We are short Hengan because we believe Hengan has fabricated RMB 11 billion of net income since 2005 which has manifested itself as fake cash on its balance sheet. Laden with debt, we assert that Hengan’s equity is ultimately worthless.
Hengan International Group Company Limited (HKEx: 1044) (the “Company” or “Hengan”) is best known for its “Space 7”, “Anerle” and “Anle” branded sanitary napkins (think maxipads) in China. In a very saturated and commoditized industry, Hengan claimed to generate 51% operating margins for its sanitary napkin segment in 1H’18, while its competitors are striving to generate 15% operating margins. Hengan’s reported historical return on assets for its sanitary napkin segment are equally questionable, claiming to achieve a remarkable peak return on sanitary napkin assets of 72% in 2016!
We believe the scheme was orchestrated using a web of inter-company related transactions to artificially inflate profits and conceal fake cash balances. Despite boasting cash and bank balances of RMB 19.8 billion and a working capital balance of RMB 7.6 billion as of June 30, 2018, Hengan has been aggressively raising debt to support its operations. In the five months from August to December 2018, Hengan issued six separate tranches of debt to investors raising a total of RMB 7.5 billion with a majority of the proceeds earmarked for working capital!
Characteristically with frauds, insiders create sham transactions with related parties to create illusory transaction volume, revenues, or profits depending on the fraudster’s desired outcome. Often these sham transactions are only on paper, and the fabricated buying and selling activity appears on the balance sheets of the counterparties as receivables and/or payables. We suspect this is how Hengan insiders have historically concealed dubious activity from auditors.
The scheme’s orchestrators have already been handsomely rewarded with significant cash dividends. Since 2005, Hengan has paid out RMB 18.6 billion in total dividends, which means at least ~RMB 7.8 billion has been pocketed by Hengan insiders from dividends. Our research has uncovered an undisclosed nefarious disposal of a Hengan revenue stream to Hengan’s CEO’s private family business at the bargain basement price of 0.7x 2016 net income! In addition, we found that Hengan’s insiders have undisclosed private businesses that claim to have transacted with Hengan on a Fujian real estate investment, increasing our suspicions that additional undisclosed benefits have been siphoned from Hengan to enrich insiders at the expense of investors.
So how do investors value a public company operated by unscrupulous insiders who use inter-company sham transactions to generate and conceal fabricated profits and cash? We think as long as Hengan’s insiders continue to be family relatives, Hengan’s cash and assets will be siphoned out to benefit insiders at the expense of creditors and shareholders. And if Hengan’s operational control was to change, we suspect the new team would find Hengan’s books to consist of overstated growth rates and profitability coupled with highly overlevered inflated asset valuations.
As this saga unwinds, we suspect defaults on debt covenants, increased costs of capital, increased leverage ratios, and reductions to dividend payments. Considering Hengan’s June 30, 2018 short-term financial liabilities balance of RMB 17.8 billion, and that Hengan raised additional short-term debts of RMB 7.5 billion in the last five months, we believe it is possible that creditors scramble to get repaid and settle debts for less than par value, leaving Hengan’s equity ultimately worthless…