Still the No. 1 Chinese Small-Cap Red Flag

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When it comes to Chinese small caps, I have to hand it to many of the short sellers -- they've done some really fine work.

Sure, that doesn't extend to every single Internet writer who's ever said anything critical of a Chinese small cap. But I think that if the bulls are honest with themselves, even they have to give a tip o' the hat to some of the work shorts have done. These intrepid bears have tracked down Chinese regulatory filings to compare them to U.S. filings, performed channel and customer checks, and done long-term surveillance on factories to assess activity levels.

And in a scary number of cases, the in-depth diligence that they've done has uncovered some ugly truths about many Chinese companies trading on U.S. exchanges. But for many U.S.-based individual investors, I think there's a simpler, more glaring factor that should scare them off many of these companies, without the need for a plane ticket to Asia or Mandarin lessons.

I'm referring to the way most of these companies hit the public markets in the first place: through reverse mergers.

For the love of an IPO
When a company does an IPO, investment bankers and a team of corporate lawyers meet with management, examine the company's numbers, visit offices and manufacturing facilities, and often spend weeks going back and forth with the Securities and Exchange Commission to get the filing paperwork for the offering just right.

Why do the bankers do all of this? Because at the end of it all, the salespeople at the investment bank will call up their money management clients -- mutual funds, hedge funds, etc. -- and say, "We've got this IPO that I think you should buy shares of." Logically, if a bank consistently sells what turn out to be junk shares to their clients, eventually those clients will respond with a "thanks but no thanks," or just opt to let the banks' calls go to voice mail.

A reverse merger, or RTO, sidesteps all of the IPO hoopla. Instead, an operating company lets itself be "bought" by a public shell company -- that is, a publicly listed company with no real operations -- and voila! A previously private company now has a public listing with no fuss and no muss.

Unfortunately for investors, the latter scenario involves far less diligence and oversight. As a result, RTO transactions are a favorite for fraudsters.

Start with suspicion
Certainly, there are plenty of counterexamples available. Consider the recent blow-up at Longtop Financial (NYSE: LFT  ) . This was a full-on traditional IPO run by none other than Goldman Sachs (NYSE: GS  ) , yet it appears that the company was impressively fraudulent.

And if we think of some of what the banks sold during the days of the dot-com and housing bubbles, it's clear that it's not unheard of for big investment banks to sell junk to their clients.

If I can draw a comparison to horse racing, though, I'd say that not every horse that runs in a high-level race is a fantastic horse -- and some may turn out to be utter duds. However, when a horse is running a $3,200 claiming race -- which means that someone can swoop in and buy the horse for the low dollar amount -- on a Tuesday at Fairmount Park, you have to start with the assumption that there's probably something wrong with the nag.

But why?
In some cases, companies simply have no choice but to hit the markets via RTO. Take American Apparel (NYSE: APP  ) , for instance. While the company didn't do an RTO, it was acquired by a "blank check company" -- a similar type of transaction that allows a private company to become a public one without the traditional IPO process.

In American Apparel's case, the company had gotten itself in over its head stocking up on inventory and building out its retail stores. It had taken on a lot of debt, and it needed cash badly. The company's financials were ugly, and I have a feeling that many institutional money managers would have balked at the deal after sitting down with CEO Dov Charney (which is a typical part of the IPO process).

In short, American Apparel needed capital and had relatively limited options for getting it.

But in many cases, it's unclear to me why some of these Chinese companies found it necessary to go the RTO route, or even hit the public markets at all. Take China Automotive Systems (Nasdaq: CAAS  ) , for example. In early 2003, the company merged into Visions In Glass and became a public company. Yet for 2003, the company reported more than $50 million in revenue, a near-$4 million profit and was even cash flow-positive. With the exception of 2007, in every year since 2004 the company's cash flow has covered its capital spending, so it doesn't appear that China Automotive Systems had any pressing need for capital.

So why go the RTO route? Why not jump on U.S. investors' euphoria over China's growth and do a full IPO? Or better still, why not remain a growing, profitable private company until, down the road, you can do a larger and potentially more lucrative IPO?

Cases like China-Biotics (Nasdaq: CHBT  ) and China Sky One Medical (Nasdaq: CSKI  ) are even more curious to me. Both companies have supposedly been growing like weeds, have been consistently profitable, and have produced material amounts of free cash flow. With financials like that, why did a reverse merger seem like the right option?

Lighting-rod stock Yongye International (Nasdaq: YONG  ) may not be quite as suspicious here, because it appears to have actually needed capital for the big investments that it's made in its balance sheet. But even there, given that it was growing like gangbusters and profitable on its P&L, was there really no opportunity to bring in a private investor and make a bigger, better splash on the public markets a few years down the road?

