No clothes of the Emperor’s had ever had such a success as these.

“But he has nothing on!” a little child cried out at last.

Executive Summary

Vitasoy International is an international manufacturer and distributor of soy milk and tea beverages across multiple markets including China, Hong Kong, Australia and parts of Southeast Asia. Founded in 1940, the company was catapulted into the limelight in recent years, after it claimed to have made a major breakthrough in China, capturing significant market share in the process. Over this period, its share price shot up by from about HK$3.50 in 2009 to more than HK$46.50 in 2019, turning it into a ten-bagger.

But the story has been oversold, with the company’s management hiding facts in plain sight. Vitasoy has been grossly overstating its Chinese and Australian profits and capital expenditures, inflating its margins while underplaying the impact of rising costs on its bottomline. The numbers in the company’s financial reports do not correspond to its filings with official sources in both China and Australia.

We have strong reasons to believe that the reported capital expenditures are much lower than they really are. The discrepancy between reported numbers and the SAIC filings are staggering and point strongly to a poor cash situation at Vitasoy. The financial sleight of hand is the only way they can trick the public into believing that they have more profits than they actually do.

Vitasoy’s main competitors such as Uni-President and Tingyi are all reporting lower margins on higher costs. While checks with the industry sources show that costs of packaging and labor have also risen dramatically, the numbers reported by Vitasoy show there has been little to no impact on margins, which is unbelievable. In fact, its margins have been rising to over 50 per cent, much higher than the industry average of about 35 per cent. It is too good to be true.

Distribution is also suffering. Inventory turnover has jumped from 15 days to 60 days. And while the company has established a firm stronghold in southern China, it has failed to make headway in the northern parts of China. The company’s poor record of launching new products means that they have to keep relying only on its decades-old soy and tea drinks. It has been losing market share in an increasingly crowded market even as it continues to trade a massive premium compared to its competitors.

In December, the company reported a slowdown in sales in China, lower than street estimates. This latest set of disappointing sales and profit figures from the company is only the tip of the iceberg - the rot runs much deeper. We will show why we believe the company is worth a lot less than what it currently trades for, even after taking into account the sharp drop in its share price over the past three months.


Vitasoy is overstating its Chinese and Australian profits

At first look, Vitasoy seems to have done exceedingly well for itself when it comes to cracking the largest market on earth.

Source: Vitasoy’s 2019 Annual Report

The company’s reported numbers show that revenue growth from its Chinese operations has been nothing short of outstanding, growing by an average of 27 per cent a year since 2015. In contrast, its performance in other markets has been stagnating.

By comparison, Vitasoy seems to be outperforming the rest of the field, with margins that are eye-poppingly good.

Source: Annual reports

How does Vitasoy manage to maintain a massive margin while its competitors are struggling? Does it have a magical formula for soy beans, or a miracle worker in its management team?

Occam’s razor states that the easiest way to solve a problem is also the most straightforward one. In this case, the answer is that the company had lied about its profits in China.

A check with China’s State Administration for Industry and Commerce (SAIC) paints a vastly different picture of the health of the company’s profits and revenue in the country. What’s worrying is that that deception has clouded the public eye over a period of time.

We looked at the profit numbers that the company reported to investors versus what was filed onshore with the SAIC. To smoothen out the bumps - since the company’s financial year does not correspond with the calendar year - we looked at the numbers over the past three years.

Source: SAIC, Vitasoy’s Annual Reports

The difference is startling. The company reported an average of RMB 451 million in operating profits over the three years - more than 40 per cent of the RMB 321 million they have filed with SAIC.

While small differences can be explained away through accounting differences, the large gap in reporting of the figures is a clear red flag that cannot be easily dismissed. How can a company of Vitasoy’s size consistently over-report its profits over such a long period of time?

Source: SAIC, Vitasoy’s Annual Reports

As a result of the massive over-reporting, margins have also been over-inflated. Based on SAIC filings, Vitasoy’s operating margins should be close to about 6.9 per cent - in line with its competitors - and not the 14.4 per cent that it says it consistently gets. Indeed, 14 per cent operating margins are completely at odds with its cost structure, growth outlook and competitive market pressures - issues which we will tackle later in this report.

The company is doing the same neat accounting trick with its Australian subsidiary. While Vitasoy’s Australian business is smaller than its units in China and Hong Kong, it has been remarkably consistent despite slowing topline growth in the country. Soy milk retail sales growth in Australia has been averaging at just 1.5 per cent a year between 2013 and 2018. Yet Vitasoy reports segment profitability of about 18 per cent, making Australia its most profitable market.

