AutoChina: The Worst Chinese Reverse Merger Yet?
by The Forensic Factor - 2/1/2011 2:02:33 PM
One company that has somehow managed to avoid scrutiny until now is AutoChina (NASDAQ: AUTC). However, after a deep dive into AutoChina, The Forensic Factor (TFF) has concluded that AutoChina is potentially the most dangerous Chinese reverse merger that we have examined.
As the AutoChina story gets exposed, we would expect a significant share decline of at least 50% and a material increase in the short interest. (Incredibly, less than 1% of the shares are short -- a true rarity among the Chinese reverse mergers).
TFF believes investors would be prudent to avoid AutoChina at all costs. At the same time, we implore regulators to protect the investing public and launch an investigation into AutoChina.
This report, Part I of II that we will publish on AutoChina, will highlight the following issues:
* An extensive use of the same gain-on-sale accounting that led to the entire sub-prime industry blowing up. As we will discuss, AutoChina's accounting methods were dubbed "Crack Cocaine Accounting" by Bloomberg in a story on the sub-prime lenders
* A mockery of U.S. GAAP accounting, resulting in massively overstated revenue and earnings that should not be relied upon by investors
* A harrowing $450 million discrepancy between operating cash flow and net income over the past six quarters
* A labyrinthine organizational structure and a reliance on related-party debt that has become the primary funding source for the core business
* The fact that the largest funding source for the company's auto loans appears to be a related-party operator of grocery stores called Beiguo Commercial Building Limited
* The most dilutive -- and shareholder-unfriendly -- earnout that we have ever seen. (The perverse earnout has potentially incentivized management to use logic-defying accounting to drive specious revenues and earnings.)
* A misunderstood market capitalization based upon future earnout shares that do NOT appear to be included in sell-side models
* Massive expense understatement and large related-party payables
* A CFO who was previously the director of research at a firm that turned out to be ONE OF THE LARGEST PONZI SCHEMES IN U.S. HISTORY
* A new auditing firm that will need to address the issues and questions raised by TFF in this report – a process that could be the impetus for a large accounting restatement
Risk of Restatement
Before delving into an accounting schematic that we thought had died with the subprime debacle, it is worth mentioning the unusual birth of AutoChina. The operating company is located in China, but the holding company is incorporated in the Cayman Islands. (We will explore the unusual corporate structure later, illustrating a similar structure to Rino International, or RINO.)
AutoChina went public in April 2009 through a reverse merger with Spring Creek Acquisition. At the time of the merger, the company's primary operations were new and used car lots in China. Just a few quarters after the reverse merger was consummated, however, the core business was disposed of (in December 2009) so that the company could focus on leasing commercial vehicles instead.
This unusual change in corporate strategy was quite a gamble at the time, given the fact that the leasing business had a history of less than one year, as reflected in the following statement from official corporate filings: "ACG's commercial vehicle sales, servicing and leasing segment has only been operating since 2008, and after the sale of our automotive dealership business is the only business we operate."
The leasing business is relatively easy to understand: A company finds a truck buyer, orders and buys the truck, provides the financing and then leases the truck at a marked-up value. The high-level leasing concept is where the straightforward part ends, however, and where the mysterious activity begins.
Simple arithmetic suggests the numbers that AutoChina provides in its financial statements are nonsensical. The company's 2010 guidance is $600 million to $650 million of revenue on 12,000 to 13,000 "leased" vehicles. This equates to exactly $50,000 of revenue per vehicle. In short, reported revenue per transaction of $50,000 per vehicle would seem to represent a sale rather than a mere "lease."
On page 28 of its investor presentation, AutoChina outlines the economics of a typical lease, which includes $48,000 of total collections over the life of a lease (26 months) and $38,000 for the cost of the truck. The difference is shown as the $10,000 of gross profit potential (before overhead and interest expenses) for 26 months.However, TFF believes that AutoChina is actually recognizing almost all of the potential profits upfront. For example, in the third quarter 2010, the company recognized more than $8,000 of gross profit for each new vehicle that it leased.
TFF views this as an extremely aggressive form of accounting. In fact, this accounting treatment is nearly identical to the "non-cash gain on sale" accounting popularized by the subprime mortgage players before they all went bankrupt. BY NOW, A PROMINENT BLOOMBERG STORY HAS ALREADY DESCRIBED THIS ACCOUNTING METHOD AS THE FINANCIAL WORLD’S EQUIVALENT OF “CRACK COCAINE.”
