11 - Corporate Codes



Valuation of the "Netainment"-investment:

1. In considering the valuation of the Netainment investment it is important to take note of the following:

1. The investment represented an investment in a subsidiary (100%) or associate (47,5%). As such it should have been accounted for by consolidation or by the equity method in the consolidated financial statement (since 1999) and not at "fair value".

2. As a minority shareholding (47,5%) the valuation (if applicable at all) should have been based on the estimated maintainable dividend flow from the shareholding and not the estimated earnings or cash flow of the entire business or group.

3. The directors specifically stated in each consolidated F/S of the Group (2000, 2001, 2002) that: "… suitable accounting policies have been used, and reasonable and prudent estimates have been made where required".

4. Prudence is defined as follows in AC000: "Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses  are  not  understated…". Prudence is defined in AC101: "…that revenue and profits are not anticipated but are recognised by inclusion in the income statement only when realised in the form of cash or of other assets - the ultimate cash realisation of which can be assessed with reasonable certainty." The above AC101 has been superseded by a new statement in 1998 but the new AC101 still contains prudence in the standard.

5. It is generally accepted that in using the discounted cash flow method one should have a high degree of certainty regarding such future cash flow.

6. 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.

7. Being an investment bank, the level of reliance placed on investment values by shareholders and the public, would be relatively higher than that in other industries. This is so because an investment bank is considered to have special skills and experience in valuating investments.

8. One could ask the question if the Group would have advanced a high portion (say R150 million) of the value of an investment similar to Netainment/Cytech, utilising the investment (47,5% shares in Netainment/Cytech) as the sole security for the advance.

2. The "Netainment"-investment was apparently housed in an unlisted company (Mikado) registered in the British Virgin Isles. It did not produce audited financial statements that were approved and signed by the directors.

3. The "Netainment"-business apparently consists of an on-line gambling casino that started its operation at the end of 1998.

4. The valuation was done by Old Corpcap's management based on-:

1. Financial information supplied by management and directors of "Netainment", and

2. Discussion with management and directors of "Netainment" and Aqua Online UK Limited.

5. The information utilised in the valuation was not independently verified by Old Corpcap's management. Neither Old Corpcap nor its officers or employees accepted any responsibility or liability for the accuracy of the valuation.

6. The valuation documents were apparently (based on evidence available to us) not disclosed to or approved by the non-executive directors of the ultimate holding company (Corpgro) until 2002. Despite this, the directors approved and signed the F/S (2000/2001 & 2002) implying that they accept responsibility for the valuation, the quantum and manner in which the Netainment investment was reflected and/or disclosed in the F/S.

7. The valuation was basically derived from discounted cash flow and/or price/earning ratio models. The basis of the cash flow/earnings model was to discount the projected future cash flow/profits (as forecasted by the Group's management) of the total business (Netainment) in perpetuity. The value of the total business was then multiplied by Corp-Invest's portion (47,5%) to determine the value of the investment in Netainment. Besides the questionable assumptions on which the optimistic cash flow or earnings forecasts were based, the value model seems inappropriate for the specific investment (47,5%) in "Netainment".

8. The above model could only have been valid on the assumption that "Netainment" was going to sell its total business to a third party and that the total value of the sale (less cost of sale) would be distributed among the shareholders of "Netainment" or that the Group had total control over Netainment and its funds. The latter would of course raise the issue of accounting for a subsidiary and the former is contradicted by the PWC-report and Frangos-report which mentioned various reasons why this course of action was not likely to occur. There is further no evidence that "Netainment" or Cytech's management indicated that such a sale of the whole business was their main or exclusive objective.

9. The investment in "Netainment" is presented by the Group as a minority stake (47,5%) in an unlisted company. This is highly questionable for the following reasons:

1. "Netainment" was housed in a fully owned (100% share holding) subsidiary, namely Mikado.

2. All valuations were based on valuation models that assumes total control over Netainment and total control over access to funds & operations.

3. The following factors like:

i) the excessive bonuses paid to "Netainment's" management,

ii) the "Netainment's" directors' refusal to draft and sign financial statements,

however indicates that although Corp-Invest exercised some influence, the management of "Netainment" (other shareholders - 52,5%) was effectively in control of the company and its future management.

