicts of interest and a minimalist approach to reporting and disclosure. If we wish to move into an era of 21st century financial accounting and reporting, our public companies will certainly need to respond to justified criticisms more appropriately and with more forthrightness than hitherto on display.

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