Tack Fat: as clear as Mudd
6 August 2007
On Sunday evening, garment maker Tack Fat Group International Limited (Tack Fat, 0928) finally released its annual report for the year ended 31-Mar-07, 5 days after the deadline. The accounts are not a pretty picture. Readers may recall that we last criticised Tack Fat, amongst others, in relation to its issuance of toxic convertibles.
In the new annual report, the auditors KPMG qualified their opinion, something which was not mentioned when the results were announced on 26-Jul-07, and only came to light in an announcement on 1-Aug-07. The qualification relates to Tack Fat's stake in 50% associate Sino Legend Ltd (Sino Legend). Sino Legend's accounts are audited by a different firm, which was not named, which gave an unqualified audit opinion under US GAAP, but KPMG said "we have yet to receive sufficient information from this firm as we consider necessary...to form a conclusion as to the adequacy of their work for our purposes..."
As we will show, that is not the only reason that investors should be concerned about Tack Fat.
History
On 24-May-04, Tack Fat agreed to subscribe US$3.33m (HK$26.0m), or US$40 per share, for 83,333 preferred shares in Sino Legend, representing 6.94% of the voting rights. Sino Legend owned 72% of the membership units of Mudd (USA) LLC (Mudd USA). The preferred shares in Sino Legend are entitled to a dividend of 8% per year "when declared by the board of directors of Sino Legend", are convertible into ordinary shares 1:1, and each has the same vote as an ordinary share. From its cash flow statements, Tack Fat does not appear to have received any dividend or distribution from Sino Legend so far.
Mudd USA in turn was a company newly formed to acquire the Mudd business from Mudd LLC (renamed Paper Denim and Cloth, LLC). The net profit after tax of Mudd USA was about US$27.8m in calendar 2002 and US$19.7m in 2003. Tack Fat entered into a manufacturing agreement with Mudd USA, which Tack Fat gave as a reason for the investment. Mudd, Mudd, glorious Mudd.
A deposit
What Tack Fat didn't mention in the announcement or circular regarding that investment was that by the year-end of 31-Mar-04, almost 2 months before the investment was announced, Tack Fat had already made a "refundable deposit" of HK$58.8m for the $26m investment. The excess was subsequently refunded. This deposit was revealed in note 19 of its annual report for 31-Mar-04. As you will see, this was the first of several such "refundable deposits" for acquisitions.
On 26-Jul-04, Tack Fat agreed to buy a further 516,667 preferred shares in Sino Legend, representing 43.06% of Sino Legend's voting rights, for US$53.0m (HK$413.4m) from Lung Investment Holding, LLC (Lung Investment). As a result, Sino Legend was 50.0% owned by Tack Fat, 47.19% by Lung Investment and 2.81% by Grandwell Investment Ltd.
The price is equivalent to US$102.58 per share, more than 2.5 times the price paid 2 months earlier. Tack Fat also agreed to pay Lung Investment US$10.0m (HK$78m) for an option to buy 250,000 preferred shares for US$15.65m, or a total of US$25.65m, equivalent to the same price per share as the main stake. The option is exercisable between 1-Apr-07 and 30-Sep-07, so there are less than 2 months left, and if the option is not exercised, then the HK$78m premium will have to be written off in this year's income statement.
Circular
This was a "Very Substantial Acquisition" under the Listing Rules, and it took them almost 8 months to produce the circular dated 18-Mar-05. The delay was due to the time taken to extract the results of Mudd USA from the accounts of Mudd LLC, which retained some non-Mudd business when it sold Mudd to Mudd USA.
The circular contained accountants' reports on Mudd LLC and Sino Legend Group produced by HLB Hodgson Impey Cheng, a name which loyal readers of Webb-site.com will recognise from this article. The Sino Legend report reveals that it has 200,000 ordinary shares issued for $0.01 each (total $2,000), and 1,000,000 preferred shares issued for US$40 each (total US$40m). So the ordinary shares get a free carry. There is no report on Mudd USA, so it is not possible to tell how much it paid for the business acquired from Mudd LLC.
At 21-May-04 (the date it acquired the Mudd business), Mudd USA had intangible assets of US$100.35m, comprising US$85m of trademarks and US$15.35m of "customers relationship". It had long-term debt of US$40m. Net assets were US$63.55m and net tangible liabilities were US$36.8m.
