Archive for June 2010
This morning, China Marine Food had a conference call to address concerns raised by myself and Chimin Sang in previous articles.
In my opinion, it was a fairly uneventful call and the company did not address the specific concerns that we have raised about the Xianghe Acquisition. Most of the discussion focused on current performance metrics and forward-looking projections regarding Xianghe.
My concern, on the other hand, relate to whether the 2009 Xianghe financial statements are falsified. I question how Xianghe could generate $7.6mn of revenue, $1.7mn of net income and $1.2mn of operating cash flow in its first 5 months of operations with (i) $44k of startup capital it received from its original founder, (ii) four hundred and fourteen dollars of capex, (iii) minimal spending on advertising, marketing and other expenses related to building a popular beverage brand, (iv) with 900x inventory turns, etc. As a reminder, the original founder of Xianghe purchased “know-how” for the algae drink for less than ten thousand dollars in January 2009. He then sold his company, which he began in July 2009 with less than fifty thousand dollars of registered capital, for $28mn to CMFO in November 2009.
My blog post and Chimin Sang’s article go into greater detail on why we are skeptical about the accuracy of Xianghe’s financial statements. Few of our concerns were addressed on th call. Rather, the company and analysts from Global Hunter, Rodman & Renshaw, Hudson Securities and Brean Murray asked about distribution channels, revenue projections, June trends, etc. The core concerns of skeptics such as myself were not addressed.
The company did mention that it was going to upgrade auditors. Certain callers in the Q&A portion of the call asked whether the new audit firm was going to be a top-5 firm or a top-20 firm, and re-iterated their desire to see a top-5 firm being appointed.
The sad truth is that even a top-5 auditor doesn’t prevent fraud in Chinese companies – those experienced with fraudulent chinese companies that went public in Singapore or Shanghai will attest to that. But I’d also agree that if the company would like to genuinely address some of the concerns I and other investors have, it would upgrade to one of the following 5 auditors:
3. Ernst & Young
4. Deloitte & Touche
5. Grant Thornton
I will provide a link to a transcript of the call when it becomes available.
Disclosure: short CMFO
ZYCPA’s Involvement in an Alleged Fraud
Please see disclosures at the bottom of this article.
Throughout my past few posts on China Marine Food Group, I have implied that the small size and unknown reputation of CMFO’s auditor, ZYCPA Company Ltd., should give investors pause.
This article takes a far more concerned stance. According to a lawsuit filed in Hong Kong last year, ZYCPA (or, more accurately, its predecessor firm) and its majority shareholder were active participants in a series of frauds committed against a foreign investor. According to the allegations, ZYCPA and the shareholder, Johnny Tang, were not mere bystanders in the fraud. Rather, Tang was allegedly an active co-conspirator who helped a Chinese businessman steal HK$108mm from the foreign investor.
My prior post on CMFO’s Xianghe acquisition provides compelling evidence that China Marine Food is defrauding investors. Specifically, I believe that the company is much smaller than its SEC filings indicate. Previously, I simply thought that the company was able to falsify its financial statements because it was receiving negligible oversight from its auditors. But if the lawsuit’s allegations are true, the actual circumstances may be far more sinister.
There are several primary documents worth reading.
First, here is the Statement of Claim for the lawsuit.
Second, here is a link to a 9-page report written by Target Newspapers, a Hong Kong business periodical, discussing the lawsuit.
Third, here is a lawsuit for defamation filed by Tang against the foreign investor.
Issued on March 23, 2009, the original lawsuit is between Christian Emil Toggenburger, and two holding companies he owns, against (i) Hung Viet Derrick Luu, (ii) Zhong Yi (Hong Kong) C.P.A. Company Ltd and (iii) Ka Siu Johnny Tang (the majority shareholder of Zhong Yi).
Zhong Yi (Hong Kong) C.P.A. Company Ltd is the predecessor to ZYCPA Company Ltd, CMFO’s auditor. Zhong Yi changed its name to ZYCPA as a result of potential bad press coming out of this lawsuit.
