For anyone who truly understands finance and accounting, reading the 8-K filed by China Marine Food Group (NYSEMKT:CMFO) on March 16, 2010 could be a horrible experience. I have seen potentially fraudulent companies, and I have had to piece information from various sources to draw my conclusion. But I have never seen a company so openly aggregate self-incriminating evidences in one single file submitted to the SEC, challenging the intelligence of the investors.
Here I present China Marine Food Group, hereafter mentioned by its ticker, CMFO, as an ongoing example on how a company can possibly take money away from its public investors, all references coming from the SEC filing mentioned above.
A little background on CMFO first. According to Yahoo Finance, “China Marine Food Group Limited, through its subsidiaries, engages in processing, distributing, and selling processed seafood products in the People’s Republic of China.” It became listed on AMEX after a reverse merger in late 2007, during which it had a concurrent private placement to attract about $20m. It did not have any other significant financial events until it acquired 80% interest of another company called “XiangHe”, who supposedly makes an algae energy drink, at a price of $27.8m, and subsequently did a PIPE for $30m.
With the help of the 8-K filed to the SEC, we can rearrange the facts in sequence and assemble the jigsaw for this incredible acquisition.
1. January 2009, Mr. Qiu, the future owner of XiangHe, paid on behalf of the Company (XiangHe, later we will know that this company did not even exist at this time) an amount of $8,776 to Yellow Sea Fisheries Research Institute [YSFRI] for the development of the algae-based drink know-how. XiangHe did not make any application for the patent during 2009. (Page F-15 bottom)
2. April 2009, Qiu leased an office space from ShiShi Huabao Jixiang Water Products Co., a subsidiary of CMFO for a term of 3 years, but XiangHe never paid a dime for rent. A later agreement exonerated XiangHe from paying any rent to CMFO. (Page F-15 bottom)
3. July 28, 2009, XiangHe was finally set up. Qiu paid $44K for registered capital. (Later I will cast doubt on whether Qiu indeed paid the money. But for now look up Page F-15 top)
4. At the same time, CMFO paid $219 to apply for trademarks for XiangHe. (So I suppose that XiangHe either did not have the people or did not have the money to apply for trademarks. Page F-16 top)
5. Oct 2009, registered and paid-in capital was increased to $733k. (Later I will cast doubt on whether Qiu indeed paid the capital. Page F-15 top)
6. For the whole year 2009, XiangHe invested $414, which reads four hundred and fourteen dollars, on purchase of property, plant and equipment. (No, I did not miss a comma or any zeros after 414! See Page F-5) This fixed assets depreciated $19, and was recorded $395 at the year end. (Page F-3)
7. With the mere $400 fixed assets, indicated as ‘Office Equipment’ in Page F-8, cheaper than the laptop that I am using to type up this article, this marvelous XiangHe made $7.6m revenue, $3.0m gross profit and $1.7m net income in the last 5 months of 2009! (Page F-4)
8. With this impressive operating result, the inventory support was a mere $11k, composed of $8.6k raw materials and $2.3k packing supplies (Page F-13). Apparently XiangHe does not need any inventory for finished products manufactured from the phantom $400 office equipment. Knowing that it incurred $4.5m (Page F-4) cost of revenue for the last 5 months of 2009, we can calculate that this amount of input materials supports its production by 11 / 4,500 x 30 x 5 = 0.4 day. Put another way, the company's inventory turnover was 409x in its first 5 months of operation, 975x if annualized. I have no further comment on this amazing production efficiency.
9. November 27, 2009, XiangHe, Qiu and CMFO entered a three-party agreement, in which CMFO supplied a 3-month term loan to XiangHe in the amount of $26.4m for working capital purposes (Note that XiangHe had total assets supposedly at $3.3m). This loan was secured by all the registered capital of Qiu in XiangHe, which was supposedly worth $2.4m. (Page F-13)
10.The agreement also offers CMFO an option to purchase 80% of XiangHe at $27.8m, all cash consideration. (Page F-14 top)
11. On January 1, 2010, CMFO exercised the option. (Page F-14)
12. This acquisition cost $27.8m cash, acquired book value $0.8m, and classified $3.5m to goodwill and $23.5m to intangible assets which, if you have not lost track, was purchased one year earlier by Mr. Qiu for $8,776. (Page 4, almost the end of the file)
My dear readers, I sincerely hope that you haven’t dislocated your jaw by now. I, for one, have never seen such an unfair transaction before.
First, this business itself is nearly impossible. It has $400 fixed assets, little inventory, zero finished product inventory, but it has a magic ramp-up of sales. That $400 office equipment has more magic power than any wizard wand you may find in Diagon Alley.
Second, CMFO had a special relationship with Qiu. CMFO paid for nearly everything for XiangHe to start up, even including a minor cost for trademarks.
Third, why did CMFO loan XiangHe so much money for such a short time, which XiangHe never needed? How was this loan "secured" with less than 1/10 worth of equity from a no-name company?
Fourth, The purchase price was ridiculous given XiangHe’s book value, short history, and an impossible business model as I discussed in the first point. The P/B ratio went as high as 35!
Who is this Mr. Qiu? If this person were real, this person has a magic wand and this person has a personal Jesus, Mr. Liu, the majority owner of CMFO. His single payout of less than $9k in January 2009 rewarded him $28.7m in one year.
It is quite likely that this Mr. Qiu is merely a puppet of Liu. It may only exist as a name, or an ID card that you can purchase for ten bucks from a Chinese farmer who would never leave his land. The whole purpose of this transaction is quite likely to funnel $27.8m from the public investors' hand to the major owner’s private pocket.
The whole SEC 8-K filing challenged its intended readers' intelligence. To end this article, I would like to raise two more issues with this company.
First, the true payment of Qiu into the company may well be below the registered capital. It may be as low as zero. The balance sheet at the end of 2009 showed an amount due from Qiu, the sole owner, for $1.4m in the assets. No line in the bottom half of the balance sheet can offset this line other than owner’s equity. Qiu supposedly paid $733k into the company, and he apparently owed the company more than this amount! If this practice can be accepted, people like you and me can set up a company and claim that we have a billion dollar equity company. It is easy: add 1 billion in the equity line and add one line of 'due from owner' for 1 billion in the assets! (Page F-3)
Second, the quality of the accounting firm, ZYCPA, is very questionable. Not only did they present an impossible business, but they made an obvious accounting mistake as well. CMFO exercised the option to acquire XiangHe on January 1, 2010, before which date the money loaned to XiangHe should be reflected on the balance sheet at the end of 2009. Both the balance sheet (Page F-3) and the cash flow statement (Page F-5) were mistakenly treated in that the loan was not presented correctly.
My case rested.
Credit: This article is a result out of reading the ‘Chinese Company Analyst’ blog here. I read the 8-K myself and generated my own view of this 8-K. Our views overlap. Without the original article, I would not have noticed the 8-K. But without that, I would generate the same view regardless. I also recommend reading his other article regarding the discrepancies between SAIC and SEC financial statements of the same company.
Disclosure: Short CMFO