Wirecard – Modern money laundering?!
The last word has not been spoken yet in the balance sheet scandal of German payments company Wirecard. But the most recent happenings already provide enough storyline for a business thriller.
Wirecard’s auditor EY refused to sign off its accounts for 2019 because of a missing $ 2.1 billion in cash balances on trust accounts that never existed in the first place. That is 25% of Wirecard’s balance sheet and forced the payment processor to eventually file for bankruptcy.
The financials of Wirecard have been questioned for years by short sellers. I remember reading one of the first short seller reports in 2014, which questioned weird and inexplicable money transfers through its subsidies.
Wirecard was the fintech highflyer in the past few years and the 2nd true German success story in the past two decades besides software giant SAP. In fact, my first stock market investment ever, was buying Wirecard shares in 2010 for roughly 8 euros a share. I had almost no knowledge about company fundamentals and my investment decision was solely based on an article I read in a shareholder magazine (shame on me!). I sold a year later for 11 euros. The fact that the shares went up 3 euros was reasons enough for me to sell (again, shame on me!).
I remember me being hopping mad and frustrated when I looked at the share price again in 2013. The shares had climbed to 20 EUR! With then almost 3 more years of experience, I decided to dig into the Wirecard fundamentals to figure out if I should buy some shares again.
The numbers were indeed remarkable. The revenue grew with 20% and the growth over the past few years was accelerating. With EBIT margins of 23%, return on capital of 12% and an almost debt free balance sheet, the company looked very promising. But there was one thing that really bothered me: the structure of the business. I simply could not grasp it. It was too complicate to understand.
Wirecard has many subsidiaries and obscure business relations in Asia that were often linked to its UK subsidiary “Wire Card UK Ltd”. In addition, acquisitions were initiated that I could not retrace. Wirecard also finances loans with third parties that I could not understand. I decided to move on and not buying the shares. I had to wait for another 7 years until I knew it was the right decision.
The Enron case in a nutshell
The Wirecard scandal reminds me of the Enron case and a meeting with former Enron CFO Andrew Fastow in a small session in October of last year at my university in Boston. Fastow, who teaches business students how not to cross the line and shares his lessons learned, became the Chief Financial Officer of Enron in 1998. Enron, once the powerful energy company and largest developer of power plants with the 7th highest revenue in the US, finally filed for bankruptcy under Chapter 11 on December 2, 2001.
On January 14, 2004, Fastow pleaded guilty to having committed fraud, served a six-year prison sentence and forfeited $23.8 million in cash and property. Shareholders lost more than $ 70 billion and its employees billions in pension benefits. The Enron scandal however, brought attention to corporate fraud and questionable accounting techniques.
Fastow is an interesting character who describes in an authentic and comprehensible way what happened at Enron through his eyes. He claimed that the real story was not told and that he thought he was doing the right thing.
The well-known “CFO magazine” actually rewarded him as the “CFO of the Year” in 2000, just 1 year before the bankruptcy. According to Fastow, he was picked due to his off-balance sheet financing method. In fact, Fastow lowered Enron’s cost of capital by bringing “weak” numbers to the footnotes. By using “loopholes” he used legal rules to his advantage. Thus, Enron could change its appearance as a company and make themselves look like a solid (investment grade) investment. Fastow says he was “technically following the rules”, but that it was indeed “not a reasonable and acceptable behavior”.
It was very common in the 1990s and early 2000s that CFOs compensation was mainly based on management and business performance. However, a CFO’s influence on these numbers is limited. Nevertheless, Fastow had the “tools to make it happen”. He admits that he was “intentionally misleading”. He adds that operating in a gray are is always dangerous and compares his situation with Hillary Clinton’s email affair which came out in 2016: Clinton had only asked if she’s legally allowed to use a private server for official email communication, but never what people would actually think of her doing that. Like Clinton, Fastow did not really understand what he did wrong until the end.
What I learned from all this
It is always easy to blame people after a blowup. However, it is an investor’s job to avoid such companies and therefore avoid big investment mistakes. As a matter of fact, the winners in the long term are the ones who make fewer mistakes. But how can one identify shady businesses? There are a few things to look out for.
Corporate executives can have an incentive to manipulate earnings and give flowerful prospects for their companies to boost their share price. This is often the case if stock options make up a big proportion of their salary/bonus. This can lead to managers who focus too much on the short and medium price movement of its company’s stock instead of only focusing on the business. The pure fixation on earnings can lead to doctored earning numbers by the management. Especially pro forma financial numbers should be seen with a healthy amount of skepticism since they are often cooked up by management with the help of creative accountants.
At Enron, certain costs were excluded and earnings, which under conventional accounting standards would be considered exceptional, were included. Actual corporate profits can decline while reported and pro forma profits can keep go up for a few more years. This happened from 1998 until 2000 with share prices following the trend.
In addition, one should be careful with investment bankers. They make money with IPOs and (often wasteful) mergers and acquisitions. Therefore, avoid hot stocks and (most) IPOs.
Most analysts do a good job but there are some who produce questionable research.
A high fluctuation of auditors and consultants can signal a problem. If companies switch their auditors too often this is a sign that something in the books might be flawed.
Furthermore, companies that buy back too many shares to boost their earnings per share should be seen critical. Buybacks are usually good for shareholders but if the company is overdoing it, long term shareholder value is destroyed (e.g. IBM or Boeing).
Energy company Enron claimed in its last annual report before they filed for bankruptcy that they are “laser-focused on earnings per share”.
A managements short term view and focus on quarterly reports is also undesirable. There are many reasons for investors not to worry about single quarterly results. One is that possible changes in the competitive position of a company can simply not be evaluated over such a brief time scale.
Earnings can also be manipulated. This can involve fraud but can also happen by using general accounting measures to inflate earnings. Well known accounting techniques include the capitalization of research and development on acquisitions, the use of off-balance sheet vehicles (Enron did that) and of derivatives to bring forward profits from future periods.
If a company temporarily drives expenses down (marketing or other essential costs), earnings can also be enhanced. This is not just short term oriented and completely unsustainable; it also can damage the profitability and competitive position of a company in the long term.
Instead, a company’s capital returns determine where the stock price goes over the long term, not changes in quarterly earnings. A company’s competitive advantage or disadvantage instead of quarterly earnings should be focused and by how much it changes. The profitability is primarily driven by the competitive environment rather than by revenue growth trends. Thus, investors should keep in mind that its often better to invest in a mature industry where competition is declining rather than in a growing industry where competition is rising.