Chimin Sang's  Instablog

7 Days Group (SVN), the third largest economic hotel chain in China, hit the IPO market this week. The stock was priced at $11, the higher end of the suggested pricing range, and closed at $12.50 in its first day's trading. J. P. Morgen, Citi and Oppenheimer were the underwriters. 

My analysis shows that it is not a good buy when compare to its peer, Home Inns (HMIN), the largest economic hotel chain in China. 

My comparison is quite straightforward and based on the following basic logic: The smallest unit of a hotel business is the hotel room, so the enterprise value of a hotel chain is the product of the number of hotel rooms and the average profitability of the hotel rooms. (Note: this relationship is more conceptual than mathematical, if you know what I mean.)

As of the end of the third quarter, Home Inns has 68,044 rooms with enterprise value $1.58 billion. It also made $15.8 million operating profit in the third quarter. In comparison, 7 days has 28,266 rooms with enterprise value $643 million. Even though It made $5 million operating income in the third quarter, it is worth pointing out that 7 days was NOT operating income positive until the second quarter of 2009, while Home Inns has been operating income positive since 2004. 

If we assume that each room of the two hotel chains has the equal earning power and Home Inns is fairly valued, we can reach the fair enterprise value for 7 Days Group $656 million, slightly higher than its current enterprise value. However, I argue that 7 Days should be sold for a much higher discount due to:

1) 7 Days was running negative operating margin for the past three years, while Home Inns was running a healthy business since 2004. The fast ramp-up of the operating margin for 7 Days during the past two quarters could be decoration for its IPO. 
2) Home Inns is the leading hotel chain, its brand more established and its hotels more mature.
3) Home Inns has a close tie with Ctrip (CTRP), the dominant online travel booking site in China, which help sell Home Inns inventory. 
4) 7 Days is an IPO, without much reporting history. 

7 Days promoted itself as the most tech savvy firm in the industry, having a member club and an easy online booking system. But they are not unique to 7 Days, Home Inns has both; it just did not tout these in its investor communication. 

Cutting into the core, Home Inns' hotel rooms have higher and more proven earning power than 7 Days Group's. At the current price, Home Inns is a much better buy than 7 Days to get exposed to the China economic hotel business.

That being said, I do not own Home Inns either because it is YET NOT selling at a price reasonable enough. 

Disclosure: No positions in all mentioned, SVN, HMIN, and CTRP, as of the writing. 

Yesterday Giant Interactive (GA) reorganized its five development teams into five daughter companies, with Giant holding 51% of equity and the teams 49%. The event was reported by the Chinese media, but not by the English media yet.

For the background knowledge, here is a short description from Yahoo! Finance about Giant. 

Giant Interactive Group, Inc. develops and operates online games in the People’s Republic of China. The company focuses on massively multiplayer online (MMO) games that are played through networked game servers in which thousands of players are able to simultaneously connect and interact. Its online games include ZT Online, a two-dimensional online role-playing game; ZT Online PTP, a pay-to-play game based on the ZT Online free-to-play game; Giant Online, a military-themed MMO game; and ZT Online Classic Edition, a version of ZT Online for players who prefer the original monetization features of ZT Online. The company markets and sells its prepaid game cards and game points through distributors and retail outlets, including Internet cafes, software stores, supermarkets, bookstores, newspaper stands, and convenience stores, as well as through official game Website. As of March 31, 2009, its distribution network consisted of approximately 280 distributors, and reached 116,500 retail outlets. Giant Interactive Group was founded in 2004 and is based in Shanghai, the People’s Republic of China. 

I cannot help analyzing this unusual event. Accounting wise, there is no effect as of now since the revenue contribution from the those projects are immaterial. Giant may show better GAAP net income because half of the loss from those companies at this early stage will be burdened by the new equity owners, the teams. Capital market is unlikely to count in that effect though and will actually price Giant pro forma so that it is not going to affect Giant's stock price in the near term. 

