|Shares Out. (in M):||24||P/E||13.9x||0.0x|
|Market Cap (in M):||294||P/FCF||0.0x||0.0x|
|Net Debt (in M):||-58||EBIT||24||0|
We recommend a short position in China Green Agriculture Inc (CGA-NYSE). We believe CGA is a fraudulent company that went public only for the purpose of raising and stealing large amounts of funds from investors. CGA operates in an industry with nearly no barrier to entry and sells a highly commoditized product but reports unusually fat margins compared to its competitors. In our opinion, the company was selling hot concepts, i.e. organic fertilizer, ag stocks and China (just like the way the company’s being named), to naïve US investors who have little knowledge about China. The stock was up again over the last couple of days on bogus rumor/speculation of an extremely remote possibility of takeover as a result of the talks of BHP/Potash bid. Much of this write up was based on the findings of excellent 3rd party research report detailing volumes of evidence of CGA’s overstated revenue/earnings, inconsistent financial statements and the stealing of investors’ money through a land acquisition. We believe several recent events will likely accelerate the collapse of the scam, similar to the earlier collapses of several other reverse merger frauds.
CGA went public in the US through a reverse merger into a shell company in Dec 2007. Simultaneous with the reverse merger, it raised $20.5MM through a private placement from a group of accredit investors, the majority of which have exited the stock a while ago. CGA subsequently raised $28.8MM and $20MM in July and Nov 2009 in two rounds of secondary offerings underwritten by Roth Capital and Rodman & Renshaw.
Through its operating subsidiaries in China, CGA primarily sells humic acid based fertilizers. The company’s latest guidance is for 2010 revenue in the range of $50.6-51.2MM and net income of $21.1-21.4MM. CGA reports a fat operating margin of close to 50% and 64% gross margin on its “high-tech” fertilizer products, which dwarfs anyone else in the same industry. The publicly stated goal of management is to grow revenue to $750MM in 3-5 years, requiring an annual CAGR of at least 70%. Of course, this is China so some people believe anything is “possible”. To fund its ambitious growth plan, CGA recently filed an S-3 with SEC registering $200MM worth of securities to be issued. The sell side analysts are of course very bullish on the stock in order for their own banks to get a lucrative piece of this investment banking businesses.
Recently, we ran across a research report by written by a chinese 3rd party due diligence outfit, providing high quality analysis and a large amount of evidence pointing to a strong possibility of CGA defrauding investors. Our local team has reviewed the report and its various supporting documents and believe these are real, credible sources that are primarily based on local government documents in China, stamped and certified by the government and the company itself. A link to the report is here. We suggest you take a look at the information in there along with the a few comments we have below.
Reasons we believe CGA is a fraud:
1. VAT Payable (Value-Added Taxes) in financial statements looks fishy.
A little background on VATs: A form of consumption taxes that exists in many countries outside of the US. It is similar but not the same as a sales tax, as it’s calculated primarily based on the value-added to a product/service in the process of manufacturing and distribution. In China, a VAT rate of 13-17% are levied on the sales price of products and, separately, companies are allowed to take deductions on its purchase of certain raw materials, services and equipments at a rate no more than 17%. A VAT rate of 13% applies to fertilizer products sold by CGA. Practically, given the deductions allowed to take, the amount of VAT as a % of fertilizer revenues should be a blended rate in a range of mid-high single digit %. It’s worth pointing out, VATs are accrued and paid on a monthly basis with very little chance of getting an extension. The understanding of our local team is VAT represents the largest category of the Chinese government’s taxation income (over 30%) and is one of the most strictly collected taxes by the tax authority. Local governments don’t have jurisdiction on VATs and have no ability to grant any extension on the payments.
The reason we went all the way to explain the basics behind VAT tax calculation is we believe the VAT payable balances disclosed in CGA’s financial statements do not make any sense at all and indicate its reported revenues are probably inflated. The findings by the research report have basically confirmed our thesis. For example, CGA reported a massive VAT Payable $5,476,791 as of September 30 2008. What does this mean? In the most optimistic scenario in which CGA has no deduction from its COGS, $5.5MM of VAT must have been accrued based on fertilizer revenues of $42MM (5.5/13% = 42). Bear in mind that VATs are paid off monthly, so this $5.5MM VAT payable must have been accrued on revenues over the past month. Therefore, the financials suggest CGA must have had $42MM fertilizer sales over a very short period of time (past 1-3 months). However, this implied $42MM revenue is higher than the $28.9MM fertilizer revenue CGA reported in that fiscal year. Remember, our assumption of CGA having no deduction against its VAT calculated on fertilizer sales? Realistically, CGA must have raw material and equipment purchases that can be deducted for VAT calculation, so the true sales that generated the $5.5MM VAT payable balance must be a lot higher than $42MM (conservatively $5.5MM VAT based on a 10% blended rate = $55MM). In summary, we question how such large VAT balances could exist! These publicly available data sources alone can support our fraud thesis.
