Archive for the ‘Chinese RTOs’ Category
The report examines a $15 million acquisition that the company made in July 2010, and raises serious questions about whether the acquisition was legitimate.
In its second quarter 10Q, the company announced it acquired Vital Glee Development Limited (“Vital Glee”) for $15 million on June 24, 2010. Vital Glee was an “investment holding company and through its subsidiary engaging in automotive shock absorber manufacturing business”. Click here for the relevant disclosure. I’ve re-pasted it below:
“On June 24, 2010, [WATG’s subsidiary] agreed to acquire 100% equity interest in Vital Glee Development Limited (“Vital Glee”), for a total consideration of $15 million of which $8.7 million was settled in June 2010. The remaining consideration will be divided into 2 equal installments and will be settled by December 31, 2010 and June 30, 2011 respectively. The Company obtained control over Vital Glee on July 1, 2010 by appointing the sole director to Vital Glee. Vital Glee is an investment holding company and through its subsidiary engaging in automotive shock absorber manufacturing business.”
Little additional disclosure was given, in the 10Q or any subsequent SEC filings.
OLP investigated the acquisition further. From speaking with management, OLP determined that Vital Glee’s operating entity was Jinzhou Lide Shock Absorber Co., Ltd. This is further confirmed by a Roth Capital report on September 30, 2010.
After some investigation, OLP found serious issues with the acquisition, which I will summarize below:
1. Jinzhou Lide was formed in April 2010
According to the AIC records for Jinzhou Lide, which are included in the OLP research report, Jinzhou Lide was established on April 26, 2010. You can also see this on the Jinzhou AIC website here (use Google Chrome’s translation functionality if you cannot read chinese).
I’m doubtful that a business that has been operational for 2 months can be worth $15 million.
Management told OLP that Jinzhou Lide was formed from a reorganization of an older company, which engaged in the same auto shock absorber business in Jinzhou. Management, however, declined to provide the name of Jinzhou Lide’s predecessor company, and I discuss below my skepticism around management’s claim.
2. Jinzhou Lide was established at the same address as another facility owned by WATG
According to AIC records (see page 4 of OLP report or the website I show above), Jinzhou Lide was established and located at:
Bohai Street, Jinzhou Economy & Technology Development Zone, Jinzhou, Laoning
This is the same address of Jinzhou Wanyou Mechanical Parts Co., Ltd., a subsidiary of the company. OLP learned this by calling the company, but you can look on this site, this site, or this site to verify that Jinzhou Wanyou is located at Bohai Street, Jinzhou Economy & Technology Development Zone, Jinzhou, Laoning. Or simply search for the chinese characters of the address and the chinese characters of Jinzhou Wanyou Mechanical Parts Co., Ltd., which are found on pages 3 and 10 of the OLP report, respectively, in Google Chrome.
Not surprisingly, we also see this address show up in this 8k from April 4, 2007, where Jinzhou Wonder Auto Suspension System Co., Ltd. sells a stake in Jinzhou Wanyou Mechanical Parts Co., Ltd. to WATG. Click here for the relevant page showing the address. Jinzhou Wonder Auto Suspension System Co., Ltd. is shown as a related party throughout several historical SEC filings, such as its 2007 10K.
We now see that WATG paid $15 million for a subsidiary that was two months old and established at the same address as one of WATG’s current facilities.
3. Jinzhou Lide had a registered capital of only $1.2 million, and yet was sold for $15 million two months after being established
Jinzhou Lide’s registered capital is only $1.2 million, which implies that its shareholders only put in $1.2 million in April 2010 to establish the business. Yet it was sold to WATG for $15 million in July 2010. I’m doubtful that Jinzhou Lide’s value rose 1,200% in its two months of operations.
4. Management has not disclosed the identity of Vital Glee’s seller
In the vast majority of M&A transactions, investors are aware of the identities of both the buyer and seller. In this case, WATG management has not disclosed the identity of the seller, and investors cannot determine the identity of the seller through any other means. Vital Glee is registered in the British Virgin Islands (BVI), and the BVI registered agent will only release the director and shareholder information if Vital Glee management consents. Upon OLP’s request, the BVI registered agent sought permission on multiple occasions from Vital Glee management, but has yet to receive approval to release Vital Glee’s shareholder information.
OLP also asked WATG management to identify the name of the seller. According to OLP, the WATG CFO stated that he does not know the identity of the seller.
