"Oh what a tangled web we weave, when first we practice to deceive" -Sir Walter Scott
On December 12, 2013, Ottoman Bay issued a strong sell rating on Mindray Medical. In our original report, we detailed our findings in a 103-page slide deck, which supports our view that Mindray Medical has systematically deceived investors and regulators, including the SEC.
SEC Action: We have submitted our documents to the SEC for further review. We find large discrepancies and outright deception in MR's filings that are nearly impossible to reconcile. We believe Mindray Medical will restate several years of filings as a result of the issues covered. We believe Mindray Medical's Board has the fiduciary responsibility to form a special "independent" committee to examine the discrepancies covered in this and our original report.
"We believe Mindray Medical (NYSE: MR) is a Strong Sell and its shares are worth no more than $15. As detailed in this report, Mindray Medical has a record of fairly egregious fraud in the past and evidence suggests this behavior has continued. The Company trades at a rich 20x FY14 PE (vs. peers at ~14x currently and 12-13x historically) despite its highly capital-intensive business model that competes in commoditized, replacement markets with significant price competition. Furthermore, so much like a typical China fraud, MR is a serial capital raiser and relies on debt or equity financing as its primary source of cash generation. Current financials show significant red flags and could be fraudulent. We believe Mindray Medical will eventually be added to the long and growing list of Chinese frauds."
Following the report, on December 13, 2013, Mindray Medical's management team issued a press release and held a conference call (hosting only buy rated analysts) to refute only "some" of our arguments. Mindray's management claimed that "The Company does not intend to enter into an item-by-item refutation," and did not provide any additional disclosures to provide more transparency for investors.
Ottoman Bay Research noted numerous deceptions in Mindray's responses to our December 12, 2013 report. The following report will outline an "item by item" refutation of management's falsehoods and misleading disclosures noted from the company's December 13, 2013 press release and conference call.
Our rebuttal report will outline the following:
Accounting Inconsistencies: Mindray claims that there are no accounting inconsistencies related to long-lived assets because in 2008 Mindray misclassifies "accounts receivable, prepayments, etc." Mindray effectively tells investors;
- "We aren't a fraud - we just had a massive accounting treatment error in 2008 that we didn't bother addressing."
Shareholders should ask when exactly Mindray planned on telling investors about this strange accounting mistreatment and whether others exist. We outline several other inconsistencies we find concerning in our report.
- In the 2007 20F, Mindray clearly contradicts its reporting in 2008. In FY2007, Mindray claimed it did NOT have any long-lived assets outside of China. Yet in the 2008 20F, the company reported having $95m of assets (21%of total) ex-China in 2007. This is a clear discrepancy. Furthermore, from 2007 to 2008, the value of the "other countries" long-lived assets declined from $91.4m to $44m, on a like for like basis (see below). Debunking management's recent claims that long-lived assets were reclassified in 2009.
MR 2007 20F pg. F-26
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MR 2008 20F pg. F-31
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- In 2008, MR's auditor PWC noted in its "Report of Independent Registered Public Accounting Firm" that the TOTAL acquired assets from Datascope's business accounted for just 16.7% of TOTAL assets or $131.2m (16.7% x $785.8m), yet Mindray reported increasing Datascope's acquired assets by $225m, a $95m discrepancy.
MR 2008 20F pg. 84
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- When Mindray disclosed the purchase accounting for its Datascope acquisition, we noted that the company significantly stepped up the value of Datascope's assets. Even more egregiously, the company stepped up current assets 500% from $5.7m to $33.2m. How is this justified?
Manufacturing and R&D Facilities: Mindray responded to Ottoman Bay by misleadingly claiming that "by our initial investigation, we have confirmed one photo is of our completed Changping, Beijing facility (not our Zhongguancun facility)." Shareholders should question how on earth this photo constitutes a "completed" facility?
More alarmingly, if Mindray has a "completed Changping, Beijing facility," why isn't it mentioned in any of the company's SEC disclosures/filings (as all 18 of its other alleged facilities) and why didn't Mindray give the address for it along with their HaiDian address?
The answer is simple. Changping, as MR should know since they bought the land there, is located in Zhongguancun. The Changping "facility" is the abandoned 48,000 square meters of land we pictured and labeled Zhongguancun, which the company claims is completed.
- To say that "this is not our Zhongguancun facility, it is our Changping facility," is akin to saying "this is not our Manhattan facility, it is our Tribeca facility."
Call it a Changping facility, call it a Zhongguancun facility; whatever management cares to call it, it is a 48,000 plot of tumbleweed that Mindray has spent shareholder cash on and is certainly not a completed facility. When, exactly, does Mindray plan on developing it?
We encourage investors to visit the Zhongguancun Life Science Park website. Investors can also verify our beliefs that Zhongguancun life sciences park is in Changping with a simple Google maps search.
To confirm that the land cited belongs to Mindray can be cited here. A press release from the Zhongguancun Science Park, Changping, confirms our view that Mindray bought the land.
The following Chinese government website actually lists the land at 57,600 square (vs. 48,000 square meters listed in MR's filings) and notes that MR intends to spend cash to develop the land. Yet Mindray claims it is completed.
MR's response to the Nanjing facility picture is a similar sleight of hand. We fully outline our response on page 3 of our report.
Again, we ask management to reveal the addresses of ALL of the company's alleged manufacturing and R&D facilities - as any public company would willingly do. It appears MR has spent shareholder cash on phantom facilities.
