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Report on aspects of the initial public offering of Vertex Group Holdings Limited in 2002

PROSPECTIVE FINANCIAL INFORMATION

Legal Requirements

Under the Securities Act 1978 and the Securities Regulations 1983 a registered prospectus for an offer of shares to the public must contain certain financial information. The registered prospectus for a company making its first offer of shares to the public must also contain certain prospective financial information.

Prospective financial information presented in a registered prospectus falls within the meaning of "general purpose prospective financial information" contained in Financial Reporting Standard 29 Prospective Financial Information (FRS-29), issued by ICANZ. Financial reporting standards are the primary indicators of generally accepted accounting practice (GAAP) in New Zealand.

The Securities Regulations 1983 do not expressly require that prospective financial information in a registered prospectus be prepared in accordance with GAAP. However, the professional standards of ICANZ require accountants and auditors to ensure that general purpose prospective financial information is prepared in accordance with GAAP (i.e. FRS-29). The Commission is of the opinion that information prepared other than in accordance with FRS-29 is likely to be misleading. As with other information in a registered prospectus or investment statement, prospective financial information must not be false or misleading. Prospective financial information will not be false or misleading simply because the results projected or forecast do not eventuate. It may be false or misleading if it is based on demonstrably incorrect, unreasonable, or incompletely stated assumptions.

The Securities Regulations 1983 require that where an issuer includes prospective financial information in a registered prospectus then the prospectus must also disclose the principal assumptions on which the prospective financial information is based. FRS-29 sets out the requirements for assumptions underlying prospective financial information.

Forecasts and projections

Prospective financial information can be presented in the form of a forecast or a projection. FRS-29 defines the two terms in the following way:

"'A forecast' means prospective financial information prepared on the basis of assumptions as to future events that the governing body reasonably expects to occur associated with the actions the governing body reasonably expects to take as at the date that the information is prepared (best-estimate assumptions).
'A projection' means prospective financial information prepared on the basis of one of more hypothetical but realistic assumptions, (or 'what-if' scenarios), that reflect possible courses of action for the reporting periods concerned as at the date that the information is prepared."

FRS-29 states that "forecasts" mean prospective financial information that is prepared "on the basis of assumptions as to future events that the governing body reasonably expects to occur as at the date the information is prepared". Investors are thus more likely, and should be able, to derive more confidence from the presentation of forecasts, rather than projections, in an offer document. For this reason FRS-29 requires that all disclosed prospective financial information shall be labelled clearly as either a forecast or a projection and "the distinction between a forecast and a projection...shall be made clear in any prospective financial information being presented".

FRS-29 also requires that assumptions used in preparing forecasts "shall be reasonable, supportable, consistent among themselves and with the strategic plans of the entity, and be applied consistently". To be supportable, best-estimate assumptions for a forecast need to be based on certain underlying fundamental indicators, namely:
- the past performance of the entity, or that of a similar entity;
- feasibility or other studies that provide objective corroboration; and
- the prevailing economic environment.
FRS-29 states further that "the extent of detailed information supporting the assumptions, and an assessment of the reasonableness of each assumption will vary according to circumstances" and "be influenced by factors such as the significance of the assumption and the availability and quality of the supporting information".

Issuers should be aware that the preparation of prospective financial information includes a decision to present that information as projections or forecasts. Accordingly, the decision to present prospective financial information as a forecast carries a responsibility for the board to check, on an ongoing basis, that the assumptions underlying the forecasts are reasonable and supportable, and based on information reflecting future events that the board reasonably expects to occur, and associated with actions the board reasonably expects to take.

This test should be contrasted with the lower standard required in respect of projections, for which the underlying assumptions are required to be reasonable, but not necessarily supportable. Assumptions for projections may be hypothetical, reflecting possible courses of action as at the date the prospective information is prepared. However, the assumptions must be realistic.

Vertex's Prospective Financial Information

The share offer made in June 2002 was Vertex's first public offer of shares. The registered prospectus for the offer was required by law to contain a prospective statement of cash flows of Vertex and any subsidiaries which the directors expected to occur in the year commencing on the date the prospectus was delivered for registration (i.e., a prospective statement of cash flows for the year ending 7 June 2003).

Vertex's financial year runs from 1 April to 31 March. Vertex sought from the Commission, and was granted, an exemption to align the prospective financial information in the prospectus with Vertex's financial year, to aid comparison between that information and Vertex's historical financial information. As a result, the offer document contained a prospective statement of cash flows for the six months ended 30 September 2002, for the year ended 31 March 2003, and for the 6 months ended 30 September 2003. In addition, Vertex included prospective statements of financial performance and financial position for the six months ended 30 September 2002, for the year ended 31 March 2003, and for the 6 months ended 30 September 2003.

The Vertex offer document stated that the prospective financial information it contained for the period to 31 March 2003 was forecast financial information, while the prospective financial information it contained for the period to 30 September 2003 was a projection.

