Dahua's 'Profits' Investigated

Author: John Honovich, Published on Jun 15, 2016

Dahua's profits are up 100%+, defying common sense and industry trends.

We hired a China economics expert to investigate the source of those profits to better understand what is truly driving the world's second largest video surveillance manufacturer.

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Comments (14)

If margins are eroding for Hivision is it significant erosion? Does it seem inevitable that their pricing starts to shift upwards to match the market or do these government "loans" continue to subsidize the product? Right now the prices are too low to be healthy but if they are somehow able to sustain it... I guess it will continue unabated.

The profits, and even revenue, are far inflated relative to true operational results and common reporting.

Are the profits real, even if one-time events?

Why are they worrying, if real?

How come it seems everyone is making money on currency, shouldn't someone be losing too?

At this point they are not making money on currency but betting that they will make money on currency in the future.

While they might be right (and might be wrong) they are a CCTV company and not a securities trading company. They should present profits from what they do and if they don't, in the long run they will have no profit at all.

Other companies that have a large load of cash, open a "group" and create other companies that invest in real-estate or the stock market but in these cases the profits or loses are attributed to these daughter companies and not cloud the earnings of sister companies.

At this point they are not making money on currency but betting that they will make money on currency in the future.

So just betting is considered making a profit?

Anyway, John says "were hedging" and that its "unlikely to continue".

I'm not a financial expert so I might be wrong.
From what I understand they are "betting" that the USD will get them more RMB per dollar for contracts that they will preform in the future.

But what if they are wrong and the USD will get stronger for some reason... In this case they will have lower total income in RMB.

Hedging means that they are covering their bases. So if they lose in one area they will earn in another. This is risk management but sometimes it used to take risks instead of managing risks.

At this point I think I should step back and let someone else with more financial markets know how take the lead :)

Many assertions by the "Chinese expert" are factually wrong.

1. The after tax income/loss from non-operating activities (non-operating profit) for Q1 2016 is 8.28M RMB, about 4% of the total after-tax profit 207M RMB.

Where did you get the 75%?

2. There was an increase of non-operating profit from 2015 Q1 to 2016 Q1. But it was not significant.

Q1 2016 non-operating profit: 8.28M RMB

Gov. Subsidies: 8.38M RMB

FMV of forex forward contract: 1.60M RMB

Q1 2015 non-operating profit: 4.85M RMB

Gov. Subsidies: 1.24M RMB

FMV of forex forward contract: -0.61M RMB

3. The sharp increase in profitability of 2016 Q1 is a result of "Big Bath" of 2015 Q1.

2016 Q1 total profit: 207M RMB

2015 Q1 total profit: 99M RMB

2014 Q1 total profit: 201M RMB

Dahua had 200M RMB + profit in 2014 Q1. 2015 Q1, however was particularly bad, even though its revenue increased from 2014.

2015 Q1, imo, was a "Big Bath", meaning that the Dahua management purposefully made this quarter look bad so that when the next year-to-year quarter performance resumes "normal", investors will see a big jump and award the company with higher stock price.

Here are a few pieces of evidence of Dahua's "Big Bath":

1. Q1 2015 had sharp increase in provision expense (estimated loss provisions of inventory and other asset; which is often subject to management's manipulation.)

2. The company, imo, did not strictly follow the matching principle and early booked some of the yearly expense to this quarter, such as marketing and sales;

3. There are many ways to manipulate profits by taking advantages of subjective accounting measurements, such as capitalizing vs expensing R&D costs and goodwill impairments test etc.

Conclusion:

200M RMB profit and 100% increase in 2016 Q1 is simply due to the deliberately trashed 2015 Q1.

2015 Q1, imo, was a "Big Bath", meaning that the Dahua management purposefully made this quarter look bad so that when the next year-to-year quarter performance resumes "normal", investors will see a big jump and award the company with higher stock price.

Except that none of the usual motives or even suspects of a Big Bathing are in view here.

If this were indeed a Big Bath, then we would imagine that the earnings were substantially higher, but intentionally reported lower. But the higher the real earnings were, the less reason for the bath. Consider if the real earnings were at 180M, is it a really a better strategy to unhinge investors and to erode confidence in future earnings reporting by reporting an abnormally low number?

Why not just smooth by fudging up a little? And then take the Bath when you really need it, with a much larger hit, so more dirt can be swept under the rug in one pass?

...the Dahua Management purposefully made this quarter look bad.

Of course, a common reason for the Bath is management trashes a bad period, and makes it worse because they are out of the bonus money anyway for that period. Or a incoming CEO bathes the outgoing CEO's last quarter to make his rookie year look better.

This selfish gain comes at the expense of investors and the long term share price which will be adversely affected by the perceived volatility, even after the presumptive "good" quarter reinstates the earnings.

But in the case of Dahua, we have an owner/founder/president who owns ~50% of the stock. No such explanations are likely when management are principals because the net effect is likely negative in such cases.

The fact that the management owns a firm can never preclude their incentive for big bath. And China has a totally different stock market that lacks transparency and tolerates insider tradings.

In the case of Dahua, can you exclude the possibility that trashing the company is to facilitate the insider tradings by families and friends of the management owners?

Meanwhile, the evidence indicated a big path. The increases in provision, sales expense and admin. expense totaled 67M RMB in 2015 Q1 by Y2Y comparison to 2014 Q1.

