1 - Corporate Codes
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|REPORT |
|of |
|Collett & Collett Associates (Pty) Ltd |
|And |
|SAB&T Inc |
|To |
|Webber Wentzel Bowens |
|in respect of |
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|CORPCAPITAL |
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|___________________________ ________________________ |
|D E COLLET B ADAM |
|On behalf of on behalf of SAB&T Inc |
|COLLETT & COLLETT ASS (PTY) LTD |
|16 November 2003 |
I N D E X
|Par. |Description |Pg |
|1. |Purpose and Scope of Investigation |1 |
|2. |Summary of Findings and Recommendations |2 |
|3. |Lack of Information |3 |
|4. |Recommendations |3 |
|5 |Detailed Findings |4 |
|6-17 |Accounting Treatment of the Netainment/Cytech-Investment in Corpcapital’s Financial |6-9 |
| |Statements According to GAAP | |
|18-29 |Important Factors to Consider in Judging the Valuations of Corpcapital’s Investment in |9-12 |
| |Netainment/Cytech | |
|30. |The Credit Card Issue |13 |
|31. |The Audit Issue |14 |
|32. |The Establishment and Role of Aqua |16 |
|33. |The Matureness of the Business and Industry |18 |
|34. |Trends, Forecast and Actuals |19 |
|35. |Actual Results Versus Forecasts |20 |
|36. |Valuation Methodologies |22 |
|36.6 |The Earnings Yield Model (EYM) |23 |
|36.7 |DCF Methodology / Model |24 |
|36.8 |The Model used for the Indicative Valuations for Netainment’s Business |25 |
|37. |The Correct Approach to Determine Fair Value |27 |
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|Index continues |
|38-41 |The Valuations from 2000 to 2002 |31-54 |
|38. |The August 200 Valuation |31 |
|38.2 |Expenses |32 |
|38.3 |Profit Forecast by Hamburger |34 |
|38.4 |A Realistic and Reasonable Approach / Forecast |34 |
|38.5 |Actual Profits of the 2000 Financial Year |35 |
|38.6 |The Weighted Average Cost of Capital (WACC) |38 |
|39. |The September 2001 Valuation |39 |
|39.2 |Credit Card Changes, Trends and Forecasts |39 |
|39.3 |Change from Micro-gaming to IMS |40 |
|39.4 |Netainment Changed its Strategy |42 |
|39.5 |Valuation Methodology |44 |
|39.6 |Profit for August 2001 and Forecasts |47 |
|39.7 |The Weighted Average Cost of Capital (WACC) |50 |
|40. |The August 2002 Fair Value |51 |
|40.11 |WACC |54 |
|41. |Conclusion on Valuations (2000-2002) |54 |
I N D E X
|Bundle A |
|AA |Graphic Demonstration of the Aqua & Netainment business history |
|AB |Accounting for Corpcapital’s Investment in Netainment (Cytech) |
|AC |Riglyne oor ekwiteitswaardasies |
|AD |Value of Company - Netainment |
|AE |Documents which we consider essential for completion of our investigation |
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|Bundle B |
| |Organigram |
| |Share Certificates |
| |Holdings - Financial Statements 2000 |
| |Holdings - Financial Statements 2001 |
| |Holdings - Financial Statements 2002 |
| |Aqua (Int) - Financial Statements 2000 |
| |Aqua (Int) - Financial Statements 2001 |
| |Aqua (Int) - Financial Statements 2002 |
| |Interactive - Financial Statements 2002 |
| |Interactive - Financial Statements 2001 |
| |Interactive - Financial Statements 2002 |
| |Netainment |
| |Cytech |
| |CFI |
| |Exchange Rates |
I N D E X
|Bundle C |
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|Schedules and charts: Netainment, Cytech, CFI Valuations |
|A1–A3 |NETAINMENT – Analysis of Management Income Statements – month to month |
|A4 |CYTECH – Analysis of Management Income Statements |
| |– month to month |
|A5–A7 |CFI – Analysis of Management Income Statements |
| |– month to month |
|B1–B3 |NETAINMENT Analysis of Management Income Statements |
| |– year to date |
|B4 |CYTECH – Analysis of Management Income Statements |
| |– year to date |
|B5–B7 |CFI – Analysis of Management Income Statements |
| |– year to date |
|C1–C3 |NETAINMENT – Analysis of Management Balance Sheet |
|C4 |CYTECH – Analysis of Management Balance Sheet |
|C5–C7 |CFI – Analysis of Management Balance Sheet |
|D |Summary of Profits and Retained Earnings of Management Income Statements |
|E1 |GRAPH – Netainment vs CFI – Year to Date Profits according to Management Accounts |
|E2 |GRAPH – Netainment (Cytech) – Actual Profit vs Valuation Adjusted Profit |
|F |CORPCAPITAL – Analysis of Management Income Statements |
|G1 |GRAPH – Aqua Expenses vs Netainment Profits |
|G2 |GRAPH – CFI Expenses vs Profit of Netainment |
|G3 |GRAPH – Advertising and Marketing Costs vs Revenue and Profit |
|H |Schedule Removed |
|I |Schedule Removed |
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| |Bundle C - continues |
|J1 |INTERACTIVE – Analysis of Income Statements |
|J1.1 |GRAPH – Interactive – Expenses vs Profit vs Revenue |
|J2 |INTERACTIVE – Revenue received from Netainment as a % of Total Revenue |
|J2.1 |GRAPH – Interactive – Dependancy on Netainment |
|J3 |AQUA ONLINE (INT. ) LTD – Analysis of Income Statements |
|J3.1 |GRAPH – Aqua Online (Int.) Ltd – Profit / (Loss) vs Revenue vs Expenses |
|J4 |CYTECH – Analysis of Income Statements – Management Accounts vs Financial Statements |
|J4.1 |GRAPH – Cytech – Different Profits for 2002 |
|J5 |CYTECH – Analysis of Balance Sheets – Management Accounts vs Financial Statements |
|K |Actual Profit vs Valuation Adjusted Profits |
|L0 |Valuation Dividend Yield |
|L0.1 |GRAPH – Valuation – Range of September 2000 valuations |
|L0.2 |GRAPH – Valuation – Range of September 2001 valuations |
|L0.1 |GRAPH – Valuation – Range of August 2002 valuations |
|L1 |Summary of Valuations |
|L2 – L4 |Sensitivity Analysis |
|L5 |GRAPH – Valuation – Range of August 2000 valuations based on Schedules L1 & L2 |
|L6 |GRAPH – Valuation – Range of September 2001 valuations based on Schedules L1 & L3 |
|L7 |GRAPH – Valuation – Range of August 2002 valuations based on Schedules L1 & L4 |
|L8 |Corpcapital Valuation – August 2000 |
|L9 |Corpcapital Valuation – September 2001 |
|L8 |Corpcapital Valuation – August 2002 |
|M |Valuations |
|M3.a |GRAPH – August 2000 Valuation – Actual Profits vs Accumulative Profits |
|M3.b |GRAPH – August 2000 Valuation – Effect of 2nd and 3rd Years Profit |
|M4.a |GRAPH – March 2001 Valuation – Actual Profits vs Accumulative Profits |
| |Bundle C - continues |
|M4.b |GRAPH – March 2001 Valuation – Effect of 2ne and 3rd Years Profit |
|M5.a |GRAPH – September 2001 Valuation – Actual Profits vs Accumulative Profits |
|M5.b |GRAPH – September 2001 Valuation – Effect of 2ne and 3rd Years Profit |
|M6.a |GRAPH – February 2002 Valuation – Actual Profits vs Accumulative Profits |
|M6.b |GRAPH – February 2002 Valuation – Effect of 2ne and 3rd Years Profit |
|M7.a |GRAPH – August 2002 Valuation – Actual Profits vs Accumulative Profits |
|M7.b |GRAPH – August 2002 Valuation – Effect of 2ne and 3rd Years Profit |
|N1 |Analysis of fees paid by Netainment to Aqua Online (Int.) Ltd & Interactive Online |
|N2 |GRAPH – Analysis of fees paid by Netainment to Aqua Online (Int.) Ltd |
|N3 |GRAPH – Analysis of fees paid by Netainment to Interactive Online |
I N D E X
|Bundle D |
|Restatement of the financial statements of Corpcapital Limited to account for Cytech and Aqua |
| |Did the Financial Statements of Corpcapital Ltd conform to GAAP and the Companies’ Act? |
| |Restatement of the financial statements of Corpcapital Limited to account for Cytech and Aqua |
| |Graphical illustration Cost Method |
| |Graphical illustration Equity Method |
| |Forex and Associated Income Workings for Restatement of Financial Statements: Workings |
I N D E X
|Bundle E |
|Directors, Related Parties & Shareholding |
|I |Introduction |
|II |Directorships |
|III |Shareholders |
|IV |The links |
|V |The advantages of the links |
|VI |Other related Entities / Individuals |
|VII |Conclusion |
|VIII |Constraints |
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|Appendices to Bundle E |
|A |Company documentation on Liebesman |
|B |Company documentation on Liebmann |
|C |Company documentation on Ellerine |
|D |Company documentation on Lazarus |
|E |Company documentation on Sacks |
|F |Company documentation on Kidd |
|G |Company documentation on Wixley |
|H |Company documentation on Hamburger |
|J |Company documentation on Dionne Ellerine |
|K |Company documentation on Harpaz |
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| |Bundle E - continues |
|L |Company documentation on Schachat |
|M |Company documentation on Shahim |
|N |Company documentation on Grolman |
|O |Company documentation on Kalkhoven |
|P |Company documentation on Rose |
|Q |Company documentation on Parker |
|R |Company documentation on Offshore Companies |
|S |Trust Documentation |
|T |Company documentation on Credo |
|U |Company documentation on Cohen |
|V |Company documentation on Trengrove |
|W |Company documentation on Van Staden |
|X |Company documentation on Moss, Shankland & Ellis |
|Y |Company documentation on Schneider |
|Z |Company documentation on Behr |
|AA |Company documentation on Rolfe |
|AB |Company documentation on De Klerk |
|AC |Company documentation on Grant |
|AD |Company documentation on Kaminer |
|AE |Company documentation on Lauryssen |
|AF |Company documentation on Sayer |
|AG |Company documentation on Welham |
|AH |Extract of Corpcapital share register |
|AI |Extract of Aqua Holdings share register |
1. Purpose and Scope of Investigation
1. The purpose and scope of this investigation as requested by Webber, Wentzel Bowens and extended by Mr Frangos, include the following:
1. Reviewing, analysing and commenting on additional information received in respect of Netainment, Cytech, Corpcapital and/or other related companies/parties.