Our conclusion is further enhanced by the 3rd party research report’s findings that sales of organic fertilizers, a vast majority of CGA’s fertilizer, are exempted from payment of VAT since June 1, 2008 (confirmed by our own checks). So how is it possible that CGA kept reporting such large amount of VAT payables and its financials showed the balances are regularly paid off? In fact, the records obtained by the authors of the research report from local tax authorities in China showed little VAT payment over the past 2 years. There has been some discussion and confusion about the reliability of the information from filings of various Chinese government agencies (such as the SAIC). We agreed on the report’s assessment that records from the tax authority in China, the Chinese State Administration of Taxation (SAT), is the most reliable source since its functions are essentially identical to the IRS in the US. The tax collector in China is not any less serious than the one United States.
There’re several possible implications from the above analysis of the unusually large VAT amounts:
2. $8MM of shareholders’ money have probably been stolen through an inflated land purchase price.
CGA’s own excuse for their lack of free cash flow this year was the $10.8MM spent acquiring an 88 acres land for its new R&D facility (basically a bunch of greenhouses). We’re going to be very brief in this part as the research report has detailed the background and large amount of evidence, proving that the actual cost of the land was only $2.5MM based on various local government documents. We have our local analysts reviewed all documentations presented and believe those are indeed authentic records, stamped and signed by a number of different government agencies such Ministry of land & resources, local treasury and taxation collection office.
3.Multiple other red flags
a) Aggressive accounting practice – large disconnect between reported earnings and cash flow and most of increases in revenue over the past 2 years ended up in large A/R. Our channel check failed to identify any customers that have significant purchases of CGA products.
b) In addition to the inconsistency between VAT tax records and SEC financial statements, the research reports have also pointed out a number of other alarming things such as record of income taxes and questionable accounting practice of recently acquired subsidiary etc . SAIC records in the 3rd party report clearly show CGA reported much less revenue and income to the Chinese commerce bureau than it does to its U.S. investors in its SEC filings.
c) Auditor – We’re not saying there’s necessarily something wrong with a small, regional auditor such as Kabani & Co. Our experience is small US auditors (even those with US educated, Chinese-speaking staff) typically lack of necessary local knowledge and working experience to detect a lot of the tricks used by the local management to manipulate its books. Kabani did have a questionable history of auditing a number of Chinese small cap companies. One prior client of Kabani was Bodisen Biotech (BBCZ.OB), which was delisted to pink sheets, attacked by various class action lawsuits alleging frauds and only miraculously made back to OTCBB recently. The interesting thing noted by the research report is Bodisen was also in the organic fertilizer business and happens to be located in the same city of Xi’an, although we couldn’t find any other connection b/w CGA and Bodisen.
d) Management – The Chairman/CEO Tao Li also owns a number of unrelated businesses and seems to lack focus on CGA. One other company of his that was taken public by Roth Capital earlier this year was a total joke and its share price collapsed (KONE-NASDAQ). Li also has a history of selling CGA shares to fund his other ventures. Current CFO Ken Ren is a new hire at the company. Our experience with him can be summarized as a bit disappointing, as he didn’t appear to be knowledgeable and experienced enough to be the CFO of an NYSE listed company. He wasn’t sure about the answers to a lot of China related questions such as VAT, Chinese fertilizer industry. It appears to us that his main function at CGA is an IR spokesperson, although our impression is that he was probably an honest person and a young man who was out from college not too long ago, w/o much knowledge of what he’s walking into by taking this job.
We believe two recent events are likely to accelerate the collapse of this scam:
Since this is a fraudulent company, they can report whatever outrageously numbers whenever they want (if the auditor keeps failing like it did before).
We’d like to end the write up with a comment by Buffett and Munger on Freddie and Fannie – when someone tells you they can maintaining a 15% CAGR growth in earnings no matter what, they’re playing accounting tricks to you. What happens when someone tells you they can maintain a 70% CAGR in earnings?
|Subject||RE: How is this different than CEU?|
|Entry||08/26/2010 04:37 AM|
Thanks for the comment. I apologize for the delayed response as I'm actual out of the country on vacation. Regarding those supporting documentations, I'd like to point out that we did not actual collect those materials. I was simply pointing out our local team and other Chinese speaking friends thought those documents look very real, because most are stamped by the governments, and some are even stamped and signed by the company itself.
