The following article first appeared as part of a longer article in the 30 September 2011 investment newsletter of Lighthouse Advisors. It has been updated and edited for a wider audience. Those who wish to investigate the companies discussed should refer to the individual companies’ announcements for relevant information.
No part of this foreword or the article below is to be construed as investment advice. The article is reproduced for informational purposes only, and the author accepts no responsibility for any inferences drawn or actions taken as a result of the article. Any opinions expressed therein are the personal views of the author and do not constitute a professional opinion for any purposes whatsoever. At the time of writing, Lighthouse Advisors is a “long-only” fund manager and holds no long or short interest in any of the companies discussed.
Benjamin Koh
Investment Manager
Lighthouse Advisors
24 November 2011
In theory, cash is the simplest asset of all and the hardest to fake. After all, one can just check the bank account. But company directors do not always do so. It is common practice to assume that the accounts, as presented, are “true and fair” unless proven otherwise.
Some examples of disappearing cash may help drive home the point.
China Gaoxian Fibre Fabric was listed on the SGX in September 2009, raising $78.2m. In January 2011, it had a second listing in Korea, this time raising $223.8m. Two months later, its auditors Ernst & Young reported that it “could not verify nor confirm the bank balances in the Company’s subsidiaries”. Trading in the shares was halted, and the auditors were tasked with an expanded scope of audit. In the meantime, the company has made a full provision of the missing cash, and its 2010 annual report shows an “extraordinary loss” of RMB 980m.
What does China Gaoxian do, anyway? Its IPO prospectus says they are “principally engaged in the production and sale of premium differentiated fine polyester yarn and warp knit fabric.” Among their products are fully-drawn yarn (FDY), drawn textured yarn (DTY), blended polyester yarn, triangular fibre yarn and warp knit fabric.
Hongwei Technologies listed on SGX in October 2005, raising $8.6m. In May 2007 it issued new shares for $10.9m, and in September 2010 it did another placement, for $4.2m. On 26 February 2011, its auditor Ernst & Young reported “issues pertaining to the cash and bank balances confirmation in its subsidiary company in China”.
KPMG was tasked to do a special audit, and its audit report released on 21 October 2011 reported that over 99% of the purported cash on the balance sheet was simply gone. The evidence KPMG uncovered strongly suggested the company had forged bank statements and tax invoices, and had made unauthorized loans to suppliers, one of which was majority-owned by the father of one of the executive directors.
What does Hongwei do? The IPO prospectus says they “manufacture and sell polyester differential fibre”. The principal products are: polyester differential pre-oriented yarn (POY), and drawn and textured yarn (DTY). This sounds a lot like China Gaoxian.
Were there hints that China Gaoxian and Hongwei’s cash might not be there? Yes. The biggest hints came from the income statements. Not just those of China Gaoxian and Hongwei, but also those of other synthetic fibre producers, specifically, China Sky Chemical Fibre and Li Heng Chemical Fibre.
China Sky and Li Heng are nylon manufacturers. Nylon, like polyester, is a synthetic fibre made from hydrocarbons, usually crude oil. Nylon and polyester are chemically different, but have similar properties and end up in similar products, namely textiles. Apparel companies typically use both nylon and polyester for use in various fabrics across their product ranges.
China Sky claims that it manufactures “four types of high-end chemical fibre (nylon) products, namely: Full Drawn Yarn (FDY), High Oriented Yarn (HOY), Air Textured Yarn (ATY) and Drawn Textured Yarn (DTY).” These sound very similar to Hongwei and China Gaoxian, even if they are made from nylon instead of polyester.
Li Heng’s IPO prospectus says they make Partially Oriented Yarn (POY), Highly Oriented Yarn (HOY), Fully Drawn Yarn (FDY) and Drawn Textured Yarn (DTY). It is China Sky’s virtual twin, and is at least a close cousin of China Gaoxian and Hongwei.
Given similar equipment, similar raw materials, similar products and similar customers, both polyester and nylon manufacturing should give similar economic results. Differences should be attributable to economics of scale in raw material purchasing, and the final price point of the product. Nylon is generally regarded as superior to polyester, and commands a higher selling price.
So the basic premise is that all four companies should have broadly similar margins, with advantages for the larger producers and the nylon producers. Importantly, changes in supply and demand in the textile market should affect all four companies similarly. Here is where the clues emerge.
In 2009, both China Sky and Li Heng reported steep declines in revenues and gross margins. China Sky’s sales fell 43%. It blamed lower sales and high fixed costs for the gross margin declining from 30.9% to just 4.7%. Average selling prices (ASP) dropped 43.2%.
Li Heng’s story was similar: sales dropped 46%, and gross margin went from 28.7% to 12.6%. It blamed the slowdown in the global economy for pricing pressure. ASP fell 37.3%.
What about China Gaoxian and Hongwei?
China Gaoxian’s sales fell just 1%. It reported higher gross margins in 2009, at 31.8% versus 30.4% in 2008. It also had higher net margins; 22.6% against 21.3% the year before. ASP fell only about 10%.
Hongwei’s sales fell 18%. Gross margins went from 30.4% to 25.5%. ASP fell about 18%.
From the viewpoint of apparel companies, nylon and polyester are interchangeable; retail customers don’t care. While the two materials are chemically different, their properties are similar enough that clothing can be designed to use one or the other, or both. If the price differential is large, it is not difficult to change the mix to use more of the cheaper material.
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It is therefore amazing that the nylon companies suffered so badly, while the polyester makers were only slightly affected. Logically, all four companies should have suffered together. Apparel companies would have surely taken advantage of the 40% decline in nylon prices to use more nylon, or to force polyester makers to cut prices severely too.
With this as background, the simplest answer to the conundrum of China Gaoxian and Hongwei is that their 2009 income statements were fake. Fake sales generate fake profits, which show up as fake cash on the balance sheet. So of course the auditors could not find the cash, since it was never there to begin with. This could have been deduced in early 2010, when the 2009 results were announced, so investors could have sold out one year before the auditors announced the issues.