stock ticker: CCME

The China Reverse Merger stock that is “Too Good to be True”

Every investor protection website, from the SEC on down, posts this advice for investors:  “If it sounds too good to be true, it is…” Looking back on major frauds like Bernie Madoff, the most common expression of regret from duped investors is framed just this way.  Yet the “too good to be true” story is always tempting — especially so for those who haven’t been burned yet.

China Media Express (NASDAQ:CCME) operates a very simple business.  They claim to be the largest television advertising operator on inter-city buses and airport express buses in China.

Just One Example of the Numbers that Don’t Make Sense

.

How can CCME generate three and a half times the revenue per screen of its competitors?  CCME has roughly 55-60K displays; VISN has appx 120,000 screens.  In Q2, 2010. VISN’s total revenue was $31 million and CCME generated $53 million from less than half the screens.  Remember that VISN operates bus advertising in major metropolitan areas, compared to CCME, which claims inter-city buses between 2nd and 3rd tier markets.    That is what the company wants investors to believe.

stock ticker: CHBT

C’mon, not anther story on the Chinese RTO market!  Sheesh!

These stories have been flogged to death by the media and anyone who buys these stocks now knows it is a caveat emptor market.  Yet last week the tables turned.  For the first time, mainstream Chinese media started to pick up on the world of fraud that exists in many of the Chinese based companies with US listings….and the first poster child was China Biotics.

On January 16^th, an independent Chinese blogger Xia Cao (pen name), produced a post calling into question various aspects of the company’s accounting and tax reporting.

But Xai Cao is no ordinary blogger.  What distinguishes his work is that he teaches at Shanghai National Accounting Institute and has developed quite a reputation for exposing financial fraud in China.  In fact, of the 125 companies the Chinese Securities Regulatory Commission has pressed charges against; Xia Cao was the first to challenge 25 of them – an astonishing 20% of the total number….a number that makes Citron jealous.

Here’s a properly translated version (not a Google Translation) :

CHBT by Influential Chinese Blogger

Then, on January 21^st, the story was picked up by the mainstream press, who took the story to another level.  The China Biotics saga was written about by Yicai First Financial Newspaper in China with the headline

“China Biotics suspected of inflating financial performance: the number of branded stores became a myth”

This writer became the first entity to speak to customers, employees, and the company itself on an independent basis.  This is something that no blogger, analyst, or journalist had ever done in the past.  But more importantly, it wasn’t just any newspaper, either.  Yicai’s First Financial is the equivalent of the Wall Street Journal and China’s oldest financial paper. More importantly, it carries the imprimatur of the Chinese Government: http://translate.google.com/translate?hl=en&sl=zh-CN&u=http://www.yicai.com/aboutus/1.html&prev=/search%3Fq%3Dyicai%26hl%3Den%26rls%3Dcom.microsoft:en-us:IE-SearchBox%26rlz%3D1I7GGLL_en%26prmd%3Divns&rurl=translate.google.com&twu=1

(A properly translated version of the Yicai article)

China Biotics Being Suspected for Inflating Financial Performances

It is Citron’s opinion that if an article comparable to this had been published by the Wall Street Journal on a US publicly-traded company, it would be halted for trading.

So What Did the Company Do?

They couldn’t possibly refute the writer’s story, because in China, he is of a very strong reputation.  And to refute the newspaper is to refute a state controlled entity, so they did what they’ve always done – turned in another quarter of “perfect” numbers and raised guidance.

They’ve now constructed a large manufacturing plant….and that is it.  This is the Field of Dreams.  Their stores don’t check out, their “distribution chain” doesn’t check out, and their “major customers” don’t check out.

Investors are left to believe either the company’s statements or to conclude that the company has produced a fictional narrative of its last five years, of an order of magnitude larger than reality.

This peculiar situation forces the auditor to actually perform an audit.

Past, Present, and Future

Anyone with a rational thought can agree that the past of CHBT is murky at best.  Now the Chinese media has given us a fair glimpse of the present of CHBT…your only hope is the future.  Unfortunately, in the publically traded markets you cannot escape your past and if fraudulent, all filings will have to be amended.  Now that is has become mainstream Chinese news, you can be guaranteed that that Chinese based auditors cannot turn a blind eye, especially when Xai Cao questions the cash in the bank, past earnings, and more importantly the taxes owed.

“If you tell the truth, you don’t have to remember anything.” — Mark Twain

It appears to Citron that the company has spun so many lies in the past that it will become impossible to cover them up in the future to an audit or the scrutiny of local media.  One that we find the funniest comes from their last 10Q when they state,

“As of September 30, 2010, we had a total of 447 employees, compared with 415 as of September 30, 2009.”

