stock ticker: HRBN

   Introduction

In 2010, the Chinese RTO space was thrown on its head when once high flying Rino International was exposed as a fraud and its customer/contractee list was shown to be fraudulent.  At the same time the CEO was taking money out of the company, the company was misrepresenting its stature in its industry to US investors.  All of this transpired under the eyes of their trouble-plagued auditor Frazer Frost. 

It was only a month earlier that Harbin Electric (NASDAQ:HRBN) prevented itself from becoming another RINO by announcing a takeover bid by its Chairman/CEO Tianfu Yang.  But that time has now come.  Citron will prove that Harbin is just as bad as RINO:  fabricated customers, management taking money from the company, undisclosed insider dealings, and the worst accounting disclosures that either Citron or any forensic accountant has ever seen.

As for a buyout?   Not happening!   This report, if printed in its entirety, would span over 100 pages.  A team of attorneys and investigators has been gathering this data for months. 

Overview

This report examines in significant depth Harbin’s purported operations and the deal documents to explore the following questions:

2. Harbin has grossly overstated revenues from its three disclosed (largest) customers.
3. Harbin has grossly overstated its export revenue. 
4. Harbin is guilty of multiple securities violations
5. Harbin's largest division has disclosed material control weaknesses in every principal aspect of its business. 

Note:  Throughout the report we will refer to a thorough investigation into Harbin conducted by a private investigative firm in China.  In order to protect our sources, Citron redacts the name of the firm,  replacing it with “X” in appropriate documents.  The executive who headed the report is a Certified Fraud Examiner with a specialty in China who has curriculum vitae more extensive than any investigator we have ever worked with.  The full report, including the redacted names, will be available to the SEC or through legal due process with Citron Research.

   Grossly Overstated "Largest Customer" Revenues

Harbin’s current 10-K (fiscal yr 2010, filed March 16, 2011) states:

“No customer accounted for more than 10% of the total revenues for the fiscal year ended December 31, 2010. Two major customers accounted for approximately 22% of the net revenue for the fiscal year ended December 31, 2009, individually accounting for 12% (DXT) and 10% (Jiangsu Liyang Car Seat Adjuster Factory), respectively. Three major customers accounted for 43% of the net revenue for the fiscal year ended December 31, 2008, with each customer individually accounting for 16% (Jiangsu Liyang Car Seat Adjuster Factory), 15% (DXT) and 12% (Guiyang Putian Logistic Co., Ltd.), respectively.”

It is the opinion of Citron that Harbin is materially misrepresenting its revenue to the investing public and thereby committing fraud on the marketplace.  Here we will review the 3 stated major customers of Harbin and the results of our investigation.

Customer #1: Jiangsu Liyang Car Seat Adjuster

The clearest sign of fraud at HRBN is seen in the interview with the purchasing agent at Jiangsu Liyang.  Jiangsu Liyang (JLA) was reported to be Harbin's 2nd largest customer in 2009 (10% of revenues), and its largest in 2008 (16% of revenues).
The customer's Vice General Manager states unequivocally that not only has his firm not ordered a fraction of what Harbin has reported, worse, their customers predominantly order manual seat adjustors, not motorized ones.

This interview is definitive and draws a clear path to fraud – more than sufficient to trigger the Material Adverse Effect clause of the bank's loan document draft. 

[  Liyang Car Seat Adjuster Manager Interview  ]

Analysis of JLA revenues per HRBN disclosures:

Year	HRBN Reported Revenues (USD mil)	% from JLA	Revenues attrib to JLA (USD mil)	Avg RMB / USD conversion rate FY	Revenues attrib to JLA (RMB mil)	Revenues as reported by JLA (RMB mil)	Revenue % over-stated
2009	223.23	10%	22.32	6.8311	152.49	0.32	98 %
2008	120.82	16%	19.33	6.9483	134.32	0.32	98 %

 

According to JLA's SAIC filings and presentation, which are consistent with its published business model, HRBN’s claimed sales to JLA were 114% of JLA’s total 2009 revenues, and 148% of JLA’s 2009 operating costs.  See the documents linked below for verification. 

[ JIANGSU LIYANG AUTOMOBILE SEAT ANGLE-CONTROLLER Credit Report and SAIC filing ]

[ Liyang 2011 Business Plan ] 

**  Interesting note:  JLA has no difficulty making public statements consistent with its SAIC documents – which is not the case with HRBN … or many other of the Chinese RTO’s.

Customer #2:  Daqing Xinchengtai Technology  (DXT)

The reported largest customer of Harbin in 2009 (and #2 in 2008) was challenging to obtain financial information from.  That is because they are not a manufacturer themselves, but rather a middleman, supplying pumps to the government funded Daqing Oilfield.  While the SAIC docs retrieved were light on information because of the “Intermediary” nature of DXT's business, the interviews were conclusive.

All of Citron’s research, including interviews, confirmed that Harbin grossly overstated revenues recognized from DXT.  It is Citron’s assessment that HRBN overstated its 2009 and 2008 sales to DXT at least by 365% and 247% respectively. 

Below is the supporting documentation:

[ Daqing Interviews ]

[ DXT SAIC ]

Customer #3:  Guiyang Putian Logistic

The last of HRBN’s “top 3” customers is Guiyang Putian Logistic (GPL), responsible for 12% of Harbin’s revenues for 2008.  ( The Chinese character name for GPL is:

贵阳普天物流技术股份有限公司 ) 

It is the opinion of Citron Research that Harbin has greatly exaggerated its sales to GPL.  As stated in the 10-K,  GPL was 12% of 2008 Net Revenue of $120,802,302. Obtaining these records was more burdensome because Guiynag is located in the Guizhou Province, a third level province in China with inferior corporate record keeping.

HRBN reported sales to GPL that would be 85% of GPL’s total revenues.  This is obviously unrealistic as validated by the purchaser for GPL.  Our source documents appear below:

[ GPL_Interview ]

[  GPL SAIC English  ]

This is what our research revealed for the only three customers ever identified in Harbin's SEC filings.  We can only imagine what the rest of the revenue book looks like.

   Grossly Overstated Exports

From 2010 10-K:

“Our automobile specialty micro-motors are purchased by customers who are first-tier suppliers to the automobile industry. We supply these products to domestic customers and also export them to OEM suppliers in North America.”

In the same 10-K they state that international sales are $20,410,902 for the year ending 2010.  Noting all of the subsidiaries of Harbin as presented in this corporate structure on their website:

 

Citron has completed an exhaustive analysis of product imports as published in Datamyne, and finds a mere fraction of the amount of imports to North America Harbin claims to be exporting. 

It is the opinion of Citron that Harbin has exaggerated their export data by a factor of multiples.  Linked here is a worksheet with our findings.   Our research shows HRBN exports of less than $4 million in 2010, compared to their reported $20+ million.

[ Harbin Exports from Datamyne ]

For all those who think that Harbin is immune to criticism because of its purported pending buyout, be advised that this company is under the scrutiny of the SEC until the moment the deal is completed.  The company is at risk of being forced to announce non-reliance on its filed financial statements at any time.  The Material Adverse Events clauses of the various deal agreements therefore hang in the balance. 

   Material Adverse Events

Even though Citron has provided strong evidence that HRBN has been fabricating revenues in its SEC filings, we are sure that many investors will say, “Who cares if the company is being bought?” 

Besides the obvious regulatory risk involved, there are critical contingencies defined in the loan docs that give the bank an out for material misstatements by the company in its reported financials.  In particular, the loan documents state:

18.12   Original Financial Statements

(a) The Original Financial Statements were prepared in accordance with the Applicable GAAP consistently applied unless expressly disclosed to the Lender in writing to the contrary before the date of this Agreement.

(b) The Original Financial Statements give a true and fair view of the Target’s consolidated financial condition and results of operations during the relevant financial year.

(c) There has been no material adverse change in the Target’s assets, business or financial condition since the date of Original Financial Statements.

(d) The Group’s most recent financial statements delivered pursuant to Clause 19.1 (Financial Statements):

(i) have been prepared in accordance with the Applicable GAAP as applied to the Original Financial Statements; and

(ii) give a true and fair view of (if audited) or fairly present (if unaudited) its financial condition as at the end of, and results of operations for, the period to which they relate (consolidated where applicable).

(e) Since the date of the most recent financial statements delivered pursuant to Clause 19.1 (Financial Statements) there has been no material adverse change in the business, assets or financial condition of the Group.

 

Securities Law Violation/Conflict of Interest 
– Part 1: Tianfu Yang’s personal loan from Harbin

 

In the 10-K we read an interesting disclosure: 

"On December 28, 2010, the Company made an advance of $1,517,000 to Tai Fu Industrial Co., Ltd., an entity owned by Tianfu Yang, the Company’s Chairman. The purpose of the advance was to accommodate an urgent cash need of a transaction for this related entity under a guarantee to repay the Company within a few days.  As of December 31, 2010, the money was repaid in full."

This disclosure brings up several issues that should be troubling to all investors:

• Why does another entity belonging to the CEO have an “urgent cash need”?
• Why does Tianfu Yang not have $1.5 million in cash to give to the other entity?  Isn’t that odd for someone proposing to sign personally for a $400 million loan?
• This transaction appears to be a clear violation of Sarbanes Oxley.  As clearly stated in section 402 from Sarbanes Oxley:

SEC. 402. ENHANCED CONFLICT OF INTEREST PROVISIONS. (a) PROHIBITION ON PERSONAL LOANS TO EXECUTIVES.—Section 13 of the Securities Exchange Act of 1934 (15 U.S.C. 78m), as amended by this Act, is amended by adding at the end the following: ‘‘(k) PROHIBITION ON PERSONAL LOANS TO EXECUTIVES.— ‘‘(1) IN GENERAL.—It shall be unlawful for any issuer (as defined in section 2 of the Sarbanes-Oxley Act of 2002),  directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.

.

Was the loan actually repaid?  Is it odd to take an "urgent cash need" loan out on Tuesday, only to pay it back on a Friday?  Who accounted for the reconciliation of the loan?  Was it paid back in full in cash on that stated date?  Or was this a postdated transaction that involved an “in kind” repayment at a later date so the company did not have to take the charge before the quarter ended ?  Or are we supposed to believe the repayment just coincidentally fell on the last day of the quarter?

Additionally, it was previously reported on by Citron that in the past that CEO Tianfu Yan and his brother Harbin Vice President Tianli Yang were previously obligated to make a civil settlement of a charge of misappropriation of funds and falsification of a bank loan document at a prior company.  While these facts do not prove fraud in Harbin, it does go to character.    

Harbin responded to this finding, not by disproving or even denying their legal wrongdoings, but rather by claiming that Tianli Yang is not a director of Harbin as Citron stated.  Just to prove the thoroughness of the work, here is a document that proves in fact that Tianli Yang is on record as a director of Harbin.

[ SAIC Filing with Tianli Yang Director ]

 Securities Law Violation/Conflict of Interest – Part 2: 
Boyd Plowman’s role in Abax and the Harbin Special Committee

 

 

Aside from Harbin’s CEO, the most important man in this process has become Boyd Plowman.  Mr. Plowman is both head of the audit committee of Harbin, as well as the appointed head of the special committee to take the company private.  This committee is at the center of the requirement that the interests of shareholders be defended.  It is under his watch that we are to trust both Harbin’s financials, and the fairness of the process by which the “takeover” transaction proceeds. 

However, the July 13, 2011 proxy statement filing is the first time investors are informed of the following :

“Shortly after Abax filed a Schedule 13G with the SEC on December 9, 2010 announcing its greater than 5% ownership of the Company common stock, Mr. Plowman, the Special Committee Chair, brought to the attention of the other members of Special Committee, as well as to Gibson Dunn, the fact that he was then serving as a director of several Abax-controlled entities including Abax Global Opportunities Fund, Abax Arhat Fund, Abax Claremont Ltd., Abax Jade Ltd., Abax Emerald Ltd., Abax Lotus Ltd., Abax Nai Xin A Ltd., and Abax Nai Xin B Ltd. (the “Abax Companies”).”

This relationship presents many conflicts of interest among shareholders / Harbin / Boyd Plowman that the SEC cannot ignore. 

1. #1.  On July 29, 2010, just before all the buyout drama began, Abax Emerald loaned Harbin $15 million at a 10% interest rate.  This would be a related party transaction, since the head of the audit committee is a director of Abax Emerald.  Worse, you would think the head of the audit committee would know better than to fail to  disclose this relationship.  The above-market interest rate alone gives rise to the question of whether preference was granted to a related party.
2. #2.  Reading the language in the filing, we are to believe that no one on the special committee ever knew that Plowman was associated with Abax?   Does this pass the smell test?
3. #3.   It has never been disclosed how much financial interest Plowman has in Abax.  Nor have been disclosed other relationships with directors of Abax, such as this investment company we found called Kilometre Growth, where Plowman is a director along with other Abax directors.  Why are these matters undisclosed in HRBN's SEC filings?

http://www.formds.com/issuers/kilometre-growth-asia-fund

Citron is amazed that Gibson Dunn did not find conflict in this relationship and that the SEC can authorize this deal without greater transparency of the Abax/Plowman relationship.  This might be the first time in the history of takeovers that the head of the special committee formed to oversee the sale of a company is actually a director of the acquiring entity.

