Last September I posted about Arafura Pearls’ announcement of an after-tax profit of $10.05 million; a sizable sum of money for any small- to medium-size operation. It assuredly seemed like the folks at Arafura were doing something right. But are they? At the time, I took little notice of the accountancy, falling arse over tit for any morsel of good news. But the continuing announcements of good news in the form of staggering profits from a company trading in an otherwise floundering industry caught my assiduity.When I first posted on Arafura last year, I didn’t take a close look at the company. Arafura is a publicly traded company. Their numbers are public. When they reported a profit of more than $10 million, whilst surprising, I took the figures at face value. But how are they determining such a high profit?
Upon examining Arafura’s income statement for the fiscal year ending June 2008, I rescind my earlier post on their profitability. It does not look like profit to me, merely the hope of a future windfall.
Sales revenues for Arafura through June, 2008 are reported to be $6,514,971, with other revenues of $398,104. So how in the hell could they report a profit of more than $10 million? Consider this! Employee expenses during the reporting period were $6,061,428. There go the revenues, right? But operating expenses are not strictly tied to employee expenses. There are equipment expenses, lease expenses, travel expenses, fuel expenses…the list goes on. Total Arafura operating expenses were nearly $15,000,000. But they made an after-tax profit of more than $10 million?
Let’s examine the second half of 2008 – the first half of the following fiscal year. Arafura’s total sales revenue was a diminutive $235,427. Their operating expenses totaled $8,107,463. That’s not within cooee of a profit. In fact, it looks like nearly an $8 million loss, right? But no, according to Arafura’s books, it’s a before-tax profit of another $4 million.
Are you gobsmacked yet? You should be. It doesn’t take a mathematician to see something is a wee bit odd here.
So where in the hell is this profit coming from??!! I found it in the income statements.
In June 2008, Arafura’s income statement showed an increase in non-current biological assets of $22,325,412. By December 2008, that figure rose again by another $10,351,838 to nearly $52 million! So what are biological assets? What might it mean for a biological asset to “not be current”?
Let's examine a few statements from Arafura’s annual and half-yearly reports.
The value of shell inventory stocks in the water has increased substantially since the half year ended 31 December 2007. Successful spawning seasons for 2008 & year to date 2009 have generated sufficient spat stocks that will be required to meet our 2009 – 1011 seeding quotas. Accordingly, the increased number of shell in the water is reflected on the Balance Sheet with a much higher inventory valuation figure.
Further
Increased hatchery production of over 1 million shell that has and will be selected into panels for growout. The spawning season runs from September to May and the 2008 output level represents a significant increase above previous years production levels to meet the recent increases in our quota level. The significance to the Company is that this hatchery production should enable the Company to meet quota levels in the 2009 season and beyond.
And further
As a consequence of the production performance for the year, the value of shell inventory more than doubled in the financial year, from $19.1 million to $41.3 million. The shell which is being farmed for the Company’s account is valued according to the SGARA accounting standard for biological assets and the shell which is farmed for the Managed Investment Scheme (“MIS”) growers are valued at cost of production.
Is this a cockup? It looks as if the profit Arafura is publishing appears to be based on the value of the shell they are producing, including the SPAT! Am I reading that wrong?
I wonder if this large write up of biological assets could possibly be considered deceptive under the Corporations Act. Presumably, they write up the value of all types of shell at whatever stage they are at, at an inflated price, thus reaching their staggering value. This could be misleading on several counts. Firstly, by giving all oysters an asset value, it presumes there is some sort of market in the pearl industry for all types of oysters. There is not. Australian farms are winding their production programs back, and most will not seed anywhere near their own quotas, let alone buy oysters from another producer such as Arafura.
Secondly, the whole industry is governed by quotas. It would be interesting to know how many oysters are included in their calculations to reach $52 million, but it must be millions. There is no scope under the quota system to use anywhere near these numbers in a legal manner.
Further, how can shell be counted at all stages of growout? What percentage of hatchery spat, or even juvenile shell actually reach the seeding table?
Finally, these figures do not take into account the dire situation the industry has found itself in. Producers are cutting back for a reason. Pearls are not selling. The market has dried up and until this world recession reverses direction, there is no bright light visible on the near horizon. Pearl oysters cannot be shelved like their pearls.