In the future, if any one of the daughter companies has a hit game, Giant will get 51% of the net income, which is a smaller percent than if it does not set up the daughter companies. Apparently Giant is betting on having a smaller cut on a much bigger pie. By having those companies standalone, Giant hopes that one of them will turn into another giant, a typical venture capitalist thinking mode. 

Somehow I do not have a good feeling about this move, which seems a bit unusual and extreme. Yuzhu Shi, the CEO of Giant, had a problem in managing the firm after he successfully brought the firm to the Nasdaq market. He commented a few times about how the employees became much wealthier and lost interest in working hard. Shi launched a new game, Giant Online, named after the company, but it failed to become a hit, much due to the lack of devotion and imagination of his team. Shi figured that he should have the teams back into the entrepreneurial mode, and hence he moved to an extreme: having the teams bear as much risk as they possibly can.

One question naturally came up is that why other companies had not done this if this were such a good way to align interests. While such a reorganization removes certain attritions, it removes quite some synergy as well. The best form of company is to have as many hard working employees as possible to work for the same goal, and it is questionable if a project team possesses the necessary elements of a successful company. Shi must believe that the benefit of interest alignment by this move outweighs the synergy loss plus the added overhead. Shi might be right in his particular case, but I don't see it a reasonable move for a properly running company. An unusual move may very possibly lead to an unusual result. 

The president of Giant commented that "if the daughter companies perform well and reach the standard to go public, we will support spinoffs". It is another dangerous thought in my view, and I hope that it was just for encouraging the daughter company leaders. The capital market does not welcome one trick ponies; the best way for both Giant and the daughter company to benefit is for Giant to swap stocks with the daughter company if the daughter company ever becomes successful. 

In my previous article about Giant, I suggested shorting Giant based on its accelerated revenue decline. My theory is still intact. Giant has been so far running inside a downward channel. It looks like that the downward pressure is not going to be lifted any time soon. I expect further price drop from here, but I am going to close my minor short position at the next dip, giving Giant the benefit of the doubt. 

Giant is on a risky move. If it succeeds, Giant's fate may be changed. If it fails, Giant will become a dwarf. I am not optimistic for Giant, but I do wish it success in its endeavor. 

Disclosure: Short GA.

On November 12th, Shanda Interactive (SNDA) made a new move to form a joint venture with Hunan TV. Capitalized with RMB 600 million (88 million USD) and headed by Danni Long, a talented TV producer who championed the Chinese version of "American Idol", this joint venture "will produce and distribute movies and television series, as well as engage in other related businesses such as agency services."

The market dismissed this news as a non-event, which I do not disagree, but this event serves an early hint of Shanda Interactive's grand strategy to expand into traditional entertainment market with 2 billion dollars in its war coffer. 

It took me a long while to understand Tianqiao Chen, the founder and CEO of Shanda Interactive. In 2006, I thought that he was simply not smart. He tried to introduce a Chinese version of Apple TV, called Shanda Box, in China, which failed miserably because 1) Shanda did not have good hardware engineering capabilities and 2) the market was not there. Even Apple TV has not been a meaningful product up to today (I think this will change shortly); let alone a mediocre product in China more than 3 years ago. However, my perception of Chen gradually changed out of my following the Chinese online gaming sector, and turned fully positive after the very recent usual carve-out of Shanda Games (GAME). 

Many investors were deeply puzzled by the carve-out.  Some believe that Shanda Interactive wanted to follow the successful example of Sohu (SOHU) carving out Changyou (CYOU). But Sohu carved out Changyou because Sohu had two equally profitable businesses, Internet portal and online gaming, and the carve-out helped align the interest of the gaming management. Shanda Interactive was a quite pure online gaming company to begin with. Why should a gaming company spin off a gaming company? It does not make much sense, does it? "The biggest question I have is, what do they need $1.5 billion in cash (for)?" Adam Krejcik of Roth Capital questioned. 

