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Morningstar | Despite Accusations by a Short Seller of Fabricating Profits, Hengan’s FVE Remains Unchanged

On Dec.11, short seller Bonitas Research claimed Hengan International Group, a leading Chinese personal hygiene and household paper product manufacturer, had fabricated a total of CNY 11 billion net profit--mainly from its most profitable sanitary napkin business--since 2005 that is now reflected as fake cash on its balance sheet and asserts the company’s equity is worthless. The share price dropped 5.7% before a trading halt was called on Dec. 12. On the next day, Hengan published a clarification to refute all the allegations and resumed share trading.

Bonitas suspects Hengan’s profitability in its sanitary napkin segment was unreasonably high compared with its competitors in such a mature market with severe competition, with 51% operating margin in the first half of 2018 versus its rivals’ 15%. We think the allegation is untenable by comparing Hengan with other much smaller-scaled regional players. We believe the higher operating margin comes from its strong brand awareness and the positive effect of economies of scale, which allows the company to have higher pricing on its products, lower advertising expenses, and lower cost of goods sold per unit.

We think the allegation of fake cash is highly unlikely given it would require either the banks or the auditors (or both) to be complicit in the fraud. Such frauds have been perpetuated in China previously but are difficult to sustain for a long period of time. They are also practically impossible for external analysts to pick up.

Regardless of whether allegations are proven to be true, we think they already undermined Hengan’s reputation and expect the share price will remain volatile in the short term. However, we think this incident should have no impact to the firm’s operations and expect the profitability will remain sustainable from a long-term perspective due to its strong record of free cash flow. Our fair value estimate for Hengan remains at HKD 70 per share, we think the shares are undervalued at current levels and become more attractive as the margin of safety increases.

Although the industry competition remains severe, we believe the company will continue to benefit from the trend of premiumization, increasing penetration rate in lower-tier regions through its small Amoeba sales team strategy, and strong sales growth from its e-commerce platform. We anticipate Hengan’s revenue and net profit to grow moderately at CAGRs of 6.7% and 7.8%, respectively, through 2022, with operating margin averaging at 25.8%.