My pick for CEO dead pool: Omar S Ishrak at Medtronic

I got a lot of nominations for CEO dead-pool but very few with clearly enunciated reasons and the reasons are what is going to determine the ultimate winner. There were popular nominations (Meg Whitman at HP just because HP is hard, Ballmer at Microsoft for missing every major trend of the last decade).

You can't win with the obvious - indeed I was almost going to suggest that Meg Whitman was a disqualifying guess...

One entry is going to be hard to beat. Someone nominated Cynthia Carroll at Anglo American literally hours before she stepped down. But in that case the writing was on-the-wall. She was a woman and not South African and her company was causing South African politics to spiral out of control. Of course the old-guard were going to gang up on her.

In any game of dead-pool the winner has to be someone with a sterling reputation and a job they should keep for decades. And the demise should be a sudden complete surprise (at least to the company if not to the CEO dead-pool player). What will win is a company where the CEO's main job is to keep his nose clean and keep a highly profitable machine humming along and where the CEO makes a stuff up so egregious that keeping him is not within the realms of possibility.

Such a speculative guess is more likely to be wrong.

So - revealing that I am going for the most outlandish suggestion I could justify (and hence I am likely to either be wrong or to win the dead-pool game) I made my pick.

Without further ado I will introduce you to Omar S. Ishrak, the CEO of Medtronic - the largest medical devices company in the world.

Well he is the CEO for now - but my guess is not for long. After all guessing that is the point of the game.

So who is Omar S Ishrak and what did he do wrong?

Omar Ishrak is the former CEO of GE Health Care Systems now the CEO of Medtronic. He has a PhD in electrical engineering from Kings College.

Medtronic has done some dud acquisitions in the past - and those acquisitions were the main reason for the departure of the previous CEO. The main problem acquisition was Kyphon, a company with a real technology for repairing damaged spines in elderly people. Kyphon got pinged for defrauding Medicare and paid a fine. The real damage however was not the fine - it was that the required change in sales practice caused Kyphon revenues to collapse (and hence meant the acquisition price was wildly inflated).

So Omar has been clear that he will be more disciplined about acquisitions.

You can see this in the following video:




Its worth reviewing what he says in this video:

First [acquisitions] need to have a very clear value proposition which are financial in nature and very granular in their content as to why we do a certain acquisition and we need plans in place that we can deliver on those value propositions.

I think this Omar Ishrak will be forced to resign because he cannot live up to the goals he set in this video (and which he has set publicly before and since).

Indeed the acquisition he is currently doing will prove far more embarrassing than Kyphon - existence of what he is thinking he is buying may even be questioned...

The acquisition in question is China Kanghui Holdings which Medtronic is paying over $800 million for and which I think will produce a write-off of about $800 million within a year. That is, this business will be a total write-off - they will have paid over $800 million for air...

The CEO's position will be untenable after that. After all, bad acquisitions have been a Medtronic problem in the past - which is why the above video starts with the (rejected) assertion that "billion dollar acquisitions" might be a thing of the past.

China Kanghui acquisition background

I can't do any better in describing China Kanghui's business than their official description:

China Kanghui Holdings, through its subsidiaries, engages in the development, manufacture, and sale of orthopedic implants and associated instruments for trauma, spine, cranial maxillofacial, and craniocerebral. The company offers 36 product series of orthopedic implants and associated instruments for trauma and spine indications under the Kanghui and Libeier brand names. Its trauma products used in the surgical treatment of bone fractures include a range of nails, plates and screws, and cranial maxillofacial plate and screw systems; and spine products used in the surgical treatment of spine disorders consist of screws, meshes, interbody cages, and fixation systems. The company also manufactures implants, implant components, and instruments for original equipment manufacturers based on their product designs and specifications. In addition, it is involved in the development, manufacture, and sale of implants and instruments for knee joint prosthesis; and titanium alloy and cobalt alloy hip joint prosthesis. The company sells its proprietary orthopedic implants to third-party distributors, who then sell those products to hospitals directly or through sub-distributors. As of March 31, 2012, it had a network of 335 domestic distributors covering 30 provinces, municipalities, and autonomous regions in China; and a network of 41 international distributors that sell products in 29 countries across Asia, Europe, South America, Africa, and Australia. China Kanghui Holdings was founded in 1997 and is headquartered in Changzhou, the People's Republic of China.

You can see the attraction for Medtronic. It is within their industry. Most importantly it has a network of 355 domestic distributors covering much of China. Omar Ishrak would obviously be attracted to that. He has said many times that the growth of Medtronic will come from China and India: distribution in China is precisely what he wants.

This is a done-deal. Investor relations assure anyone who asks that due-diligence is complete and do not seem interested in negative feed-back (or even passing negative feed-back on). The market is trading the stock with less than 1 percent spread between the market price and bid price. There is nothing it seems that can derail this bid.

It is just that I do not see this deal as having "a very clear value proposition which are financial in nature and very granular in their content," instead I just see a mess. I could be wrong though - Medtronic have done thorough due diligence (at least according to investor relations) and I have done just a little.

China Kanghui's accounts

It is axiomatic that if you generate fake profits over time you will wind up with fake net assets on your balance sheet.