Yet, this is after they closed the majority of their stores, which employed over 200 people.  This is just one of MANY inconsistencies that riddle their filings.

What is the SEC doing about this?

With no jurisdiction to enforce anything inside China, the SEC’s new Chinese Reverse Merger task force has taken the strategy of looking to US parties playing supporting roles in propping up fraudulent companies trading in the US and operating in China.  Thus, auditors, underwriters, and of course promoters are going to be held accountable for fraudulent misrepresentations made in the US markets.

Conclusion

We are pleased that the mainstream Chinese press has started to cover the RTO market.  The fact that CHBT was the first of the exposes will put additional pressure on the auditor not to turn a blind eye to the blatant misstatements in the reported financials of China Biotics.

Cautious Investing to All.

stock ticker: WHX

Citron Now introduces Whiting Trust USA (NYSE:WHX).

Just three weeks ago, Citron introduced readers to GNI, a stock with a fixed liquidation date, at which point it simply dissolves, worthless.  On any computer dividend screener GNI seemed like a nice conservative play, but in reality it is ticking bomb.  Within just three weeks, GNI has lost 1/3^rd of its stock price. (and is still handsomely overvalued.  It is Citron’s opinion that it likely has further to fall. )

No fraud, no big earnings miss, just simply a reminder that computers cannot do all of the work of man.

At the time, Citron figured GNI was a one-time anomaly in the market.  But here is another one that shares the same attributes.

Meet Whiting Trust USA.

In the most basic terms, WHX is very similar to GNI.  With 100% certainty, it also goes to a zero value.  No fraud, no deception, and fully disclosed in its filings.

WHX has been bid up to a level completely detached from its real value, having been erroneously included with comparable “real” dividend and cash flow stocks that have an enduring asset base.  While the details differ slightly, the insane mispricing of this stock is even more extreme than GNI.

The Details, But No Devil

WHX’s 10-K’s and 10-Q’s all plainly state that it is an income trust, with rights to revenues from 90% of oil and gas property sales, up to a maximum of 9.11 MMBOE (barrel of oil equivalence), a gross measure of hydrocarbon energy.  At the point where 9.11 MBOE is sold from the trust, it liquidates.  It has no other assets, and minimal cash.

10-K here:  http://www.sec.gov/Archives/edgar/data/1417003/000095012310024760/d71538e10vk.htm

“As of December 31, 2007, the Trust had no assets other than a de minimus cash balance from the initial capitalization and had conducted no operations other than organizational activities. In April 2008, the Trust issued 13,863,889 units of beneficial interest in the Trust (“Trust units”) to Whiting in exchange for the conveyance of a term net profits interest (“NPI”) by Whiting Oil and Gas. The NPI represents the right for the Trust to receive 90% of the net proceeds from Whiting’s interests in certain existing oil, natural gas and natural gas liquid producing properties which we refer to as “the underlying properties”. The underlying properties are located in the Rocky Mountains, Mid-Continent, Permian Basin and Gulf Coast regions. The underlying properties include interests in 3,086 gross (381.7 net) producing oil and gas wells. Immediately after the conveyance, Whiting completed an initial public offering of Trust units selling 11,677,500 such units. Whiting retained ownership of 2,186,389 Trust units, or 15.8% of the total Trust units issued and outstanding.

The NPI will terminate when 9.11 MMBOE have been produced and sold from the underlying properties (which amount is the equivalent of 8.20 MMBOE in respect of the Trust’s right to receive 90% of the net proceeds from such reserves pursuant to the NPI), and the Trust will soon thereafter wind up its affairs and terminate. As of December 31, 2009, on an accrual basis 2.77 MMBOE of the Trust’s total 8.20 MMBOE have been produced and sold and 0.02 MMBOE have been divested.”

Note that GNI’s liquidation date is determined by calendar, where WHX liquidates when its resource allotment of oil and gas is produced and sold.  But the effect is just the same.  Zero is zero.

As of November 2010, this trust, established in 2007, has now produced and sold about 43% of its allocated resource in just 11 quarters.  (3.54 MMBOE of its net interest of 8.20 MMBOE)  At current run rates it will pass the “half-gone” point next quarter.