Citron also notes the numerous times Plowman’s bio appears in Harbin’s filings; yet not once does it mention his directorship in Abax funds; this despite Abax’s high profile in the China investment scene following Morgan Stanley’s major stake in the fund in 2007. 

   Disclosures that the SEC Cannot Ignore

While the Special Committee was busy talking to the white shoe lawyers and bankers about a deal, the most reprehensible disclosures we have even seen in a public company were filed in the HRBN 10-K.  The disclosures are regarding Simo Motor, the largest subsidiary of HRBN, purchased in 2009 and "restructured" in 2010, at a cost of over $25 million, to integrate it into Harbin just last year.  We note that these disclosures did not exist when HRBN purchased Simo. 

“We and our independent registered public accounting firm, in connection with management's assessment of and the audit of our internal control over financial reporting as of December 31, 2010, identified five material weaknesses in our internal control over financial reporting…

Control activities related to bank reconciliation – At Xi’an Simo, the bank reconciliation for various bank accounts were not prepared accurately, which impacted the valuation and existence of the cash in bank as of December 31, 2010.

Control activities related to the reconciliation and classification of notes receivable – At Xi’an Simo, notes receivables endorsed as payment to third parties were not properly recorded, resulting in a discrepancy between the physical notes receivables on hand and the general ledger. Additionally, the improper classifications of transactions has impacted the completeness, and valuation of accounts payable / advance to suppliers and notes receivable balances at the year ended December 31, 2010 at Xi’an Simo

Control activities related to the calculation of provision of income tax – At Xi’an Simo, due to ambiguities in the PRC tax rules, the temporary and permanent differences in tax amounts were not properly identified

Control activities related to valuation of inventory allowance – At Xi’an Simo, slow moving inventories that had not been used over a year were not properly evaluated for inventory allowance.

Control activities related to inventory recording –– At Xi’an Simo, inventory movement between manufacturing facilities and sales entities were not timely and properly recorded on the general ledger.

It is especially astonishing how Simo Motors, Harbin's largest and highest visibility acquisition, has severe management control problems in every single verifiable part of this business:  cash reconciliation, tax filings, payables, receivables, and inventory valuation.  And as has been previously documented in text and video ( view here if you haven't seen it already), Simo Motors main physical plant is an antiquated 50 year old facility, with severe lack of automation of its manufacturing capabilities, requiring tens of millions of dollars in retooling and capital improvements required to to be competitive in its space.

With all the money being spent on consultants, why wouldn’t Goldman Sachs, Morgan Stanley, or Lazard recommend a new, independent forensic accountant to run these material weaknesses to ground before any deal closes? 

   Forensic Analysis

Because we knew that HRBN directors would not hire a forensic accountant to go through their current operations, we hired one ourselves to present a financial analysis of HRBN.  As noted, every potential financial acquirer walked away from this deal…maybe they saw what our forensic accountant projected.

[ HRBN Independent Forensic Acounting Report ]

   Cannot be Said Too Many Times:  Frazer Frost

Anyone following the China RTO drama is well aware of the notorious audit firm Frazer Frost, which occupies a unique spot in the history of this sector.  After all, Frazer Frost is the only auditor sued by the SEC during this entire China RTO fiasco.  Citron is actually in competition with Frazer Frost — they have as many halts as we do over the past 7 months.

http://www.theprogressiveaccountant.com/news/sec-suspends-california-audit-partner.html

“Moore Stephens Wurth Frazer Torbet, LLP and Frost, PLLC are moving to resume operations as separate entities, as existed prior to their combination in January 2010. The combined firm, Frazer Frost, LLP, will continue to exist as a legal entity until the separation has been completed. It continues to be the policy of both firms not to comment publicly on client, personnel, or other internal matters.”

“Frazer Frost”, the auditor of record for Harbin’s 10-K, doesn’t actually exist any more. (Citron especially appreciates this website.  http://www.frazerfrost.com/ )  This is what investors will see if anyone ever tries to hold the auditor accountable for the annual financial report on which this purported 3/4ths of a billion dollar transaction is based. 

Formed of a merger in early 2010, Frazer Frost was dissolved in the wake of the SEC suit for having accepted management’s assurances in lieu of its own verification in the case of China Energy Savings Technology.  Then came the exposure and delisting of RINO, whose management admitted it had fabricated revenues based on non-existent contractual relationships with large customers, again assumed valid by the same audit firm.  

With all the firepower of assembled consultants for this deal :  Goldman Sachs, Morgan Stanley, Ernst & Young, Lazard, Skadden Arps, Gibson Dunn,  and White & Case, all with their hand in the till for the deal, nobody has demanded the hiring of a forensic auditor to finally lay out a full and fair accounting of the entire company for all investors to see what’s going on.  The only numbers available are Frazer Frost’s.

   A 500 Page Proxy Statement, but
Nobody Has Done Their Homework

 

Lets see what all these high-priced consultants didn’t do.

Morgan Stanley:

“In arriving at its opinion, Morgan Stanley assumed and relied upon, without independent verification, the accuracy and completeness of the information that was publicly available or supplied or otherwise made available to Morgan Stanley by the Company, and formed a substantial basis for its opinion. With respect to the April 2011 Case, Morgan Stanley assumed that they had been reasonably prepared on bases reflecting the best currently available estimates and judgments of the management of the Company of the future financial performance of the Company.”

Lazard:

“Lazard assumed and relied upon the accuracy and completeness of the foregoing information, without independent verification of such information. Lazard did not conduct any independent valuation or appraisal of any of the assets or liabilities (contingent or otherwise) of the Company, or concerning the solvency or fair value of the Company, and Lazard was not furnished with any such valuation or appraisal.”

Goldman:

Mr. Tianfu Yang did not request, and Goldman Sachs did not provide, at any time, any opinion to the parties as to the fairness of the $24.00 offer price or as to any valuation of the Company for the purpose of assessing the fairness of such offer price. Goldman Sachs was not requested to, and did not, recommend at any time the specific consideration payable in the proposed merger, which $24.00 consideration was communicated by Mr. Tianfu Yang to Goldman Sachs and subsequently was determined by negotiations between the Special Committee and Mr. Tianfu Yang and Abax, and as a result, the Company’s decision to enter into the merger agreement was solely that of the Special Committee and the Company’s board of directors.

(Goldman apparently did not assist Tianfu Yang in the negotiations for a $400 million dollar bank loan either.) 

Audit Committee:

“Members of the Audit Committee rely without independent verification on the information provided to them and on the representations made by management and the independent accountants. Accordingly, the Audit Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal control and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Audit Committee’s consideration and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance with generally accepted accounting principles or that the Company’s auditors are in fact “independent”.”

And finally, Citron notes that all the negotiations with China Development Bank were conducted personally by Tianfu Yang, despite his having retained the world's pre-eminent investment banker as his personal advisor. 

    The Silence of the Buyers is Overwhelming

This company was left at the altar by Barings.  Worse, they were left at the altar by 73 potential strategic and financial bidders, who were offered a look at this company.   Only 3 bothered to execute an NDA, and not one offered a competing bid.

The industry has spoken.  The lack of enthusiasm for this deal speaks volumes. Initially the deal was to be funded by Goldman Sachs and Barings.  After they walked away, Morgan Stanley shopped for buyers.  Of the 73 potential bidders they bought to the table (41were strategic), only 3 strategic ones even asked for an NDA. 

For a company who is supposed to be a leader in the Chinese motor industry it is obvious that their industry does not even find them significant enough to sign an NDA.  The complete lack of interest in the deal from all parties that were brought to the table by Goldman Sachs and Morgan Stanley affirms to ridiculous nature of this alleged buyout.  This demonstrates that not only does Citron view Harbin with skepticism, but it has no credibility with any serious competitor in the space.

   Breaking Up Is Hard to Do

Deals of this size typically have breakup fees attached.  These are intended to provide a measure of assurance to investors, who have the most to lose if it fails, or the spurned buyer, for all their wasted expense and effort if a better suitor comes along. 

But like every aspect of this proposed deal, the breakup fees are a story of their own. 

Consider:

• If the company breaks up the merger, it owes the buyer group, 90% of which is Chairman Tianfu Yang $22.5 million.
• If the buyers group fails to conclude the merger, the buyer group jointly (but not jointly and severally) is obligated to pay the company a $30 million breakup fee.

Since, in neither of these cases, is any cash pledged to back these guarantees, these failsafe provisions, customarily structured to protect the unaffiliated security holders from a broken deal, result only in scenarios where the Chairman has to sue his company or the company has to sue its Chairman, for enforcement of the "guarantee". 

   The Significance of the SEC in this process

The entire proxy and Form 13E-3 is now submitted and under review by the SEC for comments and questions.  At a time when both US officials and Chinese officials are working towards the goal of reliable and transparent disclosures from Chinese listed companies, this filing is a major step in the wrong direction. 

The next step in this process is an anticipated set of questions and comments from the SEC, due within 30 days of the SC 13E3 filing date, July 13, 2011.  This report will shed light on numerous issues that should be of substantial concern to the SEC, as noted in the next section.

Where the market has done an efficient job in flushing out Chinese RTOs and other equities with unreliable accounting, the notion of hiring a team of lawyers to prop of a company with questionable financials, reconciled by non existent auditing firm is a dangerous blueprint for other Chinese companies to inflate their stock while management could possibly be selling stock into a bidding market.  Chinese nationals in management positions, insulated as they are from any enforcement of US securities law can easily orchestrate the whole process.  Therefore the SEC is a gatekeeper on a set of market integrity concerns which stretch far beyond the current Harbin drama.

   Proof that Tianfu Yang has NO INTENTION of Concluding the Proposed $24 Buyout of Harbin Electric

 

It's really quite simple.  If Tianfu Yang wanted to buy Harbin Electric he would have taken a different path.  He knew Simo's cash couldn't be reconciled.  He knew his gross margins from his antiquated factories couldn't possibly be double or triple any of his competitors.  He knew the sales to disclosed major customers were false.  More than anyone, he knows that the company keeps consuming cash, despite the profitable financial statements and projections.

ALL he had to do was declare non-reliance on the filed audited financial reports.  He would have disclosed all the internal weaknesses in the company, and gone through restatements.  He would have hired a forensic auditor, and would be able to buy the entire company for possibly under $5.00 a share.  He knew all of this and knows it today.  

For less than 25% of the pricetag of the financing he's purportedly arranged, he and a group of colleagues could have bought 100% control of the business completely legally and swiftly.  In fact, as his advisors, Goldman Sachs would have been remiss to the point of negligence had they not so advised.  Why has nobody advised calling in a forensic accountant? 

Caveat emptor.

   Conclusion

In reviewing the preponderance of evidence presented in this and previous Citron reports on Harbin, it is the unequivocal opinion of this writer that CEO Tianfu Yang does not want this deal to go through.  He alone knows what his company is truly worth, and he knows about the overstatement of revenues.  The last thing he wants is to be on the hook for a $400 million loan for a company that only made .16 cents last quarter, even considering its highly suspect accounting.  Mr. Yang was able to procure a boilerplate loan doc; Citron believes it was competently prepared, but it will never be executed.

 

stock ticker: ZAGG

Next month, August 2011, marks the 10^th anniversary of Citron Research researching and publishing on the topic of stock fraud.  China aside, Citron has uncovered and published more actionable stories of stock fraud in the US markets among domestic companies than any other research journal or column online. 

 

   Lie with Dogs, Get Fleas

What really drew Citron's attention to ZAGG was the 10-K of 3/25/2011, in which Randall Hales is appointed head of ZAGG's audit committee.  This is a move so egregious it absolutely made our eyes pop out.

Indeed, Mr. Hales is well known to Citron… 

 

Introducing Randall Hales, audit committee chairman of ZAGG

Mr. Hales is the former CEO, President, and Chairman of the board of First Scientific.  The claim to fame of First Scientific is that after the post-September 11 anthrax scare, (FSFI) claimed to be in the middle of testing “an anti-anthrax bacterial crème”. 

http://www.stockpatrol.com/article/key/anthrax2

What makes the anti-anthrax scam even crazier is that according to the SEC the company’s principal operating subsidiary was sold at foreclosure just six months before they even pulled the anthrax stunt…. and it was never disclosed.

This is the chosen new head of ZAGG's audit committee? 

