Business Page – June 06, 2004

Business Page

On the Line 2003 Annual Report - Demerara Distillers Limited Chairman refuses to provide answers

by Christopher Ram

Introduction

Business Page interrupts its series on Guyana Telephone & Telegraph Limited to review the Annual Report of Demerara Distillers Limited for the year ended December 31, 2003. This Report comes up for consideration by shareholders at the company's Annual General Meeting on Friday June 11, 2004 at the Diamond Complex of the Company.

In reverting to a single-volume Annual Report, directors have presented a sleek, glossy document impressively set in black and gold covers, with photographs of directors and various managers and staff of the companies in the group. Not only have the directors continued the practice of not submitting a Managing Director's report which itself is out of sync with the times, but the practice of a review by the Chairman of the performance of each of the companies has not been followed this year. To overcome this major handicap, Editor in Chief of this newspaper sent to Company Chairman Yesu Persaud a list of questions prepared by Business Page seeking additional information on the companies in the group. Mr. Persaud declined to respond.

The Chairman reported 'The group had a good year with revenue from sales to third parties increasing 18% from G$9.1B to G$10.7B in 2003. Profits before taxes increased 20% from G$1.0B to G$1.2B and Profits after taxes increased 8% from G$752M in 2002 to G$811M in 2003'. He also announced that the total dividends to be paid would be 0.33 dollars per share, amounting to $254M compared with $231M in 2002'.

Unfortunately for shareholders however the Annual Report has reduced the information on the performance of the companies in the group, which appeared on pages 13 -23 last year inclusive of pictures, to less than half a page! Incredibly, the performance of the seven local subsidiaries and ten foreign subsidiaries merit a mere three lines in the Chairman's Report, even less than the four lines devoted to the performance on the Associated company BEV which has gone back in the black! This drastic reduction in information sharing with members is clearly unacceptable and indefensible and is likely to come under heavy criticism at the meeting.

Showing the good face

Notwithstanding the increased profits, the reduced disclosure and the refusal by the Chairman to provide additional information, when what is presented is carefully dissected, this column's past concerns about this company seem overly if unfortunately justified. Conveniently and perhaps not surprisingly all the five year charts on page five of the Annual Report - Contribution to State, Operating Profits and Turnover - are those that have shown growth in nominal G$ terms. But consider the following profitability indicators and it is clear that something is seriously wrong with the strategy the directors continue to pursue without any apparent recognition of the consequences. (See graph)

This troubling performance is the end result of over ten years of pursuing a strategy of diversification into activities in which the group has minimal expertise while its attention is diverted from the one area in which it is truly world class - the manufacture of one of the finest rums in the world. Can you imagine the directors of Johnny Walker & Sons deciding that it is too risky to rely on their world famous product and that they should invest in medical transcription service, or that it must join some joint venture with an unnamed company to get into the cellular business? Sadly, that is what DDL has done with the result that key indicators such as return on assets, operating profits as % of capital employed and critically, return on shareholders' funds are half what they were eight years ago. Had the directors stumbled into this situation it might be understandable but they assure us that it is all based on a strategic plan devised with the support of an international firm of experts!

How they performed

The subsidiaries, local and overseas, accounted for 23.4% of the revenue (not 37.5% as stated by the Chairman), 20% of the assets, and 26% of the liabilities but only 13% of the profits of the group. The Indian Joint Venture has finally got off the ground not with a high profile substantial partner as contemplated ten years ago but with an unknown quantity Kanda & Associates (presumably a partnership).

In the venture's first year of operations, its expenses were more than twice its income. Fearing this possibility, I had unsuccessfully asked last year about the payback period for the investment. While a loss in the first year is not entirely surprising, the level cannot be ignored but more importantly, why did DDL have to borrow in India to finance a project it was pursuing for ten years?

In 2001, the subsidiaries with less operating assets made $274Mn. profit before tax of which the local subsidiaries contributed $138M. Two years later, with a greater number of subsidiaries and three times as much in assets, the subsidiaries - local and foreign - can only muster $162M. in pre-tax profits. How can the Directors justify this situation?

And how is the strategy of extending subsidiaries panning out in comparison with the parent?

