Last week CHS Inc. disclosed in a regulatory filing that as much as 12 percent of its reported pretax income since the summer of 2014 came from phony gains from trading railcar capacity.
While this means the recent audited financial statements now need to be tossed out as unreliable, what is just as surprising is how CHS turned out to be not quite as transparent as we may have thought.
Getting a clear picture of what has been happening inside often takes some work with big companies. But in this case, CHS turned out to be in a whole extra business beyond making a profit on its members’ crops. It was also making a lot of money buying and selling rail freight capacity.
It sure seemed easier in the past. CHS, based in Inver Grove Heights, is the modern version of a venerable agricultural cooperative, helping its farmer members get their product to customers and making a little money along the way.
The new annual filing isn’t going to be public for some weeks. But after reading through about 130 pages of the last annual filing for CHS, it’s no longer that easy to say how this company makes its money.
Part of the explanation for this is just that CHS is a big and complex company, routinely ranked toward the top end of the Fortune 500 list of biggest American companies. A straightforward regional cooperative serving Midwestern farmers wouldn’t have lost $230 million when a Brazilian trading partner slid into bankruptcy, as CHS did not long ago.
And the financial filings of CHS refer to some real head-scratchers, like financing conducted through an entity described as “a wholly owned bankruptcy-remote indirect subsidiary.”
Quick, and without consulting Google, what exactly is a bankruptcy-remote indirect subsidiary? How about a crack spread contingent liability?
Included in the CHS’ note on its income taxes is an effort to walk investors through how it got to a 332 percent effective tax rate for fiscal 2017.
CHS can’t be blamed for much of what might seem complex, in part because it must manage the volatility in prices of assets it owns. Some of that activity gets a little messy.
Companies like CHS, dealing in commodities such as grains and oil, have long used futures contracts to minimize the risk of big swings in prices of what they might own, a practice called hedging. If CHS owns a lot of corn, the thing to do is sell some with a delivery date a ways off or “sell short” in futures markets. Then if the price of corn plummets, the gains on the short position will make up the lost ground.
CHS wants to make it clear it doesn’t try to make money by speculating, that its profitability primarily comes from “margins on products sold and grain merchandised, not from hedging transactions,” as it said in its most recent annual filing.
One risk to be managed is volatility in the cost for shipping oil, grains and other products. And there’s a market for derivatives in freight.
As of the end of the 2017 fiscal year, as reported deep in CHS’ annual filing for that year, the company was “long” 176,000 railcars and short 75,000, for a net long position of about 100,000 railcars. That seems to mean that the company basically owned railcar capacity and would benefit if the price went up.
The financial statements reflect market values for these kinds of things, meaning that if the values increased CHS could book some profits. Determining value is easy when it’s quoted on a global exchange. When that doesn’t exist, the next-best way to assess it is to look at pricing for similar assets or other data that is “observable.”
CHS indicated that its values for commodity and freight derivatives, as of the end of the August 2017 fiscal year, were arrived at through quoted prices for the exact same thing or based on “significant other observable inputs.” That is, it wasn’t using its own spreadsheet or otherwise making up the prices.
The big problem that arose was that an employee, if not exactly making them up, was “manipulating” the values, as the company put it, along with the amount of railcars. That led to the termination of the employee and CHS’ painful admission that it had to restate its financials.
Prior to this news appearing, it’s not clear from an annual filing how any investor or farmer member could have known that the company was making money in the rail freight trading business or that there was a big number for these things on the latest balance sheet. And it was a big number, too, given that the net assets, according to the company, could have been improperly inflated in May by up to $220 million.
If there was something meaningful disclosed about the (apparently) profitable business of buying and selling railcar capacity in the section of the annual filing where management is supposed to fully describe how well CHS is doing, I missed it.
The professional investors and banks that own CHS securities or loan CHS money can afford to invest the time it takes to make sense of CHS’ financial filings and get executives on the phone to explain what can’t be figured out. Maybe 30 seconds is all that’s necessary to get the gist of a crack spread contingent liability.
But a lot of the members and others looking into CHS don’t have the ability to easily reach executives to get their questions answered. Or, probably, where to even start.