Is Lihua International Cooking Its Books? Part II

Includes: FSIN, LIWA
by: Chimin Sang

In Part I, I discussed several of Lihua International's (NASDAQ:LIWA) problem, including accelerated insider share unlock, discrepancies of 2008 revenue between its SEC filings and local media, and discrepancies of 2008 raw material purchase from Fushi Copperweld (NASDAQ:FSIN).

In Part II, we will review two more issues.

D. Dramatic Increase of Unit Sale Price of CCA

The following statements appear in Lihua's prospectus so that we know its production capacity and the actual sales (page 32).

Prior to 2009, our business focused primarily on CCA. Our CCA business consists of acquiring CCA with a line diameter of 2.05 mm from our suppliers as a raw material, reducing the diameter of the CCA by drawing it and then annealing and coating it. Our final CCA product typically has diameters from 0.03 mm to 0.18 mm, depending on customer specifications. To meet strong customer demand, we substantially increased our CCA production capacity from 2,200 tons per annum as of the end of 2006 to 6,000 tons per annum as of June 30, 2009. We plan to further increase our CCA production capacity to 7,500 tons per annum by the end of 2009. In each of the following periods, our sales of CCA were as follows: 2006 – 2,009 tons, 2007 – 4,065 tons, 2008 – 5,966 tons and six months ended June 30, 2009 – 2,959 tons.

We can also find out their CCA revenue. Especially we can find out their CCA revenue for the first 6 months of 2009 from the end of quarterly statement -- $42,490,559. I attached a screenshot here (Prospectus page Q-25).

It is not difficult to calculate the unit sale price for the CCA products:

The management explained the difference between 2007 and 2008, suggesting a better product mix. Note that the underlined number agrees with the calculation above for 2007 and 2008.

Net sales increased by 53% from $32.7 million in 2007 to $50.0 million in 2008. This increase was primarily due to increased sales volume of CCA magnet wire as driven by strong market demand, facilitated by the increase in our wire production capacity from 4,200 tons in 2007 to 6,000 tons in 2008. The increase in the overall average selling price from $8,039 in 2007 to $8,382 in 2008 also contributed to our higher revenues in 2008. The average selling price increase year-over-year is a result of larger portion of CCA magnet wire sales in our sales mix, which increased from 1,735 tons in 2007 to 4,087 tons in 2008. The percentage of our total sales represented by sales of CCA Magnet wire increased from 43% in 2007 to 69% in 2008 accordingly.

The management neither mentioned nor explained the difference between the first half 2008 and 2009. In my opinion, such a dramatic increase merits a detailed discussion.

Since CCA price is generally set to be cheaper than copper wire, it is hard to explain a price jump. If we assume that the sale price is at $8,400 per ton level and the maximum production capacity at 3,000 tons for half a year, the maximum revenue Lihua International can achieve in the first half of 2009 would be $8,400 x 3,000 = $25,200,000, far less than $42,490,559 claimed.

E. Dramatic Reduction of Account Receivable Days and Account Payable Days

Account Receivable Days (AR days) and Account Payable Days (AP days) reflect how soon the bills are paid off to the suppliers and by the customers. Though the company has more control over Account Payable Days, the customer behavior indicated by Account Receivable Days can hardly change in a short period of time.

My calculation indicates that the AR days decreased from 60 days in 2007 dramatically to 15 days in 2009 Q2. AP days decreased from 40 days to 12 days.

In its business discussion, Lihua quoted its revenue collecting policies in two places.

"For the three months ended June 30, 2009 and each of the fiscal years ended December 31, 2006, 2007 and 2008, our five largest customers accounted for 13.7%, 22.5%, 14.5% and 20.2% of our total sales, respectively, and the single largest customer accounted for 3.3%, 5.0%, 3.0% and 6.6% of our total sales, respectively. We generally extend unsecured credit for 30 days to large or established customers with good credit history. Management reviews its accounts receivable on a regular basis to determine if the allowance for doubtful accounts is adequate at each quarter-end." (page 70)

"Our collection practices generally consist of cash payment on delivery. We extend credit for 30 days to 60 days to certain of our established customers." (page 35)

The only way to explain shorter AR days for the management is that more revenue is collected as cash payment on delivery. Dramatically increased revenue and the increase of established customer from 2007 to 2008 normally would lead to longer collection period, and yet, we see AR days nearly halved during the same period.

Lihua also quoted its vendor relationship in page 69:

"We primarily use CCA wire with a line diameter of 2.05 mm, produced by our bimetallic wire suppliers, to manufacture superfine CCA wire. Our raw material procurement policy is to use only long-term suppliers who have demonstrated quality control, reliability and maintain multiple supply sources so that supply problems with any one supplier will not materially disrupt our operations. In order to avoid copper price volatility exposure, we do not maintain raw material inventory. We confirm raw material purchase orders with suppliers only when the relevant sales orders are received. On the other hand, our principal suppliers usually dedicate portions of their inventories as reserves to meet our manufacturing requirements. Suppliers are generally paid with a credit term of 30 days."

While Lihua claims that it generally paid suppliers with a credit term of 30 days, the same prospectus shows that it has been voluntarily speeding up the payment to 12 days. Hmm... what is the motivation?

How likely such a dramatic change of customer behavior could happen is quite questionable. AR days of 15 and AP days of 12 is not the China I know. On the other hand, if the revenue were exaggerated, AR days would show abnormal reduction. If the cost of goods were increased proportionally to maintain the historical gross margin, the AP days would show abnormal reduction at the same time.

F. Final Words

Here is a summary of my findings:

    • Lihua is unlocking all of its shares for sale in 3 weeks to 2 months of its IPO, not a typical 6 months.
    • Lihua's 2008 revenue is 350 million RMB according to its prospectus, but 100 million RMB according to a local radio station news piece.
    • Lihua purchased $15 million of raw materials from its largest supplier in 2008, and Fushi's largest customer purchased only $10 million from them. My evidences link Lihua's largest supplier to Fushi, but cannot link Fushi's largest customer to Lihua yet.
    • Lihua's CCA unit sale price went from $8,382 per ton in 2008 to $14,360 per ton in 2009, an unlikely number.
    • Lihua's AR days and AP days drop precipitously to 15 and 12 respectively, both unlikely numbers.

All the evidences I have gathered pointed to a high likelihood for Lihua to have artificially exaggerated its revenues. These evidences are nearly all from the company's own inconsistent filings. I am curious in finding out how Lihua would like to respond to the questions I raised.

Disclosure: Short LIWA, No position in FSIN