I will first show a graphic timeline outlining the order of events that transpired during the alleged fraud.
The cast of characters are as follows:
Christian Emil Toggenberger is the foreign investor who was allegedly defrauded and was cheated out of HK$108mm.
Hung Viet Derrick Luu is the Chinese “businessman” who allegedly defrauded Toggenburger and to whom the HK$108mm was transferred.
Ka Siu Johnny Tang is the majority shareholder of ZYCPA Co. Ltd. (successor to “Zhong Yi (Hong Kong) CPA Company Ltd.”), and actively helped Luu execute the fraud, according to the allegations. ZYCPA is CMFO’s current auditor.
Here is the timeline:
I will first discuss a summary of the fraud allegations. Then I will focus on the active role that the majority shareholder of ZYCPA played in the fraud, according to the allegations.
The events that follow are based on the allegations in the lawsuits I provided above, primarily from Toggenburger’s original lawsuit. Tang has countersued Toggenburger for defamation. The litigation is ongoing. The following allegations have not yet been proven in a court of law, and I am merely summarizing the sequence of events as alleged in the lawsuit.
Warderly Fraud Allegation
The events began when Tang introduced Toggenburger to Luu in November 2006. Tang represented Luu to be a billionaire entrepreneur who was well-connected in China and Hong Kong.
Shortly after the initial introduction, Luu and Tang met Toggenburger in January 2007 to pitch a HK$25mm loan to Warderly International Holdings Ltd, a publicly traded company on the Hong Kong Stock Exchange. Over the course of two meetings, Luu proposed that Toggenburger make a convertible loan for HK$25mm. The loan would be convertible to 20%-25% of Warderly’s equity, or pay 2% per month for 2 years until maturity. Warderly would use the loan to acquire an oil re-processing plant in Beijing from a business partner of Luu.
Toggenburger agreed to make the investment.
In March and April 2007, Toggenburger lent HK$23mm to an intermediary escrow agent. HKD$5mm was transferred to a subsidiary of Warderly, while HK$18mm was transferred to a separate unrelated investment project of Luu’s. Luu promised Toggenburger that the HK$18mm transfer was temporary and would soon be repaid, with the funds being redirected to Warderly.
Toggenburger never received any bonds or shares of Warderly. Luu received shares in Warderly for the contribution of HK$5mm to the Warderly subsidiary, and kept the shares for himself. The remainder of Toggenburger’s investment stayed locked up in Luu’s separate investment project.
Here is a graphical representation of the flow of funds:
As we can see from the graph, HK$23mm left Toggenburger and was essentially redirected to Luu.
In April/May 2007, Tang called Toggenburger to say that Warderly “was in trouble” and the Warderly agreement “was not working out”. Simultaneously, Luu was “in trouble” and could not repay the money transferred to his investment project.
In May, shares in Warderly were suspended and in January 2008, the Warderly subsidiary in which Luu had received shares was wound up.
Toggenburger had lost HK$23mm.
Car Racing Fraud
Our story doesn’t end there.
When Toggenberger found out that his HK$23m investment was lost, he was naturally not pleased. Tang, however, told him not to worry and that Luu would make it up to Toggenburger by offering another attractive investment opportunity. Luu had an equity stake in a racing car project in mainland China, and would offer part of that stake to Toggenburger at a reduced valuation.
Specifically, in a May meeting also attended by Tang, Luu offered to sell to Toggenburger a 15% share in a car racing project in mainland China. The 15% stake was valued at ~HK$40mm, according to Luu, but he offered to sell the 15% stake at a discounted price of HK$16mm to make up for the failed Warderly investment. Luu told Toggenburger that the car racing project was so profitable that investors would earn a return of 100% on their investment every 6 months. He also said that broadcasting minutes for commercials to be shown during car races had already been sold and such cash flow alone was enough for Toggenburger to get repaid his initial investment within two months.
Tang also claimed that he had seen and checked the documentation for the project (ie. contracts with Champ Car World Series LLC, the leading US car racing association); that the project was a good investment for Toggenburger; and that it was the only way for Toggenburger to recoup his losses from Warderly.
