Magical mystery tour through some oddities of RLX Technology’s financial statements

In the last couple of days more than a dozen of U.S.-based law firms announced their class action lawsuits against RLX Technology Inc., a Chinese company that debuted on NYSE in January 2021. Claimants in those lawsuits accused RLX Technology Inc. for material misstatements and misrepresentations (that led to significant financial losses incurred by stock investors who purchased the company’s shares), in what it published in its IPO Prospectus. In that regard, and given a history of past accounting frauds committed by U.S.-listed Chinese firms, it is worthwhile to investigate the RLX technology’s financial statements, in search of possible misstatements (or at least areas that may raise serious and legitimate doubts).

In the last few weeks I diligently scrutinized the RLX Technology’s accounting numbers, published in its IPO Prospectus as well as in its press releases and SEC filings (including the annual report for 2020) announced after the company debuted on NYSE. That examination led to a detection of as many as twelve material Red Flags (of both quantitative, as well as qualitative nature), that are summarized below (with the additional quantitative information delivered at the end of this post).

Disclaimer: The red flags (warning signals) discussed below do not constitute a proof or a confirmation of an accounting fraud. Instead, they should be treated as a kind of a “circumstantial evidence” of an above-average risk of serious accounting distortions and misstatements.

In this post the term “the company” is reserved for RLX Technology Inc.

Timing and sources of information for all Red Flags presented below:

1)     Red Flags no 1 through 10 are based on the company’s IPO Prospectus, as well as its Press Release (with unaudited quarterly results) published on March 26, 2021 (i.e. the accounting information available before the company published its Annual Report for Fiscal Year Ended December 31, 2020, on Form 20-F).

2)     Red Flag no 11 is based on disclosures extracted from the company’s Annual Report for Fiscal Year Ended December 31, 2020 (published on Form 20-F, on April 23, 2021).

3)     Red Flag no 12 is based on disclosures extracted from the company’s Annual Report for Fiscal Year Ended December 31, 2020 (published on Form 20-F, on April 23, 2021), combined with its Press Release (with unaudited quarterly results) published on June 2, 2021.

4)     Update on Red Flags no 1 through 10 is based on disclosures extracted from the company’s Press Release (with unaudited quarterly results) published on June 2, 2021

Red Flag no 1: The company’s own warnings and lack of reliable internal control

The company’s own outright confessions (cited beneath), regarding its staff’s lack of an adequate accounting competence, are self-explanatory. But how is it possible that an entity with a multi-billion market capitalization claims to be unable to prepare adequately to function on a stock exchange (and report its financial results reliably)? Is it too poor to afford employing a team of several competent accountants (e.g. from abroad, with a sufficient knowledge and experience in applying U.S. GAAP)?

“Prior to this offering, we have been a private company and were never required to evaluate our internal control within a specified period, and, as a result, we may experience difficulty in meeting these reporting requirements in a timely manner. Our management has not completed assessment of the effectiveness of our internal control over U.S. GAAP financial reporting, and our independent registered public accounting firm has not conducted an audit of the effectiveness of our internal control over financial reporting. However, in the course of preparing and auditing our consolidated financial statements included in this prospectus, we and our independent registered public accounting firm respectively identified one material weakness in our internal control over financial reporting […]. In accordance with reporting requirements set forth by the SEC, a “material weakness” is a deficiency […] in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis”. (p. 38 of the Prospectus)

“The material weakness identified relates to lack of sufficient competent financial reporting and accounting personnel with appropriate understanding of U.S. GAAP to design and implement formal period-end financial reporting controls and procedures to address complex U.S. GAAP technical accounting issues, and to prepare and review the consolidated financial statements and related disclosures in accordance with U.S. GAAP and financial reporting requirements […]. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control […] for purposes of identifying and reporting any material weakness in our internal control over financial reporting […]. Had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of the effectiveness of our internal control over financial reporting, additional material weaknesses may have been identified”. (p. 38 of the Prospectus)

“If we fail to achieve and maintain an effective internal control environment, we could suffer material misstatements in our financial statements and fail to meet our reporting obligations […]. Additionally, ineffective internal control over financial reporting could expose us to increased risk of fraud or misuse of corporate assets […]. We may also be required to restate our financial statements from prior periods”. (p. 39 of the Prospectus)

“The material weakness, if not timely remedied, may lead to material misstatements in our consolidated financial statements in the future”. (p. 115 of the Prospectus)

