Key takeaways from the report that may have contributed to the sharp drop in share price were:
- Loss of $0.02/share (approx. $492 thousand).
- Sales fell 50% relative to previous year’s third quarter “as a result of decreased sales orders from one of our [Australian] customers who was involved in projects in many hotels and apartments since the third quarter of 2017. We anticipate that we will gradually receive fewer sales orders from that customer in the near future.” North American sales still grew 11% relative to last year’s period. (See below, Source Q3 2018 filing)
Significant decline in cash position (from $7.8 million in Q2 to $0.9 million in Q3, largely due to increases in advances to suppliers). NVFY has reported negative free cash flows annually since 2014.
- Worries about receivables. Management is “working diligently with existing customers to shorten our collection cycle and lower our receivable amounts” (press release), but investors may remain somewhat skeptical due to long collection periods::
“As of September 30, 2018, we had gross accounts receivable of $56,236,204, of which $14,037,216 was not yet past due, $10,248,726 was less than 90 days past due, $7,866,950 was over 90 days but within 180 days past due and $24,083,312 over 180 days past due. We had an allowance for bad debt of $2,517,464. As of November 2, 2018, $2,702,716 accounts receivable outstanding at September 30, 2018 had been collected.” (Source: Q3 2018)
Even still, with the shares trading at around $0.9/share (market cap $25 million) with P/S = 0.22 and P/B = 0.36 one must wonder if it has become attractively cheap.
About Nova Lifestyle
Nova LifeStyle, Inc., together with its subsidiaries, designs, manufactures, markets, and sells residential and commercial furniture for middle and upper middle-income consumers worldwide.
The Company is a US holding company, founded in 2003 and headquartered in Commerce, California. NVFY went public in 2011 in a reverse merger (reverse acquisition with a public shell company). The Company has no material assets other than the ownership interests of its subsidiaries through which it markets, designs and sells furniture worldwide: Nova Furniture Limited in the British Virgin Islands (“Nova Furniture”), Nova Furniture Ltd. in Samoa (“Nova Samoa”), Bright Swallow International Group Limited (“Bright Swallow” or “BSI”), Nova Furniture Macao Commercial Offshore Limited (“Nova Macao”, wholly-owned subsidiary of Nova Furniture), and Diamond Bar Outdoors, Inc. (“Diamond Bar”).
(Source: Annual report 2017)
Diamond Bar is a furniture distributor based in California focusing on customers in the US (and the main source of revenue for NVFY), Bright Swallow is a furniture distributor based in Hong Kong focusing on customers in Canada (its clientele includes The Brick Limited), Nova Samoa is incorporated in Oceania (Australia) and Nova Macao is a furniture distributor based in Macao (or Macau) focusing on international customers. Specifically, Nova Macao is a trading company, importing, marketing and selling products designed and manufactured by NVFY’s former subsidiary Nova Furniture (Dongguan) Co., Ltd. (“Nova Dongguan”) and third party manufacturers for the U.S. and international markets. They are all operated under the same senior management of the Company, and management views the operations of Diamond Bar, Bright Swallow and Nova Macao as a whole for making business decisions. Nova LifeStyle sells its products – which include e.g. sofas, chairs, dining tables, beds, cabinets – through internet sales and direct sales primarily to furniture distributors and retailers.
On December 7, 2017, Nova LifeStyle incorporated i Design Blockchain Technology, Inc. (“i Design”) under the laws of the State of California. The purpose of i Design is to build a blockchain technology team. This new company will focus on the application of blockchain technology in the furniture industry, including encouraging and facilitating interactions among designers and customers, and building a blockchain-powered platform that enables designers to showcase their products, including current and future furniture designs. This company is in the planning stage and has had minimal operations to date.
(Source for all above: Annual report 2017)
As Nova LifeStyle operates in the notoriously competitive furniture industry without a clearly identifiable durable competitive advantage (e.g. brand, cost efficiency), we conclude that the Company has no moat. Therefore, we turn to the assets when assessing the value of NVFY.
Below is a rough estimate of liquidation value with recovery rates for NVFY (based on the most recent balance sheet for the third quarter of 2018):
|Assets||Q3 2018||%||Liquidation Value|
|Cash and cash equivalents||883,948||100%||883,948|
|Accounts receivable, net||53,718,740||75%||40,289055|
|Advance to suppliers||19,721,445||75%||14,791,084|
|Prepaid expenses and other receivables||186,400||0%|
|Total Current Assets||80,297,992||59,783,810|
|Plant, property and equipment, net||141,719||20%||28,344|
|Intangible assets, net||3,897,580||0%|
|Deferred tax asset||318,961||0%|
|Total Noncurrent Assets||4,620,126||28,344|
|Liabilities & Stockholders’ Equity|
|Line of credit||4,851,825|
|Advance from customers||99,402|
|Accrued liabilities and other payables||594,536|
|Income tax payable||394,562|
|Total Current Liabilities||9,389,806|
|Line of credit||–|
|Income tax payable||3,579,320|
|Total Noncurrent Liabilities||3,579,320|
|Additional paid-in capital||39,657,190|
|Total Stockholders’ Equity||71,948,992||46,843,027|
|Total Liabilities & Stockholders’ Equity||84,918,118|
(Source: Author based on Q3 2018 filing)
[*Note on recovery rates: Since NVFY is nearly debt free any liquidation would likely be quite orderly with fairly decent recovery to be expected.
