Tuesday, July 20, 2010

Oceanus -- Overhyped counter?

Recently, Oceanus came under my radar. I was always fascinated by their business of rearing abalones, a Chinese delicacy, in their farms. It had went from a share price of <20c to near 60c, before coming down again to 31.5c recently. It is interesting in its strategy to acquire farms and lands from the centre of the coast, such that it can grow both left and right sides, while its competitors would find it harder to expand because they would have farms separated by Oceanus.

Before I do any impulsive buying (like before), I made it a point to look through some secondary sources (especially the more critical ones instead of the more bullish ones). I digged out the following nuggets of information from value investing forum Afralug Forums (formerly WallStraits forum), which are rather insightful.

The most interesting paragraph is the following:
"The financial statements use fair value accounting which books estimated changes in market value as revenue. While this may comply with accounting rules, it is total nonsense from a cash flow perspective because none of the so-called fair value profits can actually be converted into cash. Only when the actual goods are sold and cash received will the company know what their real profits are."

I have indeed seen similar circumstances of such revaluation gains/losses in shipping trusts, REITs, property counters, and counters like Berlian Laju. These revaluation exercises have the ability to affect the EPS of the company, and thus, we should take note of it when valuing a company. It's interesting that this can apply too on Oceanus, something which I knew, but never thought of applying here yet.

Just like my previous post on the gearing of REITs and how revaluations can affect the gearing, revaluation can also affect the NAV of Oceanus. But as along as the abalones are not sold, it's not real profits, but "paper gain".

The 3 best posts I picked out:

From dydx:

Oceanus has just announced that 4 parties have converted a total of 37.62m existing warrants into new Oceanus shares - all at a conversion price of $0.15/warrant - and the total outstanding issued shares has now reached a new record of 2,016.55m!.....

Based on the last done share price of $0.31, Oceanus now has a market cap of $625.1m. This is actually lower than when I wrote my last post on 29Jul08, at which point Oceanus had a higher market of $759m, based on the 1,765m outstanding issued shares and a share price was $0.43 then. So it does appear that all the business growth in the last 2 years and the secondary listing in TSE via 2 TDR issues so far, have not really enhanced total shareholders' value.

Based on the Q1-FY10 results announcement released recently.....
as at 31Mar10, Oceanus had in its farms in PRC a total of 172.919m live abalones in different stages of growth. Based on the current market cap of $625.1m, I get a derived value of approx. $3.60 per abalone being attached by Mr Market now. Frankly, I am not sure whether this value or method of valuation makes any sense. But what I do know is that in a seafood restaurant near my house, I can get live small-size abalones served steamed with fresh garlick for something like $4.00 each.

From d.o.g.
Larger (heavier) abalones are worth more, so assigning the same value to abalones regardless of weight is not appropriate.

Also, the market value rises faster than linearly i.e. an abalone that weighs twice as much is worth more than twice as much in market value. So computing value by total weight doesn't work either.

Usually the abalones are sold at specific stages/weights, so it's more common to value them based on the quantity in each weight band, with a different per-weight value in each band.

The fundamental problem with abalone farming and indeed any long-lived agricultural business like timber, cattle or tobacco leaf production is that at any given time, there is a huge amount of capital at risk, while only a small part of the total value can be realized at any one time.

For abalone, it typically takes 5-7 years to reach full maturity and optimum market value. If the abalone are sold earlier, not only is the weight lower, the per-weight value received is also lower, so the IRR is lower. This has to be balanced against the negative cashflow throughout the growing period. As a result, the business owner must choose between cash flow and ultimate value.

The financial statements use fair value accounting which books estimated changes in market value as revenue. While this may comply with accounting rules, it is total nonsense from a cash flow perspective because none of the so-called fair value profits can actually be converted into cash. Only when the actual goods are sold and cash received will the company know what their real profits are.

The problem of negative cash flow is exacerbated when a company is growing, because more and more capital is tied up in the business. Thus, initial success can turn into eventual failure if the company is not able to obtain sufficient amounts of money at a reasonable cost to meet its working capital needs. More problematic is the poor market visibility: because each company only sees current market output, it believes the market is undersupplied, so it expands at a furious pace. Eventually all the new production hits the market at the same time, and prices crash.

There is a huge amount of pricing risk in abalone. Traditionally, demand has outstripped supply, resulting in very high per-weight prices. These prices have enticed many players to go into abalone aquaculture, to the extent that the market price of abalone has already begun to fall. Those who purchased abalone in Singapore during Chinese New Year should have noticed that prices were meaningfully lower this year versus last year.

Furthermore, market prices are spot prices reflecting current supply - they don't reflect the much larger future supply that is coming up. Oceanus is far from being the only abalone producer out there.

