China XD Plastics: When The Numbers Don't Add Up, There's Over 80% Downside

Summary

• CXDC reports substantially margins higher than its main competitor, yet spends much less on R&D.

China XD Plastics Company (OTC:CXDC)

China XD Plastics is a Chinese specialty chemical company which is engaged in all phases of the production of plastics, which are mainly used for automotive uses, and sells to mainly the Chinese end-market.

CXDC entered the US public markets through a reverse merger, a method that many fraudulent companies have previously used. Below is a summary of what we have found researching CXDC.

• Reported profit margins 200% higher than its larger and better funded competitor Kingfa.

CXDC's Gross Margins Are Substantially Higher Than Its Much Larger Competitor

CXDC has incredible gross margins, if you believe them. CXDC's main publicly traded competitor is Kingfa, which trades on the Shanghai Exchange. Kingfa is mentioned in CXDC's 10-K as well, the 10-K reads:

Currently, Xinda Group's primary Chinese competitor in the automobile industry is Guangzhou Kingfa Science & Technology Co., Ltd. ("Guangzhou Kingfa"). Guangzhou Kingfa entered the automotive modified plastics market in 2006 and its facilities had an annual manufacturing capacity of 375,000 MT for its modified plastics products used in the automobile industry at the end of 2012, according to the research report by Frost and Sullivan. Guangzhou Kingfa has the largest capacity expansion plans and was expected to expand to 1.06 million MT by 2015 according to Frost and Sullivan's report, but its utilization rate of production capacity is expected to be lower than that of China XD based on Frost & Sullivan's report. Guangzhou Kingfa has much larger financial resources than Xinda Group. However, we believe that it currently holds fewer number of product certifications for automotive modified plastic to the automobile industry compared to Xinda Group. Another top domestic manufacturer of modified plastic is Shanghai Pret Composites Co., Ltd. ("Shanghai Pret"), which focuses on the production of automotive plastics. It had an annual capacity and sales volume of 120,000 MT and 73,100 MT in 2013, respectively, according to a report by Frost and Sullivan.

According to that statement, it would make sense that CXDC, a much smaller company with less resources, would have lower gross margins, after all there is an economy of scale aspect to manufacturing plastics. CXDC, however, does not only have better gross margins, but substantially better gross margins.

How much higher? Well from 2009 to 2013, CXDC reported gross margins that were substantially higher than its main, better funded competitor.

And Kingfa is a much larger company, that generates billions of dollars in revenue. Consider this, in 2013 CXDC generated 45% less revenues than Kingfa but reported net income that was 184% higher than Kingfa. Since 2011 Kingfa has seen its net income decline by 21% while revenues have grown 24%. On the other hand, CXDC has seen net income grow by 133% and revenues grow by 175%.

One could argue, hypothetically, that CXDC has some sort of proprietary method of manufacturing their product that allows it to report such high margins. CXDC's R&D spending, however, has been relatively miniscule compared to Kingfa. According to this, Kingfa invests 2-5% of their annual sales in R&D.

Source: Kingfa IR Presentation

Bear in mind that Kingfa has a much larger sales number as well, so its R&D expenses will be substantially higher than CXDC's.

So it is clear that CXDC is not outspending Kingfa on R&D to generate its higher margins. Being conservative and using the low-end of Kingfa's R&D guidance range of 2% would suggest that Kingfa is substantially outspending CXDC on R&D, yet somehow CXDC manages to report higher margins?

All charts are my analysis from publicly available information.

A Curious Move By CXDC

CXDC announced the closing of its senior notes offering in February of this year.

China XD Plastics Company Ltd: Says that its wholly owned subsidiary, Favor Sea Limited (the Issuer), closed its international offering of guaranteed senior notes. The offering consists of $150 mln aggregate principal amount of 11.75 pct guaranteed senior notes due 2019.Issuer intends to use the net proceeds from the offering for repayment of indebtedness incurred by its PRC subsidiaries, for capital expenditure on a production base in Sichuan and for general corporate purposes. The Notes are guaranteed on a senior basis by the company and Xinda Holding (HK) company Limited, a subsidiary wholly owned by the Issuer and secured by a pledge of the shares of the Issuer held by the company and a pledge of the shares of the Subsidiary Guarantor held by the Issuer.

