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As one of the success stories among Chinese reverse-merger stocks, China Sky One Medical (OTCPK:CSKI) ascended from OTC BB to AMEX and then all the way to Nasdaq Global Market, all in the last year. Until last week, the stock has been one of the better-performing small-caps in the present market turmoil. Then the music stopped last week when the company was unable to file its 2008 annual report with the SEC on time.

To some, the stock’s recent retreat means an opportunity to buy into a growth story at bargain prices. To some others, however, there are ominous signs that cannot be ignored. Can the company’s 10-K filing extension be a warning sign of something deeper in its business practices? Here are a few things to consider:

1. Management has been eager to please the market with great news since it was admitted to Nasdaq last September. Management has not even failed to “schedule” (and then “un-schedule”) an earnings conference call just two business days prior to announcing the filing extension. The fact that such an eager management was no longer able to please the investment community is particularly disturbing.

2. Chairman and CEO Mr. Yan-qing Liu’s wife transferred 526,170 shares of common stock to an undisclosed third party as a “bona fide gift” as of February 12, 2009. That was worth $7.4M (RMB 50.6M) using February 12’s closing price of $14.05, or $5.4M (RMB 37.2M) using Monday’s market close of $10.34. Regardless of whether this level of gifting is out of the ordinary outside of family context, these shares have since been able to be sold freely without Mr. Liu having to file a Form 4.

3. The company changed auditors three times in the past two years. Before April 2007, the company’s auditor was e-Fang Accountancy. In April 2007 the company replaced e-Fang with Murrell, Hall, McIntosh & Co., PLLP. In December 2007 the company changed heart again and engaged Sherb & Co., LLP instead. Then on May 21, 2008 the company dismissed Sherb & co. and replaced it with MSPC (“Moore Stephens”).

Notably, CSKI’s 2007 annual report was signed off by Sherb & Co. According to a 2008 report by Barron’s, Sherb & Co. once signed off alleged revenue fabrication by a Florida financial company and has a record of deficiencies in PCAOB’s (Public Company Accounting Oversight Board) database.

It would be quite interesting to observe how long MSPC will be able to maintain a relationship with CSKI going forward.

4. Accounting irregularity is nothing new with CSKI. The company’s 2006 annual report (audited by e-Fang Accountancy) was restated twice. After the restatements, the company’s net income decreased from $4,300,401 to $624,415 (an 85% correction), and EPS (diluted) dropped from $0.31 to $0.05 (a 84% correction).

5. Mr. Jiang Qi Feng, a 25-year-old recent Master’s degree (in Computer Science) recipient (and possibly current graduate student as of March 2008), who does not have any financial background, was elected to CSKI’s board as an “independent” director on February 22, 2008. He serves on the company’s Audit Committee, Compensation Committee, Executive Committee, and Finance Committee. In particular, per the company's 10-K filing for FY 2007, management believes that Mr. Jiang qualifies as an “audit committee financial expert” as defined under Item 401(c) of Regulation S-B.

Here is Mr. Jiang’s qualification as given in company’s 2007 10-K:

"Jiang Qi Feng, joined our board of directors on February 22, 2008. From September 2006 to the present, Jiang Qi Feng has served as a Teaching Assistant and a Research Assistant at Simon Fraser University in Canada, where he specializes in biology statistics, biology research and probability. Jiang Qi Feng received a Masters Degree in Computer Science from Simon Fraser University in 2006, and Bachelor’s Degrees in Bio-Statistics and Mathematics from the University of British Columbia in 2005."

Mr. Jiang apparently was still a graduate student on a teaching/research "assistantship" with Simon Fraser University, as of the 10-K filing date March 31, 2008. Fact is, it does not take a Ph.D. to figure out how “independent” and “qualified” a non-financial graduate student (even with a non-financial Master's degree) can be on a company’s board and in particular as an “audit committee financial expert”. Management’s selection of Mr. Jiang as a director and “audit committee financial expert” seems to have sent a clear signal to the market. It does not take financial control and reporting seriously. Period.

All told, it is not quite clear to me if management is genuinely motivated to achieve the strict financial control commensurate with a public company listed on Nasdaq GM, or if it's just interested in reporting “great numbers” and news stories to the investing public. There is a fundamental difference between a team only interested in reaping short-term profit for themselves and one that is committed to growing with investors over the long haul.

Disclosure: Author does not have a position on CSKI as of this writing.

Source: Three Reasons to Heed China Sky One Medical's 10-K Filing Extension