How China Borun Has Exaggerated Its Financial Performance

Oct.27.10 | About: China New (BORN)

This article is a follow up to my previous article, “China New Borun: Born to Run or Destined to Fall”, and adds considerable new evidence to my argument that BORN has significantly exaggerated its financial performance.

I. Massive Undisclosed Debts, Tax Losses and Black Market Sales

To get a better picture of BORN’s true financials, I recently obtained copies of Borun Shandong’s (BORN’s main operating subsidiary) official tax records from the very resourceful people at GeoInvesting.com (see endnote). As I have explained before and as other experts generally agree, SAT records are very reliable since the Chinese government imposes severe penalties on companies that fail to pay taxes. Following a thorough review, I have identified several major discrepancies between these tax records and BORN’s F-1 filed with the SEC.

The first major discrepancy that stands out in BORN’s 2009 SAT record is the large amount of debt compared to its F-1 filed with the SEC. The following table shows at 12/31/09 Shandong Borun had short-term borrowing of RMB 320,800,000 while its F-1 filing only shows RMB 140,000,000, a difference of RMB 180,800,000. Even after deducting the approximately RMB 80,000,000 additional cash shown in the SAT record compared to the F-1 filing, the short-term borrowing is still more than RMB 100,000,000 higher than the amount disclosed in its F-1 filing. Furthermore, the SAT record shows there is RMB 170,000,000 additional long term debt Shandong Borun borrowed in 2009 which is not disclosed in BORN’s F-1 filing. Is it just a coincidence that BORN hid RMB 170,000,000 in new long-term debt the same year they reported RMB 166,410,631 in net income to their investors?

BORN and Shandong Borun Liabilities and Shareholders Equity at 12/31/08 and 12/31/09:

Based on its SAT record, Shandong Borun was highly leveraged and on the brink of bankruptcy at the end of 2009. Its shareholder equity was only a miserable RMB 70,335,058 compared to RMB 516,209,389 BORN reported in its F-1 filing. Shandong Borun’s staggering debt to equity ratio of 7.5 is an incredible 15X the 0.5 ratio BORN’s public shareholders can calculate from its filings. The SAT record also shows a cumulative loss of RMB 60,864,942 rather than the RMB 288,950,593 retained earnings BORN reported in its F-1 filing. Clearly the company’s historical growth was supported only by its debt and equity financing activity and not by cash flow from operations, which was consistently negative according to the SAT record.

As the following table clearly shows, Shandong Borun’s revenues, income tax and net income for 2008 and 2009 are significantly understated in its filings with the SAT. Shockingly, Shandong Borun paid no income tax and reported losses of RMB 8,178,212 and RMB 24,624,218 in 2008 and 2009 respectively while BORN in its SEC F-1 filing claims it paid income tax of RMB 26,640,990 and RMB 56,262,029 on net income of RMB 77,130,128 and RMB 166,410,631 in 2008 and 2009, respectively. Furthermore, SAT records show Shandong Borun’s sales were only RMB 141,990,308 and RMB 138,509,566 in 2008 and 2009 respectively versus the SEC F-1 filing which shows RMB 615,881,195 and RMB 1,060,493,812. For 2009, Shandong Borun reported gross margin of 5.5% compared to 23.4% BORN disclosed in its F-1 filing.

BORN and Shandong Borun Income Statements for 2008 and 2009:

Given the huge discrepancies, investors should demand management answer:

  1. What did management do with the cash from at least RMB 270,000,000 in previously undisclosed debts?
  2. Why are BORN’s sales reported in its SEC F-1 filing incredibly over 4X (for 2008) and 7X (for 2009) the sales it reported to the SAT?
  3. Why is BORN’s 2009 gross profit margin in its SAT record less than ¼ of the level reported in its F-1 filing?
  4. Why do BORN’s tax records show substantial losses?
  5. Where did the RMB 26,640,990 and RMB 56,262,029 of income taxes BORN never actually paid really go?

Together, these large discrepancies further support the conclusions of my previous article (link here) which showed BORN significantly overstated its gross margin by 3X and earnings per share by 4-5X in 2008 and 2009 as a result of the company’s antiquated technology, understated input costs and fabricated corn germ sales. Add to these troubles the fact the tax records show the financial condition of the company is even worse.

According to GeoTeam’s website, they “made numerous attempts to discuss this issue with BORN management and its IR firm, but have not received a meaningful response.” Likewise, I have been unable to get a response from management. Nor do any of the analysts who follow the company have answers. Considering BORN’s extremely low gross margins, I believe a partial explanation of the low sales and losses BORN reported to the SAT is tax avoidance. My industry contacts explain that tax avoidance via black market sales is the only way inefficient operators like BORN can survive. The motives for this are clear.

First of all, consider the fact that edible alcohol manufacturers face unusually heavy tax burdens that encourage large-scale tax evasion and black market sales. In fact, for all the alcohol produced BORN must pay 17% VAT tax and 5% consumption tax but can only deduct 13% VAT paid on its key input corn (In China VAT tax on corn is only 13%). In fact, since BORN is such an inefficient producer without advanced processing technology for making enough corn germ and CO2 byproducts the challenge to survive further compels BORN to evade VAT and consumption tax by engaging in black market sales it did not report to SAT in 2008 and 2009. These black market sales explain why BORN’s current customer base is limited to small and medium sized “baijiu” brands willing to collude with BORN to evade tax. Top tier state owned brands like Moutai (SHE: 600519), Luzhou Laojiao (SHE: 000568) and Wuliangye (SHE: 000858) will not help BORN evade tax through undocumented sales.

