Royal Ahold's Royal Hold UpPublished: February 09, 2003 in Knowledge@Wharton
Europe, it would seem, is not immune to large-scale accounting scandals that, until recently, have been a symbol of U.S. corporate greed. A case of Enron-style financial accounting fraud recently rocked Royal Ahold, the Dutch food retailer and distributor that had grown to become the world’s third-largest grocer through an aggressive, and apparently ill-fated, acquisition strategy.
Ahold surprised investors when it announced February 24, 2003, that it had overstated earnings by at least $500 million in 2001 and 2002, prompting a 60% plunge in its share price and the resignations of its chief executive and chief financial officer.
The 115-year-old Dutch company has 9,000 stores in 27 countries that serve 40,000 customers a week. Last year it had $60.9 billion in revenues, 59% from the United States where it owns the Giant and Stop & Shop chains.
In a pattern all-too familiar to U.S. investors, Ahold’s disclosures come following promises of 15% growth, a goal that ultimately became unreachable. “These sorts of pressures, which we associate with the U.S. investment industry, are worldwide now,” says Peter Cappelli, professor of management at Wharton and director of the school’s Center for Human Resources.
The problems at Ahold could also have a marked effect on the budding shareholder movement in Europe, Cappelli notes, adding that “When people are just getting into the investment business the concern is whether the process is rigged [so that] the little guy can’t win.” The situation at Royal Ahold lends support to that perception “because it appears the insiders knew what was going on.”
William S. Cody, managing director of the Jay H. Baker retailing initiative at Wharton, believes Ahold’s growth was fed by a buying binge. “In the past 10 years the company went on a big acquisition spree in Europe and the United States. Its main strategy was to let the local operations run themselves and use acquisitions as the engine of growth. Then Ahold looked to diversify out of groceries into the food service business, and that’s where the company ran afoul.”
The roots of Ahold’s current problems lie in the United States at its U.S. Foodservice division, the nation’s second largest wholesale supplier to restaurants and institutional dining systems. It was there that company officials disclosed accounting irregularities involving payments – known as promotional allowances – made to the division by food manufacturers. These payments were allegedly booked too high and were, in some cases, booked without the manufacturers’ permission.
But questions have also been raised about Ahold’s business practices in Argentina, Uruguay and Sweden, and the company is being investigated by the U.S. Justice Department, the Securities and Exchange Commission and regulators in The Netherlands. “This is pretty big,” says Oscar Poos, an analyst with Bank Oyens & van Eeghen in Amsterdam. “So many things have happened in the United States, but this is the first really large-scale fraud case we’ve seen on this side of the ocean.”
Even if the roots of the problem are in the United States, they extend directly to Amsterdam, Poos adds. “At the headquarters in Holland they should have been aware of it, and the fact that the CFO and CEO stepped down means that perhaps the checks and controls were not as good as they should have been.”
Poos predicts that the damage could easily rise above $500 million, partly because the allowance programs in question typically can add 5% to 10% to sales. U.S. Foodservice had sales of $18 billion last year, indicating the restatement could rise well above $1 billion.
As stated above, the accounting problems at Ahold relate to the way the company booked promotional advances from its manufacturers. Cody points out that food manufacturers have long offered retailers payments for prime shelf space or spots in their advertising circulars. In theory, it is a legitimate business practice that helps manufacturers lend support to a product they think will do well. “It’s part of the game. It’s almost a pay-for-play mentality. It’s something that’s been within the industry for many years.”
But lately, retailers have become overly dependent on promotional programs. “It’s now come to a point where buyers in grocery and mass merchandise chains have targets of how much they need to collect from their vendors,” says Cody. “A lot of retailers look at it as a way to supplement the bottom line.” Because grocery retail margins are so low – usually 2% to 4% – promotional revenues can have a significant impact, he adds.
Ahold is not the only grocery company facing scrutiny over the way it accounts for promotional allowances from suppliers. In November, Fleming Cos., the nation’s largest food wholesaler, reported that the SEC had launched an informal inquiry into its trade practices with vendors. Minneapolis wholesaler Nash Finch Co. postponed its third-quarter earnings report and said the SEC was conducting a formal investigation into the way it handled promotional allowances.
The Emerging Issues Task Force of the Financial Accounting Standards Board has been discussing how to account for promotional advances for more than a year. The task force reached a consensus in January that “cash consideration received by a customer from a vendor is presumed to be a reduction of the prices of the vendor’s products or services and should, therefore, be characterized as a reduction of cost of sales.”
Some retailers had tried to book the payments as revenue that flowed directly to the bottom line, according to Cody. At Ahold, the situation seems to be a more clear-cut violation of accounting rules that supercede the finer points of accounting for promotional spending. “The way they booked it they actually didn’t have the money. They based it on what their sales were projected to be … When those sales didn’t come they were in trouble.”
