Serba Dinamik: Red Flag Analysis (5279.KL)
Just a cursory one, not a forensic deep-dive
Serba Dinamik recently found itself in hot water amidst a tussle with its auditor KPMG over certain financial inconsistencies
While far from confirmed, my own cursory research aligns with KPMG’s allegations that financial shenanigans potentially exist in their books
If true, both shareholders and bondholders of Serba Dinamik might be in for a rude awakening
So if you’re a Malaysian, you’ll know that two things have captured news headlines over the weekend. One, the government reinstated a full-blown lockdown after our new daily COVID cases per million people exceeded even India’s. Second, a mid-cap O&G services company called Serba Dinamik (‘Serba’) got called out by its auditor KPMG for inconsistencies in its financial statements. You can follow through the link for all the gory details.
In essence, the aforementioned inconsistencies are mostly qualitative in nature (e.g. the wrong address being supplied to the auditor, and questionable related party transactions) rather than straight-up financial shenanigans. So it didn’t really pique my interest to do a deep dive when the news first came out. However with the deluge of related newsflow overwhelming my senses, curiosity got the better of me and I eventually gave their financial statements a quick look-see to see if I could turn over any rocks of my own.
Bear in mind that this was just a cursory exercise of pouring over their financial statements of the past few years, and in total I spent maybe slightly over an hour on it. So… do your own research, and don’t rely on me for anything. That’s my disclaimer.
Anyway, here goes:
So right off the bat, we have some things that immediately catch the eye. Firstly, Gross Profit Margin (GPM) and Net Profit Margin (NPM) are suspiciously consistent over time. For GPM, that’s not really an issue as they use the percentage of completion method to account for revenues (being a contract-based business) - which basically means that they estimate revenue based on Cost of Sales. As such, the GPM should be steady over time.
However, the consistent NPM over time does raise some questions, as their capital structure has changed quite significantly in 2019 when they raised a large amount of debt. Moreover, OPEX doesn’t tend to be fixed in nature, which raises even more questions regarding its rock-solid consistency. One could give them the benefit of doubt that since their business is capital-intensive, most of their OPEX is in the form of depreciation and finance costs (which are relatively fixed). But without doing a deep dive, it’s difficult to arrive at any definite conclusions just based on this.
Secondly, their asset base is huge… and growing rapidly. Just look at the numbers for Receivables, Inventory, and PPE. They are mindboggling for a company with a roughly RM 5 billion market cap. You can feel the growth rates just by looking at the absolute numbers.
Thirdly, we can see that Working Capital (WC) makes up a huge portion of Operating Cash Flows (OCF). Again, the amount is staggering and can be felt just by looking at it. CAPEX growth is also visibly outsized, while FCF is constantly at a borderline breakeven level.
So, right away I can tell that this isn’t a company I want to spend anymore time digging into deeper as an investment idea. There is such a plethora of decent companies in the cornucopia of stocks out there that I’m willing to give this a pass. But since the whole point of this exercise was to try and find out if any red flags exist, let’s go slightly deeper.
So this is where those red flags start waving in front of you like the beginning of a communist revolution.
Firstly, since revenue is accounted for through the percentage of completion method, I wanted to see how it translated into cold, hard cash - especially since FCF was consistently hovering around zero. One of the first things you learn in the school of accounting shenanigans is how to create fictitious Revenue through inflating Receivables. The idea is that since revenue is just an accounting figure, you can Dr Receivables // Cr Revenue into perpetuity by inflating Receivables like a hot-air balloon - without ever translating that revenue into cash (i.e. Dr Cash // Cr Receivables). Of course, this leads to an ever-ballooning Receivables amount on your balance sheet, which starts drawing the attention of investors who’ve been bitten once before.
In Serba Dinamik’s case (as shown in their financial statements above), they are growing both Revenues and Receivables incredibly rapidly - well within the double-digit range. That aligns with investor’s expectations, as a growing business is expected to have escalating receivables as well.
However, notice that OCF isn’t following the trend of Net Profit. Over the long-term, OCF and FCF are supposed to converge with Net Profit; hence OCF growth should follow the trend of Net Profit growth over the long-run (and in Serba’s case Revenue growth as well, since NPM is steady). But that’s not the case here.
It gets worse when you put the figures side by side (above table). One of the easiest red flags to look out for is OCF diverging wildly from NP over time, which is exactly what’s happening here - OCF growth is ricocheting all over the place while NP growth is stable. Now, OCF before WC growth is actually behaving in line with NP growth, so that’s supposed to be normal right?
Unfortunately, the question it subsequently raises is even more distressing. If we look at the ratios, WC as a % of (OCF before WC) is astonishingly high - consistently in the 80% range. That means that most of Serba Dinamik’s Operating Cash Flows (OCF) are a function of its Working Capital (WC) management - rather than organic business inflows. Think of stretching supplier payments out, shifting inventory around during quarterly reporting periods, etc. However, plausible deniability still exists.