Vertex's forecast statement of financial performance in the offer document predicted a net surplus of $5,814,000 for the year ended 31 March 2003, from revenues of $90,680,000. This represented an overall increase of 2% in total revenues and a 52.5% increase in net surplus compared with the reported financial results for the year ended 31 March 2002.

Assumptions

The prospective financial statements were presented along with the directors' general assumptions and trading assumptions for Vertex, which appear on pages 60 to 62 of the offer document under the heading "Prospective Financial Information Assumptions".

The revenue assumptions underlying the prospective statement of financial performance were that the core businesses would reflect a small decline over the previously reported revenues, but that the Technical Injection and Securefresh units would, on a combined basis, achieve revenue growth of 88% for the first six month period to 30 September 2002, 55% for the second six month period to 31 March 2003, and 77% for the further six month period ending 30 September 2003.

The prospective combined revenues for the core business activities for the year ended 31 March 2003 were disclosed as $74,520,000, while the prospective combined revenues for Technical Injection and Securefresh for the same period were disclosed as $16,160,000.

Technical Injection and Securefresh

The prospective financial information in the offer document separated out the revenues anticipated from the combined core businesses on the one hand, and the two growth businesses, Technical Injection and Securefresh, on the other. Those figures indicated that the revenues for the core businesses were expected to decline slightly, but that significant growth was anticipated in the Technical Injection and Securefresh revenues. The offer document recorded that:

"[Technical Injection] is the fastest growing Vertex Group business (revenues having doubled from FY01 to FY02 and being forecast to increase by over 65% from FY02 to FY03)"

and, in relation to Securefresh:

"Sales are forecast to double from FY02 to FY03".

As mentioned above, the prospective financial information for the period to 31 March 2003 was presented in Vertex's offer document as a forecast, while the information for the period to 30 September 2003 was presented as a projection. FRS-29 requires that the assumptions used as the basis for forecasts be both reasonable and supportable. FRS-29 also notes that projections might be used by an entity in its start-up phase, when certain key assumptions cannot be supported.

Stage of development of growth businesses

The Technical Injection business unit, in particular, was a relatively new component of the overall Vertex business. Mr Starnes characterised Technical Injection as being of a start-up nature:
"Our business in particular, given our start-up stage, is about 40% of our business products that are less than a year old."

Mr Hartley expressed the view that Technical Injection was not a greenfields start-up business. He stated that Technical Injection was not new in the sense that it had been supplying Vertex customers for three years, and that "it was more a case of bringing it together as a business unit for the first time, but the actual underpinning business I was informed had been there for three years".

Technical Injection was established as a separate business unit with effect from 1 April 2002. This meant that the period leading up to the IPO was the first time that actual data on the costs associated with Technical Injection's operations was available. Prior to that, standard costs were assumed for the business unit. Mr Clark's evidence showed that the separation had revealed higher than anticipated costs. These manifested themselves as significant negative variances in Technical Injection's actual operating results against plan in April and May 2002:

Q:  Was the recent trading history of Technical Injection a cause of concern to you at all?

A:  Yes. In the first two months we had suffered, obviously from a sales perspective, and we had suffered from a production variance point of view. Our labour costs were much higher than we had anticipated, and what was happening was, because it was the first -April was the first month we had split Technical Injection out on its own from what was...the injection department within the Hamilton facility, the labour costs that were coming through were higher than we had expected.

...Prior to that we had been putting into our Board pack an assumed result for Technical Injection, but it was based on the standard cost of sales...we could not calculate the actual because it [Technical Injection] wasn't split separately.

...we had obviously made assumptions based on the standards we had and allocations of some of the other costs that you had to get you down to actual gross margin between the non-Technical Injection and the true Technical Injection.

Q:  ...the actual cost of sales...were mingled in with the other businesses--?

A:  They were mingled in...We had to make assumptions on what the profitability was, on what the extra costs were beyond the standard."

The Securefresh business was acquired during 2001, and the major part of its business activity during its first year within Vertex comprised of customer trials and a small number of machine sales.

Basis for assumptions

The Commission received evidence that, to a significant extent, the assumed revenue growth for the Technical Injection business unit was based on customer information about their projected sales.

Mr Hartley stated that:

"the customer sales had been built up from what I would call hard numbers, in other words they weren't guesstimates... They seem to have been built up from discussions with customers. I was told that in some cases the customer forecasts were reduced by 60 to 70% relative to the customer's forecast.

Q: ... when you say they had been downgraded, the starting point was what customers were telling Technical Injection they were going to buy?

A: They were indicating that that was their order level, yes."

In relation to the preparation of the budget, which was used as the basis for the anticipated sales for Technical Injection included in the prospective financial information, Mr Starnes stated the following:

"Q: ... what information did you seek from your customers about the level of business they're likely to generate for you?

A: ... it depends on the customers... We looked at their numbers and then put a discount on that for the first year, which is F03. The business plan was heavily discounted because they were blue sky at that stage. Once we got closer to our budget we had a look at their numbers and then discounted by a further 10%."

