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Prior to founding Kerrisdale Capital Management, Mr. Adrangi was an investment analyst at Longacre Fund Management, a distressed debt credit fund. Prior to Longacre, Mr. Adrangi worked in the bankruptcy restructuring group at Chanin Capital Partners and the leveraged finance group of Deutsche Bank Securities.
Mr. Adrangi holds a bachelor of arts in economics from Yale University.
Long short fund, long biased no real macro analysis. We do not hold a lot of cash, especially since we launched in 2009.
We have three parts of our process:
Invest in opportunities in which market value is offered at a significant discrepancy to intrinsic business value.
Approach corporate investments as an owner of a business
Patient long-term investing creates a distinct advantage over short-term speculation
We were one of the first funds to investigate all the reverse Chinese mergers.
In June last year we wrote anonymously, and over past year and half we have identified a lot of shorts, and taken an active role in exposing them.
We compiled two lengthy 30+ page reports on Chinese frauds, China Education Alliance (CEU) and Advanced Battery Technologies (ABAT)
Our work has been mentioned by numerous media outlets, including The Wall Street Journal, BusinessWeek and the Financial Times
We have developed four metrics for developing shorts.
1. We use common sense and look for irrational growth and ROC; if it is a commodity business it makes no sense to have huge ROC. Advanced Battery had EBIT of 40%, and next highest competitor had 26% EBIT which happened to be a multi-billion dollar Indian company.
Same with China Education Alliance, EBIT margins nearly double other competitors.
2. Next we pulled their financial statements locally filed in China. In China all business entities must file financial statements with local branches and to get them you have to go to the local govt branches because the financials are not posted online. We talked with auditors, CFOs etc. in China to ensure that these filed statements provide meaningful data points and some of these companies were reporting much less revenue to Chinese Government than US Government like ABAT, CSKI, CEU; some reported $1m with local authorities, while reporting in US $50m in revenue.
3. A lot of equity dilution-ABAT had 10m o/s in 04, and 75m in 2010, raising equity numerous times despite having a sufficient amount of cash. Unnecessary equity dilution is red flag. CCME and CEU all raised capital at low valuations despite large purported cash holdings and strong FCF metrics.
4. ABAT, CEU had no name auditors, there was a lot of switching of CFOs, and many of these prior CFOs had insufficient experience. ABAT had a 26 year old with limited experience as their CFO, and a woman whose background was a financial advisor as their next CFO.
But this is not always the case; CCME CFO was former manager at E&Y and had Deloitte & Touche as their auditors.
Our short idea is Gulf Resources; GURE - we think it should be trading under $1. GURE is a manufacturer of bromine and bromine derivative products
Company went through RTO in 2006. The stock has gone down as a result of all the RTO news, but is still trading much higher than where it should be.
Gulf- claims to own assets which we believe it does not own. We believe the company's purported facilities are owned by a separate private entity owned by the chairman, and that they are not owned by the publicly traded company.
Bromine-related subsidiaries of the privately owned entity have same numbers, same addresses as those owned by Gulf.
Their largest customer, which appears to be owned by Gulf chairman, has the same address, phone number, and fax numbers as the privately owned company owned by the chairman.
The margins are irrational - 90% of China's bromine is produced in Shandong, it's a competitive commodity industry with many players. The company is commodity business but ROIC is 25%+ and EBITDA margins 40%-50% consistently over past few years.
There are many consulting firms that provide reports for commodities. We purchased one by a Chinese chemicals consultancy on China's bromine market and they list the top 30 producers in 2010. Gulf was not mentioned in the top 30 producers and Gulf's claimed production is much higher than the top producers cited in the report.
We have talked to other competitors, and Gulf is not a major player based on our calls, and some even said they think GURE is a fraud.
There are two other interesting things.
Who is helping structure these reverse merger deals?
China Finance Inc. We know some information about it because it is public with a ticker of CHFI. It has helped three companies get more than 100m market cap. CHFI gets to keep a percentage of shares and sell it for cash.
CHFI was itself an RTO company whose business was to actually complete RTOs. It helped ONP, UTA and other alleged frauds go public, in exchange for equity.
