Muddy Waters Weighs In and Eurofins Responds Immediately
Eurofins deep dive pt 11. On 24 June 2024 Muddy Waters Research announed their short position on Eurofins Scientific, publishing their dossier of evidence to support it
TL, DR
Muddy Waters Capital, led by Carson Block, is a hedge fund renowned for activist short-selling, publishing critical reports to profit from falling stock prices. The firm has accused Eurofins Scientific of extensive financial malfeasance, including allegations against its CEO, Dr. Martin, for siphoning company funds through manipulated real estate deals and questionable acquisitions. The report highlighted opaque cash accounting practices, inflated property valuations, and weak internal controls, raising concerns about Eurofins' governance and financial integrity. In response, Eurofins refuted these claims as misleading, defended its practices, and asserted sound governance and financial health. The dispute has led to significant market reactions, igniting ongoing tensions between the two parties.
Introduction
Muddy Waters Capital is a hedge fund firm founded by Carson Block, known for its activist short-selling strategy.
Background: Block's career as a short seller began with an investigation into a Chinese paper manufacturer called Orient Paper. He found evidence of fraud and published a report that caused the stock price to fall. This early success led him to establish Muddy Waters Capital and to pursue similar investigations into other companies, often alleging fraud or deception.
Activist Short Selling: Block is an "activist short seller," meaning he doesn't just bet against a stock; he actively tries to make the share price fall by publishing critical reports. These reports often rely on document dives, outside intelligence, and sometimes firsthand detective work, including undercover operations.
Tactics: Block's methods have included using a hidden camera disguised as a watch, and engaging in undercover work. He has also been known to troll his enemies on Twitter and refer to companies he deems worthless as "shitcos" or "bagels".
Influence: Despite his outsider persona, Block has gained significant influence in the financial world. He appears regularly on CNBC, and the SEC has awarded him a $14 million whistleblower award.
The Investigation: In 2021, Block's home was raided by the FBI, who seized his electronic devices. The DOJ is investigating Block and other prominent short sellers for possible coordination surrounding the publication of short reports. The investigation focuses on trading activity and possible market manipulation, not on the content of the reports themselves.
Possible Charges: The investigation is exploring whether activist shorts are engaging in a form of "reverse pump and dump". This would mean that they are publishing negative reports on a company, profiting from the resulting drop in share price, and then covering their short positions, even if the stock doesn't actually reach the value they claimed, which could be seen as a form of market manipulation.
Block's Response: Block maintains his innocence and has been vocal in his defence. He believes that the investigation is an attack on the practice of short activism.
24th June 2024
Muddy Waters announces its short position on Eurofins Scientific on twitter.
Publishing a 36 page document on its website setting out the hypothesis for its short position, Muddy Waters alleges extensive financial malfeasance at Eurofins Scientific. The core accusation centres on Dr Martin, a major shareholder, systematically siphoning funds over two decades through manipulated real estate transactions, inflating acquisition costs, and charging excessive rents. Muddy Waters supports this claim with detailed analysis of financial statements, highlighting inconsistencies in cash accounting, questionable acquisition practices (particularly the BioSanté deal in Martinique and the UK property purchase through a straw buyer), and unusually high loan-to-value ratios on Dr Martin's properties. The report further suggests weak internal controls, including reliance on spreadsheets and a seemingly ineffective internal audit team, as contributing factors enabling this alleged malfeasance, ultimately painting a picture of a company optimised for fraudulent activity rather than legitimate business.
Carson Block outlines his position in 30 minute interview.
Real Estate
Muddy Waters alleges that Dr. Martin, a controlling shareholder of Eurofins, has engaged in a pattern of siphoning money from the company for two decades, primarily through real estate transactions. This, Muddy Waters alleges, has been achieved through several methods:
Acquisition of Real Estate: Dr. Martin acquired numerous properties, often from the sellers of businesses that were also acquired by Eurofins. These properties were then leased back to Eurofins, typically at above-market rates. Eurofins seemingly overpaid for operating businesses in order to subsidize Dr. Martin's real estate purchases.
Below Market Purchase Prices: Dr. Martin reportedly paid below market prices for real estate by having Eurofins pay more for the operating businesses in M&A deals. This was often facilitated by real estate valuations that were below market value.
Above Market Rents: Dr. Martin charged Eurofins above-market rates for rent, further increasing his profits. Eurofins also generally paid for the operating expenses on these properties. Additionally, Dr. Martin extracted large rent deposits from Eurofins. Dr. Martin would also force Eurofins to accept his leasing agreements.
High Loan-to-Value Mortgages: Dr. Martin secured high loan-to-value (LTV) mortgages on these properties, often exceeding 90%. This was facilitated by low valuations and high rent cash flows backed by Eurofins' credit profile. In some instances, LTVs exceeded 100%, such as in the case of Kalamazoo Quality Way One Inc. with a 163% LTV.
Questionable Transactions:
Lancaster Property: Dr. Martin acquired the Lancaster property from Eurofins shortly after Eurofins acquired Lancaster Laboratories, possibly without paying the full price of $23.75 million. Eurofins then funded expansions of the property while Dr. Martin increased the rent.