On May 21, 2007, Toggenburger paid HK$16mm to Zhong Yi as escrow agent, with the escrow agreement stipulating that the funds would be released to Luu only if the transfer of certain racing contracts were transferred to the holding company that Toggenburger was investing in.
The HK$16mm was released to Luu without this stipulation being met.
No car races have been held pursuant to the car racing project. No revenue has been earned from the car racing project. Toggenburger received no return on his investment.
Toggenburger lost HK$16mm.
Listed Company Fraud
It still doesn’t end there.
On the last week of May, Luu and Tang introduced a further investment to Toggenburger. They told Toggenburger that they could assist him to acquire a listed company (ie. a “shell” company), and that the car racing project or any of Luu’s other projects could then be injected into that shell. Luu and Toggenberger would ultimately become shareholders of the listed company.
Between June and July 2007, Toggenburger wired HK$73mm to Zhong Yi CPA Company, Ltd, which again acted as the escrow agent. In July 2007, Luu and Tang introduced Toggenburger to a firm that introduced Toggenburger to the owners of a publicly listed shell company in Hong Kong. In October, Toggenburger signed a contract with the shell’s shareholders to purchase a majority of the shares of the shell.
In December, Toggenburger told Tang and Zhong Yi to transfer the escrowed funds to the shell’s shareholders. Tang told Toggenburger that there is “some problem”, and the transfer could not be carried out. Toggenburger was not able to complete the transaction with the shell’s shareholders.
In February 2008, Tang told Toggenburger that the HK$73mm “was being used in another account” belonging to Luu. It was “still locked” in Luu’s “other investments”.
Zhong Yi, acting as escrow agent, had transferred the funds to Luu and/or used them to the benefit of Luu, without the knowledge of Toggenburger.
Toggenburger had lost HK$73mm.
As collateral for the HK$73mm, Toggenburger had been given 1mm shares of China Oil and Methanol Group Inc., a company incorporated in Nevada. On June 23rd, 2007, Luu took Toggenburger on a day trip by car to Guangdong province and showed him 3 refineries, which Luu said were assets belonging to 3 of China Oil’s operating subsidiaries.
Ultimately, it surfaced that China Oil has no operating subsidiaries, does not own any industrial complexes and is not earning any revenue.
In total, Toggenburger was cheated out of HK$108m, according to the lawsuit:
Tang’s and Zhong Yi’s Roles in the Fraud
As can be seen from the above events, Tang allegedly played an active role in the frauds. He was present in many of the meetings between Luu and Toggenburger. He also allegedly made a variety of untrue claims that were fraudulent in nature.
In two instances, his majority-owned firm, Zhong Yi CPA, acted as escrow agent between Toggenburger and Luu. In both instances, Zhong Yi violated the terms of its escrow agreements and transferred funds to the benefit of Luu and to the detriment of Toggenburger.
In the car racing project, Zhong Yi CPA was contractually obligated to hold in escrow Toggenburger’s funds until certain racing contracts were transferred from Luu’s entity into another legal entity that Toggenburger was indirectly investing in, and certain other conditions pursuant to “closing” were met. Zhong Yi transferred the funds to Luu’s benefit without these conditions being met.
In the listed company fraud, Toggenburger transferred HK$73m to Zhong Yi for the purpose of investing in a listed shell company. Zhong Yi instead transferred the funds for the benefit of Luu. When Toggenburger asked for the funds to be transmitted to the owners of the shell company, Tang told him that there was “some problem” and that the funds were locked in Luu’s investments.
Tang also represented that he had viewed the car racing contracts with Champ Car, as well as the land title agreements to land near the car racing project to which Luu planned to develop properties, and to which Toggenburger was to receive interests. Instead, the Champ Car contracts were materially misrepresented to Toggenburger, and the land titles didn’t exist.
Tang was present in many of the meetings between Toggenburger and Luu, and recommended Toggenburger to invest funds with Luu. He was also responsible for originally introducing Toggenburger to Luu.