2. Investigation of various shareholdings, directorships, vendor control and relevant relationships.
3. Investigation of group structures and the history of such developing structures.
4. Expanding on previous reports (no’s. 1 and 2) regarding valuations of Netainment, Cytech, restatement of financial statements, accounting for investment in Netainment/Cytech and disclosure in financial statements. In the process the scope was expanded to take account of Aqua-group's’ influence on the value of Netainment/Cytech and Corpcapital's financial statements.
2. It must be noted that our findings and conclusions are based on available information. It may change or be amended, if and when other or new information and/or documents become available. We relied on the information and documents provided to us. We did not verify the factual correctness or validity of the aforementioned information or documents. We are however, of the opinion that the documents and information at our disposal give sufficient support to our findings, conclusions and recommendations.
2. Summary of Findings and Recommendations
In our opinion:
1. Corpcapital’s investment in Netainment/Cytech was incorrectly accounted for in the consolidated financial statements (AC 110) and Corpcapital’s own financial statements (not reliably measurable). See paragraph 6 of this main report.
2. The valuations for Corpcapital’s investment in Netainment/Cytech were based on inaccurate data, incorrect assumptions, and were materially overstated. The investment was not reliably measurable. See paragraph 18 to 41.
3. The financial statements of Corpcapital for the financial years (2000, 2001 and 2002) did not fairly present the financial position and results of its operations.
4. The financial statements also did not disclose all matters in the directors’ report or financial statements which were material for the appreciation of the state of affairs of the company and the group.
5. Various direct and indirect relationships between vendors, directors, shareholders and/or management led to conflicts of interest and compromised corporate governance principles within the group.
6. The accuracy and validity of the accounting records of Aqua Group, Netainment/Cytech, CFI and other related parties are in doubt due to the changing of data, moving of income and expenses between related companies, other internal control deficiencies in the accounting system and other matters referred to in more detail in this report.
7. The shareholding of Aqua and Corpcapital reflects a high proportion of shareholders whose shares are held by offshore management companies. The most common name arising being that of Schindlers. Information at our disposal indicates that the original vendors of Southgo, TPN and ABSEC Limited may be linked to those foreign management/Trust companies. This lends further support to the belief that the unusually complex structures in tax havens with no statutory requirements for audited financial statements, may have served the interest of the “original” vendors or the beneficiaries of those shares held in trust by Schindlers.
3. Lack of Information
1. We had insufficient information to fully address the issue of irregular and/or potential fraudulent accounting. If such accounting is confirmed it would most likely have a material influence on the rights and property of the following parties:
1. Investors and shareholders of Aqua Online Holdings Limited and Corpcapital Limited (old and new);
2. Some of the minority shareholders involved in the merger of Corpgro, Corpcapital Bank, (old) Corpcapital.
2. We made a list of information and documents required, which we believe will be of great assistance in addressing the outstanding issues. (See Bundle A, sub-division AE.)
4. Recommendations
We recommend that a full-scale forensic investigation be conducted into the following:
1. The records, accounts and activities of Netainment/Cytech; CFI; Interactive and Aqua Online (Int).
2. Inter-company transactions and loan accounts between Aqua group and Corpcapital group as well as between Corpcapital and its foreign associates (Netainment / Cytech / CFI / Quizwinner / WMC).
3. The beneficial shareholdings of Corpcapital (new and old); Aqua Online Holdings Limited; Southgo; TPN and the off-shore companies (Interactive; CFI; WMC; Quizwinner; Cytech; Netainment) from 1997 to 2003, as applicable.
4. The swop ratios utilised in the 2001-merger between Corpgro, Corpcapital and Corpcapital Bank and the extent to which minorities were prejudiced.
5. Valuation implications of Corpcapital’s investment in CFI and Aqua Holdings and its accounting in the records and financial statements of Corpcapital.
6. All agreements between the vendors of Aqua Online (Int); Interactive; Aqua Online (SA) and Aqua Online Holding Limited, including profit warranties, and the effect thereof on the Netainment/Cytech valuation; swop-ratios in respect of the 2001-merger and fair presentation in Corpcapital’s financial statements.
7. Any share dealings or transactions whereby the “original” vendors and/or other vendors and/or management and/or directors may have benefitted at the expense of other investors and/or shareholders.
5. Detailed Findings
1. Attached to this report are five bundles in three green files, marked A & B, C & D and E. Each bundle is sub-divided into further bundles and/or divisions and/or schedules for better and specific reference.
2. As a starting point, and for a broad background of the Aqua and Netainment group’s business history (as we see it), we refer the reader to Bundle A sub-division AA.
3. Paragraph 6 to 17 of this main report deals with the accounting treatment of the investment in Netainment/Cytech in Corpcapital’s financial statement according to GAAP.
4. Paragraph 18 to 37 of this main report deals with the important factors to consider in judging the valuations of Corpcapital’s investment in Netainment/Cytech.
5. Paragraph 31 to 41 of this main report deals with the specific valuations for August 2000, September 2001 and August 2002.
6. Bundle D deals with fair presentation and the restatement of the financial statements of Corpcapital to account for Cytech and Aqua Holdings according to cost method and equity method.
7. Bundle E deals with directors, related parties and shareholdings.
8. In paragraph 6 to 41 of this main report, which deals with Corpcapital’s investment in Netainment and Cytech, references are made to further documentation, graphs and data analysis to support our findings. In many instances there will be references to our previous reports (June 2003) and/or to information files received from Corpcapital/Cytech. As far as was practically possible we identified specific documents to support our findings.
9. Based on new information that became available to us for this report, we did change our view on a number of issues regarding the valuation of Corpcapital’s investment in Netainment/Cytech. In many instances the new information led to new findings and conclusions.
10. Although we changed our view on certain issues regarding the above valuations, the rest of our findings and conclusions, as set out in previous reports, still represent our view. We therefore did not attempt to revisit all the issues addressed in our previous report, and this report should be seen as an expansion of the previous report.
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|ACCOUNTING TREATMENT OF THE NETAINMENT/CYTECH- |
|INVESTMENT IN CORPCAPITAL’S FINANCIAL STATEMENTS ACCORDING TO GAAP |
6. Corpcapital defined the Cytech Investment as an Associate in their 2002 financial statement. We concur. This inevitably means that Netainment (previous owner of the business) was an associate too, as there are no differences in the relationship of Netainment vis-à-vis Corpcapital and that of Cytech vis-à-vis Corpcapital. Also, the original agreement (1998) between Sean Rose, Tal Harpaz and Corpcapital is still in place and nothing had changed since 1998. The investment in Netainment/Cytech was therefore always an investment in an associate. Corpcapital’s purpose for which it held the share is irrelevant to the fact that Netainment/Cytech were associates of Corpcapital.
7. Any recognition of the investment (Netainment/Cytech) must therefore start with AC 110 (See par. 01). When applying GAAP one does not have a discretionary option to classify the investment or apply an accounting standard to that classification, as one sees fit. If Cytech/Netainment were associates (which, according to Corpcapital’s own version, they were) it represented an investment in an associate and hence AC 110 applies as a starting point.