Well, the answer might be that Chen is less committed to online gaming now. It is no secret that Chen has the "original sin" feelings towards the online gaming business, a business pioneered by him in China but also a business causing addiction among Chinese teenagers. Many Chen's moves can be interpreted as his endeavor to seek alternative healthier business models, including piloting Shanda Box, purchasing literature websites, and carving out Shanda Games. Chen has burdened on himself a mission to create universally agreeable social values, which in the past has deviated Shanda Interactive from its core business and hurt its stock price. With the carve-out of Shanda Games, Chen is distancing himself from the business that once propelled him to the number one richest person in China --he only assumed a board member position. 

Chen now commits himself to a building a great entertainment empire, "China's Disney" in his own words. In my view, the true intent of Shanda Interactive's carve-out is to use the IPO proceeds of Shanda Games to fund its non-game business. After the Shanda Games IPO, Shanda Interactive now owns about 2.1 billion USD cash, a formidable amount. Chen also burned his bridge: Shanda Interactive is not going to seek business in online gaming, restricted by its agreement with Shanda Games. 

Chen has taken several steps already. He has acquired three online literature sites since 2004: Qidian.com, Hongxiu.com, and JJwxc.net. There are probably thousands of literature sites out there in China, but the majority of them are not copyrighted. Shanda's literature sites offer a copyrighted platform to allow the VIP readers to pay for premium content and make sure that the authors get paid. 

In the past June, Shanda acquired 51% ownership in Hurray! Holdings (HRAY), a leader in artist development, music production and wireless music distribution and other wireless value-added services in China.

And now, we have the Joint Venture news. Following entering into the literature and music fields, Shanda is now into film and TV. Hunan TV is one of the best run state-owned media in China, evidenced by their active copying and localizing successful TV talent shows in the States. With the Joint Venture, Hunan TV became one of the first to morph itself into an enterprise run with proper capital structure, rather than state controlled. From an investor's viewpoint, I think this Joint Venture demonstrates a proper combination of physical capital and human capital, which should lead to synergy created in the future. 

What will Shanda do next with 2 billion USD at hand? Chen hinted in an interview that he is looking for the synergy between new and old media: "The new Joint Adventure is just our first step. Please watch out for our next moves". Here are some possibilities I see so far:

1) Acquire Polybona Films, the China "Miramax". 
2) Inject more capital into the new Joint Venture with Hunan TV.
3) Acquire an online Video platform, such as ku6.com, and serve copyrighted video contents.

My hunch is that Chen's new strategy is to acquire contents in the traditional media, such as movie, TV, radio, newspaper, magazine, music, literature and so on, and build up an eco-system to foster copyrighted user interaction, either traditional or online. The key for the success of Shanda's new strategy is the improvement in copyright protection in China, which is going to improve to the same level of the developed countries in the future. Shanda's active participation will greatly speed up this process. 

In valuing Shanda Interactive, Goldman Sachs applied a 50% discount to its cash position, believing that Shanda will destroy value in its acquisition endeavor substantially. I believe the opposite, very much due to the involvement of China E-captial, a Chinese investment bank specialized in the entertainment business. I have high respect for its CEO, Ran Wang, a HBS graduate and Goldman Sachs alum. Having followed Ran Wang's blog for years, I know that his business acumen and integrity are of the top grade. 

If Chen has a chance to read this article of mine, I would like to let him know that he is on the right track to create very positive social value for China with his vision and commitment. As an investor, I would like him to consider spinning more Shanda Games off Shanda Interactive so that I can invest in his non-game vision at a lower cost. Also return excessive capital to investors if no proper large acquisition targets can be obtained. 

Four years ago, I shorted Shanda heavily and I happened to be correct. But today I have my hats off for Shanda, and I support its new strategic move with my capital.

Disclosure: Long SNDA, Short GAME, No positions in SOHU and CYOU.

