Telestone Technologies: The Great Wall of Deceit

by The Forensic Factor - 1/25/2011 1:33:05 PM

The Forensic Factor first wrote about Telestone on Jan. 11 in a report entitled “Telestone Technologies – A “RINO” in Sheep’s Clothing.”  In that report, we identified a myriad of concerns that served as the foundation of our request for the NASDAQ to halt trading in Telestone. 

Despite the gravity of the questions we raised, Telestone has failed to address many of our concerns.  Further, an investor update call held on Jan. 24 by Telestone management was replete with incriminating commentary that raised more questions than were answered.  In this brief follow-up (to be supplemented with a much more comprehensive examination of manufacturing relationships and provincial branches), TFF will highlight these troubling issues: 

* A blatant violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 that should provide sufficient ammunition for class-action lawyers and the SEC.

* An accounts receivable balance, and associated DSO level, that defy logic, and arguably GAAP accounting.

* A definitive admission from Telestone management that revenue is indeed being recognized on a percentage-of-completion basis, confirming TFF's suspicion that a restatement is necessary

* Sixteen additional questions that the company failed to address, ranging from: a distributor that was incorporated 15 months AFTER Telestone claims to have started the relationship to an unusual interest-free loan from a related party that represented nearly 50% of the company's cash on Sept. 30 and a history with an entity that appears to have had accounts frozen with large quantities of Telestone stock.

Based on the action of the stock, the investing public appears to have voted with TFF.  This morning, TFF will again ask the NASDAQ to explore the facts in our first article and also examine additional brazen misrepresentations from Telestone's Jan. 24 call.  

Abraham Lincoln once said, "No man has a good enough memory to make a successful liar."  Fortunately for the NASDAQ, the SEC and TFF, a good memory is not required in the age of public filings and recorded conference calls. In our previous write-up, TFF was extremely careful to highlight the facts, opting to leave any fraud declaration to the class-action attorneys and the regulators.  

In addition to the quote above, Lincoln also said, "It is better to remain silent and be thought a fool than to speak out and remove all doubt."  TFF believes that Telestone executives would have been better off remaining silent.  Instead, they spoke out yesterday and essentially sealed the company’s fate as a reverse Chinese merger that stands for everything regulators need to fix to restore confidence in the capital markets. 

On the update call, Telestone management chose NOT to address many of the more heinous issues that we raised in our first article -- a fact that was clearly not lost on the investment community.  Instead, Telestone management chose to wait nearly two full weeks to confront the growing conflagrations that should jeopardize the company’s public listing.  In addition to refusing to address many of our concerns, management also disconnected one investor who appeared to raise valid questions that TFF will recap below.  To top it off, management blatantly misrepresented the circumstances of the auditor changes -- a fact that we believe will be picked up on by many of the class-action firms currently investigating Telestone.

At the 15:20 mark of the call on Jan. 24, Telestone management addressed the juggling auditors -- a major concern raised by TFF in our previous report.  As we highlighted, Telestone had two auditors RESIGN within one year, the second of which was not disclosed until months after the resignation.  

Telestone disclosed that Mazars had resigned on July 13, 2009, in an 8K filing that simply stated: "On July 8, 2009, Mazars CPA Limited resigned as the independent registered public accounting firm for Telestone Technologies Corporation (the “Company”)."  Buried in Telestone's 10K, the company then disclosed auditor resignation number two: “During the Company’s fiscal years ended December 31, 2008 and 2007 and through July 8, 2009, the Company engaged Mazars CPA Limited previously as the independent registered public accounting firm prior the engagement of QC CPA Group, LLC on July 9, 2009 through January 14, 2010. QC CPA Group, LLC performed the interim reviews of the Company’s financial statements for the period ended June 30, 2009 and September 30, 2009.  QC CPA GROUP LLC RESIGNED on January 14, 2010 and the Company engaged Mazars CPA Limited as the Company’s new independent registered public accounting firm on January 18, 2010 to audit the Company’s financial statements for the year ended December 31, 2009.” 

It is the opinion of TFF that management lied and misrepresented the resignations by proclaiming that the auditor changes were in fact voluntary. On the Jan. 24 call, Telestone Vice President of Finance Richard Wu (examined in some detail in our previous report) stated: “In the third quarter of 2009, some of our shareholders recommended that we SWITCH from our long-standing auditor Mazars to a U.S.-based firm called QC CPA Group.  But soon we found out that this new auditor was not as familiar with our business and was treating some of our ordinary receivables as long-term ones.  Due to our high comfort level with our long-time auditor we SWITCHED back to Mazars.”

First, the decision to switch to a U.S.-based audit firm is understandable.  However, the decision to use an unknown firm out of Beaver Creek, Ohio, does not pass the smell test.  

Secondly, this statement by management is fraught with deceit with the clear motive of misleading investors. The decision to switch auditors was not benign and voluntary, as management seems to suggest. Instead, Telestone's public filings clearly state that both auditor changes were driven by existing auditor resignations.

