Abnormally High Margins

Who doesn't like a high-margin business? Theoretically, the higher the margins, the better the business. However, it might also be a warning sign.

When a company is enjoying a much higher margin than its peers, we need to find out the reason behind it. The company might have good reasons for its higher margin, such as serving a very niche market or having some special technology or process unknown to its peers.

However, if you cannot seem to find any apparent advantage the company has for enjoying such a wide margin, things might be too good to be true. After all, if the company is not operationally superior to its competitors, its margins should not be too different. At the end of the day, businesses with the same capital outlay, customers, suppliers, workforce and selling price should have similar profit margins as well.

We refer to a 2012 report by Anonymous Analytics on Huabao International Holdings Limited (“Huabao International”) titled “Smoke and Mirrors”.²

In their analysis, Huabao International was detailed as China's largest flavour and fragrance company, supplying fragrances to food and beverages, cosmetics, detergent and tobacco products, with the highest gross margins (upwards of 70%) compared to its peers (in the range of 40–50%). This was in the absence of any notable advantage of Huabao compared to its peers. Additionally, Huabao International was also one of the lowest spenders in research and development as a percentage of revenue compared to its peers.

Yet, Huabao International had been experiencing the fastest growth in the industry.³ So Huabao is a company that spent little on research and development, but still managed to generate the fastest growth and highest margins in the industry. From Anonymous Analytics’ perspective, this story did not seem to add up.

Trade Receivables Growing Faster than Revenue

Investors must understand that there is a timing difference between when a sale is recorded on the income statement, when the cash is actually collected, and when the inflow is recorded in the cash flow statement. Or as Alfred Rappaport, the author of Creating Shareholder Value: A Guide for Managers and Investors, says, “Remember, cash is a fact, profit is an opinion.”

For most companies, business is done by giving out credit to customers, so the cash might only be received some time after the revenue has already been booked. This gap between recording the revenue and receiving the cash flow is recorded as trade receivables – nothing uncommon about that.

Generally, it is also perfectly normal for businesses to report an increase in trade receivables with an increase in revenue. As a company generates more sales, it is reasonable to expect a corresponding increase in trade receivables. However, we should start taking notice when trade receivables increase at a much higher rate than revenue growth. Why? Because this could mean that the company might be:

• having a poor credit control
• facing tougher times in the industry (compared with peers)
• giving laxer credit terms to customers to boost revenue.

For this chapter, we can use the top players in the China sportswear industry back in 2010 as an example. Although China has many local sport brands, Hong Kong-listed Li Ning Co Limited (“Li Ning”) and Anta Sports Products Limited (“Anta Sports”) stood out as two of the key players in the industry.

In 2010, both companies were still recording good revenue growth. However, their rates of increase in trade receivables were foreshadowing issues that the sportswear industry might be in for.

• Li Ning: Revenue: ↑ 13%; Trade receivables: ↑ 51%⁴
• Anta Sports: Revenue: ↑ 26%; Trade receivables: ↑ 82%.⁵

The data implied that the growth in revenue was questionable. The two companies, or maybe even the entire industry, might be faced with an oversupply issue.⁶ Products are being pushed to the retailers but the retailers are either unable to sell the product or requiring longer credit terms from the brand owners. In short, things are not looking good, and typically trouble does not travel alone. We could spot other warning signs during this period in the Chinese sportswear industry. Aggressive marketing by many retailers was a common sight. Examples are the “Buy one, get one free” offers or “Buy one, donate one” offers that many retailers used during that period.⁷

Another tell-tale sign comes from the impairment or write-off of trade receivables. As trade receivables represent cash supposed to be received from an earlier sale, a write-off meant that that sale had literally vanished into thin air. If it was a one-time event and the impairment made up only a small portion of the company's trade receivables, we need not be too worried about it. However, if it happens too often, it might be a red flag to take notice of.

In the case of Singapore-listed InnoPac Holdings Limited (“InnoPac”), it was more than a one-off case. Between 2014 and 2015, InnoPac reported impairment charges of S$29.5 million (2015) and S$26.7 million (2014), while only recording revenue of S$817,000 and S$330,000 respectively. Its impairment in 2015 was over 97% of its gross trade receivables⁸. Side note: This contributed towards a qualified opinion from its auditor for 2015.