Accounts receivable: We use a fairly standard 75% recovery for accounts receivable. According to Q3 results, “As of November 2, 2018, $32,782,219, or 60%, of accounts receivable outstanding at December 31, 2017 had been collected.” Therefore, it seems fairly reasonable to expect a year’s collection of receivables to be around 75%, especially since management is now seemingly more focused on collecting receivables.
Advances to suppliers: This account consists mostly of, or about-to-be, inventories to be delivered. We use 75% here, which is slightly higher than the 66% for inventory, to account for the fact that all advances have probably not already been turned into inventory. Also, “Based on our past experience, all products and projects have been delivered as promised by our existing suppliers.” and most of outstanding advances are expected to be delivered as inventory in Q4 2018. (Source) So, we can safely view this account as “almost inventory”, or cash plus inventory.
Inventories: We use a fairly standard 66% recovery rate, which is akin to giving at least 50% discount to retail store buyers.
PP&E: The account is small and insignificant; we use a modest 20%.]
Based on the above, liquidation value comes down to just under $47 million or approximately $1.65/share (outstanding shares as of September 30, 2018 totalled 28,474,490). This is significantly higher than the current $25 million market value of NVFY (approx. $0.9/share).
(Notice that even if we put a fire-sale liquidation value on the Company it would still be worth around $36 million (we get that by setting 60% recovery for receivables and advances, an extreme 50% on inventories (which is certainly far too much of a write-off, given how NVFY has gross margins of around 15-20%), and 0% on everything else).)
It is also worth noting that Diamond Bar alone has net worth (book value) of at least $20 million. This is based on an agreement that Diamond Bar made with a bank in California for a line of credit, of which one covenant requires the company to maintain a minimum tangible net worth at least $20 million:
“The Diamond Bar loan has the following covenants: (i) maintain a minimum tangible net worth of not less than $20 million; (ii) maintain a ratio of debt to tangible net worth not in excess of 2.5 to 1.0; (iii) the pre-tax income must be not less than 1% of total revenue quarterly; and (iv) maintain a current ratio in excess of 1.25 to 1.00. As of September 30, 2018, Diamond Bar was in compliance with the stated covenants.” (Source: Q3 2018)
So, why the discount between price and value? Or rather, what could cause us not to get at least liquidation value (which then might explain the discrepancy between price and estimated value)? If we buy Nova LifeStyle today at $25 million why shouldn’t we expect to get at least $47 million in value?
Generally, it would be either because of deterioration (e.g. losses; net worth diminishes) and/or dilution of value (e.g. equity raise; we get less of net worth).
- DeteriorationOne way we might get less than $47 million value is through deterioration, i.e if the Company loses money and the assets are depleted. We don’t think this is a significant factor.Although NVFY reported a small loss for Q3 2018 it is not losing money at any rate that might justify such a discount to liquidation value. In fact, it has generally been profitable in recent years, focusing on growth by approximately doubling revenues and book value since 2011, and only reporting negative earnings in 2016. Even if the Company had no sales it would take approximately two years of losses for the net worth (intrinsic value) to come down to market value (based on last year’s operating expenses). For the liquidation value to go from $47 million to $25 million we would need such significant losses that they would effectively equal the Company operating with no sales for two years.In other words, the Company could stop selling furniture for the next two years and we’d still be ok. Therefore, if potential losses were the only concern, investors would still in a worst-case scenario have at least two years of breathing room (margin of safety).For those that might be worried about the drop in Australian sales we should mention that in 2017 NVFY reported approximately $26 million in sales from the region (and total sales of $106 million). If those sales would disappear, with all else being equal, the Company would still record $80 million in sales (similar to 2013 sales) and be able to deliver a modest-to-decent profit at 15-20% gross margins. So, for the liquidation value to drop from $47 million to $25 million the Company would need to lose so much money that we don’t think deterioration is a particularly concerning factor at current market prices.
