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Sunday 21 July 2013

Shenguan Holdings Ltd (0829.HK) that niggling feeling it just does not square off...

Shenguan Holdings Ltd a company based in Guanxi China, is Asia's largest edible collagen sausage casings manufacturer.  Shenguan became a HK public listed company in October 2009 and currently has a market capitalization of just over HK$11bn and net assets of RMB2.3bn.

Although revenue growth has slowed to 10%, its overall financial results for the year ended 31 December 2012 is very good on a number of metrics.  But the share price have been on a downward trend over the past two years and currently trades at 11.8x earnings multiple. 

For value investors looking for lowly rated companies with favorable tail winds and a reasonably priced share, Shenguan seems to fit the description.

But my job is not about finding reasons to invest, it is to find reasons not to.  Investing is not without risk and the risk is not about betas, or standard deviations, it is the permanent loss of capital.  This means doing homework before jumping to conclusions. 

The share price have lately been affected by negative reports of slowing growth and suspicious numbers.  These reports have only cropped up in the past 6 months but as mentioned, the share price have been trending lower since September 2011.  

Ignoring the negative reports for a second, I believe on balance Shenguan is attractive because it is in an industry that enjoys a secular trend - that of rising meat consumption in China.  But for now I cannot recommend buying the shares because of the uncertainties surrounding managements' integrity.  Even after these issues have been resolved, investing in the stock requires a wide margin of safety of at least 20% - 30% for fear of repeat offenders.  The issues are:
  • Management have been less than frank.  Its financials does not contain sufficient information for an investor to build a solid investment case.
  • The margins looks too good to be true particularly when compared against global peers. 
  • The company has not unshackled its relationship with the local government.  It recently provided RMB91m financial support to the local government without any timeframe for repayment.
While the above reasons may have been reflected in the share price, with new money, the demand for greater safety is important.  This article hopefully would help potential investors make an informed investment decision.

Rise of a national champion

Like many Chinese corporations in a centrally planned economy, Shenguan began life in 1989 as part of a state owned enterprise with a nondescript name Wuzhou Protein Factory.  The factory in turn was a unit within Wuzhou Food Products Corporation. 

In 2004, ownership was transferred into private hands for RMB75m.  Through a series of corporate re-organizations and share transactions between 2004 and 2009 have resulted in Ms Zhou Yaxian, the current Chairman and President owning 65% of the Company. 

Ms Zhou's rise within the industry is somewhat mundane.  Having been involved in the trial production of collagen sausage casings from 1979 - 1989 (and many wasted collagen casings later...) she was employed by the state corporation in charge of technology development in 1989.  She later headed up WPF between 1992 and 1997.  Since 2004 Ms Zhou was Chairman of the board of directors and General Manager of the business.  According to Hurun report, Ms Zhou is ranked 10th wealthiest self-made woman in China in 2012.

Cynics might question how Ms Zhou, a former state owned employee earning a lowly wage in a centrally planned economy, in one of the more deprived provinces engineered this leap.  We will never know the truth.  

Ms Zhou's rise is certainly not unique.  Most media attribute business success to enterprising employees (often in partnership with outside capital) seizing the opportunity to become business owners from government selling state assets.  Through hard work, determination and acumen have made themselves very wealthy.  Less celebrated version is that the founder is only a front - and that the true masters keep away from public scrutiny due to their political jobs.  I believe both versions have some merit.  And this has to do with the Chinese practice of 'guanxi'.  Ms Zhou clearly have skills and deep knowledge that are key to the success of the business - this is not to be taken lightly.  On the other hand, the 'guanxi' side requires 'payments' to be made for the political and or economic support offered.

Shenguan's share price has had a good run on the stock market but the future remains clouded by management integrity 

The Company managed to raise funds at the top end of its offer price at HK$3.10.  Shareholders have enjoyed a relatively good return since flotation.  Adjusted for a 1 for 1 bonus, the share price climbed as high as HK$5.70.  It is now at HK$3.30 producing a compound annual rate of return of 28.65% excluding total dividends received of HK$0.73. 

Too rosy financials?

Revenues grew at a compound rate of growth of 27.5% while net income grew at a more impressive rate of 31.9%. ROE is 31.9%.  What is even more impressive are the margins.  The company's operating margin grew from 48.9% in 2006 to 56.3% in 2012.  The margin is incredibly high for what is perceived to be relatively low-tech product.  Unless Shenguan has a valuable economic moat that enables it to charge high prices to its customers, its pricing power could be under threat. 

