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No. of Recommendations: 14
Despite what initially appeared to be disappointing earnings, the go-private offer minimized the impact to the share price. With another earnings release and the business continuing to grow, the most likely result will be shares being called away from us at $6.60 or slightly higher (similar to the WWIN go-private transaction). As mentioned before, management did its best to downplay the continued strength of the business. Wu has an obvious incentive to make the valuation look lower than it really is. This was seen by the company highlighting the decrease in the recognized revenue, gross profit, income from operations, net income and adjusted net income despite the lack of comparability to prior year and then subsequently listing the more relevant shipping increase. Management was also quick to write-off goodwill that probably should not have been written off. It seems management is delaying income and trying to speed up expense recognition. I think they are playing within the accounting rules and are not openly breaking any laws. Also taking away the guidance for revenue and income was another lever that management pulled to try to create more doubt about valuation.

I think overall the quarter was good, but not great. The increase in shipping of 20% means that adjusted revenue increased by at least that much (last quarter shipping increased 37% while adjusted revenue increased by 41%) due to the exchange rate gains. I would guess that adjusted revenue increased by 22 to 23% due to similar exchange rate gains over Q3 last year. Compared to 41%, this is somewhat disappointing, but still very solid (and simply outstanding for a company trading at a PE of under 3). The comment about slower payment cycles from customers this year compared to prior years was also disappointing and surprising because of the news of increased liquidity in China this year vs last year.

There was definitely good news in the release as well. Here are some highlights:

- “our business trends remain very strong”
- “We have now increased our manufacturing capacity by 52% to 70,000 tons compared to the 46,000 ton capacity that we had before this project was initiated”
- “Gross margin was 62.1% in the third quarter of 2012, compared to 60.9% for the same period of 2011. The increase in gross margin was mainly due to the decreased purchase price of certain raw materials.”
- “The Company expects total shipments in 2012 to increase 30% with a total amount of $510 million over 2011, in line with its original full year revenue growth guidance.”
- “The Company also reaffirms that its branded retailer network will be expanded to 35,000 by the end of 2012, which represents a 16.3% increase over the 2011 year-end number of 30,086”

Now for a quick look at the balance sheet. Net cash (cash minus debt) is now at negative $20M or -.41 per share. Keep in mind that the second quarter and third quarter are by far the biggest in terms of sales. The vast majority of all these sales will be collected in Q4 and Q1 next year, so a low cash position is expected. It was driven lower by longer payment cycles this year and increased prepayments to suppliers (which is a future benefit to the company, especially if they got better pricing). AR ballooned to $295M or $5.97 per share and inventory rang in at $111M or $2.25 per share. Net current assets (cash, AR, inventory, prepaids – minus AP, bank loans and other liabilities due within the next 12 months) came in at $355M or $7.22 per share. Total net assets (all assets – all liabilities) was $414M or $8.39 per share. Obviously the balance sheet still points to a business that is worth much more than the $6.60 offer price.

Some highlights from the 10Q:

Impact of delayed revenue: as of September 30, 2012 and December 31, 2011, finished goods included US$38,162,633 and US$6,340,411, respectively, of products that were sold and delivered to customers for which the related revenue was not recognized in accordance with the Company’s accounting policy on revenue recognition.

If we assume that all of this $38M shipped will be collected (a pretty good assumption with the lack of any write-offs) and assume a conservative 60% gross margin, then we should have additional revenue of $95M this year, which would give us 9 month revenue of $467M, up 35% over last year.

Backing into an EPS is more complex. Using the $95M of additional revenue and reducing it by 40% (GM of 60%) and then reducing this by the 15% tax rate you get $48.5 of additional net income. Note that all selling and admin cost have already been recognized, so only the cost of sales and taxes should be considered (let me know if I am overlooking anything here). Using the comprehensive income of $79.8M for the 9 months ending 9/30, we add the $48.5 of additional income for a total of $128.3M. Now we deduct the 4.8% minority interest to get $122.2M. Next we take out about 12.2% to represent MSPEA’s and nonvested shares’ interest to get net income attributable to YONG shareholders of $107.2M. Divide by 49.3M shares and you get an EPS of 2.17. This represents a 32% increase in net income and 31% increase in EPS (slight dilution). I think the $467M revenue and 2.17 EPS gives you a better picture of how YONG is doing through the 9 months ended 9/30. See note 23 in the 10Q for more detail on how the EPS is calculated.