We were sceptical and looked at the financial reports[1] of the company’s only subsidiary in Australia, Vitasoy Australia Products Pte Ltd. We found striking similarities in the way it reported both its Australian and Chinese profits. While onshore revenue matched reported revenue, profits were alarmingly over-declared - as a result margins were also over-inflated. One may be able to brush off the puffed figures as a mistake the first time, but was the second a coincidence? Or was it a conscious decision by the management? Either way, this should seriously bother investors.

Source: Vitasoy onshore Audited Report, Bloomberg

Reported capital expenditures do not match SAIC filings

The deception continues, we found, in how it reports its capital expenditures and fixed assets between the financial reports and the onshore filings. The large discrepancy between both sets of numbers remains puzzling and impossible to explain.

Capital expenditures rocketed 130 per cent from HKD 428 million to HKD 986 million from FY2018 to FY2019. Based on the annual report, most of it occurred in China.

Source: Vitasoy 2019 Annual Report

Source: SAIC, Annual reports

The numbers again don’t add up. According to the company’s annual reports, the company spent 214 million RMB on additional capital expenditures in 2017 and 688.9 million RMB in 2018. In contrast, the SAIC numbers show that they spent just 45.9 million RMB in 2017 and 174.9 million in 2018. The difference is staggering. We cannot rule out the fact that the company has been cooking its books to mislead its auditors, investors and the authorities in order to sustain its purported China growth story.

On its part, it is likely that Vitasoy will probably rely on its new Dongguan facility as a convenient excuse. In particular, they will likely brush off the difference as being the result of different accounting periods (SAIC reports numbers at the end of each year while Vitasoy reports at the end of March the following year). We took a closer look at this case by zooming in on FY2018 (or FY2019 for reported numbers), when the company announced its plan to build a new RMB 1 billion facility in Dongguan.

Based on the SAIC filings at the end of December 2018, the company spent RMB 46.3 million (and another RMB 99 million on intangibles) on the initial phases of the new facility’s construction. It then went on to report 688.9 million RMB expenditure in March 31. If it justifies the additional expense by saying that Dongguan was the reason for the jump in capex, this must mean that the company completed more than 50 per cent of the facility within three months - an impossible task!

This is because based on accounting standards, where engineering procurement contracts typically only realize costs on a percentage of completion basis, Vitasoy could say that the additional RMB 300 to 500 million was what caused the discrepancy in the SAIC and reported numbers. At the same time, it was announced on December 31, 2018 that Vitasoy sold 15 per cent of the Dongguan plant to Shenzhen Guangming Group. This means that Guangming would help to bear 15 per cent of the total costs of the new facility, requiring more of the facility to be completed within a short timeframe. But, don’t forget, the Lunar New Year - work basically stops in China over a period of between two and three weeks - also fell within those three months. There was no way Vitasoy could have seen so much progress in construction during that period.

All of this also begs the bigger question: was this neat accounting trick again the very tool that allowed the company to consistently hide its poor margins and cash flow over the years? Did Vitasoy sell part of its stake in Dongguan to make up for the company’s actual cash flow problem that has accumulated from years of overstated profits?

A cost structure that defies gravity

The company also has some seemingly amazing metrics when it comes to gross margins. Over the past three years, the company has logged more than 50 per cent in gross margins. This is nearly 50 per cent higher than its competitors’.

Source: Annual reports

Vitasoy’s ability to not just hold but enhance their margins defy all logic and fly in the face of what is a clear trend of rising costs on multiple fronts.

1) Packaging is one of the biggest cost components in the ready-to-drink segment of the beverage industry. Vitasoy, alongside Tingyi and Uni-President, rely on Tetra Pak for their packaging needs. On this front, costs per unit have been surging upwards by roughly 66%, as a result of higher raw material costs and recycling policies by the government. Given that packaging is estimated to form about 40 per cent of the costs of goods, the impact on margins should be huge. Tingyi and Uni-President have reflected this impact in their numbers but Vitasoy is somehow immune to margin pressure.

The numbers make more sense if the onshore filings are used as the key barometer. Based on SAIC filings, gross margins should average about 33 per cent, which places Vitasoy in line with the rest of the field - see “Vitasoy (SAIC)” grey line in the graph above.