The notes carried a surprisingly high interest rate of 11.75%. More surprising was that they were issued internationally. If the company, as it claims, is truly one of the leading specialty chemical companies then why can it not issue debt in the country in which it operates and why is it paying such a high interest rate when interest rates all around the world are at historic lows.

Increasing DSO Is A Red Flag

From the Old School Value blog:

DSO tells you how many days it takes a company to collect revenue after a sale. Look out for increasing DSO as it means the company is unable to collect payments and/or providing lenient terms to buyers. To put it simply, the company is disguising weak sales.

Here is a chart of CXDC's DSO.

Source: My analysis

Passing The Smell Test? Don't Think So

In an article by Bill Bishop he gives us six things that are warning signs that a Chinese stock may be a fraud. Let's apply this test to CXDC.

Our friends over at iChinastock (disclosure: I am an advisor to their parent company Snowball Finance) have created a list of 5 Warning Signs That A Chinese Stock May Be a Fraud:

1. Company went public through an OTCBB Transfer or other ways of back-door listing;

2. Company name starts with "China" [unless they are state-owned they cannot register a company in China starting the word "China"];

3. The products are sold in China, but there is minimal Chinese-language information about those products;

4. The business defies common sense;

5. The underwriter, audit firm and accounting firm are second tier and/or have a track record of missing frauds (like Deloitte China).

To this list I would add a sixth warning sign:

6. The CFO does not live in the same city as corporate HQ and is not a regular presence there.

So how does CXDC stack up? Turns out not so well.

1. CXDC Fails. CXDC went public through a reverse merger.

2. CXDC Fails. "China XD Plastics" as you can see the name starts with China.

3. CXDC Fails. Searching Google reveals no Chinese links on the first page.

Source: google.com

And perhaps more interestingly, CXDC does not have a Chinese-language website, although it does have what appears to be a link to Chinese-language website the link does not work and you stay on the English-language website. Compare this to Kingfa's homepage.

Source: Kingfa website

Kingfa's website has an English version, but the main website is in Chinese and the Chinese-language website is more advanced. How does CXDC have margins that are so much higher than Kingfa's if it doesn't even have a website in the language of the company that it does its main business in? Something doesn't add up.

4. CXDC Fails. CXDC not only defies common sense, it defies any rational explanation of how business is done.

5. CXDC passes. Sort of. KPMG is CXDC's auditor. I believe they pass on this one but it is interesting to note the relatively high turnover of auditors.

Source: TradingChina

Also worthy of note is that CXDC's audit fees were remarkably low until KPMG began doing the audit.

Source: My analysis

6. CXDC Fails. CXDC's CFO is based in New York City, at least according to his phone number.

So CXDC has failed 5 out of the 6 questions of the Chinese Fraud smell test. Not great.

Conclusion

CXDC does not pass the smell test. It doesn't make sense. If you are concerned about shorting the stock, CXDC has a fairly liquid options market. I think the 7.5 strikes are attractively priced and the risk/reward seems good, which month you chose is up to how aggressive one wants to be. I think shorting the common stock has an excellent risk/reward as well.

There are numerous and substantial red flags at CXDC, and my price target of $1.83 and 81% might eventually prove conservative.

Note: These are my opinions based on due diligence. It is possible I have missed something or made an error. If there is any error I will correct it immediately. My analysis is based on the facts that are publicly available.

Update: On July 31st I received a message from Shearman & Sterling LLP asking that I correct certain aspects of this article which they deemed "false and unfair." They believed that my article falsely accused Mr. Zhang, the CFO of being accused of fraud at previous positions. While I believe that my writing made it clear that Mr. Zhang was only employed by companies that were then later accused of fraud, I have deleted that part of the article. Their letter goes on to say that what I wrote regarding contacting the CFO was untrue, and that I did not contact him. What I know happened was that I called the number provided on the CXDC website for the CFO, I asked if I was speaking to the CFO and the person on the other end of the line said he was the CFO. Whether that was a misunderstanding on the other end of the line I am not sure. I have redacted this part of the article as well.

Disclosure: The author is short CXDC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.