Profitability not in line with global peer group

Making sausage casings is a profitable venture, and one that is enjoying a stable and growing revenue stream.  The market leaders are Viscofan (Spain), Devro (UK), Viskase (US) and Shenguan.  Together the four command over two-thirds of the global market for artificial casings worth approximately US$2.8bn.  Viscofan by far is the largest amongst the four commanding a 31% share followed by Devro (13%) and Viskase (12%).  Both Viscofan and Devro have a global foot print whilst Viskase mainly supplies North American markets.  Viskase is not terribly comparable as it is mainly a non-edible (i.e. plastic) casings manufacturer, hence its operating margins are considerably lower.

Given Viscofan's global footprint and size, its operating margin is 2.7 percentage points higher than Devro's.  And the share price multiple reflects the relative position of the two companies.  Shenguan by comparison is the most profitable manufacturer by streets ahead.  Its operating margins are 35.7% higher than Viscofan completely obliterating conventional wisdom of manufacturing scale and the advantages of being a global market leader.  Accepting the fact that Shenguan has a monopoly position in China and that costs differentials are much better in China it is hard to comprehend how Shenguan can earn such high rate of return without attracting any attention.  

Lowly rated share price or scam?

If Shenguan's does indeed produces such returns, it begs the question why is it rated lowest amongst the peer group?  Viscofan and Devro's PE is 17.2 and 14.5 respectively (based on Dec 12 year end figures and 17 July 2013 closing share price) while Shenguan's PE is only 11.8.

Many reasons have been offered in the press.  Comments from outright fraud to suspicious accounting to slowing prospects have all been tabled.  Forensic Asia's analyst have been the most bearish issuing a SELL report in January 2013.

DBS analyst have summarized points raised in Forensic Asia's report.  I have not been able to read Forensic Asia's report but have managed to read DBS's summary of the conference call held by management a day after the report was issued.  If Forensic Asia's report is damning of the company, then the conclusion reached by DBS's sell side analysts is even more damning of the equities industry as a whole.  These CFA qualified analysts have hardly put any critical thinking into their report - issues that can be easily picked up and picked apart seemed to have been glossed over.  Their summary assessment that all of management's responses were "reasonable" is a supreme lack of duty of care - bordering on cavalier.  Clearly nobody believed management's responses.  And the share price which have gone back up post conference call to HK$4.20 have now come down to HK$3.30.  Holding on have meant a 20% drop in share price. You can Google DBS report, but I will just highlight the areas I have found management's explanations to be unconvincing.  

Monopoly Position
  • Shenguan monopoly position is no economic moat. 
  • Viscofan's China operations started in 2010 have already produced revenues of RMB170m in its second year of operation. 
  • Viscofan estimates that the overall China market size is RMB1.9bn.  If true, Shenguan together with Viscofan already supplies the entire market.  I suspect the actual market size is higher (perhaps around RMB2.5bn - RMB2.8bn). 
Not comparable with global peers
  • Comparison with global peers is comparable.  Viscofan reports their casings business separately and over a thrid of revenue is from collagen.
  • 87% of Devro's revenue is from collagen.
Viscofan expansion is not a threat
  • Viscofan's China revenue says otherwise.  
  • It may be that Viscofan China's operations is selling at a loss to gain market share but with the entrance of a global player, margins and growth will definitely come under pressure.
R&D Spend
  • It is surprising that customers would pay RMB120m for product development.  
  • It is unlikely the small customers would have the ability to spend so much on product development so we can ignore them. 
  • Revenue from Shenguan's largest customer is RMB500m in 2011.  If we assume the Top 5 customers contribute 60% of revenues (similar level to the level disclosed in the listing Prospectus).  These customers have spent an extra 12%.  A shockingly high number.
  • Devro and Viscofan have made no mention of such spending by their customers.  It would not be unreasonable for product development cost to be absorbed by the manufacturer or recouped from slightly higher prices rather than charging customers directly for it. 
  • Because of the basic shape and method of cooking does not vary considerably it is highly questionable just what development services can attract such high rates.
  • 2012 R&D expenses is even higher RMB210m.
  • R&D policy is expensed to COGS not in Administrative expense.  It was disclosed in the 2012 financial results that Shenguan only spent RMB5.3m and RMB5.7m respectively on R&D which is included in COGS.  Management's respond of RMB30m spend in 2011 and included within Administrative expenditure is simply not true. 
  • Could it all be round trip IPO money coming back in to keep the pretense of a strong business for a bit longer? 

  • Since the conference call, management have been even less transparent in their 2012 annual report and management presentation.  For example, in its 2012 annual report, production statistics have been dropped off altogether.  Very limited guidance have been given to the future direction.  Even the recorded webcast does not contain any Q&A.

    To top it off, management have effectively loaned the local government RMB91m to clean up land and pay for relocation and land acquisition compensation fees.  The transaction have been described as "Land Development Investment Contract".  This is the 'guanxi' element coming back to roost.  Because local government have maxed out on their credit card, the local government have started to call in their chips.  Time for payback.  This point has also been raised by Forensic Asia.



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