4. According to Frangos, the reasons for refusal to sign the F/S, as provided by Payne to himself, were the following:

i) Two directors of Netainment/Cytech were self-exiled South Africans.

ii) They refused to approve and sign the F/S (as audited by FHS) on the grounds that it could incriminate them.

10. Corp-Invest's investment in "Netainment" (as far as it was relevant and represented a minority interest of 47,5%) should have been valued as a minority shareholding with the focus on future maintainable dividends and the limitations on transferability and marketability. "Netainment's" management indicated (page 238 - File 1) that no money (dividends) will be returned to South Africa. The absence of any dividend policy, FHS findings on corporate governance and the apparent lack of control over Netainment's funds would have further diminished the investment value.

11. The "home" (Mikado/Blue Eagle) of "Netainment" was not listed, did not have a dividend policy, did not produce audited financial statements, and apparently had no shareholders agreement. The effect of this (and other factors already mentioned) should have had an enormous negative impact on the marketability of the shares (47,5%) and its fair value.

12. In such circumstances, the position of a potential buyer for only the 47,5% shares held in "Netainment's" house (with all its limitations) should have been considered in valuing the investment. In such circumstances a potential buyer would base his valuation on the expected future maintainable dividend yield. Any such potential buyer had to consider that he might be at the mercy of "Netainment's" - management (other shareholders - 52,5%) as far as dividends were concerned. It leaves little doubt that the value attached to the minority share in "Netainment" (if it really was a minority) was vastly lower than that reflected in the F/S of Corpgro, Old Corpcap and New Corpcap during the various financial years.

13. Even on the assumption that the investment should be valued as a controlling share or on the DFC-basis, the assumptions made by the valuators were, at best, highly optimistic and contrary to the principle of prudence, especially in periods after August 2000.

14. In determining any future trends in the growth of revenue and net profits, a valuator would give most consideration to the history of actual results of a business as set out in the past five audited F/S, as a starting point. Where no such information exist, a valuator should consider that assuming or forecasting any future trends are fraught with uncertainty and dangers. In such circumstances a prudent valuator and/or investor should not assume a future trend forecasting results, which is materially better than the current results. This prudent attitude should even be more prevalent in a situation where the business was started up only recently and had shown exponential growth from a very low revenue base. (See reference to Netainment in 2001 F/S - "early stage venture capital"). The reason behind this is simple. If a business has $1.00 revenue in month #one and $2.00 in month #two, $4.00 in month #3, and one assumes this exponential growth could continue for the relatively short period of say 36 months, such an investment could be valued at a ridiculous price (see Annexure H). It would also be over optimistic to assume that such a business would fulfil future industry predictions for growth set in a historically high bull market (1990-2000). It is highly likely that a young start-up business, though growing fast from a low base, will hit resistance to growth in the foreseeable future. Such business or management has not yet proven that they can sustain and match industry growth (least of all forecasted industry growth). It is unlikely that a prudent valuator or potential buyer would assume forecasts materially better than actual results in such circumstances. In addition, statistics suggest that there is a very high failure rate in young start-ups. Where a company is managed by a group with relatively little experience in the gaming industry, one would imagine that the risks of failure would even be higher.

15. Even where a valuator or potential buyer may be prepared to accept such forecast where actual results (even for a short period of time) reflect growth trends as forecasted, his opinion would undoubtedly change once there is any indication that actual results do not follow the forecasted trends.

16. Where a young business's initial growth turns negative after a relative short period it is inconceivable that a objective valuator and/or potential buyer would assume future forecasts that express continuing positive growth. Even the honest intentions of management of the business that such profit results can be improved by future restructuring is unlikely to convince an investor, for he values it at a specific date for acquisition and he is unlikely to pay for potential positive results flowing from actions and/or reconstruction that may occur after the acquiring date of the investment.

17. We analysed the forecasted revenues and profits at each valuation date of the "Netainment"-investment. The forecasted trends are graphically illustrated in comparison to actual results and trends. The data used in the graphs are the same as those used in each valuation by valuators. These graphs and the source of data therefor are set out in Annexures C to D, under a document titled "Netainment Forecast Analysis".

