Cautious on Yurun: Expecting Shares to Be Under Pressure as Situation Unfolds

Aug.17.11 | About: China Yurun (CYUFF)

On Friday, China Yurun (1068.HK, OTC:CYUFF), a pork supplier and processor in China, was accused of fraud by Chinese newspaper 21cn Business. The story in Chinese can be found here. Given the controversy surrounding Zhongpin (NASDAQ:HOGS) and the CER report on Seeking Alpha (available here), we took a deeper look at the Yurun over the weekend. What we found was certainly indicative of greater problems.

For those of you who do not read Chinese, the key allegations from 21cn are as follows:

  1. Yurun receives subsidies from the local government by announcing large projects, but has made little progress.
  2. Yurun continues to expand capacity, yet the utilization of existing plants is very low.
  3. The company’s land has been pledged to banks to support loans to the chairman’s personal property development company.

To someone who has not followed Yurun, this might seem really surprising, but Yurung has been controversial for a while based on their atypical financial statements.

We took a look at the annual report, and have found a few red flags.

The income statement on page 42 shows gross profit (i.e. sale of pork versus cost of pigs) of 3bn HK dollars (HK$) on sales of 21.4bn HK dollars. This is pretty expected for a low value-add slaughter and processing company. It gets interesting when we come to the next item: “Other operating income”. Other operating income is HK$966mm, equal to one third of the reported Net Income, and since it comes below the revenue line, the net margins look much higher than an average meat processor.

So, what does “other operating income” consist of? At the bottom of page 71, we get a breakdown. It’s mainly two items: Government subsidies of HK$713mm and negative goodwill of HK$186mm. Given the article’s allegations, this would help explain why a company that supposedly generates HK$2.7Bn of profits would be entitled to government subsidies so large. They generate cash. They are profitable in line with the industry. They do not have a special technology or Five Year Plan related industry. It is beyond reason why the government would provide subsidies this large to this company (we will revisit this later).

We were really intrigued by the presence of negative goodwill. Negative good will is rarely an issue, since it would seem like a management team would be adverse to using it. Goodwill is the difference between a price paid and the value of an asset. The buyer then takes a good will writedown charge to bring down the goodwill to level reflecting the carrying value of the asset. If I buy something for 2 dollars that has a carrying value of 1 dollar, I take a goodwill expense of 1 dollar.

However if I buy something worth 2 dollars for 1 dollar, I show a negative goodwill gain of 1 dollar. What this means is that Yurun is telling us that they made acquisitions that were HK$186mm more valuable than what they paid, and that differential needs to be recognized as income. We think that is pretty ridiculous. Buying assets gives you a profit? Without disposing them? I wish things worked that way in my portfolio…

In 2010, Yurun made the following acquisitions in this table showing prices paid and they the value that Yurun assigned to them. Source is 68-71 of the 2010 annual report:

Target

Price paid

Yrun's value

Difference

% gain

Shandong Lushen Food Company

HK$9mm

HK$48.68mm

HK$39.7mm

341%

Henan Fuxin Muslim Meat Industry

HK$11,000*

HK$93.56mm

HK$93.5mm

849900%

Fuyu Linyuan Food Company

HK$12,000*

HK$52.86mm

HK$52.84mm

440233%

*that's right, only 11 and 12 THOUSAND HKD, so less than 2,000 US Dollars each

Click to enlarge

Proper negative goodwill accounting is to use the net assets acquired. However, in the supporting information in the annual report, Yurun only seems to take the asset side into account. It seems highly unlikely that someone would sell companies with assets worth supposedly millions of dollars at less than the cost of drafting the purchase agreements…

However, because of very liberal accounting rules, Yurun management can in fact revalue these assets to whatever level they want. It is meant to be a fair value calculation. Normally management teams avoid this because it may just result in writedowns in the future, but Yurun has decided they have made such great acquisitions, they want it in the income statement.

It should also be noted that Yurun recognized HK$119mm of negatie goodwill in 2009. These guys just can’t lose when it comes to buying assets.

We decided not to condemn them immediately, and instead figured it would be best to see where these numbers are coming from. We chose to look at the highest priced acquisition, Shandong Lushen, to seee if maybe it could be worth management’s assessment. Thankfully SAIC files for 2010 are now available. We were not surprised per se, but we would disagree with the valuation used.

In the AIC files, Shandong Lushen shows revenue of 8MM RMB and net profit of 386,000 RMB. We want to point out here that Yurun does NOT report the financial results of each sub, so we do not have a basis of comparison to review. However, we think that valuing the company at HK$39.7mm or a price to earnings ratio of 84x (eighty four times!) is very aggressive.

Fuyu Linyuan looks even more egregious. AIC files show a revenue of 349,700 RMB, and a profit of 30,400 RMB. It DOES show the company got a bargain buying it for less than 1x earnings, but revaluing to more than 1,400x earnings looks a bit bullish.

We want to stress here that revaluing assets is totally acceptable within the accounting rules, and KPMG’s decision to sign off on these accounts is not surprising. When buying private assets, there is no value benchmark for goodwill to be implied. However, whenever we see negative goodwill as earnings, it makes us highly suspect as to how conservative the company is being.

We have no knowledge as to the accuracy of the media reports, but we would be cautious given the initial evidence from the AIC files. In our experience, a management that cuts corners cannot be trusted across the spectrum. We will be looking into Yurun in greater depth in the future. We also would expect the shares to be under pressure as the situation unfolds.

Disclosure: I am short OTC:CYUFF.