China Sky, Takasima and Massage Chairs: A Tangled Web

China Sky One Medical, Inc. (NASDAQ: CSKI) reported in its 2006 10-K that in March 2007 it entered into an agreement with a Malaysian company called Takasima Industries for the distribution in Malaysia of China Sky's Slim Patch product.

Under the terms of the agreement, Takasima was required to generate sales revenue of US$1 million per month. The 2006 10-K also states,

Management anticipates that this strategic agreement could result in up to US$12 million in additional annual sales revenue in 2007, with a net profit margin of 20%.

This was an amount equal to 60% of CSKI's 2006 revenue.

There is an apparent conflict on the date of the agreement in China Sky's disclosures. The 10-K states that the agreement was entered into March 2007. A press release dated February 20, 2007, states that the agreement with Takasima was made "early this year."

Neither the press release nor the 10-K refers to the full legal name of Takasima Industries.

Neither the 2008 10-K nor the 2007 10-K provides any new disclosures concerning the term of the Takasima agreement, and for what period Takasima agreed to have minimum sales of $1 million per month.

The Takasima story was instrumental in China Sky claiming to have revenues grow from $19 million in 2006 to $49 million in 2007. China Sky's reported revenues from Malaysia in 2007 were more than $13 million. In 2008, however, China Sky's Malaysia sales were only $8.8 million.

Information was gained by Asensio.com that puts into question the nature of the relationship between China Sky and Takasima, and implies the transactions between the two might have been done at much less than arm's-length.

California corporate registration records show an entity called Takasima Sporting Goods, Inc. at an address in City of Industry, California. A company called Lailai Capital Corporation has the same address under California records. What makes this interesting is a connection with the principal of American Eastern Securities, Inc., the group that arranged China Sky's reverse merger and first subsequent PIPE offering, and that was a major shareholder as of April 2008.

Charles Trang Chong Hung is American Eastern's principal. Hung is listed as Registered Principal in a FINRA sanction against himself and American Eastern. Hung is also listed as the secretary of Lailai Capital Corporation in a lawsuit filed against Lailai by Union Oil BREA Federal Credit Union. See attached "Complaint for Money, Fraud, Constructive Trust and for Conspiracy."

Hung was issued stock in CSKI as part of CSKI's reverse merger in 2006. In CSKI's 8-K filed May 15, 2006, Hung appears as having 87,685 shares. American Eastern Group, Inc. appears owning the same number of shares, and another entity, American Eastern Securities, Inc. appears owning 54,803 shares. EIC Investments, LLC, whose principal is Hung's son, Charles Hung, Jr., also received 54,803 shares in the reverse merger. China Sky's Form S-1 filed April 11, 2008 shows American Eastern Group also having warrants to purchase 500,000 shares at $2 per share, expiring July 2009.

California records for Lailai Capital also show Kirk G. Downing as a former registered agent. Downing is an attorney based in City of Industry, CA who sits on the board of American Dairy, Inc. (NYSE: ADY). American Dairy was another Chinese reverse merger arranged by Hung and American Eastern Securities. In 2007, American Dairy was the subject of an informal SEC probe due to the practices of its auditor Murrell Hall McIntosh, an Oklahoma-based firm that also served as auditor to China Sky.

An internet search shows Downing's office in City of Industry, CA is located in a building where Hung's American Eastern Group and e-Fang Accountancy Corp. also have offices. E-Fang Accountancy was China Sky's first auditor following the reverse merger in 2006. After e-Fang audited CSKI's 2006 10-K, the 10-K had to be amended twice, and the earnings had to be restated. Net income went from $4.3 million to $624,415 following the restatement.

The connection between China Sky, Hung of American Eastern, Takasima Sporting Goods, and Lailai Capital may seem tentative at first glance. But there are some facts that make the connection look rather too coincidental.

The China Sky fourth quarter 2008 earnings conference call transcript states,

…we've now expanded sales of Slim Patch into South Korea and Sudan after engaging PAX-Medicare and Lai Li Investment Company as exclusive sales agents.

Lai Li Investment Company, of course, sounds very similar to Lailai Capital Corporation. (Why any company would be marketing a weight-loss product in the war-torn Sudan, where there have been recent reports of extreme famine, is another discussion entirely.)

If you visit the physical address in California where Lailai Capital and Takasima Sporting Goods have been registered, you will find that the building is now occupied by a business called Sunpentown.

Going to the Sunpentown website reveals that the company sells massage chairs, among other items. Searching for "Sunpentown Takasima" reveals massage chairs marketed under both the Sunpentown and Takasima brand names. Going to the website of the Malyasian Takasima Industries, the company touted as selling China Sky products, shows that the company lists fitness equipment as its products, but has advertisements offering massage chairs.

