CHINA-BIOTICS INC CHBT S
June 02, 2011 - 11:44am EST by
urban
2011 2012
Price: 6.90 EPS $0.00 $0.00
Shares Out. (in M): 22 P/E 0.0x 0.0x
Market Cap (in M): 153 P/FCF 0.0x 0.0x
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Description

[ This is a low-liquidity idea, please skip if this is an issue ]

China-Biotics, Inc.

Have you ever seen a stock decline 36% during a two-week period in which a single investor accumulated 50% of the float? This is what has purportedly happened in the case of China-Biotics (Nasdaq:CHBT) from May 12, 2011 through May 27, 2011. While this piece of information standing taken at face value would be extremely puzzling, the skeptic’s interpretation makes a lot of sense: I believe this is not a real transaction, and in fact that the CEO sold his entire stake of 9 million shares (approximately $80 million at the average market price during this period) through intermediaries.

I propose shorting CHBT via put options. CHBT is another Chinese reverse merger company that is clearly a fraud. I believe that this trade offers 2.5:1 upside:downside with a 75% chance of success.

Fake Revenues, Fake Stores, Fake Customers

In its SEC filings, CHBT claimed 2009 revenue of USD 71 million, while in its Chinese (SAIC) filings, its 2009 revenue was a mere USD 500k. Much has been said about the SAICs, but history has proven them to be extremely accurate and I view them as the best measure of the "degree of fraud". By this measure, CHBT is nearly 100% fraudulent.

In August 2010, Citron Research questioned the existence of the company’s retail outlets. CHBT responded with a list of addresses. Citron and Kerrisdale Capital then took pictures at these addresses to prove that the retail outlets were nonexistent. In its 10-Q for the quarter ended September 30, the company claimed to have suddenly closed 95 (out of 103 total) retail outlets in the month of September. At the same time, they reported an increase in revenues and met guidance.

A major Chinese publication, First Financial Daily, interviewed three major Chinese dairy manufacturers and all of them denied having a relationship with CHBT. CHBT claims to sell products to Bright Dairy, but that company has stated that they do not know CHBT. It is unlikely that CHBT has any substantial bulk customers. The same article indicated that CHBT’s business in supermarkets is not only much smaller than represented, but actually declining, based on the reporter’s channel checks.

Timing the Short - Auditors

There is much more evidence but suffice to say that the fraud case is very clear. The only question here is timing the short.

Luckily, I believe it is extremely likely that BDO HK, the company’s auditing firm, will resign before the June 15th 10-K deadline. BDO HK and BDO China have not “covered themselves in glory” this year. They signed 10-Ks for BORN, CMFO, GFRE, HOGS, ONP, and ZSTN in March 2011. Despite this embarrassing performance, I believe that BDO will, in the end, act rationally. BDO is one of the largest auditors in the world outside the big 4, and faces substantial legal and reputational risk. Also, the environment has changed significantly since March. The space is now under a microscope by the SEC and the mainstream media. CHBT is such a blatant fraud, that a clean opinion would be difficult to justify.

16 Chinese stocks are currently halted, not including those that were later delisted. Especially important, Deloitte resigned CCME and LFT; E&Y resigned CAGC; and KPMG resigned CBEH, even after signing for CBEH and YONG in March. I believe that BDO will follow the lead of the big 4 here. BDO China did resign the NIV account on May 14, 2011, which I take as a sign that the tide has finally turned. (note: NIV is under SEC investigation)

I have learned that BDO HK will not be taking any new RTO clients going forward, and I suspect that they will be looking to distance themselves from their existing business. They've publicly acknowledged that the status quo is unsustainable, so why would they continue to sign off, especially on a fraud as blatant as CHBT? That just seems like it would be asking for a lawsuit. One piece of disconfirmatory evidence is that BDO is continuing to audit ONP, another RTO fraud. So, while I think a resignation here is likely, it’s not definite.

Timing the Short - Management

I don’t get to a 75% chance of resignation based on an analysis of BDO’s incentives alone. I also would like to look at what management is doing here.