If its current production run rate is maintained, the trust would liquidate in just 15.3 quarters.  However, production in mature wells tends to decline, so the payout rate may decline and stretch out over a longer timespan – but this wouldn’t add to its value….it just delays when the shareholders get their returns.  While energy prices might be higher in outlying years if the payout slowed, production costs would burden those lower yields.  A longer payout path also reduces the net present value of the income stream.  The bottom line:  the timeline is not friendly to investors either way.

WHX gives investors gas

The energy market since 2008 has changed dramatically for oil and gas pricing.  These commodities used to trade close to energy equivalence.  The WHX Whiting trust was designed around this assumption — the revenue structure treats oil and gas production for sale more or less interchangeably.

But since the huge discoveries of shale oil in the US, and the relative inelasticity of gas demand, gas prices have plunged relative to oil   Last quarter, gas was 40% of WHX’s energy production, but only 20% of the revenues.

The only hope for a investors to recover today’s price in WHX would be soaring energy prices before the production quotas are reached.  But while the spot price of oil is now high (near the company’s average sales price in 2008), gas has fallen by nearly half, depressed by the supply glut due to the huge shale discoveries brought on line in the US, and is not expected to recover in coming years.   So the blended energy price (appx 60% oil, 40% gas for WHX’s production portfolio), hedged as they are, and weighed down by low gas prices for the foreseeable future, is unlikely to produce a windfall, and a poor play on oil price spikes.

Check Please!

For a normal company, dividends are a quarterly reminder of the health of the company’s sustainable cash flow.  But how do you value a company that depletes and goes away?   Standard runoff calculations are based on the present value of future payment streams.  For our model, we’ve assumed the current run rate continues, having explained why a longer run rate only defers estimated income, and won’t create additional revenue.

In our model, WHX pay 15.3 quarterly distributions plus about .20 in cash per share when the trust is liquidated appx., April 2015.

So what does WHX earn?  Since stabilizing its payouts in 2009, WHX has paid .60 to .80 per quarter.  So we analyzed the net present value of 15.3 quarters of distributions for WHX, with quarterly estimates up to 50% higher than its last 7 quarter average, and we get a most likely value below $10.00.  Even in the “best case scenario” (not likely because a huge spike in energy costs would pressure inflation and push up the discount rate), there’s just no way we come up with anything north of $15.00.

So what is this stock doing north of $22 a share?  How Can This Be Possible?

In a world where single-stock research is rapidly becoming extinct, drowned by the massive waves of quant funds and computer generated trading, the above detail – that this company is soon to become extinct – has been entirely forgotten.

Don’t take our word for it:  look at these references to WHX in articles titled “Best Yielding Stocks”, “Top Net Cash Flow Stocks”….etc., where it is compared to other stocks that …… well ….. won’t cease to exist on April 2015.   So the computers go about their merry way,   (We’re convinced that, as well as executing most trading, most of these articles are written by computers, too.)

Premise:  Hunger for yield: (12/3/2010)

http://finance.yahoo.com/news/Hunger-For-Yield-Props-Up-indie-4143308691.html?x=0&.v=2

Premise:  Highest yielding sectors: (11/29/2010)

http://finance.yahoo.com/news/HighestYielding-Sectors-indie-1660524582.html?x=0&.v=1

Premise:  Watch for gains:

http://www.zacks.com/research/get_news.php?id=013l1139

This must be a first!  … An analyst Citron agrees with.

You can’t fault Ray Jay for putting an “underperform” on this issue, with a 10 target, when the stock was 22 in May.  Even though Ray Jay was the underwriter for this issue, the facts are just the facts.  However, in the case of a normal stock, a 10 target wouldn’t be subject to depletion.  In the bizarre world of WHX, the two quarterly distributions since the date of that target actually bring it 1.44 closer to zero.  So in current terms, this Ray Jay’s 10 target is really now a market-adjusted $8.56.

Conclusion:

Any valuation above $12,00 for WHX would require a huge leap of faith. (Generally, persistent high oil prices would spur inflation, and would tend to correlate with higher discount rates.)    Based on today’s market, a market-neutral estimate would get you about $8.50, which is right in line with Ray Jay’s 10 target, less the last two quarterly distributions.

Just like GNI, the above articles simply ignore the fatal flaw in their investment premise – that this company has ongoing enterprise value, which it simply does not.

The science of stock picking , which begins by reading the filings is apparently Not Dead Yet.