“Our employees, distributors, retailers, suppliers and manufacturers may conduct fraudulent activities, such as accepting payments from or making payments to other distribution channel participants or other third parties in order to bypass our internal system and to complete shadow transactions […]. It is not always possible to identify and deter such misconduct, and the precautions we take to detect and prevent these activities may not be effective”. (p. 34 of the Prospectus)

Red Flag no 2: Lack of professional oversight over the company’s auditor’s work

If the company itself admits that it lacks an adequate accounting competence, then perhaps its auditor’s rigorous and diligent investigation of its books and underlying accounting documents may offer some guarantee of a reliability of the company’s financial statements (?). Well, not here, since its auditor’s work is not inspected by a professional supervisor, and (as the company admits in the extracts cited below) the quality of its auditor’s procedures is unknown.

“The financial statements included in this prospectus were audited by an auditor based in China, and their audit work currently cannot be inspected by the U.S. Public Company Accounting Oversight Board. If audit work performed in China is not able to be so inspected for three consecutive years, recent U.S. legislation may require that our securities be delisted or prohibited from being traded “over-the-counter”. (p. 6 of the Prospectus)

“This lack of the PCAOB inspections in China prevents the PCAOB from fully evaluating audits and quality control procedures of our independent registered public accounting firm. […] The inability of the PCAOB to conduct inspections of auditors in China makes it more difficult to evaluate the effectiveness of our independent registered public accounting firm’s audit procedures or quality control procedures […], which could cause investors and potential investors in our stock to lose confidence in our audit procedures and reported financial information and the quality of our financial statements.” (p. 55-56 of the Prospectus)

Red Flag no 3: Lack of an experienced and independent Audit Committee

If the company’s accounting staff is not very competent (as the company admits), and at the same time the quality of its auditor’s work in unknown, then perhaps a strong and independent internal Audit Committee may offer some “last resort” here? Well, do not count on it here…

First of all, according to the following statement the company do not plan to design its corporate governance structure so that its managing board is dominated by independent members:

“We plan to rely on the exemption with respect to the requirement that a majority of the board of directors consist of independent directors”. (p. 9 of the Prospectus)

In early March, 2021, the company announced that it had appointed a new independent director to its board of directors. So at least the “scope of independence” increased, since now the company’s managing board “will consist of five members, two of whom are independent directors” (so still a minority). However, the new member of the board will also be a member of the company’s Audit Committee, despite having an “extensive background and experience in strategic management and organizational behavior” (which is not an experience in accounting or auditing, right?).

Red Flag no 4: Extraordinarily high share of cash and financial assets in total assets

Now that we know that the company is featured by such serious internal control weaknesses (due to its incompetent accounting personnel and not very strong and sufficiently independent Audit Committee), combined with an unknown quality of its auditor’s work, it makes sense to check the financial statement items that seem most prone to accounting misstatements. As may be seen on Chart 1, at the end of the third quarter of 2020 RLX Technology reported cash and financial assets, whose combined carrying amount constituted almost 86% of its total consolidated assets. This is an another red flag, since many companies that in the past committed confirmed cash-based accounting frauds (i.e. accounting misstatements via overstated reported balances of cash and liquid financial assets), were featured by unusually high amounts of reported cash and financial assets (often above 50% of total assets, as may be seen within a sample of firms presented on Chart 1).

As may be clearly seen, RLX Technology’s share of PRE-IPO BALANCES of cash and financial assets, in total assets, seems extraordinary even when compared to a sample of the presented past confirmed cash-based accounting frauds.

Additionally, in many cases of cash-based accounting frauds (e.g. Wirecard), the allegedly high liquidity on the asset side (i.e. ample reported amounts of cash and other interest-bearing assets) was accompanied by high and growing amounts of interest-bearing debts. The very same pattern was observed here, since on September 30, 2020, the RLX Technology’s financial debts constituted as much as 52,5% of its total assets. So very similarly to e.g. Wirecard, the company appeared to borrow a lot, only to tie up those borrowed funds as cash and financial (non-operating) assets.

