Revealing the Shoddy Practices of China Sky One Medical

In a previous post I raised questions about China Sky One Medical Inc. (Nasdaq GM: CSKI), including an unusual insider stock transaction, past accounting irregularity, use of dubious auditors, frequent changes of auditors, and the appointment of a non-financial graduate student as a director and “audit committee financial expert.”

Here I’m trying to unveil China Sky One’s despicable, fraudulent business practices with hard facts. (Note: some of the links provided below can be slow or not functioning occasionally. If that occurs to you, just try again at a later time. In some cases, I provided double links. Note also that many of the links given here had their origin in government or quasi-government websites.)

A “Flagship Product” that Rips Off Consumers

Weight-loss products account for 24.3% of CSKI’s total revenue in the first nine months of 2008. And most of the weight-loss revenue came from company’s flagship product: Sumei Slim Patch.

CSKI’s operating company Harbin TDR (short for Harbin Tian Di Ren) promotes Sumei Slim Patch as an effortless, fast-track “Sleep & Slim” weight-loss panacea. The Sleep & Slim patch (“Shui-shui Shou” or 睡睡瘦速美减肥贴) was widely promoted in TV Shopping channels throughout China.

These programs advertised the “Sleep & Slim” patch as a product that enables the consumer to “paste, sleep and slim”, “paste at night and slim in the morning”, “reduce waist size by more than 1 Chun (3.33 centimeter, or 1.3 inch) by next morning”, “lose 1 Jin (0.5 kg or 17.6 oz) by next morning”, and so on, and so forth.

Consumers who bought into this type of ads have found the product to be totally ineffective and cause a lot of side effects (allergy, inflammation, swelling, ulcer, etc.) Complaint about this product was widespread.

All...TV “Sleep & Slim” promotions worked the same way: promise of overnight weight loss, false money-back guarantees, and little or no post-sale services.

In short, consumers were lured into buying the product and left dangling once payments were made. Talking about a mind-boggling, brazen rip-off!

Constant and Top Violator of Advertising Regulation and Manufacturer of Shoddy Products

Harbin TDR has turned out to be a constant violator of government’s advertising regulation on healthcare products.

According to report, China’s SARFT (State Administration of Radio Film & Television) and SAIC (State Administration for Industry & Commerce) banned the broadcast of TV shopping programs related to weight-loss products in July 2006.

All of the complaints above were originated from Harbin TDR’s “TV promotion” campaigns in 2008. So, Harbin TDR was apparently violating government regulations when they allowed those ads to be aired.

According to statistics from Beijing Consumers Association [BCA], “Sleep & Slim” tops the list of broadcasts of banned illegal TV ads nationwide during the two-week period from August 25 through September 7, 2008. During that period, “Sleep & Slim” promotion was aired 437 times.

Following this finding, BCA requested SARFT to order all TV networks concerned to suspend airing “Sleep & Slim” TV promotion programs immediately and prosecute violators accordingly. (See also this link.) SARFT promptly approved BCA’ request and forced the TV promotions to stop in November of last year. See here also.

Harbin TDR’s false ads and regulatory violation do not just stop on its flagship product, Sumei Slim Patch.

In 2008, Hefei Bureau of Health found company’s Jieyinling genital cleaning spray to have carried false claims regarding its capability to treat certain diseases and symptoms.

In 2007, Qingdao Bureau of Health found company's Jieyinling genital cleaning spray to have carried label illegally implying certain medical treatment effect.

In 2007, company’s ad for Kangxi hemorrhoid ointment was found (see here also) by Hebei Province’s Food & Drug Administration to have illegally used absolute language to exaggerate its efficacy.

Here and here you can also see a consumer sharing his experience with this product. He/she wrote on January 9th this year: "The American Kangxi hemorrhoid magnetic ointment is a scam. I was swindled 600 Yuan. After I used it for a month, not only didn't it cure my illness, it actually has made it worse. ... ... Hope everybody learns a lesson from me, and not get swindled again."

(Harbin TDR promoted its products as American products in China because its holding company CSKI is registered and traded in U.S. Some other U.S.-registered Chinese companies also have this practice. Sometimes this caused confusion among consumers, like this consumer also complained: "I found it to be produced by Harbin TDR; not an American product at all.")

In 2004, seven of the company’s Kangxi brand products (covering genital cleaning, skin care, throat care, and nasal care) showed up in a banned list of illegal products which were linked with exaggerated ads.

In 2003, Tianjin Bureau of Health included company's foot care product Kangxi Jiaoshuangling in its blacklist of 68 illegal products.

In 2003, Qingdao Wanbao (Evening News) counted Harbin TDR’s skin care product Kangxi Fushuangling in one of the city’s top 10 cases of violation of national food & healthcare law. It charged the product as exaggerating treatment effectiveness.

Master in Exploring the "Gray Area"

The management’s “creativeness” in marketing strategies lies in its bold exploration of the "gray area" of TV shopping, a relatively young and loosely regulated area in China.