8. AC 110 makes a very important distinction between the group’s consolidated financial statements and the company’s own financial statements. In the case of Corpcapital (like most other companies), the financial statements have four columns of figures. The two columns to the left represent the consolidated financial statements (the group), and the two columns to the right represent the company’s (holding company) own financial statements.
9. AC 110 distinguishes between these “two” financial statements. As far as the consolidated financial statement (two left columns) is concerned, an investment in an associate can only be accounted for under the equity method or the cost method (par 07).
10. There is another option with regard to the company’s own financial statement (two right columns). AC 110 gives a third option – “available for sale”. If the company chooses this option, AC 133 becomes applicable.
11. It in effect comes down to the fact that the consolidated financial statement (two left columns) may reflect different profit and financial asset figures even if the holding company’s only asset was the investment in one associate. An example of such a situation is set out in Schedule AB5 in Bundle A.
12. Once an investment moves from AC 110 to AC 133 (for accounting in the Company’s own financial statements), a new procedure has to be followed to account for the investment.
13. All the steps from AC 110 to AC 133, and the ensuing processes for recognition of investment in company’s own accounts, are set out in Schedule AB1 to AB5 in Bundle A to this report.
14. The most important step in respect of AC 133 is to determine if the investment can be measured reliably. The test for “reliably measured” is the following (par. 96):
1. The variability in the range of reasonable fair value estimates is not significant.
2. The probabilities of the various estimates (outcomes) within the range can be reasonably assessed and used in estimating fair value.
3. Therefore, if the variability in the range of reasonable fair value estimates is so great, and the probabilities of various outcomes are so difficult to assess, one should conclude that the investment cannot be measured reliably.
15. There is often a misunderstanding between the principle of “reliably measurable” in terms of AC 133 and the requirements for choosing DCF as one of the appropriate models to value the investments. DCF is just one of many models or methodologies to use in estimating the fair value of the investment. DCF may be one of the models/methodologies used to determine the range of possible outcomes.
16. One prerequisite for choosing DCF is to determine if the amount and date of each future cash investment and/or future cash income can be predicted with a high degree of certainty and accuracy. The principle of discounting cash flow and the mathematics of calculating a value from cash flow, requires a high degree of certainty and accuracy with regard to dates and amounts. Alternatively, the resulting value from applying the DCF model could bear little resemblance to the actual present value.
17. This “high degree of certainty and accuracy” is not the same as the principle of “reliably-measured” as set out in AC 133.
|IMPORTANT FACTORS TO CONSIDER IN |
|JUDGING THE VALUATIONS OF CORPCAPITAL’S |
|INVESTMENT IN NETAINMENT / CYTECH |
18. Hamburger’s indicative valuation was not specifically geared to value Corpcapital’s shares (47,5%) held in Netainment for recognition and disclosure in Corpcapital’s financial statements according to the principle of prudence.
19. The respective indicative valuation document (IVD) states clearly that the valuation was undertaken to value the “business” of Netainment for the purposes of:
1. financial accounting, and to
2. facilitate a decision on appropriate business strategy (merger, public offer, sale, etc.) [See para 1, Introduction to each IVD.]
20. In Hamburger’s Cytech Valuation document of September 2003, he starts off each valuation (2000-2002) with: “Reason for valuation: To determine fair value for financial reporting purposes.” (See page 6 par 1; page 15 par 3 and page 26 par 5) This is disingenuous, and differs sharply with the reasons or objectives set out in his indicative valuation documents (IVD).
21. The share value recognised in Corpcapital’s financial statements was simply calculated as a percentage (47,5%) of the value of the total business of Netainment. It was incorrect to assume that 47,5% of the business value of Netainment equals the share value of Corpcapital’s share in Netainment. Factors like lack of control, the specific structure involving the Aqua Group, limitations on tradability and/or transferability, unlisted shares and expected future dividend-flows will all influence a potential buyer’s mind in considering to buy 47,5% of the shares. His considerations will materially differ from a buyer who buys the entire business or 100% of the shares.
22. The approach to a valuation for business strategies like mergers, public offers or sale will differ materially from one where the fair value of an investment must be determined in a prudent manner for recognition in the financial statements, especially where any increases in values will be reflected as part of distributable income for shareholders. In approaching a merger or sale one needs not to adopt a prudent or independent minded approach, but rather one of presenting your business in the most favourable light in order to achieve maximum benefit from the potential deal.
23. Hamburger was part of the original business plan and the management of it. He was attempting to sell, list or merge it. He derived benefit (bonuses) from the successful management of the business. It would probably be unfair to expect of him to present an independent and prudent valuation of the shares (47,5%) or the business, for recognition in the financial statement.
24. An independent valuator (also assuming the position of a potential buyer), especially one with the specific instruction to have a prudent approach, would have had a much more critical and conservative approach than Hamburger. He would carefully consider the accuracy and dependability of data, the threats and/or risk attached to the business. He would specifically consider the risks/limitations attached to an investment in a share-investment of 47,5%. The vendors’ (Sean, Tal and Corpcapital) interest in and links to various service providers, like CFI, Interactive, Aqua Holdings and Aqua (Int), would hold potentially serious implications for an investor in 47,5% of the shares in Netainment. Hamburger was clearly more focussed on the potential of the business, his own business plans, and the potential results (profits, merger, list etc) that could flow from it.
25. It is probable that neither Hamburger nor Corpcapital nor the auditors (FHS) considered Hamburger’s indicative valuation as “independent” at the time. Hamburger stated the following: “I understood that Peter Kay (FHS) subsequently advised against an independent valuation.” (Hamburger Statement, page 54, par 5.) It follows that Hamburger’s valuation was not considered independent. Furthermore, in the 2002 Financial Statement of Corpcapital (page 10) they state the following: “As a result, the valuation of investments is more conservative, subjectivity is removed from income recognition .…”
26. In Corpcapital’s financial statements the directors assured the shareholders that reasonable and prudent estimates (valuations) had been made where required. They also stated in their accounting policies that they recognised all investments at fair value. The fair value is that value at which the specific asset (47,5% share investment) could be exchanged between knowledgeable, willing parties at arms-length. The directors of Corpcapital could only give this assurance by obtaining an independent valuation (not relying on Management’s figures), including the specific instructions to:
1. Value specifically Corpcapital’s share-investment (47,5%) in Netainment; and
2. To approach any estimate in a reasonable and prudent manner; and
3. To consider that such value was done for purposes of recognising unrealised profits in the financial statements of the investor (Corpcapital); and
4. To report directly to the Board, preferably to the non-Executive Directors, especially where the Executives may have a conflict of interest (like bonuses) in the outcome of the valuation.
27. This was not done. KPMG did a review of Hamburger’s valuation (par 10.3 of their report), and qualified their conclusion with: “ …. based on the information received from management.” (par 10.3.12 of their report.) KPMG’s specific instructions is unfortunately not known, but it does not seem that it was in line with that which is set out above in paragraph 26.1 to 26.4.
28. PWC was instructed to estimate the recoverable amount of the “business” of the subject company (Cytech), as required by AC 128 for assessment of impairment. (Par 2 and 3 of PWC letter of engagement.) The instructions clearly were not to value the specific investment of Corpcapital in Cytech (47,5% of shares) at fair value. The issue of prudence, as set out in the financial statements, was not mentioned. In PWC’s letter we found no evidence in their “procedures” (par 6) that they considered the group structure with regard to Aqua Holdings, Aqua (Int), Interactive, CFI and the Vendors (Sean, Tal and Corpcapital) conflicting interests in it, and how such structures and interests might influence the mind of a potential buyer of the 47,5% shares in Cytech. Fair value would assume that the buyer or valuator knows about the above structure and considered it in arriving at his own value.
29. PWC also qualified their valuation with the proviso that they will rely upon information provided by Corpcapital and Cytech, and that they assume no responsibility for the accuracy or completeness of information provided to them by Corpcapital and Cytech. It must also be kept in mind that PWC was involved in prior reviews of valuations (2001 merger of Corpcapital), and that they were previously instructed to sell Cytech or its business.
30. The Credit Card Issue
1. Hamburger now calls the “September 2001”-indicative valuation the “August 2001” valuation (Hamburger Statement page 36) and then continues to reason why his September 2001-indicative valuation was correct.
2. Hamburger confirms that the “August-2001”-valuation was finalised in September 2001 (Par 189, page 44 of Hamburger’s Statement). He claims that the credit card issue had not yet impacted the business (Hamburger Statement, par 165, 2.1.1, page 39). In Hamburger’s 2003-report he refers to the reasons for the first-year forecast (September 2001 – August 2002), and then draws a comparison between the historic revenue for the 12-month period ending August 2001 and that forecasted for the 12-month period ending August 2002.