Sino Legend subscribed US$40m for the 72,000 Class A units of Mudd USA, plus expenses of $1.52m, total US$41.52m. Mudd USA also has 20,000 Class B units, and 8,000 nil-paid Class C units, which we suspect represent some kind of management incentive which only pay out in certain circumstances. At acquisition, Sino Legend's interest in Mudd USA's net assets was US$49.73m, or 78.26% of the total, which is 72/92, supporting our thesis that the C-units are not deemed part of the minority. As a result, Sino Legend booked negative goodwill of US$8.22m.
The consolidated balance sheet of Sino Legend at 30-Sep-04 (including Mudd USA) shows intangible assets of US$91.73m and net assets (before deducting minority interests in Mudd USA) of US$63.44m, so it had net tangible liabilities (before minorities) of US$28.3m. That is the last balance sheet we have seen for Sino Legend, and it will have changed substantially since then.
Profit guarantee
Lung Investment guaranteed that the audited consolidated/combined net profits before tax, charges for goodwill, minority interests and any extraordinary or exceptional items of the Sino Legend Group for the period from 21-May-04 (when it acquired Mudd) to 31-Mar-07 would be not less than US$108m. Lung Investment would pay Tack Fat 2.95 times the amount of any annualised shortfall in the profit attributable to the stake, within 7 days after delivery of the audited accounts of Sino Legend for the year to 31-Mar-07, which accounts were expected by 30-Jun-07. In other words, Tack Fat was purportedly buying the stake on a P/E of 2.95 times annualised guaranteed pre-tax profit of US$18m (HK$140m) attributable to the stake. Assuming a 30% tax charge, that is equivalent to about HK$98m after tax.
In the latest annual report, Tack Fat said that it was "in the process of completing the finalisation of the above compensation, if any".
Sale of Mudd brand
On 31-Mar-06 (US time), Mudd USA conditionally agreed to sell the global rights to the Mudd brand outside of Greater China to Iconix Brand Group Inc. (Iconix, NASDAQ: ICON), for US$88m (HK$686.4m). According to Iconix, when the deal closed on 12-Apr-06, the final purchase price was US$45m in cash and 3,269,231 shares of Iconix. Details of the deal are included in this 8-K filing by Iconix, including a copy of the agreement. Iconix also licensed the Mudd brand back to Mudd USA for the core jean and denim products for 2 years, with an option to renew for 5 years and a guarantee to pay Iconix certain (undisclosed) royalty levels.
Clear as Mudd
For the year to 31-Mar-06, Tack Fat booked a share of loss of Sino Legend of HK$35.8m, and for the year to 31-Mar-07, a profit of HK$114.1m. However, this would be after goodwill adjustments within Mudd USA and Sino Legend, so it is impossible to tell from this limited disclosure whether Mudd USA or Sino Legend were profitable at their core. The disclosure on Sino Legend is in note 15 of the latest Tack Fat accounts. It tells us that Sino Legend's consolidated revenue in the latest year was HK$1,003m, compared with HK$621.5m in the previous year. Figures for Sino Legend's assets, liabilities and equity (the difference between the two) are disclosed, but there is no income statement or balance sheet. Assets undoubtedly include intangible assets, and liabilities include amounts due to Tack Fat as a supplier, and minority interests in Mudd USA.
It is unclear whether the brand sale of HK$686.4m is included in the revenues of Mudd USA (and hence Sino Legend) for the year to 31-Mar-07, or booked as other income, or what profit or loss Mudd USA booked on the transaction. It would be subject to some deduction for the book cost of the brands. Tack Fat does not provide any breakdown of Sino Legend's profit or loss between Mudd's core business and the sale of the brands. We also don't know whether Mudd USA has sold any or all of the shares it received in Iconix, and to what extent this contributed to Sino Legend's profit or loss.
Tack Fat now claims a 40% interest in Mudd USA, up from 36% the year before, which implies that Sino Legend now holds a 80% interest in Mudd USA, up from 72% a year earlier. This might be because the C-units have ceased to have a claim to equity, but we cannot tell.
Tack Fat's balance sheet at 31-Mar-07 includes an interest in associate (Sino Legend) of HK$546.5m. This comprises HK$261.1m (US$33.47m) of goodwill that Tack Fat paid Lung Investments when it bought 43.06% of Sino Legend, and HK$285.4m for Tack Fat's share of net assets of Sino Legend. We don't know to what extent those net assets are tangible.
In short, we consider Tack Fat's disclosure of the financial results and balance sheet of Sino Legend and its subsidiary Mudd USA to be grossly inadequate. If Tack Fat does not publish the relevant information then we are entitled to assume they have something to hide.