Inventory Growing Faster than Revenue

This red flag might be easier to spot for industries with bricks and mortar operations, compared to software or service companies. This is because a company that manufactures or sells physical goods needs to record an inventory on its balance sheet. For example, a retailer needs to keep track of its inventory at a particular point, and the direction that its inventory level is going in compared to its revenue will tell us a lot about the business. The consumer goods industry is a perfect industry to explain this concept.

Let's take an apparel retailer as an example. To make money, it must sell clothes; hence clothes are its inventory. Similar to our discussion on trade receivables, inventory should generally be growing in tandem with its revenue. Additionally, if finished goods are increased at a higher rate than the overall inventory level, it indicates that the company might be stuck with old products. In this business, inventory is not like wine; it doesn't get better with age.

One such example is Hong Kong-listed Bossini International Holdings Limited (“Bossini”). In 2011, Bossini's inventory level went up 37% to HK$412 million, of which its finished goods increased by HK$108 million to HK$405 million. In the same period, its revenue only rose by 15%.⁹

Another metric we can watch is its inventory turnover days. This is basically a gauge of the time required for a company to turn over one cycle of its inventory. This gives us an idea of how fast a company turns its inventory into cash. And, of course, the faster the better.

Since 2005, Bossini's inventory turnover days gradually increased from 71 days to 2011's 101 days.^10,11

Consistent Excessive Fair Value Gains

Fair value is an accounting gain that companies might need to record due to accounting standards. By itself, fair value gains are not inherently a negative thing. Fair value gain allows a company to restate its legacy assets at current market value instead of them remaining at cost. This allows investors to have a clearer understanding of the true value of the assets in a company. For example, Singapore-listed Haw Par Corporation Limited (“Haw Par”) holds long-term investments, mostly in its related company, United Overseas Bank Limited. From its 2004 annual report, these investments were booked at just S$311 million on its balance sheet. Yet, just by turning a few pages to Haw Par's notes to the financial statements, we would discover that these investments had a market value of S$761 million back in 2004.¹² In 2015, these investments were reflected at fair value on Haw Par's balance sheet.¹³ Valuation of marketable securities is relatively easily justified and restating it gives investors a good sense of the current worth of the company. This is fair value used appropriately.

However, for certain illiquid assets, the estimation of fair value can be rather subjective. What we mean by subjective is that these estimations might be dependent on management's assumptions. Things might not be that simple for other cases; fair value accounting might be involved with assets with more ambiguous valuations – especially for biological assets if no intermediate market exists during its growth stage. Think immature crops and livestock like pineapples, oil palms, rubber trees, poultry, cows and not forgetting abalones! Per accounting standards, these need to be valued on the balance sheet and yet the valuation of these items is hugely dependent on the assumptions that management made.

Therefore, fair value gains of certain illiquid assets might not be very useful for an investor. And if these gains consistently contribute to a large portion of the overall profitability of a company, we as investors should be cautious when analysing such companies.

Apart from biological assets, a common class of asset that appears with fair value gains is property. Property revaluation can also be subject to some assumptions from the management. Most notably, the discount rate, known as the cap rate, used to value a property can be subject to management's discretion. A lower cap rate will result in a higher value for the property. It is important for investors to know the assumptions of the management when they are recording fair value gain items. Moreover, some properties might not be up for sale by the company. In such cases, the fair value gain of the property might not be that important to an investor as compared to the actual net revenue coming from the property.

Companies in a Dilutive Mood

One way a dilution happens is when a company issues new shares to fund its expansion. The company might have spotted an awesome investment opportunity and require more funds to grow the business. If the company manages to put your new funds to good use in growing the business, and if existing shareholders have an equal opportunity, why not?

But what if the benefit from the expansion was not for existing shareholder and it also did not justify the cost of issuing new shares?

Here we have Company A in Year 1 with:

• Revenue: US$1.0 billion
• Net income: US$100 million
• Shares outstanding: 100 million
• Earnings per share: US$1.00
• Current price-to-earnings ratio (P/E): 10
• Share price of the company: US$10.00
• Value of the company: US$1.0 billion

If this company A decided to raise another US$1.0 billion at current valuation, it would be issuing another 100 million shares to new investors. With this equity injection, the value of the company would stand at US$2.0 billion. To illustrate a case where the cost outweighs the benefit, let us assume that the additional funds allowed the company to expand and grow its revenue and net income by 50% in the next year.

