Exceed: A Real Business Trading at an Unreal Valuation

Aug.10.11 | About: EXCEED COMPANY (EDS)

Background

The operating company of Exceed (NASDAQ:EDS) was founded in 2001 in Fujian. The company sells shoes and sportswear under the “Xidelong” brand name nationwide in China. The company focuses on 2nd and 3rd tier cities where there is less competition from the more expensive or international brands.

Since we began our research on this, D.B. Research issued a report on this website (it can be viewed here) accusing the company of being a fraud. We address their claims herein. Photographic evidence shows that stores are being operated near or next door to stores of competitors which would indicate the distributors are at least making enough money pay similar rents.

The biggest argument put forth to claim fraud is that the company has not paid any dividends or performed any share buybacks. In our analysis, the reason not to distribute cash is pretty clear: stopping any dilution from the warrants due to expire in November. Management cannot outright say that this is their strategy, but as the largest shareholders, it makes perfect sense that management is heavily incentivized to have the stock trading below the warrant strike price on November 8th, 2011 when they expire. Buying back stock only to face huge dilution in a few months would be pretty ridiculous, especially if the buyback price is higher than the warrant exercise price.

Business Model

Exceed primarily outsources production, instead focusing on design and marketing to differentiate their product, much like most large international brands. According to the latest 20-F: “We outsource the production of a portion of our footwear and all of our apparel and accessories to contract manufacturers.” Later in the 20-F we see that 55% of footwear volume was outsourced. On page 23, we see that outsourcing for footwear is used when internal production capacity is at full utilization.

Exceed’s products are then sold to third party distributors who in turn operate Xidelong branded retail stores. At the end of 2010, the number of retail stores stood at 4,333 across 30 provinces. Three times per year, a “trade fair” is held where Exceed displays new products for the upcoming season and distributors place orders with the company based on what kind of demand they expect. This is typical for China; Dongxiang (HK ticker: 3818 HK), Xtep (HK ticker: 1368 HK), and 361 Degrees (HK ticker: 1361 HK) all report selling in the exact same manner.

The focus on expansion and the distributor model all lead to significant receivable days. Distributors are often times entrepreneurs who are well connected in their area. Because the brands all want to develop a large scale sales network quickly, they offer pretty lax credit terms to these distributors. As the probability of collecting a bad debt via a ruling against a powerful local in China is slim to none, distributors must be chosen wisely, but also leads to a desire to keep a creditworthy distributor happy. The table below shows the days of receivables for several Chinese sportswear brands and the relationship to sales growth:

Name

Days of Receivables

Sales Growth

EXCEED CO LTD

95

34%

XTEP INTERNATIONAL HOLDINGS

51

26%

361 DEGREES INTERNATIONAL

97

26%

CHINA DONGXIANG GROUP CO

46

7%

LI NING CO LTD

52

13%

Click to enlarge

So, the more credit you extend, the better your growth! Big surprise. However, when engaging in what management calls a “land grab” as these brands try to establish themselves, and simultaneously competing for a quality local partner in a city in which you have no presence, this strategy appears to work and thus is market practice. Distributors cannot return inventory, so “stuffing the channels” only works so well, as a burned distributor just goes belly up when he cannot get rid of excess inventories.

Organizational Structure and History

Exceed once tried to list on the HK stock exchange in 2008 as “XDLong” under the ticker “977 HK” in an IPO led by Goldman Sachs. Goldman Sachs had previously invested in the company via an issuance of convertible preferred shares.

In 2009, with a “put” of the preferred shares imminent, Exceed decided to merge into a SPAC and raise additional capital to help satisfy the money they owed to GS via an issuance to New Horizon. Because it could not be certain how many shareholders of the SPAC would vote in favor of the merger, Exceed signed an agreement with New Horizon where New Horizon would invest $30 million. New Horizon is a private equity fund that was founded by Chinese Premier Wen Jaibao’s son.

