Financial Shenanigans

[dzwm87]

China Hongxing Sports released their Special Auditor report tonight.

http://info.sgx.com/webcoranncatth.nsf/V...400417B22/$file/Executive_Summary.pdf?openelement

It makes a good read. Probably this can be a good platform for us to discuss on possible "financial shenanigans" and hopefully, we are able to extrapolate it usefully to other listed stocks (which we may have or may not).

Some key notes from the Hongxing saga:
1. Original cash holding (RMB1.4 billion) was understated by an approximate RMB1.15 billion!
..Of this discrepancy, RMB335m was paid to distributors to avoid closure + to incentivise opening of new stores
(Note: Isn't this very very familiar? If a product is truly sellable, why do they need to provide such incentivise. In another perspective: Apple resellers are even willing to suffer low margins just to sell apple products)
..RMB467m due to increase in other receivables to the same distributors.
(Note: An investor always worries about surging trade receivables. Knowing this, a fraudster will not necessarily ramp out A/Rs to make it so obvious. Perhaps, we should pay smiilar attention to other receivables + RPTs as well?)

2. Financial statements consolidation was done mainly from transactions + documents obtained from the CEO's office directly; instead of their respective finance departments. Daily operations were also largely handled & supervised by the CEO's office. Throughout the report, it was continuously being emphasized that autonomy was vested in one single player - the CEO.

3. Some aggregate RMB887m was made for Expansion Expenses - well beyond the designated RMB750m budget & without any prior approval of the CFO. There were also other expenses incurred without any adequate/proper approval (from CFO).

Out of the above 3 pointers, it is hard to distinguish 2 & 3. For 2, it might prove to be good if there is an insider who is working in the company and might have a good sense of how the corporate environment is like. However, an investor can always pick out red flags from pointer 1. And if there are no valid reasons to reason the doubts, it might be better to give the company a miss.

P.S. It might be interesting to take a look at Hongxing's past annual Financial Notes to see if pointer 1 can be flagged out.

[d.o.g.]

While there was no hard proof that Hongxing was cooking its books, there were some red flags:

1. Loans to distributors

Distributors are your direct customers, they are supposed to give you cash, not the other way around. If you have to lend them money it means your products are not selling so they have no cash.

2. Poor dividends

Fantastic profits, no debt, tons of cash, yet the dividend payout ratio was poor.

3. Abnormal sales trend in 2009

2009 was a boom year for the sports shoe industry, everyone reported sales growth except Hongxing, whose sales fell by 1/3. The sports shoe companies are producing commodities - their sales have to go up and down together. Hongxing couldn't keep up. Something was wrong.

4. Ridiculous profit margins

The profit margins were simply not sustainable. Look at Nike and Adidas - they make 6-10% net margins despite having very strong global brands that support the highest prices in the world. Even Li Ning, the strongest Chinese brand, was only making 10-11%. How could a weaker local brand earn 15-20% net?

FWIW the same skepticism about margins applies to ALL the Chinese sports shoe brands. No way they can sustain 15-20% net margins. This year they are finally starting to mean-revert after several years of breakneck expansion and channel stuffing.

For evidence of channel stuffing you need only look at the trade receivables in the year they went IPO - sky high receivables to boost reported sales and profits to help the IPO. And now? They are buying back the stock from their distributors! Li Ning has done it, Dongxiang has done it. Only a matter of time before more follow suit.

Hopefully Hongxing is a good lesson learnt for investors who buy simply because the stock looks cheap - sometimes things are cheap for a reason.

[Big Toe]

Pretty much agree with dog except for the last statement,

*sometimes things are cheap for a reason* when it should read
*almost all the time, things are cheap for a reason, sometimes for more reasons than one*

If investors are naive enough to believe that all companies are honest and work hard so that they are able to repay shareholders,
time to do a reality check. Honest, durable businesses are few and far in between. The art of concealment is getting more advanced and sometimes it is not easy to detect what is going on, the good ones will go undetected for a prolonged period...until something blows up. In this case, hongxing is but an amateur fraudster.

[dzwm87]

Coincidentally, an interesting article from Next Insight:
http://www.nextinsight.com.sg/index.php/...anies-play

[egghead]

This is useful. Thanks dzwm87.

[dzwm87]

On hind sight, things may always seem easy to be pointed out but how do we know what will happen when emotions play a critical role in our decision making call?

I took a look at China Hongxing 2009 AR:
..In FY2008, a whooping RMB1.15bn (!) was used as advances to set up 358 new stores. Given the huge amount, one can start to smell something fishy. Yet, in FY2009, this amount was repaid back by the distributors. Then, another RMB108m was used as a payment on behalf of distributors. At a relatively smaller amount, an (emotionally blind) investor may have new confidence in the company. Since the RMB1.15bn was repaid back, one can simply argue that China HX may in fact truly be helping their distributors.

Let's fast forward to the present:
..In the special audit report, is it me or it's by pure coincidence that the understatement of cash is at approx. RMB1.15bn as well?

My conclusion is that we can never outsmart the mgmt if they intend to commit any fraud. Perhaps, unless we can truly argue a reasonable explanation, it might be better not to bite onto the tempting bait of "cheap valuation".

[CY09]

Maybe we could try our hands at analysing some S-chips and then look for red flags to see if they are potential frauds. Our own "Muddy Waters research" in valuebuddies