In uncovering fraud, one of our key indicators has always been the pedigree and credibility of management.   It is our study of management that leads us to believe that ZAGG is committing fraud on the investing public.  Go ahead and sue, ZAGG, you will lose.   We continue our discussion of management credibility below…but its not off to a very promising start…

 

ZAGG is presenting an intentionally distorted financial picture of its current business, playing word games while flirting with outright fraud.  Citron predicts that ZAGG will not experience the explosive growth that management and the analysts project for the future, and the retail investors piling in now as its enterprise value approaches $500 million will take huge losses as a consequence. 

 

In the first Citron report on ZAGG, we focused on cash flows, pointing out how real cash flow has been declining while inventory has been growing disproportionately to reported revenues.   These metrics come from ZAGG’s reported financials to date, revealing the company is not generating cash, but rather burning it in increasing amounts.  Their investment premise, parroted uncritically by analysts, projects a glowing picture of the future.  But this picture is directly contradicted by the competitive factors inherent in ZAGG’s core business.   

 

The heart of the issue therefore goes to management credibility.   Therefore this report covers three main points:

 

• Reliability of reported revenues in ZAGG’s core business, in light of adverse competitive factors
• Analyst track record, and whether they are worthy of investors’ trust in their recommendations
• Management credibility

   ZAGG’s revenues:  Can you take them to the bank ?

ZAGG’s protective covers for cell phones and iPads are sold through a variety of channels, but the largest one by far is Best Buy.   Any Citron reader can in fact wander into their local Best Buy and observe a whole rack of SKU’s for ZAGG’s covers for dozens of cell phone models.  These include hot selling models as well as dozens of “last year’s models” that have gone dormant, which is simply the nature of the business.

 

If you ask a sales rep, you’ll find out, unsurprisingly, that ZAGG sells some products for the current “hot models”, and the rest are dead. 

 

Analysts and skeptics have focused on the status of ZAGG’s revenues because of the huge number of “dead” SKU’s on display at Best Buy.  Big box retailers are notorious for highly one-sided, vendor adverse return policies for inventory they carry.  For example, Staples has an “open return” policy on ZAGG’s products.  Yet ZAGG has steadfastly insisted that Best Buy purchases are final and cannot be returned.  This would imply vendor market power for ZAGG which is available only to Apple, and would be highly unusual for a gadget accessory vendor. 

 

Speaking of Apple, Citron has no doubt that ZAGG is selling some amount of covers for the currently hot model: iPhone 2, plus accessories for the iPad.   But it is clear from industry commentary about Apple that it is selling huge quantities of its own cover, and there are literally hundreds of competitors for iPhone covers.

http://blogs.barrons.com/techtraderdaily/2011/07/11/apple-bachman-ups-ipad-estimates-those-covers-make-money-too/?mod=BOLBlog

 

Comparative data points keep popping up to increase the concern.   For example, just last week, on 7/6, Skullcandy filed their S-1 to go public.  As most ZAGG investors know, Skullcandy is “the brand” in the headphone and phone case market.   (Recent ZAGG acquisition Ifrogz can be considered a generic competitor to Skullcandy.)  In Skullcandy’s S-1, we read an interesting disclosure:

 

"……….We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when circumstances change resulting in a change in estimated returns."

 

It is the opinion of Citron that Skullcandy sells its products subject to an open return policy because it is simply required to do business with the big box stores.

 

This relationship description is consistent with the experience of numerous product vendors’ when dealing with major chain retailers.   Yet ZAGG claimed it could sell the same category of products to Best Buy without any return contingency….until they were forced to insert some more wiggle words. 

 

Has ZAGG really orchestrated a better deal at the major retailers than Skullcandy, a deal unique in all the world of big box retail?  Or is management not being forthright about its terms?  Remember, this issue is large enough to trigger an accounting restatement, and/or to wipe out all of ZAGG’s reported profits.

 

Citron advises that investors assess the risks here based on the company’s own words (from their 11/10/2010 conf call) :

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002774/ex993.htm

 

“Q:  Okay and then just one last question and I don’t want to be rude here or anything but would you please address one more time your contract with Best Buy and what their opportunity is to return product to you or not.  Could you lay that out on the table one more time?

 

Brandon O’Brien – ZAGG Incorporated – CFO

Sure, as we have reiterated in the past.  Our contract with Best Buy does not allow for any type of return.  We do not have the ability to send products to Best Buy more than they order.  So there is no way for us to stuff that channel.  We are fulfilling the orders that Best Buy sends to us on a weekly basis.  They get that product.  That product is theirs then and there’s no return rights on that.”

 

Just three weeks later, the company was obliged to issue an 8-K, backpedaling on that claim, having gotten so much flak that the claim simply wasn’t credible.

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002947/form8k.htm

 

On November 9, 2010, the Company conducted its Third Quarter Earnings conference call.  Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company’s Chief Financial Officer, participated in the call on behalf of the Company.  During the question and answer portion of the conference call, Mr. O’Brien was asked questions about Best Buy’s right to return products sold by the Company to Best Buy.  In response, Mr. O’Brien stated that the Best Buy contract did not allow Best Buy to return products to the Company.  As clarification to Mr. O’Brien’s statement, the Company notes that Best Buy can return products to the Company under limited circumstances, including where products are defective or for other similar customary reasons.

 

That wasn’t the only forced “clarification” either.  In the same release, they were forced to “clarify” statements made at the Merriman Investor Summit Conference, reducing the claim of “millions of dollars” of orders to just $1.5 million.

Merriman Investor Summit Comments

On November 15, 2010, Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company Chief Financial Officer, participated in the Merriman Investor Summit 2010 in New York, New York.  Mr. Pedersen gave a presentation regarding the Company and its prospects.  In the course of the presentation, Mr. Pedersen discussed the introduction of a new product, the ZAGGmate, for protection of the iPad device.  Mr. Pedersen described the ZAGGmate product and its features, its anticipated introduction date and pricing.  Mr. Pedersen further stated that the Company had received orders for “tens of thousands” of the ZAGGmate product and that companies “like a Best Buy” had ordered “millions of dollars” of the ZAGGmate product.  It has now come to the attention of the Company that some participants at the Merriman Investor Summit 2010 and others who have listened to a recording of the conference might have understood Mr. Pedersen to say that Best Buy had ordered “millions of dollars” of the ZAGGmate product.  As clarification to Mr. Pedersen’s remarks, the Company notes that as of November 15, 2010 it had received initial stocking orders for $1,500,000 of the ZAGGmate product from large, national indirect channel partners.  In addition, as of November 15, 2010 the Company had also received ZAGGmate product orders from other retail outlets, including on-line retailers.

 

The company has been very evasive about the details of their relationship with Best Buy.  The funny thing is that Citron does not fundamentally disagree with the company, we believe that Best Buy only has the right to return product under “certain conditions”.   So whether its a matter of credits against future orders, expense deferred forward, or whatever, there is a shell game being played in here with loose language.  If ZAGG really wanted to clarify this question, they should have made their entire sales relationship with Best Buy transparent.  It is Citron’s belief that they can’t – it would force them into a financial restatement.

 

These restatements should be red-flag concerns all investors.  It is Citron’s opinion that they inevitably foreshadow another kind of restatement – the bad kind.

 

   Analysts or Puppets?  Uncritical Analysts Just Parroting Management Claims

 

Two analysts cover ZAGG:  Northland Securities and the new kid on the block, Jon Hickman, at Ladenberg Thalmann. 

 

Northland, whose now notorious anointment of CCME (now delisted) as its “Top Pick of 2011”, has been very vocal about ZAGG, feeling the need to issue a note and a reiteration every time anything critical is stated in public about ZAGG.  But their justification is just a hollow echo of management’s claims.   They don’t say a word or provide any independent assessment of the risk factors and the troubling red flags surrounding management’s actions and statements.  

 

It would be no surprise that Citron places zero credibility in the work product that comes out of Northland.  Recommending that investors buy ZAGG at these levels, without even acknowledging the major risk factors in the details of their sales contracts or the quality and credibility of their management, is malpractice.

 

Hickman just came over from a small firm MDB Capital Group.  His 15 minutes of fame came in an interview just 7 months ago, in which he delivered more dogs than the Humane Society.  http://finance.yahoo.com/news/Semiconductor-Company-Rated-1-twst-556849794.html?mod=pf-real-estate&x=0

 

Let’s review the quality of his thought:

 

Ticker	Nov 4, 2010 Price	Current Price	Pct Change	Comments
SATC	4.00	2.00	- 50%	His top pick
HEV	3.75	.80	- 75%	Citron covered this stock in 2008l stock was 7.00 at the time
QTWW	9.50	5.43	- 40%
VLNC	1.30	1.08	- 20%
ALTI	2.00	1.02	- 50%

 

Honestly, these outcomes are exactly representative of what Citron’s expects from ZAGG.

At its core, the ZAGG pro-and-con argument breaks down like this:  The bullish analysts take their projections straight from the company’s guidance.  The optimistic view is that revenues will rocket higher — and all of the paper profits plowed into inventory stockpiles so far have been built up to prepare for this future.  The bull case also stands on the premise that all sales to Best Buy (by far their largest single customer) are final sales with no refund or credit overhang.  Therefore its posted revenues are clean, and its revenue growth projects into a future which can be relied upon. 

 

The bear case, as reflected in the opinion of Citron, is that the company is operating a terminal business model and has not been forthright with Wall St. on either revenues, inventory accounting, or future business prospects. 

 

If you’re going to buy this stock, you are banking on the bright future story, not its current assets or current cash flows.  Therefore, the safety of your capital will be entrusted to ZAGG’s management team. 

 

   Introducing the ZAGG team

 

Top Dog

Let’s start from the top down.  The CEO of the ZAGG is Robert Pedersen. As mentioned in the widely read Worthless Pennies report, CEO Pedersen was involved in many penny stocks over the years.  Yet, Citron wants it noted that he was not just passively involved, but while the CEO of ZAGG was supposed completely fully dedicated to his position with the company, he was moonlighting orchestrating dodgy reverse merger deals.  Below are the list of stocks and the relevant dates he appears at the center of reverse merger deals while he was the acting CEO of ZAGG. 

 

         

Ticker	Company	Merger Filing   Date	Recent price
AMBS	Amarantus Biosciences	6/3/2011	1.05
ADSYQ	Ad Systems Communications	2/12/2010	.0014
PMOZ	PrismOne	6/22/2009	.0027
BESN	Blue Earth Solutions	5/20/2008	.0011
GNAU	General Automotive	2/28/2008	.05
WSGF	World Series of Golf	2/1/2008	.01
ZNOM	Znomics	11/08/2007	.0255

 

The Face of Fraud

The public’s last line of protection in the soundness of companies it invests in is the auditor.  It is the audit committee that is responsible for all aspects of the audit relationship.  Because of the red flags regarding ZAGG’s inventory and sales policies, the auditor and the integrity of audited financials going forward is the fulcrum of the investment’s safety and soundness. 

 

As mentioned in the previous report but cannot be understated, late last year ZAGG committed blatant securities fraud by not disclosing the dismissal of the former head of its audit committee Lorence Harmer until four months after the event.  Clearly there were shenanigans involved; ZAGG appears to have eaten a substantial loss after having advanced $4 million in a related party deal with the Chairman of its own audit committee.  

 

On November 5, 2010, he resigned from ZAGG but the company never filed a required 8-K announcing the event.  To make maters worse, the company then issued a 10-Q just four days later, but made no mention of the resignation or a replacement.

 

What were they hiding?  Why did they not want the investing public, or their new auditors to know the new head of the audit committee?  Here is why.

That all becomes a little more clear once you realize his replacement is the abovementioned Randall Hales.  This choice is unspeakable from a corporate governance standpoint.  And note that is he works hand-in-hand with CFO Brandon O’Brien, whose last public company went into liquidation while he was CFO, with annual revenues barely more than $1 million.

So these are the horses you are betting on when you bet on ZAGG. 

 

   Hello Skullcandy, and a comment on valuation.

 

Once public, Skullcandy will have 27.5 million shares outstanding with management selling half of their equity at IPO.  With a brand that is growing over 100% a year and ttm revs of 160 mil and strong management, Skullcandy would have the same enterprise valuation as cash strapped ZAGG…but who cares about valuation when your business will eventually implode?

   Conclusion

Buyer beware.

 

Cautious investing to all.

stock ticker: ZAGG

Citron comments on ZAGG, Inc.  (NASDAQ:ZAGG)

Price target:

One month — $8.00

24 months — $2.00

 

Outstanding Shares: 

• 26.2 million fully diluted per Q1 10-Q
• + 4.4 million shares for iFrogz acquisition
• New Share count:  30.6 million shares

Debt:

• 4.2 million
• $5 million assumption from iFrogz
• $50 million new debt financing:

Enterprise value  $450 million +

   Overview

 

Citron notes the insightful writings of others on this red-flagged company, in particular Roddy Boyd at  http://www.thefinancialinvestigator.com/ and Worthless Pennies,  http://www.scribd.com/doc/45466615/ZAGG-Presentation-12-14-10-Final-2 , who have both carefully documented the personal backgrounds of a number of dodgy players in gadget protector company ZAGG. 

