While the China-Biotics (OTC:CHBT) management team was sleeping in Shanghai, Citron Research released a blog during the final trading hours which I believe scared CHBT investors into selling. The timing of their report was perfect because it did not give anyone a chance to expose what I believe are lies in Citron's blog until after the market closed. It is my opinion that all of Citron's claims are without merit; however, they succeeded in getting investors to shoot and ask questions later in the last hour of trading as the stock dropped on heavy volume.
Here is a list of Citron's allegations (shown in italics) and my response afterwards sharing the truth:
1. "It is a mature and stable low-margin industry."
In China, the industry is growing over 33% per year as shown in my graph courtesy of Beijing Leadership Management. To see the graph, read my Seeking Alpha article. On a global basis, probiotics are expected to grow 12.6% per year from 2009 to 2014 indicating a high growth industry, not a mature industry. Given the growth and the limited number of suppliers of probiotics, it is a high margin industry as well.
2. "It would be easy to look at the gross discrepancies between the company’s SAIC and SEC filings."
It is also easy to disregard SAIC filings since the SAIC in China is primarily responsible for renewing business licenses. Many blogs have done a great job reviewing this, including this one.
3. "It would also be possible to show pictures of the half-finished over-budget manufacturing facility side-by-side with company claims that it was already in production."
The new bulk probiotics facility in Qingpu was built in two phases, which everybody knows. Phase 1 was launched and is in production as of February 2010 and is capable of producing 150 metric tons. Phase 2 will not be ready until June 2011. Of course the photos of the entire bulk manufacturing facility looks half-finished because only Phase 1 is complete and in production. You can see photos here.
4. "The photos of their current production facilities the size of a “bathroom” where the acidophilus pills drop out of a machine two by two."
Regarding a company joining our organization, we have strict rules, they first have to abide by the voluntary quality guidelines that all our manufacturers follow, we look at their products and websites to make sure they follow the proper nomenclature, they have to read and understand our organization’s policies on antitrust and disputes and we then give them the green light. We also do plant visits to make sure the companies are legitimate (I was in Shanghai in Nov 2008) and I can ensure you they have some impressive facilities with very big productions sites. I totally understand your concerns as an investor in these turbulent times, but China-Biotics is a pretty solid company.
In addition, according to the 10-K,
this facility, which includes a level 100,000 clean room and a level 10,000 clean room, houses our office space manufacturing facilities and warehouse. The maximum current production capacity at this location is approximately 3.5 million capsules per month. We have received ISO 9001, ISO 14001, OHSAS 18001 and HACCP certifications for this facility.
It would be hard producing 3.5 million capsules "two by two".
5. "Most compelling, it would be simple to question how a company who sells the bulk of their product though distributors, who then purportedly resell them to Wal Mart (so they claim) can generate EBIDTA margins of 40-45% when their competition is at 27% max."
First of all, it is EBITDA, not EBIDTA. Given that China-Biotics can source raw materials and labor at a fraction of the European competitors, of course China-Biotics margins are higher.
6. "The company claims its high margins are due to its 'retail channel'. "
China-Biotics retail business, which is 87% from distributors and 13% from its retail stores has approximately a 70% gross margin. China-Biotics bulk business has a gross margin of approximately 67%.
7. "We could discuss how the company has been through 5 CFOs in only 4 years."
This allegation had me laughing the hardest. The first CFO listed is actually the founder and CEO who had both titles in 2006 when the company was much smaller. The second CFO was Raymond, the current VP, Finance. Then in conjunction with the secondary offering, the company knew that it needed to upgrade to an English speaking CFO who could interact with the investment community better. That is when the company hired Lewis Fan, a former research analyst, for a salary of $10,000 per month. After the secondary, he left China-Biotics to be a Managing Director of Rodman & Renshaw given that China-Biotics did not have a stock option plan. The fourth CFO was the current CAO who acted as an interim CFO until they could find Travis Cai, their current CFO. Travis makes a salary of $150,000 and will be awarded 150,000 stock options.
8. "We could discuss the company’s $50 million plus financial commitments due in 2010."
What is not mentioned is that China-Biotics has $159.7 million in cash and generates $29 million in operating cash flow over the past 12 months. The biggest component of the 2010 financial commitments is the $25 million convertible note, which is due on December 11, 2010 unless the holder decides to convert the note into 2,083,333 common shares. The rest of the financial commitments seem very normal for China-Biotics business. You can read about their current liabilities in the 10-Q.
9. "Its looming potential tax liability from questionable past financial transactions that could also be as high as another $50 million."
The company does a great job explaining its potential tax liability and has accrued for its potential cost on its balance sheet on page 26 of its most recent 10-Q. The company indicates that the liability could also be $4.9 million and states that it is more likely that the penalty will not need to be paid.
10. "China-Biotics - Where are your stores?"
The 103 retail stores as of June 30, 2010 represented 13% of retail sales and 7.8% of overall sales in Q1. Therefore, each store only generates $75,500 per year in sales, which is $6,300 in monthly sales and slightly over $200 in daily sales. These are very small stores and not a focus for the company as 87% of their retail sales come from their 27 distributors. The company has also partnered with an online retailer to sell their retail products over the internet. Given the low sales volume of the retail stores, increasing lease costs, and higher labor costs, the company has continued to close retail stores in this quarter. Given the efficiency of its distributor network and the vast potential of its bulk business, this strategy makes perfect sense. The company will provide a list of its retail stores on its website.
11. "Amazing that a company that is not at all shy in its use of PR’s had this explosive store growth without one: ribbon cutting, new store pr, or notice of opening."
If you follow China-Biotics, you would know that the company intends to rely on its network of 27 distributors going forward to push its retail sales business given that it is more cost effective and allows management to focus its resources on its growing bulk business. But for the record, they have done PR events for new stores. See this article.
12. "The auditors of CHBT are BDO Limited. BDO seems to have become the auditor du jour for questionable Chinese public companies."
BDO Limited is a Top 10 auditor. However, even though hiring a Big 4 auditor is more expensive, I believe China-Biotics will make the switch for its current fiscal year in order to put the claims of the short sellers to rest.
Based on my research, I have heard that a number of short investors have decided to create a basket of Chinese small cap stocks and short them all. Obviously, China-Biotics made it to the list, but unfortunately for the shorts, they did not really grasp the excellent fundamentals of China-Biotics, its pending catalysts for fantastic growth, or its $159 million cash balance.
However, if the Board of Directors gets pushed hard enough, they could increase the $20 million stock buyback and repurchase all available shares for sale. Given that China-Biotics has received a lot of positive press, increased institutional ownership, news of a new probiotics animal feed plant launch within two years, and the beginning of amazing sequential EPS growth from its new bulk facility, it was now or never for the shorts to come up with something to cover their large shorts positions in China-Biotics. If not, they would be squeezed into a huge loss as the average short position over the past 4 months is approximately $15.25 (based on analyzing volume and price history).
If you hear more rumors from anonymous bloggers regarding China-Biotics, you would be best served to ignore them. Better yet, just file a complaint with the SEC.
Disclosure: Author holds a long position in OTC:CHBT