No smoking gun
If you take a look around, I guarantee that you will find precious few successful, high-quality publicly listed companies -- Chinese or otherwise -- that have come to the markets via a reverse merger. Finding this out when digging into a company should put your BS-detector on high alert through the rest of your research.

This doesn't prove anything about these companies. But I'll put it this way: Last night I pulled a package of asparagus out of my fridge that had been there for a week, and it smelled funny. Perhaps after rinsing and cooking, it would have been fine, but I wasn't risking it. The asparagus found its way to the trash, and I ate some just-purchased spinach instead.

In other words, when something doesn't smell right, sometimes you're best off avoiding it and just moving on.

The Motley Fool owns shares of Yongye International. Motley Fool newsletter services have recommended buying shares of Yongye International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (15) | Recommend This Article (20)

Comments from our Foolish Readers

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  • Report this Comment On June 07, 2011, at 4:00 PM, jekoslosky wrote:

    Nice, succinct explanation on RTOs versus IPOs, Matt. I've gotta wonder, after what's happened with so many of these RTOs lately, if legit companies won't avoid that way of going public in the future. I know I'll be skeptical for a long time.

  • Report this Comment On June 07, 2011, at 5:25 PM, CSIHawaii wrote:

    The poison pen has struck again.

    The purpose of this article is to put the headline "Still the No. 1 Chinese Small-Cap Red Flag" on a wide swathe of stock names out on the news wires. This has been done knowing that they can't all be No. 1 and knowing that this will have a negative influence on the trading of all of these stocks. They also know that most people read many times more headlines than articles, so they will not necessarily know that there is nothing new being reported and that there are not even new innuendoes. This article has to be considered as deliberate stock price manipulation by Matt Koppenheffer and The Motley Fool.

    The article opens with some adulation of the short sellers and accolades for their research. This extreme bias is indicative of deliberate stock price manipulation. In reality, in the order of 10% of published research was good - but self serving. The other 90% was irrational, emotional, negative hype slinging names like "red flag" and "too good to be true" and knowingly distorting the facts - and, of course, self serving.

    The article uses the flawed premise that an RTO is a back door to the stock market rather than an alternative route that benefits the company and its eventual shareholders. The IPO route is presented as a sign of purity. In reality the IPO route itself is corrupt, guaranteeing fat earnings for the fat cats and access for the privileged - the cost of which is borne by the eventual shareholders. Faced with this prospect many companies have for good reason chosen alternatives to the IPO. The article states "If you take a look around, I guarantee that you will find precious few successful, high-quality publicly listed companies -- Chinese or otherwise -- that have come to the markets via a reverse merger" to deliberately hide the reality that the alternative is often the most sensible. The author knows and could have written "If you take a look around you will find many prestigious companies that have taken the RTO route such as Berkshire Hathaway, Occidental Petroleum and Radio Shack" - but this would not be very good for stock manipulation.

    The poison pen has struck again.

  • Report this Comment On June 07, 2011, at 6:37 PM, TMFKopp wrote:


    I'm glad we give you a forum to release all of those emotions. That would be dangerous to hold in.

    A couple of quick thoughts to offer...

    "put the headline "Still the No. 1 Chinese Small-Cap Red Flag" on a wide swathe of stock names out on the news wires. This has been done knowing that they can't all be No. 1 and knowing that this will have a negative influence on the trading of all of these stocks."

    The red flag is the RTO process, not a particular stock. So yes, all of the Chinese companies listed (LFT excepted) apply.

    Also, not that conspiracy theorists believe in things like disclosures, but I don't have any financial interest in any of the stocks above. The Motley Fool does, however, own shares of Yongye. If I were on a stock-manipulation campaign I don't think they'd be too happy with me.

    "In reality, in the order of 10% of published research was good - but self serving. "

    I understand that short sellers tend to rub people the wrong way, but I do find it interesting how often people focus on the fact that short-seller research is "self serving." What is long-focused research? Undeniably altruistic?

    "If you take a look around you will find many prestigious companies that have taken the RTO route such as Berkshire Hathaway, Occidental Petroleum and Radio Shack"

    First of all, I'd be very interested to see some details on the Berkshire Hathaway RTO.

    Past that though, RadioShack, Berk, and OXY have been publicly traded for decades. Given the number of RTOs that take place, if the best you can do is come up with three examples over the course of multiple decades then I think I can rest my case.

    Of course if you'd like to follow up with a list of quality companies that have chosen the RTO route over the past five or ten years, I'm all ears.


