So what was my first mistake?
Lousy and basic accounting skill. Looking at the current financial statements, there's in fact quite a number of doubts in its statement that I should have spotted earlier on.
First of all, lets look at their growth story as written in 2010 annual report:
Since 2008, we have made strategic changes to reposition ourselves as a mass appeal and casual lifestyle company and away from the sportswear segment.
Is it really so? In 2008, they added 3 more production lines to a total of 5 to produce an annual output of 7.2m pair of shoes. And in 2009, they added another 1 more production line to increase total output to 8.4m pair of shoes. In 2010, they sold a total of 5.42 million pair of shoes and in 2011 they sold a total of 4.63 million pair of shoes. This is a 40% underutilisation of production capacity. This should has been the first warning - Management is not following what they have said.
And if we are talking about this company, we will definitely need to talk about its receivables. Ever since it was listed in 2008, profit has been jumping literally. From an EBIT of 46m rmb in 2007, it rises to 80m in 2008, 150m in 2009 and 200m in 2011. This is pretty similar to its total receivables. While it is plausible and reasonable that receivables should rise in tandem with revenue, it is definitely not when you see the receivables turnover jump from 32 days in 2007 to 56 in 2009, 94 in 2010 and in 2011 - 130 days. It should have been around 140-150 days if not for the so called Sales Incentive Award of 52 million rmb.
What about the inventory turnover? From 40 days in 2007, it has dropped all the way to 11 days in 2010 and 2011. This implies that its inventory is able to turnover at 14 times faster than the receivables. High inventory turnover can be a very positive sign for companies like those in FMCG and fast food as it helps to increase their working capital. However, in the case of Eratat, it is unable to collect its receivables in time, which means it will need an enormous sum of working capital to be able to fuel its high inventory turnover. Given its receivables turnover of 150 days, it will need a working capital of at least 200m rmb to function since its trade payable is only at 25m. This is why a placement is being done to raise 60m rmb in May 2011 despite the fact that it has 160m in cash (This should also has been an important red flag). And a high inventory turnover means that the product is very hot-selling, but then again why did the distributors face difficulty in paying them?
The next question will then be how much cash has been generated from operation given that its profit has increased 5 folds in 4 years. From 2008 to 2011, a total of 557m of EBIT has been generated of which a total of 118m has been paid out as income tax, giving a total net profit of 339m. However, net cash generated from operation in that period sums up to only 60m in cash. In 2007 where profit is only half the amount of 2008, the company actually manage to generate 35m in cash from operation. So what has happened to the rest of the 279m of cash? it has been turned into trade receivables.
Many will then be concerned now if the 222m cash in the balance sheet is real. The answer is yes given that the auditor has checked with the bank. Why am I so confident that the cash is real given that it has only managed to generate 60m in cash so far? Well, through IPO, warrant and share placement they have raised a total sum of 300m in cash of which they have only used around 70m of it. 25m was used to create the production line for shoes in 2008 and 2009, 21m was used to purchase PPE in 2010 and another 25m was used in its acquisition of subsidiaries, Fujian Haimingwei. Therefore, the cash balance is likely to be real since it is in fact just shareholder's money that's not yet used. This raises another question, if it does not need that much of a working capital, why did it even bother listing in the first place?
And finally, the tripling in ASP (Average Selling Price) of Eratat's apparel to 242 RMB is rather surprising in FY2011 Autumn/ Winter. It is not just the fact that revenue increases by 50% that puzzled me, but the fact that gross margin remains the same at 38.2%. Using simple maths, we can easily figure out that if ASP triples and gross margin remain the same, it means that the cost of production has also tripled. So, if ASP has not tripled, will not Eratat has made a loss?
Being blinded by a growth story without checking its financial statement is definitely a road to self-destruction. I have a realised lost of 20% on this investment and it has been one of the most painful lesson I have learnt. All I have to thanks for is that my capital invested in it is rather modest and I have divested it after I realised something was wrong in Q3 2011.
The most important lesson I have learnt from this experience is that financial statement will never lie about the actual state of the company. Even in the case of a financial shenanigan, there will definitely be tell-tale sign like how the annual report will be too complex for one to understand.