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Performance Evaluation
In our last report on GigaCloud Technology (NASDAQ:GCT), we rated the stock as Neutral/Hold, reflecting our view that its performance is in line with the S&P 500 (SPY) (SPX). Since then, the stock has underperformed the S&P 500 by 19.02%.
Performance since the author's last update on GCT (Seeking Alpha, the author's last article on GCT)
Of course, I could have taken a “sell” view on this positive return, but I believe that organic sales growth was actually only about half of the headline revenue growth, while in absolute terms the company still delivered impressive growth of nearly 50% year over year.
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Gigacloud Technology reported its second quarter fiscal 2024 results last week, and I have mixed, conflicting views on this stock.
Business performance appears strong, but forensic examination shows potential red flags
Sales performance appears to be favorable
The bullish case for GCT focuses on its high business growth: On a headline basis, the company's revenue is up nearly 100% year over year.
Revenue (US$ million) (company filings, author's analysis)
On an organic basis, using my assumptions of a 30% revenue contribution from Noble House (explained in more detail in my previous note on GCT), this equates to a still-impressive 56% growth year-over-year. As founder and CEO Lei Wu pointed out in the company's Q2FY24 earnings call, the company is clearly an outlier as it is achieving this growth rate despite the overall industry growth rate being negative.
Additionally, despite industry-wide challenges, the furniture industry remains in a tough spot, with U.S. retail furniture sales expected to fall 7% year-over-year in the first half of 2024.
– CEO Lei Wu's Q2FY24 earnings call, author's bold highlights
Management's guidance for the next quarter suggests that Noble House's outdoor furniture sales will be down sequentially due to seasonality, but will still translate to respectable growth of 54% year over year or an estimated 18% year over year on organic growth.
In GCT's platform business, I believe buyer volume is one of the strongest leading indicators of future sustainable revenue growth, and Q2FY24 was a very successful quarter for GCT as the outdoor furniture season brought in a wave of new buyers, increasing buyer volume to 7,257 from 5,493 in Q1FY24.
Active Buyers (company filings, author analysis)
Even if there are no additional buyers, we can expect to see increased revenue from our existing base as new buyers increase spending after initially lower volume.
Margins (company filings, author analysis)
On the margin front, GCT saw some moderation in both gross margins and EBIT margins (I don't pay much attention to the company's adjusted numbers, as they exclude the impact of stock-based compensation expenses, which are a real economic cost to the company).
Management attributed the 190 bps sequential decline in gross margins to higher shipping costs due to freight rate increases in late April and May, but the outlook has improved as these logistics costs have moderated in July 2024.
At the EBIT level, margins declined 490 bps sequentially. Below the gross margin line, operating margins declined 280 bps sequentially, mostly due to higher SG&A costs. Management attributes this to higher headcount and fee costs. I interpret headcount growth, in particular, as a positive sign as it indicates the business is scaling up to support revenue growth.
Overall, everything about GCT looks great… probably. I'm cautious for the following reasons:
Forensic examination shows potential red flags
The Beneish M score is a forensic test that examines financial statement manipulation. It has been used by companies such as Enron to detect potential manipulation early. The following table shows key inputs for GCT using Q2FY24 LTM data.
Benesh M score input (Kelley Business School, author input from company filings)
The output M-score is -0.566, placing the company in the “high probability of manipulation” range. In particular, the probability of manipulation is 28.6%, which is high enough to warrant a potential red flag.
Benesh M-Score output (Kelley Business School, author input from company filings)
This result, combined with the lack of transparency in key reporting and the recent resignation of the CFO, makes me very wary of GigaCloud Technology, even if the company's operational performance is very healthy.
Ratings mean little when governance is questionable
It is difficult to value a company if the inputs to a valuation model are unreliable. In this case, the M-score indicates that there is a 28.6% chance that there is manipulation in the financial reporting, which will distort the output of any valuation model that uses that data.
GCT is currently trading at a one-year forward PE of 6.8x, a healthy 25% discount to its long-term median PE, although for the reasons mentioned above, this is largely unrelated to concerns about the integrity of its financial reporting.
GCT 1-Year Forward PE and MCAP (USD Millions) (Capital IQ, Author's Analysis)
Technical Analysis
If this is your first time reading Hunting Alpha articles using technical analysis, please read this post, where I explain how and why I read the charts the way I do. All of my charts reflect total shareholder return adjusted for dividends/distributions.
GCT vs SPX 500 Relative Readings
GCT vs SPX 500 Technical Analysis (TradingView, Author's Analysis)
In terms of technical analysis relative to the S&P 500, GCT has broken out of the previous weekly support I highlighted earlier. Currently, the stock is near the next major weekly support area. Even if there is a bullish reaction from this level, I think we will likely see range action first before a sustained upside. Overall, giving the company the benefit of the doubt on forensic and governance factors and adopting a bullish trend, on the technical side, it indicates that future performance will be in line with the S&P 500.
Primary risk – Errors of omission
The only reason I am not bullish on GCT is its low Forensic Benesh M Score, which suggests a 28.6% chance of manipulation in financial statement reporting. This is just a statistical model. GCT could be a valid outlier case resulting in a false positive for manipulation. Therefore, I believe the main risk to my view of not investing in this stock is an error of omission where GCT is in fact a false positive.
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The bullish outlook for GigaCloud Technology is understandable: the company has reported impressive growth rates (over 50% YoY), far outpacing an industry with shrinking revenues. Trading at just 6.8x its 1-year forward PE, the company is scoring highly on all metrics from fellow Seeking Alpha analysts, Wall Street, and the consensus from Seeking Alpha's Factor Grades + Quant Rating System, making it look like a compelling buy.
GigaCloud Technology Rating and Factor Rating (Seeking Alpha)
However, despite all this, I am hesitant to pull the “buy” trigger as the company is raising red flags on key forensic indicators. The statistical Benesh M-Score model suggests that the financial statements are subject to possible manipulation. In my previous coverage of GCT, I already expressed my disappointment in the lack of proactive and transparent reporting of some of the key indicators, such as the split between organic and inorganic growth. The low M-Score reading and the fact that the CFO, the person primarily responsible for financial reporting, has resigned from the company make me particularly cautious on this stock.
I would argue that once the governance and integrity of the financial statements are in question, any valuation discussion becomes meaningless, as such analysis primarily depends on the veracity of the financial statements reported by the company. Relative technical analysis versus the S&P 500 suggests that even if there is a bullish reaction near the current weekly support level, it will likely be preceded by range action first, with the stock price moving in line with the S&P 500.
To be clear, I want to emphasize that I am not alleging that GCT manipulates its financial statements. I am simply pointing out that reliable statistical models suggest that there is a 28.6% chance that they are. Of course, GCT could very well be a false positive on this forensic red flag check. If that were true, I would be wrong to not be bullish on the stock. But it is a risk of omission that I am willing to accept. Since there is not much clarity one way or the other about GCT's governance at this point, I take the middle line and rate the stock Neutral/Hold.
How to interpret Hunting Alpha's ratings:
Strong Buy: The company is expected to outperform the S&P 500 in terms of total shareholder return, giving us more confidence than usual.
Buy: Expected to outperform the S&P 500 in terms of total shareholder return
Neutral/Hold: We expect the company's total shareholder return to be in line with the S&P 500.
Sell: The company's total shareholder return is expected to underperform the S&P 500.
Strong Sell: The company's total shareholder return is expected to underperform the S&P 500, giving it higher than usual confidence.
My views typically last anywhere from a few quarters to a year, and are not fixed, but I will share updates on any changes to my position in a pinned comment on this article and may publish a new article discussing the reasons for the change in view.