TFF BELIEVES THAT THIS STATEMENT IS A VIOLATION OF SECTIONS 10(B) AND 20(A) OF THE SECURITIES EXCHANGE ACT OF 1934 AND RULE 10B-5 PROMULGATED THEREUNDER.   

While the scope of management's discussion was quite limited, there were other noteworthy issues.  In a press release that hit the wires around the time the call commenced, Telestone management announced unaudited preliminary results. 

The numbers are impressive when viewed in a vacuum.  But the P&L lives outside of a vacuum, with the balance sheet and cash flow statements providing a complete picture of financial health.  As TFF asserted in our last report, Telestone's results are meaningless without cash flows that approximate net income.  

Based on Telestone's guidance for revenues of $131.5 million at the mid-point, this implies Q4'10 revenues of $60.6 million ($70.9 million for first nine months).  Additionally, Telestone announced net income for 2010 of $30.75 million at the mid-point, implying Q4'10 net income of $18.5 million ($12.6 million for first nine months).  

Amazingly, the company confessed on the call that DSO's and accounts receivables increased dramatically. A major focal point of the call was again DSO's, which Wu admitted climbed to 374 days from 358 days in 2009. Equally concerning was the disclosure on the call that accounts receivable increased sequentially by $47 million (from $134 million to $181 million). 

TO PUT THIS LUNACY INTO PERSPECTIVE, USING THE MID-POINT OF GUIDANCE, THE COMPANY’S REVENUE ONLY INCREASED $17.5 MILLION QUARTER-OVER-QUARTER (FROM $43.1 MILLION TO $60.6 MILLION), WHICH COMPARES TO A JUMP OF $47 MILLION IN ACCOUNTS RECEIVABLE. 

At the 33:20 mark of the call, an exchange took place between management and an investor that illustrated management's inability to reconcile any of its numbers. WE WOULD ENCOURAGE ANY POTENTIAL INVESTORS TO LISTEN TO THAT SEGMENT OF THE CALL, WHICH ENDED WITH MANAGEMENT DISCONNECTING THE CALLER MID-QUESTON.  

Additionally, TFF found it very odd that Telestone executives placed the entire conference call on hold/mute for 15 seconds at the 35:20 mark and confessed multiple times that they could not explain the trend in the numbers that they had just provided in their prepared remarks.  Management finally capitulated at the 39:55 mark -- admitting "We can not reconcile those (numbers) over a phone call like this" – and then promised to an 8K that would reconcile the discrepancy between the 10Q disclosures. 

After digging through the September 10Q, TFF believes it has discovered the smoking gun that management was unable to reconcile. As TFF stated in our last report, Telestone is either booking unbilled receivables or is misclassifying long-term A/R as short-term. The recent management call validated our suspicion.  

On the call, Wu discussed the payment process of the Big 3 and stated (10:00 into the call): “Once their payment process is activated, usually we can collect 90% of the customer volume except for warranty-related receivables that isn't due for 24 months."  This statement appears to be consistent with the language in the most recent 10Q: “Approximately 10% of our professional services revenue are settled after 24 months of our warranty period."  

HOWEVER, THESE STATEMENTS DO NOT RECONCILE WITH THE DISCLOSED AMOUNT IN THE 10Q. TFF BELIEVES THAT MANAGEMENT’S STATED POLICY ABOUT 10% OF SERVICES SETTLING AFTER 24 MONTHS, AS WELL AS THE POLICY LANGUAGE IN THE 10Q, DO NOT RECONCILE WITH THE DISCLOSED AMOUNT OF A/R THAT IS EXPECTED TO BE COLLECTED AFTER ONE YEAR.

The September 10Q states: "Of the retentions balance as of September 30, 2010 and December 31, 2009, approximately US$3,023,000 and US$903,000 respectively are expected to be collected after one year" (Note 6 - Accounts Receivable). 

If the company has $3 million representing 10% of the professional service revenues booked over the last 12 months, then that would imply that the maximum service revenue that Telestone could have recognized over the past 12 months was $30 million. However, the trailing 12-month services revenue through Q3'10 was $66.2 million ($41.9 million first nine months of 2010 and $24.3 million in Q4'09). This level of service revenue, which comes with 10% of revenues collected after 24 months, would imply at least $6.62 million of receivables to be collected after one year. (This doesn't even include the amounts from Q1'09 to Q3'09, which would still be under the 24-month collection period and make the numbers even more challenging to reconcile). 

Given the fact the Big 3 purportedly represent 99% of revenues, TFF sees no explanation for these inconsistencies. TFF is convinced that Telestone's reported financials are irreconcilable, and management's inability to answer basic questions on the call solidifies our perspective.  

As TFF asserted in our last report, we are nearly certain that Telestone is recognizing revenues without invoicing customers and/or is recognizing revenues under a percentage-of-completion methodology without the necessary disclosures (unbilled receivables). 