The Australian industry has sailed into terribly dangerous waters. More than ever, serious long-term farmers need the support of bankers and investors.
It would be interesting to know if a lawyer or ASIC considered these tactics of theirs legal. Presumably, Arafura is attempting to show a profit to appease banks and investors, as they burn money at a furious rate (A$16 mill p.a.) while the rest of the industry scrambles to scale back, and have a pitiful income from sale of pearls ($235,000 for the half year).
In an interesting development near the end of February, Arafura released a New Issue Announcement. It reads 82,081,790 shares at $0.05 per share. The purpose of the lion’s share of shares, SHORTFALL ALLOCATION.
It might not be long before the spat hits the fan.
Posts
31 comments:
Oh shit.
Wow- sounds like Arafura is treading on dangerously thin ice...
Dear Pearl Prof,
I think you are spot on. Arafura will try to hide their bogus oyster valuations behind SGARA standards (Self generating Assets), but they have to declare "fair value" for their own farming oysters. How can they put monstorous values on spat when they will have mimimal sales after production (as their record shows), and when their is no market for spat as you point out. They survive on the premise that neither the tax dept., nor unknowing investors, understand that the only value you can extract from a pearl farm is when you finally produce pearls, and sell them. Despite whatever they say, they are doing little of either. All increased spat production will do in the forseeable market, is to accumulate further losses on grow out should they seed them, followed by minimal sales on production. They can say what they like about accounting standards, but they must take the current situation into account, and cut expenses drastically as all other producers are desperately trying to do, and not try and suck more and more funds from investors. Surely they must see their fiduciary obligations to disclose the realities of the pearl market, and not talk it up through shady profit increases. It would be interesting to know how they reach "fair value".
In any case spat is the least valuable oyster of all age groups. They have higher mortality rates and cannot be used for commercial production until at least 2 years later...on the other hand, a healthy adult oyster is really worth some money. How good are the prices for wild-caught Pinctada maxima these days?? They used to pay some $5-8 USD per maxima MOP some years ago.
I would not pay over 1 US penny for a spat.
It makes no sense. How is this legal? It looks like legalized book cooking.
I am in French Polynesia. Can I claim my farm is profitable by giving each spat a high value? I don't have investors so I would only be lying to myself.
Anonymous said...
I am in French Polynesia. Can I claim my farm is profitable by giving each spat a high value? I don't have investors so I would only be lying to myself.
As far as I know, lying to oneself is perfectly legal, especially if you are a pearl farmer in French Polynesia.
Arafura have been schamming for years,trust me they are technically insolvent now with those running costs and $200,000 worth of pearl sales in a good year.Arafura are leasing licence and quota from Arrow pearl and havent been able to make payment.Mr Dowding the ex premier of west australia was famous for doing the divorces of the high flyers then skimming the wives for a few hundred thou.The most notorious being Angela Roberts of Multiplex fame.The people in the know just shake their heads as the people line up to be skimmed by the Dowding/ Hewitt team.
Reminds me a little of Victor Kozeny.
Gobsmacked ? No. Simple accounting, for better or worse. I'm not privy to whatever accounting rules apply to spat - but if I had an interest, that sort of expertise is not hard to come by at all (public knowledge, at various prices, possibly free). Perhaps another poster here already has that at hand?
That this is public information requiring only minimal sleuthing and diligent reading, is something good, by my take. Not convinced? With the word out, only drowsy readers get burned; with the same under wraps the numbers may have never gotten so bold, but their chance of turning into snake oil would...
It is intriguing that such a company chose to go public. But again, some folks have put their cash alongside their faith in that spat evaluation. Good Karma with them!
Also, it seems logical that farmers facing the financial burden of a multiple-year growth cycle should have a way to evaluate their assets, whether there's any juice in their oranges yet or not. Never heard of oyster growers doing this, but pearl farming is that much larger an industry... Basically, why not!
The lingo may sound stupid and counter-intuitive. The underlying issues not so much... Sounds eminently useful to value the crop of spat as an asset (would assume that all relevant variables of the critter's life span get included somewhere along the way, although the procedure may not be included with the end-of-year balance sheet).