The prepaid supplies Mekong pointed out: As of September 30, 2012 and December 31, 2011, the deposits to suppliers for raw materials amounted to US$26,534,190 and US$2,616,231, respectively. As of November 2, 2012, raw materials amounting to approximately US$3.7 million were subsequently received.

And this: We increased deposits to suppliers by US$24.1 million during the nine months ended September 30, 2012 in anticipation of production demand for the next quarter. The deposits were paid primarily to a supplier of chemical components to lock in price and secure availability.

Accrued expenses: As of September 30, 2012 and December 31, 2011, the accrued expenses primarily consisted of accrued research and development expenses that amounted to US$9,338,830 and US$667,266, respectively, accrued advertising, promotion expenses and distributor seminars that amounted to US$6,330,173 and US$2,388,238, respectively, and accrued freight charges that amounted to US$547,634 and US$7,920, respectively

Accrued expenses is a grey area where management can sometimes justify recognizing expenses earlier than they should. The freight seems reasonable given the high volume of shipments, but the R&D stands out as unusual, especially at a time when the business is focusing on manufacturing and shipping. The 10Q later explains the increase here:

The increase in accrued expenses of US$14.7 million was mainly due to advertising and promotion activities, and research expenses for field tests that were conducted in the nine months ended September 30, 2012.

Customer concentration: Five major customers accounted for 47% of the Company’s total revenue for the three months ended September 30, 2012, and 47% of the Company’s total revenue for the nine months ended September 30, 2012. Five major customers accounted for 36% of the Company’s total revenue for the three months ended September 30, 2011, and 33% of the Company’s total revenue for the nine months ended September 30, 2011. The Company’s total revenue to five major customers were US$60,996,205 and US$175,677,311 for the three and nine months ended September 30, 2012, respectively. The Company’s total revenue to five major customers were US$50,892,264 and US$112,942,050 for the three and nine months ended September 30, 2011, respectively.

Now for the A/R picture:

0 – 3 months - $125.9M (41.5%)
3- 6 months - $157.5M (51.9%)
Total current AR - $283.5M (93.4%)
Over 6 months - $20.0 M (6.6%)
Total AR - $303.5 (note this does not factor in the $9M reserve)

The past due AR had me slightly worried until I read the next line in the 10Q:

All of the past due accounts receivable as of September 30, 2012 were subsequently collected in October 2012

The 10Q always lists several risks that could impact the stock price. This time they added a new one:

There can be no assurance that any agreement will be executed with respect to the Wu Proposal made by Mr Wu, Full Alliance, MSPEA, Abax and certain of their affiliates, or that this or any other transaction will be approved or consummated. The absence of a proposal to acquire our common stock would likely have an effect on the market price of our common stock.

I know that if the deal falls through, the stock will fall, but I am really rooting for this risk to play out. I strongly believe that the $6.60 offer price substantially undervalues the price of both the net assets (see balance sheet analysis above) and the value of a strong and growing business that I believe has a very bright future. I hope to be a shareholder for at least the next five years, but I seriously doubt I will have that option open to me. I strongly believe that the go-private deal will go through either at $6.60 or slightly higher. Given the most RTO go-private deals that have gone through, I don’t see YONG being an exception to the rule. I do think that the minority shareholders are more vocal here than in other go-private deals, so I do think we have a reasonable chance for an increase in the offer price. My guess is that we get taken out at $7, but I hope this view ends up being conservative. I do think shares are a strong buy on the * strong likelihood of making 22% through the go-private offer at $6.60 or 29% at $7 or if the deal goes bust, then a chance to make much more over the long-term through the continued growth of the business and decline of the negative stigma of the Chinese RTO space.

* please note that “strong likelihood” does not mean guaranteed. As with all future events, there is a level of uncertainty. Please do not invest in YONG solely on me stating I believe the buyout is likely to go through. I have been wrong many times and no one should invest based solely on my views.

Thanks for reading and let me know your thoughts/questions.
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