Red Flag no 5: High amount (over one third of total assets) of short-term investments, accounted for at fair values with Level 2 valuation inputs

Not only the company is featured by an extraordinarily high share of total non-operating assets (i.e. cash balances combined with financial assets) in total assets, but also by a suspicious breakdown of the former. On September 30, 2020, a carrying amount of its short-term investments stood at 1,3 RMB billion and made up as much as 35,7% the company’s total consolidated assets (rising further, to 38,1% as at the end of December 2020). At the same time, the company that admitted to face a “lack of sufficient competent financial reporting and accounting personnel with appropriate understanding of U.S. GAAP […] to address complex U.S. GAAP technical accounting issues”, accounts for its short-term investments by revaluing them periodically to fair values, with the use of Level 2 valuation inputs (which may be unobservable and difficult to verify):

“Short-term investments represent structured deposits and the Group values these short-term investments based on quoted prices of similar products provided by banks […], and accordingly, the Group classifies the valuation techniques that use these inputs as Level 2”. (p. F-95 of the Prospectus)

In light of the company’s self-admitted internal control weaknesses, the carrying amount of its short-term investments (almost 40% of total assets), combined with the way they are accounted for (i.e. valued to fair values, with the use of Level 2 inputs), constitutes an another relevant red flag (since estimates of fair values, based on Level 2 inputs, may be prone to significant subjective judgments and more or less deliberate misstatements).

Red Flag no 6: Interest income recognized in books but not collected

Another warning signal, related to the company’s interest-bearing assets (i.e. cash and financial assets), is related to a relatively small fraction of its interest income that has been collected already. As disclosed in Table 1, in the first three quarters of 2020 RLX Technology recognized over 24,7 RMB million of the interest income (net). However, at the same time a carrying amount of the company’s interest receivable (included within a balance sheet item “Prepayments and other current assets”), rose by as much as almost 18,7 RMB million. This means that only about one fourth of the amount recognized as interest income on the income statement, has actually been collected.

To make sure, this may be entirely legitimate in some circumstances (for instance, if the uncollected but booked interest income corresponds to some zero-coupon bonds that the company has purchased). However, it may also reflect some artificially recognized interest income, corresponding to some non-existing (i.e. fabricated) financial assets, shown on the balance sheet. Accordingly, a high share of the uncollected interest income, in total interest income, should be considered as an another red flag (particularly when combined with other red flags discussed above).

Red Flag no 7: Intended use of IPO proceeds vs. allegedly asset-light business model

From its IPO (completed on January 26, 2021) RLX Technology raised over 1,6 USD billion, that is almost 11,0 RMB billion. The intended use of those proceeds look as follows (p. 71 of the Prospectus):

“We plan to use the net proceeds of this offering as follows:

• approximately 30% for development of products and technologies and scientific research;
• approximately 25% for enhancement of distribution and retail network;
• approximately 25% for improvement of supply chain capabilities; and
• the balance for general corporate purposes and working capital.”

A declared intended use of the huge amount of the IPO proceeds (ca. 11,0 RMB billion), combined with the company’s alleged historical growth and financial performance (as reported in its Prospectus), raise serious doubts about a coherence between the former and the latter:

1)     The company allegedly intends to spend ca. 3,3 RMB billion [= 30% x 11,0 RMB billion] on its R&D projects, while in the past it was allegedly able to grow fast (increasing its revenues by almost 150% between 2019 and 2020), with R&D expenditures totaling ca. 330,0 RMB million in 2019-2020. As may be seen in Table 2, the amounts of the company’s R&D expenses in 2019-2020 (which, by the way, included significant share-based, i.e. non-cash payments) were not limited by an availability of liquid funds, since the latter exceeded the former by multiple times. So, if the company intends to spend so much (ca. 3,3 RMB billion) on its future R&D projects, then why didn’t it incur much higher R&D expenses in the recent past (given its allegedly high financial liquidity)?

2)     Likewise, the company allegedly intends to spend ca. 5,5 RMB billion [= 50% x 11,0 RMB billion] on its “enhancement of distribution and retail network” and “improvement of supply chain capabilities”, while in the past it was allegedly able to grow fast (increasing its revenues by almost 150% between 2019 and 2020), with rather low (and not increasing) amounts invested in its operating non-current assets. As may be seen in Table 3, the carrying amounts of the company’s non-current operating assets in 2019-2020 were not limited by an availability of liquid funds, since the latter exceeded the former by multiple times. So, if the company was able to grow as fast to date, with such a low capital-intensity (and high and rising fixed assets turnover ratio), then what new operating noncurrent assets does it intend to buy (for its declared intended amount of expenditures, of ca. 5,5 RMB billion)?