The question therefore remains: who owned Vital Glee and who received the claim to $15 million upon its sale?
WATG should publicly disclose the identity of Vital Glee’s sellers, and enable investors to independently access the relevant information from the BVI registered agent.
5. Jinzhou-based sources in the auto parts industry were unable to identify Jinzhou Lide’s predecessor, and weren’t aware of M&A involving any $15 million shock absorber businesses in Jinzhou
OLP identified 14 companies in the auto shock absorber business located in Jinzhou that have effective AIC registrations. They are listed here. OLP spoke to “numerous” members of this list in an effort to identify Jinzhou Lide’s predecessor and none of them were able to identify a company that could have been Jinzhou Lide’s predecessor.
Additionally, none of the sources were aware of a $15 million acquisition in the auto shock absorber sector in Jinzhou.
We have seen corporate governance issues and questionable financial and management practices at other Chinese RTOs structured and financed similarly to Wonder Auto. Like others, Wonder Auto has not chosen a top-4 auditor, instead choosing to go with PKF Hong Kong, a firm that boasts only 4 partners. Like others, Wonder Auto has eye-popping financial figures, claiming 40% to 50% revenue growth annually since 2005 and 20%+ operating income growth during that same time period, which imply extraordinarily high returns on capital on its capital expenditures and acquisitions. During the global downturn of 2008 and 2009, which impacted China just like the rest of the world, WATG doubled both revenue and gross profit, and increased EPS by 40%. The company has raised substantial amounts of dilutive equity at low valuations, such as $69 million in November 2009 at a valuation of less than 15x PE.
The facts behind the Jinzhou Lide acquisition are damning. WATG appears to have paid $15 million for a 2-month-old company established at the same site as one of WATG’s other subsidiaries. WATG has yet to disclose the seller of Jinzhou Lide, and its general disclosure of the acquisition is noticeably sparse. Numerous local competitors are unaware of a shock absorber business in Jinzhou that could have been the predecessor to Jinzhou Lide. They also have not heard of a $15 million acquisition in the sector. The shock absorber business community in Jinzhou is small enough that such a predecessor and acquisition would not go unnoticed.
If management wants to prevent further allegations of fraud, it should release an 8K elaborating on the details of the Jinzhou Lide acquisition. It should provide predecessor financial statements of Jinzhou Lide; the identity and backgrounds of its sellers; an explanation of why its initially registered address is the same as one of its subsidiary’s; a list of customers; and additional information that would allow independent analysts to verify Jinzhou Lide’s legitimacy.
Disclosure: Short WATG
Over the past few months, the topic of financial filings with China’s State Administration for Industry and Commerce (SAIC) has made frequent appearances within the U.S.-listed Chinese RTO (“reverse takeover”) sector. I and other critics have advocated that AIC filings are important data points in determining whether certain Chinese RTOs are falsifying their SEC financial statements. In cases where AIC-reported revenue, profit and assets are substantially lower than SEC-reported financial figures, we’ve claimed that this provides material evidence that the companies in question are fabricating their SEC financials.
Our arguments have made sense to many investors, but some remain unconvinced. Misleading responses by certain of the alleged frauds that AIC filings don’t matter have muddled the debate. These companies, such as CMFO, LIWA or CSKI, have claimed that AIC filings are unimportant and are not taken seriously in China, and that investors should not use these filings as data points when analyzing U.S.-listed RTOs. I strongly disagree.
The point of this article is that AIC filings do matter.
To illustrate this point in a way that hasn’t been yet done, I’m going to provide full 80-page AIC filings on two Chinese companies, China-Biotics Inc. (CHBT) and Spreadtrum Communications Inc (SPRD). Both of these companies listed on the U.S. public markets several years ago, trade at similar market capitalizations, and both file with the Shanghai branch of the Administration for Industry and Commerce (“AIC”). Unlike some AIC branches that provide only selected AIC documents, the Shanghai branch provides full AIC reports to inquiring investors.
The China-Biotics filing is 84 pages, while the Spreadtrum filings are comprised of one 76-page filing and one 34-page filing. I also provide full English translations for each filing. These filings and the English translations help address much of the misinformation circulated about AIC filings, and provide clear examples of what information is included in AIC reports, and why I’m confident that these numbers matter. The filings provide extensive information about each company’s ownership, registered capital, and, most importantly, audited financial statements filed with the local Chinese government.