3. Hamburger then states that: “The decrease in August 2001 revenue was as a result of a deliberate decrease in marketing” (2003-report, page 28, par 5.3.1.1, 4th sentence). He again repeats this statement and says the following about the significant decrease in revenue (25%) in August: “Therefore this decline was not considered indicative of any future trend.” (2003-report, page 28, par 5.3.1.2, bottom part 2nd last sentence.)
4. In Cytech’s market report of July 2001 it is predicted that the full impact of the credit card problem will be felt in August 2001 (Cytech Bundle 18, page 215 last paragraph under “General”). The market report of August 2001 (Cytech Bundle 18, page 190 par 4) then confirms this anticipated impact by stating that the credit card issue (banking crisis) settled at a decrease of ±25%. This 25% decrease corresponds with the actual decrease (24,5%) in Netainment’s revenue from July 2001 ($2 701 384) to August 2001 ($2 038 934).
5. Hamburger’s statement that the credit card issue had not yet impacted the business in August 2001 is clearly not in accordance with the 2001 Man-report version of events. The impact of the “intentional” reduction in marketing spend will be dealt with later in this report under the September 2001 valuation.
31. The Audit Issue
1. Hamburger says that as Netainment is a Netherlands Antilles company, and audited accounts are not a statutory requirement, Sean and Tal felt no need to produce audited accounts. (Hamburger Statement, page 61 par 1.)
2. He further states that Sean and Tal were reluctant to incur the expense of an audit for the September 2000 year as it was going to be repeated with the Amalco listing which was believed to be imminent. Since then no audited and properly signed financial statements for the period ending 30 September 2000 were produced. Sean, Tal and the management team also had no urgency to have accounts ready for audit despite Hamburger stressing Corpcapital’s urgent requirements for such audited accounts. (Hamburger Statement, page 62, par 10 and 11.)
3. Hamburger also explains how easy an audit would have been for August 2000 because the majority of operations were outsourced. (Page 62, par 18.)
4. An inspection of the financial statements of Interactive (BVI) and Aqua (Int) [Bundle B to this report] reveals the following audit costs:
| |Aqua (Nit) |Interactive |
| |£’000 |$’000 |
|2000 financial statement |5 700 |- |
|2001 financial statement |6 000 |5 000 |
|2002 financial statement |- |1 500 |
5. Even a high estimate for audit costs of ± $10 000 would only come to 0,2% (10 000/4 690 000) of the forecasted profits of Netainment for 2001 (done August 2000). It is simply shocking that this relatively small cost could ever inhibit the urgency and importance of an audit. Why did Corpcapital not offer to fund this relatively small cost item?
6. Despite Hamburger’s admittance that an audit was essential for Corpcapital’s financial statements, no signed-off financial statements for the individual financial years (1999, 2000 and 2001) were produced.
7. The issues of retrospective adjustment and changes of figures in management accounts; lack of internal control in accounting system; imbalance of $1 million in inter-company accounts; the moving of expenses, income and funds between Aqua (Int), Interactive, CFI and Netainment; the “ring-fencing” of expenditure and problems with cut-off procedures; were material with regard to valuations, corporate governance and accountability of management. It will be addressed later in more detail under the specific evaluation of the 2000 to 2002 indicative valuations. These issues may have been a reason why there was no urgency for audited financial statements, or why such a small cost for an audit was considered a valid excuse.
8. The audited results for the 36-month period ending 30 September 2001 were presented to Corpcapital in September/October 2001. Hamburger says the “results” reconciled to management accounts and it gave Corpcapital further comfort for the 2001 August valuation.
9. FH-PKF (auditors) reported as follows about their audit of September 2001, according to Corpcapital’s “Key Issues Memorandum”:
1. Loan account of CFI out of balance by ± $1 million;
2. Lack of internal control in accounting system.
10. How Corpcapital could gather any comfort in light of the above is beyond us. In any event, if management accounts were wrong why would the financial statements not be equally wrong? What were the reconciling items?
11. As the profits generated by valuations (based on data from Netainment’s accounts) impacted Corpcapital’s financial statements materially (±R220 million) no excuse, in our opinion, can justify the absence of timeous annually audited financial statements (signed by responsible directors who managed it) for the 2000, 2001 and 2002 financial periods.
32. The Establishment and Role of Aqua
1. Hamburger states that Sean and Tal commissioned an arms-length agreement between various entities. Market-related service contracts between Netainment, Global Admin and Interactive were concluded. (Hamburger Statement, page 11, par 52).
2. However, later in his report Hamburger states the following: “Sean and Tal strongly believed that the current monthly Aqua administration expenses were not market-related”. (Hamburger Statement, page 73, par 10).
3. In Aqua Online Holding’s financial statement for 2001, Sean and Tal, as part of the board of directors, confirmed that these agreements were at arm’s-length and market-related. (Note 19.1 of Holdings 2001 financial statement – Bundle B to this report.).
4. In the reports contained in Cytech Bundles 17 and 18, there are several references to the arms-length issue between CFI, Netainment, Aqua (Int) and Interactive (often referred to as part of Aqua). In April 2000 the Man-report (Cytech Bundle 17, page 155, par 3) noted that any potential strategy to list, merge or sell Netainment would have serious implications for Aqua Online. In a Man-report of June 2000 (Cytech Bundle 17, page 145) it is noted that one of the major issues outstanding regarding the proposed merger with English Harbour was Netainment’s relationship with Aqua. It further noted that Aqua’s charges to Netainment were not market-related, and that an arms-length agreement needed to be negotiated.
5. If one adds to this the fact that the vendors (Sean, Tal and Corpcapital) sold Aqua (Int) and Interactive to Aqua Online Holdings Limited for ( R72 million - subject to certain profit warranties - the conflict of interests becomes clear. Hamburger’s attempts to portray the Aqua group as being independent, with all trading between Aqua and Netainment as being at arms-length and market-related, simply does not concur with the facts. His own statements regarding this issue are contradictory.
33. The Matureness of the Business and Industry
1. Hamburger states: “By August 2000 the business was no longer an early stage venture capital start-up. It had developed into a leading business in its industry, and the industry was widely regarded as entrenched …” (Hamburger Statement, page 4 of summary, par 7.2.)
2. He further claims that it had a track record of increasing turnover and cash profits. (Hamburger Statement, par 127 of page 27.)
3. Firstly, the track record of profits to which Hamburger refers, started in February 2000 after CFI’s charges to Netainment were significantly reduced. (See Schedule G2 of Bundle C to this report.) This represents a period of seven months including August 2000.
4. In justifying his valuation methodology and his WACC, which he also applied throughout the valuation period (August 2000 – August 2002) he states: “The additional risk premium was intended to take into account the risk in forecasting a relatively young business in a dynamic, developing industry.” (Hamburger Statement, page 59 and 60, par 6.)
5. Hamburger states further: “ … I had an early premonition that the industry would one day mature but I was not sure when this would happen.” (Hamburger Statement, page 19, par 93 2nd last sentence.)
6. According to Hamburger: “Merrill Lynch predicted super-normal profits for the next ten years, followed by a transition phase of five years up to industry maturation in year 15.” (Hamburger report, page 32, par 147.6.)
7. Both Hamburger and Mark Mathison (MM) are now of the opinion that Netainment had transformed from an early stage venture capital investment into a leading international on-line gaming and leisure group by August 2000. (Page 5 of MM’s report – par 2.1.) MM clearly considers the words “further development of” (present tense) - which was used in Corpcapital’s financial statements – to have the same meaning as “transformed from” (past tense). We do not think his interpretation of the words set out in the 2000 financial statement is correct.
8. In justifying his forecasts, Hamburger describes Cytech as a young business growing from a relatively small base [2003-report, page 11].
9. It is important to note that Aqua Online Holdings Limited, whose listing was mainly underpinned by Aqua (Int) and Interactive (the system and service providers of Netainment) was listed (May 2000) on the JSE’s venture capital division and stayed there until at least 2002, even after Holdings reported two years of substantial profits (2000 and 2001).
10. In our opinion, the evidence is overwhelmingly in favour of classifying Netainment as an early-stage company in a relatively young and immature industry. It follows that the risk and failure-ratios which applies to entities in such categories applied to Netainment in August 2000 and even until 2002.
34. Trends, Forecasts and Actuals
1. After referring to the month-on-month volatility of actual profits, Hamburger states that it is necessary to determine the trend in profits over a period rather than one month in isolation. (Hamburger Statement page 25, par 110 and 111.)
2. Accordingly, Hamburger uses the upward trends in actual revenue and adjusted profits for his August 2000 and February 2001 forecasts.