Cautious Investing to All

stock ticker: CVVT

You have to live under a rock not to know that there is widespread fraud in the China RTO small cap space.   There is no reason to even reiterate the news coverage as the story has been flogged over and over.  There are, however, plenty of reasons to look for the next company that will fall victim to increased scrutiny.  Citron believes that this is an easy one:  the case of China Valve Technology.  (NASDAQ:CVVT)

Frazer Frost has become the poster child for bad auditing of Chinese names.  They were just sanctioned by the SEC for their lack of oversight of China Energy
http://www.sec.gov/litigation/admin/2010/33-9166.pdf Frazer was also the auditor for the now infamous, recently delisted RINO.  All of Frazer’s clients have been forced to find new auditors, which for the reasons described below, puts CVVT in an untenable position — between a rock and a hard auditor.

The fact that CVVT had one of the lowest corporate governance scores (ranked 63rd out of 70 companies) on a recent Piper Jaffray China investment study and has had a revolving door of CFO’s is not surprising in light of what we discovered.  And worse, the company made three acquisitions in 2009 and 2010, with some of the most unimaginably bizarre disclosures we’ve ever seen.

The company recently teased with news it was close to finalizing a “big 4″ auditor – but hasn’t said which one.  It is Citron’s opinion that there is no way the company can pass an annual audit of any reasonable professional scrutiny.  Citron believes that the company will execute a secondary prior to attempting to provide an audit for these acquisitions.

Citron further predicts the company will get delisted to the world of the pink sheets when it inevitably fails to produce a credible audit of its 2010 acquisitions.

Case in Point

A year ago, if you asked “what’s the cleanest, best disclosed example of a China RTO, the name Tongxin (NASDAQ:TXIC) would invariably get props.  This model truck body manufacturer with state-of-the-art facilities was one of the first – and the cleanest – reverse merger companies to list on NASDAQ.  Yet, when the company hired a “big 4″ auditor to “get legit” in 2010, the auditor was unable to produce the audit because of concerns over related party participation in the acquisition transaction.  When it failed to file annual audited financials, the company lost its listing, 85% of its market cap, and now trades for 1.20 on the pink sheets.

Our research reveals a picture of China Valve much worse than TXIC — consistently misrepresenting their business and more importantly their acquisitions, which appear to be nothing more than an instrument for insiders to extract money from the company….so sit back relax and here we go….

Acquisition History of China Valves

China valves completed 3 major acquisitions in 2009 and 2010.

Able Delight – The Myth

The Company first reported its intention to acquire the assets of Able Delight for 15 million USD on January 12,.2010, a few weeks after closing a 22 million USD private placement.  The press release described Able Delight as a leading producer of valves. The transaction was completed on February 3rd, 2010.  In CVVT’s February 8-K, the assets purchased in this transaction included 4.94 million USD of Inventory and 10.11 million USD of PP&E. ….which seems simple enough.

But then something happened in November.  Whether an SEC inquiry or pressure from the auditors we don’t yet know, but the company amended the 8-K and disclosed something closer to the truth.

In the amended 8-K on November 18th, 2010, the company reveals for the first time that Able Delight was in fact a subsidiary of billion-dollar Watts Water Technologies, (NYSE:WTS).  The SEC filings of Watts paint a very different picture of the operating profile of the company than described by CVVT.  According to Watts’ 10-Q and 10-K, Able Delight (Changsha) Valve lost 5.3 million USD in 2009.  Worse, the subsidiary was under foreign corrupt practices investigation and Watts shut it down as a result of that.

However, under ownership of China Valves, we are to believe an instant turnaround had happened.  CVVT estimated the subsidiary to contribute 20.5 million USD of revenue, twice of the previously reported revenue number by Watts, and 5 million USD of net income, instantly turning around a 5.3 million USD loss in 2009….Good luck getting that past an auditor.

Worse, we learn in the amended 8-K filed in November that only 6.07 million USD was paid for the “assets” of Able Delight to Watts (who filed that they received 5 million) and an additional 8.93 million USD went to the owner of Able Delight, purportedly for a list of other tangential expenses listed as “(approx)’.  So who is this mystery owner who received the bonanza?

Now this would get you “locked up” in the United States:
The November 8-K states the CVVT bought Able Delight from a “third party” Qing Lu, and the company lent Lu the money to buy the subsidiary.  Yet what was not disclosed is that Qing Lu shares the same residential address and co-owns the same house as Bin Li, who’s the first cousin of Siping Fang (Chairman of CVVT) and 34% owner of the Company.

The address is 1165 Rugglestone Way — Check it out yourself [http://www.city-data.com/fulton-county/R/Rugglestone-Way-3.html

It is almost as if China Valve was trying to break a record with how many securities laws can be broken with a single transaction.  From misstating ownership of a company, to an undisclosed related party transaction, to inflating revenue projections, and lastly hiding the actual name of the business, for this 4-in-1 disclosure failure … we tip our hats to their management team!