However, Citron advises that to get to the heart of ZAGG’s current problem, investors need to follow the money.  If ZAGG’s current financial reporting were as clear as its gadget protectors, we would be inclined to withhold judgment on management’s history.

But while the company is battling scarce cash, it is perilously dependent on a single concentrated retail relationship that in Citron’s opinion puts it at huge risk of restatement.  Meanwhile there’s a very troubling track record of insider transactions among management that are adverse to shareholder interests, an 11^th hour auditor switcheroo last year, and a long record of abject failure at executing on “the next big thing”.

For its readers, Citron notes these data points and connects the dots.   For reasons we will document below, it is Citron’s opinion that the company is in desperate need of additional financing, and the coming dilution will be at the hands of existing investors to fund a business model that has bankruptcy written all over it.

   Please Define “Execute”

Let’s evaluate this company from another perspective:  What management says vs what has really happened.

Last week the CEO of ZAGG came on CNBC and, while dodging the real questions of the company’s lack of cash flow, stated  “We are proud that the company has ‘executed’ its business plan.”  When Citron heard this, we didn’t know if he meant executed (to carry out fully) or executed (to put to death).  It seems that EVERY new business ZAGG has entered over the past few years has been a colossal failure.  Here is a sample of their press releases and results.

 

August 14, 2007  “RockStic”  Portable speaker system for iPod (one of thousands) — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=259618

 

May 2, 2008:  Finance animated and live-action feature films — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=307948

 

March 31, 2009  New design for Zbuds — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=374064

 

June 8, 2009  Mobile App marketplace — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=388591

 

Sept 29, 2009  Waterproofing technology — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=412063

 

October 29, 2009  Zagg box – big failure

http://investors.zagg.com/releasedetail.cfm?ReleaseID=419590

http://www.zaggbox.com/wheretobuy.php

 

Dec 22, 2009  “Zaggsparq” portable lithium battery system  – failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=432001

 

April 6, 2010  iPad Photo App — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=456981

To make matters worse, on the deal for the ZAGG box, they had their own head of the audit committee hoodwink them for over $4 million.  When the head of your audit committee pulls a fast one on the company, it is like your own mother telling you “you’re ugly”.

   The Whole ZAGG Story in one graph

Beneath the constant stream of cheerful sounding PR’s, the company’s actual financial condition as reported in its filings is appalling. There are numerous disturbing trends that can be observed in ZAGG’s reported numbers, including increasing SG&A as a percent of revenues, declining inventory turns, and that glaringly small cash balance.  But all you need to know is the little chart here from Google finance that shows the cash flows of the company

http://www.google.com/finance?q=NASDAQ:ZAGG&fstype=ii  (Click the “Cash Flow” tab)

So the business was generating zero cash a year ago.  Since then, operations have burned an increasing amount of cash, which loans and equity issuance have shored up until now.   

 

Cash was so scarce at the end of last quarter ($1.7m), that the question could legitimately be asked whether the company could make payroll this month.  (SGA alone was $8.78m last quarter)   And that is before considering how iFrogz’s current burn rate will be funded. 

 

Just a couple of the metrics that indicate the severe problems underneath the covers here:

 

	Mar-11	Dec-10	Sep-10	Jun-10
Revenues	26.976	29.253	23.06	15.047
CASH (millions)	1.767	2.373	5.886	6.402
SGA	8.782	7.251	5.427	4.294
SGA % of revenues	32.55%	24.79%	23.53%	28.54%
Recievables (millions)	18.65	23.76	14.40	9.48
Inventory (millions)	21.19	17.95	10.39	6.20
Inventory turns per year at current run rate	5.09	6.52	8.88	9.70

 

   Kissing a Frog Doesn’t Make it a Prince

ZAGG’s stock got a big boost when it acquired competitor iFrogz for about $100 million in stock and cash.

Why has the company has not filed the required 8-K disclosing the financials of the acquired company?  Are we to believe that this acquisition was done without benefit of an audit?  If not, how could it be accurately valued?  If so, why haven’t the audited numbers been shared with the market?  iFrogz is itself just a wannabe competitor for Skullcandy, and also competes directly with ZAGG SKU’s, Citron wonders why this acquisition is a justification to bid up the stock ?   ZAGG mentioned that iFrogz has operating margins in the 20% range, but we find that hard to believe — that is the range of the established brand Skullcandy line.

For stock market history buffs, Citron believes ZAGG has “Forward Industries (NASDAQ:FORD) written all over it.    http://www.google.com//finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1309464000000&chddm=909458&chls=IntervalBasedLine&q=NASDAQ:FORD&ntsp=0

The problem is that accessories for electronic gadgets is fundamentally a brutally bad business.  The Financial Investigator and Worthless Pennies did a fine job in describing the competitiveness and razor thin margins of the screen protector business.   The huge proliferation of SKU’s for each new model of gadget is a big problem under the best of circumstances.  Then there’s colors and styling.  For runaway models such as iPad2, there’s no barrier to entry.  The competitiveness and non-differentiation in the iPad case business is so bad, that even the New York Times ran a feature article on the space just yesterday:    http://www.nytimes.com/2011/07/07/technology/personaltech/a-closetful-of-options-for-protecting-the-ipad.html?_r=2&ref=business

 

   The #1 Question Management Will Not Answer

Ask anyone who works for Best Buy corporate about Best Buy’s policies for returns of unsold accessories (not to mention why they don’t private label their own).   We have.   Also, if any of Citron’s readers visited Consumer Electronics Show over the past two years, you would note that there are halls and halls dedicated to low price cell phone covers that can be imported from China for pennies.  It has become the ultimate commoditized product in the accessory market.

Because of ZAGG’s concentration of sales to Best Buy, investors are desperately in need of transparency with regard to its rapidly rising inventory.  How much of this “inventory” is good inventory and how much is required to be bought back from Best Buy?  Is this number accounted for in write-downs?  It is a VERY simple question, but management provides only circular answers.  They have always maintained that Best Buy cannot return product to them.  To this we say Bullshit.

On November 9, 2010, the Company conducted its Third Quarter Earnings conference call.  Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company’s Chief Financial Officer, participated in the call on behalf of the Company.  During the question and answer portion of the conference call, Mr. O’Brien was asked questions about Best Buy’s right to return products sold by the Company to Best Buy.  In response, Mr. O’Brien stated that the Best Buy contract did not allow Best Buy to return products to the Company.  As clarification to Mr. O’Brien’s statement, the Company notes that Best Buy can return products to the Company under limited circumstances, including where products are defective or for other similar customary reasons. 

What defines a “customary reason”?  Are you recognizing revenue on these “customary reason” returns?  Would any of your sales terms to Best Buy qualify as consignment basis ?   Do you pay cash incentives to Best Buy?  How are inventory levels determined?

The language employed by ZAGG to define this relationship is extremely unusual; we could find only a handful of companies in recent years that used it … most have since ceased filing. 

   Is Management Worthy of Investors’ Trust ?

To illustrate just how untrustworthy management is, from the 10-K filed March 25, 2011, we learn of the resignation of director Lorence Harmer.  But magically, we learn that he resigned as Audit Committee Chair back on November 5, 2010, over four months prior!  Now that would have been an event for which a definitive 8-K should have been filed.

“On March 14, 2011, Lorence A. Harmer resigned as a director of the Company.  Mr. Harmer had served on several of our Committees through November 5, 2010 including serving as the Chairman of the Company’s Audit Committee; as a member of our Compensation and Stock Option Committee; and as a member of our Nominating and Corporate Governance Committee.  Effective November 5, 2010, Randall Hales was appointed as the chairman of our Audit Committee.”

 

 http://www.faqs.org/sec-filings/110325/Zagg-INC_10-K/#ixzz1RQMFlYt6

 

We wouldn’t quibble if this was just one of those “for personal reasons” resignations.  But it seems Mr. Harmer had entered into a major related party transaction with ZAGG over the “ZaggBox”, which resulted in ZAGG having paid out deposits of over $4 million dollars, for which it got nothing.  This has now been papered over by a promissory note from Harmer, secured by real estate with collateral value insufficient to cover the principal.  And this blatant related party transaction was conducted by the Audit Committee Chair!

The larger problem here is ZAGG’s corporate transactions are laced with inexplicable and indefensible related party transactions similar to this one.  

   Beware the PIPE

The absence of an 8-K with accurate financials for iFrogz, along with Northlands constant table-pounding begs us to ask the question … what will come first:  the 8-K or the PIPE offering?

 

It has been a long time since we’ve seen an analyst with the conviction of Northland’s – 4 upgrades and reiterations in the last week!   

Too bad Northland can’t anoint ZAGG as its “Pick of the Year 2011”, that choice having already been reserved for CCME.

http://www.scribd.com/doc/47598147/CCME-Top-Pick-of-2011-Northland-Securities

Do you think Northland might possibly have an interest in getting a piece of the action in ZAGG’s financing ?    

   Note to management: 

Don’t bother responding to this report.  ZAGG is now a company with an enterprise value approaching half a billion dollars … act like one. 

The problems in this stock are not the shorts.  It is Citron’s opinion that this is what the market demands of ZAGG: 

• File an 8-K with the audited financials of iFrogz
• Give Wall Street fully transparent disclosure on your entire relationship with Best Buy, and
• Start turning a cash profit 

   Conclusion

ZAGG’s stock is priced not for its current business, but in anticipation of a highly profitable future.  However, it is Citron’s opinion that ZAGG management is simply not credible, and its track record is not worthy of investors trust.   Management’s track record is laced with blatant self-dealing, execution failures, and disclosure omissions.  The lack of transparency in its most concentrated retail channel relationship puts it at severe risk of a devastating earnings restatement.

Meanwhile, ZAGG simply has to raise cash.  It is Citron’s opinion that a PIPE could come any day, and a secondary would follow an 8-K on the iFrogz acquisition.  It is Citron’s opinion that absent their ability to raise cash from investors, ZAGG is a likely candidate for bankruptcy inside of 24 months.

Citron disagrees with The Financial Investigator on only one point:  the one where Roddy Boyd states there is no barrier to entry to ZAGG business.  NOT TRUE.   It is Citron’s opinion that the barrier is that very few companies want to enter into a low margin, money losing business. 

 

Cautious Investing to All

 

stock ticker: HRBN

If you haven’t yet figured out that there is rampant fraud amongst many Chinese stocks (mainly RTO’s), you obviously live in a “financial cave”.  The story has become so mainstream in China and the United States that it is actually featured in this week’s Time Magazine.

http://curiouscapitalist.blogs.time.com/2011/06/14/chinas-latest-export-stock-fraud/

Citron Research, the source that exposed Longtop Financial (NYSE:LFT) and the first to write on China MediaExpress (NASDAQ:CCME), now exposes the fraud behind Harbin Electric (NASDAQ:HRBN).

   Background

In its last reports on Harbin Electric, Citron has shown that:

1. the company is potentially lying on their SEC filings, as their SAIC filings document higher liabilities and significantly lower profits than they report to the SEC.   HRBN 2011_05_25

2. in the second report we described how preposterous the proposed buyout financing actually is:  http://www.citronresearch.com/index.php/2011/06/09/what-the-bank-says/

   Good Night …

It is Citron’s opinion that it is now time for the SEC to halt this security.

The future of Harbin’s stock price is currently propped on the crutch of a purported $24 buyout offer from its Chairman / CEO, which Citron believes is a sham.  With time stretching seven months since first proposed, we still have no binding, official takeover bid filed in an 8-K, just a few press releases, and now the boilerplate document of a purported supporting loan that seems half baked, as discussed in the last report.  These filings are always tagged with the company disclaimer:

“There can be no assurance that any definitive agreement will be executed with respect to this proposal or that this or any other transaction will be approved or consummated.”

 

Yet, through reliable sources Citron has just obtained documentation that

 The Harbin Chairman/CEO Has A History of Fraudulent Loan Guarantee Documents! 

 

Citron Research has obtained a settlement agreement reached between Harbin CEO Tianfu Yang and China Construction Import Export Corp.  In 2004, Mr. Yang along with his brother, fellow Harbin board member Harbin Vice President, (corrected per   http://www.harbinelectric.com/management.html   ) Tianli Yang, fraudulently obtained the official seal of China Construction Import Export Corp. (CCIE) to guarantee a loan for Tinafu Yang’s company.

In the settlement agreement with CCIE, Tianfu Yang admitted guilt in order to get CCIE to agree to drop criminal proceedings in the matter. 

(Citron has gone to great length to verify the authenticity of these documents, and will publish any challenge or correction that can reliably demonstrate that they are not authentic.)  Here they are for your viewing pleasure. 