TV shopping programs usually do not have a public address. Products are sold via telephone hotlines, delivered to consumers’ doorsteps, and often without receipts. Post-sale services are virtually nonexistent, with service numbers constantly busy or not answering.

Sometimes consumers are required to contact manufacturers directly for post-sale problems. A lot of consumers simply do not have the time and/or knowledge to pursue manufacturers. This creates an ideal condition for sales with extra low product return rate.

In such shoddy marketing setups, marketers are often willing to bear the major share of blame when regulators show up. This way, the manufacturers can continue its business almost as usual.

To a short-sighted management team, the only loser in this game seems to be the consumer. Now that regulators do not force them out of business, this same strategy always has the hope of revival in the future.

Indeed, if you know Chinese and have read this report carefully, the top sales representative of the Sumei Sleep & Slim Patch Ms. Lin has made it clear that similar TV promotion is going to resume in 2009.

Why were the fraudsters so confident about their comeback? Simply put, they are familiar with China’s regulatory environment. Policy enforcement comes in pockets and waves. Tight periods are followed by loose ones. Even during periods of enforcement, punishment is often little more than forced suspension of the shoddy marketing programs. There can be fines. But often the punishment is "worth the while."

Besides, local governments often race to promote and protect businesses in their own jurisdictions. So, even though an officer of Heilongjiang’s provincial FDA told reporters that any promotion of Sumei Slim Patch is illegal beyond its registered indication of Simple Obesity, there do not seem to be reports on any disciplinary action from Harbin TDR’s provincial or municipal government.

(Some observers have questioned if Sumei Slim Patch qualifies as a weight-loss product at all. As some of the reports above, e.g., this and this, pointed out, the patch actually has to be used in combination with weight-loss medicines to be “effective.”)

Then, there also comes the Chinese business culture of "Guanxi" (connection). If a management has good Guanxi in the government, it becomes relatively easy for them to survive regulatory troubles.

As the ultimate victims, Chinese consumers apparently might not agree to this lenient regulatory environment for enterprises. But it is hard to blindly blame the government. Recall all the actions mentioned previously that the various government organizations have taken in this Sleep & Slim scam?

Apparently Chinese government is trying to strike a balance between protecting consumers and having too rigid and restrictive rules that might stifle entrepreneurial creativity altogether. For Sleep & Slim, authorities in several provinces have issued consumer alerts, launched consumer education campaigns, and solicited consumer complaints actively.

It appears that the government prefers these soft measures over hard ones. After all, if consumers know what products to avoid, perpetrators will have received some punishment through loss of sales and tainted brands. Many violators will also have learned a lesson and be given a chance to take corrective measures and seek lasting prosperity by remaking themselves.

Sadly this inevitably leaves plenty of opportunities for recidivists. They constantly tweak their skills of deception and test government and consumers’ limits. They aim to get “stronger” after each cycle, much like how viruses work.

However, no matter how handy they can hide behind marketers and lenient regulatory environment, it is unlikely that fraudulent business practices can thrive over the long term.

Consumers always wake up and revolt, particularly in this information age when bad news can travel by the speed of light. When the time of reckoning comes, investors would be the ones to pick up the bill.

Or maybe that is of the least concern to this management? Anyhow, if a "clarification" ever needs to be given to the investors, it would be "the company does not have control over how our marketers behave." Are you feeling sympathetic already?

Questionable Financial Control

Asensio, a trading firm specializing in short-selling, has published a report about CSKI’s auditors. It has found that all four (previous and current) auditors were investigated or sanctioned by SEC, PCAOB, or other regulators. CSKI’s current auditor, MSPC, was at the center of a scandal and was sanctioned by SEC in 1999.

Aside from Asensio's findings, on November 30th 2005, PCAOB issued an inspection report on MSPC. PCAOB found six areas of audit deficiencies and concluded that “the deficiencies identified in three of the audits reviewed included deficiencies of such significance that it appeared to the inspection team that the Firm did not obtain sufficient competent evidential matter to support its opinion on the issuer's financial statements.”

As an update to my last post, Mr. Jiang Qi Feng, a young graduate student (now 26) with no prior financial background, is still serving (as of April 15th) as an “independent” director and “financial expert” on company’s Audit Committee, Compensation Committee, Executive Committee, and Finance Committee.

Some investors have also been highly skeptical about CSKI's reported gross margin. In a highly competitive industry, CSKI has been able to report markedly higher gross margin (in the high 70s) than competitors. Its reported gross margin also stayed amazingly steady even as its product mix and in particular, average selling prices [ASP] for key segments, changed significantly (sometimes wildly) from quarter to quarter.

When so many scandals and questions surround a single company, chances are there is a major credibility crisis hidden somewhere.

Disclosure: Author is short CSKI as of this writing.