Which brings me back to the strange case of Richard Azar, who (according to SEC filings) purchased 4 million shares of CHBT, or approximately half of the reported float, since May 12. This story is full of holes, some of which were reported in Rick Pearson’s article on thestreet.com.

http://www.thestreet.com/story/11127326/1/china-stocks-who-is-richard-azar.html?cm_ven=RSSFeed

It seems clear to me that a stock does not drop by 36% when someone purchases 50% of the float. Rather, a stock would drop massively if someone SELLS 50% of the float. I believe that is exactly what is happening here. I can’t prove the exact mechanics, but it could look something like this: CHBT’s Chairman sold shares to Azar at a large discount to market, which Azar promptly hedged by selling shares short in another account or purchasing puts. This is hypothetical but extremely likely based on a filing from two days ago.

On May 31, 2011, CHBT’s CEO filed a Form 4/A disclosing that the he no longer owns 4 million shares which he had previously owned through his wife. The amendment also deletes a disclosure of 5 million shares direct ownership. If accurate, this means the CEO sold his entire stake of 9 million shares, or 41% of the shares outstanding.

January 19 original Form 4:

1. Title of Security (Instr. 3)

2. Transaction Date (Month/Day/Year)

2A. Deemed Execution Date, if any (Month/Day/Year)

3. Transaction Code (Instr. 8)

4. Securities Acquired (A) or Disposed Of (D) (Instr. 3, 4 and 5)

5. Amount of Securities Beneficially Owned Following Reported Transaction(s) (Instr. 3 and 4)

6. Ownership Form: Direct (D) or Indirect (I) (Instr. 4)

7. Nature of Indirect Beneficial Ownership (Instr. 4)

Code

V

Amount

(A) or (D)

Price

Common Stock

 

 

 

 

 

 

 

5,084,037

D

 

Common Stock

 

 

 

 

 

 

 

3,979,993

I

By Spouse

 

May 31 amended Form 4:

Table I - Non-Derivative Securities Acquired, Disposed of, or Beneficially Owned

 

1. Title of Security (Instr. 3)

2. Transaction Date (Month/Day/Year)

2A. Deemed Execution Date, if any (Month/Day/Year)

3. Transaction Code (Instr. 8)

4. Securities Acquired (A) or Disposed Of (D) (Instr. 3, 4 and 5)

5. Amount of Securities Beneficially Owned Following Reported Transaction(s) (Instr. 3 and 4)

6. Ownership Form: Direct (D) or Indirect (I) (Instr. 4)

7. Nature of Indirect Beneficial Ownership (Instr. 4)

Code

V

Amount

(A) or (D)

Price

Common Stock (1)

 

 

 

 

 

 

 

3,979,993 (1)

I (1)

By Spouse(1)

Explanation of Responses:

 

1. This Form 4 is being amended to delete the Reporting Person's indirect beneficial ownership disclosed in Table I. The Reporting Person is no longer an indirect beneficial owner of the reported securities. In addition, this Form 4 is being amended to correct the exercise price and the expiration date of the options reported in Table II, which, due to an error, were initially disclosed as $14.81 and 1/16/21, respectively.

 

                         

Management went to significant lengths to bury the stock sales and disclosure. In conjunction with the Form 4/A releases, they released an 8-K indicating that options were being repriced. If not read carefully, the Form 4/As could just look like an amendment to disclose the options repricing. They also, it appears, engineered a sham transaction with Richard Azar to create the appearance of a massive buyer.

Management is dumping shares. And the reason is that they also believe that BDO will resign. They are spending time covering up a stock sale instead of trying to fool BDO. Assuming the filing is accurate, the CEO is out and no longer has much incentive to try to fool BDO.

Execution

If BDO resigns, Nasdaq will halt the stock before June options expiration. You can then exercise and hold a short position to be closed when the stock reopens much lower (I would estimate around $2-$3).

The June put options are likely to be a good bet. I was able to purchase June $5s this morning at $0.80 and June $6s at $1.20. The November options would also work—by November, the stock price will have had a few months to absorb the news, and offer some (not much) downside protection if BDO doesn’t resign.

For those who find this to be too much excitement, the 2013 Jan $5 puts have been offered in recent days in the mid $2s, though liquidity is intermittent. The odds of this fraudulent company surviving 2 audit cycles is roughly zero, given that the SEC’s response to the Chinese reverse merger scandal is likely to include assurance measures tied to FY11 audit.

Disclaimer: The author and contributors to this report are short CHBT. We may increase or reduce our short position in the future without disclosure. This report is provided for informational purposes only, and does not constitute investment advice. Investing in securities involves a high degree of risk, and should only be undertaken by (or with the advice of) investment professionals.

 

Catalyst

BDO resignation by mid-June
    sort by   Expand   New

    Description

    [ This is a low-liquidity idea, please skip if this is an issue ]

    China-Biotics, Inc.

