FINANCE WEEK
26 February 2003
Why Payne is wrong about Cytech
By Deon Basson
COMBINE a tax haven like the British Virgin Isles, known for its extremely deficient disclosure, with the twilight world of gambling – on the Internet to boot – and you get the word risk spelt out in capital letters.
The Cytech investment, in which Corpcapital has a 47,5% stake, combines these elements, in addition to several others. Cytech is unlisted; management itself valued the investment; the investment in Cytech made a large and unprecedented contribution to Corpcapital’s profit in 2000; and the status of its audit carried out in the past is under a cloud.
Nigel Payne, who investigated and exonerated Corpcapital’s corporate governance, thinks investment in and valuation of unlisted entities are risky and demands a constant and watchful eye on the part of management, the audit committee and the board.
But in Payne’s view there is no evidence of management having manipulated Cytech’s valuation or inflated it aggressively in any untoward manner.
Payne completed his investigation in just three weeks. Many other matters required his attention and he probably could not engross himself sufficiently in the world of online gambling, which has not enjoyed good fortune in recent years thus making it unlikely that Cytech escaped unscathed.
The valuation of Cytech affected Corpcapital’s profitability up to 2001 since unrealised valuation profits in Corpcapital and/or its former subsidiaries were brought to account in the income statement. In the 2000 financial year, the value of the investments rose from R4,5m to R149m, contributing a pre-tax profit of R144,5m to the Corpcapital group.
It is remarkable that Payne ignored this enormous profit contribution almost totally and made a value judgment to the effect that Cytech’s valuations were not “aggressive”.
Browsing through some Web sites providing information on listed Internet gaming companies reveals that several have folded. For others, the chips are down. These companies fare much worse, virtually without exception, than any important leading index and have been on a losing streak since 2000. The I-Gaming index fell from a height of about 275 points in March 2000 (before the collapse of technology shares on Nasdaq) to the current 79 – a fall of over 80%.
In February 2000, with the half-year-end of Corpcapital, Cytech was valued at a modest US$2,7m. A few weeks later, Nasdaq collapsed, taking the I-Gaming index with it, as shown in the graph on page 18.
Yet the same graph shows how Corpcapital ignored a global trend, raising Cytech’s valuation from $2,7m to $21,3m at the end of August 2000.
Payne was also vague about the Cytech audit. He wrote that audited financial statements had never been compiled for Cytech or associate CFI. Immediately after that, he mentioned that Corpcapital’s auditors, Fisher Hoffman, had audited the books of Cytech and CFI. Corpcapital had borne the costs. He did not state clearly for which financial years Cytech and CFI had been audited by Fisher Hoffman.
In any event, questions could be asked about the independence of this audit as Fisher Hoffman is also Corpcapital’s audit firm.
In the controversial 2000 financial year, Fisher Hoffman signed off the financial statements of the then Corpcapital, which contained Cytech’s vast contribution. The question can rightly be asked whether Corpcapital’s financial statements for 2000 reasonably reflected its financial position at that date. Payne was silent on this issue.
He did conclude that unrealised profits in 2001 did not contribute to bonuses. Again he said nothing about 2000. Corpcapital executive director Neil Lazarus had already admitted that bonuses were paid in 2000. At that time, bonuses were not yet disclosed separately but the total executive directors’ remuneration for the group for that year rose from R6,5m to R17,5m and in the case of the then Corpcapital from R2,6m to R6,6m.
Seeing that the valuation was done by management (something Payne himself acknowledged), his silence about possible conflicts of interests is remarkable. His investigation into this aspect does not demonstrate sufficient depth.
During his investigation, Payne probably had access to Cytech’s valuation for 2002 done by PricewaterhouseCoopers. Some of the risk factors mentioned in the valuation posed a substantial risk during Cytech’s acquisition as early as 1999 and should have been discounted in valuations in 2000. For example, risk factors included:
• The number of online casinos had grown from 90 in 1998 to 250 in 1999 and 1 800 in 2002, earning between $3bn and $4bn.
• Big banks in the US halted online credit transactions. Something like this does not happen overnight in America; there’s usually a long build-up.
• Casino income is on the decline. In 2003, it will be around $4,2bn compared to previous estimates of $6,2bn.
Yet optimism seems to dominate future projections. The forecast for 2003 is that the profit margin will increase from 13% to 29% thanks to a R2m anticipated cut in marketing costs. By 2003, the profit margin is expected to improve to 34%. This while a much larger listed company like the Canadian Cryptologic has only a 22% profit margin. Cryptologic does more than double Cytech’s turnover and boasts treble the profit.
In August 2000, the management of Corpcapital estimated that Cytech would earn a profit of $11,1m. The actual figure was $2,2m. For 2003, it was forecast at $12,1m. Now the estimate is $4,5m.
Management in good time identified risk factors such as new legislation against Internet gaming, new entrants to the market and the attitude of banks. Yet the valuations remained high with the profit projections extremely optimistic.
The valuations of Cytech were done on a pre-tax basis. Payne said provision was made for 30% deferred tax against unrealised profits. It would appear from Corpcapital’s 2002 annual report that the lion’s share of deferred tax was written back. In 2002, the market value basis for investments was abolished in favour of equity accounting.
If Corpcapital thought the Frangos debacle would be laid to rest after the report, it was wrong.
Lazarus speaks out
FW HAS received the following letter from Corpcapital executive director Neil Lazarus: “Please ensure that the next edition of Finance Week reflects the outcome of (Nigel) Payne’s corporate governance findings with the same prominence that you gave to the article in the Finance Week edition titled “Corpcapital’s big schlenter” (20-24 January).
“I make this request to afford you the opportunity to set the record straight and correct the misleading impression conveyed by the article in that edition.”
The Payne report enjoyed wide media coverage this week. FW does not deem it necessary to repeat all the information. However, the full report is available on www.fw.co.za
FW disagrees with key aspects of the report. It is impossible to deal with them all at once. We deal with the Cytech issue in the article on this and the next page. FW is unaware of a “misleading impression” in the article of 20-24 January.
In an earlier letter, Lazarus wrote: “I fully intend to deal with the inaccuracies of your earlier article. It would be inappropriate for me to do so before the Payne report is released. I will revert to you after the release of the report.” FW is unaware of inaccuracies and awaits a further letter from Lazarus.
Read full letter from Payne and Associates to Corpcapital concerning corporate governance.
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