A new original research report in PDF with a lot about that original design manufacturing (ODM) business that the market didn’t seem to like…

In two previous installments (here and here), we tried to unravel the negative market reaction to FUQI’s latest quarterly results in November.

We don’t really understand why the market seems to have a problem with that ODM business, and neither does William Blair & Company (see it’s November 10 report in PDF here).

What is ODM?

• The ODM business, which is part of the wholesale business, differs little from the base wholesale business in that the wholesale customers supply the raw material to Fuqi for production. Unlike the rest of the wholesale business in which distributors pay for the material, a design fee, and a processing fee, with ODM orders distributors pay only a design fee and a processing fee. The orders for the core wholesale business and orders for ODM are derived from the same group of customers. Typically, ODM orders are filled for larger customers that are also placing core wholesale orders. [p.2]

Why is it important?

• It seems that the last quarter saw a sudden rise in ODM sales
• Previously a relatively small contributor to total sales, the ODM business contributed about $19.0 million wholesale revenue, up from $2 million in the year-ago third quarter. (Excluding ODM sales in both periods, wholesale sales growth would have been 11% in the quarter, compared with 29.7% including ODM. Excluding ODM and adjusting for $5.0 million in wholesale revenues that were pushed from the third quarter into the fourth quarter, wholesale revenue growth would have been up 17%, still below our estimate of 26%.) Gross margin for ODM is at least twice that of the core wholesale business, which drove wholesale gross margin of 23.6%, compared with our 12.5% estimate, and the EPS upside in the quarter.[p.2]

Is it a trend?

• Difficult to say
• 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.[p.2]

So, we could recapitulate:

1. The last quarter displayed an unexpected rise in ODM business to $19M
2. ODM business has twice the margin of the wholesale business and it was the main driver of the earnings surprise (73 cents for the quarter versus 44 cents consensus estimate)
3. Since it’s too early to see a trend on the basis of one quarter, the market took it as a negative, zooming in on somewhat below consensus growth if one excludes the ODM business.
4. If the next quarter shows significant ODM business again, many of those fears will be turned into positives, as ODM does have twice the margin of the wholesale business

Management does include little ODM business in it’s guidance. It’s therefore noteworthy that they nevertheless increased guidance for the last quarter and whole year:

• Fourth-quarter guidance increased. Management expects fourth-quarter sales in the range of $182.0 million to $191.0 million and EPS in the range of $0.55 to $0.60, better than prior guidance set in the second quarter of $177.5 million to $185.5 million and $0.52 to $0.59, respectively. Full year 2009 sales and EPS guidance was raised to $519.4 million to $528.4 million and $2.21 to $2.27, from $509.2 to $527.0 and $1.83 to $1.94, respectively. The revised guidance assumes reacceleration in sales growth in the fourth quarter. Specifically, sales guidance is for about 40.6% growth to 47.5% growth, up from 35.8% growth (including ODM sales) in the third quarter. Management’s fourth-quarter guidance reflects a strong reacceleration of growth in the wholesale business and new store openings to achieve to the original full-year plan of 95-100 retail locations. [p.2]

This also highlights another issue, retail sales did disappoint a bit, due to delay in new store/counter openings. But management expects this to be remedied in the fourth quarter.

• Retail sales of $9.7 million fell short of our $12.7 million estimate, due to delays in new store/counter openings. Net new counter openings were eight, compared with our estimate of 15, due in part to delays associated with preparations for the Golden Week. A higher percentage of retail sales were from gold (rather than higher-margin platinum or studded jewelry), which drove a lower-than-expected retail gross margin of 22.6%, below our 34% estimate. Management maintained its full-year guidance of 95-100 new store openings and also expects product mix shift in the fourth quarter to higher-margin products.[p.2]

We conclude:

1. If ODM turns out to be a trend, it will turn a present (perceived) negative into a big positive
2. We think the negativity (ODM being a one-off) has been more than discounted in the shareprice, and we continue to be bullish on the medium term.