3)     The remaining part of the company’s IPO proceeds (i.e. ca. 2,2 RMB billion) is intended to be spent on “general corporate purposes and working capital”. However, so far the company has demonstrated a NEGATIVE WORKING CAPITAL (i.e. an excess of operating payables over inventories and receivable accounts), that contributed POSITIVELY to its reported operating cash flows (instead of draining them), as shown in Table 4.

Positive working capital is also confirmed by the company in the selected narratives, extracted from its IPO Prospectus and quoted below:

(i)                As regards receivable accounts:

“Going forward, […] revenues from sales to offline distributors will account for substantially all of our net revenues in the future”. (p. 91 of the Prospectus)

“Concurrently, we sell our e-vapor products primarily to offline distributors, where we typically receive payments before our delivery”. (p. 103 of the Prospectus)

“According to the agreements, the offline distributors make full payment to us at the time of order placement […]”. (p. 109 of the Prospectus)

(ii)              As regards inventories:

“Our inventory turnover days were 35,1 days for the 2018 period, 44,0 days for the year ended December 31, 2019 and 35,8 days for the nine months ended September 30, 2020”. (p. 104 of the Prospectus)

(iii)            As regards payable accounts:

“Our accounts and notes payable turnover days were 42,8 days for the 2018 period, 97,3 days for the year ended December 31, 2019 and 138,9 days for the nine months ended September 30, 2020. The change in accounts and notes payable turnover days reflected our increased bargaining power as our business grew”. (p. 104 of the Prospectus)

“The Group’s notes payable mainly include short-term notes, typically with terms of 45 to 90 days which are provided to the Group’s suppliers and manufacturers”. (p. F-84 of the Prospectus)

So, if the company’s business model used to entail a negative working capital (that seems to stay intact in a foreseeable future), positively contributing to its reported operating cash flows, then what are its intended expenditures on “general corporate purposes and working capital” (for its declared intended amount, of ca. 2,2 RMB billion)?

Red Flag no 8: Huge excess of allegedly available liquidity over CAPEX and dividends, combined with significant excess of financing cash flows over operating ones

This seems to be one of the most worrying red flags here, given the following observations of the data presented in Table 5:

1)     Between January 1, 2019, and September 30, 2020, RLX Technology allegedly had a cash at its potential disposal (= Cash and total financial assets as at 01.01.2019 + Total operating cash flows reported for the period between 01.01.2019 and 30.09.2020), that exceeded the company’s total investment expenditures on operating fixed assets and dividend payouts, incurred in the same period, by as many as 6,4 times.

2)     At the same time, despite such an allegedly high financial liquidity (suggested by the company’s reported huge excess of financial assets held, combined with operating cash flows, over CAPEX and dividend expenditures), it obtained positive financing cash flows (stripped out from dividends), in the amount that exceeded its reported operating cash flows by over 21%.

3)     As may be seen in Table 5, this is worryingly similar to the actual structures of cash flows reported by the selected five companies that have committed confirmed cash-based accounting frauds (in all those five cases, allegedly high free cash flows were accompanied by significantly positive financing cash flows, due to the fraudulent amounts of the former).

So, if the company is such a “cash cow” (allegedly having huge excess of a financial liquidity, over its CAPEX and dividend expenditures), then what was a purpose of obtaining such materially positive financing cash inflows (exceeding its reported operating cash flows by over 20%), in a period between January 1, 2019, and September 30, 2020?

It is worth noting, in that regards, that in the entire 2020 the company’s reported operating cash flows amounted to 2,5 RMB billion, as compared to 1,3 RMB billion reported for the first three quarters of that year. Accordingly, in the last quarter of 2020 the company allegedly generated as much as 1,2 RMB billion of operating cash flows (not much less than cumulatively in the preceding three quarters).

Red Flag no 9: Taxes booked vs. taxes paid

As disclosed in Table 6, in the entire 2020 RLX Technology reported approximately 242 RMB million of current income taxes. However, at the same time a carrying amount of the company’s taxes payable rose by as much as almost 361 RMB million. This suggests that very little (if any) of the amounts of income taxes, reported for 2020, have been paid (while the increase in taxes payable may exceed the amount of income taxes, since it may include other taxes payable, such as e.g. VAT).

