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Should we have seen the Fuqi disaster?

March 18th, 2010 · No Comments

Difficult to argue, but perhaps..

1) We’re not accountants, we work on the assumption that they do a good enough job most of the time. They didn’t here. Inventory valuation seems a pretty basic task to us and even that they couldn’t get right. Other people wonder about that too.

2) The ODM business (“Original Design Manufacturing”). It saved Q3 wholesale revenue and gave a significant boost to margins, the reason Q3 was so far ahead of expectations profit wise. While yes, it’s a somewhat curious new item. We did quote the Merriman, Curham and Ford research report in our first Seeking Alpha piece here:

  • We view these ODM orders as lower quality than core jewelry sales and need to monitor the trend to make sure this does not continue. At a minimum, FUQI management made good use of extra capacity to land high-margin business, but this is not the core jewelry business for which investors are involved in FUQI shares. [Merriman, Curhan and Ford]

But we found that comment a bit odd, because of the much higher margins, and because the jury was still out (and still is) whether it was a ‘one off’ or a new trend. If it was a one-off, it wasn’t really harming as without it revenues underperformed (but there were other reasons for that as well), but it made net profits significantly overshoot expectations in Q3.

William Blair & Co. seemed more reasonable to us:

  • Because it is difficult to predict how much of the wholesale business will be in ODM orders in the future, management’s guidance includes a normal (minimal) level of ODM business. That said, ODM has the potential to increase over time, adding a source of high-margin growth. [William Blair & Co. p.2]

Some did take the ODM item as an irregularity and argued this as ‘exhibit A’ or (‘first cockroach’). We were not swayed by that because he failed to substantiate even minimally. (The little progress on retail sales was explained by the company as a delay, so we didn’t worry about it too much.)

3) But that same author (Chimin San) did substantiate later. As explained above, we’re not swayed by his ‘one-off’ argument, but with hindsight, his questioning the hight of the margins on the ODM business is making a valuable point which we have overlooked.

4) We had a long discussion about the effects of a possible renminbi revaluation (a matter of time, in our view) with a commentator to our article, but since the renminbi has stayed put, this hasn’t impacted the figures.

5) In August 2009, a guy warned that it was all a scam. We haven’t seen that post until yesterday, and it’s difficult with hindsight how seriously we would have treated that if we had (hindsight has the wonderful capacity to change world-views..). After all, it was just one guy on a (rather notorious) message board.

The wholesale growth looks indeed rather large, but the lack of growth elsewhere is somewhat anecdotal but on first sight at least part of Fuqi’s growth could be explained by it’s take-over of Temex. We would also argue that with big ticket items like cars grow at phenomenal rates (40%+), so high growth in China with all that economic growth and wealth creation is not surprising.

6) We were the subject of rather vitriolic personal attacks (99% from someone who professed to be long, no less!) after our first FUQI article on Seeking Alpha. The lack of substance or arguments. These were attacks of a personal account, I was there for “pumping” my blog, or the research reports I quoted were “old” (which they manifestly weren’t), or I was “using SA to legitimize my blog“, “sending out cronies” stuff like that (really a lot more, you don’t wanna know).

If we put forward arguments, like we did in that first Seeking Alpha article, and meet so little (or none, actually) fundamental resistance, that strengthens us in our belief that we were right.

7) In all fairness, the most vitriolic of those posters did ask the one crucial question, if things are so good, then why is the stock price behaving like it was? However, if one takes stock prices as always and everywhere reflecting all available info (the ‘efficient market hypothesis’), then investing becomes entirely random (wiping out whole classes of jobs in the financial industry in the process).

There is plenty of evidence stock prices and divert significantly from their fundamentals (less so in the long-run), giving people who are prepared to do DD and spot these differences an incentive to do so. So we didn’t really take the low stock price as a necessary sign something was bad, more as an opportunity.

8) Negative cash-flow. We really didn’t have much of a problem with that one. The company is rapidly expanding and moving into the more profitable retail sector. That just takes up resources.

9) The secondary offering isn’t surprising either. They took over Temex, and cash-flows are negative (not dramatically so), so they needed money. It could very well have been that Fuqi’s wholesale clients were stocking up for the expected recovery.

10) Rising inventories in a growing business is also not necessarily that worrying. And after all, 2008 did constitute a bit of an economic crisis.

11) Large short-count. Having followed InterOil, which for years had a comparable short count, we know that the shorts are far from infallible. So the short count as such didn’t intimidate us, we were looking (as we always do) for arguments as to why one would be short (which we discuss above).

12) It is a real pity that there are no conference call transcripts available for Fuqi. We use these often, as we like the tyres of the company being kicked by people who know (or at least are supposed to know) the situation pretty well.

Conclusion
For the untrained accountant eye, there were relatively few signs of fundamental problems, and even for the (supposedly) trained accountants and analysts, there wasn’t much wrong. Yes, going through these signs (and the list above might very well not be comprehensive enough) with hindsight, they all get a different meaning. But to our knowledge, only two people said anything to that effect in advance and in public.

One mentioned the ODM business as a ‘first cockroach’, the other one had a far more alarming story, but he was an anonymous lone poster on a rather notorious message board. We have seen too many of these to take them all too seriously, but perhaps we should have in his case. But it was too little to make us worry (needless to say).

What happens next?
On today’s available info, this is impossible to answer. If restatements stay as they have been (very) provisionally given by the company, they could do $1.71-79 per share in 2009 and have some of the deferred Q4 spending materialize in Q1 2010. But it could also be there is something much more serious at work here. We don’t like to invest in the dark so we advice to stay on the sidelines until the smoke clears up.

Tags: FUQI