That there is no market for spat (at least not the kind with fish tanks, LOL! I can imagine he wiggly stuff gets priced when the facilities holding them are bought and sold, or when rights to harvest are... is it not?) is not terribly relevant. Lost of stuff that is never traded independently does get priced. Think... health insurance. (if you have bought 'health' by the bottle recently, please keep the secret, thank you.)
To conclude, one quick question:
If there is a right way to price spat, why not finance a pearl crop?
Not a rhetorical question... 'could even think of some reasons off the bat. That's too long for a post though and a tad out of my depth too. Here's one reason why:
http://www.pearl-guide.com/forum/pearling-industry-news/3495-ethical-pearl-consumer-2.html
If there is a right way to price spat, why not finance a pearl crop?
So what is the right way to price spat? Spat does have a value, but what is it? The value Arafura has already attributed to the baby oysters is grotesquely high. How they arrived at a fair value is the primary question here.
If a company can unilaterally determine the value of a future potential asset as a means of enticing investors, does this not influence the valuation? Especially when the future potential (but extremely unlikely) value is published as current profits?
If a company decided to drill for oil or decided to dig a gold mine, would the future potential of finding oil or gold entice investors? Possibly. But would it be considered legal, under the same provisions set by SGARA standards, for the fledgling company to consider that possible future profits as current profits?
If it were legal, how does it account for the fluctating price of oil or gold? Gold may be US$1000 per ounce today, but it won't be tomorrow.
Amazing! Hats off to the financial Houdinis of the Arafura pearling machine . I suggest a new name for the company . How about - 'Off the planet pearling Company'. Their motto ' We measure your reality'
I am a share investor, not an accountant, but have looked through many company accounts.
This is not Enron accounting. It is valuation under IFRS accounting standards for SGARA's (self-generating and regenerating assets). In most ways, it is no different to a property trust in which profit includes the gain (or loss) in value of properties. If this profit were not recognised, then the balance sheet would become meaningless over time as property values deviated from reality.
The current accounting standard for biological assets seems to be interpreted as requiring companies to place a value on these assets based on marketable value net of point of sale costs. It is only if there is no suitable information on which to base this that the company can use cost. If you look at the accounts for Atlas, they made a change in their 2007 Annual Report (refer page 32) which explains this.
Unfortunately, the assumptions required to estimate fair value can vary markedly depending upon company and auditor. It is not possible to make a fair comparison between Atlas and Arafura, as their balance dates are 6 months apart and the available data from Atlas is currently lagging Arafura. However, it is notable that Arafura has recognised a much higher value for SGARA's (although I think still has considerably fewer oysters?). Looking at the assumptions used (page 31 of Arafura's 2008 report versus page 40 of Atlas for 2007 year), it seems Arafura expects higher yields (larger pearls?) and higher prices per momme. However, most significantly, they have chosen to use a discount rate for future cash flows of 15% versus Atlas' 30%. This will have created a marked difference, but clearly auditors had no problem with either. For Arafura, the choice of discount rate may be justifiable, but over the long term will result in greater volatility in their asset values and reported profits.
I think there are reasons for and against using net marketable value vs cost for biological assets and would probably lean towards the latter as being less volatile. However, this example is a clear reminder that profit is not a meaningful number without an understanding of the contributing factors. I also believe that it behooves companies to act responsibly in NOT touting headline profit without also being clear and upfront as to the framework under which that profit was generated.
Good points Liz.
I don't think the article accused Arafura of Enron accounting. It seems to show a correlation of profit reporting when profits are non-existent.
Recognizing a value of a non-current biological asset would seem to make sense in some instances, but I don't believe it makes sense when the gross majority of those reported assets have no possible future value. Arafura is aware of this. They are pearl farmers, after all. Those profits making headlines will never, can never, be achieved in real money.
What Arafura's numbers actually show, without any fancy accounting work or SGARA disclosure loopholes, is that they are actually losing money as quickly (if not more quickly) than more or less every South Sea pearl producer today.
Hmm, yes, I see your point. Perhaps not surprisingly, Arafura have not provided full details of their valuation assumptions in the latest half year report and I have not yet been able to find details of their quota.
Is there someone here who would be able to estimate their quota and roughly calculate an approximate annual "sales value" of pearls equivalent to that quota? As a first reality test of those biological asset values, it would be interesting to establish how many years of sales that biological asset value effectively represents!