Now, Company A in Year 2 reports:

• Revenue: US$1.5 billion
• Net income: US$150 million
• Shares outstanding: 200 million
• Earnings per share: US$0.75
• Current price-to-earnings ratio (P/E): 10
• Share price of the company: US$7.50
• Value of the company: US$1.5 billion

In this case, although the company had grown by 50%, the end result for the shareholder is a negative 25% loss. This means that the growth of the company has not justified the cost of the additional share issuance, thus resulting in dilution to its existing shareholders. This is an important concept for investors to understand. Not all growth is created equal.

In the six-year period between 2010 and 2015, Singapore-listed Innopac Holdings Limited's (“Innopac”) shares outstanding increased from 1.4 billion (2010) to 4.4 billion (2015) – a 204% increase!^14,15 Also, back in 2014, Innopac proposed the issuance of two rights shares for every one existing ordinary share, totalling 6.9 billion rights shares, and up to 3.5 billion free warrants, with each warrant carrying the right to subscribe for one new share.¹⁶ The company would need considerable growth to justify the degree of this equity financing.

Yet, in the same period, Innopac hardly generated any free cash flow. Instead of growth, revenue fell drastically, resulting in sizeable losses.¹⁷ Even after tapping shareholders for capital, Shareholders’ equity tumbled 66%, from S$44 million (2010) to S$15 million (2015).

Even after tapping shareholders for capital, Shareholders' equity tumbled 66%, from S$44 million (2010) to S$15 million (2015). In summary, it could be described as paying more for a shrinking pie.

Leverage – The Double-Edged Sword

Debt is a double-edged sword – one which could make or break a company. On the one hand, leverage can increase a company's return on equity (ROE). Based on the DuPont formula, return on equity of a company is:

Intuitively, if a company takes on more and more debt, its leverage would increase, and, holding all else constant, this should generate a higher ROE for the company. However, things are not always so straightforward; with great debt comes great risks. If things go south, the company could even end up being unable to service their interest payments, leaving the company in a vicious spiral of debt.

The degree of leverage that might be considered safe depends largely on both the industry and the nature of business. For example, utility companies with a steady demand for their services tend to employ leverage to boost returns. However, the debt level must still be manageable for the company. The key word is “manageable”. Companies with manageable debt levels might not necessarily be that bad a thing.

The interest coverage ratio shows us how many times a company's operating profit covers its annual interest expenses. A company with an interest coverage ratio of just one time means that it is spending 100% of its operating profit just to service its loans. From our experience, we consider a company with an interest coverage ratio of five times as conservative (in a good way).

Commodity-linked companies, on the other hand, might need a higher margin of safety when it comes to debt management. In the commodity world, when it rains, it pours. Given that most commodity-linked companies have very limited pricing power, if they are caught during a downturn in their sector with a highly leveraged balance sheet, it might lead to disaster. A case in point is Korea-listed Hanjin Shipping Co., Limited (“Hanjin”). The company had a net debt to equity of 6.7 times. More importantly, in 2015, the company's net finance costs of KRW28 billion alone were more than its operating income of KRW21 billion.¹⁸ Thus the company had operating income that was not even enough to cover its interest payments, contributing towards their eventual bankruptcy.¹⁹

Singapore-listed Del Monte Pacific Limited (“Del Monte Pacific”) is also a great example when it comes to leverage management. The current company structure came into effect after a reverse merger (smaller company acquiring larger company). In 2014, Del Monte Pacific acquired US Del Monte Foods, Inc (separate company) from private equity firm, KKR & Co, for US$1.65 billion. With this, Del Monte Pacific quadrupled their revenue to US$2.2 billion.²⁰

However, how did Del Monte Pacific, a company with a pre-acquisition shareholders' equity of just US$231 million, pull off such a large acquisition?²¹

Simple: the answer is debt, a whole lot of debt. From total borrowings of US$0.3 billion in 2013, Del Monte Pacific's total borrowings in 2015 went up by over six times to US$1.7 billion. In perspective, this is in comparison to a market cap of just US$0.4 billion during that period.

In theory, this strategy, more commonly known as a leveraged buy-out, is simple:

• A company uses debt to acquire cash flow-generative business.
• This company then uses the cash flow generated from the new business to pay down debt.
• The company ends up owning a new business without a huge investment from its shareholders.

The saying goes, “In theory there is no difference between theory and practice. In practice, there is.” Del Monte Pacific's underlying idea still made sense and, if given time (and some luck, as with most things in life), it could work out in the company's favour. Yet, as with all issues associated with debt, it reduces the margin of error a company can tolerate. Everything would have to go according to plan for the company to generate that return. If something happens that throws a spanner into the works, it could very easily lead to a vicious cycle. From the looks of both its income statements and statements of cash flows in 2016, it appears that a significant portion went towards servicing their loans. The company had an interest coverage ratio of 1.7 times in 2016.