This type of non-GAAP accounting generates substantial "paper" income but significantly overstates and misrepresents economic income. While AutoChina's sales-type lease accounting generates 60% to 80% in upfront profits, it is important to compare those numbers to the actual cash flows of a loan. According to corporate records and TFF’s own analysis, the company does not even achieve breakeven cash flow until month 22 of a 26-month lease!
Even if AutoChina did not have to finance its leases, the company would still need 20 months to break even. Moreover, keep in mind that this analysis actually excludes a number of relevant factors – such as overhead costs, collection expenses and potential defaults – that would push the average breakeven date out even farther. Keep in mind this analysis does not even include any overhead costs, costs for collections, or potential defaults that would push the average breakeven out even farther.
This unsavory and alarming dynamic of reporting positive "accounting" profits, despite enormously negative cash flow, becomes obvious when comparing AutoChina's cash flow from operations to its net income. Based on its regulatory filings, AutoChina has somehow blown through $384 million worth of operating cash flow over the course of the past six quarters alone. This feat looks rather amazing, considering the fact that the company has reported just $69 million worth of net income for that same period. ALL TOLD, THE DISCREPRANCY BETWEEN CASH FLOW FROM OPERATIONS AND REPORTED EARNINGS CAME TO A STAGGERING $450 MILLION DURING THAT TIMEFRAME.
AutoChina's inexplicable delta between operating cash flow and net income ranks among one of the most alarming statistics that TFF has ever uncovered.
In an effort to fully confirm that AutoChina stands out from the crowd with its overly aggressive accounting practices, TFF examined leasing models at similar companies. We could not find a single U.S. company that utilized the same aggressive accounting treatment for its main business. Rather, every U.S. leasing company that TFF evaluated – including GATX (NYSE: GMT), McGrath RentCorp (Nasdaq: MGRC) and Tal International (NYSE: TAL) – used straight-line accounting methods instead.
If AutoChina employed that same accounting treatment, recognizing its revenue over the course of a 26-month period, the company’s income statement would look materially weaker. For the first three months of a lease, AutoChina would recognize a little less than $1,600 in interest revenue offset by interest expense (of $400 at a 6% interest rate). As a result, the total net interest margin would come to $1,200. Even if AutoChina recognizes a $2,000 upfront mark-up gain (which we believe should be amortized), our analysis indicates, the company still appears to be overstating revenue by a whopping 92.5% -- and gross profit by almost 60% -- on the first three months of each lease.
Meanwhile, AutoChina's "non-cash gain on sale" accounting would seem less ridiculous if the company also accrued for loan losses. As TFF dug through the disclosures and assumptions behind AutoChina's loans, however, we were shocked to see absolutely nothing accrued for those losses at all. zero accruals for losses. At the same time, by recognizing 60% to 80% of profits upfront, the company records almost all of its potential profits at once.
The potential fallout could prove serious: Due to this accounting policy, AutoChina faces potential credit losses that will likely trigger huge downside surprises (reversal of recognized gains, costs of repossessions and losses on collateral) in the future.
TFF feels that this concern is quite justified, given the recent jump in delinquent accounts relative to the minuscule provision for loan losses. In fact, TFF believes that AutoChina has reserved only $1.1 million against $410 million in loans. According to SEC filings, however, more than 4.25% of AutoChina's loans were delinquent as of Sept. 30, 2010. AutoChina’s deteriorating loan book paints a much starker picture than does the company’s paltry reserves, which represent less than 0.27% of its total lease portfolio.
For its part, AutoChina management claims that the company has experienced fewer than 20 defaults -- versus 20,000 leases -- and cumulative losses of roughly 15 basis points in total. TFF believes this claim defies all conventional logic, however. That said, of course, TFF embraces the same financial logic that would NEVER place delinquent loans into accounts receivable on the balance sheet, either. (During AutoChina’s most recent earnings call, management confessed to using this rather uncommon treatment for delinquent loans.) We were almost as shocked to hear this statement as we were to learn about the company’s unbelievably low reported losses – in terms of both frequency and severity – for its loans.
Given AutoChina’s numerous related-party transactions and its management’s checkered past (covered in more detail below), TFF feels extremely skeptical about the company’s claims of pristine credit quality. AutoChina’s new initiative – aimed at providing financing for fuel, tires and insurance – further compounds our concerns.
The lack of collateral associated with these unsecured loans should justify higher loan loss reserves. Despite an extensive search, for example, TFF has failed to locate another leasing company that provides loans for diesel. Moreover, TFF wonders why a customer base as healthy as that boasted by AutoChina would need loans to buy diesel fuel and tires in the first place … Perhaps this is a question -- along with many others -- that the new auditors will flesh out and answer.
