ROYAL AHOLD The European ENRON

Corporate Financial Reporting Analysis

Alvaro ARGELLES Ian MCKERROW Juan SIERRA Abhishek AGRAWAL

Agenda
What is Ahold today? Royal Ahold s strategy 1997-2003 Differences between Dutch GAAP and US GAAP Accounting irregularities the European Enron

Corporate Governance issues

What is Ahold today?

Ahold is international group of quality supermarkets and foodservice operators based in the United States and Europe. It is committed to offering its customers the best value, the highest quality and healthy choices, while building value for Ahold s shareholders. Ahold s main financial figures are as follows:

Royal Ahold s strategy 1997-2003

Family owned company until 1989 when professional management hired Ahold s strategy in the late 1990s was basically based on: Aggressive international expansion plan To challenge Wal-Mart & Carrefour as top international retailer 15% annual growth target in EPS: 10% internal, 5% external growth (earnings pre goodwill effect!) Expansion to be financed largely through debt and outside equity Improve investor relations Emphasis on growth, rather than shareholder value Pressure on management to achieve earnings not internal cash generation

Royal Ahold s strategy 1997-2003

Focus on fragmented, US retail grocery market
Their major acquisitions up to the late 1990s were in the North-East of the US: Tops Markets (NY/Buffalo), Mayfair (New Jersey), Stop & Shop (New England) and Giant Food (Maryland). By 1996, Ahold was close to being the largest supermarket chain on US East coast. The success of their strategy up to this point is from making pragmatic acquisitions and from taking advantage of low competition from local retailers.

From late 1990s, strategy loses direction

From 1998, Ahold suffered a number of setbacks. In 1999, the FTC blocked the acquisition of Pathmark due to market concentration concerns. The profitability of their US operations suffered and they started to acquire companies in the South.

Reckless expansion
From 1996-2000, Ahold tried to expand into Asia and Latin America with no coherent strategy. Their desire for short-term growth was not conducive to success and their expansion into these regions was a failure. In March 2000, Ahold entered the large US food service industry with purchase of US food service. Given their lack of experience in the food service industry this was an unexpected change of direction.It is evident that by 2000, Ahold was a company struggling to hit the 15% growth targets it had set itself and its growth by acquisition strategy had run its course.

Differences between Dutch GAAP and US GAAP

Since Ahold is cross-listed on the NYSE and the Dutch Stock Exchange since 1993, Ahold has to reconcile its financial statement under Dutch GAAP to US GAAP [20-F] It was not until 2001 that the investor community recognized Ahold s aggressive home country accounting and questioned the quality of reported earnings under Dutch GAAP A striking fact is the late discovery of the large differences between Dutch and U.S. GAAP numbers per the 20-F reconciliation. AHOLD s major differences between Dutch GAAP and US GAAP were the followings for the period 19972003:

Differences between Dutch GAAP and US GAAP (contd)

GOODWILL FROM ACQUISITIONS Under Dutch GAAP (in the 90s) goodwill from acquisitions was immediately charged against stockholders equity, thus not affecting the income statement However, U.S. GAAP (until 2001) required goodwill to be capitalized and amortized over 40 years, thus affecting the income statement. From 2001, the goodwill generate from acquisitions is not amortized but is annually subjected to an impairment test, with impairments charged to the income statement. Ahold relied on acquisitions to achieve the objective of 15% growth in earnings excluding extraordinary items, currency conversions and amortization of goodwill The requirement that Ahold reconcile its Dutch accounting numbers to US GAAP forced the firm to amortize goodwill in its income statement reported in the 20-F filing with the SEC. As the number and size of acquisitions increased, and as Ahold paid more and more for its acquisitions relative to the book value of the companies, the gap between Dutch GAAP earnings and US GAAP earnings at Ahold widened.
Impairment testing Impairment is the inability of a company to realize fully the expected benefits of owning an asset To test goodwill for impairment, companies must first assign the recorded goodwill to reporting units. Then, SFAS No. 142 prescribes a two-step process to determine whether goodwill is impaired Step 1: Compare fair value of reporting unit to its carrying amount, incl. related goodwill. When fair value is less than book value, goodwill shall be impaired, and the company goes to Step 2. Step 2: Compare implied fair value of reporting unit s goodwill to its carrying amount. When fair value is less than book value, the company must record an impairment write-off equal to the difference.