This is because, just before the intended IPO in HK, Exceed had issued preferred stock to Goldman Sachs on April 30, 2008. These were originally due within one year, but then were amended in March of 2009 when Exceed agreed to repurchase them for $39.5 million. They carried a hefty 12% interest rate, and if not for an extension in May, they would have been in default. So, GS agreed not to pursue the default, and Exceed found a new investor to fund the put provided they were able to complete the merger with the 2020 SPAC.

The SPAC known as “2020” became “Exceed”, and the legal structure has the Listco with 2 layers of holding companies beneath it and 2 operating subsidiaries: Fujian Xidelong Sports Goods Co, and Xidelong (China) Co Ltd.

Priced like a fraud even though SAIC files confirm revenues and profits are real.

With only two subsidiaries in China, and all revenues generated in China, it leads to a fairly simple analysis of the SAIC files in order to confirm the company is reporting accurately. The company has since uploaded these files to their website after the allegation from D.B. Research, but the ones we have uploaded were obtained via a Chinese law firm in April 2011. The ones we received match what the company has put on their website.

We uploaded the files we received to Google Docs. You can view them here:

Fujian Xidelong Sports Goods Co:

2008: part 1, part 2

2009: part 1, part 2

Xidelong (China) Co. Ltd.

2008: part 1, part 2

2009: part 1, part 2

Added together, the revenues should be the same as are reported to the SEC. Because of derivative liabilites and other considerations associated only with the offshore company, we should actually expect net profit to be higher than is reported in the 20-F. In both 2008 and 2009, the reported revenues match, but the profits are actually higher on the SAIC statements. The summary is here:

All figures in RMB '000s

Revenue

Net Profits

Chinese Name

English Name

09

08

09

08

福建喜得龙体育用品有限公司

Fujian Xidelong Sports Goods Co, Ltd

74,437

43,038

9,808

6,466

喜得龙(中国)有限公司

Xidelong (China) Co Ltd

2,003,520

1,777,243

272,292

216,843

Total

2,077,958

1,820,282

282,100

223,310

20-F reported numbers

2,077,958

1,820,282

248,019

168,528

Click to enlarge

It would be extremely important to any customer to report these numbers accurately, since it will be used to check the VAT receipts at the retail level when distributors sell the inventory to end customers.

We also checked out the brand to see how well known it is. As YUII has shown, you need to check more than just SAIC files to get comfortable. There are numerous stories about this company from both before and after the merger. You can currently see this company’s partnership with the Chinese government to promote sport.

You can view their recent ad campaign here. The ad features the Singaporean pop group By2.

D.B. Research alleges serious fraud and falsification of SAIC files. This is not impossible, but we figured the best way to check was to just go and see if there really are stores around and if they are actually selling anything. The most telling thing we found was that the stores were typically located near competitors (this is common in China – furniture, clothing, housewares, etc…all tend to be located next to each other, and people go to a particular area to shop for certain items), so the profitability of the individual stores must be similar enough to those of the HK Listed brands such that they cover rents. Also these locations were far from the “home” province of Fujian, and in a very competitive market as these cities are among China’s highest in terms of per capita salaries.

So, are there really stores out there, and are there customers? We took a trip to China on August 4th to check out the stores in Shenzhen, Dongguan, and Guangzhou without any assistance from the company. We wanted to make sure we were not being set up. What we found were stores with real customers and real salespeople ready to help. Frequently the stores were located next to other big brands meaning that the store must at least be generating enough income to justify the distributor paying the rent there. As well, we did not just visit marquee centers where one would find foreigners that would see the brand and buy the stock. Going by online searches or by asking staff at initial locations found some in the suburbs or in main shopping areas of China’s middle class.

What did we see in the stores? Well, there was some evidence of discounting, as all stores had a clearance section, and store setup was pretty similar to most competitors. We did see significant uniformity across sales floors with discounted items up front, clothing lining the walls, and shoe racks in the middle. New shoes were selling for around 30 USD dollars a pair.

Sales people showed us the more popular items. The most popular shoes appeared to be those that are similar to the Nike (NYSE:NKE) Free line with the flexible sole. Polo shirts were the most popular clothing item. One store was hiring.

