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Was the baby thrown out with the bathwater? Deswell

March 05, 2012 | About:
whopper investments

whopper investments

50 followers
Chinese reverse takeovers (RTOs) have been absolutely crushed recently as many have them have proved to be frauds existing solely to enrich Chinese management with gullible American retail investors’ money. At this point, so many of them have proved frauds that investors are basically treating them all as frauds. With that as a backdrop, a reader suggested I take a look at Deswell Industries (DSWL).

The idea behind an investment in Deswell is simple- the market is regarding all Chinese based companies like frauds, and Deswell is being lumped into the basket with them. If Deswell proves not to be a fraud, then the stock is at least a double and the investor will make a great return.

And the evidence suggests Deswell isn’t a fraud. Most of the RTO frauds came public rather recently through reverse mergers and submit financial statements that project best in class financials. For example, one battery maker that turned out to be a fraud had gross margins that were nearly 3x the next best batter maker in the world. Some companies in traditionally asset heavy industries submitted income statements that implied asset turnover faster than asset light tech juggernauts like Microsoft or Google. Some reported having enough cash on hand to cover several years worth of operating expenses but still continued to raise cash through equity sales.

None of those are the case at DSWL. Their financial performance recently has been horrendous. I’ve said this before, but in my opinion a company reporting huge losses is much less likely to be a fraud- if management’s going to commit fraud, why would they let the books show absolutely horrific performance??? Why not show fantastic returns and try to attract gullible retail investors???

DSWL also doesn’t have a couple of the other aspects of most frauds- they haven’t been selling shares like crazy and they’ve got a long history as a public company. Perhaps most importantly in arguing against the fraud case- DSWL has consistently paid a dividend. Most frauds don’t pay dividends or return cash to shareholders as they’re trying to take money from shareholders, not give it back! Insiders also own a significant batch of shares, with the Chairman owning 10%+ and a key executive owning almost 10%, and they haven’t sold any shares over the past three years(another key trait of most frauds- insiders selling out at inflated prices!). In fact, insiders have slightly increased their stake in the company.

Moving on from the fraud discussion, DSWL has some pretty impressive value metrics. Tangible book comes in at $6.70 (see their most recent balance sheet), with NCAV per share coming in at $3.67. NCAV is mostly made up of cash and investments- cash per share (the company has $25m+ in cash and no debt) comes in at $1.55+, with another ~$0.87 per share in investments. With the stock price currently at $2, you could consider yourself buying DSWL’s $2.42 per share in cash and investments for a 20% discount and grabbing their ~$4.25 in business assets for free!

And then consider that DSWL’s asset value might be understated. China has been ravaged by inflation, which means the current cost to replace those ~$4.25 in business assets is likely much higher than historical book.

So the company is obviously selling at a huge discount to asset value.

There are, however, some legitimate business concerns.

The company has historically been pretty profitable. However, results have deteriorated over past 18 months, with the company reporting pretty significant operating losses. DSWL has responded to the drop off in business well, focusing on cutting SG&A (down almost 25% YoY) and drawing down working capital to free up cash, but you have to wonder if the future for the company will look much worse than the past.

After all, DSWL is a Chinese manufacturer of basically commodity parts. In other words, they operate in perhaps most commoditzied and competitive industry in the world. The industry is undergoing rapid inflation and has new entrants coming online at an exponential pace. Those characteristics don’t exactly scream “value creation”- perhaps DSWL simply faces a long future of continued operating losses and investments at extremely value destructive rates of return in a desperate effort to stay competitive.

Overall, though, DSWL trades at such a discount to their assets that the key to investing in them will likely have nothing to do with their business fundamentals and trends; rather, it’s simply determining if they’re a fraud or not. If they are a fraud, they’re a zero. If they’re not, they’re at least a double. I don’t think they’re a fraud, but I have no key insights or skills in assessing this, so the company is a pass for me. Certainly interesting though!

No disclosure.


Rating: 3.2/5 (16 votes)

Comments

onthefringe
Onthefringe - 2 years ago


Don't mean this the wrong way: The concept is interesting. But where's the beef?

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