As I’ll discuss, Spreadtrum’s AIC report and financial statements provide evidence that SPRD is a legitimate Chinese company that generates substantial revenue and owns a significant amount of assets. Their filings give investors comfort that the company is accurately representing itself in its SEC financial statements.
CHBT’s AIC report and financial statements, on the other hand, indicate a company that is far smaller than its SEC filings indicate. Whereas SPRD’s AIC filings show a company generating more than $100m of revenue, CHBT’s filings show a company generating less than one-tenth of its SEC-reported revenue.
Both companies file with the same local AIC office. The reports are in the same format, and include similar sets of documents. Yet one shows a legitimate company, and the other shows a legal entity that has minimal business operations. Any long investor in CHBT, or critic of the legitimacy of AIC filings, has to ask himself the following question: why would CHBT provide false information in its AIC filings when SPRD doesn’t?
The answer is that CHBT management is providing accurate information to the AIC. The fake information is in the SEC filings they provide to public investors and the U.S. government, a government that does not have legal recourse to Chinese residents.
Currently, the public markets are valuing CHBT and SPRD similarly. CHBT has a market capitalization of $315m. SPRD has a market capitalization of $440m. Yet one of these Shanghai-based companies is real and the other is a fraud.
Brief background on AIC filings, and why I’ve chosen CHBT and SPRD
For those new to the debate, I’ll provide a brief discussion of AIC filings. The State Administration for Industry and Commerce is the Chinese government agency responsible for drafting and implementing legislation concerning the administration of industry and commerce in China. SAIC regulations are implemented by local AIC branches.
All Chinese companies file a variety of information with their local AIC office, including information on property leases; land use rights / building ownership certificates; capital verification reports (these show money / assets contributed by whom, and when); business licenses; the approved “business scope”; the legal representatives; applications to form the companies, with some personal information on the applying shareholders; applications to raise / reduce capital or change the business scope or term; tax and other government incentive documents; company bylaws; and, last but not least, annual financial statements.
Not all AIC branch offices operate the same way. Some provide photocopies of original documents to inquiring agents. Others email electronic data sheets. And others either provide information only verbally or require agents to visit the office and transcribe the relevant information by hand.
Furthermore, not all AIC branch offices provide the same volume of information to outsiders. Some AIC branch offices provide no information at all to the public. Some provide just financial statements. And some provide extensive reports, including financial statements, capital registrations, leases, etc.
The Shanghai AIC is one of those branches that provide full AIC reports, and in a convenient PDF document that is comprised of photocopies of all the relevant source documents.
That is why I have chosen to compare CHBT and SPRD. Both of these companies report to the Shanghai AIC. Unlike CMFO or ONP, which report to small rural AIC offices that are more secretive in terms of what they release to the public, the Shanghai AIC provides exceptional disclosure to inquiring investors.
CHBT vs SPRD
Click here for CHBT’s AIC report in its Chinese original.
Click here for CHBT’s AIC report translated into English.
The AIC report is 84 pages, and I’ve numbered the pages clearly in the bottom right-hand corner of each page. Here is a breakdown of the documents contained in the report:
- Page 1-9: Company bylaws
- Page 10-11: Registration of the company name and application to register the company (July 1999)
- Page 12-19: Lease of Pudong plant (August 1999)
- Page 20-41: Various registration documents from 1999 to 2005
- Page 42-50: Various registration documents related to transfer of ownership from management to Sinosmart Group, the BVI entity involved in the reverse merger, in 2005
- Page 51-67: Annual Inspection Report for Foreign-Funded Enterprises for 2007
- Page 68-84: Annual Inspection Report for Foreign-Funded Enterprises for 2008
There should be little doubt that this AIC filing is for Shanghai Shining Biotechnology Co., Ltd, the main operating subsidiary of China-Biotics, Inc. Here is CHBT’s organizational structure:
Growing Bioengineering (Shanghai) Co., Ltd. is the legal entity established in 2006 that owns the bulk additives operations. Our AIC filing comparison is for the years 2007 and 2008, when Growing Biongineering had no material operations. Shanghai Shining was the sole operating entity. The 2009 filings for Shanghai Shining are not yet available.
Spreadtrum is a semiconductor manufacturer that IPO’d in 2007. It had a rough 2008 and 2009, when the global downturn reduced semiconductor demand, but business appears to be rebounding. Its two largest institutional investors, each owning more than 10% of shares, are $14bn private equity firm Silver Lake Partners and $11bn venture capital firm New Enterprise Associates.