Source: Annual Reports

Even when placed within a better like-for-like field including Dali foods (another soybean brand - Dou Ben Dou) and dairy behemoths such as Yili and Mengniu, Vitasoy’s gross margins still trades significantly above the rest of the pack. Too good to be true?

2) Labor and distribution costs

Vitasoy’s staff count has been growing at an average of 5 per cent a year. Wages have also been expanding at about 10 per cent a year. But these have somehow had little to no effect on overall gross margins. Conversations with former Vitasoy management also showed that channel costs such as marketing and distribution costs are rising rapidly by between 20 per cent and 30 per cent a year. Yet Vitasoy’s margins, again, appear to have a superpower immunity to this.

3) Failed product launches means that the company continues to be completely reliant on two products to power its growth. These failed attempts at new product launches - from Vitasoy Health Plus to Vitasoy Cafe for Baristas - cost tens of millions of dollars a year but make up less than 2 per cent of its total annual sales.

Slowing sales and rising competition

The same grim reality of the company’s ailing prospects in China emerges when it comes to sales figures. Checks with the company’s staff show that the company’s ambitions to expand into the north of China has sputtered. In fact, multiple sources within the company’s sales teams all say that there is almost no organic growth in the company’s sales in the north of China while southern China remains saturated.

For example, we learned that while Vitasoy did enter the Carrefour supermarkets in north China from early 2013, the brand has exited from many stores due to a lack of marketing and distribution support. Much of this was also driven by steep competition in the north, where consumers already have high milk consumption habits and substitute products like Vita Soy Milk are just unable to compete, especially given their meagre resources to educate consumers. The same trend could be said for the other major channels including RT-Mart and Walmart.

The company had set a sales target of 20 per cent for FY2019/2020 in China but the results for the first half of the year show that sales inched up by just 8 per cent. It fell short by its own measure. Meanwhile, inventory is rapidly building up. Checks showed that, on average, inventory turnover has lengthened from 15 days to 60 days - a clear sign that dealers are overstocked on goods. With demand now muted, oversupply is likely to persist in the near future.

Dealers are also complaining of a lack of a clear marketing strategy, with poor marketing budgets to support their push. Coupled with a lack of new products, it is doubtful that the company will be able to sustain any kind of proper revenue growth in China.

Vitasoy sees itself as a high-end drink compared to its competitors and insists that it is riding on a premium of its drinks. This may have been true a few years ago but its rivals have since caught up. Many of the tea and soya milk drinks in the market have been priced at similar price points. In fact, industry leaders such as Tingyi and Uni-President have started to sell tea drinks priced directly in line with Vitasoy. With the kind of resources on marketing and their extensive distribution networks, the leaders are gunning directly for Vitasoy’s product segments. As with the previous red flags, this is yet another sign that the kind of margins Vitasoy is purporting to have are unrealistic and most likely untrue. With competition heating up, players like Coca Cola has dived into the act and gained steady market share while Vitasoy is ceding theirs.

Source: Market Research on Modern Trade and E-Commerce Channels in the Respective Cities

Our Valuation

Margins are inflated, profits are overstated and costs are surging. Even the capital expenditures could have been fudged. Yet, the company trades at a multiple of about 40 times, more than twice its larger peers such as Tingyi and Uni-President, which are three to nine times bigger and trade at an average multiple of about 20x. What does a small drinks company really have over its much bigger and successful peers?

Much of the optimism over Vitasoy stems from a belief that its successful Chinese operations will carry the company into the future. But what we have shown is that the ride may end up moving in the wrong direction. Investors are being blindsided.

Source: SAIC, Vitasoy

Stripped of its made-up Chinese growth story, the company suddenly looks much smaller and a lot more plain. Plain and ugly, it just isn’t worth the current pretty prices the market is valuing Vitasoy. Based on the SAIC reports of both the margins and profit numbers, we believe that the company is massively overvalued. It is trading at twice the premium of its competitors, which are anywhere between three and nine times as large. Scale is a big advantage in the drinks business and Vitasoy just does not have it.

Operating profit growth is just 2.9 per cent (see graph above), a tenth of the 34.2 per cent growth reported by the company. Coupled with the poor prospects for the company, it is clear that the company should be trading at below its competitors’ multiples. We believe its shares are worth just HK$10 apiece. This represents a 65 per cent downside from current prices, a generous estimate on our end.

[1] From the Australian Securities and Investments Commission (ASIC)


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