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; however, we derive a target of A$23/share based on a double blow of lower profits and a significant de-rating. With more than 50% downside, SELL or SHORT.

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.

DEBT RECONCILIATION: Screening for trouble

You can now download our Excel-based, Bloomberg-linked screen that identifies companies globally where we are unable to reconcile changes in debt on the balance sheet with the cash flow statement. This suggests that companies might be paying for assets with debt which is a non-cash item and therefore not reconciled within the cash flow statement. This has the effect of under-stating capex and over-stating free cash flows, and can distort valuations. The other reason might be that companies are deliberately misrepresenting their cash flow statements. We discussed this in detail in our report, COMING UP SHORT: Manipulating cash flows (22 Nov 2017). The model is set up to allow users to check a company individually, paste in a selection of companies or to hunt for stocks in a specific region. A live Bloomberg terminal is not required for this latter screen.

ACQUISITION ACCOUNTING: Screening for trouble

You can now download our Excel-based, Bloomberg-linked screen that identifies companies globally that might be inflating profits through the use of acquisition accounting. We discussed this in detail in our report, GOODWILL HUNTING: Using acquisition accounting to inflate earnings (1 Nov 2016). The model is set up to allow users to paste in a selection of companies or to hunt for stocks in a specific region. A live Bloomberg terminal is not required for this latter screen.

FAKE CASH FLOW SCREEN: Screening for trouble

You can now download our Excel-based, Bloomberg-linked screen that identifies companies globally that have similar characteristics to past fake cash flow frauds. We discussed this in detail in our report, FAKING CASH FLOWS: And how to spot it (10 May 2017). The model is set up to allow users to paste in a selection of companies or to hunt for stocks in a specific region. A live Bloomberg terminal is not required for this latter screen.

EXCESS CAPITAL: Fraud or poor corproate governance

It is widely assumed that companies returning capital to shareholders while reporting free cash inflows cannot be frauds, but this is not entirely true. Around 30% of past fake cash flow frauds were able to pay dividends despite reporting fraudulent free cash inflows. These dividends were likely financed from the proceeds of debt or equity. In order to spot companies with similar traits, we have created an abbreviated cash flow which monitors cash requirements, and devised a number of screens which highlight companies raising equity despite being net cash positive and generating free cash inflows. Companies where we have significant concerns include Anta Sports, Kingsoft, Webjet and Eclat. We are not claiming that these companies are necessarily frauds but simply note that their financials have traits in common with past frauds. Investors need to have comfort with their unusual financials.