With some personal work experience in China, i know the accounting for provision has large room for manipulation; and the sales cost expensed in one period often builds up long-term relationship that will bring value to the company over a period of time; and they should have been capitalized as pre-paid expense.

Although I lean towards the big bath given the evidence and possible motives cited above, all of the above are still debatable and plausible to defeat with the introduction of new information, if there is any.

But what really worries me as a reader/subscriber to IPVM is that the post is factually incorrect. Where did you get the 75% as a ratio of non-operating profit over total profit?

In the case of Dahua, can you exclude the possibility that trashing the company is to facilitate the insider tradings by families and friends of the management owners?

As in dumping the quarter, to allow family members to buy in cheaply and then profit as the stock recovers?

Here's the problem, such insider trading could not be accomplished without Fu Liquan's complicity. And that doesn't seem to me to be likely since

Fu, owning half the stock in the company at the pre-dump price, would take an immediate hit, on paper at least, far greater than the ultimate profit of the insiders. Sure he could hope that investor confidence will return to pre-bath levels and the stock claws back to where it was, so it would be a wash, but even then he's had a couple of years of 0% growth, and tarnished his company's reputation needlessly.

Or maybe Fu was selling his own shares pre-Bath and bought them back post-Bath? Again, it would have to be a major, major sell-off pre-bath to justify tanking whatever shares you still own.

I don't know about the 75%, I'm sure John will answer soon enough.

The insider trading can be short selling too. Anyway, the stock market did react negatively to the 2015 Q1 result.

On the flip side, the trashing of one quarter could be politically motivated. The 50% increase of sales expense in 2015 Q1 comparing to 2014 Q1 could be some bribe jobs. Who knows.

The idea is that there are sufficient reasonable motives for Dahua to trash a particular quarter.

Look, everything you're are saying makes sense, it's just that in this particular case since the President is long with 50% of the company stock, any strategy that intentionally depresses the stock price is unlikely to me.

Did you actually know about the company's ownership position when you made a splash with you Big Bath, or are you arguing post-hoc?

On a lighter note, in China, can one book bribery as CapEx?

No, any fees/expenses for bribery are often booked as prepaid expense, a current asset account. People do the exactly the same thing in America too. All you need to do is to convince the auditor that the expenses can generate future benefit to the company within a year.

The president owning more than 50% means little. In the case of Dahua, he simply tries to avoid looking bad for the whole year by making one quarter particularly bad. No one intends to trash the stock price. The idea of big bath is simply to move all losses to one period so that other periods would look good. The stock price volatility is simply the ramification of the earning management. That's my original argument.

First off, it appears that the Chinese expert agrees with you re: Big Bath. Noted.

One fundamental question:

Assuming a company forecasts quarterly earnings of 100M, which it meets on average, which of results would you think the market would react the most positively to?

Q1: 95M Q2: 110M Q3: 90M Q4: 105M

Q5: 100M Q6: 115M Q7: 85M Q8: 100M

or

Q1: 95M Q2: 110M Q3: 90M Q4: 55M

Q5: 100M Q6: 115M Q7: 85M Q8: 150M

3, feedback from our expert:

I'm not sure exactly what numbers he/she is looking at. According to WIND, the Chinese version of Bloomberg, which you can see in the spreadsheet I have attached and highlighted with a green cell shading, non-operating revenue was 161m RMB and non-operating expenses were 3.3 million. There is not a specific financial line item for non-operating profit so I calculated that based upon non-operating revenue minus non-operating expenses. The non-operating and operating profit do NOT add perfectly to total profit but that is actually expected. Operating income (highlighted in blue) is listed at 87million; nonoperating income is listed as 161m RMB. Together those two items sum to 248m RMB. Net profit (highlighted in yellow) in Q1 is listed as 214m RMB for a difference of only 14%. Given expected charges to net profit such as taxes and related items, this difference is close enough to be reasonable. The reason I mention this is to highlight that official stated operating profit and my calculation of non-operating profit reconcile rather closely to the official net profit amount.

As for your 'Big Bath' response, his feedback:

This is absolutely most likely what happened. I would note however a couple of things. First, this is relatively common practice the world over with significant gray area. Managers will rush to count revenue or hold off writes offs until there is a bad quarter or year. I almost take this as a given. Second, I think as an outsider we put ourselves on very slippery slope unless we have lots of better information and can provide hard information to start building "shadow" financials. The gentleman/lady writing this is likely correct about how they time shifted certain items. For many reasons though, I think we are on a slippery footing unless we decide to do a comprehensive rebuttal AND how this would materially impact results. By that I mean, let me use a simple example. Taking their Q1 numbers, let's assume the profit should be 125m RMB in Q1 2015 and 175m Q1 2016. That is 6m RMB less than their total numbers and the profits are shifted a little between time but does that materially impact the numbers? Third, most investors build this type of behavior into their thinking. They know this happens, they know it is very hard for them to tell the difference, or stop it, just they just build it into their thinking. The sun rises in the east, politicians lie, and CFO's shift costs and revenue to make themselves look good. In short, the commenter is probably right. In fact, if this is the biggest accounting problem this company has then count yourselves lucky. However, it would be exceedingly difficult to produce better numbers as an outsider and investors know this and treat companies accordingly.

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