While we were unable to find conclusive evidence that Telestone was not invoicing customers at the time of our last report, we believe management unwittingly provided confirmation on the investor update call.  At 8:08 into the call, Mr. Wu defended the company’s ballooning accounts receivable balance by stating: “A DELAY IN CUSTOMER INSPECTION REDUCED OUR ABILITY TO ISSUE INVOICES.” There is no way to interpret this statement other than by concluding that Telestone recognized revenues, booked a receivable and has not been able to collect said receivables because no invoice was issued due to a delay in inspection (approval).  

WU’S EXPLANATION MATCHES THE EXACT DEFINTION MOST COMPANIES USE FOR UNBILLED RECEIVABLES: “Unbilled Receivable” means any Receivable for goods sold or services performed for the related Obligor, and with respect to which no invoice has been submitted to such Obligor for payment of the amount thereof." 

TFF BELIEVES THIS STATEMENT IS A CONFESSION THAT TELESTONE IS IN FACT RECOGNIZING REVENUES WITHOUT INVOICING CUSTOMERS. IF WE ARE CORRECT, WE BELIEVE TELESTONE INVESTORS COULD FACE SIGNIFICANT CONSEQUENCES THAT SHOULD START WITH A RESTATEMENT.

While there is nothing wrong with percentage-of-completion accounting, Telestone has never disclosed this revenue-recognition policy and would need to restate past periods disclosing unbilled receivable. FURTHER, AS TFF HAS SUSPECTED, INVESTORS WOULD BE INVESTING WITH INCOMPLETE AND INACCURATE INFORMATION.  

If this is the case, and Telestone is not a fraud (which TFF will again leave to lawyers and regulators to determine), then this could explain the following: the astronomical accounts receivable, the lack of associated cash flows, the ability to recognize revenues with significant discretion and the unusual warranty period when revenues are recognized but apparently no invoice is issued until some inspection occurs.

In addition to the significant and material misstatements that were gleaned from the update call, TFF is equally concerned about the following questions that Telestone failed to address:

* Why did Telestone claim to work with Quell Corp a full 15 months before Quell Corp was formed? (Despite being discussed at length in out first report, TFF does not believe Quell was referenced in the prepared remarks.)

* Why is Telestone not complying with applicable Chinese tax laws, as disclosed in the company’s financial filings?

* Why did allowance for doubtful accounts decline by such a large percentage in Q3'10?

* Why are the contacts listed in past Telestone press releases so inconsistent and mysterious?

* Why did Telestone fail to include Wu in any of the company’s presentations or the management slide on its website?

* How did Wu add two years of experience to his resumes in just 10 months between his employment at China Natural Gas and China Medicines?

* Why have there been three people listed as secretary of the board, one of whom had a New Jersey phone number and a Gmail account listed as contact information? (This is a salient point noted among an entire tree of oddities in our last report.)

* Why are Mr. Wu and Quell Founder David Ballard emailing individual investors and potentially providing selective disclosures that are appearing on Yahoo message boards? 

* Given the commentary on the update call about retaining Deloitte & Touche, when can we expect an 8K on that firm’s engagement?

* What was/is the involvement of Paul Kelley with Telestone? Why did he appear in pictures with Telestone's management on the podium of the AMEX in 2005 and Nasdaq Global Market in 2007?  

* Does the frozen account of Winner International own Telestone shares? Did the company give 200,000 Telestone shares to Winner International without disclosing that in SEC filings, as Sharesleuth suggests?

* Did MCC Group receive shares of Telestone in exchange for $50,000 in loans, as ShareSleuth has also detailed? 

* Does CEO Han Daqing have any remaining business relationships with MCC Group?

* What is the nature of the loan that Daqing has provided to Telestone, and why was it necessary?

* What is the $536,000 related-party loan, and why is Telestone not collecting interest on this loan?

* Which director lent the company $4.13 million, and why was this necessary if Telestone is in sound financial health?

As emphasized in our previous report, TFF is very concerned that investors are trading in Telestone with incomplete and inaccurate information. This concern seems particularly germane given the rampant retail message board activity and individual investor interest. TELESTONE’S YAHOO FINANCE MESSAGE BOARD ATTRACTED APPROXIMATELY 359 POSTS ON JAN. 24 ALONE! 

This type of retail involvement can be wonderful for the stock market. However, if regulators intend to protect the retail experience, then it is paramount that they begin to address the massive issues that are present with so many of the Chinese reverse mergers.  TFF is hopeful that the recent attention from mainstream publications will expedite regulatory action.

In closing, TFF is confident that our requests to the NASDAQ and SEC will not fall on deaf ears. And if Report II does not garner appropriate attention, we are extremely confident that our final Report III – exploring the outsourced manufacturer and provincial offices – ultimately will.

As we said in our last report: “If it looks like a duck, walks like a duck and quacks like a duck, it probably is a duck.”

* Note: The author of this report is short Telestone stock. TFF goes to great lengths to ensure that all information is factual and referenced. All facts that we present are true to the best of our knowledge, and all opinions presented are our own and accurately reflect our actual opinion on the relevant subject being discussed at the time.