SPRD, like most companies that generate $100m+ of revenue, has more than 1 operating subsidiary. Click here for its organizational structure. Based on discussions with management, most of the revenue, profit and assets were generated at two subsidiaries in 2007 and 2008: Spreadtrum Communications (Shanghai) Co., Ltd. and Spreadtrum Communications Technology (Shanghai) Co., Ltd. I’ll refer to the former as “Spreadtrum Communications” and the latter as “Spreadtrum Technology”.
I’ve acquired and translated the AIC filings for both of these subsidiaries.
Chinese GAAP does not consolidate financial statements. To approximate the consolidated financial figures for SPRD, we need to add the figures of Spreadtrum Communications and Spreadtrum Technology. Naturally, there are intercompany payments between the two subsidiaries that distort revenue and profitability. As well, the assets and liabilities are distorted by dividends payable to other SPRD subsidiaries, as well as the SPRD parent. But for our purposes, it’s clear that these AIC filings show a real company with assets and revenue greater than $100m.
Let’s compare the financial figures between each company’s AIC filings and SEC filings:
In the case of CHBT, the AIC filings show revenue of less than $1m in 2007 and 2008. This compares to SEC-reported revenue of $31m in 2007 and $42m in 2008. CHBT’s AIC-reported total assets were $7m and $9m, compared to $45m and $94m in its SEC filings.
CHBT’s AIC financial statements are on pages 51 to 84 of the AIC filing (English translation available here). A summary for 2007 and 2008 are on pages 53 and 70 of the filing (English translation available here).
In the case of SPRD, Spreadtrum Communications reported revenue of $62m and $64m in its 2007 and 2008 AIC filings, while Spreadtrum Technology reported revenue of $112m and $91m its 2007 and 2008 filings. Together, the combined entities reported $174m and $155m of revenue in 2007 and 2008 in their AIC documents. The SEC-reported revenue for SPRD was $146m and $110m in 2007 and 2008. The higher combined AIC numbers indicate that there were some intercompany sales in the AIC filings. Total assets for the combined two entities were $116m and $126m in 2007 and 2008, compared to SEC-reported total assets of $237m and $153m. The discrepancy in assets is likely due to large cash balances and other holdings at the non-Chinese parent Spreadtrum Communications, Inc., or other subsidiaries. Again, we shouldn’t expect these subsidiary financial statements to match the SEC filings; rather, we’re mainly looking to see if the SPRD AIC filings indicate that there is a legitimate business operating under the SPRD ticker. They do.
Do We Have the Right Shanghai Shining Biotechnology Co. Ltd?
There is boundless evidence that the 84-page filing I’ve included refers to the same Shanghai Shining that is CHBT’s main operating subsidiary.
The shareholders of the company in the AIC filings are Song Jin’an, Yan Li, Huang Weida, and Yan Yihong. Jin’an is the current CEO, Li is his wife, Yihong is her sister, and all four are current or former officers, directors or shareholders of CHBT according to its SEC filings.
The main company address listed in the AIC filing is the same as the one listed in the SEC filing.
The CEO’s signature in the AIC filing is the same as the CEO’s signature throughout SEC filings. For instance, compare Song Jinan’s signature on this page from CHBT’s 2006 10K with his signature on page 19 of the AIC filing.
The percentage ownerships of the shareholders prior to the reverse merger match the percentage ownerships that China-Biotics has disclosed to the SEC. For instance, compare the response to question 14 in this March 16, 2007 correspondence with page 37 of the AIC filing (Click here for English translation).
Pages 43 to 50 of the AIC filing (Click here for English translation) provide details on management’s transfer of ownership to Sinosmart Group, the British Virgin Islands legal entity that acted as an intermediary in the company’s 2006 reverse merger. That transaction is documented extensively in the company’s SEC filings – search Sinosmart in any 10K.
There should be little dispute that we have the correct entity.
Evidence for why AIC filings do matter
I don’t think any aspect of our AIC filings gives the impression that companies can outright lie in the financial statements they file with the AIC. Each company provides lengthy and accurate information on their registered capital, leases, shareholders, company bylaws, etc. It’s a tremendous leap of faith to believe that the AIC requires accurate reporting in these aspects, but is indifferent as to whether a $40m revenue company reports sales of only $1m in its financial statements.
Here are additional reasons why we should take CHBT’s AIC filing seriously.
