Jefferies recently initiated coverage on Amira Nature Foods (NYSE:ANFI) with a Buy rating and a $13 price target, sending shares up more than 11% to $7.80. The analyst believed that accusations about accounting fraud that have weighed on the stock's valuation for some time now are unmerited, and that the company has a strong long-term outlook thanks to rising middle classes in emerging economies which should support a steady shift to premium rice. If the accusations do indeed turn out to be false, then ANFI could be an interesting long-term investment, especially at the current valuation. However, while lawsuits based on allegations of misleading financial information have so far been dismissed, there are too many red flags, and we think investors should avoid ANFI stock.
Last year, ANFI switched to a new auditor, and earlier this year, the company delayed the release of its annual financial report until July. This is enough to suggest that there might be something going on with the financials, and that it is worth taking a closer look. A few things stand out. ANFI is very aggressive in the way it recognizes revenues. The company includes income from dividends and interest on the top line. This overstates the revenues it is able to generate from its core business. ANFI is not a bank, and it should be reporting this income below operating profit as part of "other income" on the IS.
Figure 1: Summary of Significant Accounting Policies: Revenue
Figure 2: Income Statement
In addition, we suspect ANFI might be recognizing revenues from rice contract sales too early. The company's plummeting receivables turnover supports this claim. A/R currently accounts for 38% of the balance sheet, compared to 26% in 2015 and 19% in 2014. Receivables are growing at a much faster pace than revenues, which means ANFI's reported sales are not translating into cash flow. A/R is a form of accrual-based accounting that requires estimates and judgment from management, and is therefore subject to manipulation. Because accruals (as opposed to cash) account for a significant portion of earnings, it increases the likelihood of earnings manipulation.
The decision to capitalize $14.8 million of interest on expenditures for rice inventories is another concern. Firms are only allowed to capitalize interest costs for the purchases of assets that take a substantial amount of time to prepare for use or sale. International and domestic accounting rules are slightly different, but in general, interest shouldn't be capitalized for inventories that are routinely manufactured on a repetitive basis or in large quantities. ANFI notes that it stores rice for a period of "up to twelve months", but this is not long enough to qualify the rice inventories as a long-term asset. The company's inventory churn isn't a multi-year cycle, and expensing the interest costs in the current period would be more consistent with the matching principal, which is what accrual accounting is based on. By capitalizing inventories, ANFI is pushing expenses back into future periods and overstating profitability. Rather than recognize the costs on the income statement in the current period, the $14.8 million gets added to the value of inventories. In addition to overstating profitability ratios, this also boosts liquidity and leverage ratios by inflating the balance sheet value of inventories.
But the warning signs with ANFI extend beyond the financial statements, and we think there are substantial corporate governance issues that investors should be aware of. The board lacks independence: it consists of the CEO (who is also the chairman), the CFO, and three independent members. While it is common for a CEO to also be board chairman, it becomes more of a concern with smaller boards, and we worry that the "independent" directors are more responsive to management's wishes than ensuring that managers are doing what's best for shareholders. Executives receive lucrative cash bonuses that don't seem warranted based on recent performance, and a disproportionate amount of pay is tied to stock options. Stock-based compensation can be helpful if it encourages managers to take actions that maximize shareholder value, but too much stock-based compensation creates an asymmetric risk/reward profile that encourages managers to take on risky projects that often destroy value for shareholders. The three independent directors are all in charge of the audit committee, compensation committee, and the nominations committee. Ideally, these should be headed by different directors, and it's especially a problem given the lack of board independence (and influence over directors that the CEO has as chairman). We believe the questionable financial reporting practices are a direct result of weak corporate governance and a lack of independence.
Amira Nature Foods hasn't been found guilty of anything yet, but we would stay away from the company. At the heart of the problem is weak corporate governance, and this is an issue that won't dissipate even if it turns out Amira's financials are legitimate. We don't think management has shareholders' best interests in mind, and investors are taking a massive risk with this company, even though its long-term economic outlook is attractive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.