A report that was published by Glaucus Research Group on April 26th highlighted the many shortcomings of Gulf Resources (GFRE), a Chinese firm that manufactures bromine, crude salt and related chemical products. The Glaucus piece builds a convincing case that Gulf misrepresents itself in its SEC financial filings.
Given that there was other material to focus on, Glaucus did not devote much time to address the company’s extraordinary business claims.
In this article, we will explain why certain of Gulf’s business claims are too good to be true, with a focus on the most important financial metric of all: profit margins. In particular, we compare the financial metrics of GFRE to those of three other comparable companies: Great Lakes Chemical, Israel Chemicals (ISCHY.PK) and Haiwang Resources.
Haiwang is a particularly applicable comparable because the company is a direct competitor to GFRE. It manufactures a similar portfolio of products in the same region as Gulf and filed an S-1 (.pdf) with the SEC earlier this year.
Below is a comparison of the two companies’ segment breakdowns:
click to enlarge
For Great Lakes, we use data from 2004 (available here (.pdf)), the last year prior to its being acquired by Crompton Corp. Bromine, crude salt and chemical products manufacturing has stayed sufficiently competitive since 2004, such that Great Lakes’ financial figures from 2004 should be applicable.
Israel Chemicals, whose annual report is available here (.pdf), features a smaller bromine segment as percentage of sales than our other comparables, but nevertheless provides a useful data point when examining GFRE’s too-good-to-be-true operating metrics.
As a final point, we also discuss how we could not find Gulf's subsidiaries or its products on three leading Chinese vendor transaction websites, but were able to locate their competitors. This is highly unusual given that GFRE claims to be “…one of the largest producers of bromine in China…”
In the table below, we compare GFRE’s profit margin to that of the three comparable companies:
GFRE’s profit margins in 2010 are not outliers; the company has posted an EBITDA margin of 40% to 50% since 2007 (see the GFRE 10Ks for 2009 (.pdf) and 2010 (.pdf)). These margins are extraordinarily high when compared to the comparable companies. We remind investors that GFRE operates a commodity business, and does not benefit from unique technology, brand recognition or other competitive advantages. Rather, the company credits the following as drivers of its business:
We compete in our business based on price, our reputation for quality and on-time delivery, our relationship with suppliers and our geographical proximity to natural brine deposits in the PRC for bromine, crude salt and chemical production. Management believes that our stable quality, manufacturing processes and plant capacity for the production of bromine, crude salt and chemical products are key considerations in the awarding of contracts in the PRC. (source (.pdf))
It is highly unusual, and in our opinion nearly impossible, for a commodity manufacturer to consistently produce the types of margins typically only achieved by the likes of Microsoft (MSFT), Apple (AAPL) and other businesses with unique products, unless the commodity sector is benefiting from abnormal supply-demand imbalances. Judging from Haiwang’s S-1 (.pdf), we can see that bromine manufacturers in Shandong are not benefiting from any unusual supply-demand dynamics.
According to this S-1, there are approximately 75 licensed bromine producers in Weifang City, Shandong Province, which produces approximately 85% of all the bromine produced in China. We spoke with representatives from multiple bromine producers in Shandong province, including Shandong Longwei Group Company Limited, Shandong Haihua Group, Sinobrom Albemarle Bromine Chemicals Co. and Haiwang. Based on our discussions, the production methods and sources of brine for the manufacturers in the Shandong province are relatively indistinguishable. Given that Haiwang and other competitors appear to be reporting reasonable margins, it's likely that GFRE's true margins are materially lower than its reported ones.
Furthermore, there is ample evidence that bromine manufacturing in China is only marginally profitable. Bromine in Weifang City is produced from brine water which is concentrated seawater that is found underground, as is explained in Haiwang’s S-1. The bromine concentration of the brine water available in China is similar to that of ocean water (for instance, see Albemarle’s graphical depiction here). As can be seen from the chart, bromine production from Chinese brine water is less efficient than production from other brine sources, such as those available in the US or the Dead Sea.
For instance, this Haaretz article writes about how bromine manufacturing in China “border[s] on economically unfeasible levels because the concentration of bromine fell from 0.3 grams per liter to 0.2-0.18 grams per liter, compared to 10-12 grams per liter in the Dead Sea”.
