A Chinese EV giant’s financing reckoning, and a stockbroker’s commodities pivot

“I wonder to what extent Buffett’s exit was actually driven by BYD’s financial position.”

Key Takeaways

• Regulators are dismantling a massive digital voucher system used by BYD that obscured liabilities and squeezed cash-strapped suppliers
• Hong Kong brokerage GoFintech exemplifies a worrying trend of Chinese companies making desperate, value-destroying pivots into unrelated industries

By Doug Young and Rene Vanguestaine

Scrutinizing the financial health of Chinese companies often requires looking past the headline figures to understand the machinery generating them. Recent developments have exposed cracks in the foundations of two very different market players. One of those is a regulatory crackdown on a shadowy financing practice at the country’s leading electric vehicle (EV) manufacturer, BYD. The other comes in a radical, margin-crushing business transformation by a Hong Kong financial services firm, GoFintech.

While the first involves an industry titan and the other a tiny brokerage, both stories underscore a recurring theme of financial opacity and the lengths to which companies will go to manage their cash flow and growth narratives.

We begin with a complex financial instrument that has permeated the supply chain of BYD (1211.HK; 002594.SZ). According to a recent in-depth report by Caixin, the EV giant is quietly dismantling a massive digital payment system used to settle obligations with its suppliers. The system involves “Dilian” (or “BYD Chain”), a system of self-created digital vouchers backed by BYD’s own credit.

In most parts of the world, a company typically has 60 to 90 days to pay a supplier. However, BYD found a convenient way — abusing its dominant power, morally speaking — to extend that timeline to eight months or longer. In the interim, they issue a piece of paper effectively stating, “I owe you.”

If a supplier is desperate for cash, they can try to secure funds against this promise to pay, but only at a discount. If traditional financial institutions balk, suppliers can turn to a BYD subsidiary, which might offer cash at an even steeper discount. By mid-2023, BYD had issued more than 400 billion yuan ($56 billion) worth of these instruments.

It’s a lucrative arrangement for the issuer, but it looks uncomfortably like a scam and an abuse of suppliers in a tight economy. It’s surprising that Chinese regulators took this long to intervene, though the central bank has now given companies two years to comply with new rules. We recall reports from at least six months ago indicating government pressure on big manufacturers to accelerate payments to their SME suppliers. The delay in cracking down will likely force smaller enterprises to close shops or fire workers due to liquidity struggles.

For investors, the implications are significant. This system was a convenient method for BYD to keep obligations off its balance sheet, obscuring the company’s actual financial condition. As this unwinds, we expect to see an increase in liabilities on BYD’s published balance sheet. This transparency could make creditors and public investors increase the company’s borrowing costs.

It’s worth noting that Warren Buffett’s Berkshire Hathaway fully exited its position in BYD earlier this year. In light of these revelations, we wonder if that departure was linked to the realization that the company’s financial position was not as robust as it appeared. If the situation deteriorates, this financing scheme may well be viewed as the canary in China’s EV coal mine.

The risky business of constant reinvention

While BYD grapples with its balance sheet, a smaller player in Hong Kong is engaging in a different kind of financial alchemy. GoFintech (0290.HK) recently reported that its revenue skyrocketed to HK$1 billion ($128 million) in the first half of its latest fiscal year — a 40-fold increase from just HK$28 million a year earlier.

The catalyst was a move into commodities trading, acting as a middleman between buyers and sellers. However, this revenue surge came at a brutal cost, as the company’s gross margin crashed from 75% to just 6.6%. Previously a financial services provider offering stock brokerage and margin financing, GoFintech is now venturing into commodities, as well as artwork trading and tokenization.

We view this move as risky, to say the least. The pivot suggests that even in a bull market with increased trading volumes, GoFintech was likely losing market share to more aggressive platforms like Futu and Tiger Brokers.

Diversification is one thing, but we question whether the company possesses the expertise to manage the inherent risks of commodities trading. History is littered with cases where brokers are left holding the bag, discovering that the physical assets they thought they possessed were not there. Trading commodities is fundamentally different from trading stocks. If we were investors, we would either stay away or demand deep due diligence on their risk management capabilities.

This reflects a broader, troubling tendency among Chinese companies to constantly reinvent their business models. We’ve seen similar patterns with companies like Qudian, which began as a fintech lender, pivoted to prepared meals, and then attempted last-mile delivery in Australia.

Such radical shifts often signal that a company has failed in its core business. In Qudian’s case, they entered Australia simply to escape hyper-competition in China. These pivots rarely end well. When a company sits on hundreds of millions in cash, as Qudian did, management often finds creative ways to destroy that value rather than returning it to shareholders.

We believe investors should avoid companies that abandon the core businesses they mastered to venture into unknown territory. Whether it’s an EV giant squeezing suppliers with shadow currency or a brokerage chasing low-margin revenue to mask a failing strategy, the lack of transparency and strategic discipline presents a risk that is best avoided.

About China Inc

China Inc by Bamboo Works discusses the latest developments on Chinese companies listed in Hong Kong and the United States to drive informed decision-making for investors and others interested in this dynamic group of companies.

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