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Confessions of a Chinese RTO Investor

John Emerson

John Emerson

142 followers
Moses: I got scruples too, you know. You know what that is? Scruples?

Addie: No, I don’t know what it is, but if you got ‘em, it’s a sure bet they belong to somebody else!

— From the 1973 movie Paper Moon



Unfortunately for many American investors, Addie's commentary about the deficiency in the moral character of her father, Moses, applies perfectly to the management of many Chinese Reverse Takeover (RTO) companies that list on American exchanges.

I must confess that I was one of the fools who was drawn in by the tales which were woven by unscrupulous managements of various Chinese companies. The tales consisted of growth stories of small businesses selling mundane products to a rapidly increasing Chinese middle class. The stories were extremely plausible and they involved products such as traditional Chinese herbal medicines, probiotics for a highly lactose-intolerant population, or dried snack foods which are reviled by most Americans but craved by most Chinese, such as dried squid — you get the idea. The story not only appealed to American investors based upon the rapid growth of these small businesses, it also appealed to the intellect of the investor; the investor merely needed to understand the cultural differences which separated the typical Chinese consumer from his American counterpart.

Before I begin my sordid tale and delve into the specifics of the stocks in which I invested, I want to make two points: First, the main goal for many of the Chineses RTOs is to raise money through large U.S. private placings. Secondly, most U.S. investors would not have lost money or at least would have lost nearly as much money if they had sold abruptly when the plausibility of the companies earnings and their financial statements came into question. The best friends of the investor were the SEC filings and surprisingly the shorts who did in depth analysis which belied the stories the companies created and the financials that the companies published.



In the face of mounting evidence, many longs cried foul as short-sellers exposed company fraud. Instead of paying heed to their warnings and evaluating the facts which they presented, many longs continued to take the side of management without regard to the validity of the short's arguments. It was a classic argument of emotion vs logic, a circumstance which will surely be discussed in the annals of behavior finance.

The demonizing of shorts is an investing phenomena which contradicts common sense. If one takes nothing else away from this long dissertation, I hope that the reader learns to pay attention the next time a short enters one his beloved positions. The short may be incorrect in his analysis or the ultimate direction the stock takes, but he likely has a good reason for his contrarian view. Bear in mind there is no fault in being wrong, the fault lies in the inability to recognize and accept the fact that one was wrong.

The List



Every Chinese RTO I purchased had one thing in common, all were successful at selling shares through secondary offerings to American investors. For those of you who do not know, all one has do do is consult the equity part of a balance sheet and view the line listed as additional paid in capital to get a pretty good idea of how many times a company has raised capital by issuing additional stock. I reiterate the main purpose of many Chinese RTOs is to sell a story and raise capital through private stock placements not to increase shareholder value.

I will begin with the list of Chinese RTOs which I purchased over the years followed by their current trading status:

1) NWD

Successful in raising around $36 million in capital in stock offerings while eliminating all shareholder value. The stock trades at 5 cents and is awaiting permanent exile to the Pink Sheets, the stock market's equivalent to the Gulag.

2) AOB

This company was outstanding at extracting cash from American investors. In multiple private placement offerings they were able to raise close to $200 million. The management squandered the capital on numerous acquisitions which contained largely blue-sky goodwill and spent over $50 million of the raised cash on a fancy office building in a Beijing business development district. The stock now trades @ about $1.5 per share with a market cap of about $125 million. Congratulations AOB on making it from the Bulletin Board to the NYSE in a few short years, that helped facilitate the offerings.



3) JST

This would be the creme de la creme of my prior RTO holdings. JST has actually paid a steady dividend and raised capital on a limited basis. When they did raise capital a few years back they bought out minority shareholders well under the market price for the stock, actually raising equity per share for existing shareholders.



My main complaint with JST has been their consistent practice of overstating accrual earnings. Almost never has the company come close to matching its cash flow from operations to net income. Their accounts receivable are always excessive and their inventory accounting is questionable in my opinion.



4) SDTH



Over the years SDTH raised around $37 million in several rounds of fund raising from private U.S. investors. They had the distinction of ringing the opening bell at the Nasdaq. Of course, that was long before the stock was halted on March 15, 2011, pending "additional information requested." That information had to do with discrepancies uncovered by their auditors. Translated, see you on the pink sheets, and adios dinero for existing shareholders.