Extracting bromine from less concentrated brine sources requires different methods of production that increase production costs (see here). The mothballed factories that GFRE has acquired to support its alleged increase in production capacity are likely orphaned facilities that are indistinguishable from the many small producers in the area.
In short, bromine manufacturing for Shandong producers like Gulf is a high-cost enterprise. In light of this fact, Gulf’s high reported margins are difficult to believe. Furthermore, it is especially difficult to believe that a Chinese producer like Gulf can achieve dramatically higher margins than producers like Great Lakes or Israel Chemicals, which benefit from more attractive sources of brine water, modern facilities and economies of scale.
We will also compare Gulf’s inventory turns to those of the comparables. Below is a comparison of the inventory turns of Gulf Resources to comparable companies.
GFRE reported inventory turns of 48x in 2010, compared to a range of 3x to 7x for the comparable companies. Inventory turns of 48x are unusually high regardless of the industry. It's particularly suspicious for a chemicals business. GFRE’s inventory consists of raw materials and finished products. Raw materials to produce bromine, crude salt and brominated specialty chemical products include brine water, chlorine, sulfur, vitriol, ethane and ethyl ether. Brine water is pumped from underground through extraction wells, passed through transmission pipelines, moved to a refining plant, and oxidized through the addition of chlorine.
The resulting bromine is then blown out using compressed air and absorbed by sulfur dioxide or soda, while the remaining brine water is pumped into brine pans where it is left to evaporate. Companies like GFRE and Haiwang then sell some of their bromine supplies and use the remainder to manufacture chemical products. This manufacturing process is described throughout GFRE’s and Haiwang’s annual reports, including here (.pdf).
Given this manufacturing process and the finished products of both bromine and chemical products, we do not believe that the company is able to turn over its inventory every 8 days. In its S1, Haiwang discusses how it stores its inventory to receive additional revenue from price hikes.
DEFICIENT PRESENCE IN MARKETPLACE
In searching the internet to locate a suitable bromine manufacturer in China, there are many sites available for buyers. The primary sites are:
www.icis.com – provides chemical and energy market intelligence and a supplier search function.
www.chemnet.com – Chinese business-to-business website focused on the chemical industry.
www.alibaba.com – small business e-commerce site representing multiple industries.
The competitors named in the filings of GFRE and Haiwang were easy to find on the sites mentioned above. The table below lists the firms that GFRE and Haiwang describe as their competition in their 10K and S1. It also indicates which supplier sites their products are showcased on.
Finding a supplier site with GFRE’s products was more difficult. After conducting a supplier search, we found no mention of Gulf Resources or its operating subsidiaries (Shouguang City Haoyuan Chemical Company and Shouguang Yuxin Chemical Industry Company) on www.chemnet.com, www.icis.com or www.alibaba.com.
The twelve companies in the table above are not companies we chose at random; rather, they are listed as competitors by GFRE and/or Haiwang. Not finding GFRE’s products on the same sites is unusual for “…one of the largest producers of bromine in China…”
If we examine other sites that are less comprehensive or appear less relevant in the Chinese chemical market, such as www.lookchem.com, www.globalchems.com and www.made-in-china.com, we find mention of GFRE’s subsidiaries Shouguang City Haoyuan Chemical Company and Shouguang Yuxin Chemical Industry Company. However, these entities are listed not as suppliers; rather, the actual listed supplier is Shandong Haoyuan Group (not GFRE), and these legal entities are mentioned in the company description of Shandong Haoyuan Group.
Readers of the Glaucus report may recall the central argument made by Glaucus questioning the ownership of GFRE’s operating subsidiaries and suggesting Shandong Haoyuan is the actual owner of the assets. Attempting to locate GFRE’s products online points potential bromine purchasers to Shandong Haoyuan Group, not Gulf Resources. These findings support the claims made by Glaucus.
When examining a Chinese reverse merger company featuring the many red flags raised in the Glaucus report, it’s important to do due diligence on whether the company’s operating financial claims are believable. Based on our analysis, we think that GFRE’s business claims are not within the realm of reason.
Disclosure: I am short GFRE.