18. On Annexure C1 of the above mentioned documents titled "Netainment Forecast Analysis", all the revenue forecasts (for each date of valuation) are plotted against the actual revenue line (light blue line). The vertical dotted lines represent the date at which each valuation was done. In considering the revenue-forecasts, for each date or valuation one should take note that the only data available to the forecaster and/or valuator are those to the left of the dotted lines. The same principle or guidelines would be valid in interpreting other graphs.

19. Annexure C1 reflects the forecasted revenues at each valuation date (August 2000; February 2001; August 2001; February 2002; August 2002). All revenue forecasts should however be judge in conjunction with the profit forecasts, as profits forecasts directly influenced the valuation. Other factors which influenced the final value include the Rand/dollar exchange rate, cost of capital rate or discount rate, end value and terminal growth rates. However the three most important factors that influenced value and that will be analysed in this report are revenue - forecasts (starting point); profit forecasts (basis figures for value calculations) and foreign exchange variations (converting dollar values to rand).

20. The presentation and/or documents given to the Group's board for all valuations made it difficult to judge the merits of these various forecasts, assumptions and valuations. This is so because comparisons between actuals and forecasts were to some degree obscured by the format in which the data was presented. We plotted this comparison in graph-format to enable one to more easily judge the reasonability and prudence of the various forecasts.

21. The valuation for August 2000

1. In judging the forecasts relating to the above the date attention is once again drawn to comments made about young businesses which may grew from a low starting base.

2. The actual revenue growth (light blue line) from October 1999 to August 2000 (Annexure C1) shows a trend which supports the revenue forecasts (purple line) on face value. To assume that this growth rate could continue for the next 36 months, increasing the August 2000-monthly turnover by ±225% was not prudent and reasonable in the specific circumstances. The historical conditions in world market (1990 - 2000) especially on the NASDAQ, may have influenced the forecasts optimistically. One should bear in mind that the stock markets (NASDAQ) only peaked in October 2000.

3. The actual profits (light blue line) set out on Annexure C2 & C3 reflects a more volatile pattern, but does indicate a general upward trend, which on face value lend some support to the forecast (purple line). To assume that the monthly-profit of August 2000 ($400,000) would grow to above $1 million in 36 months was not prudent and reasonable in the specific circumstances. The volatility and short history of profits should have made a valuator and/or potential investor very weary about the future especially as "Netainment" has not produce any audited financial statements.

4. Although we reject the basis of evaluation (DCF or earnings model) one should probably give some credit and/or recognition to the forecast on revenue and profits, which is only one element of the total valuations. The reason being that, despite our reservations, the actual trends do lend some support to an upward forecast.

22. The valuation for February 2001

1. The actual revenue-line (light blue line) indicates that the historical growth rate may be flattening out (Annexure C1). Downward trends in world stock markets were also visible by the time of valuation. The forecasted revenues (yellow line) do not seem prudent and reasonable in the circumstances.

2. The actual profit-line (light blue line) indicates extreme volitality and a possible downward trend (Annexure C2 and C4). The forecasted profits do not seem prudent and reasonable in the circumstances.

3. Historical trends of actual revenue and/or profits do not sufficiently support the forecasts in order to accept that such forecasts still fall in the acceptable range of values to which an objective and prudent valuator could arrive.

23. The valuation for August 2001.

1. The actual revenue-line (light blue line) indicates a downward trend (Annexure C1). Downward trends in business and stock markets supported this actual revenue trend. The forecasted revenues (green line) again do not seem prudent and reasonable in the circumstances.

2. The actual profit-line (light blue line) indicates a strong downward trend with extreme volatility (Annexure C2 and C5). In addition, the lack of stability and audited figures should have made any valuator or potential buyer very weary.

3. What is especially noticeable is that although the forecasts on revenue are visibly much more moderate compared to previous forecasts, the profit-forecasts (green line), in value terms and as a percentage of forecasted revenue, is relatively more aggressive and over optimistic. The forecast is not prudent or reasonable in the circumstances.