It seems there may be a more than coincidental link between Takasima Industries, the Malaysian company claimed to be distributing China Sky products, and Takasima Sporting Goods, the California business. Given Takasima Sporting Good's connection with Hung, and Hung’s deep involvement with China Sky, there is reason to suspect that China Sky’s reported sales agent in Malaysia may actually be a related party.

If China Sky’s agreement with Takasima was not made at arm’s-length, it would be cause to doubt the reliability of China Sky’s reported sales made through Takasima.

Furthermore, there is reason to suspect that China Sky’s new sales agent for the Sudan, Lai Li Investment Company, may be a related party as well, given Hung’s involvement with Lailai Capital Corporation.

Beyond the issue of potentially related parties, there may be reason to doubt whether the Malaysian company that CSKI refers to as Takasima Industries could support the level of sales claimed. In 2007, CSKI reported that Takasima's sales of the Slim Patch were at least $1 million per month, and more than $12 million for the year, though the agreement was only signed in March of 2007 (according to the 10-K), or in February of 2007 or before (according to the press release).

Financial statements filed with the Malaysian government for Takasima Industries (M) SDN BHD show that for the twelve months ended May 31, 2007, Takasima's revenues were approximately US$4.0 million and current assets were only $1.8 million (converted from Malaysian ringgits at 3.40 MYR / USD, current at May 31, 2007).

If Takasima had been meeting the terms of the reported sales agreement with China Sky, then Takasima should have had at least US$3 million in sales from March, April, and May of 2007 alone.

Additionally, China Sky's press release from February 2007 states that Takasima has "sister companies," operating under the names "Takasima Health-Mar, Blueway International and Osiwa (M) Sdn. Bhd. of Pinway Industries." Financial statements filed with the Malaysian government indicate that these "sister" companies were all dormant in 2007, except Takasima Health-Mar.

In the case of a legitimate company with legitimate auditors, related party transactions are vetted during the audit. Given CSKI’s revolving-door audit style (see previous Asensio.com report), it is entirely possible that such vetting was never accomplished or initiated.

Disclosure: Short CSKI.

Comments

[stocklad:]

This latest article from Asensio was posted on Yahoo! five days ago.

This is one of a number of articles about China Sky One, written in a journalistic style, but lacking in journalistic content. They are obviously written by someone who spends a lot of time doing research to unearth questions, without spending time researching the answers.

It’s too bad they don’t know how to use the telephone and ask questions at conference calls because the company has been quite willing to provide answers to all questions asked.

Now, on to the articles themselves…

The first article I read was from Cabeza Howe on Seeking Alpha (7 April 09) and it tried to cast doubt on CSKI’s requested extension to the filing date for their annual report. As we found out later, the only thing driving this issue was an accounting clarification. Mr/Ms Howe cited some additional concerns, which I’ll list together with my comments:

a) Eager management – This is not a negative, but a positive.

b) Gift of shares – This is a personal matter between the donor and receiver.

c) Change of auditors – This is a good thing and to be expected by a company growing so quickly. That the company is standing pat with its current reputable auditor is also a good thing.

d) 2006 restatements – Many companies make restatements. This was a major one from the point of view of its impact on net income, but the adjustments were all non-cash in nature, the biggest one being whether or not to capitalize certain R&D costs. The second biggest one dealt with the reclassification of the value of warrants. None of this would bring into question the actual operations of the company.

e) 26 year old director – It’s interesting how things change over the years. When I was younger, it was often said “Don’t trust anyone over 30.” Now apparently, the opposite is true. This is just a non-starter as an argument.

The next article was again by Cabeza Howe (22 April 09) and it listed a few issues:

a) Slim Patch complaints mean that Slim Patch is a Rip Off – Since then we’ve found out that the products which were the subject of complaints were in fact fraudulent products manufactured and sold illegally by unrelated third parties. Also, we’ve seen information that the patch was 76.9% effective in clinical trials conducted in a hospital setting. I highly recommend you read the following posting on Seeking Alpha for more details:

seekingalpha.com/artic...

b) Violation of Advertising Standards – Also see above link

c) Questionable Financial Control – The company has grown revenue from just $8M in 2005 to $92M in 2008; of course there are going to be some control issues. The question is: Is CSKI dealing with all that growth responsibly? Based on their hiring of competent international auditors, dealing with issues as they become known, being open with shareholders and hiring PriceWaterhouseCoopers (PWC) to help them make improvements, I would say that they’re doing just fine. (By the way, what Howe doesn’t say is that we should be celebrating such magnificent growth.)

The next article was the one I referenced in the link above. That was quite a breath of fresh air.

Next up was an article by Mr/Ms Asensio (8 May 09) dealing with inventory reporting, suggesting that inventories were just too low. The company dealt with this issue at its last conference call by explaining how it manages supply and distribution to keep inventory levels as low as possible. This is a sign of good management, in my opinion.

