China Sky's Reported Inventory Belies Its Stated Earnings and Sales

An analysis of China Sky One Medical, Inc.'s (CSKI) inventory reporting, as well as certain customer and supplier disclosures, raises serious questions about the accuracy of its reported sales and earnings.

Reports previously issued by asensio.com revealed discrepancies in China Sky's stated EPS, gross margins and average sales prices, along with concerns about its corporate governance and auditors.

The inventory analysis was performed for each year that China Sky has been a public company and filed financial disclosures. The analysis compares the inventory levels each year and against other comparable Chinese companies.

China Sky is claiming that its annual sales have increased more than twenty-fold since 2004, but its finished goods inventory has declined in absolute terms by 75%. China Sky's finished goods inventory was four times greater in 2004 than in 2008, while its sales were more than 20 times greater in 2008 than in 2004. China Sky's finished goods inventory level implies that it turned over finished goods more than 365 times in 2008, and only 4.5 times in 2004.

In 2008, China Sky reported $91 million in sales, but the company reported just $55,614 in finished goods inventory at year-end. In 2004*, China Sky reported $4.2 million in sales, while it reported $229,136 in finished goods inventory at year-end.

The $55,614 in finished goods inventory China Sky reports having at the end of 2008 implies that it had less than one day's worth of sales in finished goods inventory, using the average daily sales in the fourth quarter. This is also the case for 2007. In 2004, however, the company had 81 days of sales in finished goods inventory. See Exhibit 2.

(Click to enlarge)

There are other irregularities in China Sky's reported inventory. Exhibit 4 shows the questionable reductions in the company's disclosed finished goods inventory that have occurred during the fourth quarter the past two years. In 2008, finished goods inventory declined 92% in the fourth quarter. In 2007 there was nearly a 93% decline. In 2006, the decline was 41%.

China Sky's inventory claims appear irregular when compared to other public companies selling so-called traditional-Chinese-me... products in China. As shown in Exhibit 3, in 2008 China Sky had an inventory turnover ratio that was nearly ten times greater than the average inventory turnover of three other comparable companies. While comparable companies report as much as 184 days of inventory on hand, China Sky only had 7 days of total inventory on hand at the end of 2008.

An analysis of China Sky's procurement and distribution is contained in Exhibit 1. This exhibit compares customer and supplier relationships in 2006 versus 2008. The company claimed to have customers covering the same geographic area in 2006 and in 2008. While reported revenues increased from $19.9 million in 2006 to $91.8 million, China Sky's number of customers actually decreased from 900 to 233 over the same period, according to China Sky's 10-Ks.

Exhibit 1 also notes the discrepancies in China Sky's disclosures of supplier and customer relationships between the 2007 and 2006 10-Ks. For example, in its 2006 10-K the company stated, "No one supplier accounts for more than 20% of our total raw material purchases." However, the 2007 10-K apparently contradicts this by stating that the supplier Harbin Yongheng Printing Ltd. accounted for 27% of inventory purchases in 2006. The nature of these supplier and customer relationships and the conflicting disclosures about those relationships only add to questions about the seemingly unbelievable reported inventory figures.

China Sky claims in its 2007 10-K that it "has a small inventory on hand primarily due to the enhanced productivity of newly purchased equipment and machinery, and the popularity of Company products in the market." This is the only basis China Sky gives to explain its irregular inventory level.

Perhaps China Sky is referring to its newly acquired transportation equipment as an explanation for its inventory. China Sky reports $885,880 in transportation equipment at year-end 2008, up from $318,779 at year-end 2007. China Sky does not disclose how it distributes $91 million worth of product throughout 22 provinces of China. However, it is telling to note that its $885,880 worth of transportation equipment is nearly 16 times the value of its finished goods inventory at year end.

*2004 financial information is taken from audited statements for the Chinese operating company that became CSKI through a reverse merger in 2006: Harbin Tian Di Ren Medical Science and Technology Company. The audited statements can be found in CSKI's 8-K filed May 15, 2006.

Disclosure: Short CSKI.

Comments

[stocklad:]

"The lady doth protest too much, methinks." (Hamlet, Act 3, scene 2)

May 09 09:58 AM

[stocklad:]

Perhaps a more apt reply to this article would be “Much Ado About Nothing”.

The article above leads me to conclude that China Sky One is judicious in its management of inventory. That’s one more reason to like the company.

