Archive for May 2010
This post profiles Yuhe International (YUII) and explains why YUII accurately represents itself in its SEC financial statements.
There are several hundred smallcap Chinese stocks that trade on the U.S. equity exchanges. These companies have gone public in a variety of ways, but a large number have become public by undergoing reverse mergers with U.S. shell companies. Historically, reverse mergers have been a common way to publicly list fraudulent companies, because reverse merger candidates do not undergo the same scrutiny as IPO candidates. When a company undergoes an initial public offering, it subjects itself to due diligence by the investment banks underwriting the public offering. It must also file an SEC registration statement which must pass through a formal SEC review process. In a reverse merger, on the other hand, a target company merely needs to file a “Super 8K” outlining disclosures, and can then subsequently have its stock become publicly traded. In a sense, reverse merger candidates have not been “pre-screened” by investment banking underwriters. If the “sponsors” behind the reverse mergers have malicious intentions, these Super 8Ks and subsequent SEC filings can often present misleading, or even false, information that can be difficult for average investors to identify.
In my previous article, I discussed how certain Seeking Alpha contributors have used local Chinese SAIC filings to cast doubt on the reported SEC financial of certain U.S.-listed Chinese smallcaps, including CSKI and LIWA. There is evidence that these companies are fabricating numbers out of thin air in their SEC filings. It’s unclear how exactly they would be doing this, whether through undisclosed related party transactions, lax audit firm surveillance, etc. But it’s not especially difficult to believe. Audit firms of companies like CSKI and LIWA tend to be tiny firms that are not in the top 100 global auditors. Cooking the books is not as difficult as many people believe, especially if a company is run by professional scam artists who are dealing with a lax auditor in another country that speaks a different language.
Because of some potentially fraudulent Chinese companies, the entire U.S.-listed Chinese smallcap sector trades at a discount to similarly situated companies in the United States. Investors have difficulty deciphering which companies are presenting accurate numbers, and which companies are misrepresenting themselves in their SEC filings.
This has been troubling to me, because I believe that there are numerous “real” Chinese companies that are being penalized by the false financials being reported by the likes of CSKI and LIWA.
One of those companies is Yuhe International.
Yuhe International, Inc. sells day-old chickens raised for meat production in China. The company purchases breeding stocks from primary breeder farms, raises them for hatching eggs, and sells live day-old broilers. It also engages in the production and sale of feed stock. The company operates 15 breeder farms and 2 hatcheries with a total annual capacity of 1.2 million sets of breeders and 120 hatchers. Its customers principally include distributors and end users, such as integrated chicken companies, broiler raising companies, and individual broiler raisers. The company was founded in 1996.
In the remainder of this article, I discuss three important data points that provide evidence that YUII is not fabricating its financial statements, whereas CSKI appears to be.
The topics are:
1. Comparison of SAIC and SEC financial statements
2. Comparison of history of audit firms
3. Comparison of history of equity capital raises
SAIC vs SEC financials
The first and most important part of my analysis is to compare the U.S. and Chinese financial statements of YUII.
Below is the summary comparison:
As we can see, the SEC and SAIC financials for YUII are in the same ballpark. Items of the income statement, such as revenue, gross profit, profit before tax and net income, are fairly similar when comparing the SEC and SAIC filings. The balance sheets of the financial statements filed in China and the United States are also quite similar for YUII.
The source documents for YUII can be found here:
The SAIC financials have been acquired from Qingdao Inter-Credit Services Pte Co., Ltd.
This is a marked contrast to CSKI, for instance, where the company reported $50mm of revenue in its 2007 SEC filings, compared to $1.2mm of revenue in its SAIC filings. All other financial information for CSKI also are much smaller in their SAIC filings as compared to their SEC filings. Here is the comparison of CSKI’s SEC vs SAIC numbers.
Yuhe’s financials match. CSKI’s do not. Given that a company would likely experience significant penalties in China for understating its SAIC financials by more than 50%, a reasonable conclusion is that CSKI is fabricating its SEC financial statements and YUHE is not.
