China 3C Group: A Good Deal?

14 04 2010

What if you could buy a company with $28 million in cash, a total of $60 mil in tangible assets, and only $7 mil in liabilities for a purchase price of $24 mil dollars? Would you? Of course, you’d need more information. If I were given this deal, I’d immediately assume that the company has negative earnings. But no. This company only has declining earnings, making $2.5 mil in net income for the 9 months ending September 30th. Certainly the company must be bleeding cash. Nope. It had a positive free cash flow for quarters 1-3 of $5 mil and hasn’t had a year of negative cash flow for the past 4 years.

The company is China 3C Group (CHCG.OB) and it’s on sale for only $24 million. The stock has been absolutely hammered. Down from its 5 year high of $16.00 per share ($800 mil market cap) to only $.45 a share, there are certainly reasons for the stock’s collapse.

The Business Model:

According to CHCG’s 10-Q, “The Company is engaged in the resale and distribution of mobile phones, facsimile machines, DVD players, stereos, speakers, MP3 and MP4 players, iPods, electronic dictionaries, CD players, radios, Walkmans, and audio systems. The Company sell and distribute these products through retail stores and secondary distributors. Following the acquisition of Jinhua, the Company also provide logistics for businesses in China.” CHCG uses what is known as a “store in-store” model. The company basically sells electronics from a space rented out in a retail store. As of march 2008, CHCG operated in a little over 1,000 stores. The plus side of the store in-store model is that the company does not have to deal with the costs of running an entire store. Also, I’d imagine that they’d sell more products from a store that brings in people looking to buy other goods as well as electronic goods. One negative of the store in-store model is the management fees that CHCG has to pay in order to rent space. These fees amounted to about $6.5 million for the nine months ended September 30th 2009.

The Balance Sheet (in millions):

Cash and Cash Equivalents: $28.3

Accounts Receivable: $22.5

Inventory: $8.2

Other Current Assets: $2.6

Intangibles: $35.7

Total Liabilities: $7.4

That leaves us with an equity of $90.3. If we’re talking liquidation value, the intangibles are worthless and we get $54.6. Since CHCG has no long term assets, $54.6 is also the net current asset value as Graham defined it in the 1951 edition of Security Analysis. Assuming the company only receives 75% of its accounts receivable and its inventory is really only worth half of its carried value, we arrive at a liquidation value of $42. Thus, we are buying CHCG at a 43% discount to a conservative estimation of its liquidation value. However, the company most likely won’t be liquidated.

Net Income (in millions):

2006: $11.3

2007: $22.9

2008: $26.8

TTM: $9.8

So what gives for the last twelve months? As usual, it’s not just one factor. There has been an overall (temporary?) dip in the Chinese consumer electronics market due to the poor global economy. Also, CHCG has changed its business model pretty drastically. They no longer own retail stores but rather sell electronics using a store in-store system. Both of these have led to a drop in revenues (which were $310.6 for 2008 and 257.4 for TTM).I encourage people to read the 10-Q for management’s discussion of revenues, but there are a variety of other reasons for the dip (most cell phones for sale have become 3G, yet the 3G network in China hasn’t been completed, causing many consumers to wait to purchase new phones-a temporary issue, China is offering temporary rebates which incentivize consumer purchases of electronic appliances-yet CHCG isn’t eligible for these rebates due to its store in-store business model, etc.)

Coupled with the lower gross profit, CHCG is experiencing a rise in selling, general, and administration expenses. SG&A costs have risen from $14.1 in 2008 to $20 in TTM. The 10-Q explains the cause of these increased costs as a rise in the fees paid for their store in-store model, as well as an all around raise in employee salaries. For the three months ending Sept. 30th, SG&A expenses were $5.6 or about a quarter of the TTM costs- possibly signifying a stabilization of costs.

Cash Flows:

Once again, I encourage readers to check out the latest 10-Q. There isn’t a whole lot to say about CHCG’s free cash flow other than that they are actually collecting on their accounts receivable.