Liz,
Your statements on accounting standards are no doubt according to the book, but somewhat meaningless in Arafura's case, because their production is very low ( I know, I know - it's going to be HUGE in the future- all farmers say that), prices for the whole industry have tanked, highly experienced farmers and sellers are selling perhaps 25% of their production at the moment, others are cutting back production knowing that every oyster seeded will bring about a loss. It goes on and on. Yet here's Arafura alone saying their millions of spat have an astronomical value. Ask Paspaley what the value of spat is . It's ZERO.
Even if Arafura say they can produce huge quantities from their spat, it can't happen. Look at page 2 of their half year account . Their total quota is 235,000 shell to seed. What happens to the perhaps 95-98% of shell they are currently taking up at a value of A$ 52 mill. Most will have died and the rest is capped at 235,000 seedings.
They seeded 155,000 in 2008, including Investment scheme stuff, so if they end with around 70,000 pearls in 2010 ( based on their own and others 2 year grow out cycles) this will give them maybe 50,000 momme of pearls. The current price for Aust pearls is around Y7,500 per momme ( A$120 approx.). Lets say by some miracle of marketing they outdid the collective force of the pearl world and sold everything, their total income will be A$6 million. There operation costs now are A$16 p.a., and if they want to boost production to seed and farm out their full quota in 2009 and 10, production costs would have to surge upwards from the present.
But they won't sell all their pearls. Their own performance from 2008 production/sales demonstrates this. A$235,000 income from 65,000 seeded in 2006, and 28,000 pearls harvested in 2008( half year). That's a miserable amount of pearl sales income, and the reality is that matters have got worse, not better.At very best,it seems Arafura will have income of a couple of million over the next couple of years, and massive shortfalls. So, unless they find investors to tip in literally 10's of millions over the near term, in the hope there will be a recovery some day. The pearl market may pick up slightly some day but it's history since it went over the wrong side of the hill when Japan slumped in 1991 is that prices have gone 1 way - down.
So Liz, SGARA or no SGARA, do you reckon it's right continue raising money under these circumstances?
Sure enough!
The fellows should have a much harder time over-valuing whatever grows on the bottom of their fish tanks, if there would be a realistic, common-knowledge, independent, transparent, etc. basis for that estimation out there (no news, right). Or even here (HINT - how about some back of the envelope accounting for this, Professor?)...
Financial accounting rules are easily common knowledge. Spat-to-pearl acccounting is anything but. Would imagine that there is no basis to establish a fair estimate for it (i.e. some way for fairly independent data collection).
Reminds me A LOT of Viktor Kozeny!
Love the professor bloke. Best bush telegraph ever.
I know he's not an Aussie cause an Aussie don't dob.
I'm an investor in this company, and have thought the books didn't look too convincing for some time now.
What I have read here shows me that there are others who see the same that I do in Arafura. Do you think legal action against the directors, on behalf of the investors is not out of the question?
Thank you to whichever Anonymous posted the calcs on revenue for APB. That is pretty damning. Even at the higher prices that have prevailed in recent years, it is impossible to see that a quota of 235,000pa would generate $50m+ in cashflow over the life time of the assets.
As an update, the Atlas annual report came out today with latest figures. While they are more conservative than Arafura, they have managed to sidestep the reduction in value of biological assets by (surprise, surprise!) reducing the discount rate they apply to future cashflows from 30% down to 20%. This means that while their price per momme has nearly halved, they have not had to write-down the value of biological assets. Makes any profitability reporting something of a farce.
interested in making more friends and playing with Atlas' latest numbers?
http://newsstore.theage.com.au/apps/previewDocument.ac?docID=GCA00939434ATP&f=pdf
As Liz shows, the 08 Atlas figures show there are a number of ways to maintain a profit - simply change the discount rate. But how can this eventually help Arafura. Their last annual accounts ( pg.33) show that they used a sales figure of Y 18,000 per momme, which is about 300% above the current achievable figure, and they probably calculate the sale of all their production, which won't happen.( Atlas now use a sales figure of Y 6,660 when calculating Biological Assets). Fair dinkum Liz, can you or anyone else figure out what would happen to Arafura cash flow and profit if they start using current, accurate industry sales volumes and prices. These SGARA standards seem to allow massive distortions to profit and NTA figures, and thereby lead investors straight up the garden path.