The same man who owns a majority stake in ZYCPA is alleged to have actively aided the defrauding of a foreign investor out of HK$108m. Johnny Tang is one of two partners at ZYCPA and its majority owner.
Investors should not be merely concerned that CMFO is receiving inadequate oversight from its auditor. They should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements. As discussed in previous posts, the business claims made by Xianghe are simply not possible. The Xianghe financial statements are very likely falsified.
These same financial statements are audited by ZYCPA.
At the time of writing, I and affiliated entities have a short position in CMFO.
In no part of this post do I attempt to provide false or misleading information. The discussion of events in this post are primarily based on allegations in a lawsuit from March 2009, which I’ve included in the post. This lawsuit is ongoing and none of the allegations have been proven in a court of law.
Today, CMFO announced that its 2009 SAIC financial statements match its 2009 SEC financial statements. I also posted a comment to that effect on Tuesday on my Seeking Alpha post on the historical SAIC financials. I’m going to re-paste that comment below:
I’ve received the 2009 SAIC financial statements and have had them translated.
The 2009 SAIC statements match the company’s 2009 SEC financial statements.
This by no means leads me to believe that CMFO has been accurately representing itself in its SEC filings. Rather, the chief financial officer of CMFO has indicated that he was alerted several months ago to the fact that the historical SEC and SAIC financial statements did not match. An investor on sumzero.com (login required) has also identified himself as having asked the CFO about this discrepancy several months ago. I believe that as a precaution to future allegations of fraud, such as mine, China Marine Food made sure that the 2009 SAIC filings matched their 2009 SEC filings.
I believe that I have overestimated the veracity of SAIC filings in my previous article. Now I think that they can be falsified just as SEC filings can.
The chief financial officer of CMFO naturally has a different story, and I will let him argue his case on his own. Investors can then decide whether my story or his story is the more compelling one.
The mismatch between the 2006, 2007 and 2008 SEC and SAIC financial statements was one element of my case that China Marine Food is much smaller than its SEC filings indicate. The Company’s dubious acquisition of Xianghe plays a more central role in my argument.
I will end with a final point. In this link, I have included comparisons of SEC and SAIC financial statements for four companies: FUQI, YUII, SOLF and CMFO.
For FUQI, YUII and SOLF, the SAIC and SEC financial statements are in the same ballpark. But you’ll notice that the numbers are not identical; rather, Chinese GAAP and other reporting norms will always result in differences between SEC and SAIC filings. For SOLF, for instance, 2008 SAIC revenue was $809mm while 2008 SEC revenue was $712mm. Similar differences exist in other line items as well. But in CMFO’s 2009 filings, the revenue, gross profit, net income, total assets and total equity are nearly identical, different only by a couple million dollars at most. YUII’s are fairly close as well, but there are still more discrepancies than CMFO’s filings.
While it’s ironic, my evidence for fraud when looking at the 2009 SAIC financial statements is that they match the SEC filings too closely.
Disclosure: I hold a short position in CMFO.
This article discusses a questionable acquisition that China Marine Food made in January 2010 that was used to justify a $30mm equity capital raise.
As I wrote in my last post, the financial statements that CMFO files with the SEC are substantially different from the audited financial statements that it files with the Chinese government. Whereas companies like YUII, FUQI and SOLF have matching financials when comparing US and Chinese audited financial statements, CMFO’s revenue in its Chinese filings for 2008 were 85% lower than in its SEC filings. Other financial line items were smaller by similar orders of magnitude.
The company is falsifying one set of financial statements – that’s an obvious fact. The question facing investors is whether CMFO is falsifying the SAIC financials that they file to seven branches of their own government, or whether they’re falsifying the SEC financials that they used to raise $30mm of cash from U.S. investors in January 2010.
In this article, I explain why an acquisition that the company made in January 2010 provides strong evidence that CMFO is engaged in fraudulent activities. Specifically, the company which CMFO acquired is clearly fraudulent itself.
