Zungui Haixi “ZUN” is a maker of footwear, athletic apparel and accessories. Zungui was awarded the 30th most valuable sports brand in China in 2010 and is China’s 8th largest domestic sportswear brand by revenue. Zungui is not actually a reverse takeover (RTO), however I don’t believe that that offers any extra assurance, especially given the association this company has with other TSX listed RTO’s, to be discussed in a future post perhaps.
In the following post I have raised several questions that can be and have been indicators of fraud on other Chinese listed RTO’s.
IPO
A common red flag with many Chinese RTO’s is that they will be constantly raising cash in the capital markets despite having operating cash flows that exceeds capital expenditures. The reason for this is that it will later be shown that the operating cash flows were non-existent or overstated.
In December of 2009 Zungui raised approximately $36M CAD in an IPO. The IPO was to expand future growth through increasing store locations, increasing marketing expenditures and building a new manufacturing facility.
All of this sounds good initially, but when we look at what the actual expenditures were related to this “funding of future growth” a year and a half after the IPO, I question whether the IPO was really necessary.
The cash balance has actually increased by $7M since the IPO and every quarter except the last two quarters the cash flow from operations has been positive and has been more than enough to cover any capital expenditures.
As at March 31, 2011 Zungui has claimed to have spent $18.7M of the proceeds from the IPO, a far lesser amount from the original $35M they claimed they needed originally.
Breakdown of the $18.7M
· $8.7M for expanding the retail and distribution network
· $1.8M for increasing production capacity
· $8.2M for brand recognition and awareness
The $1.8M for production capacity appears more in line with maintenance capital expenditures and hence is not what the proceeds of the IPO were meant to be used for originally. The company has recently said they have plans to build a $4M new facility although there is very little information on this.
The other $8.2M for brand recognition and awareness appears to be normal marketing expenses and a reason for an IPO should never be marketing expenses as marketing expenses should always be covered by the operating cash flows otherwise the business is not sustainable.
The $8.7M for increasing the retail distribution network is the only amount of the $18.7M that seems like a legitimate reason for the IPO. The beginning cash balance prior to the IPO was $23M which was more than enough to cover the $8.7M.
Zungui raised far more cash than was necessary to fund the future growth and on top of that, they had a beginning cash balance prior to the IPO of $23M and since the IPO the cash balance has actually increased by $7M not decreased like would be expected.
Therefore in my opinion there was no legitimate need for an IPO, which raises red flags. In the case of other RTO’s management either raised cash from investors to fund their own pockets or to profit in the form of stock options. Neither of which is good for investors.
In the case of Zungui, I can’t comment on management’s intentions but Zungui has issued a lot of stock options to management and other related parties.
Margin Comparison
In comparing the margins of Zungui to one of their larger competitors Li Ning HKG:2331 which has a very similar business model I have noticed a few concerns in the margins of Zungui. The cost of sales of Zungui is 73% of revenue while Li Ning cost of sales is 53% of revenue. This indicates either that the cost of producing for Zungui is much higher than for Li Ning or that Zungui does not have the pricing power of Li Ning. Neither of which is good, but since the business models are very similar, which is that they sell to 3rd party retailers I would suspect that the problem lies in the cost of production.
The crazy thing though is that Zungui actually has a higher profit margin than Li Ning of 19% compared to 14%. This means that Zungui has to be saving money somewhere else. Zungui is making up for their high manufacturing costs by decreasing the costs of everything else. Total selling expenses, G&A and R&D expenses as % of revenue is 8% for Zungui and 33% for Li Ning.
R&D expense and advertising expense as a % of revenue are a fraction of what they are to Li Ning. Reduced spending in R&D and advertising generally results in reduced growth in the long run. However Zungui has managed to be spending only a fraction on R&D and advertising compared to their competitors but has still managed to grow revenue at an extremely high rate of approximately 33% compared to prior year. The fact that is Zungui’s fixed costs as a % of revenue is so much less than Li Ning is suspicious.
Store Comparison
Both Zungui and Li Ning mostly rely on 3rd party retailers 95% and 92% respectively as a % of 3rd party stores over corporate owned stores.
Note: I refrain from using the word franchise when referring to the third party retailers. There is almost no disclosure about these third parties but they do not appear to meet the definition of a franchise. They are however very similar to franchises as each 3rd party store sells explicitly Zungui branded products.