1. CHBT management live in China. The AIC filings are filed with the Chinese government, whereas the SEC filings are filed with the U.S. government. Management is concerned about violating Chinese law and providing false information to the Chinese government. But they are indifferent to defrauding the US government and breaking US law. A Chinese resident does not have to obey U.S. law any more than a U.S. resident is required to obey Chinese law. That’s why they report the accurate numbers to the Chinese government, and the fake numbers to the U.S. government. There are practically no repercussions to Chinese management teams that defraud foreign investors. Numerous U.S.-listed RTO companies, like CXTI, CYXI and CHFI, have seen their management teams vanish with the companies’ assets, and suffer no legal repercussions. Defrauding U.S. investors is not a violation of Chinese law, whereas defrauding the Chinese government is.
3. On page 70 (English translation is here), near the front of the 2008 Annual Inspection report, we have a picture of Yan Yihong (the former CFO and sister-in-law of the CEO), along with her detailed personal information and the following testament:
I hereby confirm and promise that all the contents contained in the annual inspection report do not contain any fraudulent information and all the financial statements and other materials submitted are true and effective, and that I’m willing to bear any legal and related responsibilities caused due to the inaccuracy of such documents.
This is followed by the signature and personal seal of CEO Song Jin’an, as well as a seal of the company. I can’t fathom how the Chinese government would require such a testament in the Annual Inspection Report, but then allow a company to file false financial statements.
It’s far more believable that CHBT is defrauding the US government and US investors, both of which have no legal recourse to the company’s management. The Chinese government certainly has legal recourse to Yan Yihong and Song Jin’an. The existence of this sort of testament at the front of the AIC Annual Inspection reports is a strong sign that AIC financial statements do matter.
4. Why does SPRD file financial statements that approximate its SEC filings (intercompany distortions notwithstanding), while CHBT files financial statements that are a tiny fraction of its reported SEC filings? As I’ll discuss in future articles, there are ample other signs that SPRD is a real business, while CHBT is not. But even excluding any such future arguments, why would one foreign-owned Shanghai company lie on its AIC financial statements when another would tell the truth? Why would SPRD report large, accurate numbers if these filings didn’t matter? What sort of reasonable explanation can anyone come up with? Either both should be understating their numbers, or both should be reporting accurate numbers.
I firmly believe that both are reporting accurate numbers in their AIC filings.
The fake numbers are the ones in CHBT’s SEC filings.
Naturally, AIC filings are not the only signs that CHBT is falsifying its SEC financial statements. Citronresearch raises excllent non-AIC-related issues with the company here. The notion that probiotics nutritional supplements allowed CHBT to achieve revenue growth of 30%-50% annually over the past 4 years while achieving Microsoft-like EBITDA margins of 40%-45% is nothing short of absurd. The company raised $75m of cash in 2009 when it already supposedly had that much sitting in the bank, with no compelling reason for the new capital raise and dilution. Its reverse merger was organized by the same investors who’ve provided capital to renowned fraud Orient Paper, and its auditor is also the same as ONP’s (not to mention China Expert Technology’s). But we’ll get to these points in the future.
For now, I aim to make the case that AIC filings matter. The documents provided in this article provide an indication of what information AIC filings provide, and why investors should pay attention to them. SPRD’s AIC filings show a legitimate business that manufactures and sells semiconductors. CHBT’s AIC filings, on the other hand, show a virtually non-operational legal entity which its management has used to defraud public investors, as well as the SEC, and to raise $75m of cash from US investors.
Disclosure: I am short CHBT, ONP, CMFO, CSKI and LIWA
Over the past few weeks, there has been discussion around a wide variety of allegations surrounding Orient Paper. The original Muddy Waters research report was 30 pages long, and they have issued several subsequent pieces of commentary. The company, in turn, has submitted several responses to the Muddy Waters allegations and has hosted a conference call.
There has been a lot of information and keeping track of it has been difficult. The purpose of this article is to highlight the several most compelling pieces of evidence that Orient Paper is a fraud.
As I’ve written in previous articles and blog posts, I believe that Orient Paper is falsifying its financial statements. There is substantial evidence for that, but I’ll focus here on 4 of the most convincing points to me. I’ll exclude certain disputed items like the AIC filings, where the company and Muddy Waters are in disagreement over whose copies are the correct documents.
1. Top 10 Customers
Much of Muddy Waters’ research has focused on direct due diligence that they’ve done on the company’s premises in China. Yet some of the most compelling pieces of evidence that Orient Paper is a fraud comes from incriminating evidence that it has published in its own SEC filings.