A Questionable Acquisition
In January, CMFO raised equity capital partly to fund an acquisition of Shishi Xianghe Food Science and Technology Co., Ltd. (“Xianghe”). Xianghe is a manufacturer of algae-based soft drinks. The purchase price was $27.8mm.
Here is the description of Xianghe’s product:
“Xianghe is a Fujian based manufacturer of the branded Hi-Power algae-based soft drinks. Hi-Power was developed by the Yellow Sea Fisheries Research Institute Chinese Academy of Fishery Sciences in coordination with the founder, Qiu Shang Jing. Hi-Power is marketed as a high-protein content drink, low in calories and fat, which provides the consumers a combination of immune system benefits, improved digestion and reductions in hyperglycemia and hypertension. Hi-Power’s target market focuses on health conscious consumers in China’s fast-growing beverage market.”
Here is a link to an informative 8k dated March 16, 2010 about the Xianghe acquisition. Most of the following discussion is disclosed in this 8K. In this link, we discuss specifically where in the 8K we get supporting material for the statements we make below.
From the 8k, we learn that Xianghe’s product actually originated in January 2009, when Qiu Shang Jing paid Yellow Sea Fisheries Research Institute (YSFRI) $8,776 for “know-how” regarding the development of an algae-based drink. To repeat, Xianghe basically began 1.5 years ago, when Mr. Qiu purchased “know-how” on how to make a certain algae-based drink for eight thousand seven hundred and seventy six dollars.
In April 2009, Mr. Qiu leased office space from CMFO (CMFO waived the rent beginning in July) to set up his new algae-drink company. On July 28, 2009, Mr. Qiu incorporated Xianghe as a legal entity with $43,979 (that’s forty three thousand, nine hundred and seventy-nine dollars). On October 2009, Mr. Qiu contributed an additional $689,504 for a total registered capital of $733,483.
Xianghe was then purchased by CMFO for $27.8mm in November 2009, through a 2-step acquisition that was completed in January 2010.
I’ll repeat the key points. Xianghe began when Mr. Qiu bought “know-how” regarding how to make an algae-based beverage for ~$9k in January 2009. Over the following 9 months, Mr. Qiu contributed an additional ~$733k (with 90% of that in October, one month before the acquisition).
In November, CMFO purchased 80% of Xianghe for $27.8mm.
Based on my calculations, Mr. Qiu achieved a 139,160% annualized return on his investment in the algae drink.
For the avoidance of doubt, here is a graphic representation of what happened.
I find it extremely implausible that a company essentially begun in January 2009 and that received less than $750k of capital in its first 11 months of operation (with 90% of that in the 10th month) would be worth $28mm at the end of the 11th month, unless it had a truly unique patent or technology. Xianghe is a maker of an algae-based beverage. I doubt that this qualifies as a sufficiently unique product that’s worth $28mm purely because of the inherent attractiveness of the product.
Equally absurd is the fact that the “know-how” which Mr. Qiu purchased for $9k is now valued on CMFO’s balance sheet at $23.5mm.
Incidentally, Li Xiaochuan is “the researcher” of YSFRI and also an independent director of CMFO.
More Dubious Financial Statements
Xianghe was begun when “know-how” was purchased in January 2009 for $9k. The company wasn’t actually incorporated until July 28, 2009.
So one would think that Xianghe would have negligible revenue and profit in its first 5 months of operations, correct?
Not according to Xianghe’s financial statements. Keep in mind that Xianghe was audited by CMFO’s same poorly qualified auditor: ZYCPA Company Ltd. ZYCPA, according to its website, has 2 partners and 25 personnel. It received its PCAOB designation in December 2008.
Between July 28, 2009 and December 31, 2009, Xianghe claims to have generated $7.6mm in revenue, $3.0mm in gross profit, $1.7mm of net profit and $1.2mm of cash flow of operations.
With approximately $742k of equity capital (comprised of $9k for know-how in January 2009, $44k of cash contribution on July 28, 2009 and $689k of cash contribution on October 8, 2009), Xianghe was somehow able to generate $7.6mm of revenue and $1.2mm of cash flow from operations in its first 5 months of operations, from selling an algae-based beverage.
