There is an old trading desk saying to the effect of, “Hope is a [lousy] hedge.” Passed on from the wizened to the chastened, it’s usually uttered after the company whose bonds the ill-fated trader owns managed to misplace its interest payment and is pursuing Chapter XI to go and find it.
But if hope is a lousy hedge, it’s a worse investment thesis.
Harbin’s business is manufacturing three kinds of electric motors: Linear motors, like those used in oil-pumping equipment, micro-motors, like those found in the components in the interior of automobiles, and industrial rotary motors, for trains and heavy equipment. That investors are mightily interested in the company is no surprise. Since going public from a Nevada shell five years ago, its growth has been spectacular, going to $223.3-million last year from $4.8-million in revenues in 2004.
With China a seemingly permanent fixture in many investors' growth thesis, it would seem that Harbin is one of the cheapest ways to play the PRC’s evolution into a modern manufacturing colussus. It is the type of stock that investors should justly have passion about owning.
Until a good, hard look is taken at the financial filings. The unbroken line of red flags that is Harbin’s business–and its prospects–is likely to be seared in the memories of many earnest and well-intentioned investors before all is said and done.
To start, Harbin’s corporate operating margins of 26.4% are spectacular. So good in fact, that they appear to wallop even their Chinese competition by hundreds of basis points, a development that should always give the investor pause.
A passable U.S. traded comparison is China Electric Motor (CELM) – to be clear, it makes only micro-motors – whose six-month operating margin is 19.6%. Allowing for differences in product mix and geography, a 680-basis point differential in a mature manufacturing industry is eye-opening. Manufacturing is a science. In the 1980s, the Japanese auto companies nearly destroyed a bloated and inefficient Detroit because they had perfected lean just-in-time manufacturing processes, that when combined with the funding advantage of Keiretsu and (unfair) Japanese trade practices, forced a massive restructuring of the Big Three’s businesses.
So perhaps Harbin is this generation’s Toyota (TM), the cutting edge of a new manufacturing paradigm, but it’s a safe bet that isn’t the case.
A much safer bet to explain its magic margin machine is that it has only about 800 basis points of expense below the gross margin line.
There is an absolutely minimal S,G&A (sales, general & administrative) expense to doing business for Harbin and an even smaller research and development outlay. To sell $210.9 million in revenue over the past six months, it took only $14.3 million of S,G&A costs – nearly 20% of this is shipping – and about $957,000 in R&D.
An investor can then conclude, apparently, that Harbin has no real incremental expense to additional sales, that running a growing business administratively is nearly cost-free and that the high-end, best-of-breed customers management alludes to require no customization, modifications or improvements. That this happens only in dreams or in Fraggle Rock is besides the point.
There is another important “tell” in the numbers that makes Harbin stand-apart – way, way apart – and that is its return on capital versus a group of other leaders in the various market segments it competes in. See the chart here. An annualized look at the return on capital needed to generate operating income (working capital plus plant, property and equipment divided by operating income), it shows that a miracle is brewing in the cold Chinese north. Even without the billions of dollars' worth of debt that Emerson (EMR), Johnson Controls (JCI), Magna International (MGA) and Parker Hannafin have that serves to lever their returns on capital, they simply cannot compete with Harbin.
FI.com emailed Christie Shue and Katherine Li, the outside investor relations representatives, these questions about one week ago but they did not reply, so another email was lobbed in. A call was made to the number for the V.P. of finance and investor relations contact Christie Shue listed on Harbin’s press releases and she picked up, but begged off answering claiming it was late – it was, to be fair. Voicemails left for both Christie Shue and Katherine Li were not returned. [If either of them returns the e-mail or registers a comment, it will be noted in full.]
Regardless, the financials are the financials. When we are talking about products that are generally low-tech in nature, with very low barriers to entry and with margins like this, either congratulations or subpoenas are in order.
Continuing our stroll along Harbin’s boulevard of red flags, we see that revenue growth has taken a breather in the last few quarters. Apparently a big customer pushed off acceptance of a completed order of micro-motors.
Thus does a conundrum rear its head: It isn’t easy to locate the potential automaker customer – high-end or not – likely to commit to, yet push off delivery of, what appears to be a $4-million plus order. That is strange because automakers – for all their many, many faults – have a pretty keen sense of where they are in a manufacturing cycle. Not many would likely overestimate the need for micro-motors into the seven figures, especially in the rapidly-growing Chinese market. Since almost all of Harbin’s products are shipped internally – their international sales are now 5% down from 17% two years ago – the company wouldn’t have much exposure to the sluggish western economies.
Calls to large global auto manufacturers and their key suppliers were not returned.
The auto-parts business is a bear though, that’s for sure. A carmaker’s business plan is pretty easy to figure out: find the lowest cost supplier and squeeze their prices 10%-15% lower in exchange for a (presumably) larger piece of recurring business.
So investors are hoping a foreign auto-maker with a Chinese manufacturing plant delayed a shipment one quarter but is otherwise willing to accept Harbin’s 26% profit margin in an industry where cost-cutters are rewarded with their own cults of personality.
Okay, or as the Financial Investigator’s college-aged daughter is wont to say, “Good luck with that.”
In the interests of fairness, here’s a research report (pdf) from a pair of analysts that likely think the Financial Investigator.com’s concerns are all wet. Their methodology includes a guided tour of the headquarters and factory, riding around with management on an investor relations tour of New York and hosting them at their own conference. To summarize: all of Harbin’s prospects are solid and getting better.
One of the most baffling aspects of reconciling the siren call of Harbin’s numbers with the way the rest of the world has done business for centuries is seen in its debt management practices. Recall: Harbin reported earning $46.2 million and generating $49.1 million in operating cash. That would warrant favorable attention from the commercial lending units of most any of the numerous large banks stationed in Beijing, Shanghai and Hong Kong.