Comments

[Cabeza Howe:]

To read more about Chinese consumers' complaints about Sumei Slim Patch and how government authorities and the press helped victims fight the scam, read a more detailed writing at valueblockbusters.blog... or my SA Instablog (seekingalpha.com/autho...)

Apr 22 07:33 AM

[China Expert:]

I am NOT a shareholder and have NO vested interested in this company but have followed many Chinese companies for some time:

1) regarding the auditor, most Chinese company's are introduced to auditors by their equity sponsors and often times low cost is a key selling feature early on. Only later does a company realize the importance of having an auditor with credibility and reputation. I dare anyone to show me an auditor with an unblemished record. It doesn't exist. As for China's Sky's auditor MSPC (affiliate of Moore Stephens), with 12 principals and over 80 employees this is a major upgrade from its previous auditor, Sherb.
2) As for it products and markets.... that's the nature of the company's business. I must admit I question Slim Fast, but that product did not hurt Unilever Incorporated to realize billions in sales. Or how about Chattem's (CHTT) sales of Dexatrim ? and Garlique ? Who knows if they work, yet Chattem is worth almost $10 billion. As for questionable marketing .... check out the multi-billion infomercial business we have in the USA. How much of that garbage works ? How about a glove that peels potatoes quickly ? Yet, the business according to a recent Forbes article generates hundreds of millions in profits. The skill here is to find new products that appeal to the mass. Do you think the FTC and FDA are not looking at many of these products for infractions ? My primary focus on CSKI would be to validate that the $40.3 million of cash on the balance sheet really exists and the $36.8M of 2008 EBITDA was "clean" and "scrubbed". If the high margins, attractive balance sheet and significant free cash flow generation is accurate, than the shorts will have to maintain a very long term conviction that they are correct. The shorts should look at an array of Chinese small caps and they will see that "finger pointing" is possible at each and every one. On occassion one implodes but I personally don't have a lifetime to wait for the "event" to make the gain from a "short" to happen. To me, the CSKI "bear" case is pretty weak.

Apr 22 08:02 AM

[notsosmart:]

its just easier to scam in china than here.that should be obvious to all.maybe we can create a leverage derivative on scams. say for one in the u.s.,25 in china. if you have confidence in china then put your money there. im staying away. there are enough enrons & world coms right here.dont need the brics.

Apr 22 11:52 AM

[Karl Francis:]

Cabeza Howe, your arguments and wording are strangely similar to those of the known short seller and convicted fraudster Asensio, well known for his smear tactics. What's your relation with that person?

Regarding CSKI. I can't say it better than China Expert.

MSPC is a well respected international auditor group - certainly one of the best international auditors working in China. Do you pretend that this auditor has wrongly certified CSKI's impressive cash reserves and cash flows?

Apr 22 04:53 PM

[Lookatvalue:]

Well, many products don't work and cause allergies. I remember taking some antibiotics that gave me a rash. So its a given that medicinal products do not work for all individuals and probably 99% of the products eastern or western give some % of the population side affects.

I am an investor in the company because I know that the patch works. I have friends that have taken it and it has worked, however for other it hasn't so it all depends. There are many factors that can cause it to not work. Maybe body size, eating habits, dosage, abnormal health conditions, etc...

As for the financial statements, I do think that they should hire a top 10 accounting firm that would definitely cast all doubt away. However what make me feel comfortable is that the consulted with the SEC in the last delayed filing and the the SEC gave them guidance on what to do and the result were quite impressive. They've had 3 accounting changes so one more to a top 10 firm now that they can afford it, will be a really good.

The company has really expanded their product portfolio so I expect sales to continue to increase and I'm looking forward to the Test Kits. The market is untapped and CSKI has a first mover advantage.

I also like the fact the the government keeps giving the company free money (grants).

I would need more of a reason to sell my position than some customer complaints.

Apr 22 06:07 PM

[Huggy:]

Yeap, short the stock and publish a negative article on the stock, hehehe, you are such a ....(hardly find a word on you even though it should be easier.) BTW, some of 'fact' you quoted is not with CSKI, you are lier apparently :)

Apr 22 08:06 PM

[JayCasey:]

Thanks for raising these questions. I live in China and can't argue with any of your points. As one who deals with Chinese companies every day I know there are some reliable ones but I know enough about the way things work here that I never invest in any Chinese companies. I always do business with them cash-in-advance or LC. Honesty is a problem anywhere but it is a huge problem in China. I put my assets and investments in the US.

Apr 22 09:20 PM

[Think-About-It:]

Good article and points. However, I would never be able to pull the trigger on a short here on a company with such a solid balance sheet, top line growth and high level of cash flows and low valuation multiples.

Even if their products are scams they could go on like this for years. For shorting in this environment I require falling sales, a lousy business model, a bloated balance sheet etc...

Apr 23 04:26 AM

[Danny Furman:]

anyone know how legitimate BSPM is? numbers look amazing

Apr 23 04:04 PM