If you take a hard look at just about any Chinese RTOs reported finances today, you are liable to end up peering down the rabbit hole and ending up in the world of Alice In Wonderland where nothing is as it seems. In this magical Chinese RTO-land, all the rules of traditional accounting and financial modeling are ignored. In this otherworld, it is normal for companies to generate industry-leading margins and return on invested capital, despite having no special technologies, economies of scale or meaningful competitive advantages. Down here, revenue growth is insanely high; basic principles of capitalism simply don’t apply, and competition never seems to appear to challenge these unbelievably profitable operations. Seemingly anything is possible in Chinese RTO-land.
After spending many months researching this bizarre magical world of Chinese companies, I thought I had lost the power to be surprised. Nothing seemed strange in this mystical land any longer. Somewhere in between the crash of China MediaExpress’ (CCME) magical profit bus, the dark discoveries in Sino-Forest’s (SNOFF.PK) wicked woods, and the trip through China Biotics’ (CHBT.PK) house of mirrors that ended in fake banking websites, I thought I’d seen it all.
But I have been surprised anew. Lihua International (LIWA) may be one of the most preposterous Chinese RTOs yet, and it is jaw-droppingly mispriced by Mr. Market. I cannot begin to describe how much I wish that Lihua International were truly the company it is representing itself as. If Lihua is truly what its SEC filings claim, it is one of the most undervalued stocks in history, and its investors will easily make a five or even tenfold return on their investment. But the market remains skeptical; the current share price shows concern that Lihua’s story may just be another tall tale. Here are six reasons, in addition to the doubts raised by Rick Pearson, Absaroka Capital, Kerrisdale Capital, Chimin Sang and others, why I suspect Lihua will be a disappointing investment for its current shareholders.
Where’s The Competition?
Lihua operates in a brutally competitive commodity industry, and yet it purports to having stable rich profit margins despite the fact that its business provides a relatively small amount of value-added benefit for its customers. Why aren’t competitors falling over backward to compete with Lihua in this incredibly profitable opportunity? I have trouble accepting that Lihua can consistently generate in excess of 10 percent profit margins for creating basic copper products.
This is a low-margin business, and there seems to be no sort of intellectual property or other natural barrier to entry that would keep other entrepreneurs out; even introductory-level economics classes tell you that Lihua would seem never to be able to find an equilibrium at such a high profit margin level for such a basic business, particularly given Lihua's rapid growth rate which ought to add more margin pressure yet. As we have seen in countless Chinese RTO scandals, unnaturally high margins are a key marker of accounting irregularities. If you want to buy Lihua stock, you have to become comfortable with the margin picture; this is something I am unable to do. Unless basic economic principles do not apply in China, the margins just don't add up.
Capital Expenditures
In a normal commodity business, for a company to increase revenues and profit dramatically, it must also increase its capital expenditures significantly. This is only logical; in order to increase output, more production capacity is needed and as machinery wears and tears, replacement equipment must be purchased. Yet Lihua has been able to increase revenue and operating profit at a breathtaking pace without spending materially more money on capital expenditures. The following is a table showing Lihua’s revenues, profit and volume shipped compared with its purchases of PP&E and construction-in-progress (excluding payment for land use rights) over the past five years (Source: Company filings):
Year
PP&E Expenditures
Revenue
Operating Profit
Volume
(Tons Shipped)
2006
$4.9M
$15.7M
$4.5M
2,009
2007
$3.8M
$32.7M
$8.9M
4,065
2008
$4.9M
$50.0M
$14.2M
5,996
2009
$5.1M
$161.5M
$30.5M
24,983
2010
$2.3M
$370.5M
$54.3M
44,712
As you can see, the company appears to be getting something for nothing, as revenue keeps surging without any increase in capital costs. We also know that, based on the company’s own disclosures, its plants have been running near or at capacity for the past several years. In this prospectus from October 2009, for example, the company wrote:
Since our production lines have been running at full capacity for several years we intend to increase the number of production lines to better meet strong customer demand.