Investing with value style is nowhere close to easy. Stock market is so simple that we can always make money if we buy low and sell high, right? Yet it is against our human nature to buy anything when we are in danger of losing our jobs. Please allow me to quote a line from “the Matrix” movie in a different context: “To deny our own impulses is to deny the very thing that makes us human.” – “To deny our fear and greed is to deny the very thing that makes us human”.

And yet, in the stock market, we will need to deny our own natural impulses to make the right choice: We need to buy when the market is beyond panic, and sell when the market is over enthusiastic. “Wisdom on Value Investing” by Gabriel Wisdom (Wiley Publishing) prepares you for the right mindset. If you can take in information bits here and there from reading the book, subconsciously you might have some better idea of how you can be different when thinking about investment.  

Wisdom cut into the core of the mindset in the first chapter, which laid down 10 traits of the world’s greatest bargain hunters. The first trait is the default “buy when everyone is complaining, and sell when they are celebrating”. To achieve this, one would need to stick to one’s own methodology, have an exit strategy, properly diversified, and understand what risks truly are.

Value investing means that we will need to find fallen angles, such as Apple in 1997. At that time most people, including me, believed that Apple would fail due to slowness of innovation in face of the fast ‘copy and paste’ of Microsoft. Wisdom tried to offer a way to identify fallen angels against falling angles, who we should not really touch until it is truly has touched the bottom: identify those companies who still grow book value 15% annually but discounted 50% by the market. 

A big portion of this book is devoted to how to identify fallen angles in various ways: identifying nature and business cycles, identifying demographic patterns, and stock screening. Many books have covered these topics before, but Wisdom brought new lights onto them. For example, we can identify one-time calamity that will go away. Quite a few companies have stock price fallen with uncertainties of lawsuits. Once these uncertainties are lifted, their stock prices go back up.

Wisdom also touched the topic on how to sell, which is often a problem for investors due to confirmation bias. His solution: 1) sell when the reason to buy no longer exist, 2) Sell when you have a quick profit, 3) Sell when a better opportunity comes along. Many times we fail because we cannot remember our lessons well. Reading Wisdom’s advices once again may help remind us the weakness of our mind.

For people who want to have a relaxing reading to have an understanding on value investing, Wisdom’s book is your choice. But be advised that value investing is nowhere close to easy and getting your mindset adjusted to value thinking is anything but natural. Wisdom's book only shows you the door; it is you who will walk cross it. 

I became a fan of Peter “Mycroft” Psaras when he first started publishing on SeekingAlpha. If you don’t yet know who he is, check out his instablogs, articles and profile. 

The way he is different is that he clearly outlined a simple and effective framework for valuation. In what he called a "Main Street" view, he calculates a ratio called FROIC, Free Cash Flow over Invested Capital. If FROIC is above 20% consistently in the past several years, the business is very likely to be a good money-making business. He then buy such a business at a Price to Free Cash Flow ratio (PFCF) below 15 and sell at the ratio above 30, which is his "Wall Street" view. To make things easier for common investors, he simplifies the calculation of free cash flow to only adjust for depreciation and fixed assets investment.
 

PFCF = Market Price/ (Cash flow per share-Capital Spending per share)

FROIC = FCF per share/ (long term debt per share + shareholders equity per share)

I like his method. It is certainly not what I was taught in the business school, but as Warren Buffett famously pointed out that you really should not use a scale to tell if a 300-pound person is over weighted, a rough method like "Mycroft" method let you tell if a stock might be way over or way under valued at the first sight. This method is less error prone than the traditional ROE and P/E valuation because a company can ‘buy earnings’, but it can hardly buy free cash flow.

Duoyuan Printing is the only one of the four IPO stocks last week that actually went down post-IPO. Ironically, it is the only one I liked and actually purchased on the weakness. I was willing to pay up to $11 per share for it, but I was fortunate enough to get it at a little over $8 per share.

