CGA and CSKI: Lost in Translation?
by Roddy Boyd - 6/29/2010 11:29:48 AM
* Editor's Note: This article has been republished with permission from thefinancialinvestigator.com. To access the original article, complete with links to numerous backup documents, click here.
In ancient tales, a royal court’s scientific elite could conjure “The Elixir of Life,” a potion made from white gold, a few drops of which could restore youth eternally. You could be forgiven for thinking that society’s command of inorganic chemistry has progressed somewhat, consigning such stories to the dusty realms of explanatory myth.
Not so fast.
The continued prominence of a pair of Chinese reverse-merger companies, China Green Agriculture (NYSE: CGA) and China Sky One Medical (Nasdaq: CSKI), is evidence that investment returns can be had from thin air.
CGA is in the organic fertilizer trade, and CSKI is a peddler of nostrums and potions that all loosely come under the heading of “Traditional Chinese Medicine.” Primarily, though, they are in the business of staying in business, against all reason and much logic.
Both of these financial wonders emerged from the semi-appalling world of reverse mergers, in which justifiably dormant U.S.-domiciled and -listed companies appear to “take over” a fully operational Chinese company. In reality, the Chinese management assumes control and is afforded a quick route to the deep and liquid U.S. capital markets without the scrutiny and expense of a traditional initial public offering process.
There are some very good reasons why many of these Chinese managements are pretty keen to skirt the formal route.
Though both companies are quite different from each other, they share an eyebrow-raising trait peculiar to the Chinese reverse-merger world: the use of small, frequently troubled accounting firms to audit and certify their books. And like many Chinese reverse-merger companies audited by small, frequently troubled accounting firms, it appears, these companies began to report explosive gains in revenue and income – which none of their potential Western competitors could match – the minute they began trading here in the U.S.
(It goes without saying that their share prices, which benefit from mainstream listings on the NASDAQ and the New York Stock Exchange, also began to immediately appreciate dozens of times over.)
CGA uses Kabani & Company, a small Los Angeles-based firm, to handle its audits despite having $58.3 million in cash on its books. It’s not the most intuitive hire. In February 2008, the Public Company Accounting Oversight Board issued a strongly worded inspection report on the firm, questioning, in effect, whether Kabani had done even basic accounting work on an unnamed client’s books prior to certifying them.
(In an email reply to a letter I wrote seeking comment for this article, CGA CFO Ken Ren said the company is open to getting a new auditor after the year’s books are closed.)
Taking the cake, however, is CSKI. That company has made the process of firing and hiring sequentially more dubious auditors something of an Olympic sport.
CSKI started with a City of Industry, Ca.-based two-person shop named E-Fang Accountancy, which was dismissed in 2006 after the company had to restate its numbers twice that year. The California Board of Accountancy investigation into the firm and one of its two partners is truly something to behold.
Then there were Sherb and Co. and Murrell, Hall, Mcintosh and Co., both of which were hired and fired in 2008. Naturally, both shops have their own audit-related headaches they would presumably wish to see forgotten.
Murrell Hall’s headache is a lawsuit from one-time client American Dairy (NYSE: ADY), alleging that the accountancy took its audit numbers from a Hong Kong-based accountant -- and large American Dairy shareholder via an undisclosed stake in an investment fund -- named Henny Wee. Short sellers of Chinese reverse-merger stocks have long alleged this sort of subterfuge occurs regularly, although this appears to be the only documented claim to date.
Rounding off the list is CSKI’s current auditor, MSPC. The former Moore, Stephens firm, MSPC has provided truly creative accounting solutions for capital markets sociopaths like Robert Brennan and Jordan Belfort in their quest to keep stolen money. The firm’s website advertises two partners for China engagements, one of whom, Angelo Coppelino, has been sanctioned by the U.S. Securities and Exchange Commission in the past.
In a brief conversation, CSKI outside spokesman Crocker Coulson acknowledged that “many others, myself included, have told (company) management many times that a bigger accounting firm is in their best interests.” He added that management is apparently concerned that the company may be seen as too small to get the full attention of an audit partner, however, and might have its financials neglected as a result. Coulson also said he was unaware of MSPC’s disciplinary record.