4. The above forecasts (especially profit forecasts) could not, in our opinion, have fallen in the acceptable range of values to which an objective and prudent valuator could arrive. The valuation that was based on these forecasts must, in our opinion, be rejected as unacceptably high and/or misleading as to the true and fair value of the Netainment-business.

24. The valuation for February 2002.

1. The actual revenue line (light blue line) confirms a strong downward trend. The forecasted revenue (dark blue line) is in total contradiction of actual historical trends (Annexure C1).

2. The forecasted profit (Dark blue line) shows the same contradiction (Annexure C2 to C6) as the revenue forecast above.

3. The above forecasts can hardly be called anything else but "totally unreasonable". For the same reasons as set out above, the valuation should be rejected as unacceptably high and/or materially misleading as to the true and fair value of the Netainment business.

25. The valuation for August 2002

1. PWC was appointed to undertake an independent valuation on the Netainment/Cytech investment. The forecasts as set out in their reports are reflected in the graphs.

2. It should be noted that PWC based their final valuation on the "value in use" according to AC128 on a non-marketable basis (page 251 - File 1).

3. PWC concluded (Page 251 - File 1) that the "Value in use" to be as follows:

• Before taxation - R88 million to R120 million range

• After taxation- R60 million to R84 million range.

4. The value reflected in the 2002 F/S is R110 million. This implies that a valuation "before taxation" was accepted and approved by the directors for the 2002 F/S, or alternatively that the directors did not accept PWC's range of valuations.

5. According to AC128, the "Value in use" is defined as follows: "The present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life".

6. The "asset" of the Group to be valued was the 47,5% interest held in Cytech Ltd, and the "future cash flows" could only be the dividends expected to be paid by Cytech Ltd to the Group and/or Corp-Invest in the forthcoming financial periods.

7. It is important to understand what the asset (47,5% interest held in Cytech) and the estimated cash flow (dividends) from the asset represents. The facts as presented by Group, valuations and documents available to us are as follows:

• The assets represent a minority shareholding (47,5%) in Cytech Ltd. (Assumption only for the PWC-calculation).

• The Group and/or Corp-Invest has/have the ability to exercise significant influences but not control. (Assumption only for the PWC-calculation).

• The Group has a long-term interest in the asset.

• Cytech has no fixed dividend policy and its management advised that no money (dividends) will be remitted to South Africa (Pages 214 & 238 of File 1). However, an Exco-Report (Page 256, 274 and 275 of File 1) dated January 2002, states that Cytech could pay quarterly dividends to Corpcapital, up to a maximum of 50% of profits.

• There is no history of dividends.

• There is no shareholders agreement.

• There are no formal audited financial statements that were approved by the directors.

8. It does not appear from the above documents that PWC or Group's management used the estimated future dividend flow from the investment to do the "Value in use" valuation. (Detailed calculation not included in PWC documents). It seems that the valuation was simply based on the 47,5% of the profits or cash flow to by received by Cytech Ltd from the Netainment business as a whole. If that is so, the valuation is fundamentally flawed. The future cash flow to the Group and/or Corp-Invest could only come by way of dividends. These dividends were clearly not forthcoming. Only 50% of the estimated profits could, at best, be used in any determination of future cash flow.

9. The actual revenue line (light blue line) confirms the previous indication of a downward trend (Annexure C1). The revenue forecasts (Brown line) (page 237 of file 1) seems to accommodate this trend more than previous forecasts and only forecasted moderate growth in revenue. These revenue forecasts must however be judged in conjunction with the profit-forecasts.

10. The actual profit (light blue line) confirms a general downward trend with some stabilisation in the last 6 months (Annexure C2). The profit forecast (Brown line) contradicts the actual trends by a material margin (Annexure C2 & C7). The justification for this highly optimistic profit forecasts were apparently the following:

• Management believe that the Aqua admin fee will be renegotiated reducing fees from 7,5% to 3,8% of revenue (drops).

• Management indicated that re-negotiation will reduce royalties by $120,000 per annum.

• Management advised that CFI will reduce its fee from 5,5% to 4,5% of purchases resulting in a saving of $150,000 per annum.

• Marketing efficiency is forecasted to improve, resulting in a saving of $1,2 million.

• Management forecasted PAT margins to increase to 13% in 2002 and 30% in 2003 as a result as above cost savings.