To make sure, significant increases in amounts of taxes payable may be entirely legitimate in some circumstances (for instance, if a given entity benefits from some special tax treatments, e.g. an entitlement to defer its tax settlements in special economic zones). However, they may also reflect artificially inflated earnings, which are recognized in an income statement (with a corresponding increase in a reported income tax expense), but are not reported to tax authorities (and are not actually taxed). Accordingly, a high increase in the amount of taxes payable, as compared to the amount of current income tax, should be considered as an another red flag.

Red Flag no 10: “You say yes, I say no, You say stop and I say go”, or how elusive the shareholders’ participation in the company’s business may be…

The statements quoted below (extracted from the company’s IPO Prospectus), and related to the company’s control over its main operating subsidiaries, are quite self-explanatory. But they lead to the following main conclusions:

1)     The RLX Technology’s main operating subsidiary, Beijing Wuxin (VIE - Variable Interest Entity), is fully consolidated with RLX Technology’s results, even though RLX Technology owns no any shares in the equity of Beijing Wuxin (instead, Beijing Wuxin’s equity belongs to two private persons, who indirectly are also the majority shareholders of RLX Technology itself).

2)     The control of RLX Technology over Beijing Wuxin allegedly results from the contractual arrangements, between RLX Technology on one side, and the VIE’s shareholders (who are also controlling shareholders of RLX Technology) on the other side.

3)     According to the company’s statements (cited below), RLX Technology may quite easily lose its control over its assumed subsidiary, as a result of e.g. a dispute between the company’s shareholders or a divorce of one of them, or an inheritance of the equity interests in the consolidated subsidiary. In such a case, RLX Technology could suddenly turn into a kind of “shell company”, given that virtually all of its core business activities are centered in its VIE, allegedly controlled via contractual arrangements.

4)     Even if the control of RLX Technology over its VIE, based on the current contractual arrangements (instead of direct equity interests linking the parent and its subsidiary), is never lost, none of the earnings and net assets of the latter are attributable to non-controlling shareholders of the former (including IPO investors), as long as RLX Technology owns zero percent equity interest in Beijing Wuxin.

5)     There is an additional financial reporting issue here: in light of those contractual arrangements, on the face of the RLX Technology’s income statement the company’s reported consolidated net earnings should have been broken down into (i) earnings attributable to shareholders of the Parent, and (ii) earnings attributable to non-controlling interests. The same applies to total consolidated equity (in balance sheet). However, no such disclosures (related to amounts attributable to non-controlling interests) may be found anywhere in the company’s financial statements (despite an unqualified auditor’s opinion that accompanies those statements).

“Beijing Wuxin Technology Center (Limited Partnership) and Tianjin Wuxin Technology Partnership (Limited Partnership) each holds 86,77% and 13,23% of the equity interests in Beijing Wuxin, respectively. Ms. Ying (Kate) Wang and Mr. Bing Du each holds 93,635% and 6,365% of the partnership interests in Beijing Wuxin Technology Center (Limited Partnership), respectively. Ms. Ying (Kate) Wang and Mr. Bing Du each holds 1,00% and 99,00% of the partnership interests in Tianjin Wuxin Technology Partnership (Limited Partnership), respectively. Ms. Wang is a beneficial owner and co-founder of our company and serves as the chairperson of our board of directors and the chief executive officer of our company. Mr. Du is a beneficial owner of our company”. (p. 4 of the Prospectus)

“We rely on contractual arrangements with our VIE and its shareholders to exercise control over a portion of our business, which may not be as effective as direct ownership in providing operational control”. (p. 6 of the Prospectus)

“For example, our VIE and its shareholders could breach their contractual arrangements with us by, among other things, failing to conduct the operations of our VIE in an acceptable manner or taking other actions that are detrimental to our interests. If we had direct ownership of our VIE in China, we would be able to exercise our rights as a shareholder […]. However, under the current contractual arrangements, we rely on the performance by our VIE and its shareholders of their obligations under the contracts to exercise control over our VIE. If any dispute relating to these contracts remains unresolved, we will have to enforce our rights under these contracts through the operations of PRC law and arbitration […]. As a result, uncertainties in the PRC legal system could limit our ability to enforce these contractual arrangements […] Meanwhile, there are very few precedents and little formal guidance as to how contractual arrangements in the context of a consolidated variable interest entity should be interpreted or enforced under PRC law. […] In the event we are unable to enforce these contractual arrangements, or if we suffer significant delay or other obstacles in the process of enforcing these contractual arrangements, we may not be able to exert effective control over our VIE […]”. (p. 44 of the Prospectus)

