After a period of consolidation that have taken the stock some 60% lower, it seems to us that the “bad” news (if any) is more than priced in, while there is plenty of good news..

Fuqi International is a rapidly growing Chinese designer, wholesaler and retailer of gold and jewlery based in Shenzhen. Wholesale is still by far the most important part of it’s revenues (90%), but it’s rapidly growing in retail, which carries much higher margins. To expand that business, the company placed 5.58M shares at $21.5 in a stock offering in late July 2009.

It’s retail business grew from 3% of revenue (2008) to 9.9% of revenue in the first half of 2009, no doubt helped by it’s acquisition of Temix in August 2008 (for $19.7M in cash and restricted stock representing 6-7x net income and 3-4x EBITDA). As of June 30, 2009, the company had 64 retail counters, including 50 under the Temix brand and 14 under the FUQI brand, and a total of seven retail stores, which are all under the Temix brand.[Oppenheimer]

Good news:

1. Chinese economy and jewlery spending are growing at a brisk pace and doesn’t seem to slow any time soon
2. Fuqi’s track record: growing considerably faster than the jewlery market
3. Strategy of expanding business in higher margin activities, like retail and ODM (original design manufacturing) seems to be paying off already and has a long way to go still
4. The metrics are very impressive, the company with this kind of growth profile has a 2009 p/e of less than 10 and is even cheaper measured against next year’s expected earnings and a (five year) PEG ratio of just 0.33. Total cash is $173M while total outstanding debt is only $48.3M (on revenue of $466.9M and net income of $48M)
5. Insiders own nearly 60% of the company.

Let’s put a little meat on this:

1) Market growth

• 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. [Oppenheimer]
• According to KPMG, China’s luxury brand consumption reached $6 billion in 2004, accounting for 12% of the world’s total luxury consumption (after Japan and the US, at 41% and 17%, respectively) and was projected to top $11.5 billion in 2015, surpassing all countries to become the biggest consumer of luxury products with nearly 30% of global share. Meanwhile, jewelry is one of China’s largest consumption categories, closely following real estate and cars. The Chinese market is the second largest for gold jewelry and the largest for platinum jewelry in the world, as well as one of the largest diamond consumer markets alongside the US and Japan. China’s jewelry market is estimated by Global Industry Analysis to reach $18 billion in 2010. National statistics provided by the government have shown annual growth in jewelry sales of 17%, 25%, 38% and 44% in 2004 to 2007, before a slowdown to 6% in 2008 due to the weak economy.[Oppenheimer]
• Having just visited China, the thing that jumped out at me was that the real trend is simple demographics. The big takeaway of my trip is that I’m convinced of the power of the emerging middle class, and that China’s economy will eventually become much more consumer-oriented. I’m in good company — McKinsey estimates that the middle class will grow from 43% of China’s population in 2008 to 76% by 2025. That’s a lot of new consumers. [Tom Winner]
• Fuqi says young Chinese have bought into Western consumerism more than their older counterparts have, and are more easily lured by flash and glitz. That gives the company a target demographic to build its growing business around[Rich Duprey].

The excellent Oppenheimer report has a lot more information on the growth of the middle class and spending, drivers behind the market boom in jewlery. If anything, the slowdown in growth in 2008 and early 2009 might already be behind us. There is also a wealth of information on that report on the attributions of the market and Fuqi’s positioning in it.

2) Fuqi’s track record

• Revenue growth the last three years has been a rather phenomenal 74.2%
• Fuqi is one of China’s largest nationwide wholesalers of jewelry. The company has an established track record as evidenced by its consistent profitability, attractive returns on invested capital, and ability to produce over 3,500 styles per year. Competencies in design, manufacturing, sales and distribution have enabled Fuqi to outperform in good and bad economies and fend off thousands of small competitors. Despite China’s economic slowdown, Fuqi was able to grow its wholesale revenues by 147% and 32% y/y in 2008 and 1H09, respectively, when numerous competitors closed in the same period. Moreover, with an established distribution network covering eight provinces, we believe Fuqi is on track to gain share and grow faster than the sector over the foreseeable future.[Oppenheimer]

3) Strategy expanding margins

• Fuqi’s retail expansion strategy could lead to improved returns, higher margins, and brand development. Fuqi’s growth strategy is to become a vertically integrated jewelry company to achieve margin improvement and brand recognition. Growing out of a leading jewelry manufacturer and wholesaler, Fuqi’s strong design and manufacturing capability could provide competitive advantage for its emerging retail brands and stores. Fuqi’s vertical integration provides cost advantages and flexibility in merchandising, which potentially should enable its Fuqi and Temix brands to compete more effectively with existing retailers. Currently, management expects to reach 100 retail locations by year-end from 70 at 2Q09. Based on operating results to date, we believe the company is on track to improve its margins as its retail business mix increases.[Oppenheimer]
• FUQI believes that its wholesale business will facilitate its expansion plans in retail as very few retailers have a well-established wholesale platform.[Oppenheimer]

4) Metrics

• 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.[Oppenheimer]

One might also want to compare Fuqi’s valuation metrics with other companies in the sector, this is provided by Wisco Research (p.4). Fuqi comes off as particularly favourably valued compared to both domestic and foreign Jewlery companies, even more so if one takes Fuqi’s generally much faster growth and clean balance sheet into consideration as well.