Existence of Assets: Mindray's management made zero effort to provide shareholders with better disclosures regarding its cash and its questionable short-term investment balances. It is clear management's intention is to deliberately evade this disclosure. Even more concerning, management couldn't seem to get its lies straight in its rebuttal to Ottoman Bay when the company claimed "Due to China's strict capital outflow regulations and a less favorable interest rate environment outside of China in the past few years, Mindray has determined that it was more cost efficient to use third party borrowings to fund its offshore cash needs, including funds required for international acquisitions."
Despite this claim, in 3Q13 management opted to remit an undisclosed sum of cash to its HK holding company in the form of a dividend, incurring a substantial $20.8m fee to do so. Note that the company did not say how much cash was being remitted nor what the cash was for. In the same quarter (3Q13), MR borrowed $120m to finance the acquisition of Zonare.
So if what management says is indeed true - that third-party borrowings are the more efficient method of funding offshore cash needs - why did Mindray choose to incur a penalty to move cash offshore in the same quarter (3Q13) they opted to borrow? Investors should question the sanctity of the reported cash and short-term investment balances.
Earnings: We believe that shareholders should find Mindray management's explanation for negative international PBT margins highly unsatisfactory and deliberately evasive. Management should disclose how international sales and marketing costs are so substantial that they result in negative pre-tax margins. Is Mindray using aggressive transfer pricing to book profits in China (where they pay lower taxes of ~10%)? Are international operations extremely inefficient? What's going on, specifically? Note that the loss (PBT) in the ex-China business was magnified in FY12 by 178% to -$66m from -$24m in FY11.
A higher tax rate would significantly impair MR's earnings and share price.
If MR is evading taxes as disclosures suggest, this will result in significant fines, penalties, and back taxes. Aggressive transfer pricing could explain why Mindray never has after-tax cash overseas and has to rely on capital markets as its primary funding source.
We have submitted our findings through IRS's whistleblower hotline.
Auditor Issues: MR's auditor PWC signed off on financials for proven fraud CMED for fiscal years ending 3/31/2009, 2010, and 2011. Many other Chinese frauds have occurred under the noses of reputable auditors. Why should MR receive a free pass on the basis of the brand of its auditor alone? Note that in a 6/13/2013 SEC correspondence, it was brought to investor attention that the company's auditor's work had not been reviewed by The Public Company Accounting Oversight Board or ("PCAOB") and MR had not disclosed this risk factor for nearly 5 years. The PCAOB is responsible for validating the work of auditors to prevent fraudulent behavior.
New falsehoods told by management since our December 13, 2013 report
- MR has not paid a mandatory 2.3% excise tax in the U.S. for all of 2013. Call it gross negligence or willful neglect; the law requires semi-monthly deposits (this means cash, not balance sheet accruals as management falsely stated on its call).
- We provide audio evidence that Mindray explicitly lied to the SEC and DB analyst Jack Hu about its return policy. MR indeed accepts cash returns. Investors can confirm our beliefs by simply calling Mindray North America at 1-800-288-2121.
- We find MR's rationale for building out so many R&D centers in China simply implausible. MR claims to have more R&D centers in China alone than GE has for its entire global business.
Numerous outstanding issues Mindray failed to address
- In 2010, MR would have likely defaulted on its debt if the company had not misled investors regarding its 2010 equity offering. We lay out a fact pattern which details how Mindray came dangerously close to defaulting on its $141m loan with the Bank of China and its $25m working capital loan with HSBC. Despite reporting $305m in cash the previous quarter, Mindray was unable to fully pay its $47.1m payment to the BOCHK, resulting in the loan being modified. Furthermore, its $25m working capital facility with HSBC was cut nearly in half to $13m. Then on 3/4/10 MR priced a secondary offering of 4 million shares at $38.20, raising $152.8 million in new cash, deceptively claimed the equity raise was for "business development and for general corporate purposes" per S-1. Coincidentally, MR repaid its full $110m balance and HSBC WC loan in March 2010, the same month as the offering. They only had to repay $44m in June of 2010 and the remaining $66m was coming due a full 15 months later in June of 2011. MR also repaid an unexplained $54m TL facility (borrowed on 4/2009) in 4/2010, bringing its bank balance to zero.
- Mindray's CIO, May Li, explicitly lied about Zonare's Japanese distributor disruption. Shareholders should find this concerning because the disruption in Japan accounted for nearly 25% of Zonare's revenue that will not return. To compound matters, management avoided discussing distributor HDX's 11/1/2013 lawsuit which alleges that Zonare engaged in "intentional fraud."
- Statements by MR's head of Europe, David Yin, imply European sales are far lower than the $100m+ the company reports. Furthermore, David Yin discloses that Mindray runs its entire European operations through its location in the Netherlands (Europe headquarters), which services 30 countries out of what is a 3,080 square meter office and a leased 1,380 square meter warehouse. Link to video support.
- Management stepped up the value of Datascope's assets significantly, including egregiously stepping up current assets by 500%.
Conclusion: Mindray Medical is a house of cards operating on borrowed time. Mindray trades at a rich 20x FY14 PE (vs. peers at ~14x currently and 12-13x historically) despite its highly capital-intensive business model that competes in commoditized, replacement markets with significant price competition. Furthermore, Mindray's investors face material downside and have significant exogenous risk from regulatory, tax, and oversight investigations, which is likely to occur. We believe real earnings (adjusted for fraud) for FY14 will be $1.10. Assigning a peer-aligned 14x multiple gives us a price of $15.40, or 61.5% downside from current levels.