    Have you ever seen a stock decline 36% during a two-week period in which a single investor accumulated 50% of the float? This is what has purportedly happened in the case of China-Biotics (Nasdaq:CHBT) from May 12, 2011 through May 27, 2011. While this piece of information standing taken at face value would be extremely puzzling, the skeptic’s interpretation makes a lot of sense: I believe this is not a real transaction, and in fact that the CEO sold his entire stake of 9 million shares (approximately $80 million at the average market price during this period) through intermediaries.

    I propose shorting CHBT via put options. CHBT is another Chinese reverse merger company that is clearly a fraud. I believe that this trade offers 2.5:1 upside:downside with a 75% chance of success.

    Fake Revenues, Fake Stores, Fake Customers

    In its SEC filings, CHBT claimed 2009 revenue of USD 71 million, while in its Chinese (SAIC) filings, its 2009 revenue was a mere USD 500k. Much has been said about the SAICs, but history has proven them to be extremely accurate and I view them as the best measure of the "degree of fraud". By this measure, CHBT is nearly 100% fraudulent.

    In August 2010, Citron Research questioned the existence of the company’s retail outlets. CHBT responded with a list of addresses. Citron and Kerrisdale Capital then took pictures at these addresses to prove that the retail outlets were nonexistent. In its 10-Q for the quarter ended September 30, the company claimed to have suddenly closed 95 (out of 103 total) retail outlets in the month of September. At the same time, they reported an increase in revenues and met guidance.

    A major Chinese publication, First Financial Daily, interviewed three major Chinese dairy manufacturers and all of them denied having a relationship with CHBT. CHBT claims to sell products to Bright Dairy, but that company has stated that they do not know CHBT. It is unlikely that CHBT has any substantial bulk customers. The same article indicated that CHBT’s business in supermarkets is not only much smaller than represented, but actually declining, based on the reporter’s channel checks.

    Timing the Short - Auditors

    There is much more evidence but suffice to say that the fraud case is very clear. The only question here is timing the short.

    Luckily, I believe it is extremely likely that BDO HK, the company’s auditing firm, will resign before the June 15th 10-K deadline. BDO HK and BDO China have not “covered themselves in glory” this year. They signed 10-Ks for BORN, CMFO, GFRE, HOGS, ONP, and ZSTN in March 2011. Despite this embarrassing performance, I believe that BDO will, in the end, act rationally. BDO is one of the largest auditors in the world outside the big 4, and faces substantial legal and reputational risk. Also, the environment has changed significantly since March. The space is now under a microscope by the SEC and the mainstream media. CHBT is such a blatant fraud, that a clean opinion would be difficult to justify.

    16 Chinese stocks are currently halted, not including those that were later delisted. Especially important, Deloitte resigned CCME and LFT; E&Y resigned CAGC; and KPMG resigned CBEH, even after signing for CBEH and YONG in March. I believe that BDO will follow the lead of the big 4 here. BDO China did resign the NIV account on May 14, 2011, which I take as a sign that the tide has finally turned. (note: NIV is under SEC investigation)

    I have learned that BDO HK will not be taking any new RTO clients going forward, and I suspect that they will be looking to distance themselves from their existing business. They've publicly acknowledged that the status quo is unsustainable, so why would they continue to sign off, especially on a fraud as blatant as CHBT? That just seems like it would be asking for a lawsuit. One piece of disconfirmatory evidence is that BDO is continuing to audit ONP, another RTO fraud. So, while I think a resignation here is likely, it’s not definite.

    Timing the Short - Management

    I don’t get to a 75% chance of resignation based on an analysis of BDO’s incentives alone. I also would like to look at what management is doing here.

    Which brings me back to the strange case of Richard Azar, who (according to SEC filings) purchased 4 million shares of CHBT, or approximately half of the reported float, since May 12. This story is full of holes, some of which were reported in Rick Pearson’s article on thestreet.com.

    http://www.thestreet.com/story/11127326/1/china-stocks-who-is-richard-azar.html?cm_ven=RSSFeed

    It seems clear to me that a stock does not drop by 36% when someone purchases 50% of the float. Rather, a stock would drop massively if someone SELLS 50% of the float. I believe that is exactly what is happening here. I can’t prove the exact mechanics, but it could look something like this: CHBT’s Chairman sold shares to Azar at a large discount to market, which Azar promptly hedged by selling shares short in another account or purchasing puts. This is hypothetical but extremely likely based on a filing from two days ago.