One of the best examples of that is in its 2008 and 2009 Top 10 Customers. Here are the two lists, from the SEC filings:
Muddy Waters puts it well:
“ONP’s 2009 top 10 customer list shows that it replaced 80% of the 2008 customers. The strange item is that the minimum level needed to enter the top 10 lists stayed constant at around $2.1 million. In other words, one could reasonably expect that almost all of the companies who did $2.1 million or more in business with ONP in 2008 should do at least as much in 2009. But this was not the case, as eight of the 2008 top 10 customers disappeared. Yet, ONP did not lose any revenue. It grew by 56.5%.
The paper manufacturing business in China is highly competitive. First you have to make the product. Then you then have to sell it. “If you make it, they will come” is no less realistic in China than in the United States. Particularly when the product is highly commoditized – such as paper is.
For a company to lose most of its top 10 customers and not have sales decline requires significant effort by all throughout the organization. To lost most of its top 10 customers and still grow the company at 56.5% is a remote possibility.”
And here is the company’s response:
“Muddy Waters also accuses Orient Paper of churning and burning its top 10 customers and misrepresenting its sales volumes to these customers. Those who have followed Orient Paper and studied the Company’s 10-K and other financial disclosures carefully over the past two years understand the following Company developments. Almost all of the Company’s top 10 customers are printing companies that buy printing/writing paper. The Company traditionally has a large number of small packaging plants buying its corrugating medium paper and very few, if any, of them make to the top 10 list. Within the group of printing/writing paper customers, significant changes in Orient Paper’s product portfolio occurred in 2008 and 2009. In 2008, HBOP started producing writing paper, thanks to the 1760# Fourdrinier Multi-Cylinder Production Line that was placed into service in March. In the Fall of 2009, because of the skyrocketing cost of imported wood pulp, Orient Paper stopped producing high-grade offset printing paper, which requires virgin pulp (rather than recycled paper) as a major raw material. In an effort to push for a lower-priced medium grade offset printing paper, the Company converted the writing paper production line in September 2009 to concentrate on producing more medium grade offset printing paper. As a result of these shifts in product offerings, the top 10 customer lists of 2008 and 2009 had very different compositions. Orient Paper had more white paper sales sold to those customers who switched to the Company’s mainstream medium grade offset printing paper.”
Orient Paper is a paper manufacturer. It operates a commodity business, and Orient Paper doesn’t have any special technology over and above its competitors. As well, while China is a faster growing economy than the United States, it is nevertheless competitive, and paper demand isn’t growing at 50% a year. The Company can’t simply change its product mix, replace 80% of its Top 10 customers and nevertheless grow revenue by more than 50%.
2. The Video
The visual evidence presented by Muddy Waters makes a compelling case that Orient Paper is falsifying its financial statements. While the new digital photo lines provided in subsequent pictures may appear somewhat professional, the main legacy production lines shown in Rick Pearson’s TheStreet.com video demonstrate a business far smaller than what the SEC filings indicate.
To best examine the visual evidence, it’s best to look at Competitors’ plants, and then compare those plants with the Muddy Waters facilities:
– See pages 14-17 of the Muddy Waters report available Here
Based on the videos and pictures, Orient Paper’s main plant is of materially lower quality than that of its competitors. The machines are old, run-down and appear incapable of producing high quality paper. As well, the videos show substantial steam generated in the facility, which conflicts with the company’s claims of producing high quality paper. Once paper is exposed to water, it becomes no longer flat, and cannot be billed as high quality.
3. Muddy Waters’ Claims that the Company’s Top 10 Customers Could Not Have Purchased As Much Product As ONP Claims They Have
In its report, Muddy Waters tried to contact each of the Top 10 customers that Orient Paper lists in its 10K. Five were contacted or otherwise verified, and Muddy Waters lists their phone numbers in its report. Any outside third parties can independently contact them, given that Muddy Waters makes their contact information readily available.
Click here for a table where Muddy Waters documents its diligence on its Top 10 customers.
Based on its findings, Muddy Waters concluded that Orient Paper has fabricated its sales figures to those customers. Five of the customers were too small to be able to buy the volume of paper that Orient Paper claims it purchased from them. For instance, at a company to which Orient Paper alleges selling $3.4m of product, the cleaning woman answered the phone during business hours and was the only employee working. She said that there were only a few employees at the business and all were part-time. Four of the companies within Orient Paper’s Top 10 could not be found, had no website or had no one answering the phones during business hours.