“The shareholders of our VIE may be involved in personal disputes […] that may have an adverse effect of their respective equity interests in our VIE and the validity or enforceability of our contractual arrangements with our VIE and its shareholders. For example, in the event that any of the shareholders of our VIE divorces her or his spouse, the spouse may claim that the equity interests of the VIE held by such shareholder is part of their community property and should be divided between such shareholder and the spouse. If such claim is supported by the court, the relevant equity interest may be obtained by the shareholder’s spouse or another third party who is not subject to obligations under our contractual arrangements, which could result in a loss of the effective control over the VIE by us. Similarly, if any of the equity interests of our VIE is inherited by a third party with whom the current contractual arrangements are not binding, we could lose our control over the VIE […]”. (p. 45 of the Prospectus)

Red Flag no 11: Why is RLX Technology so generous to its auditors?

In its annual report for fiscal year 2020 (Form 20-K) the company informed that in the year ended December 31, 2020, its total audit fees amounted to 22.460 RMB thousands (source: Item 16.C, p. 115 of the company’s annual report). Table 7 contains comparable data, regarding audit fees (in the last fiscal year), compiled for a sample of largest (by market capitalization) 100 Chinese companies listed on NYSE, including RLX Technology Inc. Since there exists a strong positive correlation between the audit fees and entity’s size (as proxied by total assets at year-end), the entire sample of 100 firms has been sorted in order of decreasing carrying amount of total assets (in RMB thousand), and then divided into five equally numbered quintiles, so that Quintile 1 includes 20% firms with largest total assets, while Quintile 5 captures 20% smallest companies (in terms of total assets), etc.

Observation of data shown in Table 7 leads to the following main conclusions:

1)     Within the investigated sample of 100 Chinese companies (with largest market cap), listed on NYSE, there exists an obvious and strong positive correlation between the amounts of audit fees on one side, and a given firm’s size on the other side: while the smallest firms (in terms of their total assets) paid less than 5,0 RMB million for audits of their books, on average, the median audit fee for 20% of the biggest firms exceeded 27,0 RMB million.

2)     A carrying amount of RLX Technology’s total assets (on December 31, 2020) locate the company within Quintile 4, in terms of its size. In other words, it is a business with a relatively small scale, featured by below-average total assets. However, the amount of its audit fees paid in 2020 locate it within Quintile 1, i.e. among the top 20% of largest Chinese firms listed on NYSE (while none of the twenty firms that fell into Quintile 2 paid more than 20,0 RMB million, for their audits in the last fiscal year).

3)     In other words, despite reporting total assets that constitute only 37,6% of the whole-sample median (i.e. 4.059.885 RMB thousand vs. 10.785.525 RMB thousand), RLX Technology’s audit fees exceeded the whole-sample median by more than 120% (22.460 RMB thousand vs. 10.056 RMB thousand).

While the findings discussed above were based on the averaged numbers (medians), Table 8 presents data for selected individual companies, with total assets between 3,0 RMB million and 5,0 RMB million (i.e. of a size comparable to RLX Technology). As may be clearly seen, among its peers (i.e. NYSE-listed Chinese companies with total assets between 3,0 RMB million and 5,0 RMB million), RLX Technology emerges as an obvious outlier, in terms of the amount of audit fees that in paid to its auditors in the last fiscal year:

1)     Despite reporting total assets at the amount virtually equal to the in-sample median, the company incurred audit costs that exceeded the in-sample median by over 120% (22.460 RMB thousand vs. 10.103 RMB thousand).

2)     The firm with the second largest amount of the audit fees (i.e. Hutchinson China Meditech Ltd.) incurred the audit costs lower by 8,5% than RLX Technology (20.556 RMB thousand vs. 22.460 RMB thousand), despite reporting total assets with the carrying amount higher by 11,5% (4.525.738 RMB thousand vs. 4.059.885 RMB thousand).

All observations discussed above raise questions about possible reasons of the RLX Technology’s above-average audit costs. Without any insider’s insights the following possible explanations (among others) may come to mind:

1)     The company simply overpays for its financial statement audits, e.g. because of its lack of an orientation in the market prices for such services in China (charged on companies of the similar size, as proxied by the amount of total assets).