I had a quick play with some figures, but, was making near blind guesses guesses on some assumptions, so will almost certainly be misleading. However, under my comparable model, the value of biological assets dropped from $52m to $16m when the sales figure dropped to Y6,600 offset by exch rate to 62. The assumption on costs was quite critical though – higher costs than I allowed could potentially send the value to zero.
Looked to me like one of the other major differences between Arafura and Atlas values may be in Arafura allowing for 2nd and 3rd seedings from their stock. I think this may be worth about $20m of the $52m cashflow, although I stress that my model is extremely crude and could be misleading.
Overall, these types of models are very sensitive to assumptions, so I think are a dangerous form of asset pricing unless the input data is very standardised and very long-term, non-trending data can be used. As it stands, Atlas could, next year, add second seedings into their calculations resulting in a value write-up to record a profit, while suffering cashflow stress...
Holy Batman. If pearl companies have to write down their profit because of variations to their biological assets, companies like Arafura and maybe Atlas will be up the proverbial creek in a barbed wire canoe without a paddle. I really feel for their poor old investors
Seems even the auditors aren't happy with APB's accounting. While they haven't been forced to amend the 2009 accounts, the auditors found their valuation basis for biological assets to be flawed and suggested the $5.5m profit should in fact be a $9.4m loss.
Cant thank you all enough for rescuing my life savings. Was about to go hard into this one. Being a value investor I thought this company might go under and deliver a handsome distribution. I also thought that with reputable auditors in place that these 'biological assets' would be carried at fair value and be completely tangible. My other thought was that with all the aggressive farming Arafura have been doing recently along with a board of Chartered Accountants that the company may start soon bringing in some real money.
Thanks again everyone,
Going to buy a copy of Security Analysis,
Chris
Very intresting
Has anyone have any more information on how they are trading ?
Arafura are now claiming to be cash flow positive by the end of this financial year which means about 10 months away. They have been releasing new shares at increasingly low prices to fund over the last year and now offering at 1.5c. This values the company at $7m.
The conversations above are all focussed on book value. This is a company in a developmental phase. Seeding is growing rapidly each year and harvests lag seeding by 3 and 5 years (second harvest). So harvest will be significant only at 2013 and so profits should be calculated on projections of costs and sales after this date, provided they can be funded through their period of making losses.
I calculated their sales at $40m from 2013 using a farmgate price of $150 and relatively poor harvest outcome versus their prediction. Costs I put at $20m. This should then be a company earning 20m on an ongoing basis with a barrier to entry (many years of loss during early seeding and growth and quota system). A p/e of 3 would not be unreasonable pricing the company at 60m in 2013. Discount to today and a reasonable intrinsic value might be around $30. So the present offer at 1.5c giving you the company for $7m seems like a good opportunity.
All this requires that they do not go on making offers for new share releases for much longer as if they require another $7m of funding at 1.5c (doubling shares outstanding) and you don't participate then you have just lost half your holdings. Current investors will have lost out in this way - the new offers at such low prices has brought money in at the great expense of previous shareholders. But if you are one of the ones buying at these sub 1.5c prices it does look attractive.
So there we go - voluntary administration. Not really surprising after and glad to read that one investor at least managed to avoid after this discussion.
Liz
Any news about whether operations are actually continuing or whether they will liquidate. I still have quite a few shares and wondering if new management will do their utmost to maximize the payout to shareholders. They still had quite a lot of stock under the water so I imagine they need to strip down operations to the minimum to at least retrieve the inventory and then perform a bulk sale to another company perhaps for a payout that is not delayed by years.
Try checking through the documents on the Korda Mentha web-site as to what is happening.
http://www.kordamentha.com/creditor-information/australia/88
From pg 12 of the Dec Creditors report:
"The outcome for the Company‟s shareholders is still unclear. However, if creditors vote to accept the proposal for a DOCA and the sale of the corporate shell is achieved, shareholders may obtain some effective return through a capital restructuring."
Looks like there may have been some significant loss of value on assets due to lack of staff/maintenance. The MIS investors will be affected by this.
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