Harbin Chairman Civil Settlement

Harbin Chairman Civil Settlement (translated…)  ( … PDF format )

Signature of Tianfu Yang on SAIC doc that matches signature of settlement agreement

This link shows the signer from China Construction is the official legal representative of CCIE:

http://www.ypofchina.com/ep/detail3.aspx?id=335628

Citron recalls vividly how vociferously Longtop officials decried as “unfair” and “irrelevant” when Citron’s published references to a lawsuit, documenting prior misconduct of the Chairman of Longtop.  Similarly, this document goes directly to management’s credibility and trustworthiness.  And since Harbin’s buyout valuation rests solely on the credibility of the Chairman and his offer, this should be the end of the road for the Harbin charade.

Citron wonders how this disturbing legal baggage will reflect on Chairman Yang creditworthiness to his bank or any other bank evaluating this deal.

Citron asks:  Why all this effort to keep people’s attention off the underlying business?

 

Citron believes that, absent this sham buyout offer, shareholders are holding a company that is a potential 0….yes a 0, as in donut.  We believe the company has undisclosed liabilities, as we have seen with companies such as Longtop Financial.  Also, even with its limited disclosures, Harbin as a company is far too dependent on lending to support a business with heavy capex burdens, slimming margins, and decreasing revenue.

 

So now we are supposed to believe that a company, run by a gentleman with a disturbing history of loan misrepresentation, is actually obtaining a signature loan for $400 million, to buy out the publicly held shares at a 40% premium?  And this transaction is going ahead in a market environment so rife with skepticism about Chinese stocks and skittish about economic concerns that no Chinese company has sold a bond in the high yield market since May 26? 

http://www.reuters.com/article/2011/06/16/us-markets-stocks-adrs-idUSTRE75E6BF20110616

And this transaction is predicated on the numbers filed by the most notorious discredited auditor in the China space? 

And who is the purported lender bank?  China Development Bank – a bank who has become too familiar with China stock fraud.  They are the lender for the recently decimated Sino-Forest:

http://www.reuters.com/article/2011/03/23/idUS232730+23-Mar-2011+PRN20110323

Ask yourself if a little professional skepticism isn't warranted here. 

   The curious case of Harbin’s 2010 bank loan

Citron believes that in reality Harbin is a money pit with hidden liabilities that are consuming its cash. 

Only a month after the original “takeover announcement”, over six months ago, Harbin’s Chairman executed a $50 million dollar bank loan for the company, collateralized by his personal stock holdings, worth more than double the loan amount at the time. 

We ask one simple question.  Why?  If you really have $55 million in the bank, earning less than 1% interest, would you borrow $50 million at 8% interest if you don’t desperately need the money?

Clearly its an expensive transaction – the company is paying $1.9 million interest quarterly to service the loan (at 8%), while earning less than $200,000 interest on its free cash balances.  And according to more recent filings, they've never used the money.  It supposedly just sits in their bank account.  (Sorry to be so damn obvious.)

Regardless of what the reason is, it bodes poorly for a company that expects to get financing to go private for a 70% premium to market. 

 

  Not Only Does Citron Not Believe Harbin…but neither does Wall Street.

 

It is not only Citron that doesn’t believe the takeover but obviously Wall Street doesn’t either. 

Here is a typical Wall Street risk/arb spreadsheet, showing the difference between the current market price and the proposed takeover price for dozens of deals in process. 

https://spreadsheets.google.com/a/citronresearch.com/pub?hl=en&hl=en&key=0AkR3if0ljyredEZ4N2RFSzVzQVF3QW5iWkpmSjd4cXc&single=true&gid=0&output=html

 

Note that these stocks all trade within a few percent of the proposed  takeover price.  Yet Harbin has never traded higher than the range of 50% to 70% of its takeover price. 

 

To illustrate a final point we’ve made previously about the China space, there’s a tremendous vulnerability for US investors who assume  “a stock is a stock is a stock” if it trades on the Nasdaq or the NYSE. 

Investors are going to face “mission impossible” when trying to avail themselves of the customary legal protections they assume are available to shareholders, for companies domiciled in China.  Here’s a news story about one of the early civil shareholder suits, which can’t even get papers served on defendants domiciled in China.  Buyer beware!

http://newsandinsight.thomsonreuters.com/New_York/News/2011/06_-_June/Plaintiffs_hit_first_roadblock_in_China_fraud_case/

 

   Conclusion

 

For those of you who do not read Citron, yesterday another China coverage stock was halted:  China-Biotics  (NASDAQ:CHBT) …. How long until Harbin faces the same fate?

Citron has hundreds of pages of SAIC documents – the in-country filings of Harbin’s subsidiaries over the years.  These documents do not even remotely resemble the company that Harbin portrays to US investors in its SEC filings. 

But needless to say, we think no bank in China or anywhere else would dream of relying on Harbin’s SEC filings, generated by a disgraced auditor, as a basis providing hundreds of millions of dollars in high-risk financing to fund a huge premium to pay off US investors.

Citron sees no reason to drown readers in paperwork to prove a fraud that is too obvious.  If need be, we will continue to publish information on a timely basis that we find is relevant to investors.

 

Cautious investing to all.  

stock ticker: HRBN

  ** Post-publication afterthought:

 

To demonstrate just how stupid this is, if this $400 million dollar non-collateralized, personally guaranteed signature loan is to be believed, it is Citron's belief that it would be the largest single unsecured signature loan ever issued by any bank.

Citron challenges anyone to document a larger loan by any bank in any country in the world on similar terms.

 

   It's official!  Well, sort of ….

Today Harbin Electric (NASDAQ:HRBN) files its latest document in the unfolding soap opera of whether it can complete its private takeover transaction announced last October.

It includes a sizable boilerplate document from China Development Bank purporting to document the extension of a $400 million credit facility that allegedly provides the financing so the Chairman Tianfu Yang can take HRBN private at $24 a share.

While the document appears really impressive, it says almost nothing about security for the transaction.  The entire structure of the loan depends on the personal guarantee of Chairman Tianfu Yang and Ms. Luo Qian. 

Now we know banks in China in the past have been loose with lending.  But a $400 million dollar loan based on a personal guarantee, when they wouldn’t lend more than $50 million (with a huge spiral pledge of stock to collateralize it)  just six months ago? 

We don't think so!  

In China, you can not get a $400 million dollar loan because you know someone.  But you can get a commitment letter for a $400 million dollar loan if you know someone.

   Nice and Simple

If this deal is so simple the Chairman can just finance it with a simple signature loan, why didn't he do it last fall when it was announced?  He didn't need Barings, he didn't need Morgan Stanley, he didn't need Goldman Sachs, and he didn't need Bain.  He didn't need 7 months of deliberations by a "Special Committee".  It would be done by now, and the stockholders would have been delighted.

   Today’s Headlines in China

This week, China’s leading business magazine, Caijing, publishes its cover story on China stock frauds.

 http://translate.googleusercontent.com/translate_c?hl=en&ie=UTF8&prev=_t&rurl=translate.google.com&sl=auto&tl=en&u=http://magazine.caijing.com.cn/2011/cj292/index.html&usg=ALkJrhgYWFySGTOfRWE6j9qf7xfDGZ1JAw

 In this article they quote me, Andrew Left, editor or Citron Research, referencing my work uncovering the many frauds among Chinese companies with US stock listings.  You might not be aware that I have been writing on stock fraud for 10 years.  I uncovered my first China stock fraud over 4 years ago (XFML).  Since then I have covered 11 others.  All but 1 are down an average of 80% from the time of first publication.  One is halted, two have been delisted, and one has seen criminal indictment against management — with many more to come, we suspect.

 

I am just getting warmed up.  Citron is now asking the investing public to think out the story of HRBN for yourself.  See if you come to the same conclusions as regulators, investors, grand juries, and media on the prior opinions of Citron Research.

It is Citron’s opinion that  Harbin Electric is deceiving the public.  If the stock does not get halted for its numerous SEC violations, we believe it is at best a $5 stock.

   THIS IS NOT FINANCING…THIS IS A CHARADE

THIS IS MISLEADING TO INVESTORS AND IS AN ACT OF A DESPERATE COMPANY.  Look at this simple timeline:

 

Date	Event
Oct 12, 2010	HRBN announces a $24/ share buyout by the CEO and Baring Private Equity — with no 8-K filed and no terms attached. Goldman Sachs Private Equity Asia Group announced as financial advisor to the acquisition vehicle.
Nov 22, 2010	The company borrows $50 million from China Development Bank.  In an odd move, the bank does not securitize the loan with company assets, but rather the Chairman’s stock – 7 million shares — $130 million in stock – for a $50 million dollar loan
Nov 23, 2010	Barings backs out of the proposed management buyout.  Goldman Sachs’ Private Equity Asia Group role revised to “advisor to Chairman Yang”.
Apr 15, 2011	Phone call between Chairman and William Blair analyst – for which an 8-K was subsequently filed – because Chairman stated he was making a bid for the company the following Monday – No such bid was ever made.
May 10, 2011	Company files 10-Q for Q1 2011, reporting drastically compressed margins and lowered earnings, and reducing guidance.
May 12, 2011	SEC 13D filed, stating the HRBN board received a formal proposal – yet no 8-K was ever filed with the proposal terms.  It is in this 13D that we read about the aforementioned alleged financing, with no documentation of terms of the agreement.

 

And now today, we get a SC13D, and all it says is that the Chairman proposes to finance this transaction with …… drum roll…..a signature loan! 

Now it is time for everyone to think….simple common sense…the same common sense that has guided Citron's reporting to be one of the premier destinations for finding information about deceptive China stocks.

 

At first we thought the financing was coming from Baring, but it took them less than a month to back away.  The company then said they are working with Goldman Sachs, who undoubtedly has access to capital at the snap of a finger for a legitimate LBO, but nothing happens there.  And here is what we hang our hat on.

 

The alleged financing is now a commitment letter for $400 million from China Development Bank, the same bank which lent Chairman Yang $50 millon in November.  Yet, this existing loan was not made with the company, rather its proceeds purportedly go to Chairman Yang’s company, Tech Full, based in the Cayman Islands and recently domiciled in Nevada.  It is no more than a holding company that holds stock. 

And now this new loan, 8 times the size,  is supposedly based only on his personal guarantee plus Ms. Luo Qian?

 

So let us see what has changed between the first financing and the second (alleged) with the SAME BANK.

 

• China stock fraud has moved from the blogosphere to front page of WSJ and mainstream China and Hong Kong press.
• Over 20 Chinese RTO’s have been halted and/or delisted and only a few have reopened.  Therefore anyone with loans outstanding collateralized by shares in any of these stocks is up the Yangtze River without a paddle.
• HRBN’s auditor has been disbanded after being charged with fraud by the SEC.
• The chairman of HRBN’s audit committee (and also the chairman of the “Special Committee” overseeing this deal) has been sued for a fraudulent transfer by the bankruptcy trustee of his former employer.
• The company has reported lower earnings with negative cash flow.
• It has come to the attention of the investing world that HRBN’s SAIC documents show substantial liabilities never reported by its auditors in its SEC filings.
• Baring Private Equity walked away from financing the deal
• The mighty Goldman Sachs was not able to find financing for the deal

So the company is back to square one – with the bank who lent them $50 million in November. 

Now let’s assume for a moment that China Development Bank does not have internet and does not know how to read the news in English or Chinese  and now has no idea of how sentiment towards Chinese stocks has changed in the intervening months.  Let’s say they decide to stick to the same terms as the original deal…

On the same ratio of his currently outstanding $50 million loan, Chairman Yang would be responsible for posting over $1 billion in liquid marketable collateral to borrow $400 million.  So unless he owns an NFL team or the Mona Lisa ….how in the world would China Development lend $400 million to a Cayman Island Company with no assets or collateral? 

 

Mind you, that is under the best of conditions.

 

In most LBO’s you cannot use stock as collateral.  More importantly, the bank has already made it clear that they have no interest in the assets of the company as collateral.

 

The bank is not in the business of making bad loans…look at the hard-line deal they cut with HRBN last November under circumstances far better than now.  If you believe that the bank will lend $400 million to a Cayman Islands company to buy another company that they wouldn’t fund for $50 million in better times, then I have a large wall to sell you North of Beijing. 

   What Keeps a Banker Up at Night?

 There is an old adage: when you owe the bank $1 million, you lose sleep.  But when you owe the bank $50 million, then the banker loses sleep.  With the amount of Chinese RTO’s that have just ceased trading altogether, no amount of collateral of shares and Ambien can make this banker sleep at night.   If this stock gets halted or breaks below a certain price on a hard core investigation … the bank could wipe out its profits on billions of dollars of good loans with one $50 million write-off.

By the way, as a funny footnote, China Development bank was actually a client of Longtop Financial, which is still halted. 

http://ir.longtop.com/index.php/content/content_print/456.html

What makes this whole sideshow interesting is it seems that the company is doing everything in its power to keep the stock price up…in the initial loan agreement the bank made it clear that if they believed their $50 million loan was in peril, they would sell stock and keep selling even if it means they need more than the pledged 7 million shares.  It is the belief of Citron that HRBN is a struggling company doing whatever they have to do in order to keep that share price high enough.  Like the game of musical chairs, when the music stops will the bank have a seat?

