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By Tim Hanson (TMF Mmbop)
August 6, 2009

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August 06, 2009 - RELATED TICKERS: FUQI

There are just eight days left until we'll have the first-quarter winner of our CAPS Champion of the World Contest. With a strong finish many players are still within striking distance of the prize, so this thing is far from settled. But even if you haven't entered yet, or have some catching up to do, we still have nine months until we award the grand prize, so sign up here, if you haven't already.   And now, this week's idea from GG co-advisor Nathan Parmelee...

Just about everything China-related has been on a tear the last few months and the market hasn't reached the point where it separates the high-quality businesses from the pretenders. But it will, because as Ben Graham noted, the market is a voting machine in the near-term and a weighing machine in the long-term. My idea for this week comes up more than few pounds short on the valuation front, and should prove a profitable short.

Short Fuqi International (FUQI)Thesis

Fuqi International has shown explosive revenue and earnings per share growth over the last few years, but with Fuqi International all that glitters isn't gold. For every dollar of earnings growth Fuqi creates it consumes at least $0.50 in cash to support its working capital for expansion -- and in some years more than the dollar in earnings it created. So what looks cheap on the surface isn't a bargain at all.  In fact, the secondary offering completed by the company last week is a perfect example of how this high growth company needs plenty of cash financing fuel to its growth.

Business description

China-based Fuqi International designs and makes jewelry from gold, platinum, and other precious metals and stones. The majority of its business is as a supplier of luxury jewelry to distributors, wholesalers, and retailers throughout China, but in 2007 it moved into running its own chain of retail stores with a focus on diamond jewelry and other precious materials. In the past working these products were special orders Fuqi fulfilled for its customers. However with the 2007 acquisition of Temix, Fuqi picked up 7 stand-alone stores and 43 counters in department stores where it sells some of its designs directly to customers.  

A silly valuation

At 16.7 times earnings (or about 20 after the secondary offering) Fuqi's shares don't look all that expensive. It's 13x EV/EBITDA multiple hints at how expensive it is, but it's when you really start poking around under the hood at cash management that Fuqi starts to look much more expensive.

In the last twelve months Fuqi generated $31.1 million in net income, but only $16.5 million in operating cash flow and just $15.4 million in free cash flow. So what looks reasonable at 17x-20x earnings is actually selling for close to 40x free cash flow. Investment in inventory and slow collections of accounts receivable are the culprit as Fuqi's cash conversion cycle has nearly doubled from 57 days in 2006 to 110 days today, and in the last three-plus years Fuqi's operating cash flow has consistently trailed its earnings. All these qualities are classic red flags of an unsustainable growth model. A more reasonable valuation for Fuqi is about 15x operating cash flow, which makes it substantially over-valued at $24 per share.

Give this one a thumbs down, and pick up some easy points in the next 9 months.