Wednesday, June 30, 2010

Are Those Really Sales?

HQ Sustainable Maritime (HQS) cultivates tilapia and other marine life using aqua-farms. It then sells these fish as part of health and food products throughout Asia, Europe and North America. While the company trades for just $73 million, it reports net current assets of $92 million, and profits (in the latest fiscal year) of $8 million. But upon further examination of the company's financial statements, the actual value of the company's net current assets and profits comes into question.

In the last fiscal quarter, sales were up over 30% from the year-ago period. Sounds good, right? Until one notices that the "accounts receivable" balance is up almost 140% over this period! This suggests the company has been giving its product to anyone who will take it and counting those transactions as sales (which then flow through to profits) without regard for accepting payment. In fact, from the current numbers, it seems as though it takes a full year for the company to collect cash after a sale.

No big deal, one might say. So what if the company finances its customers a little bit, it's still a good deal right? It may indeed still be a good investment, but it does introduce new risks which mitigate its appeal. Only after understanding these risks can the investor make an informed decision as to whether to go ahead with this potential investment.

From an asset point of view, this situation increases the loss to the company should one or more of its customers default. There is some concentration of customers for this company (the top 5 customers account for 37.5% of sales), so without knowing more about the finances of these customers, there is a potential risk here. Receivables represent much more than half of the company's net current assets, so if the investor thinks he is buying assets, he should know there is some larger than normal downside risk attached to them.

From an earnings point of view, the high receivables suggest sales levels aren't actually elevated from year-ago levels. The company is potentially telling customers to take delivery on the product now (to be counted as a sale for the company) without having to pay any time soon. As such, customers are willing to take large deliveries, which pumps up the company's sales and profits without any real basis. Had the company's credit policy been the same as it was last year, the company might even be operating in the red for all we know!

A cursory look at a company's financials can tell an investor whether a company holds promise as a potential value investment. However, the analysis cannot end there. Further scrutiny should be applied to determine if the company's numbers may be overstated. In so doing, the investor can make the investment decision armed with a full knowledge of the risks a company is facing.

Disclosure: None


rayhaan said...

yo mr. Saj, just wanted to thank you for endowing me (thru ur blog as well as replying to my undeniably amateurish and irritating questions) which i think has greatly helped steer me towards rational and rewarding investing. Ur blog has been a great influence on me especially i guess , coz it makes investing look fun!. Anyways coming 2 d point, d effect ur blog has had on me became even more apparent , today wen i was reading an investopedia article about jim cramer ,about whom one has to look no further than wikipedia to conclude dat his opinions shud at the very least b taken wid a grain of salt! It seems dat he's effectively bearish on u He said he was down on rim coz even though it had beaten analysts expectations it did'nt have enough momentum . Also he said dat little cellular capacity wud also b a hindrance towards future growth.he was also bearish on best buy(dunno y?).Even though it s pretty clear he's being 2 pessimist especially wen he blames d reforms in washington 4 lower corporate profits despite d market at a historically low p/e of 12! (here's a decidely unfair fantasy, how bout a karsan vs cramer column or sumthing? Think bout it) wots ur take on cramer's 'concerns'? also do u think d lack of any 'real' earnings can b detected by luking at d cash earnings? Another quick q. I know running kvf is a full time job but do u think doing a videos on youtube b a gud idea, say like a vlog ? P.s thx 4 being such a gr8 teacher 4 everybody who reads ur blog, u've all the qualities save one.

Saj Karsan said...

Hi Rayhaan,

Thanks for the kind words!

When the market is bearish on a company (like it is on RIM), it is exactly the time I want to start accumulating a position. The future earnings of a company are extremely difficult to predict, so when the market prices in a severe drop in earnings (by pricing a company at a P/E of 10 that has an ROE of 30% and no debt), this presents opportunities. Not all such situations will pan out though, so as such I could be wrong on RIM. If one can accumulate a portfolio of such "opportunities" though, in my opinion one can do very well over the long term.

To speak to your specific points, yes cellular capacity might start to become a problem, but this appears much worse for the data-hungry competition than it does for RIM on a relative basis. In general though, this is an industry in growth mode, so most players will likely see sales growth in the coming years.

I haven't even considered doing videos...what do u see as a benefit over and above the current text version of this blog? Surely, I am not nearly as entertaining as Cramer, so I'm not sure where I can add value.