The next piece was done by Asensio (15 May 09) and dealt with margins and inventory levels. Once again, these issues were dealt with at the conference call. BTW, the margin issue related to the fact that Mr/Ms Asensio thought that the margin on contract sales should have been significantly lower than on the company’s own products, hence an anomaly when the first quarter margin didn’t change much from previous quarters. Instead of picking up the phone or asking a question at the conference call, he/she wasted everyone’s time with this issue. Thankfully, someone else asked the question at the conference call and the issue was put to rest. Hint: the margins on the two types of products were very close.

At this point, I should stop and point out one investor’s reply to this Asensio article. A poster named China Expert said…

“Manuel, I know you've done good work in the past, but this one will be a tough one. You're going to have to sit and wait this one out for a long time. There is no Chinese company that you can't pick apart and find a few things that don't add up. CSKI is one of many. I suggest you short a portfolio of them. If the $48.8 million in cash is "really" in the bank and this company is debt free and generating real "free cash" than I don't see a bullett that will "finish" this company. I really don't care whether the products work or not, to be honest, I've spend thousands of dollars at my local CVS on medications that seem worthless. Check out the most recent "Consumers Report" on all those infomercials gimmicks being sold in our country. About 90% are worthless. Is China any different than the U.S. in selling worthless things to their consumers ? NOT !...... I predict you will be short this one for a long time, splitting hairs when your voicing concerns ! I personally like more "substance" in a good "short". Like a broken clock which is right twice a day, you may be right eventually. For now, the "red flags" of caution are simply not as glaring as you make it out to be. There is another small Chinese pharma company out there that is actually now paying a cash dividend and actually buying back their own shares. If CSKI does this, your going to be in a heap of trouble with your position. ......Postion: None”

I suggest that the shorts pay careful attention to this poster’s remarks.

The next article was by Asensio (20 May 09) and its main point that PWC should have been hired as the company’s auditor instead of just a consultant. This goes against the grain of former posts suggesting that there had been too many auditor changes. The company had already addressed this issue at the conference call by stating that they have a perfectly good auditor, that this auditor had been accepted by large independent shareholders and that the big four auditors had shown no interest in taking on the company in the prior year.

The latest article is the one posted on this board today. It relates to an apparently tangled web of contacts that suggest some non-arms length dealing and then tries to question CSKI’s audited revenue numbers. Personally, 10 minutes after reading the article (five days ago), I’d forgotten just what it was about; it was that clear. I’ve no doubt the company will address this latest salvo at some point, but the question in my mind is: Does it really matter?

Each and every point raised by various “journalists” has been dealt with. The company has been open and forthright about its operations time and time again. In a way, I suppose we should thank these individual complainers for raising their issues. The company’s responses thereto have made them one of the most transparent and open I’m aware of. Nevertheless, it is getting a little tedious to have to deal with their complaints every time CSKI issues one of their many good news releases.

Does all of this seem like the two “journalists” are trying to stop an avalanche by throwing snowballs at it? It does to me. In fact, when I think about this from a bottom line perspective, I keep coming back to the following: If the cash on the books is real, then the earnings have in fact happened. I think the auditor would agree.

May 31 10:12 AM

[stocklad:]

It's time to put my money where my mouth is in terms of China Sky One...

There’s no question that CSKI’s growth is very strong, but what is the fair value of the company’s stock?

For comparison purposes, I looked through the component companies of the Halter Index to find some other pharmaceuticals in China. I added a few more I’m aware of to arrive at the list below. I avoided OTC companies, because their valuations are really out to lunch right now. Next, I decided upon a few metrics that might be interesting and went to Reuters to pull together some information. The cash/share and debt/share figures I calculated myself from the latest issued financials.

Here’s the chart (I hope it comes out all right; there's no preview button on this website), then I’ll talk a bit about the data before trying to put a value on China Sky One.


Co ..… Rev Incr* …. EPS Incr* …. TTM P/E .… Cash/Sh …. Debt/Sh …. Guidance

AOB …. +18.85% …. -24.90% ....... 8.42 ………. $0.99 …..… $1.70 ……… none
CHBT .. +32.50% ….. -3.49% ….… 10.69 ………. $3.89 …….. $1.35 …….… none
CSKI … +100.06% .. +67.44% ….… 7.52 ….…… $2.97 .…... $0.00 ….. rev up 40%**
KUN .… +23.42% .. -246.68% ….….. n/a …….... $0.05 ...… $ 0.65 ……… none
SCR …. +12.13% …. -54.53% .....… 11.25 ……... $2.00 ….…. $0.17 ……..… none
SSRX .. +23.67% …. -18.76% ……. 35.49 ….…… $5.25 …….. $0.00 … rev up 21-26%
SVA ..… -25.91% …. -98.51% ……. 18.31 …….… $0.54 …….. $0.24 … rev up 18-29%
TCM .… -35.88% … -536.73% ……... n/a ……..… $2.47 ….... $0.60 …….… none

* Revenue Increase and EPS Increase are for the latest reported quarter over the same quarter of the prior year.
** Excludes acquisitions
Note: Per share amounts are per ADS amounts for some companies

If I’ve made any errors, I’d be happy to correct them.