II. Further Analysis of the antiquated “Borun Wet Process”

In a research article titled “A Comparison between the Modified Wet Method and Semi-Dry Method Corn Processing Technologies in Ethanol Plants” (酒精工厂改良湿法与半干法玉米处理工艺的对比)published in the authoritative trade journal “Cereal and Food Industry” (2010 Volume 17 Number 3 粮食与食品工业期刊2010年第17卷第3), four types of corn processing technologies (Dry, Semi-Dry, Modified Wet and Wet) are compared based on technological and economical indicators (see table below):

Item

Dry

Semi-dry

Modified Wet

Wet

Soaking or Steam Dampening

N/A

Steam Dampening

Soaking

Soaking

Duration in Hours

12

6~12

36~48

Temperature (C)

Normal

65

50

Grinding

Once

Twice

Twice

Twice

Germ extraction method

N/A

Dry

Wet

Wet

Germ extraction Ratio %

0

7.0-7.5

6.5-6.8

6.8-7.5

Oil Content %

20-25

46-48

48-50

Corn Oil Yield %

0

1-1.5

3

3

Starch Content %

30-35

34

34

Fermentable content %

70

74.5

77.8

100

Waste water generation

N

N

Y

Y*

Electricity consumption

Low

Relatively low

Relatively high

High

Steam Consumption

N

Y

Y

Low

Capital Investment

Low

Relatively low

Relatively low

High

Level of labor requirement

Low

Relatively high

Relatively high

High

Economic Benefit

Low

Relatively low

Relatively high

High

Production cost

Low

Relatively low

High

High

Click to enlarge

*corrected from the original Chinese document which contained a typographic error

From this table, the researchers conclude, “The dry method cannot recover any byproducts such as corn oil. The wet method has a very high production cost. Therefore as a result both methods have been abandoned”. The researchers go on to point out the inherent flaws in the wet method, which create long production cycles (long duration of the soaking cycle), high electricity consumption, large investment requirements (equipment) and high operating costs. The researchers ultimately favor a “modified” wet-method but note that this method has not been successfully applied on a large scale in China due to technical barriers.

Borun’s existing patent covers a non-modified wet method of production. According to the Invention Patent Application for “Corn Fermentation based Ethanol Production Method” filed by Shandong Borun Industrial on April 15 2008: “This invention involves a wet method of corn germ extraction, specifically a wet method of corn germ extraction and fermentation for ethanol production.”

The details of Borun’s wet method disclosed in the patent application include a long soaking process for the corn of 48-50 hours, typical of other wet methods. By comparison, the next generation modified wet method analyzed in the research article only requires 6-12 hours of soaking. The “Borun Wet Method” that BORN management has so emphatically hyped to shareholders is in fact merely a minor modification and improvement of the typical wet method, which according to all reports is antiquated as an alcohol production method in China.

Another research article titled “Take Another Look at Semi-Dry Grinding Method for Ethanol Plants” (对酒精厂玉米半干法粉碎的重新认识)published in the trade journal Liquor Making (November 2001, Volume 28, Number 6 酿酒20011128卷第6) analyzes COFCO’s 200,000 ton semi-dry process plant in Zhaodong and concludes that the semi-dry method is more profitable than the wet method. The researchers mention in the article that the Shandong Jiujiu wet method plant was under construction at the time of publication. Recall BORN’s CTO Wei Qi was previously the CTO of Jiujiu which later filed for bankruptcy.

Most importantly, as I pointed out in my prior article, BORN management is clearly aware of its antiquated wet process method and recently hired Henan Wantongtong Machine Manufacture Corp., Ltd to upgrade its wet method production lines to the superior semi-dry method used by most large edible alcohol manufacturers in China.

Conclusion:

As of the date of this article, BORN management and IR team have failed to respond to the questions raised in my prior article. Nor have they responded to analyst or investor inquiries regarding these issues. Piper Jaffray’s senior analyst Anson Chan recently raised his price target for BORN by 127% from $9.70 to an outrageous $22.00 based on his increased “confidence” in BORN, which he believes will exceed revenue guidance by a mere “2%-4%”. Furthermore, Chan described the 20% drop following my first article as a “good entry point” without seriously addressing any of the issues. Chan made no estimate of the shipping costs of corn from Daqing to Shandong that add by my estimates RMB 200 per ton to BORN’s costs. Nor did Chan address BORN’s inability to produce and sell the corn germ they claim.

Incredibly, Chan continues to assure investors that BORN “is the first company to use wet milling for ethanol production in China” and that there is no toxic waste problem. This is clearly wrong. As any expert in China will tell you, and as its patent application shows, BORN’s wet process method is the same as other traditional wet methods: totally inefficient, antiquated, environmentally destructive and unprofitable. Management themselves have admitted this to my expert who toured their plants. Management has even gone so far as to engage a 3rd party to upgrade its antiquated plants to the semi-dry method used by the major competitors. If you don’t believe me just call them and ask (good luck getting an answer). Once again if you listen to Wall Street analysts who convince you to buy at the high right before insiders start selling once their six month lockup expires and ahead of BORN’s large anticipated follow-on offering, you are destined to lose.

Note: GeoInvesting LLC asked me to disclose that “GeoInvesting does not form definitive opinions of fraud based solely on SAT/SAIC filings. We just want to be aware of all possible risks, however minute, before we make an investment. We obtained the annual financial statements which is filed by BORN for the annual income tax calculation from SAT."

Disclosure: No position