AvTech Labs: In 2005, Dr. Martin obtained two mortgages on the AvTech property shortly after Eurofins acquired AvTech for a combined 163% LTV.
1 Dukes Green Avenue: Eurofins purchased this property in the UK from a straw party, Permitted Developments Investments No. 9 Limited (PDI), for an estimated ~€4 million premium after a nine-month holding period. PDI's address was the same as Eurofins Food Testing UK Limited, suggesting the intention to transfer the property to Eurofins.
Eurofins' Misleading Statements: While engaging in these transactions, Eurofins misled investors by claiming it did not acquire real estate because it would "immobilize capital at low rates of return".
Use of Straw Buyers: Eurofins used straw buyers, like Permitted Developments Investments No. 9 Limited (PDI), to facilitate markups on properties before they were purchased by Eurofins.
Questionable Acquistions
Muddy Waters alleges that Eurofins has engaged in a number of questionable acquisitions, with several instances suggesting potential malfeasance and inflated valuations. They suggest that:
Decreasing Acquisition Size: As Eurofins has grown larger, the size of its acquisitions has become smaller. In 2019, acquisitions averaged $5.0 million of annual revenue, which declined to $3.1 million by 2023. This trend is counterintuitive for a growing company, and most acquisitions do not meet the threshold for disclosure, keeping much of the spending opaque. This raises concerns that the company may be making many small acquisitions to mask the overall use of funds.
BioSanté in Martinique: The 2022 acquisition of BioSanté, a chain of medical laboratories in Martinique, is particularly questionable. Eurofins paid €80.9 million for BioSanté, which had a 2022 EBITDA of €3.8 million, resulting in a high EV/EBITDA multiple of 21.3x. Given that Martinique is a small, declining island, it's unlikely BioSanté has much room to grow. The report notes that the total investment in Club Med Les Boucaniers, a major resort on Martinique, was only ~75% of the reported cost of BioSanté. This disparity suggests that Eurofins may have overpaid for BioSanté.
1 Dukes Green Avenue (UK): In 2019, Eurofins purchased a property in the UK at 1 Dukes Green Avenue under questionable circumstances. Eurofins bought the property from Permitted Developments Investments No. 9 Limited (PDI), a company that appeared to be a straw buyer, for an estimated ~€4 million premium after a nine-month holding period. PDI's address was the same as Eurofins Food Testing UK Limited, suggesting the intention to transfer the property to Eurofins. It seems that no significant value was added to the property during the nine months PDI held it.
Real Estate as a Driver: Former employees stated that Eurofins sought to acquire businesses with real estate for Dr. Martin to buy, suggesting that real estate deals, not the operating business, were a key driver of some acquisitions. It has been reported that Dr. Martin had Eurofins pay more for operating businesses so that he could pay below-market prices for the real estate.
Lack of Transparency: The vast majority of acquisitions don't meet the threshold for disclosure, keeping much of the spending opaque. This lack of transparency makes it difficult to assess the true value of the acquired assets and raises concerns about potential manipulation.
These acquisitions, combined with the evidence of Dr. Martin's siphoning of funds through real estate transactions, suggested to Muddy Waters that Eurofins may be using acquisitions as a way to mask malfeasance or to move money out of the company. The company's focus on smaller acquisitions and questionable real estate deals raised serious questions about the integrity of its financial reporting and overall business practices.
Opaque Cash Accounting
Muddy Waters claimed that Eurofins' cash accounting practices were opaque and designed to maximise confusion, potentially masking issues such as overstated cash balances. Several issues caused Muddy Waters concern, specifically:
Cash Pooling and Inter-company Receivables: Eurofins uses a cash pooling system, primarily through a Luxembourg entity, Eurofins Finance Luxembourg S.à r.l. Business Units (BUs) transfer excess cash to National Service Centers (NSCs), which then send the cash to the Luxembourg pooling entity. While this process is not unusual, the issue arises in how these transactions are recorded. Instead of keeping inter-company receivables separate, many of Eurofins' entities combine these receivables with their cash and equivalents when preparing their financial statements. This practice makes it difficult to discern how much real cash the company actually holds.
Lack of Disclosure: The report notes that in most of Eurofins' entities, there is no separate disclosure of cash versus inter-company receivables. This lack of transparency makes it challenging to assess the true cash position of the company. The Spanish entities are an exception, where the notes to the financial statements disclose the portion of cash accounts that are represented by receivables. This disclosure indicates that approximately 90% of their cash and equivalents are related-party receivables. This is not standard practice and is not seen in other companies that pool cash.
Weaknesses in the Cash Confirmation Process: There appears to be a lack of direct interaction between the consolidation-level auditor (Deloitte) and operating entities during the cash confirmation process. The cash confirmation process is reportedly handled by the NSC, excluding BU leaders, which is a potential material weakness in the audit procedures. This lack of direct interface increases the risk that the auditor might fail to detect receivables booked as cash.