Again, I’ll demonstrate my points with a graphical representation:
The financial statements for Xianghe provided in the 8K that is “audited” by ZYCPA are indisputably fraudulent. The Xianghe story is completely implausible, and any investors who think otherwise simply didn’t take the time to read the March 8K. Xianghe does exist and does make algae-based drinks. But it is not worth remotely close to $28mm and it did not generate remotely close to $7mm of real revenue in its first 5 months of operations. The numbers, like those of CMFO, are fabricated.
The acquisition of Xianghe served as a way for the creators of CMFO to justify a $30mm equity capital raise in January 2010. The vast majority of the $28mm that was used to purchase Xianghe was either redirected to personal bank accounts or used for some other dubious purpose.
At the time of writing, I and affiliated entities have a short position in CMFO and a long position in YUII. I intend to trade in these securities subsequent to this post. I may also initiate positions in other stocks mentioned in this article, including CSKI and LIWA.
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 list your concerns in the comments section and I will address them.
This post is meant to serve as reference material for some of the discussion points in my post “CMFO and Xianghe: A Dubious Acquisition”.
I’m going to provide the primary source material behind various statements that I make in “CMFO and Xianghe: A Dubious Acquisition”. Most of the source material is from the Amended 8K that CMFO filed on March 16, 2010.
I will list the statement in italics, and then the supporting language from the SEC filing on which I base that statement.
Xianghe’s product actually originated in January 2009, when Qiu Shang Jing paid Yellow Sea Fisheries Research Institute (YSFRI) $8,776 for “know-how” regarding the development of an algae-based drink.
Support from 8K dated 3/16/10:
“In January 2009, Mr. Qiu paid on behalf of [Xianghe] an amount of $8,776 (equivalent to RMB 60,000) to Yellow Sea Fisheries Research Institute (YSFRI), Chinese Academy of Fishery Sciences for the development of the algae-based drink know-how.”
In April 2009, Mr. Qiu leased office space from CMFO (CMFO waived the rent beginning in July) to set up his new Algae-drink company.
Support from 8K dated 3/16/10:
“In April 2009, the director and sole owner of the Company, Mr. Qiu leased an office space under an operating lease with Shishi Huabao Jixiang Water Products Co., Ltd (“Jixiang”) for a term of 3 years with fixed monthly rental, expiring in April 2012. According to a release letter signed between Jixiang and the Company, [Xianghe] was released from paying any rental for the period from July 28, 2009 (Inception) to December 31, 2009.”
On July 28, 2009, Mr. Qiu established Xianghe as a legal entity with $43,979 (that’s forty three thousand, nine hundred and seventy-nine dollars). On October 2009, Mr. Qiu contributed an additional $689,504 for a total registered capital of $733,483.
Support from 8k dated 3/16/10:
At the date of inception on July 28, 2009, the registered capital of the Company was $43,979 (RMB300,000), which was fully paid-up by Mr. Qiu.
On October 8, 2009, the Company approved to increase its registered capital from $43,979 to $733,483 (equivalent to RMB5,000,000) by additional cash contribution.
As of December 31, 2009, the registered and paid-in capital totaled $733,483.
Equally absurd is the fact that the “know-how” which Mr. Qiu purchased for $9k is now listed on CMFO’s balance sheet as $23.5mm.
Support from 10Q from 3/31/10:
The “know-how” is valued at $23,471,410
Content of section titled “More Dubious Financial Statements”
Support from 8K:
From the audited financial statements of Xianghe provided in the 8K
Please read the disclosures at the bottom of this article.
In my previous two articles, I’ve written about how several Seeking Alpha contributors have used locally filed Chinese financial statements to provide compelling evidence that certain U.S.-listed Chinese companies may be frauds.
All foreign-invested enterprises must file financial statements with the State Administration for Industry and Commerce branch of the Chinese government. These documents are not available electronically; rather, a local Chinese citizen must go to the appropriate local branch to access these documents. Fortunately, certain third-party credit agencies provide this service to foreigners for a fee.