Only 1 of their Top 10 customers, Boading Huatai Printing Co. Ltd, was large enough to theoretically purchase the amount of paper from Orient Paper that ONP claimed.
Here is Orient Paper’s response:
“Muddy Waters has stated that it believes that “all but one of Orient Paper’s top 10 2009 customers are too small (if they even exist) to buy the amount of product that ONP claims they do.” This accusation is false and Orient Paper believes that Muddy Waters’ methodology is inappropriate for establishing substantiation in a fraud case. Business practices in China are different from those in the United States, where many businesses are willing to reply to sensitive trade account confirmation given a properly drafted written confirmation request from the trading partner and the confirmation performed by legitimate third parties, such as auditors. Unsolicited, improperly phrased enquiries are usually met with misleading or inaccurate results. In addition, even in the U.S., auditors who perform written or telephone confirmations must perform additional alternative procedures to get in contact with the relevant parties to be confirmed before any conclusion can be reasonably made. While Muddy Waters claims that they were unable to verify the existence of some of Orient Paper’s customers and made no effort to ask Orient Paper for assistance; many institutional investors; investment banks, such as Roth Capital Partners; and the Company’s auditor, BDO Limited, have all performed due diligence on Orient Paper’s large customers and have confirmed and communicated with their selected sample companies during the last twelve months. Among these parties, Muddy Waters is the only one that claims Orient Paper is providing “false information” about its top 10 customers.”
Orient Paper’s response is basically twofold.
First, it claims that Orient Paper’s customers would lie to Muddy Waters about their size because that is standard procedure in China. I doubt that’s the case.
Second, it claims that a variety of third parties have done the necessary due diligence on Orient Papers’ customers. As I’ve previously written, BDO Limited has demonstrated an inability to do proper due diligence in the past, given that it was the auditor of China Expert Technology, which was a complete hoax. I would not rely on their work. The investment banks working with Orient Paper are third-tier firms that have embraced Chinese RTO smallcaps mainly because the sector generates them a tremendous amount of fees, not because the companies whose offerings they underwrite are real. As for the institutional investors in ONP, I will not make an unwarranted generalization because a variety of funds invest in Chinese RTO smallcaps, and they do so for different reasons and according to different investment theses. But some of the funds that do proper on-the-ground business diligence on Chinese RTO smallcaps like Orient Paper are indeed savvy and have generated outstanding returns from the sector. But their goal isn’t necessarily to avoid frauds.
4. Further Inconsistencies within the SEC filings
In addition to the unlikely 80% turnover within the Top 10 Customers, there are further inconsistencies within Orient Paper’s SEC filings.
First, Orient Paper’s alleged inventory turns are extraordinarily high for a paper company, and when compared with competitors. On page 25 of the Muddy Waters report, we see a comparison of ONP’s inventory turns when compared to competitors. ONP’s 17x 2009 inventory turns is high for any manufacturing business, let alone a paper company in an industry where its listed competitors’ inventory turns are 4.3x, 5.6x, 6.4x and 7.7x.
Second, as an additional blogger wrote in a post last week, if the company grew revenues by 57% and earnings by 45% in 2009, why was its employee count 600 in both years? In fact, an old video on the company’s website (the video doesn’t download properly in many browsers) says that the company had 863 employees. If that’s true, how has revenue grown from $40m in 2007 to $102m in 2009 while employees have actually shrunk 30%?
That blogger highlighted further inconsistencies. How did the company have a 37-member R&D department that only cost them $30,130 in 2008? How do you more than triple sales in 3 years while spending only a collective $655 (six hundred and fifty five dollars) on advertising and promotion in those 2 years?
There is substantial additional evidence that Orient Paper is falsifying its financial statements that I have not touched upon.
The company and Muddy Waters are disputing whether the SAIC financial statements match the SEC financial statements. I also have acquired SAIC documents with the personal seal of ONP chairman Zhengyong Liu, and may post them at a future date. Either mine and Muddy Waters’ documents are false, or the ones recently submitted to the Hebei AIC are falsified.
As well, I have not touched on whether ONP could theoretically purchase a production line for $27m, when Muddy Waters has provided evidence that the most expensive highest capacity 5.6m corrugating medium production line would cost less than $10m.
I have not touched on how the recycled scrap inventory shown in the video and various additional Muddy Waters’ pictures could be worth the amount that ONP values them at in its financial statements.