Nevertheless, this is made worse by the fact that the company has consistently non-existent FCF. If a business delivers consistently breakeven FCF over a sufficiently long 5-year period, only an irresponsible investor wouldn’t start asking questions. Remember that FCF and NP are supposed to converge over time - the gaps between them should only represent timing differences.
Which circles back to the earlier point about creating fictitious Revenues through inflating Receivables. If a company’s FCF is consistently hovering around zero over time, wouldn’t that lend credence to the theory that the company is potentially playing fast and loose with revenue recognition? After all, those Receivables being recognised through Revenues aren’t being translated into cold, hard cash.
Subsequently, it stands to reason that Serba Dinamik could be hiding inflating Receivables through the illusion of Growth (a la a modified version of Tyco). By consistently growing Revenues, they are able to justify the soaring Receivables. If they can keep kicking the can down the road with fictitiously growing Revenues, they can keep hiding the ever-ballooning Receivables under the rug, right?
Which kinda ties in with the accusations being thrown at the company by their auditor KPMG. Among the key inconsistencies highlighted by KPMG were the existence of supposedly fictitious customers and suppliers, the latter of which appears to be controlled by Serba’s shareholders themselves. If you can control costs and receivables, you could in theory pull off the above shenanigans, no?
Think about what such a plan might entail. Recall that Serba’s revenues are estimated based on the percentage of completion method, which is calculated based on Cost of Sales (COS). Hence by controlling suppliers, they can control their COS - which should allow them to control Revenues. Those fictitious Revenues can be perpetually hidden under an ever-growing balloon of Receivables, which can in turn be hidden by showing ever-increasing Growth - which can be cultivated by increasing COS. Which means that the lynchpin of the entire operation relies on just one component - COS.
So if we wanted to test whether this theory had even a smidgen of attachment to reality, what signs would we look for? Well, what do you need to increase Cost of Sales? Obviously you’d need cash - and we mean the cold, hard variety this time, not the fictitious type. You’d use that cash to buy raw materials or inputs from suppliers, which given the ever-expanding Revenues you’re trying to fertilize would inevitably involve rising Inventories.
Which… you know, just happens to be growing like a weed. And is also one of the subjects of the KPMG dispute (i.e. large material-on-site balances located in foreign countries). Also, why is Payables as a % of Receivables so low? Also, why is Payables as a % of Inventory so low? Aren’t they supposed to be taking those raw inputs from suppliers and turning them into work-in-progress (WIP) Inventories? Where’s the money for those swelling inventories coming from, if not from extended credit terms from suppliers?
… … …
This is getting awkward.
Just to spell it out for those of you who weren’t born with a calculator in your hand, it’s plausible that Serba has been massively borrowing to fund its non-stop expansion of Inventory. Any normal person would expect that those debt proceeds would go towards funding CAPEX - especially considering how Serba’s business is capital-intensive in nature. However, as we can clearly see above, Inventory CF as a % of Borrowings is half of CAPEX as a % of Borrowings! What on earth kind of inventory are they stocking up on to the tune of 50% of CAPEX?
This is like the financial version of the kid who keeps going “and then? and then? and then?” non-stop. I haven’t even begun doing a deep-dive yet, and I’m already ready to short it (unfortunately, you can’t effectively short stocks in Malaysia).
What started as just sticking my head into a rabbit hole turned into falling into Narnia - and coming face-to-face with Aslan. I’m going to qualify by saying that this is far from a complete analysis. There is a 90% chance that I’m simply missing something crucial which completely debunks the thesis described above. But I’d love to be proven wrong, because this is too wacky to be true. Hopefully one of you beautiful geniuses out there can add some more flavor to this financial spaghetti.
A few other things which caught my attention:
No aging analysis of receivables in the latest financial statements - even though KPMG highlighted it as a key audit matter.
The huge PPE carrying amount is mostly composed of ‘Plant & Machinery’ and ‘Tools & Equipment’. I honestly don’t know enough about this business to comment.
Public shareholder float appears to be only around 30%. The top two shareholders (who are also on the board) hold about 30% of outstanding shares; one of them appears to have trimmed his position from 19% as of FY19 to a hair above 7% today. The top two domestic pension funds hold about 15% of outstanding shares. I would roughly estimate the free float to be less than 50%.
Disclosure: I am neither long nor short Serba Dinamik in any capacity.
Edit (27/6/21): A kind reader pointed out a formulaic error in my previous FCF calculation, which showed that the company had consistently negative FCF over time. I have since corrected the error, showing that the company had consistently breakeven FCF instead - which fortunately doesn’t change the overarching narrative. Apologies for any potential confusion.
Serba Dinamik’s financial information: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=5279
Serba Dinamik’s Investor Relations website: https://serbadinamik.listedcompany.com/
Recent news article about KPMG vs Serba Dinamik: https://www.theedgemarkets.com/article/kpmg-raised-audit-issues-transactions-involving-over-rm3-billion-says-serba-dinamik