Tomatoes is an European company. It is in the business of selling software products. One of its main competitors is listed in India. As part of analyzing the Indian competitor, I analysed many global companies in the same field and came across Tomatoes.
Whatever you see about the business and financials of Tomatoes, you will just find one thing – excellence. By number of products sold, they are No.1 globally since last many years and what’s more, they are gaining market share. The revenue of this company has grown (through organic and inorganic means) at CAGR of more than 20% and, EPS has compounded at a CAGR of 19% since 2013 and stock has compounded at CAGR of around 38% from 31 Dec 2012 to 31 Dec 2019 (before the outbreak of corona virus). ROE is crossing 40%. It is truly unbelievable.
You might be thinking that I am going to point to a fraud in this company to prove that it’s too good to be true. But I will not because I cannot. All accounting conventions were properly followed and applied. No fraud is committed. Still this company has managed to find a way to enrich its employees (CEO included) without taking the cost into the P&L.
So what did they do? Stock options (SO) and Stock appreciation rights (SAR). Let me explain in detail. Generally these instruments results in cost to the issuing company at two levels:
· Fair value of the options (FVOTP): When SO/SAR are allotted, the fair value of this option is accounted for as an employee expenses in P&L over the vesting period. Fair value calculation is complex. We will not get into its details for now.
· Cost of dilution (COD): When employees finally convert the options into shares, the number of shares increases, resulting in dilution for the existing shareholder. This is accounted for as a dilution which reduces the EPS in P&L.
No one can escape or reduce the FVOTP but the actual COD can be reduced by use of treasury shares. Under various rules, companies can buy back their own shares from open market and keep it as treasury shares without cancelling them. Treasury shares can then be used to allot shares on exercise of the SO/SAR at strike price. By use of treasury shares company might reduce the true COD if the buyback price is lower than the market price prevailing at the time of exercise of the options.
So if new shares are issued the COD is difference between strike price and market price on date of exercise and if treasury shares are used than COD reduces to difference between the strike price and buyback price. Remember COD do not get eliminated in treasury shares. It just got reduced because buyback price might be lower than market price at the time of exercise. So in this case company buys in its own shares in secondary market at buyback price and gives them to employees at strike price resulting in a loss to company.
The real trick to manage accounts comes from the way accounting for both the ways of COD works. While in case of issue of new shares, the actual COD is accounted in form of reduced EPS from dilution, however in case of use of treasury shares no new shares are issued and hence there is no impact on EPS. Under accounting conventions, COD when treasury shares are issued, goes directly to share premium account as debit to share premium. This negatively impacts net worth of the company without any impact on P&L or EPS. Thus under the current accounting conventions, you can issue shares to employees from treasury shares as compensation without any COD impact on P&L or EPS.
Tomatoes did exactly that. Over last many years company has issued huge amount of SO/SAR to employees, bought its own shares from market in billions and gave it to employees at substantially discounted strike price. This whole exercise resulted in loss (COD) of around US$ 1 bn to company which is sitting in share premium account as a debit. For that matter the sum of accounting profits generated by the company for last 10 years is only US$ 900 mn. So for last 10 years, company has paid all of its profits to employees (CEO included), without shareholders getting to know about it from P&L. What a marvel act it is!! Practically employees have taken out huge amount of cash from the company and shareholders are busy counting growing EPS, ROCE, ROEs and compounding share price (partly due to companies own large open market purchase of shares to be denoted as treasury stock).
What is even more interesting is the fact that, the business has performed superbly in spite of all the loss making overseas acquisitions the company has done over the years. It means that either the company has unbelievable turnaround capabilities or the organic performance itself is so superior that the company could easily more than compensate for the losses in its acquisitions. Since 2013, the company has acquired five loss making companies with total annual revenue of US$ 137.5mn at the time of acquisition. It paid nearly US$ 620mn for all these acquisition mostly funded by debt. I hope all of you know how Wirecard (a German payments company) might have used overpaid acquisitions in India to create fictitious revenues in the parent firm. If not read this. (https://www.ft.com/content/b3672388-200a-11ea-b8a1-584213ee7b2b).But I am not sure whether this is another Wirecard in making simply because I have no means to analyse how and through what route they paid for various acquisitions. They might have truly turnaround their acquisitions or might have witnessed a very handsome organic profitability growth.
But there is a famous saying “Top line is vanity, bottom line is sanity and cash flow is the reality”. This company really proved the saying given the fact that they had to borrow huge sums for all the acquisitions that they have done. The debt/equity is now close to 2.5x in spite of fabulous financial performance. Moreover, over the years, employees have sold millions of dollars of shares so allotted as SO/SARs, in the open market.
Interestingly the CEO “retired” in 2019 while in early 50s of his age. But here is the surprise, old timer CFO is now CEO. In an investor presentation company said “Since 1/1/2019 Tomatoes has not used treasury shares to meet the demand of SARs”. But here you go in 2019 annual report and you will find a charge of US$ 279Million in Share premium. May be the company is right, it’s not SARs. It’s SOs this time. Whatever it is, it’s really funny. “The more it changes the more it stays the same”.
It took a huge fight in early 2000s to get FASB in the US to say that share based payments are an expense and needs to be recognized in P&L. I am sure years of fight will also follow to change the accounting for treasury stock way of SOs and SARs. But for the fight to begin against any disease, disease should become widespread first. We are dealing with coronavirus currently. Outbreak of TS (treasury stock) virus will follow because world over dishonest people are constantly looking for honest ways of committing dishonest acts.
But do not worry. I am not going to spread the virus in India by this note. Companies Act 2013 unknowingly/unintentionally has introduced a preventive vaccination.
However there is another way to do the same act in India. Indian companies have started using it as well. But fortunately, due to the certain other regulations, listed companies will not be able to execute it in large amounts. To avoid the large scale outbreak among/through the readers, I am not going to discuss that way here. But for sure the knowledge of its presence and limits to which Indian companies use it, will help me in assessing the corporate governance standards in corporate India.