The Acquisition of Hanwei Valves

In the asset acquisition of Hanwei Valves, we see again that the Company did not do what it said in its 8-K filed on April 9th, 2010.
The “Asset Transfer Agreement” referenced in the 8-K filing contains four parties:

• Party A: Henan Tonghai Fluid Equipment Co., Ltd.  (Subsid of China Valve)
• Party B: Shanghai Pudong Hanwei Valve Co., Ltd.   (Acquired Company)
• Party C: Shanghai Hanhuang Valve Co., Ltd             (Owner of B)
• Party D: Hong Kong Hanxi Investment Co., Ltd.      (Owner of B)

In the Company’s 8-K filed on April 9th, 2010, it clearly stated several points leading to the conclusion that Party C and D, which owned Party B (from which assets are acquired) are unrelated parties.  But here is a document that tells us a different story. In another seemingly undisclosed related party transaction, this document below shows in fact that China Valve owned party C prior to the acquisition.

Furthermore, the company presents this transaction as an “asset sale” and goes as far as to claim that Party C and Party D represent that the tangible and intangible assets of Hanwei Valve (including but not limited to land, buildings, equipment and intellectual property) are not subject to any collateral, pledge, lien or any third party claims. Party C and Party D will take all responsibilities arising out of any claims if the representations are not accurate.  It further lays on non-compete clauses…the whole 8-K can be read here.

http://www.sec.gov/Archives/edgar/data/1080360/000120445910000787/form8k.htm

Yet we read as of today that CVVT did not in fact buy just the assets but rather they bought the whole company, which could easily include undisclosed liabilities.  MORE IMPORTANTLY, when you buy just the assets of a company, you do not have to file financials on the acquisition but when you buy a full company, you are required to….so its another auditing nightmare….good luck.  Below is proof that China Valve now owns all parties B, C, and D.

The Yangzhou Rock Acquisition

Yangzhou Rock was the smallest acquisition transaction of the three, a mere 7.3 million USD. Without diving into too many details, there are at least two points of suspicion.

1.    Before even agreeing upon a price, China Valves paid 6 million USD upfront for Yangzhou Rock which simply makes no sense, unless of course you had some “relationship” with the seller.
2.    Like the other transactions, China Valves paid for a mere 2.2 times PE for         Yangzhou Rock which leads to the question:  Why would anyone sell such a business for 2.2 times PE?

Unless of course the numbers are completely fictional as we saw in the example of Watts Water.

Through its own filings and disclosure on the three acquisitions it completed, China Valves has been claiming an annualized 94 million USD revenue and a blended gross margin of 43.4% on these three acquisitions. They are simply too good to be true. The words “too good” is not being used lightly here

Nothing about this company seems to make sense.
·    They represent gross margins that are by far the highest in a commoditized sector, yet they make no investment for innovation:  their R&D Budget for 2010 is around $150K.

·    They compare themselves to Emerson, a company 100 times larger, yet CVVT claims they have twice the operating margins….good luck explaining that to your new auditor.

·    They are able to buy a competitor at P/E of 2.

Who’s Minding the Store?

The SEC is currently wrestling an enormous and intractable problem.  This entire wing of the market has gone completely off the regulatory rails.  Disclosure failures that would result in immediate stock halts and criminal actions are being uncovered daily.

Yet, getting any jurisdiction for serious regulatory efforts in China is very problematic, even more so with a holding company structure in yet a 3rd jurisdiction, typical for China RTO’s.  (CVVT’s holding company is in Hong Kong.)  Yet nothing of an enforcement nature happens without the explicit permission of the Chinese government.

So the SEC task force’s approach is to hold the US counterparties accountable for these entities.  Before the analysts rush to defend these regulatory quagmires, they are going to have to consider their own vulnerability for being held accountable for issuers’ practices that make such a joke of basic disclosure rules.  A 2010 big 4 audit will not be as easy to acquire as another no-name valves maker.

Conclusion:

This company needs substantial cash going forward – which puts it in a cynical race between a secondary and an audit.

Citron expects the secondary is going to win – and there’s no safety valve for investors who are the likely losers.  Consider the rush to close this secondary in light of how difficult it will be to actually procure a real audit.  This is stuff that would just never be permitted in US exchanges.

How sustainable is this picture?  Citron suspects it ends with the color pink.

Cautious Investing to All