In previous articles, I compared the SAIC and SEC financial statements of YUII, CSKI and LIWA. The numbers for YUII matched, whereas they did not for CSKI and LIWA.
In this post, I compare the SAIC and SEC financial statements for China Marine Food Group Limited (CMFO). The numbers do not match.
This provides evidence that China Marine Food Group Limited may be a fraud. In addition, I note additional data points that raise questions about whether CMFO’s financial statements accurately represent the financial condition of the underlying business.
I also present the response of the chief financial officer of CMFO to a question on why the SAIC and SEC documents don’t match, and provide my opinion on his response.
Before discussing CMFO’s SAIC statements, let’s discuss the legal organizational structure of CMFO. This is important because each subsidiary files separate SAIC financial statements. Chinese GAAP does not consolidate subsidiaries, and therefore it’s important to determine which subsidiary generates most of the company’s revenue. We can then compare the SAIC financial statements of this main operating subsidiary with the SEC filings.
Here is CMFO’s legal organizational structure, from an annual report. We use the 2008 org structure, because we are comparing their 2006, 2007 and 2008 financials.
The U.S.-based, publicly listed entity is China Marine Food Group Limited. Nice Enterprise Trading H.K. Co., Limited, its subsidiary, is based out of Hong Kong. Nice Enterprise has one subsidiary, Shishi Rixiang Marine Foods Co., Ltd (“Rixiang”), which is based out of China. Rixiang is a foreign invested enterprise that owns two other subsidiaries: (1) Shishi Huabao Mingxiang Foods Co., Ltd. (“Mingxiang”)and (2) Shishi Huabao Jixiang Water Products Co. Ltd (“Jixiang”).
Where are the operations primarily held? Rixiang. We know this by the following disclosures in the 10K:
“With effect from January 1, 2005, Rixiang acquired the business operations of Mingxiang, which subsequently became a property holding company. Rixiang was incorporated as a FIE and was granted the tax incentives for FIEs, and was exempted from income tax for 2005 and 2006… Jixiang is also a property holding company and is not subject to tax.”
Elsewhere throughout the report, the Company also makes clear that Rixiang generates all of the Company’s operating revenue, such as “All of our production is undertaken by our subsidiary, Rixiang” in the “Our Products” section.
From the above disclosure, we also know that Rixiang is an FIE. As an FIE, Rixiang must file accurate annual financial statements with the Administration for Industry and Commerce branch of the Chinese government.
SAIC vs. SEC financial statements
I have had a local third-party credit agency go to the local AIC office in Rixiang’s jurisdiction and photocopy their financial statements.
The figures above are in Remnimbi. In the chart below, we convert the Remnimbi to US dollars, and compare key financial line items with CMFO’s SEC financials:
As we can see, CMFO reports much higher numbers in its SEC filings than its SAIC filings. In its SAIC filings, the company generated only $2mm of revenue in 2007 and $7mm in 2008. In its SEC filings, it allegedly generated $36mm in 2007 and $49mm in 2008.
Compare that with Yuhe, which generated $21mm and $34mm of revenue in 2007 and 2008 in its SAIC filings, compared to $22mm and $36mm of revenue in 2007 and 2008 in its SEC filings.
As we discussed earlier, Rixiang is the primary operating subsidiary of CMFO. It is also an FIE. As a result, Rixiang’s financial statements should accurately reflect CMFO’s actual operating results.
But they don’t.
The CMFO’s response to the discrepancies is the following, based on an email:
“It’s a formality in China to file the operating figures with SAIC on an annual basis. We used to hire an independent agent firm to do the filing on our behalf as the process itself is quite tedious though. Guess the agent firm has used kinds of outdated figures to do the filing and thus discrepancies appeared as a result.
Since there won’t be any anticipated influence or harm over those inaccurate historical figures with SAIC, we don’t believe it’s necessary to re-file the statements. That said, we will switch to another sizeable agent firm to do the 2009 filing and will make sure the numbers so filed are consistent with our book record going forward.”