2)     The company’s auditors are “partners in crime”, if the company indeed committed an accounting fraud. But that would mean an outright corruption (“we know what You did last summer, but we’ll stay silent about it, as long as You pay enough for it”), that seems unlikely, although not entirely unimaginable (vide: Arthur Andersen’s stories from the millennial past).

3)     Without any misconduct on their part, the company’s auditors might have been fully aware of its significantly increased audit risks (the question would be, however, for what reasons?), that they have compensated for by pricing in the increased risk into their audit fees charged on RLX Technology.

Red Flag no 12: Weird behavior of RLX Technology’s accounts payable turnover

An investigation of trends in the company’s accounts payable turnover leads to the following observations:

1)     On p. 86 of its Annual Report 2020 (in the first paragraph of sub-section “Accounts and notes payable”) the company disclosed that the deferred payment terms, offered to it by its suppliers, typically fall within 45-92 days range.

2)     Then, in the second paragraph of the same sub-section, the company informed that:

“Our accounts and notes payable turnover days were 42,8 days for 2018 period, 97,3 days for […] 2019 and 156,0 days for […] 2020. The change in accounts and notes payable turnover days reflected our increased bargaining power as our business grew.” (emphasis added)

3)     So, in fiscal year 2020, allegedly due to the company’s stronger and stronger bargaining power (against its suppliers), it claimed to be capable of extending its average settlement periods (of accounts payable) to over two months longer than its agreed-upon LONGEST terms (i.e. an actual turnover of 156,0 days vs. 45-92 days contracted in its notes payable).

4)     However, in the first quarter of 2021 the company’s payables turnover ratio fell from 156,0 days in 2020 (as calculated by the company) to 105,0 days [1], despite a continued fast revenue growth (which, according to the company, constituted the main driver of its prior lengthening of its payables turnover periods).

5)     Accordingly, after three consecutive years (2018-2020) of a constant extension of the company’s payables turnover ratio, to much above what is suggested by its contracted payment terms (45-92 days), in the first quarter of 2021 the prior trend suddenly reversed and the value of the ratio fell towards the level closer to the agreed-upon payment terms.

However, in the first quarter of 2021 (i.e. in mid-January 2021) the company raised a lot of money from its IPO. Taking it into account leads to the following imaginable sequence of events, in case of the hypothetical accounting misstatements:

1)     If, hypothetically, the company inflated its revenues and earnings (reported in its IPO Prospectus), with a corresponding overstatement of its balances of liquid financial assets, then in reality it could become more and more financially illiquid across 2019 and 2020.

2)     Such a deteriorating actual financial liquidity could have translated into longer and longer payment intervals (of the company’s payables to suppliers), seemingly due to the company’s stronger and stronger bargaining power (but in reality perhaps due to eroding financial liquidity), to much longer than its contracted payment terms (i.e. 156,0 days of the actual turnover vs. 45-92 days set in the contracts)

3)     In such a hypothetical scenario, only in the first quarter of 2021, AFTER THE COMPANY RAISED A LOT OF REAL CASH VIA ITS IPO, it could become capable of settling significant amounts of its overdue payable accounts (which, in turn, would be manifested in a sharply falling payables turnover ratio, from 156 days in 2020 to 105 days in Q1 2021). After all, if the company’s bargaining power (against its suppliers) strengthened further in the first quarter of 2021 (when its revenues grew by almost 50% q/q), then what could be another reason for an observed sharp shortening of its payables turnover period?

[1] = (Average from Accounts and notes payable on 31.12.2020 of 1.459.792 and Accounts and notes payable on 31.03.2021 of 1.561.471 / Cost of revenues in Q1 2021 of 1.294.423) x 90 days

Update of Red Flags 1 through 10 (based on unaudited Q1 results)

An investigation of the company’s selected unaudited accounting numbers, for the first quarter of 2021, leads to the following observations:

1)     Update of Red Flag no 7:

(i)                 In the first quarter of 2021 the company spent 211.634 RMB million on its R&D expenses, i.e. only 1,3% more than in the fourth quarter of 2020 (and much less than an amount of available liquid assets that it reported in its IPO Prospectus, not to mention the amount of funds raised from its IPO). Why doesn’t it correspond to the company’s alleged IPO goals (declared on p. 71 of its IPO Prospectus)?

(ii)               In the first quarter of 2021 carrying amounts of the company’s operating non-current assets (i.e. Property, plant and leasehold improvement combined with Intangible assets and Right-of-use assets) increased by immaterial amounts. Why doesn’t it correspond to the company’s alleged IPO goals (declared on p. 71 of its IPO Prospectus)?