Some fairness is called for: The concern here isn’t that smaller accounting firms cannot add value. Nor are the so-called Big Four always reliable guardians of shareholder interests. Still, these two companies have deliberately contracted with smaller, less rigorous outfits that have proven they aren’t inclined to dispute management.
Giant accounting firms, such as Deloitte Touche or PriceWaterhouseCoopers, are going to send staff into a client’s offices to examine a measurable sampling of the records of its commercial activity: bills of lading, invoices, a count of inventory, tax records, payments to vendors and the like. Cash outflows are matched to invoices and then reconciled. Auditors ask questions about things like arms-length transactions. It is boring, time-consuming and grows more expensive as the enterprise grows.
But it is the only guarantee that an equity investor has that an outside party has scrutinized a company’s operations.
There is also the behavioral angle to consider as well. Traditionally, fast-growing young companies make getting name-brand auditors and well-known law firms a key part of their efforts to gain credibility and prestige. For several years, investors and advisors have repeatedly told the managements of CGA and CSKI about the “poor optics” conveyed by their use of smaller, less-capable auditors. The only reason that executives in their shoes would decline to obtain an established auditor is if having close scrutiny of their books is not in their best interests.
Given that both companies emerged from the primordial ooze of reverse mergers, they also share what can be summed up as “The ‘Ick’ Factor.”
CGA’s case is particularly illustrative of such stock-listing alchemy. The company began life as a ridiculous venture called Discovery Technologies, which owned a handful of Mexican restaurants in Colorado only to close them down after trying and failing to purchase 17 Arby’s fast-food outlets. After a decade’s dormancy, the company emerged again when a member of a Boulder “blank check” outfit called Creative Business Solutions -- which appears to specialize in buying busted public companies and merging them into companies that could use the listing -- took over.
In short order, Discovery Technologies, whose stock was trading for less than a penny a share, managed to buy Green Agriculture Holdings and complete a $20.5 million private placement. About six months later came the change in name and structure, producing what is now known as CGA.
If it seems that a bunch of papers were shuffled around to no real effect, think again.
There was ample treasure to be had in the filings that converted a failed Arby’s franchisee into a Chinese organic fertilizer mini-colossus. Just look at the insider sales records for the two senior principals of Creative Business Solutions (listed as the “management” of Discovery Technologies). The transactions for one of those insiders, Michael Friess, show a better-than-passing acquaintance with the world of penny stocks and their promoters. Moreover, regardless of one’s investment goals or philosophy, we can all agree that it is always nice to purchase shares for less than 1 cent and sell them for $2.23 down the road.
The acres of paper tossed off in a reverse merger and its attendant securities offerings, including name changes and flurries of press releases, often obscure some remarkable self-dealing. The CEO of CGA, Tao Li, had 3.15 million shares of stock socked away in escrow pending the company’s achievement of a $12 million net income target. Based on the Oct. 9 grant date, that block of stock was worth more than $40 million.
Within days of receiving the escrowed stock, Li was selling shares, something he has not been shy about doing over the past nine months. (Note that, apart from his share grant, he never purchased any shares during this period.)
These companies can also weave dreams out of the mundane in their audited financial statements.
Based on those filings, the operating margins at CGA are a sight to behold. The company is simply blowing away long-standing global competition like Potash (NYSE: POT) and Mosaic (NYSE: MOS) in the Chinese fertilizer market. Even allowing for its organic niche, CGA wallops companies for whom fertilizer production, research and marketing is virtually a religion.
So what gives?
A contrary take to CGA’s nearly 50% operating margins is that the company has so much profit — $17.85 million in operating income from $35.89 million in revenues for the first nine months of its fiscal 2010 -- because it doesn’t really have many expenses. It costs CGA a bare $1.3 million to sell almost $36 million in fertilizer and produce. But if the company spreads beyond the handful of provinces it markets in -- and if the boom in fertilizer demand slows -- it will have to spend a lot more than that just to keep sales stable.