    On May 31, 2011, CHBT’s CEO filed a Form 4/A disclosing that the he no longer owns 4 million shares which he had previously owned through his wife. The amendment also deletes a disclosure of 5 million shares direct ownership. If accurate, this means the CEO sold his entire stake of 9 million shares, or 41% of the shares outstanding.

    January 19 original Form 4:

    1. Title of Security (Instr. 3)

    2. Transaction Date (Month/Day/Year)

    2A. Deemed Execution Date, if any (Month/Day/Year)

    3. Transaction Code (Instr. 8)

    4. Securities Acquired (A) or Disposed Of (D) (Instr. 3, 4 and 5)

    5. Amount of Securities Beneficially Owned Following Reported Transaction(s) (Instr. 3 and 4)

    6. Ownership Form: Direct (D) or Indirect (I) (Instr. 4)

    7. Nature of Indirect Beneficial Ownership (Instr. 4)

    Code

    V

    Amount

    (A) or (D)

    Price

    Common Stock

     

     

     

     

     

     

     

    5,084,037

    D

     

    Common Stock

     

     

     

     

     

     

     

    3,979,993

    I

    By Spouse

     

    May 31 amended Form 4:

    Table I - Non-Derivative Securities Acquired, Disposed of, or Beneficially Owned

     

    1. Title of Security (Instr. 3)

    2. Transaction Date (Month/Day/Year)

    2A. Deemed Execution Date, if any (Month/Day/Year)

    3. Transaction Code (Instr. 8)

    4. Securities Acquired (A) or Disposed Of (D) (Instr. 3, 4 and 5)

    5. Amount of Securities Beneficially Owned Following Reported Transaction(s) (Instr. 3 and 4)

    6. Ownership Form: Direct (D) or Indirect (I) (Instr. 4)

    7. Nature of Indirect Beneficial Ownership (Instr. 4)

    Code

    V

    Amount

    (A) or (D)

    Price

    Common Stock (1)

     

     

     

     

     

     

     

    3,979,993 (1)

    I (1)

    By Spouse(1)

    Explanation of Responses:

     

    1. This Form 4 is being amended to delete the Reporting Person's indirect beneficial ownership disclosed in Table I. The Reporting Person is no longer an indirect beneficial owner of the reported securities. In addition, this Form 4 is being amended to correct the exercise price and the expiration date of the options reported in Table II, which, due to an error, were initially disclosed as $14.81 and 1/16/21, respectively.

     

                             

    Management went to significant lengths to bury the stock sales and disclosure. In conjunction with the Form 4/A releases, they released an 8-K indicating that options were being repriced. If not read carefully, the Form 4/As could just look like an amendment to disclose the options repricing. They also, it appears, engineered a sham transaction with Richard Azar to create the appearance of a massive buyer.

    Management is dumping shares. And the reason is that they also believe that BDO will resign. They are spending time covering up a stock sale instead of trying to fool BDO. Assuming the filing is accurate, the CEO is out and no longer has much incentive to try to fool BDO.

    Execution

    If BDO resigns, Nasdaq will halt the stock before June options expiration. You can then exercise and hold a short position to be closed when the stock reopens much lower (I would estimate around $2-$3).

    The June put options are likely to be a good bet. I was able to purchase June $5s this morning at $0.80 and June $6s at $1.20. The November options would also work—by November, the stock price will have had a few months to absorb the news, and offer some (not much) downside protection if BDO doesn’t resign.

    For those who find this to be too much excitement, the 2013 Jan $5 puts have been offered in recent days in the mid $2s, though liquidity is intermittent. The odds of this fraudulent company surviving 2 audit cycles is roughly zero, given that the SEC’s response to the Chinese reverse merger scandal is likely to include assurance measures tied to FY11 audit.

    Disclaimer: The author and contributors to this report are short CHBT. We may increase or reduce our short position in the future without disclosure. This report is provided for informational purposes only, and does not constitute investment advice. Investing in securities involves a high degree of risk, and should only be undertaken by (or with the advice of) investment professionals.