3. In his August 2001-valuation Hamburger plots a graph from November 2000 to August 2001 and concludes that it reflects a “flat” period. He then reasons that the downward movement of 25% from July 2001 to August 2001 does not represent a downward trend because they intentionally planned it that way. (The affect of the credit card issue on the August 2001 revenue has already been discussed.) However, this "flat” graph (2003-report page 29), is misleading if you compare it with Netainment’s revenue history from 1999 to August 2000. (See annexure C1 from our June 2003 report and Schedule G3 from Bundle C of this report.) The graph on Schedule G3 shows that the early high-growth trend had turned flat at around January 2001. This “flatness” continued until June 2001, despite material increases in marketing expenditure. It further clearly indicated that trouble lay ahead after the credit card issue showed its affect in August 2001.
4. When explaining the downward trend in profits (see graph on page 31 of 2003-report) he stated that: “The historic profit performance is not necessarily indicative of the future.” (2003-report, page 30 par 5.3.3.1 last sentence.)
5. From here on (September 2001-valuation) Hamburger relied mainly on their expansion and cost-savings plans to justify higher profit forecasts for the future. These forecasts did not materialise, and the actual trends continued downwards.
35. Actual Results Versus Forecasts
1. In forecasting profits, the indicative valuations were not only aggressive in the year following the valuation date, but were equally aggressive in the second year following the valuation date (August 2000 – February 2002 valuations).
2. In justifying forecasts (revenue and profit), the 2003-report only compares the first year of forecasts against actuals. His reason for this is: “ …since failure to meet the key assumptions in these forecasts affected subsequent forecasts.” (2003 report, page 13, par 2.1).
3. The fact is that each valuation discounted all future years’ forecasts (year 2, 3, 4 etc) to arrive at a value in August 2000, August 2001 and August 2002. This value was recognised in Corpcapital’s financial statement as distributable profits.
4. To demonstrate the complete picture in respect of the difference between forecasts and actuals, we compiled the following two graphs:
1. A graph comparing each valuation’s accumulated profits as per forecast (in $) to the accumulated actual profits (in $) of Netainment/Cytech (see Schedules M3.a; M4.a; M5.a; M6.a in Bundle C to this report), and
2. A graph reflecting the effect that each valuation’s 2nd- and 3rd-year profit forecast had on the final value outcome of each valuation. (See Schedules M3.b; M4.b; M5.b; M6.b and M7.b in Bundle C to this report.) What these graphs in fact illustrate is that the forecasts of the 2nd and 3rd years, which Hamburger does not attempt to justify, had the greatest effect on the eventual outcomes of the valuations.
3. It is important to realise that, in its simplest form, the 2nd year profit forecasts result from increases based on the first (1st.) year’s forecast, and that the 3rd year profit forecasts result from increases based on the 2nd year forecasts. The 3rd year forecasted figure then forms the base profit to which the terminal growth rate is applied into perpetuity in order to determine the terminal value (TV). That implies that if your profit forecast is too high in any of the first three years, this excessive value will be perpetually carried forward into your terminal value. A conservative growth rate (3% to 5%) for terminal value would mean very little if your forecasts in any one of the first three years are too high.
5. It is clear from the above graphs that profit forecasts and the resultant valuations had very little in common with the actual performance of the business.
36. Valuation Methodologies
1. A lot has been said about the valuation methodology and the correct model.
2. The fundamental principle and/or objective of all valuation methodologies or models is to determine the present value of the net future income stream flowing from that asset. Whether one would use earnings yield, dividend yield or discounted cash flow, all models have the same end goal and that is to determine the present value of the net future income stream from that asset.
3. The net asset value underpins the above valuation methodologies in that a business (relevant to owner of business or controlling shareholders or 100% owners) is not worth less than the net realisable value of its assets and liability. It's also a reality check for other valuations in the sense that differences between net asset value and other values must be considered.
4. A dividend yield is appropriate to a minority shareholder because his only return on his investments is the present value of the future expected dividend stream from that investment. This is an appropriate methodology where the minority shareholders have very little say in the management of the business and the distribution of its assets. From the information we have now received, Corpcapital had significant influence over both management and asset distribution, and this methodology would therefore not be the most appropriate in the circumstances.
5. In the circumstances, the earnings-yield model and the DCF or combination thereof, will be considered.
6. The Earnings Yield Model (EYM)
1. The EYM (in very basic terms) requires that one determines the historical profits, adjust it where required, and use the adjusted value (FSE) as a basis for the future income stream.
2. Any anticipated growth (AGR) in the business profits will be deducted as a percentage from the expected fair earnings (FEY) for such an investment.
3. A fair earnings yield (FEY) for an investment must be determined after considering all risk factors associated with such an investment. The FEY will then be reduced by the AGR.
4. Value of investment is therefore = FSE discounted at a net rate (FEY–AGR) = FSE x 100 ( (FEY-AGR).
7. DCF Methodology / Model
1. To apply this method effectively and correctly one must be able to predict the net future cash income stream (FCIS), and the dates it will materialise from the beginning of the investment or project until the end, with a high degree of certainty and accuracy.
2. In this model (DCF) you do not estimate the growth of the future business as a percentage (like the AGR) for deduction against the FEY or WACC, because any future “growth” must be accommodated in your FCIS.
3. The WACC also has a slightly different emphasis than the FEY. It reflects the cost of obtaining the capital for such investment. A risk rate can however be added to the cost of capital to determine your WACC.
4. A building project would be a good example to demonstrate the principles of DCF. You need to invest R100 immediately and a further R100 at the end of the first year (all building costs) to obtain a cash inflow of R300 (revenue from sales) at end of year two. If one assumes you would fund the full R200 with a bank loan at 10% p.a. the present value of the project would be calculated as follows:
|Year |Future |WACC (10%) |Current Value |
| |Value | |R |
| | |Discount the future | |
| | |value | |
|3 |R300 |( |1.21 |= |248 |
|2 |R100 |( |1.10 |= |(91) |
|1 |R100 | | |= |(100) |
| |Value of project |= |57 |
8. The Model used for the Indicative Valuations for Netainment’s Business
1. The methodology or model used for Netainment is in fact a half-breed or hybrid between the EYM and DCF which is well known (hereinafter called the Hybrid.)
2. Because Corpcapital (Hamburger) considered it a young and fast-growing business, the historical profits were probably considered too low to use as a base to determine the future sustainable earnings (FSE) and apply a normal AGR (growth rate) to it.
3. In the indicative valuations the forecasted future profits for the first three years following the valuation date were not inhibited by any general terminal growth rate. In the 2000-valuation they increased the adjusted historical profit ($1,8 million) by 158% in year 1, a further 136% in year 2 and a further 9% in year 3 to establish a profit base of $12,1 million.
4. This $12,1 million was then used to calculate the terminal value at a general growth rate of between 3% and 5%, and a discount rate (WACC) of 24%. The terminal value (TV) was calculated as follows:
TV = $12,1 million x 100 ( (24-5%)
TV = $63,6 million.
5. The TV was then converted to the present value by discounting the $63,6 million value at 24% over 3 years. This discounted TV-value was then added to the present value of the forecasted profits for years 1, 2 and 3, which then equals the estimated value of the business of Netainment.
6. The method used to determine the TV is in essence the same as the EYM. Only the profit forecast which is supposed to represent future cash flow (at end of year 1, 2 and 3) are similar to a pure DCF-model.
7. In theory there is nothing wrong in applying such a Hybrid-DCF, except that it is a very value-sensitive model, meaning that valuations can be materially inflated by unrealistic or unsubstantiated increases in the first three years of profit forecasts. If the first three years of profit forecasting (which will form the base year for calculating the TV) cannot be determined or predicted with a high degree of certainty and accuracy, one cannot reliably measure the investment with this Hybrid-DCF. In such circumstances it would make sense to follow a more conservative route and to use the EYM or a hybrid of such ETM. In the EYM one could also account more easily for the risk attached to the specific share investment (47,5%) of Corpcapital.
8. The value-sensitivity of the Hybrid-DCF and the variability of value-outcomes are clearly demonstrated on Schedules LO.1; L0.2; L0.3; L0.5 to L0.7 of Bundle C to this report.
9. The values marked “low” and coloured green and stands to the right of the Corpcapital valuations (2000-2001), and PWC-valuations (2002), are values which, in our opinion, could possibly reflect fair values, especially because it approximates an EYM with fair provisions for the various risk factors. This is however subject to the qualifications of “reliably measurable”.
37. The Correct Approach to Determine Fair Value
1. The South African Institute for Chartered Accountants issued a guideline for Equity Valuation in 1993. It is specifically aimed at independent valuations. A summary of an Afrikaans-version is set out in Bundle A sub-division AC.
2. The guideline makes it clear that it does not have the authority of an accounting standard, but where a member (CA) of the Institute deviates from it, the onus of proof is on the member to justify his deviation.
3. This guideline is supported (as indicated in the Guideline) by the South African courts, and specifically the principles as set out in Pietermaritzburg Corporation vs South African Breweries Ltd [1911 AD 501] en Novick vs Comair Holdings Ltd [1979(2) SA 116(W)].