History of Audit Firms
A Chinese smallcap is likelier to be fraudulent if it does not use a top tier accounting firm. These companies frequently cite cost as a reason to avoid using a top tier accounting firm, but I’m not convinced that this is their real reason. Any company making more than $5mm in net profit can definitely afford a top five accounting firm. Given the higher valuation multiple that a top tier firm would bring, it’s a no-brainer to use a top firm as their auditor.
I believe that most Chinese smallcaps don’t use top tier audit firms because they would not be able to pass their audits. In a best-case scenario, the Chinese company does not have proper internal controls or accounting infrastructure in place to give top tier auditors comfort. The cynic’s view is that many Chinese smallcaps don’t use top tier audit firms because the KPMGs and PWCs of the world would be better able to detect fraud.
Let’s analyze YUII, CSKI and LIWA in terms of their history of auditors.
When YUII went public, it initially engaged Child, Van Wagoner & Associates as its accountant. Child, Van Wagoner is not in the list of the top 100 accounting firms in the United States (see here).
On December 8, 2009, however, the Company decided to upgrade to Grant Thornton, a top 5 audit firm. A lot of discussion has been focused on Grant Thornton’s subsequent decision in March 2010 to resign as auditor, due to an inability to reconcile certain related party transactions. What’s missing from the discussion is how YUII is one of the few Chinese reverse merger smallcaps that actually tried to upgrade in the first place! I believe that unlike many other smallcaps, YUII felt that it had nothing to hide, and tried to upgrade accountants to set itself apart from companies like CSKI. While that move backfired when Grant Thornton resigned, YUII management has stated that they intend to upgrade to a top 4 audit firm as soon as they can. My bet is that they will because they’re not making up their numbers.
CSKI’s history of audit firms has been shoddy. Since going public, the company has had 4 different audit firms, none of which are in the top 100. The Company began with e-Fang Accountancy Corp., and then followed it up with Murrell, Hall, McIntosh & Co. LLP in April 2007, Sherb & Co. in December 2007, and finally Moore Stephens PC in May 2008. Currently, MSPC is being sued by a shareholder for signing off on fraudulent patents that CSKI claims to hold but actually doesn’t, according to the lawsuit. The lawsuit is available here. MSPC’s response is here. This will be an interesting litigation to watch unfold.
LIWA’s accounting firm, since it went public, has been AGCA, Inc. AGCA, based out of Arcadia, Californa, is not a top 100 audit firm. It’s a conspicuously nondescript firm for a public company that claims to have generated $17mm of net income in 2009.
History of Capital Raises
Finally, let’s look at the history of capital raises at our three companies.
A key fact to look at when trying to separate real from fraudulent Chinese smallcaps is to analyze the company’s history of raising equity capital. The reasoning is simple. Virtually all Chinese smallcaps are controlled by one or several significant Chinese owners. Typically, these owners were the founders of the company, or purchased the assets from the government during a privatization. If a company is real, the owners treasure the equity and are reluctant to dilute their ownership stake unless they’re being properly compensated, or if they are starved for capital and are using it for high return-on-equity purposes. If a company is a fraud, the owners don’t treasure their ownership stake, since they know that the assets they own are worth far less than the amount that the Company’s market capitalization values them at. They are perfectly happy to raise equity capital from U.S. investors in any way they can, even if that means issuing shares at large discounts to the trading price, or issuing dilutive warrants that wreak havoc on the capital structure.
In a way, the end game of devising a fraudulent Chinese company is to steal money from U.S. investors by raising equity capital and siphoning it off into managements’ personal bank accounts. Management of fraudulent companies don’t care too much about being “diluted” because they know that they don’t own assets that are as valuable as the high market capitalizations of their companies.
In our analysis below, we are going to ignore the capital raises involved with the initial reverse merger. All reverse merger companies must raise capital when they go public, just like all IPO companies must raise capital. Our concern is with private placements and public offerings after the company has already gone public and raised initial capital.