We’ve been down this road with CSKI. The CFO of CSKI said a similar thing in 2008 when asked why CSKI’s SAIC numbers didn’t match the SEC numbers. He promised that 2009 numbers would match. But in more recent discussions, he has revealed they will not.
What is actually going on? My belief is that CMFO is fabricating its SEC financial statements. FIEs in China must file accurate audited financial statements. I’ve spoken with dozens of accountants and CFOs of verifiably legitimate Chinese companies, and they have all confirmed this. It’s understandable to have small differences between SAIC and SEC filings, due to subsidiary consolidation and Chinese vs US GAAP. But CMFO’s 2008 SAIC revenue was 85% lower than its 2008 SEC revenue. That’s not due to GAAP accounting differences.
In my opinion, fraudulent Chinese companies like CSKI, LIWA and CMFO are making up numbers out of thin air. To fool their accountants, the companies are using sophisticated and undisclosed related party and off-balance sheet transactions to inflate financial statements. They are using phony bank statements to fake cash. It’s unclear how exactly they are doing it. But the differences between the SAIC and SEC numbers provides compelling evidence that they are finding a way to do it. After all, there is a lot of money to be made – companies like CSKI, LIWA and CMFO have raised $25mm+ each in secondary equity offerings or private placements, all for dubious purposes. If they are indeed fraudulent, these funds are likely being siphoned to a large degree to personal bank accounts.
These are shocking allegations, yes. But the world of Chinese reverse-merger smallcaps is a shocking one, and given the very low valuation multiples, it’s clear that many other investors suspect similar wrongdoings.
Other Signs that CMFO is a Fraud
The main thrust of our argument that CMFO is a fraud is that the Company’s SAIC and SEC filings don’t match. But as we did with our last two posts on YUII, CSKI and LIWA, we’re going to highlight other signs that make us concerned about trusting CMFO’s SEC financial statements.
Again, we’ll compare CMFO with YUII.
In our last post, we explained that Yuhe’s attempt to upgrade to Grant Thornton was a welcome contrast to the audit history of many other Chinese companies that have gone public via reverse mergers.
CMFO’s auditor, ZYCPA Company Ltd., is equally as questionable as LIWA’s and CSKI’s auditors. It is not listed in the top 100 global audit firms. It has 2 partners and 25 personnel, per its web site. Given that CMFO alleges to have generated $70mm of revenue and $15mm of net income in 2009, ZYCPA appears to be a woefully inadequate auditor for the company.
But if CMFO is making up its numbers, it would certainly find an easier time defrauding one of the two partners at ZYCPA than a top-5 audit firm like Grant Thornton.
As we discussed in our last post, a key thing to monitor when examining whether reverse-merger Chinese companies are frauds is to see how much capital they’ve raised via secondary private placements and equity offerings.
Naturally, we have no issue with capital raises. Companies need to raise funds to grow. But with Chinese companies that have gone public through reverse mergers, we see a tendency to raise large sums of money at large discounts to current stock prices, with dilutive warrants attached, and for dubious purposes. Indeed, if a company is fraudulent, a capital raise is the primary goal of creating a China-based fraud in the first place. The funds are taken from U.S. investors and deposited in the personal bank accounts of the scam artists.
With Yuhe, we have not seen any dilutive and/or unnecessary secondary offerings thus far.
With CMFO, we saw a $30mm private placement on January 20, 2010. The purpose was: “The Company intends to use the net proceeds from this offering for working capital and general corporate purposes.” From its SEC filings, the company allegedly had $7mm of cash at December 31, 2009 and has generated positive free cash flow (measured by cash flow from operations less capital expenditures) for each of the past three years. It’s unclear why the company needed additional cash.
The dilution was not especially egregious though, and the new shares were issued at only a 9% discount to the prior 10-day trading average and a 12% discount to the prior 30-day trading average.
At the time of writing, I and affiliated entities have a short position in CMFO and a long position in YUII. I intend to trade in these securities subsequent to this post within the next three days. I may also initiate positions in other stocks mentioned in this article, including CSKI and LIWA.
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 list your concerns in the comments section and I will address it.