SMC (6273): Accounts Beg Questions; SMC Keeps Plug on Answers.

Transcription

1 Well Investments Research Director of Research: Yuki Arai December 15, 2016 SMC (6273): Accounts Beg Questions; SMC Keeps Plug on Answers. SMC responses, dated December 13, 2016 and December 14, 2016, to our original report SMC (6273): Puncturing the Myth barely address the key issues we have raised. The company claims there is "no problem" with their accounts and offers no evidence to support its position. The company s comment on Seiyo is simply that they "have been with the auditor since 1987." We didn t expect anything else. We and the investment community have yet to hear any empirical response on the important issues. 1. Pledged shares by TON Finance BV. The pledge could be oddly similar to the Satyam fraud case in India where the Chairman pledged shares to use cash to inject into the company. a) Why are these shares pledged and where has the cash gone? b) Why are the Dutch and Japanese regulatory disclosures different in terms of how many shares were pledged and when? c) Which disclosure is correct? d) Kazumasa Yajima is listed as the Resona representive for TON finance in the 2009 Edinet filings. What role does he play? 1

2 2. Cash. We believe that interest income ex. Japan and China being negative is a smoking gun. SMC conveniently claim that the missing cash sits in USA, Hong Kong, Taiwan and Brazil. As we demonstrated in the report, however, it is unlikely that those entities hold any significant cash. a) This should not be difficult to verify. SMC, when can we expect to see notarized copies of cash balances for the remaining subsidiaries? b) Why should investors rely on the audit of SMC s manufacturing subsidiary in Singapore, which holds JPY49 billion in cash(jpy41 billion in 2014), when its audit takes less than 14 days to complete and the company secretary is married to a recently retired partner of the audit firm overseeing the account? c) A significant portion of SMC s purported cash, JPY24 billion in SMC (Beijing) Mfg. Co. Ltd. (in 2014), sits in its manufacturing subsidiary in Beijing China. Considering that a large portion of sales from this subsidiary are to Japan, why does SMC want to park cash in China from where it is difficult to extract cash? 3. Relationship with Seiyo Audit. The company justifies using Seiyo by claiming that "we have been with them since 1987". It sounds like a touching sense of loyalty. However, with a business as large, complicated, and diverse as SMC s this is not an appropriate business justification. Tokyo Electron, which is similar in size to SMC, used O.Yu/Seiyo until 2004 and has since changed to KPMG. SMC shareholders deserve to know the honest state of the company s accounts. We call for a robust audit firm to be appointed by SMC, one that has the scale and scope to do a complete global audit. At the very least, given the grave nature of evidence unearthed by our research, we call on SMC to appoint a large auditor to do a one-time global audit. Our questions remain: a) How can Seiyo properly audit and oversee SMC s consolidated financials? b) Six of Seiyo s seven public clients all have financial years ending in March. As Seiyo only had 16 accountants until July 2016, we want to know: How many were overseeing SMC? c) Why are some consolidated subsidiaries unaudited, particularly in Japan and including the Toyo Warehouse, which is located in the same office building as Seiyo? 4. Auditor churn. SMC fails to provide a trustworthy audit for its international operations as well as for the Japan business. a) Why does SMC use disparate small local auditing firms overseas and why are they replaced on a haphazard basis? b) The company claims that the local subsidiaries choose their own auditors. Then why does it look like there was a coordinated effort to change the overseas auditors en-masse between ? c) Why did the UK subsidiary rehire an auditor that had hitherto made material errors in the accounts? 2

3 d) Why has the British subsidiary failed to file details on its auditor resignation? When can we expect this to be remedied? We believe this is a violation of the UK Companies Act. 5. Inventory. We demonstrated that a number of subsidiaries have written down far more of their own stock in percentage terms than the consolidated entity yet SMC provided this negligible response on the issue: On inventory valuation, SMC uses relevant accounting standards and carries out appropriate inventory devaluation. Contrary to the claims made by the report, it is not the case that SMC carried useless inventory. a) What are those accounting standards? Who applies them? b) Why are UK accounting rules on inventory NOT applied to the rest of the Group? c) Indeed, and this is the key issue with SMC, why is there no UNIVERSAL application of accounting standards? 6. Consolidation. In their response SMC claims the following [T]he report alleges that SMC frequently changes the scope of consolidation. This is not true. It should be noted that with numerous non-consolidated subsidiaries and related party entities SMC can effectively fabricate revenue all day long and to its heart s content. a) We challenge SMC to publish a current and historical list of its consolidated and unconsolidated subsidiaries. b) We call on SMC to provide a detailed breakdown of the entire group and all related party transactions. 7. Operating margin. Analysts following SMC have glossed over the operating margin issue. As can be seen in the table below, operating profit at the parent level, which includes intersegment sales, is almost identical to that on the consolidated level for third-party sales originating in Japan. With the Parent and Consolidated OP in Japan almost matching it implies that intersegment sales are made at cost and that the margins in Japan s third-party sales have increased dramatically. 3

