Fuqi International's (OTCPK:FUQI) stock price slashed 28% after hours on Tuesday after the company announced the postponement of its Q4 earning release and accounting errors materially impacting reports for the previous three quarters.
Specifically, Fuqi found that it overstated earnings for the first nine months of 2009 by "approximately $0.15-$0.19 per share". Further, the company lowered its estimates for Q4, cutting EPS to $0.24-$0.28 from the original $0.55-$0.66.
Only hours after the announcement, an investigation leading to a class action lawsuit was initiated by a law firm.
This is a big surprise to many, including me, who wrote an article back in December 2009 discussing my unfavorable view on this company due to an accounting irregularity in its Q3 report. I suspected that the company was involved in some sort of related party transaction to make its earnings expectation, but I did not doubt the accuracy of the numbers. I was wrong.
I was right in raising the issue with the accounting irregularity though. In my previous article, I only mentioned the problem but did not elaborate on it. In responding to a reader's comment, I explained in detail:
ODM (Original Design Manufacturing) is an irregular item; we have never heard this item before the last earning call.
Without ODM, the revenue is a miss.
If without ODM, the revenue is a beat, then ODM is a nice-to-have and a positive item.
If revenue is a beat only with the addition of ODM, the ODM becomes a suspicious item, a made-up to make the revenue expectation.
To get a good picture of a firm, you have to remove the irregular item. When removing the irregular item, we find this company had a missed quarter.
To shed more light onto this issue, here are some numbers: ODM for Fuqi's Q3 was $19 million. Including this one-off item, the company made $127 million revenue, slightly BELOW the Street consensus. This ODM business is of such a high margin that it doubles the gross margin of the wholesale business. A rough calculation shows that it should have gross margins of around 90%.
Here is how the management describes the ODM business in the Q3 conference call:
Now, specifically to ODM, as I interpreted that in definition, that customer usually provides the raw materials used to produce the finished product in our production facility, which -- we use our labor, expertise, and know-how. So, from this particular quarter we were able to have a few sizeable orders from a few customers, that they actually were new. And they, basically, requested a few sizeable orders that were using hard gold to build some of the gold statues.
If you sit back and think a little bit more about the wholesale business, it is actually a labor intensive business. There are tens of thousands of designs and limited quantity on each design, so the process can hardly be automated. Human is the deciding factor in the production quantity. With that in mind, we should not expect gross profit to vary too much from quarter to quarter, which is the product of the number of experienced workers, the hourly production and the total hours put in per worker. And yet, we find out that the gross profit from wholesale business is $27.8 million in Q3, roughly equal to the total gross profit of the previous TWO quarters, $28.6 million.
Motley Fool published 10 articles pumping Fuqi. Out of seven analysts covering this stock, four strong buys, two buys and one hold, dismissing the ODM issue. Some of them even called ODM a growth opportunity. Despite the high ratings, the stock traded sideways, underperforming the broader market.
The weirdest thing about this stock is that some heavyweight hedge funds have long since discovered Fuqi's problems and have been shorting this stock. Short interest on the stock has been steadily rising since May 2009. Half of the float has been sold short according to the most recent data. The interest cost of borrowing the stock is between 8%-12%, one of the highest you can find. Judging from the time from which the short interest increased, I can tell that the hedge funds knew the company had accounting issues months before the problematic Q3 report.
It looks like a huge trap, hedge funds being the hunter, investment bankers helping setting up the trap and John Doe investors in the trap.
The takeaway from this fallout is that when you see the first cockroach, the ODM, don't just walk. Instead, Run!
In my previous article, I also mentioned Lihua International (LIWA) as another name I disliked. In my opinion, Lihua's problem is only much more severe than Fuqi's. It is time to clean out the weeds and let green grass grow.
Disclosure: No positions on FUQI or LIWA at the time of writing