Meanwhile, AutoChina has listed regional accounting firm Crowe Horwath as the company’s auditor for fiscal year 2009. TFF finds this rather odd, however, since Crowe Horwath didn’t even establish its Chinese business until September of that year.
For the fiscal year just completed, Big 4 accounting firm PricewaterhouseCoopers will be performing AutoChina’s year-end audit instead. While this change may appear promising on the surface, TFF would like to highlight Duoyuan Printing (NYSE: DYP) as a cautionary tale for investors.
In 2010, Duoyon switched from a regional accounting firm to Deloitte. When Deloitte began the audit, it soon uncovered worrisome accounting discrepancies. Once these issues came to light, Duoyon saw its stock plunge more than 62% in a matter of just three short days.
We have prepared a number of questions and concerns for PwC to address when the firm begins work on its first audit of AutoChina this month. Given the issues highlighted above (and those covered below), TFF would not be surprised if AutoChina winds up restating its financial results.
The Organizational Chart
If Sherlock Holmes wanted a new challenge, we would ask him to decipher the baffling ownership structure that stands out as a hallmark at AutoChina. A convoluted chart, found in AutoChina’s corporate filings, illustrates both the inherent complexity and risk of the ownership structure at the company.
This summary, taken from an article in China Economic Review, offers a good description of that complicated arrangement: "In April 2009, Spring Creek acquired ACG, a Cayman company owned by Honest Best, and changed its name to AutoChina International. ACG was formerly KYF, Inc, a holding company set up in 2007 by the CEO of AutoChina, Li Yong Hui. ACG operates three subsidiaries: Kaiyuan Logistics, Kaiyuan Auto Trade, and Hebei Xuhua Trading. All are owned by Hebei Kaiyuan Real Estate Development, a company founded in 2005 by Li."
TFF cannot overstate the risks associated with this type of ownership structure. To illustrate, we invite investors to compare the organizational chart for AutoChina to that featured by another well-known Chinese reverse merger that this type of structure presents for investors. We invite investors to compare AutoChina's org chart with the org chart of another well known Chinese reverse merger: none other than Rino International. SOMETIMES TWO NEARLY IDENTICAL PICTURES CARRY MORE PUNCH THAN ALL OF THE FORENSIC ANALYSIS IN THE WORLD.
Three for One
The organizational structure highlighted above also comes with one of the LEAST shareholder-friendly earnout agreements that TFF has ever reviewed. AutoChina adopted that arrangement as part of its reverse-takeover deal. According to AutoChina’s corporate filings, the agreement calls for the company to give its CEO “between 5 and 20%” of the total shares outstanding annually as an “earnout” payment.
As a result, AutoChina shareholders literally face at least 5% dilution – every single year – regardless of the company’s performance. That earnout is scaled (from 5% to 20%) according to AutoChina’s level of annual growth and obviously not based upon actual cash flow.
In early 2010, AutoChina issued CEO Yong Hui Li more than 2.6 million shares – diluting investors by the maximum amount of 20% -- under the terms of this agreement. Shockingly, this vulpine program will remain in place until 2013. If AutoChina continues to award Li the maximum stock allotment under this deal – issuing him another 19.5 million shares over the course of the next three years – the company (with 20.3 million shares outstanding as of Sept. 30) will dilute ordinary shareholders by roughly 50% in the process.
This just might rank as one of the most lopsided compensation packages ever offered to a corporate executive.
Moreover, TFF believes that this massive future dilution has yet to be reflected in AutoChina’s stock price. At the same time, in yet another perverse twist, should AutoChina actually hit analyst expectations, then the sell-side price targets would be off by 50% (due to the exploding share count). In other words, on a fully diluted basis, AutoChina could see its market value double to $1.1 billion over the next few years with its stock price essentially remaining flat. For AutoChina to maintain its same valuation, the stock would need to fall by 50% during that same time period.
For TFF, the most worrisome aspect of that earnout agreement may its focus on “reported” EBITDA growth (and not on a per-share basis, either) as the financial metric of choice for measuring success. TFF believes that AutoChina could have selected a number of other metrics – such as return on equity, free cash blow or even EBITDA per share – that would have been much more shareholder-friendly instead. Yet AutoChina has settled on a benchmark that basically incentivizes its CEO to pursue the most aggressive revenue- and earnings-recognition policies possible instead.
To read more about the potential fallout from this practice – and numerous other red flags at the company – click here to access the entire story.
* Disclosure: The author of this article is short AutoChina stock. TFF goes to great lengths to ensure that all information is factual and referenced. All facts that we present herein are true to the best of our knowledge. All opinions presented are our own and accurately reflect our opinion on the relevant subject being discussed. We recommend that investors perform their own extensive due diligence before buying or selling any security.
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