In my previous article, I discussed several problems of Lihua International (LIWA): Unusual insider share unlock, discrepancies of 2008 revenue between its SEC filings and local media, discrepancies of 2008 raw material purchase from Fushi Copperweld (FSIN), dramatic increase of unit sale price of CCA, its main product, and dramatic reduction of account receivable days and account payable days.
On Friday morning, Fushi Copperweld (which I will hereafter refer to as Fushi) released its earning report for the third quarter, which helped shed more lights onto Lihua's potential accounting fraud.
Fushi is special to Lihua because they are in the same sector and they sell to the same market, in which Fushi is the industry leader. Fushi is one of the first in China to have started Copper Clad Aluminum (CCA) wire business, and it is the largest by far. Lihua does not have the capability to clad copper over aluminum. Instead, it purchases CCA wires from other manufacturers, the largest supplier being Fushi, and draws them thinner. In some cases, paint is applied to the finished products for use in manufacturing electric magnets. From the beginning of 2009, Lihua entered a low margin scrap copper business. Fushi is both a peer and the largest supplier of Lihua International, which makes the comparison of the two apple to apple.
Fushi disappointed its investors. For the third quarter, Fushi's revenue decreased 25% compared to the same period in 2008. The analyst consensus was $55.4 million, a 13% drop, but Fushi only made $47.7 million.
According to the management, "the decline was driven primarily by a decrease in average selling price (21.6%) resulting from lower raw material prices." But what price is the management talking about? On a consolidated basis, Fushi saw 3.7% decline in output, which means 10,100 (2008 Q3 output) x (1-3.7%) = 9,726 tons and $4,904 per ton. In my previous article, my calculation shows that the selling price of Lihua for the first half of 2009 was $14,360 per ton. Hmm... Are these two companies truly in the same industry?
Well, let's dig further. As in my previous articles, I will organize the findings in sub-sections.
A. Significant Difference of CCA Unit Sale Price between Lihua and Fushi
To compare apple to apple, I compared the unit sale price of CCA, the main product for both companies. For Lihua, it means that the new business of scape copper is not included; for Fushi, it means non-China located sites are excluded since they are mostly on Copper Clad Steel (CCS) business. Fortunately, all the supporting data can be found in SEC filings for both companies.
Since the beginning of 2009, Fushi saw its unit sale price compressed due to the lower copper price. However, Lihua's sale price has been defying the gravity. In the second quarter, its unit sale price increased to a jaw-dropping $16,958 per ton, nearly 300% premium over $4,349 per ton of Fushi Dalian.
There are quite a few problems associated with this huge difference, knowing that the products are essentially the same with different thickness and the raw materials of Lihua is the finished product of Fushi.
- How can wire drawing create 300% margin?
- How can CCA price of Lihua not following the margin-plus pricing scheme of the wiring industry?
- Why is Fushi not adding some drawing machine to extract the profit of Lihua if this is such a lucrative business?
- WHAT is the raw materials of Lihua anyway? The CCA raw material cost was $18.2 million for the second quarter. With the production 1,545 tons, the unit raw material cost was $11,845 per ton. What is this kind of material? It certainly does not look like anything Fushi manufactures.
B. Significant Difference in AR Days between Lihua and Fushi
Though the two companies are in the same sector, their AR days difference makes one feel like that they are NOT serving the same market.
AR days is the average days customers pays off the bill of the company. Many accounting Shenanigan such as channel stuffing and irregular revenue recognition leak their trace in AR days because AR days link the revenue with the balance sheet and the balance sheet, as its name suggests, does need to be BALANCED. It is also much easier to relax the account receivable collection than tightening the collection because tightening collection typically causes customer loss.
For the last quarter, Fushi further relaxed its bill collection to retain their customers in face of lower utilization of its capacity. Quoted from their earning release:
Accounts receivables at September 30, 2009 were $69.1 million compared to $49.8 million on December 31, 2008, an increase of 38.8%. This increase is primarily a result of extended credit terms in 2009 to certain credible customers that have long-standing business relationships with us in order to capture increased market share.
While Fushi is relaxing the account receivable collection, Lihua is certainly NOT living on THIS earth -- it was able to grow its revenue at full capacity without adding proportional account receivable. The numbers suggest that customers have been flocking into Lihua, paying them cash to buy products 4 times as expensive as they would from Fushi and ignoring the generous pricing and payment terms from Fushi.
C. Significant Difference between Lihua AP Days and Fushi AR Days
Due to the well established supplier/customer relationship between Fushi and Lihua, the payment period of Lihua paying TO Fushi is the exact same payment period of Fushi receiving FROM Lihua. Thus we should expect some positive correlation between Lihua's AP days and Fushi's AR days. Yet we see that these two are negatively correlated from the following graph.
It is especially interesting to look at year 2008, in which Lihua buys 46.5% of its raw materials from Fushi. (For more detailed relationship link, refer to my previous post)
Its prospectus states that "For each of the fiscal years ended December 31, 2006, 2007 and 2008, and the three months ended June 30, 2009 our five largest suppliers accounted for 100% of our total purchases, and our single largest supplier accounted for 31.9%, 26.8%, 46.5% and 21.1% of our total purchases, respectively." (page 70)
In year 2008, Fushi's AR days is 82 days and Lihua's AP days is 18 days. Even if we assume that Lihua pays all other suppliers cash on delivery, Lihua's AP days would be 82 x 46.5% = 38 days, far more than the 18 days calculated.
Fushi is under the pressure of the economy slowdown: Its revenue did not make the expectation and the utilization ratio of the Dalian facility dropped from 88% in the second quarter to 78.6% in the third quarter.
Lihua, Fushi's downstream wire drawing firm, however, is able to get away with selling the market finer wires at a quadrupled price with 100% utilization of capacity up to the second quarter.
Well, maybe Fushi investors should fire all the management in face of the great "achievement" of Lihua. Their "faults" include:
- They could not shorten the account receivable days like Lihua did. It is huge saving on the capital if they do.
- They sold raw materials to Lihua only to allow Lihua to make 300% margin on it OR They sold raw materials actually at more than $11,000 per ton but reported less than $5,000 per ton.
- They cannot sell their products at $16,958 per ton, like Lihua did.
- They "grossly overlooked" how "lucrative" buying more wire drawing machines can be.
Friday is a sorrowful day for Fushi -- its stock dropped 3.5% on the news, making its market cap $186 million. It suffered a 26% drop in a month. Maybe the Fushi management should learn how to fabricate fairy tales from Lihua, whose market cap is now standing at $222 million. What a reward.
All my calculations are show in the following screenshot. The data are all from SEC filings. Click to enlarge.
Disclosure: Author is short LIWA and has no position in FSIN.