Li Ning revenue per store is approximately $190,000 compared to Zungui revenue per store of approximately $104,000 per store. This is concerning to Zungui especially since the gross profit margin of Li Ning is 47% which is significantly higher than Zungui gross profit margin of 27%.
Therefore the gross profit on selling goods to these stores is about $28,000 per store for Zungui and about $90,000 per store for Li Ning.
I would assume that the mark-up by the 3rd party retailers would be similar for Zungui and Li Ning. I question how profitable these 3rd party owned stores are to the 3rd parties that are selling Zungui branded products and whether they are even profitable at all. The difference in revenue and income per store between Zungui and Li Ning is somewhat suspect, which makes the revenue amount and the number of store locations suspicious.
Inventory Turnover
Another red flag that makes the inventory account suspect is the high turnover of inventory. Inventory turns over at Zungui approximately 25 times a year which is about every 15 days.
As a comparison Li Ning inventory turns over approximately 7 times a year or every 52 days. For every inventory cycle of Li Ning, Zungui has had 3.5 cycles!
The inventory turnover is very suspicious. Of course maybe Zungui is using a new type of just in time inventory production strategy to keep costs down, but that wouldn’t explain why Zungui gross margin is just 27% while Li Ning has 47% gross margin.
Website
Another common red flag for Chinese reverse mergers seems to always be their website, especially when the product is designed to be sold to individual consumers. I am referring to UTA and COGO.
The website for Zungui is no different and is full of red flags, which begs the question whether the website is designed to sell products to Chinese consumers or whether the website is designed to dupe investors.
Here is the company’s website, feel free to follow along.
1) On the home page of the company there are 11 links, but only 3 links actually work. I would have thought the China’s 8th largest sportswear brand would have a working website.
2) I click on the casual shoes link and I notice only Caucasian models which I find strange given that they sell 100% to Chinese consumers.
3) They still have promotions from Chinese New Year’s 2011 and earlier. Chinese New Year is in January, which was 7 months ago. I had the same result with the Chinese version of the website. Is it just me or should I not expect a company of this size to be able to update their website more often.
4) The picture of this shoe shows up twice either by going to “2011 new products” and going through the 2011 new products catalogue(they call it album) or clicking on the “life leisure” shoe on the main page of the “casual shoe link”.
I know it is hard to tell what that logo is from here so I have blown the size of the image up.
Does anybody else recognize this logo?
How about now?
For those of you not familiar with the logo, Diesel is a very popular and expensive clothing brand from Italy.
Okay, but now I am really confused. Why is a Diesel shoe showing up in Zungui 2011 new product catalogue? Does Diesel know about this?
Maybe Zungui has some kind of arrangement with Diesel to manufacture Diesel products. But then again the company says they don’t manufacture for any other parties and I found this shoe in their 2011 new products category, so that doesn’t really make any sense either.
The only reason I can think of as to why Zungui would have a Diesel shoe in their 2011 New Product catalogue is that Zungui didn’t have any of their own shoes to put in the catalogue because the 1,000 newly designed shoes they claim to create each year doesn’t actually exist.
I noticed that some of the other shoes shown on the website have logo’s that are not the logo of Zungui that would be worth further investigation however I did not recognize the logos off the top of my head.
When something like this is so blatant, you have to question managements integrity and wonder what else there is that they might be hiding.
5) Usually the point of a website is to search or browse through the products offered. No option to do that here. Only a very limited number of products are actually shown on the website and one of those was a Diesel product.
6) There is also no online store. I have tried to purchase Zungui products online from anywhere but have had no such luck.
7) So if I can’t purchase their products online maybe they can at least tell me where I can go in China if I wanted to go purchase their product. I was able to find a “store locator” section on their website but it appears as though it has never been updated or has never worked. Clicking on the different areas of the map would result in nothing happening.
This website served almost no useful purpose for an actual consumer, but it did look pretty. This makes me think that the website was created more for investors than anything else.
Thoughts for E&Y
If the revenue is overstated than the cash balance would be overstated. All auditors of Chinese companies should do what Deloitte did here for Longtop Financial. This is a great NY Times article. Another thing E&Y might try is a surprise visit to few of the 2,000 locations. If the locations exist and seem legitimate enough than the revenue may be plausible.
Disclosure
I wrote this post for fun. I am currently not long or short this company, however this could change in the future.
