Why Are AAC’s Reported Profit Margins Higher And Smoother Than Apple’s? Part I

A new report out from top short-seller Gotham Research on a Hong Kong company  AAC Technologies LTD (Ticker = 2018): Why are AAC’s reported profit margins higher AND smoother than Apple’s? Part I

Gotham City Research’s Opinions

• AAC has used 20+ undisclosed related parties & dubious accounting to overstate & smoothen profits since 2014. In this regard, AAC reminds us of Longtop Financial Technologies.
• AAC has used these hidden entities to evade Apple’s labor standards specified in the Apple Supplier Code of Conduct.

Example #2: ZhongBeiTong Magnetic Materials

Gotham City Research has reason to believe that ZhongBeiTong Magnetic Materials is a significant undisclosed related party:

• The company estimated it would enter into RMB 150 million transactions with AAC in 2016.
• ZhongBeiTong Magnetic Materials declared itself (in its filings) as a related party supplier to AAC because Ingrid Wu, one of the unit’s main shareholders and board members, shares the same name as the woman who is the wife of AAC CEO Mr. Pan and an AAC board member.
• In contrast, AAC has never disclosed ZhongBeiTong Magnetic Materials in its annual report.

Introduction

GOTHAM CITY RESEARCH first heard about AAC Technologies LTD in 2015, an Apple supplier, when Apple was said to have found a defect in components produced by AAC for the Apple Watch.1 With AAC’s stock up nearly 3x since then, we decided to re-visit AAC recently. Upon a cursory review, AAC appears to be an exceptionally good company with notably higher and smoother margins relative to its peers2:

AAC margins are so good, it has reported higher & smoother margins than Apple, Google, & Microsoft3:

What is AAC Technologies’ “secret sauce”? How does AAC, an Apple supplier, achieve higher and smoother profit margins than Apple, Google, & Microsoft? Some have attributed AAC’s superior & smooth margins to a myriad of factors, such as workforce automation.4 While some of these explanations may sound plausible, we see it differently.

In our opinion, the evidence supports a more nefarious explanation: AAC uses undisclosed related party suppliers to inflate and smoothen its margins. Such an explanation may seem far-fetched, except that there are a number of case studies of companies that relied on nearly identical schemes to overstate profits (and whose share prices subsequently declined). Take for example, Longtop Financial Technologies Ltd (“LFT”), a formerly US-listed Chinese company that used undisclosed related parties to overstate its profits.5 In this regard, AAC reminds us of LFT (coincidentally, AAC uses the same auditor as LFT did).

Unlike certain schemes that can last indefinitely, Gotham City Research believes that AAC’s apparent schemes will come to an end shortly. We believe Apple (and other parties) will conduct their own investigations, and independently come to similar conclusions as we have.

We believe shares will initially decline to 40 HKD – 50 HKD per share, as the undisclosed related party supplier revelations are digested. We see far greater downside potential if the company were to concurrently experience the same problems that other Apple suppliers have in the past, e.g. increased competition, pricing pressure from its customers, wage inflation, etc. In this and coming report(s), we will explain our case for these opinions.

AAC Gross Margins are Exceptionally High and Smooth – Are Margins Too Good to Be True?

“When I see a bird that walks like a duck, swims like a duck, and quacks like a duck, I call that bird a duck” – James Whitcomb Riley

AAC Technologies Ltd is an Apple supplier based primarily in China. AAC has managed to report exceptionally high and smooth profit margins since 2014, especially when compared against its direct competitors (which sport lower and volatile margins – typical of other Apple suppliers)1:

AAC profit margins were not always this smooth. The company’s margins were less smooth prior to 2014:

Extraordinary claims merit extraordinary explanations

What is AAC’s secret sauce? Why have AAC’s margins been particularly smooth since 2014? In our experience, companies that make extraordinary claims – for example, report exceptionally high and smooth profit margins – are extreme outliers2:

is AAC more like a Google, Microsoft, or Apple – exceptionally good companies:

Or is AAC more like Longtop Financial Technologies or Quindell – fraudulent companies:

AAC’s explanation regarding its “good” margins seems insufficient

In the case of Google, Microsoft, and Apple, their extraordinary feats are apparent. All three companies have changed the world, pushing the human race forward. It is difficult to imagine a world where one of those companies were to suddenly disappear. Can we say the same about AAC Technologies? Is there extraordinary evidence that explains the exceptionally high and smooth profit margins? The company claims that its gross margins can be explained by the following3:

The Company is a world-class Total Technology Solution Provider. The Company delivers customer focused solutions across many technology segments. Not only has the Company invested in advanced materials research, product designs and building up intellectual property portfolio, the Company has also invested heavily in manufacturing automation to achieve operational excellence in manufacturing efficiency. The above form the bases of the Company’s good gross margins achieved.

Gotham City Research believes that the company’s explanations do not sufficiently explain its anomalously high and smooth profit margins since 2014 for the following reasons:

• Evidence of significant undisclosed related party companies. Undisclosed related parties were present in both the Quindell & Longtop Group frauds.
• Additional observations that cast doubt on the company’s explanations regarding its profit margins, as we detail later in this report.

A better explanation: undisclosed related parties & dubious accounting to overstate earnings?

We did, in fact, find extraordinary evidence, but of a different variety. This evidence – which include local filings & field research – suggests that there are at least 20 undisclosed entities are managed and/or owned by associates of AAC’s CEO. We summarize below the relationships which the evidence suggests are involved4:

Local SAIC filings & field research suggest that at least 20 undisclosed entities managed and/or owned by those with direct ties to AAC’s CEO (see the next page for a tabular version of the below diagram)5:

Article by Gotham City Research

See the full report below.