Moreover, without the $53 million CGA raised in two equity offerings, the company’s operational and financing activities for the nine months would have used up more than $7 million. As a result, investors may want to give CGA’s books a yellow card since there is a looming discrepancy between the company’s lush profit margins and its ability to turn that income into cash. Almost invariably a sign of future woes, this yawning gap forces companies into a vicious cycle of consistently issuing debt or selling stock to make up the difference.
It gets even starker: Through March 31, CGA made $15.3 million in net income but generated only $2.6 million in free cash flow. Very few companies can lay claim to operating margins around 50%. But only one member of that club fails to generate cash.
(In an email, CGA claimed that it would have generated ample cash flow if the company had not spent about $10.8 million on land-use rights for a new research and development center.)
Still, the challenges of investing in the likes of CGA are routine. CSKI, however, is an enterprise apart, a “Garden of Earthly Delights” for an investigative reporter; it may yet prove surreal for an investor, though.
A developer and marketer of a class of healthcare and diagnostic products falling loosely under the “Traditional Chinese Medicine” umbrella, CSKI has benefitted from the strong identity many Chinese people -- especially those from rural areas -- have towards these treatments. This makes a certain rough sense: China has undergone a revolutionary shift in demographics and living standards over the past 15 years, and accordingly, familiar cure-alls and old-time remedies represent a connection to a less-complex recent past.
So despite China’s increasing affluence and expanding access to formally trained medical personnel, many Chinese citizens embrace CSKI’s roster of products – which include (among many other things) a dental ulcer spray, weight-loss and menstrual-discomfort patches and do-it-yourself tests for kidney disease, cancer and heart attacks.
From a medical standpoint, however, there is no two ways about it: CSKI customers are getting royally hosed.
There are indeed important roles for naturally occurring organic compounds, vitamins and minerals in personal healthcare. But CSKI isn’t really selling this. Rather, the company is the 21st century version of the potion peddlers from the Old West.
Consider CSKI’s leading product, the Sumei Slim Patch. That patch is essentially a piece of adhesive gauze that has been treated with a compound called Saponin, which the company touts as “effective in regulating the excessive secretion of hormones, while promoting others to foster weight loss and prevent weight gain.”
Oh, is that all?
Let’s take a brief look at Saponin. This is a compound from the soapwort plant that, when liquified, has been used most frequently to produce foam in a beverage. There are claims that it may help eliminate cholesterol, but the valid scientific backing to these claims is pretty light. Moreover, as a concept, the weight-loss patch seems lacking.
Meanwhile, although Saponin is toxic in large doses, CSKI and others that peddle the patches often fail to mention that some customers suffer from rashes and skin discomfort whenever they use those products.
(As CSKI’s outside spokesman, Coulson noted that all of the company’s products have been approved for sale by the China State Food and Drug Administration. However, he also conceded that the Chinese approval process tends to be less rigorous that that exercised here in the U.S. That process becomes even less vigorous for non-prescription items such as ointments, sprays and patches.)
The joys of a stroll through the financials of this company are many -- too many to enumerate here -- but a few stand out from the recent past and deserve to be shared.
For starters, between the second and third quarters of 2008, CSKI shifted its business mix rather suddenly. In 2007, CSKI generated about 25% of its sales from distributing personal healthcare products. The following year, however, the company virtually eliminated that business altogether.
Fair enough. Companies enter and exit businesses all the time. What catches the eye, however, is that CSKI’s gross margins stayed between 76% and 78% (the company’s astronomical, but traditional, run rate) even as its revenues soared by 120% on a year-over-year basis. Most companies, when shifting out of a business that produced a quarter of revenues, would be forced to take a big economic hickey as other units took time to pick up the slack. (It is, of course, piling on to note that CSKI’s margins for this business were well above 50%, compared to 5% margins for similar companies operating here in the U.S.)