I've had quite a few inquiries about our previous ideas TPI and CEU, asking what kind of checks we have done. For CEU, our confidence came from the endorsement a friend of ours who was among the earlier PIPE investor in the CEU. We trust their DD and, as I understood, they had access to some internal materials from the company. It was also one of the few OTCBB stocks we invested in that has acutally worked out well. For TPI, we are among the first round private placement investors ourselves. The works we did include reference calls with customers, suppliers and verified their factory's capacity is consistent with the volume they claimed.
With regard to the auditor issue, what I actually meant to say is it's hard to judge the legitimacy of a company just based on the auditors they choose to hire. As I pointed out, there's nothing necessarily wrong with a small auditor like Kabani and, in fact, I have 2-3 names that audited by one of the big 4 but are still potentially frauds. My impression has always been even the best auditors don't catch very well conceived frauds.
All reverse merger stocks are trading at a discount to their IPO-ed peers for the implied risk about possible fraud and weak governance issues. I even doubt a lot of investors can tell the differences b/w a reverse merger and traditionally IPO-ed stocks. If you don't know which companies' reported numbers you can trust, you probably figured it's best to remove this whole group from my selection universe. This is why I agreed with rjm59's assessment that there's actually opportunity to pick up some real, good ones at cheap prices, given how contrarian the whole Chinese small cap group is.
|Subject||RE: cannot locate a borrow|
|Entry||08/26/2010 04:38 AM|
Hi specialk992, check your email.
|Entry||08/26/2010 03:45 PM|
have you asked management about the "inflated land purchase"..thanks
|Subject||Update, Barron's and oliver1216's question|
|Entry||08/30/2010 03:56 AM|
First of all, I apologize for the typos in this write up and it was completed over night in a rush. As I understand, the short interest in CGA has spiked over the past a few days, so people looking to open a new short pos are looking at 120-140%+ annualized interest to borrow.
There's a huge article that trashes everyone in the RTO game by the Barron's over the weekend, detailing the background, performance history and some great facts about several Chinese RTO stocks, including CGA and its association with a known, convicted stock promoter. This is an excellent piece and huge negative publicity for every stock mentioned in it, although I don't necessarily agree with all points made by the authors.
There's one little confusion that the Barron's article had about the difference between two Chinese government entities, SAIC and SAT. The article quoted CGA Chairman/CEO Li saying "Legitimate reasons exist for why [China's State Administration for Industry and Commerce's] reported financial statements do not match those numbers filed with the SEC.". We'd like to point out that the State Administration for Industry and Commerce (SAIC) is just like the Commerce Department in the US, the financial information and records held by it was not reviewed or audited by the government so can be unreliable at times. However, the findings 3rd party research report was based primarily on is the tax records from the Chinese State Administration of Taxation (SAT), the equivalent of the IRS in the US. I don't think I need to explain why info filed to the tax authority can't be faked. So I think the evidence of fraud is quite strong here. The Barron's article incorrectly stated the revenues reported in SAIC filing as "in its tax filings in Xi'an it reported less than $8 million."
Link to the article:
Regarding the purported "inflated land purchase price", I think the research report has collected the strongest, most extensive supporting documents to back up its investigation. Some of the documents are even stamped and signed directly by CGA's subsidiary. To answer oliver1216's quesiton, we have not asked mgmt about this for a number of reasons I don't want to discuss publicly here (I'm happy to discuss with anyone in private if you can leave me your email). Judging from the lack of response from the mgmt so far, here's the list of events I expect to see (listed by their likelihood of happening):
1. CGA will keep ignoring the accusation and pretend such things don't exist (we've seen this happening with other RTO frauds before).
2. If asked about these issues, CGA will surely attack the credibility of the anonymous 3rd party research while not being able to provide any meaningful counter arguments against the questions raised by the report. The IR and promoters of the company will also cite the "massive amount" of due diligence done by CGA's "reputable" investment bankers, investors and other supporters. Without giving you a valid answer to any of the questions, they will ask "who should you trust"? This is a typical tactic used by several other Chinese RTOs to respond to allegations of fraud.