Basically, I did this chart to see if there was something that would indicate what a reasonable price/earnings multiple might be for CSKI. The companies in this chart are all over the map when it comes to market valuations, but the data is quite interesting.

Let me say before making some points that I realize the information isn’t perfect. I know a couple of these companies better than the others and I am aware of specific circumstances for each that would influence valuation. Nevertheless, let’s see what we can glean from the data:

1. Most of the companies are growing revenue right through the recession, although none are even close to CSKI.

2. None of the companies has earnings per share (EPS) growth, except CSKI which is outstanding.

3. Other than SSRX, China Sky One has the most unencumbered cash (cash minus debt in this case).

4. Only a few of the other companies feel comfortable giving guidance during the recession but, of those that do, CSKI is projecting the highest revenue growth. (BTW, they are on track to meet their guidance.)

5. CSKI has the lowest P/E of the bunch. A couple of companies had negative trailing twelve month (TTM) earnings, so they can’t be counted. Of the remaining companies, the average P/E is 16.83. Personally, I don’t look much at averages, but the number is interesting.

Based on my experience with pharmaceuticals, I would say that a decent company with a reasonable pipeline of future products and 10-15% growth would garner a P/E of at least 15. CSKI’s pipe is robust and its growth – historical, current and expected – far exceeds the 10-15% range. In a decent market, I would give it at least an 18-20 P/E. Under these market circumstances, I’d think a 15 P/E would be reasonable, if not a little on the modest side.

To this, I would add unencumbered cash. I know some people who would add unencumbered working capital, but let’s be conservative.

This leads to the following valuation:

Fair value = ($1.96 trailing twelve months EPS x 15 P/E) + $2.97 cash = $32.37.

I should be clear in stating that this is not a sell point, IMHO, but a reasonable valuation based on current market conditions.

Expect this valuation to go up over the coming months. If guidance comes to fruition, then the value might be something like $37.00. With another acquisition, we might see something in the order of $40.00-$45.00 within a year. The company has said they can foresee continued growth over a five year period.

Anyway, these are my thoughts on the valuation issue. When the shorts tell you that the price has topped out at some arbitrary figure, you might want to think about the longer term.

It’s no wonder that the institutions are slowly increasing their positions in China Sky One Medical.

Regards

i22

May 31 11:18 AM

[stocklad:]

I just made the statement that institutional interest is increasing. In this regard, I looked up the numbers 5 weeks ago and found that institutions owned, at that time, 14.1% of the outstanding shares. That has now risen to 16.8%. Here are the latest numbers from NASDAQ:

CSKI CSKI
China Sky One Medical, Inc. NASDAQ-GM


Institutional Holdings Description |



Company Details
Total Shares Out Standing (millions): 17

Market Capitalization ($ millions): $244

Institutional Ownership: 16.8%

Price (as of 5/28/2009) 14.74


Ownership Analysis # Of Holders/ Shares

Total Shares Held: 56/ 2,790,827

New Positions: 18/ 293,008

Increased Positions: 39/ 671,588

Decreased Positions: 12/ 185,798

Holders With Activity: 51/ 857,386

Sold Out Positions: 4/ 28,914

May 31 11:33 AM

[Keep it Pos...:]

I wonder why Seeking Alpha keeps this Asensio guy as a columnist? Obviously, he is using the website and the readers for his own personal gain, without any respect for any facts. This takes away from Seeking Alpha's credibility.

Jun 01 08:29 AM

[Lookatvalue:]

I like the fact that Asensio is keeping a cap on the stock. Gives me a chance to accumulate. I

In Manuel's article he mentions a company called American Dairy (ADY) I took a look at the company and WOW!!!!...I wish he had mentioned it earlier. The stock has appreciated over 100% since their 1Q 2009 earnings annoucement!!!

It is true that they CSKI and ADY had the same auditors (MHM) and both companies fired the auditor. ADY hired Grant Thornton and CSKI hired Moore Stephens.

Moore Stepehens is not as big as Grant Thornton, but not small by any means. The company must realize by now that to completely wipe out all doubt, they will need to hire a "Grant Thornton." I suggest maybe even better, PWC, Deloitte, KPMG, or Ernst & Young.

I predict this will be the companies next move, just the pure annoucement of them hiring a new firm will send the stock soaring!!! Can't wait until we see the biggest short squeeze ever!!

Jun 01 05:43 PM