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Wednesday 21 August 2013

Slipping on its own sausage skin, Shenguan's disturbing interim report

It has been awhile since my last post as I have been preoccupied by the half year reporting season in Hong Kong.  So far, the half year results have not been too bad.  I do not have hard data but overall, its been pretty bad for the manufacturing and basic materials sectors.  But I would not classify it as a disaster.  Where there have been positive news, it has been tempered with rising costs and slower revenue growth compared to the experience of the last 3 years.  

News on the street that China / Hong Kong markets are cheap, I believe, are wide off the mark.  In fact a lot of the quality names are trading at quite high multiples.  Case in point, SaSa (PE 28), Want Want (PE 31), Tencent (PE 41), AAC Tech (PE 20), Mengniu (PE 36) amongst others.  Hong Kong's cheapness, I believe is due to its large financial and real estate sector.  It is only appropriate that investors demand a margin of safety where there are concerns over asset quality and mounting debts in the system. 

For the careful investor, stock picking not index buying is the rule.  And you should be asking "why I should own this stock" not "why shouldn't I own this stock."  This change of emphasis should help to lessen your chances of making stupid mistakes. 

Shenguan needs to become more transparent 

I reviewed Shenguan Holdings Ltd. (0829.HK) a couple of weeks ago and decided that, despite its seemingly high profit margins and favourable prospects, the careful investor should give it a wide berth.  Shenguan gave a good story at its IPO in Oct 2009.  Now approaching its fourth year as a public company, the cracks have started to appear.  And it is not so much about cracks in industry prospects, which remains intact, but rather cracks in its corporate governance and management's less than frank assessment of the business.

Shenguan's revenues and net income over the period is down 1.3% and 2.6% respectively.  Management blamed the drop in revenues down to customers running down stocks and a preference for shorter wieners (no jokes here).  The greater fall in net income is due to the rise in utility and raw material costs and higher depreciation charges.  Operationally, the business have been impacted by the move to using whole pieces of cattle inner layer skins which have affected efficiency during the transitional period and the installation of new heating technology interrupted production.

Floating pig carcasses down the Huangpu River and bird flu outbreak clearly did not help the situation.

This all seems plausible, and it is a good story for a not so good result.  But without disclosing production data of casings produced and the number of production plants it has installed since it stopped reporting the number half way through 2011 is a red flag for me.  Indeed I have already raised the point about the decreasing level of disclosure in the MD&A section post IPO.  Instead, the "wishy washy" MD&A section, which any person with moderate intelligence can get looking at the numbers, leaves you none the wiser.

Another area of concern I have is the never ending capital expenditure.  Net PPE have been growing faster than revenues in 4 out of 5 years and increased 12% in the first six months.  Perhaps it is justified but without production data, I can only conclude the capex number is highly suspicious.  This suspicion is warranted because the company have made it clear that shareholders come second after the company dished out RMB92m in soft loans to the local government during the last financial year.  One wonders how much of the capex are actually soft loans or money that has just disappeared down the rabbit hole as opposed to enhancing production capability which will benefit the future.

Another area of concern is the huge increase in inventory.  Inventory turnover came in at 2 times compared to 3.4 times in the previous period.  It is carrying 70% (RMB144m) more inventory compared to the previous period.  No explanation have been given for this sharp rise.  Either the company have made a monumental mistake carrying too much inventory or it is simply pushing costs out to later periods or both.

If this be a small company, not Asia's largest sausage casings manufacturer, I'd be inclined to take a leap of faith and overlook some of the poor disclosures.  In this instance I'd rather keep my distance regardless of my previous good experience with UK listed sausage skin manufacturer Devro PLC.

The combination of lower profitability, higher inventory and capital expenditure have pushed the bank balance lower by RMB394m since the start of 2013 to RMB491m.

Clearly I am not the only one who is sceptical of this stock.  The company's stock had dropped over 4% since its interim results.  Even the announcement of a special dividend of HK2.8cents and share buybacks have not been able to stem the slide to HK$3.30. 

Shenguan remains a young public company, and the accounting gimmicks can only fool investors so long.  I think Shenguan will surprise on the downside in its 2013 annual results - there I said it here first!

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