Friday, March 23, 2012

GLG Corp, a case study of (not) doing proper due diligence


GLG Corp (GLE) is a Singapore-based company listed on ASX in Australia which provides apparel/knitwear supply chain management services. GLE's major customers are clothes retailers in the United States. It acts as a middleman between the retailers and the clothes manufacturers in China and other Asian countries. GLE is recognized in the industry locally as an established player. It's a micro-cap with a market cap of $18.50m.

GLE's share price has been hovering around $0.25 for quite some time. I originally looked at this company in mid-2011. Its value has improved substantially since then. NACV is now $0.34 per share and with the improvement in US economy its operation risks have subsided significantly. GLE has never lost any money since it was listed in late 2005. Both its margins and ROE before GFC look good. Average earning in the last 6 years comes to $0.085 per share. With a conservative 6.5x multiple, it will be worth $0.55. (GLE reported earnings in USD. But since exchange rate is close to 1, the difference isn't material in this discussion.)

So, we are looking at a 50%-100% upside. What did I do? I quickly bought a stake, of course. But the fun starts now.

Because the value looks so good, I actually wanted to buy more. But before committing more money, I decided to do more due diligence. There were 2 things in its financial statements that I initially grossed over. First is an "Amounts advanced to other parties" appeared in the financing activities section of the cash flow statements in 2012H1, 2011 and 2010. What the heck are they? I couldn't reconcile them to the balance sheets.

The other one is how GLE accounted for its trade receivables. It disclosed in the Notes that it did some kind of "offsetting" which seems to be related to how GLE accounted for its trust receipts. I re-read those few paragraphs a few times but was still not sure how the offsets worked. Besides, an entity called GLIT was mentioned here. GLIT was the spin-off from GLE when it was initially listed. It is a clothes manufacturer. In other words, it's GLE's supplier. It's actually GLE's main supplier. I'm not an expert in trade financing. So if I draw the wrong conclusion, someone please correct me. But why did a supplier have anything to do with receivables? On the top of that, GLE has also provided some $16m loan to GLIT since 2010.

With some google searches and through some Singaporean contacts, I tracked down 2 other public companies operating in the same industry in Singapore with comparable size: Ocean Sky and FJ Benjamin. Comparing their balance sheets to GLE's, I noticed a few things straight away. GLE holds far less cash, inventories and account payables than its competitors. GLE essentially has a very different capital structure than its fellow competitors. How so? Also, I didn't see the kind of trust receipt offsetting that GLE used.

If GLE is not a outright fraud, the only explanation I can think of is GLE doesn't do its own manufacturing while the other two competitors do. GLE outsources its manufacturing to GLIT. But, is it truly outsourcing?

By piecing together all these observations, I come up with a theory: Legally GLIT is an independent company. But it isn't, both commercially and financially. It's still part of GLE. As one can imagine, their operation is more capital intensive and they has probably lost money in the last few years. GLE has been shuffling money down the pipe to keep GLIT alive. Beyond the $16m loan shown up in the balance sheets, I guess GLE swept the transaction details all under those "trade receivables". Beyond that, nothing else about GLIT appears in GLE's book. The operation is basically off balance sheet. How profitability is the combined entity, GLE and GLIT together? What is the overall ROE? No one knows.

These are not facts. It's a guess.

But I was uncomfortable enough that I got rid of my stake at a small lost.

p.s. I was fully aware of Steve Johnson's post about a mistake in their financial statements. That alone didn't deter me from buying GLE. Stupidity? Greed? Maybe. But now with other supporting evidence, it fits the theory. It also fits the theory why GLE used a big name accounting firm in a small town.

(Disclosure: No Position... now)

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