So here we have a company “running at full capacity” and not spending meaningful amounts to expand capacity, and yet is increasing sales, volume and profitability by leaps and bounds. This just seems impossible. How could revenue go from $15.7M to $370.5M while the company was consistently at full capacity and not spending much on new machinery or other capital investments?
It just makes no sense. Basic economic principles dictate that for a copper products manufacturing business to increase revenue more than twentyfold and profit more than tenfold, it has to increase spending on plants and equipment. Luckily for Lihua shareholders, Lihua is a special company seemingly immune to this economic law as well.
Over the past five years, Lihua has boosted revenue from $16M to $371M and operating profit from $5M to $54M without investing a meaningful amount into expanding its production capacity. Lihua claims to have generated tons more revenue through existing facilities and its capital expenditures have in fact declined, dropping to a 5-year low of $2.3M in 2010. This is inexplicable.
Production Outages
As demonstrated above, Lihua it seems, has already achieved two economic impossibilities; they can keep margins very high for a commodity business despite maintaining blistering growth in a brutally competitive industry sector. Furthermore, their smelters have the unheard of ability to crank out more product even while receiving less and less capital expenditures to maintain existing capacity or add new capacity. For investors thinking they have found the Holy Grail, it gets even better. Lihua is one of the very few businesses out there who can have its much of its production capacity, it seems, out of service for a nearly four month span without impacting earnings. Incredible!
According to an investor who attended Lihua's Investor Day in May, one of Lihua’s copper rod production lines was out of service on 05/24/11 during the Investor Day at its Danyang facilities. According to the China360 report, during their site visit on July 12-16, both copper rod furnaces were out of service. In addition, one of the anode smelters was also offline. Their follow-up site visit August 3-4 noted that one of the two copper rod furnaces was back in service. This seems to imply there was a three-month period from May until July that no copper rod – and only copper anode -- was produced. And both anode and copper rod output should have been reduced, it would seem, due to the outages noted in China360’s July visit.
You would think that this three-month long outage in producing copper rod – the somewhat higher-margin of Lihua’s two products -- would have a negative impact on Lihua's earnings for their most recent quarterly results. Fortunately, no such negative impact was made as Lihua announced “record quarterly revenue” of $167 million which was more than double versus the same period in the previously year. Lihua is indeed a very rare, special company that can shut down it a product line for months at a time while still being able to produce record quarterly results.
Stock Buyback
You'd think with Lihua's incredible results that insiders would be buying stock hand over first both in their own accounts and through a robust corporate share buyback. But no, Lihua’s current share buyback is laughably small compared with the company’s reported financial statements. The company currently reports $98 million of cash on the books, and is forecast to make another $75 million or more in profits (though free cash flow may be lower, as the company has historically failed to convert much of its profits into free cash flow) next year, and yet it is buying back a mere $15 million of stock over a one-year period? Why would that be? Even more oddly, the company has only repurchased $2.1 million (as of 8/9/11) of stock out of its $15 million plan it does have in place.
With Lihua shares trading at near their lowest levels since right after their RTO-uplisting in 2009, you’d think management would be buying up as much stock as possible. If there was ever a time, that time would be now. The return on investment of a share buyback is incredible, if of course, the reported financials are real. A company earning a 10% profit margin on half a billion dollars a year of revenue and doubling its revenues annually would be worth many multiples of Lihua’s current $193 million market cap. If management is truly running one of the most profitable and fastest-growing businesses of our time, it should be buying back shares aggressively rather than running a pathetic little $2.1 million share buyback.