A number of the companies they helped go public never did well.
Others have written up long reports about CHFI companies. Carson Block of Muddy Waters, which wrote on Sino Forest which was held by John Paulson, wrote initially on ONP and Glaucus Research has written on UTA. UTA was 30 page fraud report.
CHFI would lend that cash to companies that CHFI insiders or related parties were affiliated with. You can do keyword search on Edgar, if you do one on the companies that China Finance was lending out to you could see that they were lending out the cash back to related parties.
Gulf is audited by BDO, which has audited other Chinese reverse merger frauds. Was auditor of China-Biotics, which was one of the first companies we exposed.
China-Biotics claimed to have 100 stores, and we sent out our investigators to view them, and some of the locations were parking lots. Many of the locations were just some products on shelves.
BDOwatch.com was set up by another investor discussing an open letter that was sent to BDO partners, and another investor met with the chairman of BDO Ltd to discuss the evidence for fraud at CHBT. BDO did a deeper audit of China-Biotics, and discussed all the evidence for fraud and that China-Biotics even set up a fake bank website to confirm transactions they did to show to BDO.
Conclusion:
Related party transactions- YONG’s suppliers had same phone number as registration of YONG
Sham transactions - CMFO purchased a soft drink maker, and then filed an 8-K, and the target originally had the same exact headquarters. It was able to generate $7m in revenue in first 6 months, not reasonable.
ABAT claimed to purchase a battery maker in 2010 for $20m, and they really bought them earlier in 2008 for $1m, but never disclosed it in their fillings. We only found out because the original owner sued them because ABAT never paid the seller of the target the full amount they owed.
Channel Checks-Many of ONP’s customers were too small to purchase the amounts they claimed to.
CCME makes TV on buses, and we called other TVs-on-buses companies and they believed them to be a tiny player.
Site visits: CEU an education provider; we visited class room facilities and they were vacant and unfurnished.
One mistake we made was Jennifer Convertibles
When the recession came the company became EBITDA negative. They had no debt, but were increasing the terms of their suppliers through A/P.
We thought the company would emerge from the recession, and thought it was worth 4-5x our money if it did not go bankrupt, but it filed for bankruptcy in July 2010.
We knew that the company was risky, so we only put 1% of our capital because we knew there was bankruptcy risk.
Q&A:
Are these frauds just RTOs or any Chinese stock in the US? Have policies made it safer to invest in Chinese stocks?
Regulators are working together to prevent the fraud. It is not an auditor’s job to prevent fraud; we think auditors just need to go through their check list. The fraud being committed is by Chinese individuals not subject to American laws, so the best way to prevent this from occurring in the future is to get American and Chinese regulators to work together.
We do not think fraud is within just RTOs: Longtop is a good case of that. China has a whole network of lenders who help companies commit fraud. In America it is harder to find auditors or banks to commit fraud. In the US if you want to have 100m cash, you will not find a lender to lend you $100m temporarily to show the auditors, but in China you have shadow lenders.
Longtop was a real company but was making up statements because it was able to bribe bank officials. Of course, many Chinese companies are legitimate and China is an economic power. Eventually the short sellers and regulators will weed out the fraud.
We do a lot more checks on small caps than on larger US companies which we own.
Disclosure: None
Disclosure: None
http://www.valuewalk.com
About the author:
I am VP of Business Development for Sum Zero (http://sumzero.com), the largest community of buy-side analysts; consisting of over 5,900 hf and mf analysts, and over 3,600 extensive investment write-ups. I have prior experience in a value based pe firm focused on PIPE transactions in micro-caps, and at a value based research firm, which focused on smid caps. In my personal portfolio I have outperformed the market by a cumulative ~48% since 3/2008 (inception date). I can be contacted at jacob(at)sumzero.com for sumzero related inquires. My website is http://www.valuewalk.com/ Visit Jacob Wolinsky's Website
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GURE is a well known and respected company with solid foundations. This is a rehash of all the untruths that have been spread by shorts in the last half year.
I would be careful before publishing this kind of tripe, the SEC is watching!