3. This possibility is remote but we looked into it and thought it could actually happen. Given CGA's influence over local government entities in a small place such as the county in which the land was purchased, they may actually be able to have the original records of land purchases amended and publish renewed copies of the documents from the local Land & Resources Bureau. Same thing could be done to the SAIC filings (check out the history of ONP, LIWA). The only thing we're confident that CGA will not be manipulate is the records at SAT, since VAT regulations/collections are under national government jurisdiction.
|Entry||10/02/2010 11:29 AM|
A lot of long holders of numerous US-listed Chinese companies have begun moving their holdings into cash accounts, making them unavailable for their brokers to loan out. I don't know a thing about CGA, and have no opinion on the short thesis, but there is a pervasive feeling that a lot of aggressive short sellers have begun manipulating these stocks by establishing positions, often through options, and then publicly releasing inflammatory reports, often just prior to option expiration. Clearly, there have been a number frauds uncovered in the US-listed Chinese space, but the short thesis on some of those subject to attack has been questionable in a number of cases as well, and there is a spreading feeling that many legitimate players are suffering badly from guilt by association.
Only time will tell who is right and who is wrong, but there is definitely a growing movement to more aggressively attack the short side, and part of that has been the movement to put shares in the cash accounts. The Chinese management teams, who are admittedly generally not very savvy from the standpoint of capital markets activity, have been learning pretty quickly.
|Subject||RE: RE: Update|
|Entry||10/03/2010 05:57 AM|
I appreciate the thoughts and comments. Before we move too far, I'd like to point out the importance of make a clear distinction from most of the legitimate Chinese companies that went public through an IPO and the ones that came to US public markets through a "backdoor", i.e. SPAC, reverse merger. It is the latter group our discussion will be focusing on, because I haven't seen any short seller attacks alleging fraud on SINA, JOBS, EDU, SOHU, SPRD, NTES, VISN etc, except recommendations to go short based on valuation and fundamentals. As a suggestion for the Chinese mgmt teams mentioned by you that were "learning pretty quickly", I'd like to borrow a few excellent comments on the debate over the reverse merger Chinese stocks from specialk992 on Seeking Alpha here at: http://seekingalpha.com/article/223704/comments
What would prove these companies aren't fraudulent? Any number of things:
1. Successfully suing one of the short sellers
2. Paying a substantial cash dividend
3. Buying back a substantial amount of shares, preferably with debt lent by a bank that did heavy due diligence (not a small portion of a PIPE they just did at a much higher price)
4. Being acquired by another firm for cash (not shares in another Chinese reverse merger)
Until any of those happen I will be highly skeptical that the short sellers are wrong
Here're my comments, additions to the above 4 points and the reason I think all these RTO/SPAC chinese stocks will always trade at a dismal valuation,
1. Successfully suing one of the short sellers - So far I haven't seen any one company launching a lawsuit against a short sellers that has published a "inflammatory" report. My guesses are none of these companies wants to or is able to be subject to the negative publicity of such debate, for one thing, their future need to raise capital from investors. Most companies have been intentionally invasive in face of such issues and will not publicly respond with a PR unless they absolutely have to (with a substantial drop in stock price). ONP was the most aggressive defender of the short seller attack I've seen, and it doesn't take a genius to see what's wrong with the company.
2. Paying a substantial cash dividend - I'd like some help of locating a 2nd reverse merger Chinese company that even pays a regular cash dividend. The only one I've seen was TPI, which subsequently discontinued the payout.
3. Buying back a substantial amount of shares, preferably with debt lent by a bank that did heavy due diligence (not a small portion of a PIPE they just did at a much higher price) - Given the massive amount of cash a lot of these US listed Chinese companies have on their B/S, incredible growth prospects and low valuation (depressingly low by US standards), I don't see any reason why the insiders of such companies don't aggressively buy back the float. Even better, do it through a dutch auction with a term loan from a local bank, not some working capital LOC. Funny most of the buyback happened in the space so far were heavy storm clouds without much drop of actual rain. I'd like to see mgmt of a RTO company stating they have bought back 5, 10, 20% of shares at x price along with their earnings report, not a stand alone publicity type of PR announcing some large amount of buyback authorization then following on to explain all the "restrictions" they have in terms of the amount of shares to buy.
4. Being acquired by another firm for cash (not shares in another Chinese reverse merger) - My argument here is for a company with legitimate operations and smart insiders who care about their own equity, it is impossible for them not to be speaking with a number of buyout funds if their stocks are trading at 6-7x multiple of earnings. This is where I can confidently say it's NEVER going to happen, especially for those reverse mergers happened after the release of new "M&A" rule by Chinese government in September 2006. I'd suggest an investor with a takeover thesis to speak with any conservative lawyers representing a buyout fund. Most RTOs (not all) happened after that regulation are essentially bending such M&A rules, and a lot of large investors, corporate buyers typically do not acknowledge the validity of their convoluted legal structure. On the other hand, given the weak corporate governance and a BOD established merely to meet listing requirement, do you think they will really act in your best interest in case of a takeover? For those who think I'm exaggerating, please research the history of SNEN. For the investors whose thesis don't include a takeover, the effect on your investment is the RTO companies will almost always trade at a discount to the market. When I look at long investments in RTO stocks, a target multiple of 8-10x EPS/FCF is the most I'll give to them.