Mr Starnes noted that Technical Injection's small customer base differed in terms of the length of customer relationships with Technical Injection. He noted that among the customer base Prima was relatively new start up company; Zee Tags had come on board just six months prior to the budget period; and Fisher and Paykel Healthcare's custom was around 18 months to two years old.

The evidence indicated that the quality of customer information was often highly variable and inherently unreliable. Mr Berney, of Prima ( a Technical Injection customer) was asked:

Q: "In terms of the volumes of business you did, coming back to the period up to March 2002, had your business with Vertex been consistent or were there lumps in it in the financial year?"

A: "No, it hadn't been consistent at all. It was very lumpy. We - probably the most consistent thing about it was that we tended to miss our forecasts".

Mr Berney did go on to say that Prima had frank and regular ongoing discussions with Vertex in relation to Prima's planned volumes of sales, and whether it was on target to achieve them.

Mr Watts gave evidence as follows:

"[Technical Injection] was struggling because some of their customers had decided to introduce their new products more slowly...we're very dependent on that customer saying to us 'yes I'm going to take this quantity'...but in the end if he doesn't it's very hard for management to deal with it...

...even if they get a new contract today with a new customer, it's got to be tested and proven and it will take months to get through."

...customers are very difficult at times about giving you 'forecasts' because they want to maintain a position in your delivery queue, so, they hold back giving you reality checks and that's what happened here. The reality has set in and they have reduced their orders significantly.

...I think at times, you know our customers like many others, particularly in plastics, are very vulnerable to having good 'forecasts' but not always getting them in reality."

Mr Watts told the Commission that at the time of preparation of the prospectus he had a concern about the level of growth forecast for Technical Injection:

"... the one that worried me was TI and where it was heading because it had shown 100% growth in sales the year before, and this prospectus was saying it's going to get another large piece of growth. Not usual in the plastics business."

"I was particularly comforted though... that they did know their products and their markets very well, they knew their customers very well, and they had down cast the customers forecast by half or 60%, significant reduction... it looked reasonably conservative to me..."

Conclusions about forecasts and projections

The evidence given to the Commission suggests that the two growth units were at an early stage of their anticipated growth phases. In the case of Technical Injection the business was established as a separate business unit just prior to Vertex's IPO. It was undergoing a significant restructuring phase to grow its business operations; and its true operating costs and profitability on a 'stand-alone' had not been clearly established at the time its 2003 budget was approved and incorporated into the prospective financial information for the offer documents.

The Commission is of the view that the revenue growth assumptions for Technical Injection and Securefresh were not misleading, as there was nothing in the evidence provided to indicate that it was unreasonable to expect the stated growth to occur. However, it considers that the assumptions underlying that forecast revenue growth were based mainly on customer information that was inherently highly uncertain.

The Commission's view is that the underlying bases for the revenue growth assumptions for Technical Injection and Securefresh rendered them of type that should be viewed as "hypothetical possibilities" rather than "supportable best-estimate assumptions" as defined in FRS-29.

The fact that the customer-based estimates supporting the growth assumptions were heavily discounted did nothing to remove the inherent uncertainty and lack of reliability which characterised that information. It merely reduced the potential financial impact of that uncertainty.

The Commission considers that, taken together, the circumstances surrounding the assumptions used for the growth business units suggest that they should not have been used to provide the basis for revenue growth assumptions for a forecast.

The Commission is of the opinion that the prospective financial information for the growth business units at the EBIT level would ideally have been described as a projection rather than a forecast.

However, the Commission also recognises that Vertex did produce prospective financial information in relation to the core business units that had a basis in assumptions which appeared to be supportable for the presentation of forecasts.

Presentation of components of prospective financial information: forecasts and projections

The Commission recognises that where an established business is seeking to raise funds from the public it is important, as a matter of credibility, that the business is able to demonstrate a degree of confidence about its prospects, and that this ability may not be reflected if the business presents projections rather than forecasts. However, the Commission is of the view that, where an offer document separates out prospective financial information for identifiable business units or parts of a business, issuers should be able to present the information for some business units as forecasts, and for others as projections. It may be desirable and appropriate to do this where the quality of the information underlying the assumptions is lower for some business units than others. It is likely that the business unit with the lower quality information will have a larger deviation in actual outcomes from predicted outcomes.

If this were permitted, forecasts could be made for the separately identifiable components of the business where the assumptions underlying the prospective financial information are reasonably expected to occur and are supportable. Projections could be presented for those identifiable components of the business where the underlying assumptions are hypothetical and realistic only.

PwC submitted to the Commission that it was not aware of any case in which one reporting entity, for one financial period, has reported prospective financial information comprising both forecasts and projections.

The Commission recognises that FRS-29 draws a clear distinction between forecasts and projections in terms of presentation and disclosure requirements, but is silent on whether any particular set of prospective financial information can be made up of both forecasts and projections.

The Commission is of the view that this should be permitted and that the Financial Reporting Standards should provide clear guidance on this matter. The Commission refers this question to ICANZ.

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