     

    Catalyst

    BDO resignation by mid-June

    Messages


    SubjectWho is the ultimate loser?
    Entry06/02/2011 02:16 PM
    Membertyler939
    I have not done any research on this situation, but it reminds me a little of Genesisintermedia (due solely to thelarge buyer).  For those of you unfamiliar with this company (this goes back a while, and I am doing this from memory, so forgive me if I get some of the details wrong), this was an absurdly valued "internet" company controlled by associates of international arms dealer Adnan Khashoggi.  They bought the bulk of the float, loaned it out through varios brokers, and had accomplices inside the stock loan departments who released funds in return for the loan of shares.  They kept buying stock and loaning it out.  After 9/11, they couldn't keep up the scheme and the stock collapsed.

    SubjectRTO?
    Entry06/02/2011 03:36 PM
    Memberwan161
    Great write-up.  Can't wait for the yogurt to hit the fan. 
    Excuse my ignorance, but what does "RTO" stand for?
     
    Also, the FY ends March 31.  Why wouldn't the 10K be due June 30th instead of June 15th, as you state?  I believe 10-Ks are due 90 days after the FYE.
     
    Also curious if you've spoken to the one sell-side analyst who covers this stock (who cut it to sell yesterday, coincidentally)?  His name is Yale Jen at Maxim Group.  Has he visited any of the imaginary facilities?
     
    Thanks

    SubjectSAIC
    Entry06/02/2011 03:52 PM
    Memberwan161
    Hi, another questions please - how/where did you access the SAIC filings on CHBT and are they availablein English?  I've tried searching around some sites I found using google, but there wasn't much that seemed useful.  Do Chinese companies make public filings at the SAIC like companies in the USA make filings with the SEC?  Are those filings only in Chinese?  Do you have any links you could share?
     
    Again, great write-up.  Fascinating stuff.

    SubjectRE: SAIC
    Entry06/02/2011 04:07 PM
    Memberurban
    You typically have to go through a credit agency such as Qingdao who will send a lawyer to the AIC office. The charge for this service is around 2,000 RMB.
     
    However, in the case of CHBT, Kerrisdale and others released the SAICs publicly.
     
    http://chinesecompanyanalyst.files.wordpress.com/2010/08/chbt-aic-filings-in-english-translated2.pdf

    SubjectRE: BDOWatch
    Entry06/06/2011 09:41 AM
    Memberspecialk992
    A very similar website titled "Deloittewatch" popped up right before Deloitte resigned on CCME.

    Subjectvaluation
    Entry06/07/2011 01:02 PM
    Memberbafana901
    You can then exercise and hold a short position to be closed when the stock reopens much lower (I would estimate around $2-$3).
    In most cases the Chinese fraud stock fall below $1. Why do you pick $2-$3 ? Thanks

    Subjectresignation
    Entry06/07/2011 04:12 PM
    Memberbafana901
    I worked for one of the big 4 audit firms in three countries, not China. In my experience resignations are not a last minute decision. Generally if there is a whiff that the audit threatens your reputation one tends to resign asap. Given the evidence it seems that BDO's decision is easy so why the delay? Have the other RTO resignations also been last minute?

    SubjectRE: resignation
    Entry06/07/2011 04:28 PM
    Membermajic06
    "I worked for one of the big 4 audit firms in three countries, not China. In my experience resignations are not a last minute decision. Generally if there is a whiff that the audit threatens your reputation one tends to resign asap. Given the evidence it seems that BDO's decision is easy so why the delay? Have the other RTO resignations also been last minute?"
     
    Yes.   No idea why, but yes - usually.  
     

    SubjectRE: Rally
    Entry06/08/2011 01:13 PM
    Memberurban
    I don't know what caused the price movement, it could be a coincidence or it could be news leaking. I will note that CCME and SNOFF are both up 20% also. Call volumes are also low and concentrated in the ITM strikes. The other BDO companies have not rallied and in fact a couple are down big.

    SubjectRE: RE: Rally
    Entry06/08/2011 02:37 PM
    Member4maps
    Well, I don't know it it's related but last night (I think it was after market close but not sure) the SEC suspended trading on 17 stocks and CHBT wasn't among them. Maybe some see it as time to close their shorts (no Congressman Weiner jokes please) before these get suspended too? I sure wouldn't want to be paying the short rental during a shutdown.
     
    http://sec.gov/news/press/2011/2011-120.htm 

    SubjectRE: Sino Forest and Wellington, Thoughts?
    Entry07/05/2011 06:58 PM
    Membertyler939
    Casper, fwiw, interactive brokers has a 500K+ short position that had to be covered yesterday, fyi. (which they did around the 1.790 level).
      Back to top