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A Fool’s Take on Bonita Research’s Short Thesis on Best World International Limited

It certainly has not been a good start to the year for Best World International Limited (SGX: CGN). The company was embroiled in controversy in February when a Business Times article cast doubts over the substantiality of the company’s sales figures in China. Best World quickly halted the trading of the shares on the same day and made clarifications regarding the news.

Now, a new short thesis by an activist short seller, Bonitas Research, has caused more panic among shareholders of the company. After the release of the report on Wednesday, 24 April, Best World shares plunged 9.0%. The company has once again halted the trading of its shares.

Here’s a quick breakdown of Bonitas Research report and what shareholders should do now.

A little background on Best World

Best World is a multi-level marketing (MLM) company that sells healthcare products, most notably is its DR’s Secret line of premium skincare products. Best World shares have surged over the past six years due to an almost six-fold increase in revenue and a staggering 52-fold increase in net profit from just S$1.4 million in 2013 to S$72.8 million in 2018.

According to financial filings by the company, the immense growth was driven by sales in Taiwan and China. In 2018, Taiwan and China contributed 32 and 54% of total sales respectively. In China, Best World does not have a multi-level marketing license and hence sells its products to third-party players known as franchisees who, in turn, sell the products to their network of distributors.

Best World recognises sales when the products are delivered to these franchises.

An overview of Bonitas Research’s report

The activist short seller provided a damning 28-page report on Best World. From what I have seen from the report, the analyst took a lot of effort to visit some of the franchisees in China and to talk to member reps of the company. There are multiple allegations of fraud within the company, similar to Bill Ackman’s short on Herbalife.

Here are the key allegations made in Bonitas Research report:

  1. Best World fabricated at least S$31 million of its reported 2017 sales to one major customer and overstated 2017 net profits by at least 130%.
  2. Secretly conducting MLM business in China where it is not licensed to.
  3. Best World is selling its products to member reps and not end-consumers. Member reps are, in turn, buying these products in the hope of getting rich by selling the products on.

Evidence that Bonitas Research provided

The analysts who wrote the report provided evidence of why they are making these allegations. Below are some of their key findings that back up these allegations.

Regarding fabrication of sales figures:

  1. The company has reported an unreasonably high net income margin of 24.7%. In comparison, other direct selling companies like Nu Skin, Herbalife and USANA only earned net profit margins of mid to high single digits. Bonitas Research analysts believe the high net income margin was achieved by inflating sales figures and consequently profit numbers.
  2. Bonita’s analysts also believe that Best World could have inflated its cash flow numbers as trade and other payables were unusually high in 2018, while trade and other receivables dropped to all-time lows.
  3. Bonita’s analysts believe they have identified the export agent for Best World sales to China (before 2018, Best World sold its products to the sales agent who would, in turn, sell its products on to other distributors). However, the sales agents costs of goods sold from its financial filings were $31 million less than what Best World reported as sales to its main customer in China. As such, Bonitas believes the sales figures were inflated by at least that much.

Regarding conducting MLM business in China without a license:

  1. Bonitas Research analysts spoke with a Taiwan-based member rep who said that she was asked to host training sessions in China. The rep showed a picture circulated by the Best World owner holding up a license. However, on closer inspection, the license in the picture was awarded in 2016 for wholesale health and supplement business and did not give Best World authority to operate a direct selling sales scheme for its skin care products nationwide.

Regarding most sales being directed at reps rather than end consumers:

  1. When Bonitas Research analysts visited franchisees in China, they did not sell individual products but instead tried to convince the analyst to become a member rep by purchasing RMB20,000 worth of products.
  2. The analysts also pointed to fake reviews online and the large price premium on the products.

A Foolish take

These allegations are certainly damning for the company. Most worryingly, if the allegations are indeed true, it shows that top management executives in the company are willing to make fraudulent claims and to lie, even to its own member reps.

If the Chinese authorities confirm that Best World is indeed carrying out MLM activities without the necessary permit, it could also jeopardise Best World’s China business and its future cash flow.

I do applaud the research that has been done so far and the legwork it took to visit the sites in person. If the claims of limited end consumers are true, then Best World could effectively be ruled as a Ponzi scheme, which might prove fatal to the company’s operating licenses in its other markets such as Taiwan.

Another red flag was the large amount that the company paid to its auditor EY in 2017. Best World paid S$398,000 in non-audit fees to EY in that year, around 10 times as much as it has paid in any previous year.

From my point of view, if proven true, these allegations would mean that even audited results of the company might not be accurate. As such, company valuations may be inflated based on past earnings.

While the relevant authorities have not substantiated Bonitas Research’s claims, the evidence on the report is certainly worrying.

Although I have previously defended Best World, this new report brings to light new allegations that could materially damage Best World’s business. In my opinion, investors should avoid investing in the company. Current shareholders should try their best to dig deeper into the company or to be safe, drop the company from their portfolio until the air clears.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.