Why we shorted Austal: 9 warning signs that signalled choppy waters ahead

Donald Trump was not the only individual to be indicted by a grand jury over the weekend. A US Federal grand jury returned an indictment against three Austal USA LLC employees, a wholly owned subsidiary of Australian listed shipbuilder Austal Ltd, for orchestrating an accounting fraud. 

The SEC alleges that Austal USA’s former president, the former director of the Littoral Combat Ship program, and the director of financial analysis co-conspired to artificially reduce the cost of specific projects by tens of millions of dollars and that the parent company prematurely recognised revenues. 

All three defendants have exercised their fifth amendment right to silence to protect themselves from self-incrimination. What was it that Donald Trump says about people who plead the 5th? 

For transparency, the Plato Global Alpha Fund has been short Austal Ltd since the 6^th of April, 2022.

One of the key motivations for being short was a high number of Red Flags. Plato has developed 100+ Red Flags to identify both potential landmines to avoid on the long side and potential short opportunities. 

Most companies have zero or one Red Flags. Austal Ltd has nine, outlined below, which led us to initiating a short position.

Red Flag 1: Historic breaches of disclosure laws

In 2022, the Federal Court of Australia ordered Austal Ltd to pay AUD$650,000 after finding the company contravened continuous disclosure laws.[1] 

Austal Ltd admitted, and the Federal Court concurred, that in FY2016 the company had failed to disclose a probable profit write-back in excess of US$90 million. As any serious investor will tell you, there is always one more cockroach in the kitchen, and so it has proved for Austal.

Red Flag 2: Very poor board rating

Any organisation is only as good as the oversight provided by those at the top. An appropriate nautical metaphor might be that the fish rots from the head. 

The failure to disclose likely profit write-downs in 2022 we believe was indicative of poor governance and oversight. Other than the chairman, the board has entirely turned over since 2016 when the disclosure breaches occurred. The current board consists of the chairman, the CEO, and four independent directors. The chairman is not independent and the nor is the lead director.[2] 

Of the independents it is not clear from the Austal home page that any have direct experience in the shipbuilding industry with the exception of Lee Goddard who has only been on the board for three months.[3]

Red Flag 3: Very poor audit rating

We always keep an eye on the quality of a company’s audit. Not all income is created equally. If the audit process or report is poor, a haircut should be applied to reported income. The presence of accounting controversies, and the level of risk oversight and disclosures are key. In 2018, proxy advisory firm Ownership Matters, said Austal Ltd. did not disclose enough information about a Tax Office assessment for its 2017 accounts. 

In 2021, a top US Austal executive resigned after an external investigation found the company had built Navy vessels with parts that did not meet military specifications, and underestimated costs.

Red Flag 4: Worst possible Institutional Shareholder Services (ISS) score for overall governance practices

ISS provide industry leading governance evaluations based on audit quality, board composition, compensation practices, and shareholder rights. Austal received the worst possible score from ISS which did not exactly fill us with confidence.

Red Flag 5: A positive dividend, and negative operating cashflow

Over the last twelve months, Austal Ltd paid out AUD$28.9m in dividends. Meanwhile, cash flow from operations (CFO) was negative AUD$13.7m. We are almost always bearish on companies with negative CFO, let alone if management thinks it is a good idea to be simultaneously paying out a near record dividend.

Red Flag 6: Health & Safety record

Austal USA has been fined in the past for health and safety violations including improperly labelling hazardous chemicals and allowing workers to be overexposed to copper fumes. Back in 2013 in Australia, the Department of Fire and Emergency Services responded to a hydrogen sulphide gas leak at Clarence Beach Road in Henderson. A spokesperson for St John Ambulance said seven people at Austral ships were affected by the chemicals.

Red Flag 7: Historic cybersecurity breaches

In November, 2018, Austal Ltd admitted that hackers had breached its defences and gained access to ship designs. Not a great look for a defence company… The attack resulted in an investigation by the Australian Cyber Security Centre, the country’s peak body. The post-mortem investigation revealed that passwords were bought on the dark web. The hackers probably should have saved their money. According to news-sources in 2020, the passwords were Password123 or Austal123…[4] this all speaks to poor internal controls and governance.

Red Flag 8: No insider buys in over 12 months

According to both Reuters and Bloomberg Insider Transactions, there have been no purchases of Austal stock in over a year from the chairman, CEO, or any of the board of directors. In February 2022, non-executive independent director Michael McCormack purchased a mere $13,840 worth of shares, but even that was an exercise of rights. Before that you had to go back to June, 2021 to find a meaningful share purchase by a board member ($214,000 worth of shares).

Red Flag 9: Fund ownership is dominated by index-like funds

The largest fund invested in Austal is the Statens Pensjonsfond Utland or SPU (The Government Pension Fund of Norway) which holds 1.96% of the company – the SPU is currently invested in some 9228 listed companies. The second largest fund investor has 1919 holdings, and the third has 1473. Almost all of the massive passive index funds are represented in the top ten holders. While that can sometimes be the case due to the sheer size of these funds, the almost complete absence of truly active managers in the top ten of the shareholder register is an obvious cause for concern.[5]

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