 

  The Risks of Regulatory Attention

Further, Citron suggests the SEC and the NASD are already having a hard look at the practice of announcing "private buyout" deals that lack material basis.  Numerous currently halted China stocks are the subject of bogus takeover announcements right now. 

   Conclusion:

Don’t forget that after Chairman Yang gives you his wink-wink nod-nod at the social clubs throughout Harbin or on phone calls with analysts — use your common sense.  If you do not, you might end up on the wrong side of the trade like the many other Citron detractors of the past.

 

Cautious investing to all.

 

stock ticker: HRBN

Citron issues further commentary on Harbin Electric (NASDAQ:HRBN)

At the risk of overstating the obvious, Chinese stocks have fallen out of favor fast with US Investors.  And for good reason. 

  What's New?

A lot of things have changed since Harbin’s elusive $24 per share buyout offer was floated eight months ago.  Since we published on HRBN last week, yet another high profile China “blue chip” – Sino-Forest (TRE in Canada, SNOFF in the US) has been decimated by allegations of fraud from Muddy Waters Research.  The stories of Chinese frauds have gone from the back pages of weblogs to front-page news in business journals worldwide.

The SEC has also recently stated its intention to increase scrutiny of US-based auditors within its inquiry into Chinese reverse-merger companies.

http://online.wsj.com/article/SB10001424052702304563104576361422372121248.html?mod=googlenews_wsj

One thing for sure hasn’t changed:  Harbin’s auditor still is listed as Frazer Frost, a firm which no longer exists.  Frazer and Frost have dissolved their partnership; Frazer, who remains as Harbin’s auditor, also has RINO and CVVT to its credit, among other notorious stock failures in the China space.

 

And another thing hasn’t changed in the past eight months.  Harbin Electric still stands by a “phantom bid” by its Chairman to take the company private.  Even though there is no formal offer, no committed financing, and the company’s reported financial performance has eroded materially in that time, investors are sitting on the edge of their seats waiting for the approval of this gesture by a “special committee” formed by Harbin.  Citron expects the next press release from the company to be an “acceptance” of this buyout offer, or at the very least, a special meeting of this special committee.

 

Before we go into who is on this special committee, lets first address the absurdity of this eight-month wait at the hands of the “special committee”.  Why would it take three men a total of eight months to approve an informal offer to take the company private at a significant premium?  Heck, the US Congress took less time to bail out the entire banking system and the US automakers!

 

“The Company’s Board of Directors has formed a special committee of independent directors consisting of David Gatton, Boyd Plowman and Ching Chuen Chan (the "Special Committee") to consider this proposal.  The Special Committee intends to retain independent advisors, including an independent financial advisor, to assist it in its work. No decisions have been made by the Special Committee with respect to the Company's response to the proposal. There can be no assurance that any definitive offer will be made, that any agreement will be executed or that this or any other transaction will be approved or consummated. A copy of the press release is filed herewith as Exhibit 99.1 to this current report on Form 8-K and is incorporated herein by reference.”

   Introducing “The Committee”

While Citron eagerly awaits the special news this special committee will be generating soon, we’d like to introduce the players to you now. 

   Introducing committee member #1:

The chairman of the special committee is a gentleman named Boyd Plowman.  Mr. Plowman is the former CFO of Fleetwood Enterprises and is the chairman of the HRBN audit committee as well.  Interestingly enough just two months ago, the trustee of his former employer, now in bankruptcy, sued him.

 

“Plaintiff alleges on information and belief that Defendant used or benefited from his senior position with the Debtors to cause or to influence the Debtors to use corporate assets to make Benefit Plan payments to himself and other insiders at a time when the Debtors were insolvent.”

Plowman_Complaint

Note: Citron does not believe this makes Mr. Plowman a bad person and we do not know the end result of the lawsuit.  It just shows that Mr. Plowman has no problem playing “loose with the rules”.

 

… and now, Member #2

 

The next member of the special committee is David Gatton.  The company has no problem publishing the many accolades of Mr. Gatton :

http://www.wikinvest.com/stock/Harbin_Electric_(HRBN)/David_Gatton_Board_Member_Chairman_Compensation_Committee

 

However, Citron notes that Mr. Gatton was also on the board of directors of Bodisen Biotech.  Bodison was one of the first and most notorious of the China reverse merger stock frauds, after being a battleground stock for some years.  Of course, the company blamed its eventual demise on short sellers.

 

http://geoinvesting.com/forums/yaf_postsm3635_BODISEN-CASE-ANALYSIS–COLLUSION-BETWEEN-STOCK-SHO.aspx

 

Bodisen was eventually delisted in March of 2007, but Mr. Gatton did not resign until February of 2008.

 

Again, this does not make Mr. Gatton guilty of any crime.  It just shows that he is not immune to aligning himself with unscrupulous companies whose strategy for “creating value for shareholders” is essentially doing battle with short sellers. 

   …and Member #3

The last person on the special committee is Ching Cheun Chan. Much like Mr. Gatton, the company details many accolades in Mr. Chan's career. 

http://www.harbinelectric.com/boardofdirectors.html

But we also see he was also a director of a broken penny stock in Singapore called Azeus Systems.

http://www.securities.com/Public/company-profile/SG/Azeus_Systems_Holdings_Ltd_en_1690368.html

Azeus now trades for .08 cents

http://finance.yahoo.com/q?s=A69.SI%2C+&ql=0

 

Ching Cheun Chan was also on the board of a dubious US penny stock named Rotoblock, which he just resigned from in February 2011.  That stock currently trades by appointment at $1. 

In 2008 it was promoted to a brief high of $10 per share. 

http://finance.yahoo.com/q;_ylt=Ao5wT.DeGQ0I.sIDHyLZEwfxVax_;_ylu=X3oDMTFjOXRqY2NlBHBvcwMxMgRzZWMDeWZpU3ltYm9sTG9va3VwUmVzdWx0cwRzbGsDcnRiY29i?s=RTBC.OB

He also has stints on advisory boards of ZAAP and ALTI, which trade for 50c and a $1, respectively. 

http://people.forbes.com/profile/chan-ching-chuen/39300

Again, this does not make Mr. Chan a bad person; it just seems to Citron that he is a name for hire who does not mind aligning himself with any public company regardless of their credibility.

   Conclusion

 

So as investors mull over this phantom bid, Citron believes it is important to note the pedigree of the three gentlemen who we believe will be at the epicenter of Harbin’s next PR. 

 

The fact that Harbin has delayed its response for so many months, while expecting investors to be keep paying to keep the stock price up, just takes us back to the good ole country sound “That’s  My Story and I’m Stickin’ To It”. 

 

( For those of you who have never heard it….you can read these lyrics here:

http://www.lyricsdomain.com/3/collin_raye/thats_my_story.html  )

Citron advises readers not to believe what the company says, only what it does.

That’s our story and we’re stickin’ to it. 

Cautious investing to all.

stock ticker: HRBN

  Harbin Electric (NASDAQ:HRBN) Does their buyout story really make any sense?

 

 

 

Citron has received worldwide press exposure for its first-in-the-market commentary exposing China MediaExpress (CCME) and Longtop Financial (NYSE:LFT).  The driving force of our commentary has been and will continue to be simple common sense.  Whereas most analysts are busy listening to the company or blindly vouching for management’s statements, we reference a more profound source — the simple question, “Does this make any sense?”  So in keeping with the spirit of that question we present to you Harbin Electric.

On October 11, 2010 The Harbin board announced it received a “proposal of going private” from its Chairman Mr. Tianfu Yang.  Notice a proposal is not a buyout offer — it is just that — a proposal.  To Citron, this is like a “promise ring” exchanged between teenagers.  It is now eight months later and we still don’t have our engagement; shareholders just stare at their promise ring with hope. 

Citron asks…”Does this make any sense?”  Let us examine the deal.

When the proposal was announced in October…it was pre-RINO, pre-CCME, and pre-Longtop.  (These three notorious blowups have set the tone for finding fraud in China stocks over past 8 months).  Note to Harbin management:  “If you couldn’t secure the financing in October…than good luck trying now.”

  Listen to the Bank

 

One month after the CEO put the promise ring on the fingers of shareholders, he turns around and enters into a term loan facility with China Development Bank for $50 million.  Yet, the bank does not securitize this loan with the assets of the company or with its cash flow.  Rather, the bank collateralizes the loan with 7 million shares of Harbin stock pledged by the CEO … with provisions calling for him to pledge additional shares of stock if the price goes lower.  At the time of this transaction, he pledged stock worth $140 million USE collateral value for a $50 million loan.  What does the bank know that we don’t?

Well, if anything, this transaction created one powerful incentive for the CEO to keep his stock price higher.

   SEC vs SAIC

 

Those who believe SAIC filings do not make a difference are invited to skip this paragraph. 

The reason Citron believes SAIC filings are relevant in the case of HRBN, is that the sources of funds for Harbin’s proposed going-private transaction are money from within China — whether it be a partner or a bank.  Is it so far fetched to believe that possibly the banks in China rely on documents produced in China?   Citron has obtained copies of the HRBN SAIC docs from two different sources and they paint a completely different financial picture of the company than it presents in its SEC filings.  Below are the Chinese copies of the SAIC docs along with a spreadsheet summary of the numbers comparing them to SEC filings.

SAIC docs: 

Weihai Tech Full-0809, 

Shanghai Tech Full SAIC

Xi'an Tech Full SIAC

Harbin Tech Full annual inspection 08

Harbin Tech Full annual inspection 09

Spreadsheet compilation: 

HRBN 2011_05_25

The takeaway from Citron is that the SAIC filings reveal low profitability and undisclosed liabilities.   After the “Longtop fiasco” we understand that hidden liabilities are a larger and more real concern than ever.  The SAIC docs from Harbin and Shanghai Tech Full Electric reported consistent losses in both fiscal years 2009 and 2010. The Harbin subsidiary lost 1 million and 3 million USD in the two years respectively and the Shanghai subsidiary lost 2 million and 1.3 million in those two years.

  IS THIS WHAT THE BANK KNOWS??

 

A simple consolidation of HRBN’s four subsidiaries based on subsidiaries’ Chinese filings showed no more than $12 million USD of profits versus $80 million net income reported on its SEC filings in the year 2010. Additionally, it appears HRBN grossly understated its liabilities on its SEC filings when compared with a consolidated version including all of its subsidiaries. HRBN showed a total liability of $180 million on its SEC filings while consolidation of its subsidiaries yield a total liability of $244 million; similarly in year 2010, its SEC liability was $151 million versus a consolidated $276 million shown on the SAIC docs.  

  What a buyout should look like … if it was real.

Nine months ago when this “proposal” was released management could argue that things are done differently in China and shareholders need to understand.  Sorry, we now see that is just not true.  Just last week China Fire’s (CFSG) management agreed to a buyout with Bain Capital.  In that deal, we see a definitive partner in Bain and definite closing dates.  On May 31, we witnessed 2 deals get done.  The first was an investment into (YONG) from Morgan Stanley, a deal that posted with a firm closing date June 10, 2011.  The next is taking private of  Funtalk China Holdings (FTLK) by Fortress for cash. 

Of course, Citron cannot validate that all of these deals will get closed.  But lets look at the 3 key aspects that they all have.

 1.  There is definitive funding.

 2.  There is a definitive partner.

 3. There is a definitive timeline. 

With these 3 engagements from strong suitors on the table, Harbin Electric shareholders are obligated to look at their promise ring with wonder, doubting if it is nothing more than a cubic zirconium.

The overarching issue that defines HRBN as a complete outlier in these private equity transactions is the purported price of the deal.  All of the above stock transactions are priced relative to a trading range for the stock.  The most real of the above deal appears to be FTLK which is being acquired for $7.20 a share, a midpoint of where it has traded over the past 52 weeks.

At $24, the HRBN buyout promise is a price the stock has seen only on three brief visits during its entire trading history – once in 2007, and the others after the deal was announced.  Other than that, there is zero credibility to this price – it is simply made up. 

After all, their last quarter results reflected a disastrous compression of margins that would have sent a normal stock reeling lower, especially considering the debt load of the company.

   What are They Hiding?

 

Beyond the alleged unstated liabilities and lower revenue numbers, Harbin is a business without much sizzle.   HRBN was a reverse merger which has rolled up various electric motor manufacturers, is the primary operator of a large, antiquated, formerly state-owned electric motor manufacturing facility.  The company has burned over $90 million in cash, and would require a huge new capital investment to reach a tenable position in the current intensely competitive landscape.  Their 40-year-old factory, which makes small motor parts, appears to be everything but state of the art.