I have not touched on how ONP can generate the same gross margin as its competitors despite its outdated equipment and far lower economies of scale.
But even without touching on the additional evidence that has been disclosed over the past few weeks, the points highlighted in this article provide compelling evidence that Orient Paper is falsifying its financial statements.
Disclosure: I am short shares of ONP.
I have spent much of the past month describing why I believe that China Marine Food Group (CMFO) is falsifying its financial statements. My posts and articles are here, here and here. From my posts, it should be clear that I don’t think CMFO is the only U.S.-listed RTO Chinese company that’s making up its numbers.
Another one is Orient Paper. Over the next few weeks I will explain why I believe this is the case.
Today, I will focus on a research report published by Carson Block and Sean Regan at “Muddy Waters LLC” earlier this week.
You can access it here.
This post will summarize several of Muddy Waters’ allegations. I urge readers to read their entire report, as my brief post does not do it justice.
1. Like CMFO, ONP is using an acquisition to justify a large equity raise that it is likely using for dubious purposes, such as redirecting the funds to personal bank accounts.
On April 12, ONP announced that it had entered into an equipment purchase agreement with Henan Qinyang First Paper Machine Limited to purchase a corrugating medium paper production line with an annual production capacity of 360,000 tons for $27.8m.To fund the acquisition, ONP raised $27m in a secondary equity raise underwritten by Roth Capital Partners.
Muddy Waters wrote this:
“We spoke with the purported seller of the equipment, Qinyang, and four other Chinese papermaking equipment manufacturers. Qinyang told us that its highest capacity 5.6 m corrugating medium production line (the type ONP purports to have purchased) produces only 150,000 tons per year and costs approximately $4.4 million. This stands in stark contrast to ONP’s contention that it is purchasing a single line from Qinyang that will produce 360,000 tons per year for a total price of $27.8 million.”
Qinyang further stated that no Chinese manufacturer makes a 5.6m corrugating medium line that can exceed 200,000 tons per year. Furthermore, the most expensive line was no more than $7.3m. Muddy Waters provides a table showing the companies contacted, their URLs and the rough prices of their highest capacity 5.6m corrugating medium production lines.
No company quoted a price greater than $7.3m.
In my opinion, ONP is either misappropriating 60% of the capital raise and using the remainder to purchase a line, or misappropriating all of the $27m capital raise and purchasing no line.
2. ONP also made a $5m capital raise in October 2009, allegedly to purchase digital photo coating lines owned by He bei Shuang Xing Paper Co. Ltd. But according to Shuang Xing’s audited financial statements with the Chinese government, its fixed assets were worth less than $500k.
With CMFO, we saw a similar instance where the company purchased a company for an amount far more than the target could reasonably be worth. With the case of Shuang Xing, ONP appears to be using the asset purchases as justification to raise equity, which was then likely diverted to personal bank accounts, in my opinion.
3. ONP’s SAIC financial statements show revenue, profit and assets that are far lower than their SEC financial statements, according to Muddy Waters.
In due time, I’ll publish a post independently discussing and providing ONP’s SAIC filings. But I want to mention here that based on Muddy Waters’ research, the SAIC and SEC financial statements don’t match.
The company has claimed that Muddy Waters had acquired the AIC documents for the wrong company. Muddy Waters have refuted that, and has provided evidence demonstrating their case. We’ll discuss this more in future articles.
4. Muddy Waters provide visual evidence comparing ONP’s plants / technology with competitors’ plants.
Here is a video provided by thestreet.com’s Rick Pearson on ONP’s facilities.
In contrast, here are pictures of two competitors’ plants.
Shandong Chenming Paper Holdings Ltd.:
Nine Dragons Paper Holdings Ltd.:
The differences between the Orient Paper plant and the competitors’ facilities are striking. The Orient Paper facilities are old, shoddy and in poor condition, whereas competitors’ machines appear far more professional and new.
There is numerous additional evidence in the Muddy Waters research report that illustrates how Orient Paper is falsifying its financial statements and inflating its assets and operating metrics in its SEC financial statements. In future posts or articles, I will elaborate on some of the financial metrics. I will also explain how the Company’s auditor, BDO Limited, is not the same as BDO Seidman, and how certain Chinese companies have been using auditors within the BDO family to trick investors into mistaking them with the more reputable U.S.-based BDO Seidman.
Disclosure: short CMFO and ONP
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.