5) CHBT

CHBT boasted stellar financials, terrific earnings growth and excellent free cash flow seemingly sufficient to fund operations as well as expansion considering they had a received a $25 million convertible note from Pope Asset Management in 2007. Furthermore, they had stated in conference calls that they did not anticipate any need to raise additional capital.



They impressed investors with their dual business plan and their terrific margins. Not only did they sell probiotics in bulk recording much better margins than competitors, they also were building an extremely profitable retail network which had established well over a hundred profitable units, at least so they reported. It turns out the retail network did not bear any resemblance to the way it was detailed in the annual or discussed in conference calls. Shorts demanded addresses and when they received limited information they took pictures and asked questions. Shorts also unveiled SAIC filings for CHBT which bore no resemblance to SEC filings in regard to net income and revenues.

CHBT decided to raise cash without stating any specific reason in 2009 and they were successful in raising around 75 million in additional capital after fees. A very surprising move considering the outstanding "liquidity" of the company. No specific reason for the secondary was given during a conference call which followed the offering other than they were considering making an acquisition.

Numerous shorts have entered the stock including Citron (formerly Stockleman), a short with a long history of uncovering fraud. Citron has vehemently contended that CHBT is a fraud. Currently the stock is trading around $10 per share.



6) CMFO



CMFO provided shareholders the opportunity to exit the stock after providing an in-depth description of how they spent most of the $30 million they raised from a private placement offering in 2009. In essence they bought 80% of nothing, or at least a business they could have formed on their own for next to nothing. Instead they spend $28 million, paying a transitory owner for an 80% stake of a business which he allegedly created in a matter of months.

Here is the SEC filing that describes the boondoggle in detail: http://www.dailyfinance.com/company/china-marine-food-group-limited-common-stock/cmfo/ase/8-K/10685144/html/sec-filings

The following is a summary of the filing:



1) A director of CMFO invents a algae-drink formula and sells it to a "private party" named Mr. Qui for less than 9,000 dollars in January of 2009.



2) The sole owner (Mr. Qui) of the business who bought the drink formula from the CMFO director, rents office space for three years in April of 2009. He is released from his obligation to pay any rent by July 28, 2009, which corresponds with the inception of his algae drink business.

3) Mr. Qui starts his algae drink business with less than $44,000 on July 28. He subcontracts all drink bottling and packaging and acquires no patent on the formula.



4) In the period from July 28 to Sept. 30, 2009, the start up business allegedly records revenues of 4.5 million dollars. Remember the capital required to start the business was listed at $44,000.



5) In the period from July 28 to Dec 31, 2009, the business allegedly records approximately $7.6 million in revenues and approximately $1.6 million in net income.

6) On Jan 1, 2010, CMFO exercises their option to buy the business paying $27.8 million for 80% of the company. That includes just under $23.5 million for the intangible asset "Algae-based drink know-how " and about $3.5 million for goodwill. Bear in mind that a CHBT director allegedly sold the drink formula to Mr. Liu for under $8,000 dollars in January of 2009, less than a year later CMFO values the drink formula at around $23.5 million.

In summary when you add in the $3.5 million in goodwill to the $$23.5 million in intangible assets listed as algae-based drink know-how, the secondary offering money was used to purchase an 80% stake in $27 million worth of nothing. Seinfeld was a show about nothing; apparently this was a purchase about buying nothing, or more likely a direct scam to redirect the secondary offering money back into the pockets of the management.

The question one must ask is why would a company spend nearly $28 million for 80% of a company which they could have started up for next to nothing, with a drink formula that was invented by one of their own directors? The answer seems obvious to a rational short but not to an emotional shareholder.

The stock currently trades for about $3.5 per share.

Summary

Starting in early 2005 I purchased six Chinese RTO companies at various times. By early 2010, I had sold out of my last position involving all of the aforementioned companies. With the exception of JST, all the companies were either outright frauds or otherwise destroyed nearly all of the shareholders value by the frivolous use of secondary offerings, mainly financed by American investors.



NWD would have resulted in a total loss of capital now trading for 5 cents and almost certainly is headed for the Pink Sheets. SDTH has been halted by the Nasdaq and would have probably resulted in a total loss of capital as well, in the event it reopens for trading. AOB egregiously squandered virtually all of their multiple shareholder secondary offerings. CHBT and CMFO appear to be fraudulent in nature, in my opinion, although they are both still trading. Finally JST would have been a decent buy and hold investment to this point.



Many other examples of potential Chinese RTO frauds are turning up on a regular basis. CCME and ONP are several other examples. Investors would benefit themselves by steering clear of these companies in light of the epidemic of corruption which is being uncovered.



