walt373 (99.86)

Net-Net Stock: CHCG - Worst Case Scenario

May 10, 2010 – Comments (0) | RELATED TICKERS: CHCG.OB

I wrote this first in a Yahoo discussion post, and thought I'd share it with CAPS too. This is about China 3C Group (CHCG), a net-net Chinese OTC stock. Their business is selling consumer electronics. Currently they have a market cap of $21M, $30M in cash, $58M in current assets, and $8M in total liabilities. They lost $1.2M in 2009, but they are free cash flow positive, and made $26M in 2008 on $310M in sales.

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In the "Came out with financials" thread by stockfooly, he estimates that losses will increase by $3M per quarter, because that has been the trend for the past few quarters. I disagree with this prediction and here I'll explain why. I started a new thread because this is a pretty lengthy post.

I doubt their losses will go higher than $6M per quarter and here is why:

operating gains and losses = gross profit - operating expenses

Let's examine gross profit first. Gross profit is unlikely to go negative because it is simply the difference between the price they pay to their suppliers and the price they charge customers. CHCG has very high inventory turnover as evidenced by the small amount of inventory on their balance sheet compared to their sales ($7M vs $200M). Because of this, when they cannot sell goods for more than they cost to buy from suppliers, they can quickly stop buying and selling. So, for worst case, assume $0 for gross profits.

Next, look at operating expenses. For CHCG, this consists of SG&A. This number has been going up every quarter as they increase salaries, hire more workers, and pay for maintenance for new stores. This number is within CHCG's control, so I see no reason for this number to jump to $9M, $12M, etc. Rather, I expect this number to decrease as CHCG tries to control cost. Worst case, it will increase by a little bit. Most recently, (Q4 09) their SG&A was $5.765M. So if it grows a little, you have $6M.

Looking at their balance sheet, the $29M in cash tells me they can ride out at least one year of this worst case scenario, and probably two if you include their accounts receivable (which they seem to have a good record of collecting) and inventory, before being in financial difficulties. Their balance sheet is better than many of their competitors, which is important and something I will come back to later.

The main issue with the company right now is the gross profit margin. Historically, CHCG has had 10%-15% gross margins, and the latest quarter has seen a steep decline to about 2.5%. According to management, this is due to a tough competitive environment, probably forcing retailers to slash prices in order to entice consumers to buy. I view this problem as temporary, because selling electronics in China is basically a commodity service, meaning other electronics retailers will be in the same boat.

Capital flows from less profitable to more profitable industries, resulting in mean reversion when profitability goes toward the extreme in either direction. In other words, when business is bad, companies tend to exit, making business better for the ones who stick around. CHCG's balance sheet strength lets me know they will not be among the first to go bust, and there's a good chance they will be around when profitability returns to the sector. It's only a matter of time when either demand returns, or smaller and less financially strong companies leave the business of electronics retailing.

One catalyst for improvement is the development of China's 3G networks. This was cited as one of the reasons that cell phones sold poorly - consumers were waiting for the 3G networks to be deployed before buying 3G cell phones. According to some articles I found (here is one, you can Google more), 3G phones have been selling well.

Other than that, though, I can't really comment on this specific industry - electronics retailing in China - or this specific company beyond what's already been discussed. For all I know, we could be stuck in a slump for years... however, I think the risk/reward for this stock is a good one, and if you can stomach the risk, I think a small position makes sense. Disclosure: I'm long CHCG.