Sales to Mudd USA
Tack Fat's largest customer in the two years to 31-Mar-07 was Mudd USA, which bought garments worth HK$535.8m (2006: $412.0m) or 27.5% (2006: 24.9%) of Tack Fat's sales. At year-end, Mudd USA owed Tack Fat $205.5m (2006: $294.2m), equivalent to 4.6 months (2006: 8.6 months) of the year's sales.
An XXESS deposit
On 25-May-07, Tack Fat agreed to buy, for HK$330m in cash, 90% of Best Favour Ltd (Best Favour), from Xbert Investments Ltd (Xbert), which is guaranteed by Mr Zhang Wen Kai, about whom we know nothing. The owner(s) of Xbert were not disclosed. Best Favour, through its subsidiaries, is "principally engaged in the fashion design and management of its XXESS brand of smart casual wear... through a chain of over 200 self-operated and franchised retail apparel stores...across the north-eastern region of the PRC...".
The announcement says XXESS is "one of the leading apparel brands in the PRC." We cannot find any web site for XXESS, or any mention of the products on the web. Such is the reach of the web, that when something is missing from Google, one begins to wonder whether it exists. On further inspection we see that the latest annual report now refers to it as XXEZZ, and there is indeed a brand of that name, and here is its web site. But why didn't Tack Fat even get the name right in its acquisition circular?
The purchase price was supported by a valuation of 100% of Best Favour at $384m by BMI Appraisals Ltd at 30-Apr-07, although their report was not published. Readers may recall that name from this article.
Best Favour made unaudited net profit of HK$31.7m for the year to 30-Jun-06. The unaudited net assets of Best Favour at 30-Jun-06 were $87.6m. As this was only a Discloseable Transaction, not a Major Transaction under the Listing Rules, no accounts were published, and we don't know whether the net assets include intangible assets such as goodwill.
What the announcement and the circular dated 18-Jun-07 didn't mention, and what the annual report now reveals in note 18, is that by 31-Mar-07, two months before the agreement, Tack Fat had already placed a "refundable deposit" of HK$281.8m with Xbert. This shows a great degree of trust, given that there was no acquisition agreement at the time. A pattern of such trusting behaviour is emerging, because there was a deposit for the Mudd investment on or prior to the 31-Mar-04 year-end. We don't know whether Best Favour group has been a customer of Tack Fat.
Unlisted equity investment
In the year ending 31-Mar-04, note 17 reveals an investment of $15m in unlisted equity shares. We could not find any explanation of this investment. In note 16(b) of the accounts for 31-Mar-06, the Chairman Mr Kwok Wing underwrote the carrying value by offering to buy it for $15m. The offer was made on 29-Jun-06, good for 4 months, and the Group was "in the process of evaluating the offer" when the accounts were finalised. According to note 34(f) of the 31-Mar-07 report, the investment was disposed of to an "independent third party" on 1-Jun-07. We'll probably never know what the investment was or why it was made.
Another deposit
The "other prepayments and receivables" as at 31-Mar-05 (see note 16(b)) included a prepayment of HK$30m for an "investment in unlisted equity shares in a joint stock company in the PRC" which was awaiting a reorganisation of the investee and supposedly repayable within 1 year of the prepayment if the reorganisation did not complete. Two years later, this amount was still outstanding at 31-Mar-07 (note 18(c)), and is "refundable in cash in the event that such reorganisation is not complete within certain specific date." Well it may be "certain and specific" to Tack Fat, but it isn't to us - greater disclosure should be made on this. What is this investee? What does it do? Has this investee also been a customer at any time?
Conclusions
Tack Fat's accounts are, quite literally, as clear as Mudd. Far greater disclosure is needed on the financial results and balance sheet of Mudd and Sino Legend, so that investors can understand whether Mudd is actually making a profit on its core business, whether it is able to service its accounts payable to Tack Fat, and what its net tangible assets are.
Investors also need to know whether Tack Fat will exercise its option to acquire 20.8% of Sino Legend before it expires on 30-Sep-07, and if not, why not. If the option is exercised, then Sino Legend and Mudd USA will become subsidiaries, and any accounts receivable will be eliminated on consolidation. If the option is not exercised, then Tack Fat will have to write off the $78m option premium and explain why it didn't want to take control of Mudd.
Explanation is also needed for why Tack Fat failed to mention, at the time of its initial investment in Mudd, and at the time of its recent investment in Best Favour, that it had already made substantial deposits for the deals prior to its previous year end and before any agreement on the investment and acquisitions had been reached. Explanation is also needed for the $15m unlisted equity investment (now sold) and the outstanding $30m prepayment for another investment which has been in limbo for over 2 years.
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