September 7, 2018

The sharemarket soared to another record high this week as investors continued to react positively to the phenomenal June 2018 year profit announcements.

Seven listed companies reported profits in excess of $700 million and a further six achieved net earnings between $500 million and $700 million.

Retail investors continued to pour money into the market in response to dividend increases of between 20 per cent and 40 per cent. Seven of 50 companies in the NZX50 Gross Index raised their dividend by more than 50 per cent.

The profit and dividend increases were greeted with widespread enthusiasm, but some groups, particularly the Shareholders’ Association, continued to advise caution.

The association reiterated that profits were inflated as most of the June 2018 year record earnings figures were “underlying”, “normalised” or “adjusted” profits and were well in excess of audited earnings.

The association told members they should focus on audited profits and a company’s free cash flow, as these were far more important than adjusted earnings, which were mostly unsustainable.

The chief executive of the Institute of Chartered Accountants rejected these warnings. He said one of his main objectives was to reduce the number of rule-bound requirements his members faced.

Accountancy, like any other business, had to become more market- and client-focused. If clients wanted to highlight adjusted earnings then they were entitled to do so because they had a better understanding of their business than auditors.

The institute’s president backed his CEO, saying: “We are fed up with this tall poppy syndrome in New Zealand; the media is always criticising accountants because we are successful.

“We still hear New Zealanders whingeing about inadequate auditor supervision of the finance company sector a decade ago. When will Kiwis move on? The finance company sector collapsed 10 years ago, the whingers should shut up and look to the future.

“There is a new business paradigm, a period when directors and management are acting much more rationally and ethically than in the past.

“There won’t be a repeat of the finance company debacles of the late 2000s. You can be absolutely sure of that.”

The four electricity generators – Contact Energy, Genesis Energy, Meridian Energy and Mighty River Power – have raised particular concern because they continue to make huge positive adjustments to audited earnings. The four generators reported total adjusted earnings of $1.63 billion for the June 2018 year, compared with audited profits of $926 million for the same period.

The new Mighty River Power chief executive said senior executive bonuses were based on adjusted profits, not audited profits, but it was ridiculous to suggest that these earnings were deliberately inflated to benefit senior management.

He said: “The majority of New Zealand companies remunerate their executive team on the basis of adjusted earnings, but criticism of this approach is typical of the country’s tall poppy syndrome.

“When will left-wing journalists realise that a large percentage of the country’s wealth is generated by senior executives of our largest companies?”

The chairman of Genesis Energy believed electricity companies were justified in paying dividends in excess of audited profits and free cash flow.

He said the domestic business environment changed dramatically when the country’s median house price reached $1 million.

In response, the Reserve Bank reduced the loan to value ratio to 60 per cent on all residential mortgages, and former Prime Minister John Key allowed individuals to use all their KiwiSaver funds to buy a house, regardless of their age or whether they were buying their first, second or 10th home.

As a result the banks were now flush with funds, said the Genesis chairman, and were lending aggressively to businesses.

The electricity generators had taken advantage of this and were now partly funding their dividends through bank borrowings.

He said this was a win-win situation for everyone as the Crown, which still owned 51 per cent of Genesis, Meridian and Mighty River Power, received higher dividends as did retail investors.

Asked whether this strategy was sustainable, he said: “Of course it is, there is a new business paradigm, Genesis has massive unused credit facilities with the banks, and these facilities will not be revoked as we operate in a very stable sector.”

The adjusted earnings controversy is expected to be raised again at Telecom’s annual meeting this month, as the company made 29 adjustments to its June 2018 year audited profit, compared with 23 amendments to its June 2017 year earnings.

At last year’s annual meeting, a fund manager asked the company why it felt justified in including all capital profits in adjusted earnings but excluded all impairments and write-offs.

The chairman replied that fund managers include all capital profits in their accounts and there was no justification for him to criticise Telecom for doing the same.

Telecom included all capital profits in adjusted earnings because it expected to repeat these on a yearly basis but it excluded impairments and capital losses because these were one-offs and were unlikely to be repeated.

Similarly, the company did not include losses on financial instruments – foreign exchange hedge, interest rate swaps etc – in its adjusted earnings because it believed that these losses would be reversed in the following year.

The discussion at last year’s Telecom annual meeting was extremely technical and of little interest to most shareholders.

The company’s large dividend increase and the whiff of sausage rolls and savouries brought the discussion on adjusted earnings to an abrupt end after 15 minutes of discourse.

Another fund manager, who spoke to this column on condition he was not named, said creative accounting, particularly in relation to adjusted earnings, was becoming more and more of a concern.

He had employed an analyst with an accounting background, rather than financial analyst experience, to help him decipher company accounts because of all the adjustments that were being made.

He didn’t know how retail investors, particularly new investors who participated in the electricity IPOs, managed to work out the true earnings of these companies.

The fund manager said he was at primary school during the 1980s sharemarket boom and the latest controversy made him realise for the first time how individual investors could be seduced by creative accounting.

Late last night this column finally managed to talk to a stressed chairman of the Shareholders’ Association.

He said it had been a frantic few weeks as the association had decided to go on the front foot over creative accounting and profit adjustments, and he’d had to respond to a huge number of media inquiries.

“We have a massive housing bubble, the benchmark sharemarket index has doubled over the past three years, companies are borrowing to pay dividends and chief executives are receiving huge bonuses based on adjusted earnings,” he said.

The association had undertaken a large amount of research into the accounting issue and had tried to engage the Institute of Chartered Accountants with little success.

The association’s research showed that 91.2 per cent of the country’s 217 listed companies had announced adjusted earnings that were different to audited profits with 181 of these adjusting profits upwards and only 17 making negative amendments.

The average age of the Shareholders’ Association’s members was more than 60, and most of them remembered the 1980s and other sharemarket bubbles.

“We urge the Institute of Chartered of Accountants to introduce accounting standards that are consistently applied by all companies, or to at least clarify what adjustments can be made and when” the association’s chairman pleaded.

“Otherwise this bubble will end in tears, as do all sharemarket bubbles that have been hyped by creative accounting”.

Brian Gaynor

Portfolio Manager

Disclosure of interest: Milford Asset Management holds shares on behalf of clients in most of the companies mentioned in this article.