So I took the recent news of a "definitive agreement" to buy CFSG by Bain (a large and reputable private equity shop) very badly. After all it was a profit opportunity wasted because I never got around to reading the accounts.
What I found was a strange company – one that I did not understand – in fact one that made me think I don't understand very much at all. The clever people at Bain want to buy this company with a value of almost $300 million – and – for the life of me I could not have picked it.
Lets start at the beginning...
This is amazing. The company has $41.9 million in accounts receivable: over 6 months of revenue employed in working just there. Then it has $40.7 million in costs in excess of billing. Another 6 months revenue employed there. And another $10.3 million in prepayments and deferred expenses, $1.1 million in employee advances, $1.7 million bidding deposits, and a relatively trivial $6.7 million in inventories. The company has deployed over 100 million dollars in working capital on behalf of their customers and they count all that as current assets. This company looks like it is in the business of financing their customers.
Three are also 14.4 million in notes receivable and that looks like explicit customer financing.
I am an accounting geek - and I can't resist an accounting geek's aside here. Current assets are - by definition - assets that the company can reasonably expect to turn to cash within a year. (If they take longer to turn to cash they are not current.) This company has more than a year's revenue locked up in working capital. Can someone explain to me how it is possible to consistently have more than a year's revenue locked up in working assets and have them all counted as "current"?
So the company is thin on inventory but very strong on financing their customers through receivables and through costs in excess of billings and even through notes receivable.
They are however very thin on actual plant and equipment. Here is the plant and equipment line:
They have 9.6 million dollars of plant and equipment - less than 10 percent of their working capital provision. If you look at the balance sheet this is not a manufacturing company (there are very few actual manufacturing assets). This is a finance company financing its customers (conventional and nuclear power stations, petrochemical plants, railways etc) through working without billing and by being slow to collect. They also explicitly provide finance through notes.
Very strange. Especially as the customers almost certainly have better access to funding that what is really just a little fire-and-security company.
Fortunately for us the plant and equipment line is further broken down in the 10K.
Buildings and improvements
Less accumulated depreciation
Now I am really puzzled. Before depreciation they only have 900 thousand dollars of machinery.
They have three times more "transportation equipment" (trucks and cars) than machinery. They even have more "office equipment" (computers, desks) than machinery.
This is a very peculiar manufacturer indeed. It operates almost without machinery. I assure you 900 thousand dollars - pre-depreciation - does not buy you very much manufacturing kit - even in China. (If you do not believe me start looking up prices for things like wire-drawing equipment equipment on Alibaba.)
Come to think of it - there is not much in in these accounts for buildings either: $7.5 million before depreciation. Even in China that buys a single large building. It hardly buys a campus.
Whilst the company is extremely willing to finance its customers (by extending credit through large receivables or by work in excess of billing) it does not draw much funding from their suppliers.
Accounts payable to related party
Billings in excess of costs and estimated earnings
Total current liabilities
The main thing to note here is that the "working capital liabilities" are much smaller than the "working capital assets". They only have 7.7 million in accounts payable for instance versus over 40 million in accounts receivable.
There is no debt - but there are 19.7 million in accrued liabilities - all subcontractor expenses.
Summary thus far
This is a really strange company: its a manufacturing company whose balance sheet contains next to no manufacturing equipment but vast extensions of credit to the customers. It is certainly not the business described in the "business description" part of the accounts.
Margins and the P&L
The P&L shows a fat margin business - albeit one with declining profitability:
System contracting projects
System contracting projects
General and administrative
Depreciation and amortization
Gross margins are over 50 percent of sales. Net margins (even in the relatively poor 2010 year) were 17.5 million/80.0 million or almost 22 percent.
I like to break this margin down into the two things the company does. The company seemingly provides credit to all its customers (I think we demonstrated that above), and it does manufacturing and installation.
It provides roughly 15-18 months credit to its customers (look at the working capital provision). It should make about 7 percent margin on that (just reconfigure as a loan). The rest of the business makes about a 15 percent operating margin. That is down sharply from prior years - but is still a quite nice manufacturing margin.
