Brian Gaynor: Start-up forecasts usually miles out

New Zealand's listed companies are absolutely hopeless at financial forecasting.

This conclusion is based on an analysis that shows only four of the 24 new listings in 2000 and 2001 achieved their profit predictions.

The survey does not cover companies, including Compass Communications, eVentures, Fisher & Paykel Healthcare, Kirkcaldie & Stains and Rubicon, that have not completed their key transaction as a New Capital Market (NCM) company or did not make pre-listing predictions.

It also excludes several others, including Air New Zealand, Certified Organics, Natural Gas and Tourism Holdings, that had major acquisitions and/or capital raisings since the end of 1999 and also failed to achieve their profit forecasts.

These unrealistic blue-sky forecasts have serious implications for the sharemarket because more than half the 24 companies are now trading below their issue price.

Entrepreneurs are optimistic individuals who have a natural tendency to inflate forecasts. They establish businesses or make acquisitions because they anticipate a positive outcome.

This is where experienced independent directors enter the picture; they should temper the natural enthusiasm of entrepreneurs and put a stamp of reality on profit forecasts.

One of the most important aspects of the NCM was that experienced directors would be appointed to these start-ups, yet all but one of them have failed to achieve their profit forecasts.

The inability of so many companies to meet their predictions indicates that independent directors have become subservient to management and they are not carefully scrutinising forecasts.

Investment bankers should also check profit predictions but they have a conflict of interest because it is easier to sell a new issue when forecasts are bullish.

Investors may also expect auditors to check the forecasts but this is not the case. According to the first schedule of the Securities Regulations 1983 the auditors report must contain the following statement: "In our opinion, the prospective financial information, so far as the accounting policies and calculations are concerned, has been properly compiled on the footing of the assumptions made."

In other words auditors must ensure only that companies comply with accounting standards and the calculations are correct. They have no statutory obligation to question the assumptions on which the forecasts are based.

As far as NCM companies are concerned, the independent appraisal report was supposed to play an important role in assessing the value of the key transaction or first acquisition.

But shareholders have also been badly let down by this process and Finzsoft Solutions is the only NCM company to achieve its forecasts. This is mainly because the company took a more cautious approach to its international expansion after the September 11 terrorist attacks.

Selector Group, the second NCM company to list, bought a human resources software developer for $15.7 million through the issue of 28.6 million new shares at 55c each. The newly acquired company had achieved total sales of only $100,000 at the time of the acquisition and the purchase price included $14.3 million of goodwill.

The directors claimed that they undertook a comprehensive due diligence of the new acquisition and PricewaterhouseCoopers concluded that the software developer was worth between $13.3 and $18.1 million.

Selector has been a disaster. It reported sales of only $342,000 for the year to March and a net loss of $11.6 million, including a goodwill writedown of $9.2 million. The acquisition has left a sour taste with investors, particularly as two of the three Selector directors were also shareholders of the software developer.

Mowbray Collectables was the only profitable NCM company in the latest financial period. But the Wellington-based company failed to achieve its target, as it reported a net profit of $37,000, compared with a forecast of $136,000 for the year to March.

Powerco, the New Plymouth-based electricity and gas distribution company that services Taranaki, Wanganui, Manawatu, Wairarapa, the Hutt Valley and Porirua, has produced the best result relative to forecast.

The company predicted net earnings of $28.1 million, earnings per share of 10.1c and a 12.6c dividend for the year to March. The actual outcome was a net profit of $33 million, earnings per share of 14.8c and 13.1c fully imputed dividend.

The result was boosted by the acquisition of the Hutt Valley/Porirua Basin gas network assets for $120.7 million last July.

Why didn't any of the other new listings boost their earnings by making a value-enhancing acquisition?

Powerco has already established an excellent reputation for shareholder communications.

The company's annual result was announced to the stock exchange on April 11, just 11 days after balance date, and it has just released a very informative annual report. Powerco also has one of the better investor-orientated websites.

Briscoe and Vending Technologies are the only other non-NCM companies to achieve their profit forecasts and their share price performance has benefited as a result.

One of the more frustrating aspects of profit forecasts is the unwillingness of directors to update their projections or even acknowledge that they have been published.

Software of Excellence was listed in December 2000 after issuing 5 million new shares to the public at $1 each. The company reported a loss of $697,000 for the March 2001 year, slightly better than the forecast loss of $846,000.

On December 17 last year the company issued an extremely bullish newsletter. The letter painted an optimistic picture of progress in Britain but made no mention of the net profit forecast of $2.4 million for the year to March.

The market response was immediate, with the share price leaping from $2.45 to $3.60 in the eight trading days after the release of the newsletter.

On December 28 one director sold 10,000 shares at $3.40 and on January 8 another sold 30,000 at $3.35.

On January 31 Software of Excellence issued a profit warning. Chief executive Paul Weatherly said the result for the year to March would be influenced by the timing of several large contracts and "results could easily be plus or minus more than $1 million".

The company finally reported a net loss of $191,000 for the year to March, compared with the net profit forecast of $2.4 million. The result included a change in depreciation policy that boosted the bottom line by $108,000.

Several questions need to be asked about Software of Excellence's profit forecasts:

* Why did the company issue a bullish newsletter in December but make no attempt to relate this to its published profit forecasts?

* Was it purely coincidental that two directors sold shares after the optimistic newsletter but before the profit warning?

* Why hasn't the board kept shareholders updated on the $4.6 million profit forecast for the year to next March?

* If the failure to achieve its 2002 profit forecasts was mainly due to the timing of major contracts, is it logical to assume that the company will report net earnings in excess of $4.6 million for the March 2003 year?

As pointed out in a previous column, most of the money raised through new issues in this country goes to the vendors of existing shares rather than the company. As a consequence it is extremely important that these forecasts are not inflated to enable the sellers to get out at a high price.

It is also important these forecasts are constantly updated so the market is kept informed and insiders do not have the chance to take advantage of uninformed investors.

Unfortunately, independent directors are not scrutinising forecasts carefully enough and companies are not keeping the market fully informed of likely changes to their profit predictions.

* bgaynor@xtra.co.nz