A Hard Look at the Quality of Sutor Technology's Earnings

On 11/15, Sutor Technology (SUOT.OB), a manufacturer of added-value steel products, returned impressive results for Q1 2008. Revenues were up 62% yoy, operating income up 142%, and net income up 118%. EPS for the quarter was a whopping $0.17 compared to $0.09 for the same quarter last FY.

However, on closer inspection of the company's 10Q, an interesting fact emerges. The company's GROSS MARGINS for sales to non-related parties was essentially ZERO:

Revenues: $57.8m
Cost of Sales: $57.6m
Operating Income: $0.2m

In contrast, most of its income derives from sales to RELATED PARTIES:

Revenues: $41.7m
Cost of Sales: $30.5m
Operating Income: $11.2m

In other words, a full 98% of its operating profit is from RELATED PARTIES SALES. And what are these companies? All I can find in the 10Q was as follows:

The Company sells to and buys from various companies who are owned or controlled by the Principal Shareholders. These other companies are composed of 20 former sister companies with which the Company conducts significant transactions.

Significant indeed. How do we know if these transactions are done on an arm-length basis? We don't, and that's the trouble. These can easily be sweetheart deals designed to ensure profitability at SUOT, at the expense of the non-listed entities.What is very telling is how the cost of buying goods from related companies fell even though revenues remained the same, as follows:

Revenues (Related Parties): (Q1 2007) $41.3m (Q1 2008) $41.7m
Cost of Goods (Related Parties): (Q1 2007) $39.5m (Q1 2008) $30.5m

How can COGS fall by 29.5% when sales remained almost constant, especially when the gross margin of non-related parties sales decreased dramatically? In the same 10Q, advances to suppliers increased by more than $30m in the last quarter. And perhaps related to this, short-term loans outstanding to related parties expanded from just over $2m to $31m. You decide for yourself what this means. But until the issue is resolved, I'm going to assume a current EPS of zero for SUOT.

My Position: None.

Comments

[Researcher59:]

China OTC Player, you are misinterpreting the information on the income statement. The COGS for revenues from related parties does not correspond directly to purchases from related parties …. those two figures are independent. They do not provide enough information to determine what the difference in gross margins (and profits) is for sales to related and unrelated parties, however they do state that unrelated party sales are increasing and command HIGHER margins than related party sales.

Two excerpts from the latest 10Q -

[1] In December 2006, we started to transfer the market channels from our related parties to our Company, which resulted in the increase of our direct sales to unrelated parties for the three months ended September 30, 2007. We expect our sales to unrelated parties as compared with sales to related parties will continue to increase in the next few quarters.

[2] Approximately 41.92% of our revenue was derived from Shanghai Huaye and its affiliates in the three months ended September 30, 2007, decreased from 67.26% in the same period last year. We expect to continue to maintain the relationship with Shanghai Huaye in the future, but plan to further increase our direct sale to end customers in order to increase our margins.

To clarify further, lets say they purchased 50% of their raw materials from a related party, but only derived 10% of revenues from another related party (there are 20 related sister companies in all)…. and the remaining 90% from unrelated parties. That obviously does NOT imply that 50% of total COGS are applied to 10% of sales!

Absent further information, one can only determine overall gross margins (and profits), not specific gross margins for related and unrelated party sales. Gross margins were 12.9% in the Sept quarter, 14.5% in the June quarter and 11.3% in the March quarter. By contrast, if one were to mix apples and oranges, and attempt to determine specific gross margins for related and unrelated party sales from the income statement, one comes up with margins for related parties of 36.8% in the Sept quarter, 132% in the June quarter and (19.1%) [negative] in the March quarter. The numbers go haywire because they cannot be derived in that fashion.

Sutor Technology Group is growing very rapidly and should continue to see steel production ramp up when a new production line comes online in February ….

As per the 10Q –

Jiangsu Cold-Rolled is constructing a HDG Steel production line which can produce both HDG of cold-rolled steel and hot-rolled steel and is expected to become operative by approximately February 2008. The addition of this new production will help the further growth of revenue in 2008.

Earnings are due out next week and the company has scheduled an earnings conference call to discuss the results. Steel prices have been very strong in Asia over the past few months and I’m expecting another excellent quarter. I think the stock represents a good value in the low $4’s.

2008 Feb 08 08:20 AM