4. MM’s interpretation (par 12 of his report) regarding the net asset value is incorrect. The Collett and Adam report of June 2003 (par 11.1.6) reads: “Any majority share valuation (like the DCF in Cytech) should in the end be compared to the net asset value of the business to determine if the difference between net asset value and the results obtained by the DCF-method or earnings model is fair and/or justifiable.” This comparison is prescribed by the abovementioned guideline as a reasonability test. It is important because it compels the valuator to explain why he differs so materially from the net asset value and it may lead him to reconsider his valuation. To some degree this reasonable test is the same as the different requirements set out in AC110 for accounting for an investment in the consolidated financial statements (equity-method) and the company’s own financial statements (available for sale-options leading to fair value). If accounted for differently in the consolidated financial statements and company’s own financial statement, the difference between fair value and equity or cost value would be reflected and would probably require explanation, at least in the directors’ report.
5. MM’s reference to AC428 is considered irrelevant as it does not apply to the Cytech valuation. In any arm’s length transaction between willing and knowledgeable buyers and sellers, the relative size of the share-investment (e.g. 1% versus 100%) will be very important, particularly in respect of an unlisted investment.
6. What MM and Hamburger fail to address is whether one of them would have bought shares in Cytech at their valuations value - a reality check or reasonable test recommended by the above guideline. The simple question is this: Would MM (who says the size of the investment does not matter) have paid R4,6 million (R220 million ( 0,475) for 1% (one percent) of the shares held in Netainment (in August 2000) or R2,3 million (R110 million x 1% ( 0,475) for a 1% (one percent) share in Netainment/Cytech (September 2002)?
7. Another important reality check or reasonable test prescribed by the guideline is the following: What would be the cost to start a similar business. Why would a buyer rather pay R313 million (R149 ( 0,475) in 2000 for Cytech, than attempting to start up such a business by himself at a much lower cost. A likely buyer was obviously an entity from the gaming industry which would have had the basic industry knowledge to do its own start-up. Why would it pay R313 million for a business which was only profitable for seven months, locked into deals with several mutually-owned subsidiaries which were not market-related, and various other factors already mentioned above? The venture cost the vendors ( R3,6 million ($600 000 @ 6.00). A potential buyer will therefore weigh up this start-up cost against the existing business cost of R313 million and then ask himself if the premium of ( R309,4 million is justified for a young company in a young industry with only a seven months profit history.
8. The reason for the above reality check or reasonable test is of decisive importance. “Fair value” is defined by AC133 as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction (Par 09). In determining the fair value of one’s own business or that of another, various models, techniques and assumptions could easily lead to unrealistic values. Reality and/or reasonable checks are therefore important to ensure objectivity, soberness and prudence.
9. Despite tension between Sean, Tal and Corpcapital, and the nuisance value of the 5% shareholder (Dawson Systems), we could not find any evidence that Hamburger recommended or Corpcapital offering Sean, Tal or Dawson Systems the valuation-values for their shares in Cytech. Neither do they answer the question if they (Corpcapital) would have financed such a business or any other project of another third party for the amount of ( R273 million (R463 million x 60%) taking the shares as security (2001 financial year). After they eventually gave the business to PWC to sell we are not aware of any subsequent exciting offers refused by Corpcapital.
10. When applying the reality checks or reasonable tests, and considering the risk attached to the business (also shareholding of 47,5%) the values used by Corpcapital as fair value in their financial statements is, in our opinion, not credible.
11. The above were reinforced by confidential information (Document – E mail - AD1; AD1/1 and AD2 in Bundle A.) received by us on 16 November 2003, just before finalisation of this report. The above documents reflect the following:
1. Amanda Kenny, Trust Officer of Dawson Systems Limited, made an e-mail enquiry to Ms Feldman (Schindlers) about the up-to-date value for the company, Netainment NV, on 9 November 2000. (Bundle A - see date at bottom of AD 1/1, question on AD 2, par 2; reference to Dawson Systems – top of AD-2; and reference to subject company, ”Netainment NV” at bottom of AD 1/1).
2. Amanda Feldman responded (Bundle A - Document AD 1/1) that the up-to-date value of Netainment was Zero (AD 1/1).
3. The directors at the time, Schindlers, therefore confirmed that the value of Netainment in November 2000 was “zero”.
4. The implication is that Netainment’s directors, Schindlers, who must have contacted Sean, Tal or Hamburger before confirming such a valuation, believed Netainment NV to be of no value.
5. It may be that it was an indication of or a reference to Dawson System’s Share of 5%. Although we accept that a 5% share would be much less than 5% of total business value, it can’t be zero.
6. Based on MM’s arguments (size of share holdings does not matter), Dawson System’s shares’ value in November should have been no lower than $2,6 million ($52 million x 5%).
| |
|THE VALUATIONS FROM 2000 TO 2002 |
38. The August 2000 Valuation
1. Revenue Forecast
1. Revenue was forecasted (Indicative Valuation Document, par 7 – hereinafter called IVD) as follows for next three years:
|Historic Actual |Forecast |
|$’000 |$’000 |% |$’000 |% |$’000 |% |
|2000 |2001 |increase |2002 |increase |2003 |increase |
|13 760 |32 852 |
|2000 |2001 |% |2002 |% |2003 |% |
|$’000 |$’000 | |$’000 | |$’000 | |
|1 813 |4 690 |
|$’’000 |2001 |% |2002 |% |2003 |% |
| |$’000 | |$’000 | |$’000 | |
|1 813 |2 846 |57% |
| | |$’000 |% |$’000 |% |$’000 |% |
| | |2001 | |2002 | |2003 | |
|Bonuses Paid |(700) |(1 806) |158% |(4 262) |136% |(4 645) |9% |
|Adjusted Forecasts|1 113 |2 884 | |6 809 | |7 458 | |
|Bonuses |(700) |(1 099) |57% |(1 154) |5% |(1 212) |5% |
Adj. Forecasts |1 113 |1 747 | |1 834 | |1 925 | | |
2. It must be borne in mind that Sean and Tal were considered as key-figures by Hamburger, with whom Corpcapital did not want to be “heavy-handed”. (Hamburger Statement, par 6, page 68.)
3. Valuations which include the above bonus-values are set out in Bundle C to this report, Schedules L0.1; L0.2; L0.2; L5; L6 and L7.
2. The Weighted Average Cost of Capital (WACC)
1. Hamburger set out the assumptions and reasons for coming to a WACC of 25% in his 2003-report (Par 6, page 3).
2. We don’t disagree with these assumptions, but we are of the opinion that the following was not considered sufficiently, or at all, in determining the WACC for specifically Corpcapital’s shares (47,5%) in Netainment. Further factors which should have been considered:
– Shares held in a “tax haven” country (say +1,0%);
– Company not listed (say +1,5%);
– Transferability of shares impeded by agreement (first right of pre-emption) (say +1,5%);
– The intricate link between Aqua Holdings, Aqua (Int), Interactive, Netainment, CFI and the conflicting interests of the Vendors (Sean, Tal and Corpcapital) (say +3,5%);
– Dependence on Sean and Tal (say +0,5%).
3. The above would be valid concerns of a potential buyer who was interested in buying only 47,5% of the shares in Netainment. It would have added a further premium to his WACC. Such a further premium could easily have amounted to 8% (1 + 1,5 + 1,5 + 3,5 +0,5).
4. A further premium should have been added for the steep growth forecasted for 2001, and especially Hamburger’s forecast for 2002. The steeper the growth forecast, the greater the risk of not achieving it, and therefore the larger the premium to be added to the WACC. In the above forecasts (IVD and the realistic forecasts referred to above) such a premium could range from 2% (realistic forecast) to 15% for the huge growth forecast by Hamburger for 1st (2001) and 2nd (2002) year.
5. Valuations, including these risk premiums, are reflected in Bundle C to this report, Schedules L0.1; L0.2; L0.2; L5; L6 and L7.
39. The September 2001 Valuation
1. In considering the 2001 valuation one should first consider the material change in circumstances as stated in Hamburger’s 2003-report: “The change in software and admin costs created a significantly different business …” (Page 26 par 5.2.)
2. Credit Card Changes, Trends and Forecasts
1. US banks’ changing policy towards credit cards came to the fore in October 2000 (note to Management Reports / Statements - hereinafter called “Man-report” - Cytech Bundle 17 – page 109 last paragraph) and the full impact of it was expected to reflect in the August 2001 figures. (Man-report – Cytech Bundle 18 - July 2001 – page 215 last paragraph under “General”) August sales dropped by 25% because of the credit card issue (Man-report – Cytech Bundle 18 – par 4, page 190). Also see reference to the credit card problem in the September 2001 – IVD. (Page 5 paragraph at the top.)