Marketing professor Stephen J. Hoch explains that booking promotional allowances early is the flip-side of a tactic used by manufacturers known as channel-stuffing. In order to meet sales goals, manufacturers ship excess product to retailers knowing it will sit in inventory for some time, cannibalizing future sales. “This is the retail side of what’s been occurring on the manufacturing side in the last several years,” he said, citing problems at Gillette, Campbell Soup and Bristol-Myers.
According to Hoch, every industry performs some quarterly juggling to make financial targets. “It’s a common practice, but it’s not a sustainable practice because eventually it’s going to catch up with you. Maybe they were thinking that everybody does it so there’s nothing wrong. They’re going to find out they were wrong.”
The pressure to resort to accounting tricks, he adds, stems from flaws in Ahold’s broader strategy, which was to buy regional supermarket retailers and gain economies of scale and savings through consolidation of back-office and buying operations. Other chains sought to do the same thing, modeling themselves on the successful expansion of chain drugstores. However, Hoch notes, grocery stores are more complicated than drugstores and depend to a greater extent on regional suppliers and marketing.
Ahold began its buying spree in 1976 when it acquired a Spanish supermarket and the Bi-Lo chain in the American South. In 1996 it bought Stop & Shop for $2.9 billion and added dozens of chains in Latin America, Europe and Asia. It tried to buy Pathmark Stores in 1999, but that deal was blocked by the U.S. Federal Trade Commission. Ahold subsequently turned to food service for growth, acquiring U.S. Foodservice for $3.6 billion in 2000.
“There was lots of potential,” explains Hoch. “It looked like Ahold was one of the larger retailers in the world, and the promise was the company could come over and kick some butt. Instead it basically milked whatever existing market share it had.”
With the exception of its 1998 acquisition of Giant in the Washington, D.C. area, Ahold erred in buying second-tier retailers in slow-growth markets, particularly in the Northeast, Hoch adds. Then, to make up for its operational problems, Ahold – like other retailers – turned its attention to promotional allowances as a potential profit-center. “That only takes your eyes off the ball. If you continue trying to make money selling display space, you’re going to compromise the kind of decisions you make.”
Ironically, he says, much of the acquisition strategy at Ahold, and other retailers, was driven out of fear of competition from Wal-Mart Stores, which has become the world’s largest food retailer through a program of internal growth – not acquisition.
A Pandora’s Box of Scandals
While there have been several smaller accounting scandals in Europe, the troubles at Ahold come as regulators are working with their U.S. counterparts to harmonize accounting practices by 2005, Cody points out. “I think there is opportunity for more European scandals. The more you dig the more you will find. When Europe switches to international accounting standards in 2005 that will probably open up a few more Pandora’s boxes.”
Cody says the accounting issues cannot be attributed to confusion over different accounting practices in the United States and Europe. “Most of the suppliers are global. If Procter & Gamble is a supplier you’re going to be dealing with them all over the world.”
According to Enitan Adebonojo, an analyst with the Center for Financial Research and Analysis in Rockville, Md., it is not clear whether new U.S. laws requiring auditors to certify their work led to Ahold’s disclosures. She says they may have come to light more as a result of the FASB task force.
The problems at Ahold, she suggests, will stir more aggressive European auditing. “Up until this time these types of issues were seen as a U.S. problem.” Now that it’s clearly not only an issue in the U.S., “I think auditors will probably wake up and pay closer attention to their audits.”
The pressure to provide earnings growth of 15% a year occurs on both sides of the Atlantic, she added. “Whenever a company claims it is going to earn 15% a year you have to take a second look at how they’re meeting those targets. If the market is not going their way people bow down to the pressure and begin to make up numbers … It usually starts small – here and there – and then it just snowballs out of control.”
For now, Ahold remains afloat with a $3.35 billion line of credit that quieted early speculation that the company might face liquidation. “The likely way this will play out is for Ahold to sell off bits of the company,” says Cody, adding that the largest U.S. supermarket retailers, Albertsons and Safeway, may be interested in Ahold’s Northeastern stores.
“Ahold could still survive in a smaller way, particularly in Europe,” he suggests. “But the company would look to sell operations in the United States because it needs the cash.” Carrefour of France, the world’s second largest retailer, has indicated an interest in pieces of Ahold, but not the entire chain.
For now, Ahold is dependent on the mercy of a syndicate of banks, including ABN AMRO, Goldman Sachs, ING and JP Morgan. “Most of Ahold’s [better] performing retail operations in the United States and Holland – the crown jewels – are in the hands of the banks,” says Poos. “It is still a profitable company. It would not be such a good move by the banks to just liquidate the whole thing.” But you never know, he adds. These days, “most banks have problems themselves.”