One of the risks I see with CHCG is the fact that it’s in China. Most investors think that this is a great thing because of China’s economic growth. However, China is not exactly a pro-freedom country. Changing regulations and government decrees could have a negative impact on CHCG- and that is one risk which I have no idea how to quantify. Also, CHCG’s income for the three months ending Sept. 30th 2009 is ($1.7) million. That is, they lost $1.7 million in the third quarter. Financial results for all of 2009 come out April 15th or 16th, and we’ll see then how the 4th quarter went. Perhaps the company lost even more money. The amount that CHCG could lose in the 4th quarter is not substantial, yet this thing is priced for a financial Armageddon.

Why the discount?

When I see a company that is highly undervalued at first glance, I immediately assume it’s too good to be true (because it almost ALWAYS IS). In this case, I don’t see a valid reason for the discount. A glance at the Yahoo! Finance message board reveals a couple reasons investors hate CHCG. As the market cap began to fall from its $800 mil high, large investors were forced to sell their shares and further depress the price.  The company seems to have lost its analyst, surely causing even more investors to flee. Watching your investment fall to nearly nothing is going to cause some pissed off investors. If you knew that the underlying value of the company was actually much higher than the stock price, you wouldn’t mind watching the price fall so you could invest more. Although most people seem to understand this principle, very very few actually follow it. Personally, if the price of CHCG fell to $.25, I’d very happily purchase more. Further pissing off investors, the company has failed to file its earnings on time for the 3rd straight earnings release. I’m not sure why this bothers investors since the earnings are usually only 15 days late. Perhaps it shows management’s disregard for its American investors. Finally, the latest reason to hate CHCG is that it could be demoted to trading on the pink sheets. Since its 10-K is going to be late, there is a risk that CHCG will no longer be traded OTC. As one Yahoo! Finance user put it, “if the OTC is the gutter the pinks are the sewer.” However, any rational investor realizes that the exchange that a stock is traded on has nothing to do with the company’s value. Liquidity is the only thing that will suffer as a result of trading on the pinks. As a long-term investor, I’m not bothered by a lack of liquidity.

To sum it up, I think CHCG is a heck of a deal. Unless the 10-K announces that China has sunk into the sea, I’m going to be an investor in this company until Mr. Market realizes his error.

Disclosure: Author is long CHCG with a cost basis of $.45.




2 responses

14 04 2010

Well written and organized!

Some mistakes (I believe):
“They no longer own retail stores but rather sell electronics using a store in-store system.”
– I think you accidentally reversed these; as of 2008 the company is closing less profiatble store-in-store operations and is beginning to open franchise retail outlets.

Some other risks/reasons:
– For the last several years their gross margin has been consistently decreasing due to increased price competition. Management has been seemingly straight-forward in saying that they don’t see their store-in-store operating style being a viable/profitable business model. Hence they are switching to a RadioShack/Best Buy type of format- a format which management and this company has little experience with, and which perhaps investors are weary of.

So then we’re left asking, what if the new format fails as well and this company begins bleeding cash? Will management close up shop quickly and return all of that margin of safety that you talked about (current assets) back to investors? Or will they continue burning it until only the shell of a company is left and they become bankrupt?

Also, even if management was to liquidate promtly and with fair closing expenses, how much can get back to U.S. investors? Chinese liquidation laws are fuzzy and if you read their 10-k it is difficult to tell (at least it was for me) what will happen in the event of a liquidation.

Some redeeming factors:
Management owns between 40 and 60% of the outstanding shares, (different sources report different numbers, though all I have seen fall in that range). This greatly aligns their interest with other shareholders, and will hopefully prompt a “good” liquidation should their business fail, since up to 60% of those current assets could be sent to their own pockets.

Best case scenario is a company that looks a lot like RadioShack, except with a better macro environment and less operating debt. Weighing the risk and potential, combined with a long investor time horizon, produces for me, like you, a near-screaming buy.

I also caveat this post with purchases around 0.45. Feel free to tear my analysis up, especially if anyone can enlighten me on Chinese liquidation laws, which I have spent a substantial amount of time trying to research.

15 04 2010

Hey Shai,

You’re right about the business model. CHCG went to the store in-store model back in 2007, and while they’ve started opening retail stores, they’re still predominantly using the store in-store method.


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