The Fuqi International (FUQI) puzzle

Stellar performance, surpassing expectations, but share price is stagnating and there is a surprisingly large short position. We can’t explain it but here is a very thorough research report from Oppenheimer in PDF with a $38 price target…

Here is the report in PDF

Some points:

  • We believe China’s jewelry market will grow 10%-15% annually in the next 3-5 years, supported by the country’s fast-growing GDP, increasing disposable income and large and growing middle class. China’s rapidly growing GDP, over 10% annually in the past decade and expected to grow 8% despite the global economic downturn this year, has generated increasing wealth among its citizens.
  • Fuqi’s sales are positively correlated to gold spot market prices, suggesting rising gold prices benefit Fuqi by driving higher revenues. During periods of rising inflation, demand for gold and gold jewelry increases as consumers seek to preserve value of their savings. Meanwhile, as Fuqi employs FIFO method of accounting to record its COGS, a rise in the price of gold has resulted in margin expansions, as we have seen during 1H09. The company estimated the recent gold price increase contributed 1.5-2.5 percentage points to gross margins. Conversely, if spot prices fall, Fuqi’s revenue growth and margin expansion could slow or even decline.
  • In our opinion, strong balance sheet positions Fuqi to pursue its strategy of organic expansion and acquisition. Jewelry is a capital-intensive business with sizeable working capital to stock inventories and purchase raw materials. We estimate Fuqi currently has $140 million in cash as well as $87 million in inventory (as of June 30), most of which is gold and liquid. In addition, we believe Fuqi’s strong balance sheet allows the company to take advantage of market downturns to make acquisitions at attractive prices, as evidenced by its acquisition of Temix in August 2008, which has proven to be highly accretive to date. In addition, we believe management’s interest is well aligned with investors’ as Fuqi has significant insider holdings.
  • Fuqi has an aggressive retail outlet expansion plan and bifurcated branding strategy. The company is targeting organic growth of 30-35 new stores in 2H09. In general, the Temix brand targets young urban modern consumers that prefer platinum and diamond jewelry while the FUQI brand is marketed to a broad group of elder mid-level income consumers who purchase more traditional gold and platinum jewelry and jewelry gift items. Fuqi’s average retail price of diamond jewelry is $800-$3,000 and the average price of gold jewelry is $200-$300. The retail mark-up for gold and platinum is typically 20-30%, while for others, including diamond, k-gold, studded jewelry, and gem stones, ranges from 30%-50%, depending on designs.

So:

  1. It’s cheap (less than 10x 2010 estimated earnings)
  2. It has a strong balance sheet
  3. It’s operating in a rapidly growing market
  4. It has an excellent execution history
  5. It’s aggressively expanding in retail business, which generate higher margins
  6. Rising gold prices gives it a further significant boost
  7. The latest quarterly results exceeded expectations

What’s not to like? Well..

Cash flow is a bit of a problem. If you go to page 18 of the report, you see that cash flow from operations has been negative since 2007. There are two culprits here:

  • Accounts receivable
  • Inventories
  • The latest quarterly result added Advances to suppliers as a substantial negative post

These are not terrible problems, it’s what expansion does (the business is quite capital intensive) and inventories use up more cash because gold prices are rising pretty fast as well.

So although this is a minor concern, it’s compensated by so many positives that we’re still at a loss to explain why the shares are not significantly higher. Almost half of the float is short, very curious indeed.

3 thoughts on “The Fuqi International (FUQI) puzzle”

  1. Conservative guidance and a conference call that was bush league – making it appear ODM work is new – it is not – and can’t be countd on. even without it, growth would have been north of 50% qrt/qtr. they will get it right next time. See Gene Marcial Bus Week article – they have it at $50 by end of 2010. I agree.

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