Global Hunter
Lihua's insiders aren't alone in holding back enthusiasm for Lihua shares. The company has been able to garner few banking relations and little analyst coverage from top firms. Lihua claims to be on the verge of producing a billion dollars a year in revenue. Don’t you think they could get a better financial sponsor than the China RTO-scandal tainted Global Hunter? This is the same Global Hunter that infamously stuck up for China MediaExpress with exhaustive reports even as it was being revealed as a fraud. Global Hunter has been a banker to and/or provider of analyst coverage for numerous Chinese scandal-ridden companies. Why is Lihua so tied to Global Hunter, particularly in spearheading the recent "independent" China 360 report that I discussed previously?
Wall Street falls over backwards to support nearly profitless IPOs like Pandora (P); every banker out there would love to partner with Lihua if it truly were a half billion dollar business that is revolutionizing the copper recycling and basic copper products manufacturing business with its incredible growth rates and surprisingly high margins. I cannot believe that Lihua, if its reported numbers are true, would be incapable of generating fawning analyst coverage from big banks seeking to do business deals with Lihua.
Wall Street has backed numerous small Chinese firms; just in the past few months, we have seen Morgan Stanley (MS) take China Zenix (ZX) public in a fairly small IPO. Even more recently, moderately profitable Chinese company Taomee Holdings (TAOM) publicly IPO’d with big institutional backing. Taomee is a mere $300 million market cap company with far less reported revenue and profits than Lihua, yet it could get Credit Suisse and Deutsche Bank to bookrun its IPO and it has already picked up research coverage from Oppenheimer and Stifel Nicolaus.
Upper tier financial institutions are more than happy to provide financing for even small Chinese firms. If Lihua is a company intent on joining the big leagues – as its soon-to-be billion dollar annual revenue run-rate would indicate – it should get big league financial backers and analyst coverage. Until Lihua gets better institutional backers, its shares will struggle; Global Hunter issued a report reiterating its buy position and attempted to discredit arguments against the company last Thursday, and yet the stock fell several percent upon release of the report. Global Hunter is simply not credible like a top-tier Wall Street backer.
CFO
In my opinion, Yang Roy Yu seems like an odd choice to be CFO of Lihua International, which purports to be on the verge of becoming a billion dollar a year operation within several years. He is 28 years old, and his prior track record includes stints as CFO of Songzai International Holding Group (now US China Mining Group) (SGZH.ob) which is a bulletin-board traded $2 stock, and as an employee at Fushi Copperweld (FSIN), another Chinese RTO. Fushi is particularly interesting because it is supposed to be acquired by Abax Global Capital at $11.50/share. Despite the deal being announced last November, the deal still hasn’t closed, and Fushi shares have slumped to $6/share, indicating the market’s belief that the deal has a good chance of not closing.
It seems strange that Lihua would bring in such an inexperienced CFO whose track record features only two short stints with other questionable Chinese microcaps. Once again, I must question why Lihua is picking inexperienced folks to partner with as it runs an allegedly soon-to-be billion-dollar-a-year business. It makes no sense to not have Goldman Sachs or Morgan Stanley as your providers of financing and research coverage if you’re one of the fastest-growing, highest-margin copper products manufacturing companies in the world. And it makes little sense to hire a relatively inexperienced 28-year-old to be CFO when Lihua reports having the money and business size to attract someone at a higher pay grade and experience level.
Lihua's Story: Full Of Impurities
Lihua International seems at first glance to be a fantastic investment opportunity. Any sort of standard P/E or cash flow analysis would put the company's valuation at many multiples of today's level. But to believe Lihua is worth more than its current stock price, you have to disregard a lot of discordant signs.
For one, the company seems big on paper, yet it inexplicably deals with small-time partners such as Global Hunter and Lihua's own inexperienced CFO. In addition, it is hard to see how Lihua can have shut down production capacity for such a long period without negatively impacting its quarterly results. But most importantly, you have to believe Lihua is capable of defying basic economic principles if you are an investor in its shares. Its margins and its capital expenditures seem – to those of us who have taken even rudimentary economics classes – to be utterly preposterous. I have one question for Lihua shareholders: Do you believe in miracles?