People appeared to be familiar with the stores and the brand. We had been told that there were stores on certain streets or in certain areas, so we also asked people walking around if they knew where the Xidelong store was. Most people knew where it was and pointed us in the right direction, there appears to be decent brand awareness.

SPAC history

Having been the result of a SPAC merger and having Crowe Horwath as an auditor has dragged the valuation of Exceed down to obscenely low levels. At the time of the IPO filing in 2008, the company was audited by Ernst & Young, but they switched to Horwath upon merging with the 2020 SPAC. Why did this occur? According to page 65 of the S-4 filed on July 20, 2009:

Therefore, on or about January 30, 2009, 2020’s management team introduced Crowe Horwath to Windrace as a potential auditor on behalf of Windrace for the Acquisition and discussions commenced as to the most efficient way of conducting the audit. It was agreed that the audit of Windrace would be undertaken under IFRS, with 2020 to provide pro forma financial information under United States Generally Accepted Accounting Principles (“U.S. GAAP”).

Horwath was also the auditor of 2020 prior to the acquisition, so this would result in no auditor change at the listco level. An auditor change could have delayed the merger and kept the company from badly needed capital during the financial crisis. Needing to repay Goldman Sachs, the company could not afford for there to be any delays. The introduction by 2020 made the entire process much easier. The letter from GS accepting the SPAC merger subject to being repaid is attached as Exhibit 10.31 to the aforementioned S-4.

So why hasn’t this obscenely cheap company changed their auditor, bought back stock or paid meaningful dividends? One reason: the warrant overhang. Merging into a SPAC is not the best deal for the target. As a result of the SPAC, there are currently 9.765 million warrants outstanding with a strike price of 5.25. These expire on November 8th, 2011. Management is aware of this problem, and the lack of action is an attempt to avoid the dilution these warrants could bring if they expire in the money. It is actually in the interest of long term shareholders to avoid any buybacks or dividends until these warrants expire. The potential dilution is huge: almost 35% if all of them are exercised.

Our conversations with the IR of the company at recent investor conferences lead us to believe that the lack of action is a strategy, and they know they are benefiting from the fear of Chinese companies listed on US exchanges. They told us that there is little incentive to switch auditors or pay dividends and drive up the price of the stock only to get diluted in a few months by the warrants.

They characterized the warrant holders as non-fundamental investors that are hanging on after the SPAC merger completed. They would be right in this assessment. A number of the holders prior to the merger appear on numerous SPAC registers. Their incentive would be to exercise and sell immediately.

In addition, we have heard that many of the holders are pushing the company to use various types of cashless exercise or exchange mechanisms. It is our belief that many of the funds are actually quite small or currently unwinding, and there is a good chance that not all of the holders choose to exercise in full because of cash constraints (the stock is non-marginable).

Valuation

So – even in light of this, is it still worth buying? We would say yes. Even taking into account the dilution, the fair value is still well above the current share price:

Comparables

P/E ttm

361 DEGREES INTERNATIONAL

6.38

XTEP INTERNATIONAL HOLDINGS

8.6

LI NING CO LTD

7.17

AVERAGE

7.38

EXCEED CO LTD

2.67

Valuation

Net Income 2010 (mns)

53.28

Market Cap at Average P/E for sector

393.384

Shares out

25.412

addt'l shares from warrants

9.765

Fully diluted share count

35.177

Value per share assuming full exercise

11.18

Click to enlarge

We are agnostic to the warrant exercise at these levels. If the stock was higher, we would be worried about the overhang, but the ability to buy at these levels and take advantage of the uncertainty surrounding Chinese companies listed in the US certainly trumps any short term share issuance concerns.

This company is much smaller than the others, and taking the credit risks of the distributors certainly has to factor into the valuation, so over $11 may be aggressive, but the current share price is far below fundamental value. The risks are more than compensated for in the current share price relative to the potential upside, and I view this as a compelling buy.

I am happy to exchange ideas with others on interesting risk/reward situations, in particular those looking at China (from either the long or short side).

Disclosure: I am long EDS.