Inconsistent Cash Accounting Policies: There is evidence of entities within Eurofins having inconsistent cash accounting policies. For example, Eurofins BLC Leather Technology Centre Ltd. (BLC) has a policy that excludes pooling receivables from cash and equivalents, but its accounts show that it includes £1.073 million of inter-company receivables in its "Cash at Bank and in Hand" balance of £1.2 million. This means the actual cash was only £124,000. This discrepancy highlights the confusion arising from combining receivables with real cash and could lead to double-counting of cash.
Historical Issues and Auditor Confusion: Eurofins has a history of confusing cash disclosures. In 2023, Deloitte had to reclassify €682 million of receivables and payables in the 2022 accounts. This significant adjustment suggests considerable audit risk, confusion in the accounts, and possible manipulation. There are also inconsistencies between Eurofins' public disclosures of cash and its statutory filings, particularly in 2011 and 2012.
Changes in Accounting Policy: In 2023, Eurofins changed its accounting policy for “Cash and Cash Equivalents,” now recording them "net if an enforceable...". This change is different from peers like Bureau Veritas and raises questions about the company's practices.
Spreadsheet-Based Reporting: Internal financial reporting is often done using spreadsheets, which is seen as a weakness in internal controls and creates opportunities for manipulation. This, combined with the complexities of the cash pooling system and the issues with cash confirmation, paints a picture of a company with intentionally opaque cash accounting procedures.
The report concludes that Eurofins’ cash accounting practices seem designed to confuse and potentially overstate cash balances, making the company optimized for malfeasance.
Muddy Waters Reports Move Markets
Investors, traders, take Muddy Waters reports seriously. This was no exception.
Share prices dropped to lows not seen since the world declared the covid lockdown in 2020. Whilst Eurofins took time to respond to Shadowfall’s reports in 2019, not even mentioning them by name, it would have been suicidal not to make some kind of response, and they did, this time within 12-24 hours.
Eurofins Response 25th June 2024
Eurofins has responded stating that the allegations are inaccurate, irrelevant, biased, and/or misleading. Eurofins believed that Muddy Waters (MW) did not engage with them to verify their information, which led to the spread of misinformation.
Acquisition of BioSanté: Eurofins refuted the claim that their purchase of BioSanté in Martinique was an unsuitable investment by stating that the multiples for the acquisition were within the lower range for the sector and that it has since delivered accretive margins.
Cash and Equivalents Reporting: Eurofins clarified that while local GAAP requirements may differ, all intercompany transactions are eliminated in the consolidated financials. Cash amounts are also systematically audited at both local and consolidated levels. They stated that the allegations of potential double-counting of cash at Group level are unfounded.
Property Purchase: Eurofins claims that MW used the wrong address and values to falsely portray the purchase of Permitted Development Investments No. 9 as a way to inflate the property's value through a straw buyer. According to Eurofins, this is not the case.
Accounting Software: Eurofins states that the company uses recognised technologies such as Microsoft Dynamics, Microsoft Great Plains, IBM Cognos, and Coupa, not spreadsheets with "unacceptably loose internal controls" as alleged in the report.
Revenue and Cost Per Employee Ratios: Eurofins explains that differences in revenue per employee and cost per employee ratios compared to other companies were due to geographical factors, the type of services offered and the sectors served. They highlighted that, unlike some peers, they focus on testing, which requires highly skilled staff and generates higher revenues per employee, as opposed to inspection and certification which is more labour intensive. They also emphasized their focus on more scientifically advanced testing services for the biopharmaceutical sector.
Historical Transactions: Eurofins stated that some of the comments made by MW refer to events that occurred 10 to 20 years ago when Eurofins had less access to capital and higher indebtedness, and that they have disclosed how and why the real estate acquisitions were done with their main shareholder at the time to avoid exceeding financial leverage ratios. Eurofins also states that all real estate transactions with related parties were done at arm's length terms.
Eurofins maintained that its financial performance and corporate governance were sound. They stated that they have a solid cash position, which enabled them to redeem a €448m Eurobond early. They also state that they commission statutory audits covering almost 100% of external sales, EBITDA and total assets, performed mostly by Tier 1 and Tier 2 audit firms, even when not required by local regulations. Eurofins also pointed to the existence of a Board-level Sustainability and Corporate Governance Committee that ensured that related party transactions were at arm's length terms. The company stated that it complies with all reporting obligations in Luxembourg and also with relevant French AMF regulations, since it has historically been listed in Paris.
Eurofins' CEO, Dr Gilles Martin, stated that the report's claims are "baseless accusations" and "blatantly false or misleading statements". He suggests that the report's author is inexperienced with Eurofins, its sector, or its history and that the author was negligent in their research. He also cites examples that easily disprove MW's allegations by looking at publicly available information.
Eurofins has shared its response with its auditors, Deloitte Audit, as the report's insinuations may unjustly cast doubts on their work. They will be working with their auditors in preparing further analysis as required. Eurofins intends to make the truth clear to all of its stakeholders.
Initial reaction to Eurofins rebuttals in the financial press was that Eurofins hadn’t done enough to address the issues raised by Muddy Waters and the war of words between the two parties was just beginning. More to come in pt 11.