The numbers using the most credible and acceptable measures are again frightening. While the company earns a return on average assets of 10.5%, the subsidiaries earn 7.3%. While the net profit/sales of the company is 12.9%, the subsidiaries is only 6.4%. And perhaps most staggering of all is that while the company pays an effective tax rate of 29.1%, the subsidiaries pay an effective rate of 60%. Even the most elementary form of tax planning would tell the directors that it was highly tax-inefficient to have the distribution company as an entity separate and apart from the manufacturing company. Apart from poor strategy, the 60% tax rate suggests that some of the subsidiaries are making some serious losses and/or are caught up in Minimum Tax.

Over budget, under achievement

In the 2000 Annual Report, the Chairman listed ten activities/acquisitions in a major US$15M Expansion Programme for 2001-2003 which he said would be financed by the issue of 230 million shares, a Bond Issue and Bank Loans. Over the three year period, expenditure on the Expansion Programme has exceeded budget by close to US$7M even though a number of the activities have not been achieved.

Neither the share nor the bond issue has taken place with the result that the company's and the group's debt exposure is reaching alarming proportions. The ratio of total liabilities to Net Worth is described in the Almanac of Business & Industrial Financial Ratios as "one of the most important on capital structure" being an indicator of the company's long term paying ability. For the company the debt equity ratio (which shows the extent to which the owner's equity can cushion creditors' claims) is 76.7% while for the subsidiaries it is 142%. And if we look at Debts to Total Assets the situation is also striking, these being 43.4% and 58.5% for the company and subsidiaries respectively.

Over-exposure

What is very interesting about the company's loan profile - other than the fact that nowhere are bank loans distinguished from other loans or that the Directors' Report understated the loans held by subsidiaries - is where the new loans are taking place. All the four new loans taken out in 2003 were done via subsidiaries and of these three were by foreign subsidiaries and denominated in foreign currency. The balances on these loans at the end of the year amounted to $534M, including a Euro loan of $335M over an unusually long period of 25 years! Recall that up to late last year the Chairman had assured this newspaper that there were no new foreign currency loans up to June 2003. Yet the full year figures show that three of the four new loans taken out during the year were foreign currency loans for the subsidiaries. Could the Chairman not have volunteered this information in December last year?

The reader can only speculate on whether the new strategy to raise funds is dictated by the fact that the parent company may be over-exposed to the Guyana banks. Indeed it was only two weeks ago that the Stabroek News carried an advertisement whereby the company gave a First and Third Charges to the Bank of Nova Scotia to secure an unspecified facility. This is presumably for the $1BN loan used to finance the Hamilton Bank loan buyback. Readers will recall that in the review of the Group's half year results published in this column last December we insisted that the gain of approximately $1.1M has not been accounted for in the books - an issue which cannot be swept under the carpet.

The group's Net Loans/Overdraft position has increased from a negative position of $263M in 2000 to $1,957M in 2003 - an increase of 644%! The subsidiaries over the same period have seen their net exposure increase from $235M to $1,090M - an increase of 363%. In the 2001 Annual Report, the Chairman announced that the Company in 2002 would restructure the financing to minimise financing cost but just the opposite has taken place. Net interest expenditure increased from $97M in 2000 to $202M in 2001, $239M in 2002 and is now a staggering $328M in 2003. What kind of restructuring is this and should shareholders not be given an explanation?

The adventurous expansion and borrowing strategy the directors have pursued over the past several years will clearly impact on its credit rating, cost of funds and more importantly profits available for distribution. For this purpose it is useful to look at the times interest is covered by profit before interest and taxes EBIT, since interest is both tax deductible and is paid before dividends. In 1999, interest was covered 9.97 times and in 2000 11.2 times. Since then it has declined to 4.6 times - less than half of what it was in four years. In 2000 dividends as a percentage of interest was 178%, in 2001 - 114%, 2002- 97% and 2003 - 77%. Sooner rather than later, should this trend continue, the only beneficiaries of the group will be the creditors.

Trademark

Another major concern is the vast expenditure on trade marks. The 2000 Annual Report claimed that the company owned Trade Marks in forty (40) countries. Yet since that time over three hundred million dollars have been expended on 'acquiring' the El Dorado Trademark in the United States of America and Europe. This column continues to have great difficulty understanding this substantial expenditure even in the light of the Chairman's assertion last year that the cost of registration is 'very expensive'. Our research tells us that it costs less than one thousand dollars to register a trademark exclusive of legal fees. Had the El Dorado Trademark been previously registered by other persons and did it have to be bought from them?

