Saturday, February 25, 2012

Eratat Lifestyle - My First Stock, My First Mistake

This was the first stock that I bought, after I was enticed by its growth story of positioning itself in the premium market where there is higher profit margin. Profit margin is growing and profit and revenue have been jumping higher and higher each year. Coupled with its high cash position and low P/E of less than 2, this seemed to be the ideal stock.

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.


  1. Wow that's a good loss. For you to lose only 20% yet learn so much. Pales in comparison to my larger losses haha. Anyway I think you have come a long way. Still in awe of your thought process.

    1. it's not just a 20%... Out of my first 10 trades, i made losses in 9 of them. Though these sums up to only 11% of my total capital, it has scared me enough to take up a more structured fundamental approach. And of course, I have to thank ValueBuddies - peer pressure helps a lot :) Can't imagnie what will happen to me if I stumbled onto a trader's forum

  2. A very impressive piece of reflection!

    Never let a good mistake go to waste, and you seem to have profited from it ;)

    Now look at your previous post:

    Are there similarities between your "assumptions" on compounding and your believing in the growth story of Eratat?

    We are only young once. So go out there and get more bruises and cuts!

    I am so envious of you!

    1. As I said it was my first stock, I did not have any idea how to analyse the financial statement then. All I knew then was that this stock has a great growth story and it is reflected in the earning. And the P/E is like less than 2. So I thought it must have been that people treated it like all the other S-chip, so it will make a great "value-buy".

      Right now, I am in fact wondering if it will work if we were to diversify and place an equal amount of capital into every S-chips. Will we be able to generate at least 10% return?

      It's definitely good to get all the bruises now given that my capital is still small. but my failed "stock-picking" techniques at the start with only a 10% success rate compelled me to learn as much as possible.

    2. One thing to consider is from a broader perspective: Is it better to select individual stocks whilst analyzing the balance sheet in-depth and the like, or just better to buy an index fund? I guess it all comes down to what one believes. If you feel you have the time, skill and discipline to beat the overall market, go for it; otherwise, and index fund could just be the best bet. Or, perhaps a combination of both techniques.

    3. I am currently looking for a 10% capital gain and 5% dividend gain. Will I be able to achieve that? Maybe yes or maybe no. Well, it's never easy to be an enterprising investor who is perhaps just looking for a few more percentage points in return over the Index.

      Nonetheless, I do believe that this will be a fun, enjoyable and rewarding journey even if one is not taking into account the monetary aspect of it.

  3. oh dear, reading the first couple of pars tells me that you are missing the key elements of the picture.

    a. regarding shoe production increases: U had assumed Eratat was producing more & more sports shoes. It's wrong. They produce casual lifestyle shoes (which are of course different from shoes for running/basketball, etc).

    b. Inventory turnover days : The bulk of Eratat's revenue is from apparel -- this is contracted out to suppliers. Therefore Eratat doesn't have apparel inventory the way FMCG players do. Yr comparison is flawed for lack of understanding of the business.

    1. a) Be it whether they are producing what king of shoes, it is still a fact that they put in money to increase factory output but end up producing only half of its 8.4m output. The 20m rmb spent in this area could have been saved up. And, Eratat has make it clear that they are going for apparel as they have higher margins than shoes. Then they say they are going to premium brand to have even hgiher premium.

      b) Shoes are being produced by their factory while apparel are contracted out. However, given that its inventory is at 26m and trade payable is at 25m, it will means that Eratat has to self-finance 5/12* 700k = 300m in cash for it to secure its good for the next half of the year.

      My illustration of FMCG is to show how high inventory turnover can be positive if receivable day is less than inventory turnover day. In Walmart, Macdonald and Amazon case, they have NEGATIVE working capital since they can turonver their inventory in less than a month, while they can choose to pay back trade payables after a month or 3.

      However, if it is high inventory turnover + 5 months to collect receivables, the company will have to do some more share placement to raise its working capital. This is what's happening to Eratat now. Else if it is not in its inventory and trade payable, what happen to the other 650m of COGS? Obviously, Eratat will have to pay for them next year.

      And, the latest announcement says that subsidies will only be 5% of revenue. This is rather tricky...

      With its Net profit margin at 14%, a drop in 5% revenue= net profit margin drop to 9%. This means that Eratat net profit will drop by 33% next year if revenue remain the same.

  4. Hallo!
    I'm momoeagle in a number of stock forums. I have warned others about Eratat following my previous mistakes, but been flamed in some forums :p

    These were my very early postings on Eratat:

    My latest is at valuebuddies forum :)

    1. How i wish that i could have learnt as much about accounting at the start... but well, it's all too late to say that now.

  5. Don't forget that the price you go in and out are very important considerations. Eratat at 40 cents, 20 cents, 10 cents, 5 cents... all have very different implications. If possible, tag or benchmark your analysis to a relevant price.


    1. thank you, i will take your suggestion into consideration next time. anyway, i bought it at 1.50 and sold it at 1.25.

  6. yikes, you deleted my posting which raised valid points about yr wrong assumptions!

    a. shoes - u assumed sports shoes. it's wrong. Eratat has switched to doing casual lifestyle shoes.

    b. inventory turnover -- Eratat doesn't hold inventory like other players since it contracts out the manufacturing upon receipt of orders at its 2 trade fairs.