So, let’s assume for a moment that the buyout offer is not real, and cannot be consummated.  Why does the company find it necessary to keep this crutch?  It is the opinion of Citron that without the buyout offer, this stock could see single digits as investors realize they own a piece of China’s past, and not its future.  As long as the CEO can continue to put out press releases of advisory committees and 8-K filings alluding to “wink wink” conversations with analysts, the charade will continue.

Note to Harbin management:  If you are serious about buying the company, then take the ridiculous $24 price off the table, let the stock trade freely, and only then go in and buy it at a significantly discounted price to today’s offer  … then maybe you can get your financing and gain some credibility with Wall Street and your bank financeers.

 

  Bottom Line

 

If HRBN couldn’t secure financing when the story was good, how can they do it now?    

Harbin and the Chinese RTO space is no longer hot nor sexy.  In fact, it is toxic.  Harbin operates an old world manufacturing plant, producing largely commodity products at slim margins, with rapidly escalating prices for materials and labor.  And of course this was BEFORE the SEC task force on China RTO’s, before the halts, when it seemed like a good idea to take it private.  It is Citron’s opinion that investors had better ask themselves what this stock is worth without the buyout offer. 

        

  The Company’s Response

 

We can predict it now.  The company is sure to respond with a PR insisting its “special committee” is continuing its work to further the proposal.  Or maybe we will read about a formal offer made by the CEO “contingent on certain financing”….  We can even read of a fancy law firm or investment bank that has been hired to move this proposal along.  Not to mention, we will likely read about the evil short sellers who are out to “get the company” … IT IS ALL WORTHLESS RHETORIC!  There is only one thing the company can do at this point …SHOW US THE MONEY AND CLOSE THE DEAL! 

Anything short of a definitive closing is a disappointment and worse, it is a sham.  It is the opinion of Citron that this deal will not close – not at $24, and not at a price above half of $24. 

Cautious investing to all.

 

 

 

stock ticker: CHBT

   Citron Reprints Forensic Research that shows China-Biotics is lying about their customers and production.

 

 

The market is now brimming with stories on the fraud in the China RTO space.   We are witnessing the unprecedented reality of more than a dozen companies domiciled in China and trading on major US exchanges, to be halted by regulators and now queued up for delisting. 

http://www.reuters.com/article/2011/05/11/us-china-shortsellers-idUSTRE74A71F20110511

  Brief History Lesson

Long before this space became crowded with investigative researches trying to hunt down the needlelike facts in the haystack of hype that is smallcap investing in China, Citron was there.   In fact, we would like our new readers to appreciate that in May 2007, Citron broke the story about its first China-domiciled stock scam.  

Xinhua Finance Media Limited (NASDAQ:XFML) apparently had pretty good credentials too.  Brought public via the “high road”, an IPO by JP Morgan and UBS in March 2007, XFML was a $12 to $14 stock with credibility, analyst coverage, and a bright future.   Its CEO rang the opening bell on the Nasdaq when its IPO opened.   The only problem was it was a complete scam, as reported by Citron in May 2007.

http://www.citronresearch.com/index.php/2007/05/21/citron-reports-on-xinhua-finance-media/

Yes, there was much umbrage taken.   Analysts such as JP Morgan and CIBC reiterated their buy recommendations on the stock, with CIBC calling the situation a “good buying opportunity” on “weakness” in the wake of the Citron report.   http://caps.fool.com/Blogs/analyst-says-xfml-good-buying/8284  

Although the stock slid into single digits, interest perked up when no less than Yucaipa Funds, led by highly regarded investor Ron Burkle, announced in September 2007 that it was taking a major equity position in the company.   http://www.reuters.com/article/2007/09/26/xinhua-yucaipa-idUSN2617968220070926

By the end of 2008 XFML was a penny stock.  It had cratered not because of Citron’s report, but because it was, as Citron reported, a collection of self-dealing and related-party rollup transactions designed solely to enrich its promoters and scam investors.

Yesterday, criminal indictments were handed down, charging the principals involved with stock fraud.  

For the rest of the lesson, readers compare the original Citron report in May 2007 (linked above), with the Wall Street Journal article published yesterday. 

http://online.wsj.com/article/SB10001424052748704681904576317022268762608.html?mod=googlenews_wsj

  Current Situation

Today, Citron revisits a stock first reported last September, the curious case of China-Biotics (NASDAQ:CHBT).   Now China-Biotics isn’t a high-prestige name taken public by Wall Street’s finest.  In fact they lost support of all of their analysts.

Nothing the company has said about its operations, either then or since, has checked out.   

In the interest of the truth, Citron understands that good research comes from many different sources. With permission of the publisher, Citron today shares a forensic research piece written by a firm specializing in on-the-ground research in China called China Economic Review.  We believe this is the best piece of research on China Biotics that you probably have never seen.

Clkck Here:    CER — China Biotics Research

The last line of defense separating the continued fleecing of US investors in these names is the company’s annual audit.   And that brings us to the flurry of halted stocks in March, because that is when those companies’ audits were due.  China Biotics is on a March 31 fiscal year, so it and a batch of other companies don’t face their day of judgment until June 15^th.  Next month, Citron predicts investors will see another flurry of news and stock halts, as the next wave of this story hits.

Cautious Investing to All

 

 

stock ticker: LFT

   Management Continues to Mislead Investors

 

Two weeks ago Citron Research reported on Longtop Financial (NYSE:LFT).  Citron questioned whether the third-party agency disbursing payroll, benefits and other HR functions for over 80% of Longtop’s technical employees was in fact an unrelated party, as Longtop has claimed for over two years.  Just last week, the company vehemently denied our report, and went so far as to conduct a conference call, replete with analysts’ defense of the name.

One week after Citron’s report, Longtop CFO Derek Palaschuk, resigned his post as head of the audit committee of the heavily anticipated IPO Renren.  This confirmed our suspicion that something very shady was going on at Longtop.  It appeared as if Wall St. was preparing for the next shoe to drop on Longtop….well here it is.

Here is the proof — what you all have been waiting for.  As Citron was preparing part II of its investigation into Longtop, we were beaten to the punch by respected research shop OLP Global.  Now, while Citron will not distribute a copy of the OLP Report (call them up and become a client), we today post documentation that proves Xiamen Longtop Human Resources (XLHRS) is indeed a related party to Longtop Financial.

This linked PDF contains routine governmental filings of XLHRS and its SAIC filings.  These documents from 2007, 2008, and 2009 are signed by employees of Longtop Financial’s legal department, who have apparently been handling and signing off a variety of routine government filings for Longtop Human Resources (XLHRS).

Proof of Ownership Relations

So now we are supposed to believe that XLHRS, located on Longtop Financial’s premises, has only one client, Longtop Financial, used the same email servers, AND had staff from Longtop’s legal department personnel sign their administrative filings with the government … but they’re NOT a related party.  C’mon….Really?

Once you get beyond the shock that legal responsibility of XLHRS is administered by Longtop employees, you get to the financials of XLHRS, as disclosed in the SAIC documents, which tell an ominous story that strongly warrants the scrutiny of objective third party verification.

AIC of XLHRS

According to LFT 20-F, XLHRS is to receive a service fee for all 3,200 employees they “handle” for Longtop’s mostly technical and professional workforce (appx 76% of its headcount).  This service fee is defined as “for salary + bonus + social insurance + other expense for the entire year”.  On a conservative basis, this would amount to $400 to 500 million RMB.

Yet, on these SAIC docs we see a total revenue (or service fee) of merely $5.1 mil RMB.

Every other number of the SAIC filings shows that XLHRS would be underpaying the government for benefits for Longtop Financial employees, but that is a sideshow if the company is lying about its revenue by such proportion.

Now we understand that much has been made about the inaccuracies of SAIC filings, but please note that these filings from XLHRS ARE AUDITED.   The accounting firm is Xiamen Xinzhou Certified Public Accountants Co., Ltd  http://www.xmxzxg.com/about_xz.asp

This throws out the whole myth of just scribbling some numbers on the paper and submitting them to the government.  Clearly these filings do not accurately reflect a company handling payroll, benefits and human resources expenses for 3,236 people, operating under an agreement such as this:   

http://www.sec.gov/Archives/edgar/data/1412494/000095012310065856/c03364exv4w36.htm

Citron believes that one of the two scenarios stated below is true…which one we don’t know.

1. Longtop Human Resources (XLHRS) is and was always a related party to Longtop Financial, essentially a captive entity created to hide expenses of Longtop Financial, and/or underpay employee benefits.  They never in fact paid LFT employees as stipulated by SEC filings and press releases, but rather were always a vehicle to hide off balance sheet transactions.
2. Longtop Financial is a fraud of massive proportion that does not operate nearly on the scale that they claim … either way, Longtop Human Resources is still a related party.

Ximamin Longtop Human Resources (XLHRS) is apparently not doing the size and scale of non-related party business that was reflected to Longtop Financial shareholders.  As to the other details, we will let it all play out in the many lawsuits that the company faces. 

In order to properly deliver any form of transparency to Wall Street, investors and analysts need to know who is paying Longtop’s employees, who is paying their benefits, are the amounts proper as according to Chinese law, and are the expenses being fully reflected on Longtop’s financials.  

 

  The Deloitte Conundrum

On the conference call last week defending the company, Longtop's CFO made an extraordinary claim that his relationship with the company's auditor, Deloitte, was "very close, third only to his relationship to his family and the CEO”.  Leaving aside for a moment the impropriety of such a statement (after all, auditors work on behalf of the shareholders and the integrity of the markets, not the company insiders), the evidence posted today places Deloitte in a very uncomfortable position.  How could anyone charged with verifying the accuracy of Longtop's Financials look at these documents and dismiss the reasonable concern (not to mention professional skepticism) that Longtop's largest expense line item is being transacted through a related party with full transparency ?

If Longtop insists XLHRS is unrelated, Deloitte has the responsibility to "audit XLHRS from the outside", considering at its tax filings, and all government payroll benefits deposits purportedly made on behalf of Longtop's employees, to "open the black box" of Longtop's staffing expense as wide as possible to the light of transparency.

Meanwhile, Longtop has stated its full confidence that its 20-F, due next month, would be signed off by its auditor with no reservations. 

Lastly, it is Citron’s opinion that believing an unrelated third party ran your human resource business to make $30,000  a year (according to filings) is as crazy as believing that a Chairman of a company would just give away $80 million in stock to his employees because money doesn’t really mean that much to him (as per the CFO’s explanation).

For those of you who have the benefit of being a client of OLP, we recommend you read their full report on Longtop.  They do an excellent job at explaining the history of broken acquisitions by Longtop and other shortcomings in their story. 

  Conclusion

We hope this can end any debate as to whether the company has been deceiving its investors.  It is not the time to host any more conference calls or cover ups.  The excuses have run their course.  It is now time to confess, let the auditors figure out the necessary restatements, and let the real Longtop Financial Technologies stand up.

Cautious Investing to All.

 

stock ticker: MOBI

Update:  May 4, 2011: post-Conference Call Comments:

 

.

In its research note this morning, Piper Jaffray raised their target for MOBI from 12 to 15, stating concerns for its fundamentals are “overblown”.   Citron calls Piper liars and challenges them on this issue.

What is the truthful Company Description?

(We removed the Piper commentary — as expected Piper required that we take down their research page.  )

Piper’s note repeats MOBI’s claim that “It operates the leading mobile app store in China.”

This statement is not true.  The company CFO claimed it was based on “independent” research, but on today's conference call, admitted it was a 2009 study commissioned and paid for by the company.

If Piper cannot describe the company accurately, they have no business claiming to publish analysis of it, much less raise multiples or targets.

As the links on the Citron report (below) demonstrated yesterday, this claim by MOBI is 100% FALSE.   Even the company has backed off that language in its company description in today’s PR.  Citron challenges MOBI, or Piper for that matter, to show a single credible and independent source verifying that MOBI’s app store is in fact the “top mobile app store in China” – or in the top 10, for that matter.

If in fact the they were the #1 mobile app store in China, it would only prove the obvious – that they are doing a very bad job of monetizing it!   If they were what they say, their revenues would be ramping sharply through the roof right now, while the cheap feature phone market is at its peak.

Instead, revenues were flat to lower last quarter, and will apparently not materially improve this quarter.   Meanwhile, it's their expenses that are ramping sharply higher as they add headcount to service their patchwork “payments network”.

In light of these obvious facts, Piper’s justification for raising its target is to …. (drum roll) … increase the multiple?!?  Talk about "nothing new"…!  Not on Wall Street.   

  Piper says "Nothing new"  and Citron agrees

Piper says there is "nothing new" …  A statement we agree with.  It is the same company that couldn’t make payroll just eight months ago until its IPO got done at $8, and traded thereafter at $6 per share.  Its not generating new revenue or profits either.  Its competitive position with regard to the China mobile handset market isn't new since then. 

We challenge anyone to argue that the future penetration of feature phones is going to be greater than that of smart phones in China.

Citron has great respect for Gene Munster.  We are surprised and disappointed that this piece of sloppy research would go out with his name under it.