But rather than borrowing a lump sum in the capital markets, or from a commercial bank, they have borrowed from a series of banks using short-term, interest-only structures. In July, Harbin entered into a $15-million credit facility with ABAX, a hedge fund in Honk Kong run by former executives of Citadel Investments LLC. Again, the 10% interest-rate is, apparently, negatively amortizing and is rolled back into the principal balance. For all the world, Harbin looks like a sub-prime real-estate flipper circa 2006. Put another way, well-constructed and seriously managed enterprises reporting those levels of income and cash-flow numbers do not do this.
Another head-scratcher is Harbin’s guarantee of $18.36 million in loans for “third parties' bank loans.” To whom? And why? This is an amount equal to 37% of its cash flow and 48% of its net cash positions last quarter, but there is no disclosure on it. Companies in certain circumstances guarantee the debt of (very important) customers and key employees – neither of which apply according to the filings – not third parties. There is no reason that comes to mind for this to happen which is anything other than problematic. That it is being intentionally withheld makes it worse. This will end badly.
Exactly how the auditor allows this – or FINRA or the SEC for that matter – to go undisclosed is pretty astounding.
On second thought, with an auditor like Frazer Frost, how this happened is understandable. The old Moore Stephens firm, it has been the first call for Chinese reverse-merger enterprises with great numbers to report which have need of an understanding auditor. The kind more inclined to act as part ally and part sponsor. The type of auditor who isn’t going to do invasive things like spend an extended amount of time in Mainland China or demand reams of paperwork, such as contracts, bank statements and invoices. Click here for a mention of Moore Stephens and the work they and their competitors do on behalf of their clients.
One could go on.
There is the emergence of an $8.1 million allowance for obsolete inventory, shortly after a large acquisition – the company had previously reserved under $800,000 prior to the purchase–that they are now reversing out into net income, because few things say “value” and “judgement” like a 10-fold spike in obsolete inventory after a big acquisition.
Also, Harbin, like other companies with business practices gleaned from the pages of National Lampoon, advances money – a lot of money – to suppliers. There is no other high-tech manufacturing corridor, in the U.S., Europe or in Asia, where it is assumed that producers will readily capitalize their vendors. Moreover, it’s probably a solid bet that most vendors who don’t have enough capital to make their components without subsidy aren’t selling to a company that makes high-tech, high-margin products. At best this is awful for Harbin’s cash-flow; at worst, major governance suspicions come into play as it is difficult to know who these vendors are or if their relationship to the company is properly disclosed.
Like all Chinese reverse mergers, the cast of characters in Harbin’s background is positively electric, a movable feast of self-dealing, enlightened disinterest and delusion-for-profit.
There is Benjamin Wey (he sometimes uses “Wei”), there is the Kabani (pdf) accountancy and there is Barry Raeburn, a former v.p. of Finance who, while happily promoting the wonders of Harbin to investors, was simultaneously churning out product at paid-research-into-crappy-companies shop J.M. Dutton. Looking under these rocks is fun and rewarding, but appears to make little difference to their investors. There is a rough sensibility in being indifferent to the dubious characters that seem to pop up at every single Chinese reverse merger. After all, if you can feel comfortable investing capital in a company that claims to earn what no one else can remotely earn in a commodity market, then what’s a little sketchiness in the ex-IR guys past?
Ultimately, the skeptic is forced to concede that the prospect of a $24 per share joint CEO/Barings Private Equity Group Asia Ltd. buyout is bracing. Fair enough, and as the CEO, Tianfu Yang, is also a member of the National People’s Congress, maybe he can see some things coming down the pike that no one else can.
But where is the buy-out money coming from?
Goldman’s (GS) statement in the 13-D hardly seems unbridled enthusiasm, expressing a “Preliminary indication of interest to potentially provide debt financing.” The most expensive legal minds of a generation came up with that sentence to express Goldman’s willingness to look into the matter but not to have any liabilities or commitments if and when they run away.
Nor is it very clear how ready institutional investors – this assumes that the prospective loan is syndicated out – are to lend to a company that has these sort of debt-management habits. Even if Goldman gets the deal done in 24 hours, there is little chance that this is going to be light-touch interest-only payments. Yang and Barings are asking a lot of its balance sheet and income statement to support $470 million in covenant-heavy debt. In terms of cash-flow, the amounts at stake are the whole shooting gallery for Harbin – with a 7% interest-rate, there is nearly $33-million in interest expense, at 9%, it’s more than $42 million.
Here’s a question: If Harbin has to advance suppliers and their builders cash to get materials and construction underway to fuel the “growth” in their “growth story,” where are they going to come up with the money to make the additional interest expense? If they stop fronting cash and slow down on expansion, then what do they do generate the extra revenue and cash?
Then there is the question of where the CEO, who earned a little more than $38,000 last year, is going to come up with his chunk of more than $275 million. He can pledge his stock for a loan but would only be able to borrow a fraction of its value. For its part, Barings – with its new $2.5-billion buyout fund – isn’t saying much.
That’s a very, very smart move the farther along this buyout goes.
It’s perfectly understandable that someone would sue for a higher price. No one wants a dream to end and the prospect of an LBO in the scandal-plagued Chinese reverse-merger sector is so astounding that the temptation to grab for more is surely overwhelming.
But arguing that a buyout of Harbin is fair at $34 or $24 is wholly besides the point.
The cost of hope – that is, the cost of making hope a component of one’s investment strategy – is the eternal risk of your capital. Some sneak through and make a profit before others can get out. Others, Prometheus-like, are sentenced to an endless array of bullish analysts and seemingly positive announcements and releases, only to witness the deterioration as once again truth comes back to roost.
Time after time.