2. Hamburger states in his 2003-report (Cytech valuation -–September 2003) that their decision to curtail marketing in August 2001 was intentional, and it resulted in the revenue decline in August 2001. He further argues that this decline in August 2001 was not indicative of any future trend. (Page 28, par 5.3.1.2 – bottom part; 2003-report).
3. The validity of the above argument must be considered carefully. The drop in revenue in August 2001 was, according to the 2001-man-reports referred to above, caused by the credit card issue. Furthermore, it was noted by Hamburger himself that market expenditure in one month may only yield returns in future months (Hamburger Statement, par 110.1 and 110.2 on page 25). As set out in Netainment management’s report graph-analysis (Bundle C, Schedule G3), the market spend for June and July 2001 was particularly high. Hamburger’s argument for ignoring the downward trend in revenue for August 2001 did not concur with the facts. This incorrect assumption or conclusion is reflected in his September 2001– indicative valuation which, in our opinion, was unrealistically high and not in the range of a prudent and independent valuation.
3. Change from Microgaming to IMS
1. Netainment / Cytech changed from Microgaming (MGS)to IMS from October 2001. According to the September 2001-IVD the change to IMS constituted a weakness as it represented “new untested software” (Page 6 under heading “Weaknesses”).
2. The September 2001-IVD does not specifically refer to the above change under “Major assumptions” for revenues and it was apparently not considered to affect future revenue despite IMS being considered new and untested.
3. Hamburger now says: “The software (IMS) was considered of similar quality to the Microgaming (MGS) platform …” (2003-report, par 5.3.1.2 – page 28 – 4th sentence.) He further says that another online casino (the largest) had previously successfully changed from MGS to IMS. (Par 5.3.1.2 – page 28 – 5th sentence.)
4. Hamburger’s statements in his 2003-report differs materially from the September 2001-IVD. “New, untested software” as stated in IVD does not concur with Hamburger’s 2003-report which implies that IMS was a tested known-to-be-successful system.
5. Hamburger’s statement later says that the software change in October 2001 proved to be a mistake as the software was found to be of a lesser quality than MGS (Page 54, par 224.3). However, they only realised this close to a year after changeover. It was also not fully comprehended until 2003. (Page 47, par 198.7.)
6. There is no indication that any premium for risk of changeover from MGS to IMS was added to the WACC. This constituted a major flaw in the 30 September 2001 indicative valuation which, in our opinion, is materially overstated.
4. Netainment Changed its Strategy
1. The September 2001 IVD refers to the launching (by Netainment) of additional casino brands in October 2002 (par 4 page 7 under heading “Revenue”). This probably referred to the planned Quizwinner / Lucky Liner products.
2. By around March 2001 Netainment decided to appoint Evan Hoff (EH) as CEO and Alex Asteng (AA) as Financial Manager to support a comprehensive growth and diversification strategy. (Par 146, Page 31 of Hamburger’s statement of 1 October 2003.)
3. They held a strategic planning session on 28 March 2001, and the conclusion drawn by the strategy document resulting from the above meeting is as follows: “… that Netainment should develop a multiple product strategy …” (Par 148, page 33 of Hamburger’s Statement.) This development and roll-out of new gaming products, and the consequences thereof, is noted by Hamburger (par 155 of page 36). The identity and range of multi-products for development are mentioned in Hamburger’s statement (Par 157, page 36). Hamburger says that this strategy was known to him since the February 2001 valuation. (Par 151, page 34.)
4. On 17 August 2001, the strategy of bulk growth was reinforced (Cytech Bundle 18, page 229 of Man-report under “Commentary”). It was also concluded that a new product was needed to penetrate markets further. (Cytech Bundle 18, page 229 of Man-report – last sentence under heading “May”.)
5. At the Tombola / Manco meeting of 15 August 2001, it was decided that a contract be signed with Aqua for launch of Quizwinner in November 2001. (Cytech Bundle 18 - Man-report, par 4 of page 204 and par 5.3 of page 205.)
6. Hamburger states that the development and roll-out of new gaming products consumed senior management’s time and utilised other company resources. (Hamburger’s Statement - Page 36, par 156.)
7. In effect, Netainment has embarked on expansion including the development of new products. The development of new brands and products was also necessary to further penetrate markets.
8. They approved a budget of $500 000 to develop Quiz. CFI would fund it initially, and Aqua would develop it. (Hamburger Statement, par 157.2 of page 36 and Cytech Bundle 18, page 204, par 4.) No motivation as to why a transaction processing company, like CFI, should fund the development was given, but likely reasons will be discussed under “Valuation Methodologies”.
9. What is clear, however, is that the casino was committed to the development of new products in the foreseeable future, and needed to consider the future cash outflows for such developments in any valuation. Valuations which include relatively small additional provisions for such future development cost ($250 000 annually) are reflected in Bundle C to this report, Schedules L0.2; L0.3; L6 and L7.
5. Valuation Methodology
1. After extensive research Hamburger came to the conclusion that the DCF would be the most appropriate method to value a business: “It is particularly relevant for cash-generative, high-growth businesses that requires little re-investment/capex for future growth” (Hamburger Statement, par 127 of page 27 and 127.1 of page 28) He further avers that other valuations methodologies cannot adequately provide for future changes in business, and that these methodologies (PE valuations) use comparable data businesses and indices that are not strictly comparable (Par 127.2 and 127.3 of page 28). This is quite a statement if one considers how many times Hamburger used “comparable” businesses and indices to support the indicative valuations.
2. Hamburger explained the methodology used in his indicative valuations further in his statement: “Profits were assumed to approximate cash flows on the assumption that:
– Capital expenditure would approximate depreciation, and
– Working capital would be neutral.
These assumptions were based on the historic performance and nature of the business”. (Hamburger Statement, par 2 of page 59).
3. In the August-2000 indicative valuation this is backed up by the assumptions under “Revenue” as follows: “No further casino brands launched.”
“No development of portal strategy.” (2000-IVD, page 6 under “Revenue”).
4. As stated above, the whole business changed during the 2000/2001 financial year and the foreseeable future. Netainment changed its strategy to one of growth, re-investment for future growth, development of further brand products and portals, and expansion of infrastructure, e.g. fixed assets like computers, software, etc. The new strategy requires the re-investment of profits and cash to fund this growth, and that capital investment would not equal depreciation for some time to come.
5. The underlying assumptions and reasons for choosing the DCF-model (Hybrid) therefore substantially changed in 2001 and were not valid any longer. The Hybrid could of course still be used, if one made provisions for the future cash-outflows and/or re-investments which will be required to back the new strategy of growth (and possibly the survival of Netainment). An additional annual investment in development (used in the valuation as an additional annual depreciation) could have been included in the projected profit forecasts. There is no indication that this has been done.
6. It is possible that Hamburger and some of the Executive members were aware of this dilemma and decided to circumvent it by “ring fencing” such costs and development outside Netainment/Cytech.
7. As already indicated above they commissioned Aqua to do some of the development and CFI to fund it. For what possible reason a transaction processing company like CFI should fund product development for a casino is not clear.
8. It appears that some of the costs associated with Quizwinner and Digiturf were accounted for in Netainment’s records, but that they had to be reversed and recharged (to separate entities) so that Netainment’s books would present a “true picture”. Certain write-offs were also recommended by the auditors to ensure that “take-on balances are clean” going forward (Cytech Bundle 18 – Man-report dated 12 September 2001 – page 18, par 4.5). The above probably resulted in the write-off of a loan ($908 005) to Dawson Properties for the establishment of a marketing structure. (Cytech 2002 financial statement, page 9, note 5). Some of Quizwinner development costs were apparently capitalised in Aqua (Int)’s 2001 and 2002 financial statements and later written off by “impairment”. A debt to an inter-company, probably related to this development, was also waived by Aqua (Int) as an administrative expense. The total amount involved exceeds £1 million (2001 financial statements of Aqua (Int) – Intangible assets £564 912 – note 8, page 9, and 2002 financial statement of Aqua (Int), note 20 on page 14 - £439 376 for debt.) Also see to what extent development and expenses were further accounted for in Quizwinner and WMC (Bundle AA to this report, Schedule 8).
9. The difficulty and risks in valuing a business (even more so for a 47,5% shareholder) are further emphasised by ABN-Amro: “ …the valuations of e-commerce and internet-related players are increasingly difficult to determine given the disparities in demand forecasts and the evolving business model” (Hamburger Statement, par 127.6, page 28).
10. Under the above circumstances the variability in the range of valuations an independent and prudent-minded valuator could come to and the risk associated with the assumptions on which the valuations were based, are simply so great that we are of the opinion that it is not possible to reliably determine the value of the shares of Corpcapital in Netainment (47,5%) or even the business of Netainment.
6. Profit for August 2001 and Forecasts
1. Although the revenue dropped substantially in August 2001, the profits reflected in the management accounts and those referred to in the forecasts rose substantially. One reason for this was that the marketing expenditure decreased from $831 975 in July to $323 609 in August (61%), much more than the revenue decrease of ± 25%.