5. I personally would like to add the following from what I'm seeing from my own standpoint.
It's amazing to see the vast difference between what some of the long holders believe (in the ivory tower) and what we're seeing in the ground. It is simply amazing some investors who have visited China only a couple times would step out and defend a possibly fraudulent on the record with their names/reputation at stake. I've seen investors raising money for funds in the sizes of $40-50M only to invest in US listed Chinese companies, and yet don't even have any knowledge/understanding of the basics of things such as VIE legal structure. They thought I was scaring them when I told them their investment in a company with improper legal structure could become a piece of paper to nothing. For those who believe in the fault of short sellers manipulation, I'd suggest them move to China and live there for 5-10 years (even better, trying to start a business here). I believe your views would be much different after those years, regardless of being successful or burned there. For example, most people from the papermaking business to whom I've shown the Muddy Waters report believed the company is a total fraud, yet there're still investors in US defending the company to death (both institutions and retail). We have a enthusiastic crowd here in the US supporting CCME. The first time I mentioned the CCME business to two of our China-based analysts, both of them immediately thought it was a joke because they didn't think the inter-city bus routes reach a audience base attractive enough to sell that kind of volume. It's not the fault of any smart US analyst who hasn't done enough analysis, you just have to spend enough time in China to figure that out. For the recently exposed CHBT, I don't know the situation well enough to comment, but I'd caution the long holders think twice before going out to risk your own reputation to defend the company, because you don't enjoy the same kind of anonymity like most of the short sellers. A lot of I spoke with people within Chinese investment community believed CGA is a joke and rumors floating around saying the Chairman was so proudly bragging him being able to deceive "stupid" US bankers and investors, while we still have people in the US who strongly believe it's a the best ag play for the decade. I was once asked by someone was it really possible CGA was not defrauding investors but merely not paying their taxes in China? No, because the legal consequence for a Chinese boss not paying taxes is much much more severe than defrauding US investors.
The most damage of having these fraudulent RTO companies is the depressed valuation received by good, legitimate Chinese smal companies. Yes, we do hold shares in a number of RTO stocks, which we believe to be real. The other frustrating thing happens when you're trying to talk to mgmt/shareholders of a legitimate private Chinese companies into doing a pre-ipo or PIPE and going public in the US, you normally hear they question why they want to go public in a market where their equities get only 6-7x PE?
I agree only time will tell who is right and who is wrong.
|Subject||RE: RE: RE: Update|
|Entry||10/03/2010 10:09 AM|
All good points, and I appreciate the detailed response. From a valuation perspective, I think the biggest valuation overhang on many of these companies is the VIE issue. The "contractual arrangements" have always concerned me, given that I'm no expert in Chinese law and have always had some difficulty understanding what protections investors really have, and whether they would really be legally enforceable w/in the Chinese legal system. Certainly, they first time one of these VIE breaks down to the detriment of US shareholders the whole group will end up in a complete bloodbath.
There are, of course, US-listed Chinese companies that don't employ this structure. TXIC and BWOW come to mind. BWOW, interestingly, converted from a VIE to direct ownership not long ago. I'm not aware of any reverse-merged companies that do not employ the VIE structure, but my knowledge is by no means comprehensive. I do believe that the SPAC route has incrementally more legitimacy than the reverse-merged route.
CCME, in my opinion, will be the most interesting to play out. The per-bus monthly volumes on inter-city of $400 don't strike me as excessive, although I'm admittedly no expert. If they execute on the repurchase it either shows a brazen indifference to the value of their cash or provides some comfort that they're for real. In addition, I think its critical to note that at least one of their "legitimate" publicly-listed competitors who have been claiming that the company can't be real is the same competitor who has lost contracts to CCME.
Anyway, appreciate your thoughts. As I said, my original post wasn't intended to call your CGA thesis into question; merely to provide a bit of market chatter that might help explain why your borrow was called in.
|Subject||RE: Author Exit Recommendation|
|Entry||05/23/2011 11:58 AM|
hxf82, any updated thoughts on this name, given what has been going on since your exit post? Would you recommend reestablishing short positions? Also, reading through the thread you stated the following on a previous post:
"I was once asked by someone was it really possible CGA was not defrauding investors but merely not paying their taxes in China? No, because the legal consequence for a Chinese boss not paying taxes is much much more severe than defrauding US investors."
What exactly are the consequences for defrauding US investors? Are there any (other than bragging rights)?