One of my client asked me about a particular company that is listed in Hong Kong and Shenzhen. She wanted to buy this company.
Company X2 (existing clients need to login to see the name) is not a small company. It has a market capitalization of HKD 173 billion or about SGD 30 billion. (For reference, the average market capitalization of the STI is 34 billion.) More than 90% of its customers are from China.Recently, the share price surged like nobody business due to a market rumor that the chinese government will be introducing a new regulation that is in favour of this company . Here is a chart on how it surged:
Since the typical investor is to buy when price go up and sell when share price goes down, I am not surprise this company attracted the attention of many investors.
I do not think this company is a good investment. Here is why:
The annual report[1] showed that the company has a pretax profit of RMB 6.57 billion (page 47) in the year 2016. Yet, its operating cash flow for that same year was a negative RMB 1.85 billion (page 53). Why is this so?
The main reason was a whopping increase of receivable of RMB 19.1 billion. What are receivables? Receivable occurs when a company recognize a particular sale as revenue but it has yet to collect cash from its customer. In year 2016, 58% of its current assets are in receivables. This is in contrasts to 2015 when receivable was 49% (page 49).
Footnote 23 shown that more than half of its receivables are more than three months old. Its own auditor provided a compilation of the days receivable trend for the last 5 years as shown below (page 2):
| 2016 | 2015 | 2014 | 2013 | 2012 | |
|---|---|---|---|---|---|
| Days receivables | 132 | 116 | 118 | 86 | 83 |
As it can be seen that the days receivables have been increasing over time. Days receivables is calculated as receivable divided by revenue multiply by 365 days. It is the average number of days a company will take to collect payment from its customers. My own calculation of receivable for 2016 is 45,732,885 receivable / 100,207,703 revenue x 365 = 166 days. This is far higher than that provided by the annual report.
The increasing days receivable over the years imply that Company X2 is facing a continuing problem of collecting payment from its customers. The problem appears to be getting quite serious recently.
Some may ask, how can a company continue its operation when operating cash flow is negative? For this case, the company is supported by issuing shares and borrowings as shown below:
| 2016 RMB’000 | |
|---|---|
| Operating cash flow | (1,845,571) |
| Cash flow from investing activities | (13,421,402) |
| Cash flow from financing: | |
| ...Proceeds from issue of a perpetual loan | 595,800 |
| ...Proceeds from issue of shares | 14,473,000 |
| ...Shares issue expenses | (103,930) |
| ...New borrowings | 31,223,339 |
| ...Repayment of borrowings | (26,691,182) |
| ...Interest paid | (1,970,560) |
| ...Perpetual loan interest distributed | (185,155) |
| ...Dividends paid to a non-controlling shareholder | (51,690) |
| ...Dividends paid to owners of the parent | (1,001,228) |
| ...(Increase)/decrease in pledged deposits | (18,177) |
| Net cash flows from financing activities | 16,270,217 |
Interestingly, despite having negative operating cash flow, Company X2 continued to pay dividends to its shareholders. To be precise, it issued shares worth a total of RMB 14.4 billion and then paid more than RMB 1 billion back to shareholders. Does it make sense to take money from shareholders and then to return them? I am not surprised as many investors invest because of dividends. But actually, these dividends were simply part of their own money.
Lessons:
- It is possible for a profitable company to be actually making losses.
- The dividends shareholders receive could actually come from their own money rather than from the underlying business of the company.
- A share price can surge due to rumors instead of fundamentals.
- Investors always lose money. This is the rule of the game.
[1] Login required to see the footnote.
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