  • Report this Comment On June 07, 2011, at 9:42 PM, RetiredAl wrote:

    I agree as to the value of short-siders. They force on to consider alternative outcomes most of us, with our optimistic biases, ignore.

    CAAS has had the Vice-Premier of China visit a facility and vouch for the company. The company has changed accountants- to one of the top internationally recognized firms. The company has forecast 20% bottom line improvements over the next several quarters. Insiders own a nice chunk of the company.

    As a small investor, CAAS is the type of profitable,"real" & growing Co. I search for. Too bad that "ALL" Chinese small caps are lumped together.....BUT when the future becomes the past, investors buying in down here may be smiling all the way to the bank! I HAVE A SMALL CAAS POSITION.

  • Report this Comment On June 08, 2011, at 12:33 AM, bigbigbarry wrote:

    If you guys think IPOs are safe, you have no ideas.

    I agree that any RTO w/ a small auditor is a landmine. However, I can also tell you from I-Banking experience that IPOs aren't any safer than RTOs w/ Big 4 auditors (like CCME, CBEH). There's still a lot of risk.

    Why? Because InvBanks do minimal due diligence. They make a few calls to customers, check mgmt references, and that's about it.

    If a company's going to cook its books, it's only hard task is to fool the auditor.

    If it can get by the auditor, then the rest is cake. And bankers won't have a clue.

    That's what happened w/ DGW. That's what happened w/ Longtop (LFT).

  • Report this Comment On June 08, 2011, at 10:12 AM, TMFKopp wrote:


    "However, I can also tell you from I-Banking experience that IPOs aren't any safer than RTOs w/ Big 4 auditors (like CCME, CBEH)."

    Sorry, but this is a ridiculous statement. As I noted in the article, you're not 100% in the clear with a company that's done an IPO, but to say that it's "no safer" is wide of the uprights by a long shot.


  • Report this Comment On June 08, 2011, at 10:38 AM, dabynelson wrote:

    "... ... Both companies have supposedly been growing like weeds, have been consistently profitable, and have produced material amounts of free cash flow. With financials like that, why did a reverse merger seem like the right option ... ...".

    Please think before writing! In CSKI's case, RTO went first. The money from RTO was used to acquire and grow busines. Then, the revenue increased. It is logical!

    No wander, our beloved country has become a nurturing bed of financial crimes!

  • Report this Comment On June 08, 2011, at 11:27 AM, TMFKopp wrote:


    Have you looked at the numbers? CSKI did the RTO midway through 2006. It brought in $2.7m in stock sales that year, but it was $2.7m that the company apparently didn't need because it was free cash flow positive and would have finished the year with 40% more cash than the prior year even *without* the share sale.

    The first time that CSKI raised a significant amount of money was in 2008 ($23m). But between 2005 and YE2007 it still managed to grow revenue 6x, profit 7x, and cash flow 10x. And given that the company *still* has nearly $50m on the books today, I have to wonder what it needed that most recent round of capital raising for.

    "The money from RTO was used to acquire and grow busines. Then, the revenue increased. It is logical!"

    It would seem logical, if the company actually needed public-market funding to grow. But it didn't.


  • Report this Comment On June 09, 2011, at 9:18 AM, MKArch wrote:


    Every stock has someone saying mean things about it but not every stock trades for single digit P/E's. Citron, Muddy Waters & John Bird would be nobodies with blogs that no one cared about except for their uncanny track record for sniffing out true frauds. I've read quite a number of their "hit pieces" and a lot of the information is verifiable just by looking into the companies SEC filings. I've read all of the counter arguments I could find and they all amount to some version of the circular logic that shorts have an agenda so they are lying.

    Matt makes a good point about long side analyst agenda's. There were no repercussions for all the analyst pumping the dot coms in the late 90's or home builders and banks 6 years ago. When those stocks finally blew up the analyst just hid behind the fact that all of the other analyst were wrong too. Everybody is waiting for Citron, Muddy Waters and John Bird to trip up because they have no where to hide. IMO their reputation is a whole lot more valuable to them than the long side analysts reputation is to him or her. The shorts have to be right. The long analyst just have to make sure they stay with the herd.

  • Report this Comment On June 09, 2011, at 6:41 PM, AaronRogers wrote:


    Let's say for arguments sake that all of your points are correct and 95% of all chineese RTO's are frauds but your chineese company is the 1 or 2 that isn't. What more than a big auditor like Orient Paper did does it take?

    As an educated skeptic what would you need to see to change your thesis on a particular company? Please write an article or a blue print that you and your colleagues would agree upon to convince the world that your company/a company isn't and shouldn't be lumped in with the rest.

    Audited statements aren't working for you. 10k's aren't working. What does work?