Let’s first look at CSKI. CSKI raised $25mm on January 31, 2008. The capital raise was comprised of 2.5mm units at $10 per unit, whereby each unit contained 1 share and 0.3 warrants to purchase shares at $12.50. The 10-day and 30-day trading averages prior to the capital raise were $12.50 and $13.28. Excluding the warrants, the new shares were issued at 20% and 25% discounts. But there’s no reason we should exclude the warrants – they were issued with a strike price at a value equivalent to the 10-day prior trading average, and at a discount to the 30-day trading average. This was an extremely dilutive financing. Per the Company’s registration statement at the time, use of proceeds was: “for: (a) acquisitions, (b) new product marketing, (c) expenses related to the Offering and the Registration Statement (defined below), and (d) general working capital purposes.”
Next, let’s turn to LIWA. LIWA raised $30mm, in the form of 3.7mm shares at $8.05, on April 8, 2010. That’s an 8% and 9% discount to the 10-day and 30-day average trading price of LIWA prior to the capital raise. It wasn’t an especially dilutive financing. Use of proceeds was “for the construction of a new smelting facility, which is expected to accelerate the production of refined copper products”. According to SEC filings, LIWA had $46mm of cash prior to its capital raise and generated $15mm of cash flow based on cash flow from operations less capex in the last twelve months ended March 31, 2010.
Finally, let’s look at YUII. YUII has not done any capital raises aside from its original reverse merger private placement.
If CSKI and LIWA are frauds, and have used private placement and secondary offering proceeds for bogus purposes, they have effectively stolen $50mm from U.S. investors. We know definitively that YUII has not yet stolen funds raised through a dilutive and/or unnecessary secondary offering from U.S. investors.
I’ve provided three important data points providing evidence that YUII is accurately representing itself in its SEC financials, unlike CSKI. LIWA remains an open question, given the recently emerged dispute between it and Qingdao Inter-Credit Services over whether its SAIC documents are accurate, or whether Inter-Credit’s financials for LIWA are the correct ones. Inter-credit, for its part, currently maintains that its numbers for LIWA are factual and that they doubt the authenticity of the financials posted on LIWA’s website.
The most important data point discussed in this article is the comparison of SEC and SAIC financials. The numbers match for YUII. They do not for CSKI. Any criticism of this article should first and foremost address that fact. From my research, I believe that foreign invested enterprises must file accurate financial statements with their local Chinese governments.
At the time of writing, I and affiliated entities have a long position in YUII. In the past, I have had a short position in CSKI. I may trade in any of the securities discussed in this article at any time, including within the next three days.
In no part of this post do I attempt to provide false or misleading information. All facts presented in this post are true to the best of my knowledge. All opinions presented on this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please contact me at email@example.com. If I agree with your assessment, I will make a relevant comment clarifying the false or misleading information in the comments section of this post.
FUQI International, Inc. (FUQI) has been one of the more talked-about stocks within the U.S.-listed Chinese smallcap space over the past few months. The main reason is because the company announced accounting irregularities on March 17, sending the stock down ~40% over the subsequent few days. The stock remains 50% below its March 16th closing price.
For anyone who can read a cash flow statement, FUQI has had suspiciously large working capital usages since the company went public. The Company had -$22mm, -$8mm and -$22mm of cash flow from operations in 2007, 2008 and the nine months ended 9/30/09, which equates to a cumulative -$52mm of cash flow from operations during that period. And yet its net income was $14mm, $28mm and $38mm in 2007, 2008 and the nine months ended 9/30/09, summing to a cumulative positive $80mm of net income during that period. The accounting never made sense to me, and it’s no surprise that FUQI “identified certain accounting errors that are expected to have a material impact on the previously issued quarterly financial statements… the cost of sales for each of the periods were understated and gross profit and net income, as a result, were accordingly overstated”.
If FUQI was indeed inflating its net income through aggressive accounting, it was at least cooking its books the old-fashioned way. In this brief post, I intend to compare FUQI’s SEC and SAIC filings. Unlike CSKI, where the SAIC-reported 2007 revenue is 95% lower than its SEC-reported revenue, FUQI’s SEC and SAIC numbers are in the same ballpark. As a result, we can be confident that FUQI has some sort of real, and probably valuable, business behind the murky set of financial statements that it provides to investors. The same cannot necessarily be said for CSKI.