In the USA, trademark is a federal matter meaning that the owner of the trademark registers it once only in the USA and it is good for several years. The same is true of the countries of Europe most of which would have already been covered by 2000. The Chairman should give details of this expenditure.

Inventory

Inventory accounts for 33.75% and 40% of the company's and group's total assets respectively. Even more significantly it accounts for 73% and 76% of the company's and group's current assets, i.e. those which in theory can be converted into cash within a twelve month period. Clearly the valuation and realisability of the inventory are critical to the financial state of the company. Despite the overwhelming significance of inventory and the range and diversity of products in which the group companies trade, the financial statements have just two lines setting out the policy on valuation of inventory.

That a company whose flagship product is aged rum has more in 'spares, containers, goods-in-transit and miscellaneous stocks than it has in finished stocks and work-in-progress is hard to understand. This becomes stranger when the Chairman tells shareholders that the company in 2003 invested US$2M in aging rums even as work-in-progress amounts to a mere G$6Mn. or US$30,000. This US$2Mn. is in addition to G$600Mn. the Chairman reported was spent in 2001 in the aging of stocks for El Dorado.

These doubts are not relieved when inventory is measured by the number of days' stocks on hand. In the case of the company, there are 248 days of inventory on hand and in the case of the subsidiaries, close to one full year's inventory on hand. Even if we take finished goods and exclude the containers and spares, the company has 112 days of inventory on hand and the subsidiaries 326 days. Where is the inventory management strategy? Without the benefit of a meaningful response to our questions on inventory last year, we remain concerned about the accuracy of this inventory figure.

And how come no other group company has any work in progress? Did the Audit Committee check this?

The Audit

The company has rejected efforts over the past year to provide copies of the financial statements of subsidiaries - all private companies - as well as information on the names of the auditors of the subsidiaries and indeed whether all of these are audited. In some jurisdictions such as in Florida where DDL (USA) has its operations, an audit is not mandatory and that is likely to be the situation in the Netherlands as well. In other words one cannot determine whether the financial statements of all the subsidiaries are audited.

The directors have spread the audit work around the local firms including Deloitte & Touche, Nizam Ali & Company, PKF Barcellos Narine and Jack A. Alli, Sons & Company. The Managing Partner of Bisheswar & Company, Mr. C. Bisheswar is a director of the parent company in 2002 and his firm cannot therefore be associated with the group as auditors.

Auditors Deloitte & Touche, the parent company's auditors have reported that the financial statements conform with International Accounting Standards (IAS) and the Companies Act 1991. The auditors clearly did not consider the several cases of non-compliance with IAS's, including the treatment of exchange difference on consolidation, exclusion of some related parties non disclosure of details of a very significant contingent tax liability and inadequate information on currency exposure significant enough to warrant them taking a stand. Similarly in 2002 the auditors reported that there was a full compliance even though the company was in breach of IAS 19 Employee Benefits.

International Standards on Auditing (IAS's) also impose on auditors a duty in cases where other information in documents is inconsistent with the audited financial statements. It is therefore incomprehensible to see the glaring inconsistency in relation to subsidiaries' turnover on page 14 and the Profit & Loss Statement on page 23. Again there was a similar problem in 2002 when the Chairman reported that foreign subsidiaries contributed $112M of the $154M in pre-tax profit leaving $42M to be contributed by local subsidiaries. Yet the total of the pre-tax profit less losses of the local subsidiaries as narrated by the Chairman was almost twice as much. The question one has to ask is which number is correct?

Conclusion

While the profit position of the company has improved during 2003, the group is facing some fundamental difficulties, difficulties of governance, accountability, transparency, liquidity and profitability. The strategy of which it speaks so proudly has seen its results and performance decline over the last ten years. It would be in some difficulty if the Court rules in favour of the Revenue Authority on its claim and the company has to pay G$1Bn.

The audit profession has a responsibility to shareholders and the public which is badly served by inadequate information in financial statements with which leading audit firms are associated. It is time that the Institute of Chartered Accountants of Guyana break its silence on the serious defects in financial statements reviewed in these columns over the years.

We trust that this review limited both by space and time will contribute to shareholders' better understanding of the annual report. We further trust that the regulators, the Stock Exchange, the Securities Council and the accounting profession will play their part to protect the interest of shareholders and the public at large.

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