Although I believed I was investing when I purchased the above mentioned companies, in reality I was playing a game of "greater fool." I was fortune to escape but I was even more fortunate to attend to the filings of the companies while listening and evaluating the arguments of the short sellers. Those two policies should be followed on all of one's holdings, not just Chinese RTOs.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (27 votes)

Comments

tonysf
Tonysf - 3 years ago


The SEC is asleep again. The auditors collude with clients.
LwC
LwC - 3 years ago
Hey, thanks for that very interesting read about the Chinese RTOs. Often when I read reports such as yours, I am reminded of an article about the foreigners' experience doing business in China that I once read in the Asian Wall Street Journal while on the plane during one of my many business trips into China during the '90s. The statement from the article that sticks in my mind even after all these years later is:

"When there's a dollar worth of profit on the table, the Chinese want a dollar and one cent of it."

BTW at that time it was illegal to carry foreign publications into China, so I had to leave the Journal on the plane. It was common practice for the cabin attendants to count the publications that were handed out and to be sure that they collected them before landing.

superguru
Superguru - 3 years ago
"When there's a dollar worth of profit on the table, the Chinese want a dollar and one cent of it." -LwC

LOL, these chinese must have got trained at Wall Street and then reduced their expectations to account for communist system at home.

noblepaladin
Noblepaladin - 3 years ago
The biggest problem is that the laws don't protect US investors. Some of these are outright frauds. Some of these companies may be real. If you were to visit on foot, you'll find legitimate operations. However, US stockholders don't actually own the company, they own a shell. Usually the shell only has a contract with the actual company, where the shell company is entitled to the profits. However, what is to stop the Chinese company from overpaying management so there is no profits? What is to prevent the Chinese company from spinning off profitable assets? The structure of most of these RTOs are simply bad. It makes it too easy for fraud to be committed. And when it is easy, it will happen too often. CCME is a shell that contains a real company. There is video evidence that the buses exist. Their online store exists, some people brought iPads from it as due diligence. However, the company simply ignored their auditors, ignored the board of directors, and now they have stopped communicating with shareholders. RINO is also a company that exists, people have seen the factories. However, they have gone dark too. I don't know if the financials are overstated or fraudulent, but the fact that these companies can simply choose to go dark and there is apparently nothing that the shareholders can do is very disturbing. Even if the company is real and all the financials are legit, what is to stop the company from going dark one day and disappearing?

There are a few Chinese RTOs are doing management buyouts. CSR is the latest. I think that the buyout is real, as there are some big name lawyers and bankers that got hired to work on the deal (frauds do secondaries to take money in, not waste it hiring lawyers and bankers to fake a buyout), but the shareholders are still getting crappy deal. CSR is clearly worth a lot more than the buyout price, but shareholders will agree to the buyout simply because they want out. They realize that these RTO structures are not enforcible, so they'll take the low bid. It seems like the best possible scenario investing in these RTOs are a buyout that is at a small premium to market price, which doesn't adequately reflect the real value of the Chinese company (not the shell). And the worst case scenario is that the company is fake or that the company is real but management simply severs ties with the shell that the US shareholders own. Doesn't look like a good trade.
traderatwork
Traderatwork - 3 years ago
Warren Buffett said: If I'm not smart enough to find value in US, how can I be suddenly so smart if I look/hunt at 1000s of miles away from home?

And here you are looking at Chinese companies, I'm Chinese and I speak 5 different dialects of "Chinese", 50 years of communism destroyed a lot of traditional thinking/value of the good part of the culture, current generation of (main land) businessman think: Money first and nothing come second, moral? gone, code of ethics? Are you kidding me?

I've seen enough of these good "Chinese Businesses", my advice, they are not worth the piece of paper that written on it.
Jinpan
Jinpan - 3 years ago
The reason JST stands out from this group is because it was NOT a Reverse Takeover stock like the others. JST's Initial Public Offering (IPO) dates all the way back to 1998. In fact, JST was one of the first Chinese companies to list on a U.S. exchange--long before any of these dubious RTOs started popping up.
user6244
User6244 - 3 years ago


Oh yeah NWD I got suckered for a loss of 11.5K , The more I read all the fillings from the very beginning the dirtier it got till I almost puked. Becuase I was new at investing I though maybe I was wrong and things would turn out but alas I should have went with my gut feeling and bailed long ago..about the time LLU dumped a load of shares well below the going price...at the time of .17

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