Differences between Dutch GAAP and US GAAP (contd)

Major changes that took place in US GAAP goodwill treatment, caused following adjusments: - 2001 - 2002 impairment of 728m (lower valuation of Disco JV in Argentina) impariment of 1.85Bn (lower valuation of US Food Service)

It seems that Ahold overpaid in order to achieve its growth in earnings

Number of acquisitions vs Adjustment to Earning under US GAAP

20 18 16 14 12 10 8 6 4 2 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1500 1000 500 0 3500 3000

# acquisitions

2000

Acquisitions

Divestments

Adjustment to Earnings

Millions

2500

Differences between Dutch GAAP and US GAAP (contd)

JOINT VENTURES Up to 2000, under Dutch GAAP impairment losses did not have to be recognized and all goodwill relating to joint ventures was charged directly to shareholders equity upon acquisition. After 2000, goodwill must be amortized over its useful life with a maximum of 20 years. FINANCING Sale and lease back operations Ahold entered into sale and leaseback arrangements with various financial institutions, whereby the Company sells various retail properties and simultaneously leases them back from the purchaser. Dutch GAAP if a sale and leaseback transaction transfers substantially all risks and rewards of ownership to the buyer and the transaction is established at fair value, the gain or loss on the sale is recognized immediately in the consolidated statements of operations. US GAAP gains are recognized based on the degree to which the seller retains the right to use the real estate through the leaseback. Where the seller retains substantially all of the use of the property, the gain on the sale transaction is required to be deferred and amortized over the lease term. Where the seller retains only a minor use of the property, any profit or loss generally is recognized at the date of sale. Losses are recognized immediately upon consummation of the sale. As a result of the aforementioned difference between US GAAP and Dutch GAAP, certain gains that were recognized at the date of sale and leaseback transactions under Dutch GAAP were deferred under US GAAP.

Differences between Dutch GAAP and US GAAP (contd)

FINANCING (cont d) Derivative instruments Under Dutch GAAP, gains and losses from derivative financial instruments that are designated and qualify as hedges are deferred and recognized in the consolidated statement of operations in the same period in which the underlying hedge exposure affects earnings. US GAAP (adopted by Ahold as of January 1, 2001) requires that all derivatives be recognized as either assets or liabilities in the consolidated balance sheet and measured at fair value. Depending on the documented designation of a derivative instrument, any change in fair value is recognized either in income or shareholders equity (as a component of accumulated other comprehensive income).

RESTRUCTURING PROVISIONS Under Dutch GAAP, Ahold recorded provisions when it entered into plans for store and distribution center closures or sales. Effective January 1, 2001, restructuring provisions are recorded for expected costs of planned reorganizations only if certain specified criteria are met. Under US GAAP (through December 31, 2002) the criteria that had to be met in order to record a restructuring provision, including a requirement to communicate terms of a restructuring plan to employees prior to recognition of the related provision.

Accounting irregularities

JV consolidation

What Ahold did: In order to fully consolidate revenues and earnings from subsidiaries, Ahold claimed effective control over 5 South American JVs where it owned only 50% of the shares by providing control letters signed by top executives of these JVs Ahold hid from its auditors secret comfort letters destined to the other shareholders of these JVs, where it denied that it held effective control of the company Result: Ahold overstated net sales by approximately EUR 4.8 billion ($5.1 billion) for fiscal year 1999, EUR 10.6 billion ($9.8 billion) for fiscal year 2000, and EUR 12.2 billion ($10.9 billion) for fiscal year 2001 Ahold overstated operating income by approximately EUR 222 million ($236 million) for fiscal year 1999, EUR 448 million ($413 million) for fiscal year 2000, and EUR 485 million ($434) for fiscal year 2001 What Ahold should have done: According to Dutch and US GAAP, revenues and earnings should have been consolidated following the Equity Method, that is, in proportion to the stake owned (50%), and not fully consolidated

Accounting irregularities

Contingent liabilities

What Ahold did: Ahold did not disclose a contingent liability derived from the obligation of buying out its partners in the Argentinean Joint Venture Disco, in case this subsidiary were to default on the payment of its debt In 2001 Ahold estimated that the probability of this event triggering the liability was remote , even though Argentina was already heading towards a major financial collapse, and thus did not disclose the liability neither on its Balance Sheet nor in the Footnotes Only in 2002 did Ahold s management judge the likelihood of a default as reasonably possible, but not probable Result: As a result of Disco defaulting on one of its payments, the partners exercised their put option, and the transaction resulted in an overall loss to Ahold of 372 million in 2002 What Ahold should have done: Contingent liabilities are conditional on a certain event taking place in order to materialize According to US GAAP, contingent liabilities should be disclosed: On the Balance Sheet: if the management estimates as probable the likelihood of the event on which the liability is contingent In the Footnotes: if the event is judged to be possible but not probable No need to disclose: if the likelihood of the event occurring is considered remote

Accounting irregularities

Vendor rebates

What Ahold did: Ahold s subsidiary US Foodservices (USF), as most food retailers, received a large number of vendor rebates (promotional allowances) if USF purchased certain merchandise volumes. These rebates accounted for the majority of US Foodservices income during 2001 and 2002 These rebate contracts generally included prepayments for multi-year contracts, which were recorded as current period earnings USF managers systematically booked rebates to compensate for any shortfall in projected earnings, therefore meeting their target earnings (and thus receiving their generous bonuses) To do so, they induced vendors to confirm false promotional allowance income, manipulated accounting entries, forged cash receipts, and made false and misleading statements to the company s auditors Result: The USF rebate fraud resulted in Ahold overstating its earnings from 2000 to 2003 by more than $800 million What Ahold should have done: The matching principle establishes that revenue should be recognized when two basic criteria are met: Earned: the company has substantially performed the service or delivered the good Realizable: payment collection is reasonably assured In this case, the rebates were prepaid, but were only earned when Ahold actually bought the merchandise from its vendors at the end of the specified period Ahold should not have recognized revenues until the period for which the rebates were given expired and the purchase volumes required were met

