As I was going through Fuqi International‘s (FUQI) most recent quarterly and annual reports I noticed some accounting warning signs.
Fuqi International is a recent IBD 100 story stock. Fuqi met the IBD’s basic criteria as a fast growing company with a technical breakout and subsequently the stock was bid up to new heights. More and more momentum players bought into its story: China, emerging market, rising middle class, rapid revenue and earnings growth. However, it looks like Fuqi International might have some problems backing up their meteoric rise.
Margins
Sequentially, 3Q gross margins increased 36.78% and from a year ago it increased 100.51%. 3Q operating margins increased sequentially 45.94% and from a year ago it increased 115.38%. 3Q net margins increased sequentially 50.92% and from a year ago 122.07%. Yes, margin expansion is a good thing and you can see in the previous quarters that the company had continually expanded their margins but when they explode higher like they did this last quarter it raises some questions. Management from their 3rd quarter 10-Q explains why their margins expanded so much.
The increase in profit margin was mainly attributable to an increase of product segments and an expansion in retail sales, which resulted from an increase in brand awareness, an opening of additional jewelry counters and shops.
When I check Fuqi’s new margins against the retail jewelry industry margins and Tiffany and Co.’s margins (TIF) they are pretty much in line with each other. I do not think Fuqi has the brand awareness that a Tiffany and Co. does nor do they have the brand awareness to charge the prices that a Tiffany and Co. do. Fuqi’s retail operations are only 2 years old and only account for 7.66% of their revenue according to the 3rd quarter 10-Q. Wholesaling accounts for 92.34% of Fuqi’s revenue but margins were able to double from a year ago from a division that provides 7.66% of their revenue? Maybe this can happen but I have a hard time reconciling the two.
Receivables
A substantial portion of our working capital consists of accounts receivable from customers. As of December 31, 2008 and 2007, approximately 57% and 25% of our working capital, respectively, was attributable to accounts receivable. In addition, we have seen a significant increase in our provisions for bad debt. – FUQI 2008 10-K, 3/31/2009
Fuqi has a large amount of receivables outstanding and on a year-over-year basis receivables have outgrown sales. 2008 vs 2007 receivables grew 193.23% while sales grew 152.55%. 2007 vs 2006 receivables grew 177.25% while sales grew 57.51%.
Subsequently, days sales outstanding on a yearly basis have increased as has inventory turnover. Days sales outstanding have increase sequentially 36.78, 65.09, 75.58 from 2006 through 2008 respectively. The increase can partially be explained by Fuqi’s move into retail sales as the retail business typically has a slower turnover than wholesaling but if Fuqi’s receivables remain bloated it will crimp their cash flow and disrupt business operations.
There is some good news in this department. On a quarterly basis receivables have stayed in line with sales growth or just slightly ahead but excluding the recent 3rd quarter, days sales outstanding has increased each quarter. Also 3Q 2009 days sales outstanding has increased over 3Q 2008.
The 3rd quarter is a recent improvement but is it a trend reversal or just a one time improvement? This is a crucial data point to follow in the next quarter/annual report.
Cash Flow
If Fuqi International (FUQI) can’t get its receivables in order it could face an operating cash flow crunch. Actually, they could already be facing it now.
Fuqi’s ttm free cash flow to equity is positive but only because of Fuqi’s financing activities. So far every quarter of the ttm and every year that Fuqi has made an annual report under US GAAP it has had negative operating cashflow. Its operating cash flows are negative because of its large negative changes from its working capital base, its growing receivables. Fuqi is making sales but its credit terms could be too generous as operating cash flow seems hard to come by for them.
The only reason Fuqi has reported any positive free cash flow to equity is when it adds on more short-term debt and/or does follow-on offerings for its common stock. As you can see in the image below Fuqi had a follow-on offering in this most recent quarter for $112.995 million. Each quarter the company has drawn on more and more of its credit lines. Short-term debt is the proverbial sword of Damocles hanging over your head, one slip up and those lines could be called in.
All numbers are in millions except per share amounts, net total payout, and capex as a % of operating cash flow. Click image to enlarge.
Adverse Opinion
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the company internal control over financial reporting as of December 31, 2008 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 30, 2009 expressed an adverse opinion. – Fuqi 10K 2008, 3/31/2009 (emphasis added)
This could be a one time event but it is not a good reflection on the management of the company that they are lacking the internal controls to prepare their books in a timely matter. It leads one to ask how much oversight is there to produce an accurate financial picture for the company too.
Buyers beware! Fuqi International is a story stock and its stock price has reacted well but Fuqi’s financial statements paint a different picture.
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