FACTORING WITHOUT RECOURSE: Fooling investors most of the time

Companies which factor are normally trying to present a picture of their financials which is very different from the economic reality. As such, they are incentivised to be less than forthcoming, aided by limited disclosure requirements. How then to evaluate a company when a material portion of its assets have magically disappeared? In this report, we explain how factoring can transform financials and how to spot it. We have scrutinised nearly 400 Asian companies, documenting 163 where there is evidence of factoring and highlight 16 with the largest programmes. Most companies refused to engage with us, highlighting this topic’s sensitivity. Finally, we identify those with the largest factoring programmes that might make for interesting shorts.

Technology One: Growth illusion

Technology One’s growth in the last couple of years has been an illusion. It has used various accounting tricks to pull forward revenue and profits, artificially creating growth and hiding a major slowdown. New rules on revenue recognition in FY19 have left a big hole in TNE’s profits, which it filled by starting to capitalise development costs. However, most of the benefit is from the low initial amortisation charge, which will be a major headwind to profit growth as it increases. Overall, we estimate FY19 profits were inflated by over 200%. In our view, it will be hard for TNE to maintain its target growth of 15% per year.

NEW DOGS, SAME TRICKS: Frauds in 2019

Accounting fraud is on the rise, with 13 confirmed cases globally in 2019, up from seven the year before, prompting a 30% share price decline on average. The abuse of acquisition accounting and aggressive revenue recognition is common, but frauds were dominated by Chinese companies faking their profits and hiding the evidence as fabricated cash. This was originally limited to overseas-listed Chinese companies but now appears to have spread to A-shares. Our Fake Cash Flow model successfully identified these frauds, sometimes many years in advance; an identifiable catalyst was an operating cash flow shortfall in recent reporting periods. We have highlighted seven companies with similar traits within. As for Asian short-sellers, they published 23 reports in 2019, a 35% increase from the year before but returns were negligible. Only where a report prompted a default, investigation or resignation was there a meaningful share price reaction.

CHINA GAS HOLDINGS (384 HK): Pipe dreams

China Gas is busy booking substantial revenue and profits from the addition of rural customers, despite being unable to supply them with gas. The government, which ultimately foots the bill, won’t pay up until this happens, although when exactly remains unclear. In essence, the company is front-loading profits, as evidenced by weak operating cash flow, propped up by rising payables, including short-term bills. This smacks of period-end window dressing. At the same time, capex and debt have increased substantially, although the full impact is hidden by the use of off-balance-sheet financing vehicles classified as joint ventures. Longer term, profits from gas connections are unsustainable, presenting a challenge to profit growth. 

FLAWED COMPASS: Free cash flow metrics misleading investors

Investors are increasingly using free cash flow as a measure of performance; however, there is no standard definition and it is particularly easy to window dress. As a result, commonly used free cash flow measures are often unreliable. For example, (i) acquisitions of subsidiaries can materially understate capex, particularly companies structured with substantial liabilities and the purchase of assets using leases; (ii) the capitalization and then rapid amortisation of intangibles shifts expenses out of operating cash flow - these payments are often ignored in free cash flow measures; (iii) companies are using share-based pay and other non-cash payments to hide costs. Our research highlighted four of the biggest culprits as WiseTech (WTC AU), GDS Holdings (GDS US), iQiyi (IQ US) and Bilibili (BILI US).

CIMIC: Engineering Profits

We estimate CIMIC has inflated profits by around 100% in the last two years through aggressive revenue recognition, acquisition accounting and avoidance of JV losses. A lack of supporting cash flow has been obscured by the increased sale of receivables and reverse factoring of payables. While reported net cash was 69% of equity at YE18, we estimate adjusted net debt-to-equity of 74%. CIMIC’s refusal to provide substantive answers to our questions suggests it has something to hide. Its shares trade on a premium multiple of 19x FY19 consensus earnings.