Here are most of my reasons, in point form:

PRODUCT RELATED
- Large and diversified portfolio of approximately 100 products including:
- Patches
- Creams, ointments, drops and sprays
- Diagnostic kits
- Injectibles
- Tablets and suppositories
- Many drugs in for SFDA approval
- Company-controlled sales force as well as third party distribution
- Three acquisitions in 2008
- Expansion into prescription drugs
- Strong and expanding drug pipeline including:
- Sudden cardiac death early exam kit (revenue potential of $20+ Million)
- Breast Lesion drug (revenue potential of $146.2 Million)
- Management that is pleased to open its facilities to shareholders

FINANCIAL
- Revenue growth from $8M to $92M since 2005
- High gross margin of 76%
- Reasonably controlled expenses
- Earnings growth from $2M to $29M since 2005
- Earnings per share growth from $.19 to $1.87 since 2005
- Cash on hand of $40M
- Working capital of $58M
- No debt
- Judicious inventory management
- Reasonable level of accounts receivable
- Strong cash flow which should be able to fund 2009 CAPEX

FUTURE
- Strong 2009 guidance of $128M-$130M revenue and $38M-$39M net income
- Guidance doesn’t include acquisitions
- Management is predicting continued growth over the next five year period
- The company can easily afford to commence payment of a dividend, if it so chooses

Let me close off this listing of positives for CSKI by stating that the company appears to be driven to be successful, as pointed out by their press releases. Over the last year (by my count), they have issued 17 drug/pipe related releases, plus 4 related to distribution agreements/export arrangements, 1 for an acquisition, 1 for a guidance increase, 2 for a change of market for the stock (OTC to AMEX to Nasdaq) and 2 for scientific recognition. That’s about one positive news release every 2 weeks.

Disclosure: I am long on CSKI and I don’t concern myself with the day to day stock price movements. This is such a lovely long term growth story.

May 10 12:21 PM

[stocklad:]

The formatting of my point form reasons for owning the stock didn't quite turn out as intended. Let me try again.

Here are most of my reasons (for owning the stock), in point form:

PRODUCT RELATED
- Large and diversified portfolio of approximately 100 products including:
..... Patches
..... Creams, ointments, drops and sprays
..... Diagnostic kits
..... Injectibles
..... Tablets and suppositories
- Many drugs in for SFDA approval
- Company-controlled sales force as well as third party distribution
- Three acquisitions in 2008
- Expansion into prescription drugs
- Strong and expanding drug pipeline including:
..... Sudden cardiac death early exam kit (revenue potential of $20+ Million)
..... Breast Lesion drug (revenue potential of $146.2 Million)
- Management that is pleased to open its facilities to shareholders

FINANCIAL
- Revenue growth from $8M to $92M since 2005
- High gross margin of 76%
- Reasonably controlled expenses
- Earnings growth from $2M to $29M since 2005
- Earnings per share growth from $.19 to $1.87 since 2005
- Cash on hand of $40M
- Working capital of $58M
- No debt
- Judicious inventory management
- Reasonable level of accounts receivable
- Strong cash flow which should be able to fund 2009 CAPEX

FUTURE
- Strong 2009 guidance of $128M-$130M revenue and $38M-$39M net income
- Guidance doesn’t include acquisitions
- Management is predicting continued growth over the next five year period
- The company can easily afford to commence payment of a dividend, if it so chooses

May 11 02:02 PM

[User 223026:]

Another anonymous short seller at work! Based on its form this msg appears to be a second posting from the same source that put out a comparable diatribe in late April. Unless the author stands to profit from such postings, they would not appear. My guess is that this person is playing the stock in a 3-4 point range. I, for one, appreciate these efforts because they create opportunities for me to continue to accumulate CSKI stock.

May 13 10:28 AM

[China Expert:]

I suggest the writer ask their questions regarding inventory on the conference call !

May 13 09:37 PM

[stocklad:]

Good points, User 223026 and China Expert. Q1 2009 results just came out and, as anticipated, they're outstanding. A few quick points:

1. Cash is now at $2.97 per share, which means China Sky One can afford more acquisitions and a dividend without dilution.

2. Working capital is now at $4.01 per share (with no long-term liabilities!)

3. Revenue was up 100% over Q1 2008.

4. More importantly, sales from the company’s own products rose 162% over Q1 2008 (third party sales were discontinued at the beginning of Q1 2009), which means that the company’s core business is soaring.

5. Fully diluted earnings per share were up 67%, even with that large increase in R&D expenses.

6. That big jump in R&D expenses should result in sustainable growth well into the future.

This is just so very impressive. Kudos to CSKI management!

May 13 11:50 PM