(iii)             In the first quarter of 2021 the amount of the company’s working capital FELL (releasing cash). Why doesn’t it correspond to the company’s alleged IPO goals (declared on p. 71 of its IPO Prospectus)?

2)     Update of Red Flag no 9:

(i)                 In the first quarter of 2021 the company’s taxes payable rose by 135,9 RMB million (from 363,6 RMB million on 31.12.2020 to almost 500,0 RMB million on 31.03.2020), while at the same time it reported a current income tax, amounting to ca. 171,0 RMB million. This means that in a five-quarter period between 01.01.2020 and 31.03.2021 the company’s taxes payable rose cumulatively by 496,8 RMB million, as compared to the company’s reported current income taxes that amounted to 412,9 RMB million (i.e. it seems very likely that the company paid insignificant amounts of income taxes, if any, in the last five quarters).

SUMMARY OF THE KEY QUESTIONS FROM THE MAGICAL MYSTERY TOUR:

The analysis presented above led to the following crucial questions, regarding the RLX Technology’s corporate governance and financial reporting risks:

(i)                 How is it possible that an entity with a multi-billion market capitalization claims to be unable to prepare itself adequately to function on an international stock market (and report its financial results reliably)?

(ii)               Why do not the company have a board of directors with majority of independent members (and the Audit Committee that includes more members with an adequate accounting and auditing experience)?

(iii)             What was the reason for accumulating such huge amounts of the company’s pre-IPO liquid assets (i.e. cash combined with financial assets), constituting almost 86% of its total assets, and funding them with a significant load of financial debts (borrowings), that made up over half of its total assets (as on September 30, 2020)?

(iv)             What exactly are the “structured deposits” (included within short-term investments), that recently made up as much as almost 40% of the company’s total assets and how exactly are they valued to fair values (with Level 2 valuation inputs)?

(v)               Why have a majority (ca. 75%) of the company’s interest income, reported in the first three quarters of 2020, not been collected? What financial investments is that interest income linked to?

(vi)             If the company intends to spend so much (ca. 3,3 RMB billion) on its future R&D projects, then why didn’t it incur much higher R&D expenses in the recent past (given its allegedly high financial liquidity)?

(vii)           If the company was able to grow as fast to date, with such a low capital-intensity (and high and rising fixed assets turnover ratio), then what new operating noncurrent assets does it intend to buy (for its declared intended amount of expenditures, of ca. 5,5 RMB billion)?

(viii)         If the company’s business model used to entail a negative working capital (that seems to stay intact in a foreseeable future), positively contributing to its reported operating cash flows, then what are its intended expenditures on “general corporate purposes and working capital” (for its declared intended amount, of ca. 2,2 RMB billion)?

(ix)             If the company is such a “cash cow” (allegedly having huge excess of a financial liquidity, over its CAPEX and dividend expenditures), then what was a purpose of obtaining such materially positive financing cash inflows (exceeding its reported operating cash flows by over 20%), in a period between January 1, 2019, and September 30, 2020?

(x)               Why have most (if not all) of the amounts of the company’s current income taxes, reported for 2020 as well as for Q1 2021, not been paid (and instead accumulated on a balance sheet as taxes payable)?

(xi)             How does the company intend to enforce its control over its major VIE (Beijing Wuxin), in case of possible disputes between itself and the VIE’s shareholders?

(xii)           How does the company intend to obtain a direct equity interest (controlling share) in its major VIE (Beijing Wuxin), in order to make its alleged control over the VIE more sustainable and reliable?

(xiii)          What was a reason for lacking disclosures (in financial statements published in the company’s IPO Prospectus), related to the amounts of earnings and net assets attributable to the non-controlling interests?

(xiv)          Why did the company incur in 2020 the audit expenses on the above-average amounts (incommensurate with the company’s size, as proxied by its total assets)? Did they reflect the grossly increased audit risks, faced by the company’s auditors?

(xv) If the company’s bargaining power (against its suppliers) continued getting stronger and stronger in the first quarter of 2021 (when its reported revenues grew by almost 50% y/y), then why its payables turnover, allegedly correlated with the company’s bargaining power, shortened sharply by one third (i.e. from 156 days in 2020 to 105 days in Q1 2021), just after it raised a lot of cash from its IPO?

J.W., June 21, 2021