 

  MOBI’s market in their own words

MOBI states that their market is composed of “young, uneducated and poor” Chinese youth.  The CFO got excited describing his market buying "virtual homes and virtual furniture".

Wake up people!  Their market can’t buy real furniture, but they’re going to spend increasing millions in MOBI’s virtual fantasy world? 

The CFO also commented people don’t like to pay for game apps on Android – they like the free ones – but still claims they’ll be paying up for games on Maopao – real soon now!

 

  Future of mobile phone business in China

This is the future of mobile phones in China, and it is foolish to pretend otherwise:

http://www.businesswire.com/news/home/20110504006147/en/Android-Increases-Smart-Phone-Market-Leadership-35

It is obviously the platform that developers are clamoring to make their hot new games for — a large, worldwide market, not a niche market held captive between China wireless operators and certain handset manufacturers.

  MOBI claims it is a technology company

Look at their R&D spend last quarter and the last year.

Citron sticks to its opinion that MOBI addresses a low-spending niche market in China, with a rapidly obsolescing technology platform which has already seen its best days, and reiterates its generous $3 target.

Citron asks Piper – what is the expression for “buggy whip” in Chinese?

  Cautious investing to all….. and be particularly skeptical of pied pipers!

 

Original report:

Citron Reports on Sky-Mobi Limited (NASDAQ:MOBI) With a Price Target of $3….read to understand.

 

Citron Research understands and respects the recent surge in pre-eminent Chinese internet stocks.  While the financials of many of these companies might not be compelling today, some offer unique business models and the potential to establish their dominant competitive positions in their spaces, driven by China’s rapidly growing internet user base.  Whenever you get these manias, many companies “ride along on the coattails”.   In the case of Sky-Mobi  Limited (NASDAQ:MOBI) the company has manipulated the truth to hide their dying business model.

What MOBI Is:

Sky-Mobi sells games and other applications for low-end “feature phones” (i.e NON-smart-phones) in China.  Their non-game products include chat applications for several social network websites.

The company currently has no position in the smart phone or high-end cell phone business.  The company operates an application store, but so does every major cell phone manufacturer.   

Nokia and Android-based phones are garnering major market shares in the high-end and smart-phone markets, where MOBI does not compete… and leaves it facing irrelevance.

What MOBI Is Not

MOBI is not a leading application store in China.  Even more important, MOBI is not a play on the Chinese mobile internet / social networking market.  MOBI is not a tech company and does not have market share or disruptive technology. 

The stark reality is that “feature phones”, which MOBI's business addresses, are inexpensive phones that DO NOT browse the internet, DO NOT have maps, GPS  or local search, and are not capable of forming social networks, or participate in locally targeted crowd marketing apps like Groupon.  They enable Chinese feature-phone users to text-chat with one another while playing simple graphical games on small screens.  Users can also post text messages onto certain social network platforms like Facebook and Twitter.

Within the next couple of years, a new and cheaper generation of larger screen touch-screen Android-based smart-phones will sweep into the China cell marketplace, delivering this functionality.  MOBI is just another wannabe in this market.  There is no investment thesis in MOBI gaining a foothold in this new market against many better-capitalized competitors from its current business model.

IPO or Bust – (It was the bust)

The first sign of trouble with MOBI was evident as its IPO date approached.  In the same week that YOKU and DANG represented some of the hottest IPOS of 2010, the Sky-Mobi IPO was a total dud.

First, the IPO, which attempted to raise $150 million had to settle for $58 million (gross) due to lack of demand , but even so, pricing had to be set at the low end.  Then it broke syndicate, finishing down 25% on its first day of trading, contending for the record of the worst IPO first day performance of 2010.  Then, it fell a further 20% in the following days (during the extremely strong December 2010 rally).   There was just no demand for this stock, and it bottomed around $5 a share.   

The problems at MOBI were evident as stated in this article from a China Tech Journal, which stated that MOBI better go public now and raise money because their business was about to be made obsolete.

http://www.c114.net/news/16/a568999.html

"Sky's not a good time, Song Tao said that the company unable to pay wages for several months, has been exhausted state." — translation courtesy of Google Translate

(Song Tao is MOBI's Founder, Chairman, Chief Exec. Officer, Member of Audit Committee and Member of Corp. Governance & Nominating Committee) 

Conclusion:  Some companies go public to thrive, but Sky-Mobi went public to survive.  This was just five months ago….has anything really changed?

How the Company is Lying to Investors

MOBI claims to be the “largest App store” in China.  THIS IS A LIE – It is not even close to the truth.   Here is the real list of top App stores in China:

http://thenextweb.com/asia/2011/01/20/nokia-ovi-store-is-the-top-application-store-in-china/

MOBI also claims that it is a leading mobile social network in China….another lie.  Here’s the list of top social networking sites in China … No MOBI here:

Or here:

Or here:

Or even among the top 15 here:

Here’s what they say in their own filings about their nascent attempt to stimulate social network-based business:

“We anticipate that community-based applications with social network functions, such as mobile social games, will generate an increasing percentage of our revenues in the foreseeable future. However, we began operating pilot test mobile social games in 2008 and only have limited experience in this area.”  (emphasis is Citron’s)

 

Metrics Show Lies … and Doom

"Figures don’t lie, but liars figure." – Samuel Clemens

In MOBI's most recent fiscal quarter, ending March 2011, it claims its registered members roll has grown from 12.5m to 58.6m — a stunning increasing of 368.8% year over year. Is it too good to be true?   Sorry, it is.

The problem with its “registered members” is that the number of inactive members is growing even faster.   MOBI’s filings don’t compute the number of inactive members, but it does count “active members”, using a very weak definition.  To be counted as “active”, a member has to visit their app store just two times during the same month – and ONLY FOR ONE MONTH in a three month reporting period.    Nevertheless, while their active user count grew 10.64% q over q, their “inactive” (or staled out) members grew 35.2%, to a whopping 47.6 million.  Yes folks, the little number they don’t disclose is that 83% of their “registered members” are inactive, even by their own weak definition of “active membership”. 

This demonstrates that “membership doesn’t have its rewards” when it comes to MOBI.  The notion that members somehow comprise a nascent pool of monetizable online community is an intentionally created mis-perception.  In English we call that a lie.

Not to mention that cell phone sales in China grew 57% in 2010, mostly smart-phones.   It is tough to believe that MOBI during that time could grow members 400% — exclusively from non-smart phone users.

http://articles.timesofindia.indiatimes.com/2011-01-24/hardware/28369506_1_china-mobile-mobile-phones-3g

As we saw this week with the restated Renren user numbers, it is not uncommon for Chinese internet statistics to exaggerate membership numbers.   http://www.nytimes.com/2011/05/02/business/global/02ipo.html

The disconnect between perception and reality is clearly outlined in MOBI’s reported numbers.   For example, the company typically makes headlines out of huge percentage gains in non-monetizable (and notoriously unreliable) numbers such as numbers of downloads.   But they don’t mention that average revenue per download has plunged – their reports not only fail to mention it, they don’t even calculate it!

 

 

	3 Months — Sept 2010	3 Months — Dec  2010	Pctg  Difference	Comments
Downloads	719 million	846 million	+ 17.6 %	Woohoo!  Big Headline!
Revenue per Download	.031c USD	.024c USD	( 22.3 % )	Shhh!  Lets not mention this.  (MOBI doesn’t report this  calculated number)
Site visits	3.3 billion	3.5 billion	+ 6.6 %
Total Revenues USD	25.994m	24.210m	( 6.86 %)	Contracting revenues?  Hello?
Gross Profit USD (Total Revs  less Cost of Rev	7,326 m	7,367 m	0.56%	Flat.  Ugh.
Profit from Ops	224	(919)		Down by 1.14 million q over q
R&D expense USD	1,936 m	1,935m	0.0%	No change
Sales Mktg	1,809 m	2.076 m	+14.75%	Up double digits
G&A USD	3.393 m	4.273m	+25.91%	Up double digits

The company has become a financial disaster since IPO — and it wasn’t so great beforehand.

The most charitable way to spin these changes is that the company is already experiencing “the law of large numbers”, in a sector subject to brutal competition, short-lived fads, and a roar of competitive “noise”.   Its most profitable days were when it was operating on a shoestring with very limited capital, with a couple of hot game titles. 

More likely, it was a very poor candidate for IPO, and is now relegated to a small niche in the cell phone add-on space which has already seen its best days.   Even after doubling headcount over the last year, they have been unable to ramp revenues; while they face plateau'd revenues, they're absorbing declining margins on every front.

Financials are terrible compared to KONG

At its peak last week, MOBI sported a market valuation north of $700 million dollars with $79 million dollars in cash, and no long term debt.   KONG had a market valuation of around $325 million dollar with $157 million dollars in cash and 3.5 million USD long term debt.   MOBI and KONG’s respective enterprise values are $621 million and $172 million. Even though MOBI commands a hefty valuation when compared to KONG, it doesn’t appear MOBI has a substantially different business model from KONG

Comparable Valuation of MOBI and KONG

 

( All figures USD )	MOBI	KONG
Shares Outstanding	32.17	37.31
Market Cap	697.2	326.1
Current Share Price	21.67	8.74
Cash USD mrq	69.7	139.2
Enterprise value	627.5	186.9	MOBI priced 235% higher than KONG
Revs last qtr	24.2	36.1	MOBI 32.97% less than KONG
Revenues trailing 12 months	96.9	149.6	MOBI 35.3% less than KONG
Profit / loss from operations last q (before adjustments)	-0.9	4.9	MOBI 5.8 million less than KONG
Profit / loss from operations trailing 12 months	1.0	4.0	MOBI 3 million less than KONG

 

MOBI sports an enterprise value more than twice that of KONG, but KONG shows it is a better value by every metric of revenue and profit, both for the most recent quarter and year.    In fact, KONG is valued at 1.14 times its 2010 revenue while MOBI is valued at 7.7 times its 2010 revenue – over 6 times higher!

EVEN though Kong is a better business, (it sells some iPhone games) if we were generous to MOBI and gave it the same valuation as KONG at 1x revenue, the stock price would be $3  – Hence our target.

Risks all over the business …read for yourself.

Citron knows what normal risk factors look like.  Most companies state the boiler plate language that we see over and over.  But not MOBI — at least they were honest about the risks.  If you read the prospectus you see a company that is being attacked on all sides of their business model.

http://sec.gov/Archives/edgar/data/1500252/000095012310112702/h04425b4e424b4.htm

 

Squeezed by the Cell Phone Companies:

“Such measures make it more burdensome for users to purchase applications and content through our application store. As a result, some users purchased fewer applications and less content through Maopao or even ceased purchasing. In addition, when more SMSs need to be transmitted to effect the same volume of transactions, we face more billing and transmission failures. All these adversely affected our revenues. In addition, in September 2010, China Mobile began implementing another set of new measures which require users to send triple confirmation SMSs before a transaction can be effected.”

Hurt by the handset manufacturers:

 “Handset companies often pre-install other mobile application stores in addition to Maopao, which could adversely affect purchases of applications and content on Maopao, resulting in a decrease in our revenues. In addition, certain handset companies may consider entering the mobile application store market, and our relationships with such handset companies may be adversely affected as a result.”

Problems with billing:

“These situations are known in the industry as billing and transmission failures. In the fiscal year ended March 31, 2010 and the six-month period ended September 30, 2010, the monthly MR amounts we received from mobile network operators were approximately 20% to 30% lower than the monthly MO amounts recorded on Maopao …”

Competition they can’t overcome:

“New technologies in our industry could render the technologies and product offerings that we are developing or expect to develop in the future obsolete or uncompetitive, thereby potentially resulting in a decline in our revenues and market share.”

Then on April 27, Nokia invaded their space:

http://www.pcworld.com/businesscenter/article/226388/nokia_sees_growth_in_use_of_mobile_app_for_rural_china.html

Which all leads to the key statement:

“Our failure to anticipate or successfully implement new technologies could render Maopao uncompetitive or obsolete, and reduce our revenues and market share.”

If this it wasn’t onerous enough, MOBI is in the shadow of the PRC government regulators too.   To create an alternative to being dependent on billers to collect user fees, MOBI created its own form of payment, called “K-Currency”.

“Our item-based revenue model may cause additional concerns with PRC regulators who have been implementing regulations intended to limit the total amount of virtual currency issued by online game operators and the amount of purchase by an individual game player. The restrictions imposed by the above rules may result in lower sales of our virtual currency, and could have an adverse effect on our revenues from games. If our operations or the applications and content on Maopao are deemed to have violated any of these rules and regulations, we may be subject to penalties and our results of operations may be materially and adversely affected.”

Conclusion

The company reports just one more time – next week – before expiration of MOBI’s (six month) stock lockup looming just next month. 

Citron believes that this company is doomed and will eventually trade below whatever cash they might have left.  This is a terminal business model.  How does one say buggy whip in Chinese?

Cautious Investing To All