Besides all other qualitative and quantitative methods I applied in analysis, I used “Mycroft” method to double-check my thesis. I use a relatively conservative forward view of 20% growth in the top line and bottom line in 2010.

RFOIC has been consistently over 20% in the past 5 years except for 2007, when a relatively large investment was made. Financial Year 2009 (ended in June 2009) RFOIC adjusted using pre-IPO equity is 29%. So Duoyuan Printing passes the "Main Street" view test. 

Its current PFCF ratio for 2010 is at 9. Using the entry ratio of 15 suggested by Peter leads to $13 per share, giving the current price 62% upside just leading into the entry price. 

My calculation is summarized in the screenshot.


Disclosure: Long DYP. Readers should be aware of the substantial risks associated with IPO.  Reading through the whole prospectus to understand the business is extremely important. 
 

In my previous article, I discussed several problems of Lihua International (LIWA): Unusual insider share unlock, discrepancies of 2008 revenue between its SEC filings and local media, discrepancies of 2008 raw material purchase from Fushi Copperweld (FSIN), dramatic increase of unit sale price of CCA, its main product, and dramatic reduction of account receivable days and account payable days. 

 

On Friday morning, Fushi Copperweld (which I will hereafter refer to as Fushi) released its earning report for the third quarter, which helped shed more lights onto Lihua's potential accounting fraud. 

 

Fushi is special to Lihua because they are in the same sector and they sell to the same market, in which Fushi is the industry leader. Fushi is one of the first in China to have started Copper Clad Aluminum (CCA) wire business, and it is the largest by far. Lihua does not have the capability to clad copper over aluminum. Instead, it purchases CCA wires from other manufacturers, the largest supplier being Fushi, and draws them thinner. In some cases, paint is applied to the finished products for use in manufacturing electric magnets. From the beginning of 2009, Lihua entered a low margin scrap copper business. Fushi is both a peer and the largest supplier of Lihua International, which makes the comparison of the two apple to apple. 

 

Fushi disappointed its investors. For the third quarter, Fushi's revenue decreased 25% compared to the same period in 2008. The analyst consensus was $55.4 million, a 13% drop, but Fushi only made $47.7 million.

According to the management, "the decline was driven primarily by a decrease in average selling price (21.6%) resulting from lower raw material prices." But what price is the management talking about? On a consolidated basis, Fushi saw 3.7% decline in output, which means 10,100 (2008 Q3 output) x (1-3.7%) = 9,726 tons and $4,904 per ton. In my previous article, my calculation shows that the selling price of Lihua for the first half of 2009 was $14,360 per ton. Hmm... Are these two companies truly in the same industry?

 

Well, let's dig further. As in my previous articles, I will organize the findings in sub-sections.

 

A. Significant Difference of CCA Unit Sale Price between Lihua and Fushi

 

To compare apple to apple, I compared the unit sale price of CCA, the main product for both companies. For Lihua, it means that the new business of scape copper is not included; for Fushi, it means non-China located sites are excluded since they are mostly on Copper Clad Steel (CCS) business. Fortunately, all the supporting data can be found in SEC filings for both companies. 

 

Since the beginning of 2009, Fushi saw its unit sale price compressed due to the lower copper price. However, Lihua's sale price has been defying the gravity. In the second quarter, its unit sale price increased to a jaw-dropping $16,958 per ton, nearly 300% premium over $4,349 per ton of Fushi Dalian. 

 

There are quite a few problems associated with this huge difference, knowing that the products are essentially the same with different thickness and the raw materials of Lihua is the finished product of Fushi. 

1. How can wire drawing create 300% margin?
2. How can CCA price of Lihua not following the margin-plus pricing scheme of the wiring industry?
3. Why is Fushi not adding some drawing machine to extract the profit of Lihua if this is such a lucrative business?
4. WHAT is the raw materials of Lihua anyway? The CCA raw material cost was $18.2 million for the second quarter. With the production 1,545 tons, the unit raw material cost was $11,845 per ton. What is this kind of material? It certainly does not look like anything Fushi manufactures. 