Here is the financial comparison for FUQI.
Compare that to CSKI:
Naturally, FUQI’s SAIC and SEC filings do not match exactly. SAIC filings are done in Chinese GAAP, whereas SEC filings use US GAAP. Chinese GAAP treats a variety of items differently than US GAAP, including capital expenditures, depreciation, etc. It also does not consolidate subsidiaries, whereas US GAAP does.
For our purposes, we are merely trying to see if the SAIC filings show a real business of some respectable size. For FUQI, the SAIC filings demonstrate that a real company generating a material amount of revenue exists in China. For CSKI, the SAIC filings indicate the opposite.
The CFO of CSKI has claimed that SAIC filings don’t need to be accurate. That doesn’t jive with my discussions with lawyers, accountants and CFO’s of verifiable Chinese companies, who claim that Chinese Foreign Invested Enterprises must provide reasonably accurate and audited financial statements in their SAIC filings. And from looking at FUQI’s numbers, I question why FUQI would provide SAIC financial statements that show revenue and total assets that are of the same magnitude as the items reported in their SEC filings, if it didn’t need to.
The more correct story, in my opinion, is that CSKI reports SAIC revenue that is 95%+ lower than its SEC revenue because its actual revenue is indeed 95%+ lower than its SEC revenue.
Disclosure: I have no position in either FUQI or CSKI. I may initiate a position subsequent to writing this post.
Recently, there have been several Seeking Alpha contributors that have written posts comparing the U.S. and Chinese financial statements for various U.S.-listed Chinese small capitalization companies.
The relevant articles can be found here:
Manuel Asensio and “Waldo Mushman” on China Sky One Medical (CSKI):
Steve Chapski on Lihua International (LIWA):
In these articles, the authors compare the SEC financial statements of Lihua International and China Sky One Medical to the financial statements shown in their “SAIC” filings.
What are SAIC filings? SAIC filings are the audited financial statements that all Chinese “foreign invested enterprises” (FIEs) must file with the local government offices of the Administration for Industry and Commerce (AIC). The term “SAIC” refers to the “State Administration for Industry and Commerce”. These financial statements are filed annually, as part of the “Annual Inspections Report” that all foreign invested enterprises in China must submit to their local government authorities.
Some people, including the chief financial officer of CSKI, claim that companies can file “fake” SAIC filings, whereby they materially misstate their financial statements in their SAIC filings. Based on my discussions with numerous accountants, lawyers and CFOs of verifiably legitimate Chinese companies, I do not think this is true. My understanding is that there are significant penalties for any Foreign Invested Enterprise that materially falsifies financial statements that it is filing with the local Chinese government. These SAIC audited financial statements should approximate the relevant tax filings that companies file with the Chinese government. If companies falsify their SAIC filings, they would be also falsifying their tax filings. With a company like CSKI, we’re seeing SAIC financials come in at 90%+ below their SEC financials – the Chinese government would not tolerate under-reporting and tax evasion of this order of magnitude.
As a result, the likeliest answer, in my opinion, as to why the SEC and SAIC filings are different is that companies like CSKI are falsifying their SEC filings. This is not especially difficult to believe, because the rapid growth and high margins of the companies are a bit too good to be true.
Dubious Financial Claims
CSKI has seen revenue grow from $8mm to $20mm to $49mm to $92mm to $130mm from 2005 to 2009. EBITDA margins have grown from 20% in 2006 to 38% in 2009. And what exactly does the company do? It makes a variety of traditional chinese medicines, such as the “Sumei Slim Patch”, which is a patch that people wear to foster weight loss; the “Pain Relief Patch”, which is a patch that alleviates fevers, headaches and heart dysentry; Hemorrhoids Ointments; herbal dental ulcer sprays; diagnostic kits for early stage diagnoses of heart attacks, etc. None of its products seem particularly special, and the company reports steady, rapid growth across all its segments, whether it be Patches, Ointments, Sprays or Diagnostic Kits. Read the rest of this entry »
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