5) Insider holdings

• we believe management’s interest is well aligned with investors’ as Fuqi has significant insider holdings. Following the recent $100 million follow-on offering, the company’s officers and directors as a group own an aggregate of 48% of total outstanding shares, including 42% owned by chairman and CEO, Mr. Yu Kwai Chong.[Oppenheimer]

Sell-off?
The company had a very large positive earnings surprise in the last quarter (eps was 72 cents versus consensus expectations of 44 cents, and just 31 cents in Q308!) and upped it’s guidance for the last quarter, as well as the whole of 2009 (to $2.21-$2.27). If that didn’t get investors happy, they also expect 2010 wholesale revenue to grow at least 25% while retail revenue is expected to increase at least 50% in 2010.

However, its shares, which had already come back from the high’s in the 30s, sold off sharply and have been in a funk ever since. On first sight, that doesn’t make sense, so we digged deeper into this paradox.

We managed to acquire four recent research reports (available here) and have been meticulously studied these in order to come up with any rational explanation for this seeming paradox. Even more curious is the large short position (47% of the float), so we zoomed into anything that could possibly be negative to assess its seriousness. This is what we found.

1. Negative cashflow
2. Wholesales ex-ODM missed projections
3. ODM business a one-off?
4. Retail sales didn’t get off to a flying start
5. Gold price

Let’s discuss these.

1) Negative cashflow
Investments predate returns for companies expanding as rapidly as Fuqi has. Rising material cost (gold) further ties down cash-flow, so we’re not overly alarmed here.

2) Wholesales ex ODM missed projections
According to Wisco Research:

• Revenue of $127 million fell below our $131 million estimate because of a political issue that hindered sales at the end of September. 2009 was the 60th year anniversary of China’s National Holiday and the government didn’t allow jewelry sales for several days before the Oct. 1st holiday on the security concerns, which means FUQI was not able to deliver products and record revenues during that period.

According to William Blair & Co.:

• 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%.[p.2]

So, ODM saved the day and more than compensated for the closing down during the quarter for political reasons. The market apparently took this as a negative, but that seems odd to us. These are two one-offs, perhaps, or not. The closing down certainly is a one-off, but is the ODM business? If it’s not, instead of a negative, this should have been interpreted as a positive. Let us explain.

3) ODM business a one-off?
Essentially, the jury is still out on this. First, what is ODM (original design manufacturing)?

• 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. [William Blair & Co. p.2]

How high are these margins, compared to the wholesale business?

• 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.[William Blair & Co. p.2]

Which is why we really have a hard time understanding the following.

• 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]

How can it be lower quality if they carry at least twice the margins of traditional wholesale business? The only way that could possibly be true is if these are a one-off. Is it a one-off?

• 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]

So, managment doesn’t factor in a whole lot of ODM business but nevertheless increased expectations for this year and the next (see above), a sure sign that they expect the disappointing wholesales ex-ODM to be a one-off. What’s more, because margins on ODM are at least twice compared to wholesale, if they become a trend, that would be a huge positive for the stock.

We conclude: the market seems to think that the disappointing wholesales ex-ODM was permanent and the positive ODM surprise a one-off, but it’s much more likely to be exactly the other way around.

4) Retail business disappointed in Q3
One important plank of the strategy towards accelerating growth and margins is to grow a retail business, which carries much higher margins compared to their traditional wholesale business.

• 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.[William Blair & Co. p.2]
• Retail margins below expectations. Retail margins of 22.6% came in below our 31.5% estimate and the 38.0% margin last year. Management attributed this to product mix with more lower-margin platinum products (investing) instead of gold/gemstone products (gift-giving). We expect margins to rebound in 4Q with more gift-giving holidays vs. none in 3Q. [Merriman, Curhan and Ford]

So there were some reasons for last quarter disappointments in retail, but both management and Merriman expect things to pick up in this quarter. As we’ve already shown above, management expects retail to grow at least 50% next year, due to an aggressive expansion.

• The Retail business is making good progress. Currently, FUQI has 72 retail counters. The company plans to have a total of 95-100 retail locations by the end of 2009 and additional 80-100 retail locations in 2010. [Wisco Research p.2]

5) Gold price

• Unexpected volatility and price declines in gold and platinum spot prices could negatively impact Fuqi’s financial performance. 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.[Oppenheimer]

While there has been a pullback in gold prices in the last two weeks, these are still considerably higher than a year ago. Unless one expects gold to crash, this should still be considered a net positive.

Conclusions
We really have a hard time interpreting all this as a negative, therefore. So let us conclude:

1. For a company that’s rapidly expanding and having to purchase raw material at ever higher prices, it’s not a serious problem having negative cash flow.
2. Wholesales disappointed in Q3, but that was a one-off. This is both explained by the forces that produced the disappointment (forced closure because of holidays) as well as management upping expectations for Q4.
3. The ODM business that produced a huge positive earnings surprise could very well be a more permanent feature. Because it’s high margin nature, this could add a significant new driver, we really cannot understand those who argue the ODM business is a negative. At the minimum, it was a one-off and wholesale growth returns to trend. More likely, ODM keeps adding more to the bottom line.
4. The same reasons that produced the one-off disappointing wholesales were partly responsible for the disappointing retail margins as well (as was the product mix). However, management and analyst are pretty convinced this will be (more than) remidied in Q4 and next year.
5. We think that the sell-off from the 30s to the high teens is way overdone.