    1. i didnt delete it. it was just labeled as spam by blogspot. If i have deleted it, i will not have been able to restore it:)

      Fear not, the day when I really want to be draconian, I will ban the use of anonymous

  7. I am not observer2 but I re-post here his/her comment in the NextInsight forum which is useful in providing balance and perspective to the discussion in this blog:

    One of the valuable tips for investors is to really “understand well the business that one invested in”. Some of the comments made in this forum clearly reflect a lack of understanding of Eratat’s business. To understand Eratat better, those interested in Eratat may like to ask themselves the following questions:

    What is Eratat’s business model? Is Eratat’s management on the right track to transform Eratat from a Sportswear business to a “Casual Lifestyle Wear” business? [Also see JP Morgan’s comments on PRC Sportswear - ]
    Assuming you are now the owner of Eratat, how would you make a success of Eratat’s current business?
    High receivable is a risk factor. What has Eratat done to deal with this risk? How is this risk compared to the risks of accounting fraud, insider’s mismanagement, poor business or business downturn, etc.?
    Eratat has rewarded its distributors for their good performance. [In FY 2011, revenue of RMB 1,041 million was raked up by 12 distributors as against RMB 968 million by 17 distributors in FY 2010]. Is it necessary to give such reward? Would you do it if you run such a business?
    Eratat intended to subsidise distributors to renovate their premises to give it a classy, high-end look. Is this necessary? Would you do likewise if you were the boss of Eratat?
    Is Eratat likely to succeed in transforming itself into a seller of high-end casual lifestyle wear in one or two years’ time?

    Ken Ho and Kelly Tan of Eratat had dealt with all the issues above in detail at their briefing sessions to investors, and those interested to know more of the company should find it useful to attend one of these sessions. Ultimately, it is for each individual to decide whether he/she wants to invest in Eratat (or any other company) after knowing the full facts of the company. If Eratat can succeed in sprucing up its image as a high-end casual lifestyle wear supplier, shareholders taking a stake at current price level could well reap a whopping windfall; otherwise, its share price could just languish in depression like any other poor S-chips, depending on market condition.

    As for the fall in Eratat’s share price since March 2011 which would likely have caused depression to many Eratat’s shareholders, I only have one simple question to raise – Which penny stock did not have a big fall in share price since March 2011?

    1. Sure, i welcome discussions a lot so long as there's no malice, advertisement or spam. Discussion is where one's investment acumen can grow and perspective broaden :)

      Eratat is defnitely on the right track from transformation of sportswear to casual lifestyle wear and now to premium apparel. It is precisely this business model which draw me to invest in the stock in the first place.

      And High receivables is the main factor of discussion on Eratat. How much of a risk is that? I can tell you it is extremly high even if we were to assume that there's absolutely no fraud involved in the revenue. Since we have no evidence of so, i shall not be assuming it is.

      The receivables collection days are currently 5 months if we take into account the so called distribution. Eratat COGS is around 700m RMB. 5/12*700= 290m RMB. This is how much of a working capital that Eratat will need on the assumption that revenue does not grow. and what if revenue continues to grow at maybe 20%? eratat will need 350m rmb in cash. And this is precisely the reason why Eratat has been introducing share placement. if receivables continue to stay the same way at 5 months and revenue continues to grow, Eratat will have to do numerous other share placements or risk being sued for default. In the business world, many start-ups die due to cashflow problem and not exactly profit.

      If i were Eratat, will i give sales incentive? No.
      So what if i give them sale incentive, will they be able to grow my revenue because of this? Not really.
      They will be able to stay loyal to the brand - No, the best way is to make sure that your product continues to sell as well.

      So what will I do? I will rather use this pile of money to do aggresive advertisement to raise the profile of my products. Succesful advertising increases demand at every price. In this way, i grow my profit, while my distributors enjoy higher profit. Isn't this a much better method?

      Eratat will only succeed not because of their success in sprucing up its image but that they will be able to collect their receivables. Else, there's a limit to how much it can grow its revenue given its lack of working capital to purchase more goods.

      Most penny stocks did fall in price, but then again I am never concerned about the price. What I am concern more about is if it is value for mmoney. Even if my stock will to fall by another 50% the next day, I will buy more so long as the fundamental does not change.

      As for Eratat, sales incentive distribution and a likely 33% drop in net profit this coming new FY has definitely changed its fundamental :)

  8. This yeat will be a gd year for Eratat. Advertising is not enough. The shop image, space etc will also affect whether a consumer will purchase it or not. Thus renovation is necessary. Would u immediately go outside and buy a product just because of a gd advertisement u saw on tv. Renovating shop hv a longer lasting effect on branding. U shld come gor briefing to understand the biz model. They are headingvthe right direction n eratat's growing well.

  9. wow... u are vindicated .. in 2014 Jan 30... there are a lot of counters to invest. Exit if u find anything suspicious, why toy around with our own $$$ right? good work

    1. Thank you. I guess momoeagle deserves more of a praise than i do for his perseverance in warning people of this company time and again.

      The sad truth is that once again people are likely to lose their hard-earned money. I wonder how long more will it takes for the market clean up?