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Large daily declines in small Chinese stocks shouldn't surprise investors anymore, so it took me a few days to follow up on Tuesday's 20% drop at QKL Stores (Nasdaq: QKLS ) , a big-box grocer operating out of northeastern China.
Expecting to find titillating accusations that the company's stores didn't exist or that its auditor (the reasonably reputable BDO China Li Xin Da Hua) once shot a man just to watch him die, I almost dozed off when the only news was a disappointing earnings report. Because of a slower-than-expected store openings and higher-than-expected operating expenses (caused by preparation for store openings that haven't happened yet), QKL's third-quarter results came up short of analyst expectations for both sales and earnings.
Is this an opportunity?
QKL Stores is an interesting investing proposition because of its focus in northeastern China and specifically Inner Mongolia, Liaoning, Jilin, and Heilongjiang provinces. These four provinces are home to 150 million to 200 million people (depending on your source), and their local economies should be among the fastest-growing in China over the next few years. That's because they're closely tied to China's agricultural and mining sectors, industries where the demand and prices for outputs are rising, and because the Chinese government has focused its development plans for the next few years on raising standards of living in tier 2 and 3 cities.
Since we're bullish on both rural China and the Chinese consumer at Motley Fool Global Gains, QKL Stores would seem like a natural fit. If all goes according to plan, then QKL should benefit from robust same-store sales growth as well as its ability to triple or quadruple its store count from the current 38.
What's more, because northeastern China is a bit of a backwoods, multinational competitors such as Wal-Mart (NYSE: WMT ) , Tesco (Nasdaq: TESO ) , and Carrefour have yet to establish a significant presence there. According to Wal-Mart's website, it has just 13 stores in the four provinces in which QLK operates. This means that QKL should have a few years to grow without facing meaningful competition and could turn out to be a natural acquisition target for one of those multinationals as they expand nationwide in China. Wal-Mart, for example, has already demonstrated that it likes to grow through acquisitions abroad, most recently with its interest in Massmart in South Africa and rumors of a pending deal in Indonesia.
Put this one on your watchlist
When I dug deeper into QKL, however, I found myself unable to get excited about the current $4 stock price. In addition to a corporate structure that makes me uneasy (the U.S.-listed holding company' s only claims on its Chinese operating subsidiary are via contract) and a messy capital structure that has included warrants, convertibles, and additional share offerings, the company's growth will require significant capital over the next few years. While the current $50 million in cash on the balance sheet will go a long way toward meeting these obligations, the company will either need to raise more capital or figure out a way to be more profitable in order to meet growth estimates and earn an attractive return on that store investment. That's also why I'm skeptical of some recent claims by institutional analysts that QKL would be a candidate to be taken private -- an emerging trend among small Chinese stocks given recent moves by Harbin Electric (Nasdaq: HRBN ) and Fushi Copperweld (Nasdaq: FSIN ) .
Furthermore, while QKL achieved an impressive 9% operating margin in the past, profitability has been declining with expansion. Management needs to not only reverse that trend, but sustain 5% to 6% operating margins over a few quarters to show me that they are capable of generating profitable growth. And I'd also like to visit the stores and verify traffic, location, and building quality before I can be sure that they might be attractive to an acquirer.
At the right price, QKL looks like an interesting play on the rural Chinese consumer, so put this one on your watchlist and see if an uneasy market will eventually be willing to sell it to you cheaper.