Accounting irregularities
FTC Blocks Pathmark acquisition

stock price performance

Ahold acquires US FOOD SERVICE

Ahold stock performance

1400%

1200%

1000%

Earnings restatement announcement causes 60% drop in share price

Perform ance

800%

600%

400%

200%

0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

Acquisition of local retail grocery chains

Earnings discrepancias
Ahold relied on acquisitions to achieve the objective of 15% growth in earnings. However as the base increased, Ahold needed larger and larger deals to hit this target. Under Dutch GAAP goodwill purchased was immediately charged against the stockholder s equity. Hence acquisitions did not impact the earnings. However under US GAAP goodwill was capitalized and amortized over a period impacting the earnings. As Ahold paid more relative to the book value of the companies, the gap between Dutch GAAP and US GAAP increased significantly. In early 2002 Ahold reported a 16% EPS growth in Dutch GAAP but a 17% EPS decline in the US GAAP (the numbers were restated later). While there were a lot of unexplained gaps between the US and Dutch GAAP, investors didn t bother to investigate these because majority of Ahold s shareholders were Dutch. After the accounting fraud came to light, Ahold had to restate the financials for the years 2000 and 2001. Earnings in 2000 went down to 442 million euro from 1.115 billion euro. Similarly in 2001, earnings dropped from 1.113 billion profit to 254 million loss. Ahold s auditors suspended 2002 year audit pending the completion of investigations. As a result of these announcements Ahold s stock price fell 59% in a single day. S&P too downgraded Ahold s credit rating from BBB to junk.

Corporate Governance Failure

OWNERSHIP AND CONTROL STRUCTURE
Ahold s founder family owned founder/priority shares with options to dilute 100%. The CEO, Van der Hoeven, eliminated the family oversight by convincing the family to sell its holds to institutional investors. Van der Hoeven then avoided blockholder monitoring by putting the voting controls of the institutional investors in a foundation, which was strongly influenced by Ahold s management. This situation is best reflected in 1997 shareholder meeting where a single foundation, with 19% preferred shares, controlled more than 63% of the voting rights. Quite understandably the chairman of the foundation decided to vote in favor of all the management proposals. The institutional investors agreed to this arraignment in return for preferred dividends which secured early returns for them. These measures decreased the shareholder s ability to control and discipline management and the management acted without any oversight.

MANAGEMENT BOARD
The management board was dominated by the CEO. He appointed loyal managers without consulting the board. A lot of managers were former from recently acquired companies and they continued to manage the subsidiaries they previously managed. Ahold s management also successfully circumvented the role of dividends as a disciplining device. It initiated choice dividends which allowed shareholders to choose between stocks or cash dividend. The ratio of shares to cash was always set such that shareholders chose the stock dividend. This allowed the management to influence the cash outflow without any dividend reduction. The short sightedness of the management was further encouraged because of the incentive structure at Ahold. Managers exercised their stock options immediately and carried very few stocks of the company. During late 90 s management s options payouts were often 600% more than of their cash compensation. All of these led to poor internal control and didn t align management s interests with long term growth of the company.

Corporate Governance Failure

SUPERVISORY BOARD Ahold s supervisory board was not independent due to the presence of former managers and supervisors with conflicting interests with the shareholders. For example, Nelissen, a board member, was the CEO of Amro, one of Ahold s main banks. Nelissen was also on the board of Ahold s auditor, Deloitte. Although unproven, it is widely believed that Nelissen was the main reason why ABN-Amro s analysts continued to give a strong buy rating to Ahold even when their numbers looked questionable. In return, Ahold rewarded the bank by giving 16 equity and debt underwriting projects. Conflict of the interests was not the only problem; a lot of board member were either overcommitted or didn t understand the business. When asked about the misuse of accounting differences between US and Dutch GAAP, Schneider, an art professor and a supervisory board member mentioned that she didn t understand the issue. She said, I don t feel responsible, I am not a business person .

Conclusion
Ahold initially was successful in growing through acquiring retail stores in USA because of the synergies and the economies of scale. However after the anti-trust ruling against it, Ahold couldn t come up with a coherent strategy to drive future growth. The high equity price put pressure on the management to continue delivering high growth numbers. Hence they went for mergers and acquisitions in unrelated areas leading to greater integration problems which reduced the earnings growth. This ultimately forced managers to show growth by cooking the books. While there were both internal and external monitoring structures, these were systematically undermined because of a dominant management. Moreover, since management held very little of the company s stock and since the incentive compensation was based on earnings growth, governance shortcomings were amplified and also provided a direct motivation for the management fraud. Ahold shows that the absence of a family or major blockholder monitoring in combination with an unconstrained management can be devastating for the continuity of the firm and its performance.