IMHO it would not be surprising if within the next 5-10 years, abalone becomes a commonly available food, available year-round at affordable prices. Good for consumers, not so good for producers.

For further reading, here's the 2008/2009 annual report of the Tasmanian Abalone Council:


In particular page 21 (Quota Holder Sub-Council Report) quotes Peter Cook, a keynote speaker at the 2009 International Abalone Symposium, as saying:

"Higher market prices of the past 10-15 years have been the engine powering farm expansions; however a “perfect storm” is currently driving market prices down 30% or more. A devastating combination of (1) a 400% increase in farm production in the past 9 years (much occurring in the last 3 years) and (2) the world economic downturn and (3) continual lack of development of “home markets” resulting in over 98% of the worlds farmed abalone marketed to Asia Pacific countries. Premium species are driving the Chinese market, with production and demand in China being a dominant factor but, unfortunately, not necessarily impacting overall world demand as many people expected”.

In other words:

1. Past abalone prices were very high;
2. Farms ramped up production; and
3. There is now oversupply.

This oversupply situation probably explains Oceanus' attempts to set up abalone restaurants and create a captive offtake channel. Unfortunately restaurants have their own issues as Oceanus is finding out.

And of course we have the other problem of biological assets - since abalones are living things, they can die from disease, stress, pollution etc. Insurance is often costly or simply unavailable. Even when insurance is available at a reasonable cost, and is actually claimed and paid, the company is reimbursed for its inventory losses, but not for market share losses. By the time it rebuilds production capacity years later, its old customers would have already turned to other suppliers.

Investors in Oceanus should think very hard about:
a. access to working capital;
b. abalone pricing; and
c. a "black swan" type event killing the abalone inventory.

That should inform their view as to its true value as a business, and its merits as an investment.

From musicwhiz
1) The CEO of Oceanus has been constantly featured in magazines, news reports and even on TV show-casing his abalones and his business model. To me, this smacks of something wrong – why is the CEO of a company spending more time promoting his business rather than running it? In my personal experience, the best CEOs are the ones who lay low, keep to themselves and just work hard on growing the business. These are usually CEOs who under-promise but over-deliver; unlike some CEOs I’ve met who do exactly the opposite (i.e. over-promise and under-deliver)! To put it in one sentence – there was way too much hype surrounding this company; hence valuations would have been pushed up too high because of this hype (and inflated expectations).

2) D.o.g has adequately explained the fair value accounting problems, and I have always felt that companies with biological assets always tend to use Fair Value accounting which is technically correct but in practice, it means nothing at all. As an accountant, any gains arising from a revaluation of either assets or inventory should have been conservatively and prudently accounted for in Equity under “Capital Reserves”, and NOT brought to the Income Statement to be recognized as fluctuating gains and losses. This departs from the old concept of “lower of cost or NRV” which was the prevalent practice pre-2000 (before the Enron collapse and subsequent Sarbanes-Oxley Act). Now, companies have become over-zealous in “revaluing” their inventory and investments, to the extent of producing absurdities when it comes to interpreting this financial information. Companies such as Wilmar and Guangzhao IFB (suspended) also have this item in their income statement, and frankly so did China Milk as well. To me, the concept of fair value is just that – merely a concept. The practical implications of fair value are that you assume you can divest or sell the asset for that exact fixed price, which in the real world may be all but impossible as it may upset the supply/demand balance. A good example would be mark to market of share investments based on market prices; but when it comes to selling, if liquidity is not present, the huge cascade of sell orders will easily crash the price.

3) Regarding the huge working capital requirements of the business, one should note that this may be the reason for the Taiwan Depository Receipts (TDR) plan which Oceanus has rolled out a while back. The plan was to issue new shares as part of the TDR plan to raise more funds to grow more abalones. I think the dual-listing “fever” which has hit our shores can clearly show up which companies have a constant need to raise capital, and which can simply grow using internal cash flows.

4) A quick glance at Oceanus’ 1Q 2010 Balance Sheet ended March 31, 2010 also shows that fair value gains made up the bulk of their revenues at RMB 177 million. The Balance Sheet itself shows a drain in cash from RMB 561 million as at Dec 31, 2009 to RMB 298 million as at March 31, 2010, an outflow of close to RMB 263 million in just 3 months. Their current assets also consist of RMB 910 million of abalones, which as d.o.g. mentioned may or may not be able to realize their fair value due to downward price pressures and a potential future over-supply situation. Hence I would view the current asset balance with appropriate suspicion. In addition, a look at the cash flow statement will also show negative free cash flow for the Company.

1 comment:

  1. Yes this counter seems overhyped to me. Its price may go up ($0.38?) and may also come down($0.20). Currently, the risk-rewards dont seem attractive. I will only get interested if it falls to 0.25 from a technical pov.

    No dividends also. Only good for trading.


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