Europe's Year of Nasty Surprises
In a global downturn, Royal Ahold (AHO ) should have been the ultimate defensive play. The 116-year-old Dutch company is the world's third-largest food retailer, with supermarket chains including Albert Heijn in Europe and Giant and Stop & Shop in the U.S. But on Feb. 24, Ahold sent European markets tumbling when it admitted overstating earnings at subsidiaries in the U.S. and Argentina by at least $500 million in 2001 and 2002. Chief Executive Officer Cees van der Hoeven resigned along with his chief financial officer, and bond-rating agencies downgraded Ahold to junk status. "We're furious. We never expected anything like this: [We] trusted their long-term strategy," fumes a top executive at a major European financial group that is a big Ahold investor. His shares lost 60% of their value the day of the Ahold disclosures.
Ahold shareholders aren't the only ones waking up to a miserable accounting headache. Not long ago, investors were celebrating the rapid growth of once-stodgy European companies as they snapped up foreign acquisitions and introduced U.S.-style management and stock options. Ahold was a prime example. More and more of these highfliers are being dragged back to earth by the nasty surprises buried in their ledgers. So far, Europe hasn't produced a bombshell to rival Enron Corp. or WorldCom Inc. But companies such as Ahold are exposing wide cracks in Europe's financial regulatory systems. Says Alasdair Murray, an expert on corporate governance at London's Center for European Reform: "It's probably more by luck than by design that we haven't had anything on the scale of Enron."
Corporate Europe's cross-border shopping spree has made it particularly vulnerable to accounting problems. Over the past decade, Old World companies have shelled out hundreds of billions of dollars on foreign acquisitions, from Daimler's purchase of Chrysler (DCX ) to the buyout of Universal Studios by France's Vivendi (V ). These huge deals challenge the number-crunching skills of even the best CFOs and auditors and put the European companies under enormous pressure to prove they made the right move. "Acquisitions are complicated, and your accounting needs to be conservative. But there's a temptation to be aggressive, to move the stock [price] up quickly," says Bernard Liautaud, CEO of Business Objects, a French software company with extensive U.S. operations.
For investors, untangling a company's finances becomes a lot harder once it hits the acquisition trail. Peter Reilly, a London-based Deutsche Bank analyst who has closely tracked such companies, says accounting rules on acquisitions often make it easy for companies to show big savings and profits while glossing over more worrisome figures. For instance, under U.S. generally accepted accounting principles (GAAP), it is almost impossible to determine the methods used to calculate the fair value of purchased assets. "It can make reported profitability more or less meaningless," Reilly says. Conversely, when foreign companies switch to GAAP, amortization rules can hammer earnings.
Stock options give managers an extra incentive to report dazzling results. While options are still rare in Europe, they're on the rise, especially at acquisition-hungry companies. Ahold CEO van der Hoeven cashed in $3.3 million in options during 2000 and 2001, while the company's CFO, Michiel Meurs, took home $1.2 million.
In Ahold's case, such high compensation almost seemed justified. Ahold regularly posted 15% annual earnings growth after embarking on a $19 billion shopping spree in the 1990s. It became the most popular stock among Dutch retail investors, who could buy shares with coupons and points earned by shopping in Ahold stores. But investors got a shock early last year, when Ahold switched to U.S. GAAP accounting and 90% of its $1.2 billion reported 2001 earnings disappeared. The reason: U.S. rules require immediate amortization of the goodwill premium paid on acquisitions, whereas Dutch rules stretch out the amortization over 20 years.
At the core of Ahold's Feb. 24 earnings bombshell was the operation of its wholesale food distribution company, U.S. Foodservice, acquired by Ahold in 2000. Ahold's auditors, Deloitte & Touche, discovered that the company had overstated revenues from discounts that suppliers provided Ahold for promoting their products in 2001 and 2002. No one is alleging yet that there was fraud, but the U.S. Securities & Exchange Commission, Dutch prosecutors, and Amsterdam stock-market regulators are investigating.
Clearly, however, conservative accounting is often an early casualty when a company sets its sights on rapid growth. Consider the case of Altran Technologies, a Paris information-technology consulting group. Its accounting has been breathtakingly complex, since aggressive acquisitions mean the group has to report results from more than 180 operating companies. Still, as recently as last year, Altran seemed unstoppable, with sales projected to grow 16%, to $1.45 billion, after its April acquisition of the non-U.S. businesses and worldwide brand name of consulting giant Arthur D. Little. Then, disaster: In October an internal review led management to restate first-half earnings down by $23 million. On Feb. 21, French prosecutors announced they were investigating the company for "presentation of false information," just as new CFO Eric Albrand announced that 2002 results would be "far below" market expectations. Albrand, while admitting that the company has had problems with loose controls, says he has not been officially informed of the investigation. Panicked investors have since sent shares tumbling 40%.
Why don't auditors detect such problems earlier? Sometimes they do, as in the case of Ahold. In other cases, auditors may be part of the problem. Last year, Irish drugmaker Elan Corp.'s (ELN ) shares collapsed after journalists discovered large research & development expenses were concealed in off-balance-sheet entities set up by former top managers -- who had also once worked at KPMG, Elan's auditors. Elan and KPMG deny any impropriety. An SEC investigation is under way.
Pressure is building for tougher regulation. By 2005, the European Union will require all companies listed on European exchanges to adopt international accounting standards (IAS), which are considered stronger than the rules current in most European countries. EU Internal Market Commissioner Frits Bolkestein said on Feb. 24 that his office will soon issue new guidelines for corporate governance.
However, even the most carefully crafted rules won't stop companies from publishing misleading numbers. And shareholder-rights groups are disappointed that the guidelines planned by Bolkestein will be voluntary. European regulators generally have far less enforcement power and fewer resources than their U.S. counterparts. "We need active supervision as well as rules," says Paul F. de Vries, vice-president of Euroshareholders, a Brussels lobbying group, who says he wouldn't be surprised to discover more bombshells lurking in corporate books. If he's right, Europe's dealmaking binge could turn into one heck of a hangover.
By Carol Matlack in Paris, with John Rossant, and David Fairlamb in Frankfurt and Kerry Capell in London