Wednesday, September 2, 2009

Reward vs Risk

Orsus Xelent (ORS) is a Chinese cell phone maker that trades for $22 million on the AMEX. The company has a ton of risks:

  • Almost all of its sales are to one distributor. Having one customer is always a risk, though this risk is somewhat tempered by the fact that many consumers purchase Orsus' phones.
  • This distributor owes Orsus $76 million, or more than three quarters worth of sales at the current pace!
  • As a foreign-owned entity in China, its taxes are about to double.
  • The company prides itself on being innovative and meeting end-user needs, yet its R&D budget was about $11,000 in the latest quarter.
  • It has guaranteed a $17 million bank loan to one of its suppliers.
In many cases, these risks would be enough to turn a value investor away from a company like this. But as Mohnish Pabrai notes, value investing is about investing in companies with upside potentials larger than the downside risks. Clearly, there is some risk with Orsus Xelent, so what possible upside is there that can trump these risks? The answer is the company's low price on several levels.

First of all, Orsus trades for a P/E of around 2! Companies normally trade at such levels if earnings are expected to fall drastically. For Orsus, however, earnings and revenue this year are expected to be even higher than they were last year, as the company continues to supply more and more of rural China with mobile phones.

The company also trades for about half of its liquid assets. While those assets do include a ridiculously large sum due from its main distributor, that number has come down in the last quarter. Furthermore, the company has taken out a 3rd party insurance policy on the overdue receivables, which should provide some protection. The distributor is also guaranteeing a portion of Orsus' outstanding loan, whatever that's worth.

Orsus can hardly be considered a risk-free stock. Nevertheless, despite a huge number of risks, the upside potential of this company was too high for this value investor to ignore. This penny stock trades at a massive discount to its earnings and to its assets. Time will tell if that discount is justified.

Disclosure: Author has a long position in shares of ORS


Anonymous said...

Maybe its just the stereotypical poor quality of anything with a "Made in China" label, but how do you do you get comfortable with the risk of owning something in China? Corruption and a very flippant administration obscure the picture so much in my mind. The layering of government participation in debt and equity in Chinese companies also gives them leverage to undertake pro-employment and anti-shareholder ventures.

Anonymous said...

Also see CHCG. They have been trading at a P/E of 1 and change for at least a year now. I think investors just don't believe the numbers.

Azeem said...

"In December 25, 2008, Xingwang entered into an irrevocable Credit Guarantee Contract (the “Guarantee Contract”) with Zhong Hui Guarantee Corporation, a third-party guarantee company licensed by the PRC government (“Zhonghui”)..."

how do you feel about the guarantor here? finding it tough to get comfort with the receivables situation

Anonymous said...

Are you considering the yet-to-close deal with Dalian Daxian Investment Development Co., Ltd.? They are acquiring Dalian Daxian for $14m (60% of the company). Sparse info on this company. How are they to pay for it? Dalian Daxian Inv. Dev. Co., Ltd. engages in the manufacture, assembly, testing, and packing of electronic products. The company is based in China.

PlanMaestro said...

Barel, there are MANY Chinese small caps trading at P/E<4. So to balance risk rewards it is also important to look at relative value in a sector, industry or geography.

Take for example the example already mentioned of CHCG a cash flow positive company with no debt, with several clients and a history of explosive growth. Recent management decisions have been questioned however I will quote a post of a good friend:

"It's got $0.48 in cash. It's got a bunch of inventory that it can recoup through the store in store model (without even making a profit it can turn inventory into cash and then basically liquidate the retail business).

So basically you get the trucking company, the retail company (if any) for free.

Did you notice that CHCG has $11 million in a fund available for distribution to shareholders in the circumstance of its liquidation? That would put us at $0.58 per share in cash available for liquidation.

In other words so long as cash burn doesn't start, this could be liquidated for a profit even if the businesses fall through."

Saj Karsan said...

Hi Anon1,

I'll try to speak to this in a future post, as there are some additional issues. However, the short answer is I would argue all governments pose the types of threats you discuss, the US is no exception.

Hi Anon2 and PlanMaestro, I'll check out CHCG soon.

Hi Azeem, good question! It's difficult to know what that guarantee is worth. There is some info available if you're willing to search for it, though.

Hi Anon3, My understanding is that this deal is on hold, and has been for almost a year. The company is a supplier to Orsus, but Orsus would like to vertically integrate a little more. For now though, they are happy to lease and keep this a variable cost.

Unknown said...

I am a little confused. This company only has about 10M of debt, but it also has approximately 50M of other liabilities (accrued expenses and accounts payable). It also has no fixed assets (such as PP&E) to support these other current liabilities.

So if you were to take the 118M in net current assets, and divide the AR by two (93/2 = ~46), and add on the 24M of remaining current assets you come out with about 60M of current assets. Considering that the company has 10M in debt and 50M in other current liabilities, I kind of feel that conservatively, the company doesn't offer any margin of safety.

Is this the wrong approach to include current liabilities in the net net equation?

Saj Karsan said...

Hi Jeff,

Including current liabilities is definitely necessary, but chopping off A/R in two arbitrarily could lead you astray. I would recommend trying to determine what that line item is worth rather than using a straight formula approach of a 50% multiple.

Ali said...

The risk side to ORS has outweighed the potentials. That co is trading 20% where it was last year.

How do you see it today? Would the potentials outweigh the risks at this price, or is it going down?


Saj Karsan said...

Hi Ali,

Difficult to say. I would say understanding the solvency of the customer owing the A/R and the insurance company insuring the A/R are the keys.