If there is any reduction in profitability or cash flow from the business, management might need to either (1) dilute shareholders and raise more funds, (2) borrow more or, in the worst-case scenario, (3) declare bankruptcy. All the above hold significant risks to its shareholders.

Seemingly Unnecessary Borrowings

This can be simplified to the question of, “Is the cash really there?”

We tend to assume that cash is fungible: $1 of cash = $1. Moreover, many investors also assume that auditors can easily verify cash balances through a simple bank statement. However, is this as foolproof as it seems?

Most of the time, we don't see much of a need to ask much questions about a company's reported cash values. But there are instances that led us to question the reported value of the company's cash balance. Our earlier case study of Singapore-listed Eratat Lifestyle Limited (“Eratat Lifestyle”) comes to mind.

Back in 2012, Eratat Lifestyle traded close to their net cash (less total liabilities) level of RMB283 million (about S$57 million) or S$0.12 per share. To place things in perspective, Eratat Lifestyle's shareholders' equity was RMB949 million, indicating that the company was only trading at 0.3 times its book value.²² In its Q1 2013 report, even with a huge cash balance on its book, Eratat Lifestyle issued a RMB103 million bond with an effective interest rate of about 17%²³ (Hint: this was expensive).

Why would a company with an extremely strong balance sheet raise a bond at such a high interest rate (in a low interest-rate environment), when it is still profitable? Why would they need to do that? We could not arrive at a logical explanation for this action. Unless for some reason, its cash position wasn't where it was supposed to be.

In 2014, our suspicions became reality. Eratat Lifestyle was suspended after defaulting on their bond interest payments. This is a company with RMB584 million in cash, and yet could not even afford to pay its bonds' semi-annual interest of just RMB8 million.²⁴

As we mentioned before, red flags very rarely travel alone. As we like to say, red flags are social animals – they like gathering together. In Eratat Lifestyle's case, we also found out that the company's trade receivables were over 50% of revenue – implying it took more than half a year to collect cash from customers.²⁵ That is an extremely high figure and one that does not bode well no matter how you see it.

Shortly after defaulting on their bond, both Eratat Lifestyle's shares and CEO were suspended.²⁶ A short while later, the Chief Financial Officer (interim Chief Executive Officer) also resigned.²⁷ Ironically, the company was awarded with a corporate governance award just two months before this news went public.²⁸ This is a cautionary tale to investors that it is important to do our own research instead of relying too much on the opinions of others.

Massive Reshuffling of the Company's Officers

When we talk about company's officers we are referring to its directors, executives (Chief Executive Officer, Chief Finance Officer and key management) and the company secretary. It is part and parcel for personnel changes in a company, it is part of a natural succession process. However, when we see a massive exodus of the company's management, or even the auditors (before their term is up), it might be a sign of trouble within the company that warrants deeper research.

Here is one such example. This is what took place at Hong Kong-listed Chaoda Modern Agriculture (Holdings) Limited between 2003 and 2007:

• 2003: Auditor PricewaterhouseCoopers resigned²⁹
• 2003: Independent Director resigned³⁰
• 2004: Executive Director (co-founder) resigned³¹
• 2005: Executive Director resigned³²
• 2005: Chief Finance Officer resigned³³
• 2006: Company secretary resigned³⁴
• 2007 Auditors Baker Tilly Hong Kong Limited and CCIF CPA Limited resigned.³⁵

Subsequently, the company was targeted by Anonymous Analytics. Anonymous Analytics released a report 11 Years of Deceit and Corporate Fraud.³⁶

Infamous Directors and Major Shareholders

We know that most major shareholders have considerable influence over a company. How about its directors?

The directors are the ones setting the direction and policies for the company. We think that is pretty important too. Hence directors with a good reputation on the company's board are always welcomed.

On the flip side, investors invested in companies where their directors or major shareholders do not have that great a reputation might find themselves in a different position. Therefore, we should investigate the directors and/or major shareholders on the companies we are interested in. Note: Major shareholders also include corporates.

Some points to look out for are directors and major shareholders:

• that are consistently making seemingly value-destructive moves
• that are repeatedly on the board of other companies that have been suspended or delisted
• who do not have a good reputation
• with frequent regulatory brushes
• that overpay themselves despite poor performance in the company.