B. Significant Difference in AR Days between Lihua and Fushi

 

Though the two companies are in the same sector, their AR days difference makes one feel like that they are NOT serving the same market.

 

AR days is the average days customers pays off the bill of the company. Many accounting Shenanigan such as channel stuffing and irregular revenue recognition leak their trace in AR days because AR days link the revenue with the balance sheet and the balance sheet, as its name suggests, does need to be BALANCED. It is also much easier to relax the account receivable collection than tightening the collection because tightening collection typically causes customer loss. 

 

 

For the last quarter, Fushi further relaxed its bill collection to retain their customers in face of lower utilization of its capacity. Quoted from their earning release: 

 

Accounts receivables at September 30, 2009 were $69.1 million compared to $49.8 million on December 31, 2008, an increase of 38.8%. This increase is primarily a result of extended credit terms in 2009 to certain credible customers that have long-standing business relationships with us in order to capture increased market share.

 

While Fushi is relaxing the account receivable collection, Lihua is certainly NOT living on THIS earth -- it was able to grow its revenue at full capacity without adding proportional account receivable. The numbers suggest that customers have been flocking into Lihua, paying them cash to buy products 4 times as expensive as they would from Fushi and ignoring the generous pricing and payment terms from Fushi. 

 

C. Significant Difference between Lihua AP days and Fushi AR Days

 

Due to the well established supplier/customer relationship between Fushi and Lihua, the payment period of Lihua paying TO Fushi is the exact same payment period of Fushi receiving FROM Lihua. Thus we should expect some positive correlation between Lihua's AP days and Fushi's AR days. Yet we see that these two are negatively correlated from the following graph. 

 

It is especially interesting to look at year 2008, in which Lihua buys 46.5% of its raw materials from Fushi. (For more detailed relationship link, refer to my previous post) 

 

Its prospectus states that "For each of the fiscal years ended December 31, 2006, 2007 and 2008, and the three months ended June 30, 2009 our five largest suppliers accounted for 100% of our total purchases, and our single largest supplier accounted for 31.9%, 26.8%, 46.5% and 21.1% of our total purchases, respectively." (page 70)

 

In year 2008, Fushi's AR days is 82 days and Lihua's AP days is 18 days. Even if we assume that Lihua pays all other suppliers cash on delivery, Lihua's AP days would be 82 x 46.5% = 38 days, far more than the 18 days calculated. 

 

========

 

Fushi is under the pressure of the economy slowdown: Its revenue did not make the expectation and the utilization ratio of the Dalian facility dropped from 88% in the second quarter to 78.6% in the third quarter.  

Lihua, Fushi's downstream wire drawing firm, however, is able to get away with selling the market finer wires at a quadrupled price with 100% utilization of capacity up to the second quarter. 
 

Well, maybe Fushi investors should fire all the management in face of the great "achievement" of Lihua. Their "faults" include:

• They could not shorten the account receivable days like Lihua did. It is huge saving on the capital if they do.
• They sold raw materials to Lihua only to allow Lihua to make 300% margin on it OR They sold raw materials actually at more than $11,000 per ton but reported less than $5,000 per ton.
• They cannot sell their products at $16,958 per ton, like Lihua did.
• They "grossly overlooked" how "lucrative" buying more wire drawing machines can be. 

 

Friday is a sorrowful day for Fushi -- its stock dropped 3.5% on the news, making its market cap $186 million. It suffered a 26% drop in a month. Maybe the Fushi management should learn how to fabricate fairy tales from Lihua, whose market cap is now standing at $222 million. What a reward.

 

All my calculations are show in the following screenshot. The data are all from SEC filings. Click to enlarge.

Disclosure: Short LIWA, No position in FSIN.