It is a staggering manufacturing margin for a business which has almost no capital employed in manufacturing equipment. All that margin on only $900 thousand of machinery in a manufacturing business is really strange.
So what manufacturing equipment do you get for $900 thousand?
The key to this is working this out is going to be what sort of equipment they use and whether they really do anything special on it (deserving fat margins) - and how on earth do you run a large manufacturing company with only $900 thousand of machinery.
So I went looking at their website for pictures of the plant and machinery and (thankfully) the company obliged. Here is a sampling. Alas some of the pictures are very low resolution. I did not take them: they came from the company's website.
The caption on the above photo is "Production Line of automatic fire protection electronic products".
The captions on these are "Full-scale fire Test Center" (both above ground and underground section).
This photo was captioned "The photoelectron workshop".
And here is their Design Center though the eagle-eyed will notice that it is also the fire-test center photographed above:
The whole campus is shown on their web-page with the main manufacturing subsidiary (Sureland) in the background and the two main other buildings in the foreground. There is a little wide-angle to exaggerate the size of the campus - but there are still three substantial buildings plus the underground testing center. These are not the only buildings the company uses.
These are a pretty impressive set of buildings. It is surprising that they can be purchased for $7.7 million (pre-depreciation) as per the accounts. I thought they might be leased but the words rent or lease do not appear anywhere in the annual accounts (except where they lease a house for one of their executives). So we can presume these buildings are owned.
A fire testing facility (especially an underground one) would have some equipment in it - but probably not much as it gets burnt every now and again (which is presumably what "testing" is about).
I have absolutely no idea what they do in a large "photoelectron workshop" but I figure it must be full of equipment.
Whatever - there is a lot of building here for $7.7 million and (presumably) a very large amount of equipment filling those buildings (with a cost of only $900 thousand).
I am startled. By this time I confess: I don't understand.
I presume Bain and the other people backing this takeover are perfectly happy with the audit they received. I presume they have done their own due diligence - after all the auditor is Frazer Frost. Frazer Frost is (to my knowledge) the only American audit firm thus far sanctioned by the SEC
over China frauds. (Eagle-eyed observers will notice that the firm sanctioned by the SEC is named Moore, Stephens, Wurth, Frazer & Torbett. The firm has been through a few name changes and restructures
Still - Bain are taking this company private. I hope they have double-checked the obvious audit problems. The most obvious problem is determining whether the current assets (most notably receivables and work done but not billed) are real. Bain are competent people - I presume they have done that.
But Bain are clever people so I presume they have that covered.
Why this deal must be real
As I said repeatedly, I do not understand these accounts, but I have only spent a day looking over them. Lots of prestigious organizations and people are involved in this deal. They must all be cleverer than a two-bit hedge-fund manager sitting at a desk near the beach in Australia. Even if individually they are not as clever as me they must collectively be cleverer than me. Here is a partial list of people working on this deal:
That is a pretty remarkable lot. Whilst I usually dislike appeals to authority I have to cede to such an overwhelming collection of intellect.
So what does Bain see in the deal?
Once you work through all this - and you accept the accounts as the gospel truth - you realize that Bain has a true bargain.
This is possibly the most efficient purchaser/constructor of buildings in China if not the world. They purchased all those buildings for $7.7 million.
They are without question the most efficient purchaser or constructor of machinery in the world. They equipped this entire company with machines for $900 thousand before depreciation.
They also have a huge and presumably easy to collect lot of current assets outstanding. There is $150 million in current assets here - and they should - with better management - be able to turn $100 million into cash without impacting the business. After all, the customers are solvent parties that do not need all that credit extended to them. $100 million additional cash plus the $28 million cash on the balance sheet will offset more than a third of the purchase price for the business. It should pay off the bulk of the bank debt so Bank of America should be fine.
This deal is a work of genius. Unfortunately as a stockholder I will not be around to enjoy it. CFSG is going private.