  • Report this Comment On June 10, 2011, at 9:06 AM, MKArch wrote:


    If you read some of the recent auditor resignations these scams have enlisted local bank officials to help forge bank statements. I think Matt's point is probably even if there are a few legit companies in the Chinese RTO space how do know what to believe?

    Citron's latest target is HRBN which has an 8 month old take private offer from it's chairman. Citron called b.s. recently an then suddenly the company came up with a commitment letter from China Construction Bank. You can go to Citron's site to see a pretty rational argument about why the bank signed a *commitment* that will never materialize and the whole thing is a joke.

    Again looking at what these frauds are willing to do and the network thats supporting them and realizing U.S. investors have no recourse once the companies are outed why bother trying to walk through the land mines?

  • Report this Comment On June 10, 2011, at 1:14 PM, AaronRogers wrote:

    MKArch- Thank you everything said seems true and makes sense and as such I am not invested but do truly and have truly liked CSKI.

    As believing that one is real from this group of RTO's what should I be looking for to convince the market that company is legit? What is the road map that investors would believe? My reasoning for asking is simple. When the 1 legit emerges that's the one to be in. However, the market has to believe so what are the pre cursors I should be looking for? What does investors need to believe?

    I honestly think its gotten so bad the only way is for a company to willingly ask and subject themselves to the SEC in order to be cleared. Anything short of that would be dispelled as fake. Imagine if your company was the legit one. You do 10k's. You are audit compliant and your too small to do anything expensive to convince. So what do you do?

  • Report this Comment On June 10, 2011, at 4:07 PM, MKArch wrote:


    If you want my own acid test for a legit China small cap or RTO it's matching SAIC and SEC filings. Find a company that reports substantially the same financial information to it's own government as it does to investors half way around the world and there's a decent chance you found a legit company.

    Unfortunately CSKI doesn't fit that bill. They report something like $120M in revenues and something like $25M in net income to investors half way around the world who can't do anything about it if the company is lying (IMHO they are lying). They report a couple mil. in revenues and they lose money to their own government who can do something about it if they are lying. CSKI is absolutely lying to someone and Occam's Razor suggests it's the investors half way around the world with no recourse.

    The RTO defenders will point out that the SAIC filing is not their actual tax filing however it is derived from them and it is checked by the SAT which is the tax authority. The defenders also have no explanation for why the Chinese filings should not be accurate other than they are cheating on their taxes but it's not a big deal because everyone does it in China (not true). To believe this you have to also believe the Chinese tax authorities are too stupid to go on EDGAR and see what these companies are reporting to the SEC.

  • Report this Comment On June 10, 2011, at 5:26 PM, tonykau wrote:


    As far as I know, SAIC and SEC filings should never match. Accounting principles are materially different in China vs. USA, and, as you mentioned, the accuracy of SAIC documents are unimportant (to both the company and the government). The SAIC documents are filed with the equivalent of the Secretary of State for licensing, who, beyond continued business operation, is uninterested in the actual numbers.

    These accounting differences include filing each business unit and subsidiary separately - where, in the US, we would expect the parent company to have an umbrella filing. The publicly listed company is typically just the shell company, with minuscule financial activity. The SEC requires that filing to include the operational subsidiaries, but the SAIC filing has no such regulation, and, in fact, would be inaccurate to include subsidiary activity in that filing.

    SAIC documents are not tax filings. Taxes are paid locally and confidentially. That information is not legally public information as per Chinese government regulation.

    Furthermore, calling into question the integrity of the audited SEC filings is a serious accusation. Yes, there has been accounting fraud in every country involving companies of every size, across a plethora of different auditors (including big 4 American firms). Tiny, inexperienced auditing firms are a warning signal (for any company in any country), but why would a reputable auditing firm risk its integrity and reputation (the only thing accounting firms really have) by intentionally propagating fraud?

  • Report this Comment On June 10, 2011, at 6:44 PM, MKArch wrote:


    I never said the SAIC filings were unimportant and beg to differ. Give me some proof other than you say so that they are unimportant. The mere fact they are required by the Chinese government makes them important. I also didn't say the SAIC and SEC had to be identical just substantially the same. It's my understanding though that the information is identical for most of the large legit Chinese domiciled companies. It's primarily the RTO's that have the mismatch problem. The shorts who dig up the SAIC filings also know about the subsidiary vs. holding company issue and routinely account for all of the subsidiaries and also major customers and suppliers as well. This is a red herring argument of the RTO apologist. As is the SAIC doesn't count argument. Do you want to take a stab at explaining why a company like CSKI would report about 1% of the business to the SAIC that they report to the SEC if the SAIC doesn't matter? BTW there have been more than just a few frauds they are falling like dominoes.

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