China-Biotics: Strategy or Cover-Up?

Dec.31.10 | About: China-Biotics, Inc. (CHBT)

Imagine that a Hollywood director is making a new film and he offers you and your four buddies a million dollars. You only need to skydive from 8000 feet up. You all agree and the director gives you parachuting instructions along with five parachutes which he has packed himself. After reading the instructions, buddy number one jumps out of the plane, the parachute doesn't open but just before he smashes into the ground he radios back that there was no chute in the backpack. Buddy number two shrugs his shoulders, looks back at the instructions and says, “It's OK; it says right here that the other parachutes are packed and ready to go.” You try to get him to face the fact that something outside of the narrow parameters of the instructions has already contradicted the former assumptions and any trust he might place in the document. Buddy number two looks a little concerned for a moment, but decides to call the director personally. After nodding his head five times, “uh huh ... I see ... Wow ... you don't say … well, that's it then,” he gets off the phone and says, “It's O.K. The director confirmed the instructions. Everything's correct. And besides, the first backpack was only one-fifth of the scene and the other four-fifths – that would be us – are different. There's a million dollars waiting for us at the bottom. We're good to go.”

How does the lesser portion of a failed test grant total confidence in the untested remainder? How can a larger quantity trump the poor quality of its own reporting and not also trump our claim to intelligence? Easy. Investors do it all the time. They are in my opinion doing it right now with China-Biotics (OTC:CHBT). When there's a lot of money and a reputation that you can win or lose, you're in a very emotional predicament. Investing is too often not a logical exercise consequent of restraining emotions, but an exercise in enabling emotions by way of logical precision. Evidently, the 1/5 of a failure is too uncomfortable of a thought, given the sweet dreams that we would have to give up, and so we avoid any evaluation of the quality of the plan. This leaves the remaining 4/5ths of the enterprise substantially superior in quantity – and this quantity feeds our emotions. At this point excessive precision with the accounting lends us confidence. And when confidence rises up to challenge the fact of a solid turd; it is usually confidence that wins that turd.

Who would really be the second skydiver in the situation? Is it too ridiculous of an example? Yet, why should this situation sound so implausible? Here we are with such situations in the stock market every day. Let's go with a China-Biotics rundown.

In brief, management claimed 111 retail outlets in their Form 10-K March 2010 and then 103 in the June 2010 10-Q. (here and here)

Retail Outlets were a strategic part of China-Biotics, at least as of March 2010. From the 10-K:

We continue to survey cities in China to assess and select suitable locations for new outlets. As part of our strategy, we will also consider licensing franchisees to operate retail outlets in due course.

We intend to expand our operations by opening additional new retail outlets to facilitate direct sales of our products to customers.

In preparation for the opening of additional retail outlets, we have also been actively recruiting and training retail sales staff. We have already successfully recruited a number of very experienced sales professionals and have trained a pool of sales staff.

We continue to survey cities in China to assess and select suitable locations for new outlets.

We intend to expand our operations by opening additional new retail outlets to facilitate direct sales of our products to customers.

After the June 10-Q claim of 103 outlets, Citron Research challenged those numbers, claiming that many of the retail outlets were pure fiction, and noted the lack of published addresses.

Management then published a list of addresses, which you can find here (.pdf)

Some short-sellers hired investigators to test addresses and take photos. Out of 43 locations they covered, only 2 were branded retail outlets. 18 were products on the shelves of other company's retail stores. The other 23 locations came up as short as my position in the stock. (see here)

There was a furious debate between Longs and Shorts and it was anything but clear how many stores there really were. We all knew that some of them existed. I wondered if the short-sellers didn't conveniently select these 43 and pass over the remaining 60 or so because they were indeed stores. Not so. The issue was quickly resolved by the company itself. From the September 10-Q, we find China-Biotics' next claim,

In our continuing effort to shift our focus from retail business to bulk business and to improve operating efficiency, we closed 95 retail outlets during the quarter ended September 30, 2010.” They also said that they added a few outlets, ending with a new store count: “we are operating 15 retail outlets in China.

From 100+ in June to 15 in September. Closing 95 retail outlets in one quarter. I try to imagine the workload on existing staff, the logistics and red tape. This was either a financial strategy or a cover up. But even if we accept this as a legitimate strategy, how could it also be financially efficient? Why shift focus from a profitable segment of the business? Let's go back to the March 2010 10-K, before the Citron Research report was released:

The promotion and sale of probiotics products has historically been most effective through word-of-mouth marketing. We believe that the use of Community Network will provide an additional channel to educate the public about the benefits of probiotics and to provide advice on health related matters.

We believe that the use of Community Network to market and sell our products will be cost effective compared with the traditional advertising and selling through distributors, and that it should increase our profit margin.”

“Profitable” and “Cost effective”?