And that you can determine the profits are real by proving the assets are real, or you can determine the profits are false by proving the assets are false.

That is the nature of double-entry accounting.

If you read the accounts and you question the income you are by definition questioning the assets (or visa-versa).

So here are Kanghui's accounts - first the income account in thousand of USD.

Net revenue	51948
Cost of revenue	-14689
Gross profit	37259
Operating expenses:
Selling expenses	-6605
General and administrative expenses	-7692
Research and development expenses	-1933
Operating income	21029
Interest income	2530
Government grants	688
Other income	296
Other expenses	-299
Foreign exchange loss	-1361
Income before income taxes	22883
Income taxes	-3738
Net income	19145
Net loss attributable to non-controlling interests	94
Net income attributable to China Kanghui Holdings’ shareholders	19239

It is a mighty profitable business - on 52 million in revenue they generate 19 million in post-tax profit. The purchase price of over 800 million is an extremely fancy multiple - but they are - it appears - getting something - indeed a world-beating profit-margin in an attractive company.

They are clearly not getting an R&D team of note however - the R&D is less than $2 million and cumulative R&D is a drop in the ocean. It is not original equipment they are after then - it must be the distribution team.

Here is the balance sheet - and whoa is this an amusing balance sheet:

ASSETS
Current assets:
Cash and cash equivalents	60391
Bills receivable	933
Short-term investments	12234
Accounts receivable, net	13915
Inventories, net	17621
Prepayments and other current assets	2135
Deferred tax assets	1444
Amount due from related parties	901
Total current assets	109574
Non-current assets:
Property, plant and equipment, net	41282
Intangible assets, net	9855
Prepaid land lease payments	3624
Goodwill	24681
Long-term Investment	4004
Deposits for non-current assets	752
Deferred tax assets	388
Other assets, non-current	41
Total non-current assets	84627
Total assets	194201
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	3063
Accrued expenses and other liabilities	10389
Income tax payable	922
Deferred revenue	—
Uncertain tax positions	667
Amount due to related parties	181
Total current liabilities	15222
Non-current liabilities:
Deferred government grants	1018
Deferred tax liabilities	2361
Total non-current liabilities	3379
Total liabilities	18601
Equity:
Ordinary shares (par value of US$0.001 per share; 1,000,000,000 shares authorized as of December 31, 2010 and 2011; 136,821,600 shares and 140,401,842 shares issued outstanding as of December 31, 2010 and 2011, respectively)	162
Additional paid-in capital	145057
Accumulated other comprehensive loss	-3115
Statutory reserves	7216
Retained earnings	24847
Total China Kanghui Holdings shareholders’ equity	174167
Non-controlling interests	1433
Total equity	175600
Total liabilities and equity	194201

Inventories are 17 million dollars - not a big number - but over 400 days of cost of goods sold.

We are asked to believe that in the relatively fast changing world of medical technology this company produces world-beating results whilst keeping well over a year in inventory and doing next to no R&D.

Strangely capital equipment is over 41 million - several years of cost-of-goods sold. It is a very strange business indeed that sells medical implant equipment (small devices you can fit easily into the palm of a hand but which cost huge sums of money) which has next-to-zero R&D but plant and equipment equal to over two years cost-of-goods sold.

Moreover without any obvious change in the business the plant and equipment well over doubled in the past year.

My qualms

These accounts ask us to believe that China Kanghui is

(a). Miraculous - learning how to make a substantial medical implant business on very thin R&D,

(b). Hopeless, keeping well over a year inventory - an out-of-control stocking process, and

(c). Suddenly and rapidly becoming massively capital intensive despite producing very small devices that involve no R&D.

There is an alternative hypothesis: the profits are fake, the huge inventories and plant and equipment are a balancing item.

If the alternative hypothesis is correct (and it is only a guess) then I am waiting for and expecting Omar Ishrak's resignation. And I can't wait - I will win the game of CEO dead-pool.

On-the-ground checking

I am not the only person who has thought China Kanghui has funky accounts. Other hedge funds have paid for investigators on the ground in China - and they have tried (unsuccessfully) to report their results to Medtronic.

Alas it seems Mr Ishrak has a protective cocoon around him that makes it impossible to approach him with anything that is negative to his agenda. He probably - at least until this blog post comes out - has no idea that people think he is a misled by his staff if not personally a fool.

But for the benefit of readers let me say what the on-the-ground checking shows. Amongst other things it shows that

(a). The property, plant and equipment in the SAIC (ie Chinese domestic) accounts did not match the SEC filings. [This check is hard to do now because SAIC accounts have become unavailable.]

(b). More importantly it showed that Libeier distributors would not even distribute Kanghui products - casting doubt on the assertion that they own Libeier (and hence casting doubt on the assertion that Medtronic is even buying worthwhile distribution in China).

Of course I could be wrong

The Medtronic people say they have done thorough due diligence. I have just poked around from my office, reading the accounts, interpreting the obvious.

But my gut interpretations of accounts are right often enough, and the on-the-ground research backs them.

For an outlandish guess on  CEO dead-pool this is a pretty good gambit.




John