A management team that can, in one quarter’s time, radically shift a company’s product mix without affecting margins and still post triple-digit revenue growth should not be concerned with day-to-day business tasks. Rather, those executives should be lecturing other companies around the world – at $15,000 a talk – on how they managed to pull off that remarkable feat.
CSKI’s regulatory filings reveal other surprising developments as well. Buried deep in the back of a quarterly report from 2008 are charts detailing the amount of products sold by CSKI, and the amount of revenue they produced for the company, in 2007 and 2008. CSKI’s “lose-weight series” and the company’s anti-hypertension products, which accounted for about 30% of revenue, underwent volatile price swings during those years. The average price charged for the first plummeted from $10.56 in 2007 to $5.53 in 2008, while the average price for the second dropped from $9.63 to $8.23 during that same period. For its part, CSKI said that the company negotiated equivalent price cuts from its key suppliers in order to combat this trend.
At this point, we can safely conclude three things. First, something was (and may still be) terribly, terribly wrong at CSKI. Second, CSKI management assumed that the public would be too stupid to flag the company for its astonishing explanation. And third, any serious auditor would have launched an investigation into the transactions of a unit whose main product is gauze pads seeped in an organic compound that underwent a major price swing – of almost 50% -- over the course of a single year.
It is very difficult to imagine that a business could sustain a 48% decline in the average selling price of its key product (25% of its total revenue) yet nearly double its net income. Harder still is imagining that the product’s profit margins were intact because something akin to a gauze-pad supplier in China was able and willing to cut its prices in half and remain in operation.
To be fair, the third quarter of 2008 is a long way away from 2010. Still, a company that puts forth a convoluted explanation that defies basic business logic once may be tempted to do so yet again.
Despite revenue growth patterns that are more common to NASA than the SEC (notwithstanding a disappointment in the first quarter), the present and future for CSKI may be more cloudy than not. That’s because John Bird, a 60-year-old retired entrepreneur from the hill country outside of Austin, Tex., has made uncovering the truth about the company’s financials his personal mission. A businessman with a diverse background -- he was involved in everything from owning movie theaters to fried-chicken restaurants -- Bird became an amateur corporate sleuth (and later a profitable short seller) of some of the more memorable scams of the 1990s.
Stumbling upon CSKI last spring, he became baffled by its growth claims. Probing further, he hired investigators to go to China and pull the corporate records of the company’s various operating subsidiaries.
Bird hit what he presumed was short-seller gold. His investigators came across Chinese-language credit reports and statutory filings that painted an entirely different picture than what was reported to the SEC. Several key units, for example, were reporting revenues more than 75% lower than what was in their SEC filings.
Bird has since launched a website featuring those reports. On that site, Bird notes point-blank that he has “come to believe that CSKI is actively committing fraud.” He has also taken to the company’s Yahoo! message board, where he has angered numerous investors by arguing his case.
The market didn’t see it quite Bird’s way, and he suffered some sharp losses last January. Unlike most short sellers, however, Bird was not inclined to fade back into the woodwork and call it a day. With time and money on his hands – and mounting anger over roughly $90,000 in losses -- he hired a law firm to check out CSKI’s patents. As it turns out, the company had claimed $15 million in patents that it did not have.
So Bird sued MSPC.
Rather surprisingly, Bird’s legal team seems to be enjoying the upper hand so far in pre-trial motions, winning permission to move forward with their discovery efforts. As part of this process, MSPC must produce its working audit papers on CSKI as evidence. If CSKI’s cash balances roughly equal the revenues reported in the company’s previously hidden Chinese filings, Bird hopes, then the final result could be “game over” for the company.
Or maybe not.
Chinese reverse mergers run on a special kind of hope and belief. When investors look at reports of incredible profits, they truly hope and believe that their shares are a down payment on a dream.
The men who put these companies together from the bone yards of the free market appear to hope and believe something rather different, though. As a result, the John Birds of this world – who demand proof and evidence in the place of promises and dreams – take their victories against the Chinese money machines at the margins, one expensive pre-trial motion at a time.