Is there a relationship between the “community networks” and the “retail outlets”? According to a July 15, 2009 press release for the fourth quarter and full year (2009) results we find the statements:

During the fourth quarter of the 2009 fiscal year, net sales increased 18.9% to $15.5 million from $13.1 million a year ago. The increase resulted from significant growth in the sales of new products, most of which were sold in the Company’s Shining-branded retail outlets, and growth in the bulk additive business. The Company’s established retail outlets and well-trained sales assistants contributed to the rapid revenue growth from new products through its customer-oriented sales model and establishment of the Community Network, which provides health education and probiotics-related seminars to health-conscious consumers in the middle and high income levels.

Profitable. Cost Efficient. Driven by the community networks which were enabled by the retail outlets and their trained staff. If so, why close those retail outlets? How would a move to wholesale distribution be more efficient and profitable than the efficiency and profitability already in place? What will happen to the community networks and the “rapid revenue growth”?

What happened between 103 stores in June to 15 stores by September 30? One difference impossible to ignore is the emergence of the short-sellers' photos.

In the June 11, 2010 press release we find the statement,

The long-term growth prospect of retail probiotics products in China is promising as more and more Chinese become aware of the benefit of probiotics to enhance their health condition. Therefore, our current business lines continued to generate record growth momentum.

Nonetheless, after the negative report by Citron Research, in a mere three months we went from 103 retail stores to 15. Just out of curiosity, how does the investor experience that subjectively? Does he feel like the rug is being pulled out from under his feet or that his mind is not connected to reality? Neither. Interestingly, the once furious debate over how many retail outlets there really were is now ho-hum chatter about whether or not their absence is meaningful or meaningless. The explanation now is that revenue from the retail outlets was only a small portion of total revenue; the greater part of the business is still intact.

But if we can't trust the management what basis do we have for declaring any percentages of revenue from either the retail outlets, the standard distribution channels, or the bulk business? How do we know it is a small portion? Or big? Does a poor quality report find itself overthrown by its own touted large quantities or is the mind overthrown by an ego that “deserves” to be inflated … I mean, wealthy?

The entire question of the unreliability of reports seems to have made no mental impact whatsoever. The stock was soaring as I wrote this.

Of course, any failure of the retail outlets does not guarantee the failure of the distribution and bulk businesses. It is in fact not impossible that the others might function as claimed. It is however my own estimation of the reliability of the reports that must shift, and with the adjustment, the probability of the outcome needs to be recalculated. I don't believe in telekinesis. My mind doesn't move the facts in China; the facts coming in from China must move my mind. At this point it is imperative to inspect the business from outside of the official statements and documents, not to mention how important it is to vet the engineers and promoters. Is the management honest? We certainly don't have an accident here. We don't have the 103 stores we had last June. We have photos. We have a claim of 15 stores. Did we have a strategic reduction or a cover up? Or is the issue so small it is not worth considering, given the huge growth story for 2011? This point is crucial. Imagine sitting at a poker table and letting a man who cheated the last hand play out the next because you listened to what he had to say and found nothing amiss.

We sometimes have an opportunity to test what we hear with what can be seen. Or we can enlarge the message and mentally shrink the evidence against it until it is so “negligible” the happy story overwhelms our attention again. This emotionalism comes equipped with a very curious slide-rule: How do you rate the impact of a loss on a scale from small to even smaller? By the logic of a “negligible” impact of lost outlets we should be more bullish on the reduction of stores if the revenue contribution had been zero percent, but we can't do that because that would lend credence to the suggestion that most of the stores were complete fictions to begin with. On the other hand, the greater their contribution to revenue the more irrational closing the stores would be – not to mention the greater the hit the closures will have on next year's numbers due to lost revenue. So to promote the stock at this point you have to go small with the outlet revenue, but not too small. If Goldilocks is going to steal this porridge she needs Baby Bear revenue: “This one's really bad; that one's worse, but this one's just bad enough.” (Then the bears come home.)

The last thing I need to do at this stage is to rely on the story and the numbers given in the SEC documents as filed thus far. The company's admission to 15 retail outlets this last quarter should have been a power-fact. But it was a mere 1/5th of total revenue? Or 8%? ... 5%? Leaving us 80% of the old revenue? Or, maybe even 90%. But who cares for the remainder? What is four-fifths of zero reliability? A gamble on a random outcome. After having such proof of the unreliability of the management's SEC reports it then requires a failure in self-auditing to continue supplying precise answers to even the most concrete questions of cash flows, assets, new buildings and contracts. To think otherwise, business knowledge would have to dwarf your experience with the reality behind it. At this point, one simply has no intelligent justification for certain types of questions, like, “Based upon this document, how much …. ?” Yet, what happens? When a really good get-rich story is underwhelmed by its own poor facts it usually takes flight.

Disclosure: I am short CHBT.