When Things Vanish into Thin Air

When it comes to vanishing financial documents, it seems like fires and grand theft auto are the way to go. This puts the “dog ate my homework” reason to shame.

Just a week after the auditor flagged certain discrepancies in their invoices, there was a fire at Singapore-listed Sino Techfibre Limited's office and administrative premises in the early hours of the morning. In the company's statement, the fire “destroyed the Company's books and financial records which were kept in the affected office premise”.³⁷

In another case, in the middle of a forensic audit ordered by regulators, Hong Kong-listed China Animal Healthcare Limited (“China Animal Healthcare”) had their lorry stolen while the driver was having lunch. You might ask, “What was so special about this truck?” It just so happened that this very truck was carrying five years' worth of the China Animal Healthcare's original financial documents. Interestingly, a week later, the truck was found. However, the documents were nowhere to be found.³⁸ In most vehicle thefts, you would expect the truck to be the main target. Maybe not this time.

Substantial Shareholder Divesting Significantly

When shareholders divest their shareholdings, it can be for a variety of legitimate reasons. In our opinion, substantial shareholders paring down part of their stake is not that big of a deal – it happens all the time. But if the quantum is significant, then something might be up.

A general rule of thumb is that when a major shareholder starts selling down its stake fast, especially in the open market and without a logical reason, it might be worth taking note of.

Significant Related Party Transactions

Like leverage, related party transactions on their own are not necessarily negative – as long as they are properly disclosed and the deal is fair. As a matter of fact, we think that, if done properly, related party transactions can be a good thing – the company can get better terms compared to those out in the market. In addition, we also should not be too concerned if the amount of these transactions is not that significant to the company as a whole.

But if related party sales take up over 50% of your sales, it should be a significant deal worth investigating. As Singapore-listed Kingboard Copper Foil Holdings Limited (“Kingboard Copper Foil”) was recently in the spotlight, let us explore the issues that its shareholders are concerned about. In their 1999 IPO prospectus, it was highlighted that Kingboard Copper Foil sold the majority of their copper foils to the Kingboard Group, at discounts ranging from 5% to 30%. This meant that almost all Kingboard Copper Foil's income came from their parent. In the same document, Kingboard Copper Foil also mentioned that they were looking to diversify their customer base.³⁹ Fast forward to FY2010, and Kingboard Copper Foil's sales to their parent group still made up 89% of revenue.⁴⁰ In other words, Kingboard Copper Foil was a captive manufacturer with little ability to raise prices and serving only its parent company.

What made some minority shareholders concerned was the alleged negative impact on the company's profit margins. This led to certain shareholders voting down the renewal of the interested party transaction mandate, risking almost all of Kingboard Copper Foil's revenue.⁴¹

When Taxi Drivers Become Your Portfolio Advisor

APS Asset Management is one of the largest and most successful fund management companies in Singapore. During an interview, Wong Kok Hoi of APS Asset Management Private Limited once mentioned that during a business trip in Switzerland, a taxi driver started to brag to him about his Japanese stocks' performance. That was the point when Mr Wong decided that the market had gone too far. Shortly after, the fund manager unloaded most of his Japanese stocks. Just weeks later in December 1989, the market crashed.⁴² Is that coincidence? It might be. Or is it?

The key takeaway is not to blindly follow the crowd. When the man on the street is freely providing you with stock tips, it might just be the sign to head for the exit.

Innovative Business Deals

When a company starts using customised business deals to boost income, it is worth taking note of. For example, in 2016 an operator of one of the largest number of dairy farms in China sold about a quarter of their cows. Although this was operationally significant, it was not the issue which made us do a double take. What was so special was that they were leasing them back in a sale and leaseback agreement.⁴³ I am sure that we have heard sale and leaseback deals that involving property. But cows? Now that's a first. This brings a whole new meaning to the term “cash cows”. Analysts commented that it was not very common to use cows as collateral. We agree.

Viewed financially, the deal helped the company to lower their debt levels considerably. However, this type of off-balance sheet financing model might be more about financial window dressing than effecting any real improvements in operation. Side note: We are more interested to find out more about the party that bought all of their 50,000 cows!

If you are interested to know more about financial irregularities, we highly recommend Tan Chin Hwee and Thomas R. Robinson's Asian Financial Statement Analysis.⁴⁴

Table 7.1 shows a checklist of the red flags covered in this chapter.