11. Insofar as it could be relevant, the above intentions and/or views of management of Cytech (Netainment) should have been weighed against the various negative factors set out in PWC report (page 215 of File 1).

12. Previous valuations have also referred to future cost savings by management to increase profits, but actual profit history as set out on Annexures C2, C11, C12, C13, C14, C15(a) and C15(b) clearly indicates to the contrary.

13. AC128 states the following: "Future cash flows should be estimated for the asset in its current condition. Estimates of future cash flows should not include estimated cash inflows or outflows that are expected to arise from:

a) A future restructuring to which an enterprise is not yet committed, or

b) Future capital expenditure that will improve or enhance, the asset in excess of its originally assessed standard or performance".

14. Firstly, the asset represents a 47,5% share in a company over which business or enterprise the Group or Corp-Invest, by its own assertions, does not have control. In other words, the "enterprise" referred to above is not in control of the Group and the Group cannot commit to the restructuring. Secondly, how can one accept such future restructuring and forecasts on beliefs, advice and forecasts where actual history points to the contrary? Thirdly, all such restructuring would inevitably have had a negative effect on other interests of the Group like CFI and Aqua if the above beliefs or advice materialised. Did the Group provide for such negative influence on its other interests? As Aqua was listed at the time (de-listed since), the market would probably not have been aware of these future negative reductions on its income. The listed price at year-end would therefor not reflect these factors. Did the Group provide for this or did they continue to use the market price at end of financial year?

15. Despite the obvious weakening of markets, increasing competition that would put pressure on profit margins (profit/sales) and the actual profit margins achieved over three previous financial years (2000-2002) which varied from 8% to 13%, the PWC-valuation seemingly accepted that profit margins of 29% to 34% forecasted for 2003 and 2005 [see Annexure C14(e)] were prudent and reasonable. It is difficult to see how an independent minded valuator could consider such profit forecasts as prudent and reasonable.

16. We are therefore not convinced that the beliefs or indications and/or forecasts of Cytech's management justified valid expectations that all the cost-savings would be realised.

17. The profit forecasts, in our opinion, were not prudent and reasonable in the circumstances. The valuation based on these forecasts must therefore be rejected as unacceptably high and/or misleading as to the true and fair value or "value in use" of the 47,5% share investment in Cytech Ltd.

26. Annexures C18(c) and C18(d) reflect the general trends of valuations made by management versus actual revenues/profits throughout the period. It is evident that the valuators neglected to give sufficient weight to actual results and trends in arriving at their valuations.

27. Influence of movements in foreign exhange rates.

1. The influence of the weakening rand had a major impact on the valuation of the "Netainment"-investment [See Annexure C18(a) and C18(b)]. As illustrated on Annexure C18(b) the Rand/Dollar exchange rate increased by the following percentage margins:

|Period |% Margins |

|August 1999/August 2000 |13,6% |

|August 2000/February 2001 |11,6% |

|August 2000/August 2001 |20,0% |

|August 2001/February 2002 |40,5% |

|August 2001/August 2002 |23,5% |

|Overall from August 1999 to August 2002 |68,3% |

2. As the above movements impacted materially on both the asset-value and investment income/impairment write-off, the effect of these movement on value and profits should have been disclosed separately in the F/S and interim results.

3. During the periods that the exchange rate improvements had a positive effect on revaluations, no disclosure of its effect on profits or valuations were made in the F/S or interim results (2000, 2001 and 2002). However, when the Rand strengthened and it impacted negatively on the profits and value, such negative influence was highlighted in interim results on 28 February 2003.

4. In terms of AC103, par .15, (Annexure E2) the influence of exchange rates on profits for the 2000 and 2001 financial years should have been disclosed separately.

5. Section 299(2) and paragraph 66(2) of the Fourth Schedule of the Companies Act also require that the above influences of exchange movements should have been dealt with in the Directors' Report.

6. This selective disclosure or non-disclosure of items with a material influence on profits or the Group's financial position has the implication that the information disclosed in the Group's F/S (especially 2000 and 2001) was neither reliable nor neutral (see par .31 and par .36 of AC000, Annexure E1).

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