2. However, before accepting the actual profit results for the month of August 2001 or the 2000/2001 financial year at face value, the following should be considered:
1. As noted above, there were serious problems with cut-off procedures, and
2. Bonuses paid to Sean and Tal were added back as a once-off expense not to be provided for again, and
3. There are no financial statements (audited or not) that confirm the actual result for the specific period from 1 October 2000 to 30 September 2001, and
4. Management accounts and numbers were continuously affected by cut-off problems, changes and retrospective adjustments (Cytech Bundle 17, par 3 of page 141, par 4 – last sentence on page 145; Cytech Bundle 18 – par 1.4 of page 86).
5. This problem is worse where specifically the month of August 2001 is concerned. The management accounts, according to the Man-report dated 12 September 2001, reflected $340 000 (Cytech Bundle 18, page 185, par 4). The figure reflected in their valuation management-report is $365 000. (See annexure D11 to Collett and Adam report of June 2003, page 905). In the management reports which form part of Corpcapital’s Bundle no 25 / Cytech Bundle no 18, the profit reflected on page 151, amounts to $507 711. (Also see Bundle C, Schedule G3 for effect of change.) It is obvious that the profits for August 2001 were adjusted several times, even after the September 2001 indicative valuation.
6. The extent to which write-offs were done at year-end (30 September 2001) so that the take on balances were “clean” are further complicated by Cytech’s “DRAFT” balance sheet which refers to a “Capital distributions declared”, which amounts to $2,889 million. (See Bundle B to this report, page 170, page 6 of the draft financial statement of Cytech under the heading “Share Capital and Premium”) This read together with FH-audit findings (September 2001), reporting an inter-company-loan difference of $1 million, lack of internal controls in accounting system and Netainment funds utilised by WMC/Tombola and Quiz, raises serious doubt over the actual profits reported in either 2001 or 2002.
3. As set out in Annexure C2 of our June 2003 report, Schedule E2 of Bundle C to the report, the general trend in profits were downwards and the August, September 2001 doubtful “upward rally” did not reverse this trend. In our opinion the general downward trend in profits and revenue was not reflected in the indicative valuations of September 2001. Valuations which incorporate these downward trends are reflected in Bundle C, Schedules L0.2; L0.3; L6 and L7.
7. The Weighted Average Cost of Capital (WACC)
1. The risk associated with the business has increased by a material margin, mainly because of the following issues:
1. Credit card (25% drop in August and potential further influence);
2. MGS change to IMS (new and untested);
3. Change in strategy to go for growth (additional capital outlay);
4. Development of further products and brands (not sure if it will be successful and huge costs);
5. Problems with management (Evan Hoff severely criticised);
6. Accuracy, reliability and timely presentation of accounting data.
2. The above risk factors should have added a substantial premium to the WACC of 24% which were first determined in 2000. This was not done in the September 2001 indicative valuation. The 2001-indicative valuation continued with the same WACC of 24% which, in our opinion, constituted a fundamental flaw in the valuation.
3. Valuations which add a further conservatively measured premium of 4% (in addition to the 2000-premium) to the WACC are reflected in Bundle C, Schedules L0.2; L6 and L7.
40. The August 2002 Fair Value
1. As already mentioned above, the instructions to PWC were to value the business of Cytech. As indicated above, it was incorrect instructions for the valuation of Corpcapital’s specific share investment (47,5%).
2. PWC started off with an adjusted profit of $2,192 000. This adjusted profit was apparently based on the month-to-month version of Cytech’s profit. We do not have the management accounts for May 2002, but assume that the balancing figure in the reconciliation between PWC’s adjusted profit – after adding back the $600 000 for the marketing team – is the profit for May 2002 ($221 000). As set out on Schedule K2 in Bundle C, the actual profits before adjustments were calculated at $1 592 000 ($1 371 000 + $221 000).
3. Cytech’s “DRAFT” financial statement for 2002 reflects a profit of $540 000. (See Cytech financial statement in Bundle B.)
4. The profits reflected in the management accounts (year-to-date version) reflect a loss of $565 000. (See Bundle C Schedule K1 and K2.)
5. These differences are material. If the “DRAFT” financial statement reflects the true profits it implies that PWC’s valuation could be overstated by $24 million. [(1 592 – 540) discounted at 22% @ 10,6 @ 47,5%] If the year-to-date versions of the management reports are correct then it implies that PWC’s valuation could be overstated by $49 million [(1 592 + 565) discounted at 22% @ 10,6 @ 47,5%].
6. These differences are material and could be indicative of possible irregular or fraudulent accounting. The only way to determine the true position is to have access to all records of the group and have it subjected to a full forensic audit.
7. As stated in our first report of June 2003, the projected increases in profits for the PWC valuation were unrealistically high and were not supported by actual results or any trends.
8. Furthermore, the results for 2002 were achieved after the following was set in place:
1. “Ring fencing” for development expenses;
2. Decreasing the charges from the Aqua Group with the result that Interactive in effect stopped trading. (Bundle C Schedule N3.) It also materially contributed to Aqua (Int)’s huge loss for the 2001/2002 financial year. It must be taken into account that Interactive and Aqua (Int)’s combined losses amounted to R28,6 million for 2002 (R7 818 + R20 802 – Bundle AA to this report – Schedule no 10). The rates and/or charges of Aqua (Int) and Interactive against Netainment/Cytech were materially reduced or completely eliminated from October 2001, although the vendors maintained (in the financial statement of Aqua Online Holdings) that these charges were market-related. To get the above charges so drastically reduced was only possible because Aqua (Int), Interactive and Netainment were controlled by the same vendors.
3. The point is that abnormally large cost savings were achieved in the 2001/2002 financial year as a result of the “ring fencing” and “controlled” drop in charges from service providers (Aqua and Interactive). Despite this, the actual profits of Netainment dropped from $2,95 million ($4,5 million adjusted) in 2001 to $0,54 million ($2,19 million adjusted) in 2002. It is near impossible to justify why profits (as projected in PWC’s valuation) would double in the ensuing year (2003) based on the above facts and track record of Cytech / Netainment.
9. The profit forecasts increases of PWC for 2003 (105%) and 2004 (30%) on “adjusted-profits” simply were not realistic, nor achievable. It is doubtful if PWC were aware of all the circumstances and facts mentioned above. Whatever their knowledge, the value of R110 million recognised in Corpcapital’s 2002 financial statements, was materially overstated in our opinion.
10. The more important feature of PWC’s valuation is the range of possible values PWC came too. The values in their valuation scenarios varied between R39 million (2nd valuation) and R227 million (1st valuation). This is a very wide range of values which supports our view that the value of Corpcapital’s investment (47,5% share) could not be measured reliably.
11. WACC
1. The downward trends in profits and revenue, management’s inability to reverse the downward trends in revenue and profit, the unchallenged knowledge that IMS proved to be a failure and various other factors already mentioned in this and previous reports, would have added a further premium to the WACC (24%) plus any premium already outlined in this report for the previous September 2001 valuation.
2. Valuations based on an additional premium of 4% (2002) are set out in Bundle C Schedule L0.3 and L7.
41. Conclusion on Valuations (2000-2002)
1. Cytech/Netainment’s business was subject to high risk. According to PWC it is fraught with a tremendous amount of uncertainty. (Page 215 of File 1 – reference in our first report.) This risk is amplified by the incident reported in August 2000. A casino client of CFI and Aqua had been investigated for money laundering and certain funds of CFI had been frozen for a period. (Cytech Bundle 17, page 118 par 3 - 2nd sub-paragraph and page 112 par 2 – 3rd paragraph.)
2. Cytech/Netainment was closely linked to its associate companies like Aqua (Int), Interactive and CFI. Expenses, charges, finance, funds and/or income transactions moved between these entities and the extent thereof was controllable by the vendors (Sean, Tal, Corpcapital). Many transactions, on vendor’s own version, were not arm’s length. (See Schedules E1; E2; G2; J1.1; J2.1; J3.1; N2 and N3 in Bundle C.)
3. The accuracy and reliability of Netainment/Cytech’s accounting records are in serious doubt. (Also see Bundle C, Schedules E1; E2 and J4.1.)
4. Final, proper, signed and audited accounts were not provided. (Bundle B.)
5. The valuation methodology could easily lead to distorted values if the ensuing three year’s (following current year) profits were incorrectly forecasted. In our opinion, materially incorrect (too high) forecasts were made for the abovementioned three years. These incorrect forecasts distorted the terminal values and final investment-values.
6. If one assumes that all outcomes of the values as set out on Schedule L0.1 to L7, represent those valuation-values of bona fide and independent valuators, the variability in the range of reasonable fair values is so great and the probabilities of various outcomes so difficult to assess, that one cannot conclude that the investment was reliably measurable.
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