THE OVERSEAS CHINESE: Top 30 US-listed Chinese Companies

It was all supposed to be so easy: just analyse the 30 largest US-listed Chinese companies and evaluate the risk. Well, it wasn’t. This share class has an unusually high historic track record of fraud and shenanigans, likely stemming from the deliberate avoidance of regulatory oversight through the exploitation of Foreign Private Issuer status. The accounting picture is further muddied by the use of Variable Interest Entities (VIEs) where we suspect there are large undisclosed tax liabilities. These issues are complicated and need explaining, hence the length of this report. Our analysts regarded over 70% of this sample as a high accounting risk, and found multiple examples of shenanigans. The end result is that we could only find three companies that we regarded as low risk, including BeiGene, Autohome and Yum China. Meanwhile, our top shorts focused on those with unrealistic business models and deteriorating expectations, including Bitauto, Pinduoduo and Bilibili.

SMOKE & MIRRORS: Embellishing performance using non-GAAP measures

Accounting standards are designed to make life easy for investors. As such, companies moving away from GAAP measures should be regarded with suspicion. Our review of the 30 largest Chinese domiciled ADRs shows an increasing use of adjusted, vaguely defined and non-GAAP metrics which, in some cases, greatly exaggerates performance. This has likely led to inflated valuations and created a potential shorting opportunity as reality bites. The worst culprits are Bitauto, JD.com, Pinduoduo and Vipshop.

A&G Master Screen

We’re pleased to launch our Accounting & Governance (A&G) Master Screen, a major new addition to our product line-up. This enables users to evaluate portfolio accounting risk, and to search for companies with specific accounting traits. A significant development is the introduction of positive accounting flags, as opposed to negative ones. This will, hopefully, help users find companies with desirable accounting traits, not just problematic ones. The screen has been pre-loaded with over 10,000 companies globallly, based on the latest year-end scores from six of our accounting modules, including Profit Manipulation (Beneish and Montier), Fake Cash Flow, Excess Capital, Acquisition Accounting and Debt Reconciliation. To get started, simply watch the video and download the screen…

CHINESE SPORTSWEAR: Fake or Fabulous?

Nine out of the sixteen Chinese sportswear companies listed since 2005 have turned out to be frauds, all of them from Fujian. Their financials shared a number of characteristics which are rarely exhibited by other listed companies. The most obvious giveaway is that past frauds were more profitable than sector global leaders, such as Nike. Unfortunately, of the seven remaining companies, Anta, Xtep and 361 Degrees share these fraud-like traits, and also come from Fujian. Indeed, Anta’s FY17 operating margin is the third highest ever recorded in the sector; the other nine in the top ten turned out to be frauds. SELL or AVOID all three.

ACCOUNTING RISK: Assessing the top 100 companies in Asia ex-Japan

In assessing the accounting risk at the top 100 companies in Asia ex-Japan, our analysts highlight 36 companies with high risk, and short-list six where it is acute. We have previously written on four of these and are in the process of following up with management on Gree and Mengniu Dairy. Furthermore, our quantitative scoring system highlights a further seven companies with risky accounting, including Mahindra & Mahindra, New Oriental Education, Alibaba, Hikvision, Amcor, Huaneng Power and Atlassian. The report includes write-ups of all 100 companies with links to our screen and published financials.

CELLTRION: Gaming the accounting

Since 2010, Celltrion has generated 98% of its sales from its sister company, Celltrion Healthcare, which has been unable to sell 55% of the product that it’s bought. Celltrion Healthcare appears to have been established to buy unapproved drugs from Celltrion. It is highly unlikely that an outside third party would have bought these drugs, and we question the economic substance of these past transactions for Healthcare. We think Celltrion’s profits are significantly overstated, by as much as two-thirds in 9M17, owing to continued channel stuffing at Healthcare and the capitalisation of R&D costs. We therefore apply a 50% discount to 2018 consensus forecasts and assume a generous 30x P/E multiple to derive a Celltrion target price of KRW65,000/share, 80% below current levels. SELL/SHORT.