Within a very short span of 2 years, Esprit Group (Esprit) changed from being a stock market favourite to a disaster - see figure 1. Listed on the 2nd Board in May 1996, Esprit is principally involved in civil engineering and building works, marine and geotechnical engineering, property development and trading of building materials. Under its Chairman, Dato' Mohamed Embong, and CEO, Goh Chee Khen, the group had ambitious expansion plans which subsequently soured. On the surface, the collapse of Esprit seems similar to the others that we have featured and like the previous stock selection specials, the collapse of Esprit offers valuable investing and management lessons.

Figure 1 : Turnover and Pretax Profit of Esprit

a) Rapid Expansion and Diversification

Expansion of Core Business

Upon its listing, Esprit successfully amassed RM205 mln worth of contracts in the land-based construction segment, almost doubling their order books to RM542.4 mln for 1996. Among the major contracts secured were the construction of the KLCC retail podium and the interchange at KM37 of the KL-Seremban Expressway. For its marine engineering-based construction segment, the group secured a 500-acre land reclamation project at Tanjung Bidara, Melaka. To meet the demand of these contracts, the group had invested RM76.2 mln in fixed assets like construction machinery, hydraulic excavators, bulldozers, dredgers, barges, tug boats, etc in 1996 and 1997.

Diversification into Property Sector

In June 1996, Esprit acquired Esprit Development (Seremban) S/B (EDSSB), which subsequently, entered into a joint venture agreement with Padat Sepadu S/B to undertake a development project consisting of residential and commercial buildings in Seremban with a gross development value of RM335 mln. EDSSB then acquired a leasehold land, measuring 8.766 acres in Bukit Tembok for a cash consideration of RM4.9 mln, to facilitate the construction of 6 to 9 storey business parks, with gross development value of RM380 mln. Hence, in 1997, the group integrated the above development projects and renamed it as `Seremban Capital Square', a prestigious corporate and commercial hub expected to be completed over 8 years and valued at more than RM800 mln.

Maiden Foray into Indonesia

Via its wholly owned subsidiary, Esprit Overseas S/B, the group, on Oct 1996, entered into a joint venture agreement with PT Jasa Marga, the Indonesian Highway authority and a local Indonesian company, PT Mawatindo Road Construction to undertake the privatisation of a proposed 24.5 km Semarang-Demak toll road in Indonesia. It would involve an investment of RM572 mln for a 30-year concession, on a `build-operate-and-transfer' basis. Esprit Overseas S/B was to hold a 35% equity stake in the joint-venture company and the right to acquire a further 44.4% interest later. The group's construction arm, Esprit Corporation Sdn Bhd, was subsequently appointed as the main turnkey contractor for the construction of the toll road.

So, despite its relatively small shareholders' funds of RM30.8 mln in 1996, Esprit successfully secured numerous construction and property development projects and expanded to Indonesia. Like the others, prospects seemed pretty good. However, the operations of the group came to an abrupt standstill in 1998. By Feb 2001, with negative shareholders' funds and working capital of RM412.9 mln and RM417.9 mln respectively, Esprit deteriorated to the PN4 category.

b) Overstretched Financial Resources

Warning Signs

Maybe it was the economic boom and the 2nd Board bubble in 1995-96 that made investors, bankers, brokers, investment bankers and regulators all giddy in the heads. By the time Esprit was listed, warning signs were written all over. What were these ? From 1991 to 1995, sales of the group surged from a mere RM17.94 mln to RM173.01 mln. In that short 5-year period, pretax profit skyrocketed from RM0.70 mln to a whopping RM9.23 mln. This alone would have made one wonder about the sustainability of its growth. A look at its 1st annual report as a listed company would change these worries into justified fears. Sales in 1996 were RM202.84 mln, generated by only RM30.83 mln in shareholders' funds, a sign of overtrading. Not surprisingly, Esprit relied heavily on borrowings - a whopping RM233 mln. In very simple terms, each dollar of sales was "backed" by a dollar in loans.

At a more serious level, it also made the reasons for listing Esprit suspicious. Esprit was growing very fast and this was financed by large borrowings. When it went public, Esprit should have raised new equity to lower its high borrowings. It did not but instead made an offer for sale. Were the promoters and related parties going for a quick buck ? In addition, it borrowed mostly on a secured basis but provided credit without security.

The rapid growth from 1991-95, the very high level of gearing in 1996 and the way Esprit went public, meant 3 things : [1]. Esprit was very vulnerable to an economic downturn or negative surprises, [2]. Its financial management was very imprudent and [3]. How real was the growth from 1991 to 1996 ?

Massive Losses

Esprit's sales plunged 70% from 1997 to RM50.35 mln in 1988 while its working capital deficit skyrocketed to RM402.9 mln. In 1998, Esprit recorded a humongous loss of RM427.4 mln. Table 1 below gives a breakdown of the major items.

Table 1 : Breakdown of losses in 1998 (RM mln)

Credit Crunch

By Jun 1997, the group's total debts rose to a massive RM357.2 mln (almost 7 times shareholders' equity), with short-term borrowings at RM255.6 mln. In 1997, Esprit tried to address this by making a private placement of 1.999 mln new shares and raising a relatively small RM22 mln. But due to its still highly leveraged capital structure, it was too late, too little as the group easily succumbed to the effects of the Great Asian Crisis in 1997/98.

The sharp rise in interest rates drove up its debt servicing cost to RM49.9 mln in 1998. In addition, measures introduced by the government to tighten liquidity resulted in banks freezing its credit lines. The group's infrastructure and construction projects were stopped as funds were exhausted while its property development projects were either slowed down or abandoned.

Cash Flow Crisis

Esprit was dealt another blow when the authorities prohibited corporate exercises from early 1998 onwards. It forced the group to abandon its corporate restructuring scheme, which involved a rights issue to repay its borrowings and finance its Indonesian joint venture. Subsequently, financiers called-in on the loans and credit lines were withdrawn.

In 1998, the group terminated the Semarang-Demak expressway project in Indonesia when its principal financier placed Esprit Overseas S/B under receivership on Mar 1998. As a result, the group suffered losses as the joint-venture investment and advances to the joint venture partners and turnkey contractor were written-off. In the first instance, RM572 mln for a 24.5 km expressway looks too expensive and one wonders how Esprit would have made a decent return from the project.

On top of the foreign exchange losses suffered, the group had to write-down its fixed assets such as dredgers and barges to negligible prices due to forced sales and make provisions for doubtful and bad debts. The stoppage and delay in its construction projects exposed the group to claims for liquidated damages while its property development project in Seremban was held in abeyance till the completion of a restructuring exercise.

Public Reprimand & Fine

On 16 Sep 2000, Esprit Group Bhd was publicly reprimanded and fined RM125,000 for its failure to make immediate announcements on the termination of its joint-venture project in Indonesia (a delay of 21 months) and appointment of the receivership for Esprit Overseas S/B (a delay of 21 months).