4 SMC Japan OP Analysis FY08 FY16 JPYBn Japan Parent Sales (Third party and Intersegment) Operating profit (Third party and Intersegment) OPM 23% 28% Japan Consolidated Consolidated Japan Revenue by Origin (Third party only) Operating profit (Third party only) OPM 37% 58% Japan Parent OP as a % of Consolidated Japan OPM 93% 95% 8. Resona Kessai. SMC claims in its response that to streamline the costs associated with issuing and managing promissory notes, SMC changed over to factoring." a) It is unlikely that the supplier is bearing the cost of the factoring. So, is SMC paying a fee to Resona Kessai to manage its payables? If so, how much are you paying to Resona Kessai and what is the size of the savings SMC has made by introducing this scheme? b) If there is a substantial saving, why does no other competitor use this scheme? c) Why is SMC unable to process its own bills (even though SMC is cash rich )? d) Why issue promissory notes instead of paying in cash (which incurs no commission)? 9. Benelux entities related party transactions? We demonstrated that there are SMC entities not owned by SMC but by the Nauta Group. These share office space with Ton Finance and a deconsolidated SMC subsidiary called Shoketsu Finance. a) What is SMC s relationship with the Nauta Group and the other Beneluxbased related parties? b) How is inventory accounted for in the European Central Warehouse? Is this off- or on-balance sheet? c) Why does SMC co-own the European Central Warehouse with the Nauta Group? d) Why has SMC not disclosed the Benelux-based businesses as related parties? e) How does SMC account for the sales between the SMC s group companies and unrelated companies under Nauta Group? 4

5 NEW ISSUES In addition to the above, there are other significant issues and discrepancies which we do not believe the investment community is aware of, including: 10. Chairman Takada and management have been selling down shares for years. If you follow the number of shares held by Chairman Takada in his name in the Yuho financial disclosures, his directly owned shares have decreased steadily from 176,900 at the end of March 2011 to only 10,000 shares at the end of March In addition, in years past, several board members including corporate auditors have held (and in many cases have sold) significant shares in SMC despite the company NOT having a management incentive program or stock options program. In some cases, the number of shares represented millions of dollars. 11. Related Party Sales. Our report shows that the company uses intragroup sales to manage inventory writedowns. Related party sales at SMC Pneumatics Singapore have been running at around 16% of sales for the past two years. a) Why are these related party sales NOT disclosed in the consolidated accounts? b) Who are these related party sales to? Are they to nonconsolidated subsidiaries? If so, how are they accounted for in the consolidated accounts? 12. Unreasonably fast audits. Manufacturing Singapore is not the only subsidiary with a suspiciously fast audit, the others include: a. SMC Industrial Czech: 9 days (FY 3/15) b. SMC Germany: 10 days (FY 3/13) c. SMC Shoketsu Philippines: 15 days (FY 3/15) d. SMC Pneumatics Philippines: 11 days (FY 3/12) e. Malaysia Shoketsu Engineering: 16 days (FY 3/15) f. SMC Pneumatics Malaysia: 16 days (FY 3/15) 13. Who audits the US? Interviews with former employees claim the auditors are from Japan. We know it is not Seiyo, so who is auditing SMC USA? 14. Cash. If Japan is so profitable, why is the majority of cash purportedly overseas? Investors should demand that SMC appoint an independent, impartial third-party committee to investigate its accounting of all consolidated, non-consolidated group entities and related parties. Furthermore, SMC should disclose the names of all consolidated and non-consolidated subsidiaries, as well as clarify its numerous related party transactions. We strongly encourage investors to look further into SMC accounts. Anyone can verify our claims by accessing all of the publicly-available filings which we listed in Appendix 5

6 D of the original report dated December 13, We continue our research into SMC. The more we dig, the more problematic SMC s affairs look. We plan on having another update for subscribers soon. 6