- DilutionThis brings us to dilution. If NVFY sell shares today through a secondary offering it won’t have an instant effect on liquidation value (we’ll have more shares and more cash with net worth unchanged; e.g. 100 shares with net worth $1000 and value $10/share become 110 shares with net worth $1100 and value $10/share).The expected effect on value depends on how the cash will be used. A very productive use should increase per-share value whereas the opposite would diminish it.To err on the safe side, let’s assume NVFY would sell shares and just use the proceeds to cover costs (everything else would remain unchanged) – the cash would then come in and go out, leaving us only with more shares outstanding. This might occur if the Company needed cash (and could not borrow) to bridge the gap between making a sale and collecting receivables (cash conversion cycle) – something that has now become more likely as cash on hand has diminished, sales have largely been made on credit with long collection periods, and the recent loss may strain borrowing capacity (although NVFY is near debt free). With liquidation value at $47 million ($1.65/share), outstanding shares at nearly 28.5 million, and market capitalization at $25 million ($0.9/share) the Company would need to double the share count for the net worth (intrinsic value) to become equal to market value. It took the Company nearly ten years to increase the number of shares outstanding from 12 million in 2010 to 28 million, so the likelihood of that happening anytime soon is next to none, not to mention that the Company does not need anywhere near the cash that such a share offering would raise.In other words, NVFY could sell shares today (doubling the number of outstanding shares), burn the cash (literally) and we’d still come out even. Basically, the Company would need to sell so many shares and use the proceeds in such an unproductive manner that we don’t think dilution is a particularly concerning factor at current market prices, i.e. potential dilution does not justify the large discount today between price and value.
Based on all the above, we think NVFY is definitely undervalued. Although it may not be the prettiest of investments, the market price has deviated so far from the real fundamentals and minimum intrinsic value that it offers investors a relatively low-risk investment with a decent margin of safety, both in terms of time and value.
The concerns following the release of Q3 2018 results – possible losses, lower sales in Australia, collection of receivables, decreased cash position and potential equity raise – are minuscule when compared to the large difference between price and true value, and do not justify the excessive discount;
- Losses would need to be extremely large to justify the low market price (equal to two years without any sales).
- Lower sales in Australia may decrease profits but will not wreak havoc on the bottom line – in fact, the Company should manage to remain fairly profitable.
- The Company has shown that it can collect receivables (e.g. in November it had collected 60% of outstanding receivables from December 2017) and intends to do so with more vigor going forward.
- And lastly, the decline in cash (largely due to increased advances to suppliers) is not necessarily a big concern. NVFY can operate by collecting receivables and since the Company is near debt free it is not fully constrained in terms of borrowing capacity. Even if it were to raise the cash levels by issuing new shares it would only have a relatively small effect compared to the large discount between price and value – the Company would need to double the share count, and raise much more cash than it needs, while keeping net worth unchanged, to dilute the value towards the current market price. That is, the discount is so large that it easily allows for an equity raise without harming returns.
There are other factors that may come to play, e.g. NVFY has a majority shareholder (Steven Qiang Liu, vice president of Diamond Bar Outdoors, owns 36% – still not a controlling (+50%) shareholder), the Company is relatively small with a stock that is thinly traded, three of its main customers accounted for approx. 50% of sales in 2017 (source), and it operates in a highly competitive industry. Still those factors could never justify the current low market price.
So all in all, market concerns are overstated, resulting in an unjustifiable discount between price and value – making Nova Lifestyle very undervalued.
While performing the analysis we became somewhat wary of the firm’s accounting history with regards to its auditors. Currently NVFY’s auditor is Centurion ZD.
Centurion ZD CPA Limited has served as the Company’s auditor since 2016. Prior to that it was Marcum Bernstein & Pinchuk LLP from 2011 until May 2015, with Crowe Horwath (Hong Kong) serving in the interim.
The reason why we mention NVFY’s auditors is that there has remained some skepticism towards both Marcum Bernstein & Pinchuk (example) and Centurion ZD (see here). Both are and have been auditors of small, Chinese companies (often established through reverse mergers) that have listed (and delisted) in the US public and over-the-counter markets. But the background of Centurion ZD was what mainly caught our eye.
Centurion ZD was formed in April 2016 by a merger of two independent CPA firms, Dominic K.F. Chan and AWC Limited (previously Albert Wong & Company; Albert Wong is now banned from being an associated person of a registered public accounting firm). And in November 2017 there was a disciplinary case that involved Centurion ZD.
Nova LifeStyle appointed Centurion ZD in 2016, just right after Centurion ZD was formed. This was also after the firm had terminated its relations with Marcum Bernstein & Pinchuk, after which it employed the otherwise respectable Crowe Horwath (Hong Kong) – but only for a few months (since Crowe Horwath stopped auditing public companies). If everything was to the absolute highest standards one would have expected NVFY to appoint a new auditor of the same or similar quality as Crowe Horwath. Instead they went with the brand-new auditor whose history wasn’t entirely spotless. We should mention though that the director formerly responsible for NVFY’s account at Crowe Horwath (Hong Kong) joined what is now Centurion ZD and was responsible for the Company’s account at the new auditing firm) (source). Since NVFY is so largely operating in North America it would make more sense and increase credibility if the Company appointed a well-respected US-based auditing firm.
Although NVFY generates most of its sales in North America (primarily from Diamond Bar) it still originates in China, with management being Chinese or with Chinese relations, and the Company’s subsidiaries operating in China (e.g. Nova Macao sourcing from NVFY’s previously-owned Nova Dongguan, Bright Swallow is also Hong-Kong based). Seeing how NVFY was listed through a reverse merger it obviously raises question as to whether this Company is like the many other small Chinese ones that fraudulently flooded the US market some years ago.
Please note, we are not accusing NVFY of fraud. Most of the fraudulent Chinese companies have tended to overstate revenues and inflate the balance sheet, often with large cash accounts and profits. Their operations were also primarily based in China. Nova LifeStyle has rather done the opposite – revenues have been somewhat unstable (fluctuating between regions from quarter to quarter), the cash levels are low, and the operations are to a relatively smaller extent in China (they mainly source and sell there). Although NVFY jumped on the Blockchain train it does not necessarily indicate any fraudulent behavior – it may rather only raise investor skepticism and be a business decision born from hype. Oftentimes the fraudulent companies have had one controlling shareholder (with over 50% ownership) – NVFY has one majority yet non-controlling shareholder (Steven Qing Liu), which still owns “only” 36% (he just became a majority shareholder in June 2017). However, NVFY also has a very small institutional ownership (less than 5%), so the majority shareholder can wield significant power (we also noticed that NVFY changed its bylaws to require only a third of stockholders to attend shareholders’ meetings – this would possibly allow Steven Qing Liu to exert significant control against non-attending, disperse retail investors). With that said Nova LifeStyle may have some similarities but surely not all the characteristics of a Chinese fraud.
We have not found any accounting irregularities with Nova LifeStyle or anything that might clearly indicate it being like the other delisted or fraudulent reverse-merger Chinese companies – the only thing we’ve found are the questionable auditors, but nothing specific at NVFY itself.
We also take comfort in the fact that Diamond Bar is US based with the Diamond Sofa brand being very real and the Company’s main source of revenue (it is e.g. sold at Walmart and Amazon among others). It is also trustworthy to see that Diamond Bar has a line of credit with a bank in California, thereby giving NVFY more credibility and putting some foundations under the value of the Company (as the covenants adhere to).
But since accounting is of fundamental importance we would be much more comfortable if Nova LifeStyle had a fully respectable, US-based auditor. With Centurion ZD as the current auditing firm we therefore remain more cautious about NVFY.
Nova Lifestyle looks significantly undervalued.
The Company is selling far below liquidation value, even below fire-sale value.
Despite reporting a small loss in Q3 2018, raising some concerns regarding future sales, receivables, cash levels and more, it does not justify the large discount between price and value. Lower sales in Australia will not drastically diminish profits, the Company has shown that it can collect receivables, and it still has ample room to borrow in order to fund the cash conversion cycle or issue shares without affecting value to great extent.
At the current market price (approx. $0.9/share, market cap $25 million) with liquidation value near $47 million ($1.65/share), the Company could effectively operate for two years with no sales or double the share count without causing investors to lose money.
Therefore, we believe the shares offer a great margin of safety – both in terms of time and value. Conservatively accounting for a $2 million loss and an increase in outstanding shares by 2 million still gives us a liquidation value of $45 million while the shares should be worth at least $1.5/share.
With regards to potential catalysts for price correction we think NVFY may become an attractive takeover target especially for someone interested in the Diamond Sofa brand (despite NVFY having a majority shareholder; considering the low valuation and returns on the stock he should not stand in the way of a fair offer – if he rejected an offer near the current market price it would only be a credible confirmation of the undervaluation, him being vice president of Diamond Bar). Also, if management stays true to its intentions to improve the credit policy it may free up some cash to extend and initiate the share repurchase program authorized in December 2017. And with the price below $1/share we may very well see some insider buying. Absent any earlier events, we will at least be looking to the next quarterly/annual release as a trigger for the NVFY stock.
The only concern that we have is with regards to the firm’s auditors (Centurion ZD). For that reason we are significantly more cautious about NVFY, but take some comfort in the fact that the Company’s main source of revenue – Diamond Bar – is based in the US, has net worth of at least $20 million, and is required to fulfil specific covenants by a bank in California.
If we can absolutely rely on the Company’s accounting then NVFY is a definite buy, and an especially good addition to a Graham-like net-net basket.
But since we have some reservations about a few factors, especially with regards to the auditors of Nova LifeStyle, we feel it prudent to be more careful in our recommendation. Therefore, given the currently available information and provided we don’t discover evidence of any irregularities, we cautiously recommend NVFY as a buy.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NVFY over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.