China Education Alliance: A Fantastic Investment Opportunity Courtesy of Short Sellers

Jan.20.11 | About: China Education (CEAI)

As a result of writing the report “CEU: the Next New Oriental Education” in September, I was inundated with requests for advice from investors following the Kerrisdale short blog in November. Due to the time constraints, I was unable to answer most of these requests. However, I would like investors to know that I find the investment much more attractive than before, and I have used the opportunity to lower my cost basis significantly. Not only is the price extremely compelling, but the company has gone a long way to prove its validity such that I am more confident in this investment than I was before. We’ll go through the evidence below, but before we do, I want give the reader a short primer on Chinese Stock Cyber Smears and how they can provide fantastic long investment opportunities.

Introduction on Chinese Stock Cyber Smears

I was at first caught flat footed this summer when the cyber smears on Chinese stocks started to occur in earnest. However, once I figured out the game, I realized this was the best money making opportunity I had been given in a long time. It occurred to that because this is an incredibly lucrative money making opportunity for short sellers, they wouldn’t stop until the universe of available targets was exhausted. This means any publicly listed Chinese stock (especially an RTO) trading above $5 on a major exchange is fair game for a short attack, and investors should assume they will all get attacked eventually, because the profit potential for the shorts is too great. Therefore, as an investor, this means the only safe Chinese investments, and actually the best opportunities, are the ones that have already been attacked.

This may seem counterintuitive, so let me explain in greater detail. As an investor, your ability to make money is really determined by the strength of your co-owners in a stock. If they are weak hands who will sell at the first sign of trouble or the first small pop in the share price, you are going to have a tough time making money. The Chinese stock universe, especially the RTOs (where there has been no sophisticated investment bank marketing the shares to sophisticated institutional buyers), is full of a lot of weak handed shareholders, people who are speculating on growth at a low multiple, but don’t really understand what they are investing in, and just want to make a fast buck. It is very hard for most US investors to perform any due diligence on these Chinese stocks. Because the prevalence of fraud is higher in Chinese companies, all it takes is an allegation of fraud, and all of these shareholders run for the door fast. It is like the old stock market adage “escalator up, elevator down.”

Here is where the jungle scenario plays out. You’ve basically got 4 groups of investors, the lead shorts, follower shorts, strong longs and the weak longs. The lead shorts sell short before their report is released, but they do not push the price down significantly. As soon as the report comes out, the weak longs panic and start dumping shares. At the same time the follower shorts think they’re on to “a real fraud that’s going to zero” so they start shorting when the price is already down, and typically thereafter write obnoxious messages ad nauseam on the Yahoo! message boards. In the end, the weak longs and the follower shorts provide a depressed share price and liquidity for the lead shorts to cover (and they cover fast) and the strong longs to buy in at extremely depressed prices. In a few months the stock price recovers and the follower shorts get burned, sometimes in a pretty brutal short squeeze. In case it was not evident to anyone, this is how the game is played. The lead shorts and the strong longs feed off the follower shorts and the weak longs. There are of course variations on the theme, but all you have to do is look at the charts of OTC:CHBT, OTCPK:CCME, CISG, UTA, and newly OTC:CVVT, to know that this is happening.

This lengthy introduction was necessary to give the reader a better understanding of the game that is being played in the Chinese stock space, and therefore more appreciation for the case of CEU, a Chinese company which was cyber smeared but whose share price has not yet recovered, and which now represents a great investment opportunity. Normally you have to do much more work as a strong long in a cyber smear, but in the case of CEU, this is really a no brainer. All the evidence is provided in the 8-Ks for anyone to read. Yes, dollar bills do lie on the street for the taking. Let’s take a look at the evidence.

The Cash is There

The number one piece of evidence CEU has given is bank cash confirmations in its 8-K shown here. These bank confirmations are more meaningful than bank statements because the bank is giving a confirmation and thus assuming a liability for the inaccuracy of the information. Pay attention here. Normally an auditor will not get bank confirmations for quarterly statements, but rather only for the annual audit. However, the CFO Zack Pan asked the auditor to do extra due diligence on the 9/30/2010 financials, including getting bank confirmations. The bank confirmations were collected by Sherb on November 5th, 2010 before the cyber smear on CEU was released on November 29th 2010. This is not ex post facto evidence concocted to refute the Kerrisdale report.

This is to me the ultimate proof. You can’t rely on the financial statements if the cash is not what it should be. You can rely on the financials if the cash is there. The most important financial statement is the cash flow statement. You can say whatever you want about Sherb as an auditing firm, but I can tell you that the cash flow statements were spot on because the cash would not add up otherwise. Therefore, I trust the financial statements. CEU was worth 3x the current value last year when (i) the company was smaller and had less cash, (ii) it had the same auditor, and (iii) it hadn’t proven through bank confirmations that all the cash was there. It is now larger and has proven a greater amount of cash than the prior year. There is no reason why the company should be trading at this price. This is a gift. Normally you have to do a lot of work to be a strong long in a cyber smear campaign. This time all you have to do is show up and read the 8-K.

SAIC Filings are Meaningless

Ever since John Bird pulled the SAIC filings on CSKI, this has been a lead tactic of short sellers. Short sellers like to write confusing statements about “official government filings” that contradict the SEC filings. Not very many people understand that SAIC filings have no meaning and are in no way the same as or connected with tax filings. The SAIC is like the chamber of commerce in China. It is not the State Administration for Taxation (SAT). All Chinese companies have to file with the SAIC each year to renew their business license. Most companies file statements with the SAIC that grossly understate profitability and show a weak balance sheet. There are several reasons why: (I) The SAIC filings go into the public domain and can be accessed by competitors, customers, suppliers, and government officials who want “favors.” Thus companies have every reason not to want to have these figures put in the public domain because it can negatively impact their business if they show a large and profitable business with a strong balance sheet and lots of cash. (II) The SAIC does not check the veracity of the numbers, so the likelihood of getting caught is very low. (III) The penalty if caught is only RMB 50,000 ($7600). Being no different from most other Chinese companies, CEU also underreported to the SAIC. I am not saying that is right, but it is local convention and does not say anything about the validity of CEU.

I have a good friend who is a managing director of a US funded China private equity fund. I asked him about the SAIC filings. He said when his fund does due diligence, “we don’t even look at those chamber of commerce filings. Everyone for the most part files junk. We look at the tax filings and the bank statements and try to follow the cash.” If you underreport to the SAT, the penalty will be severe and harsh. SAT filings are most likely to be correct, but SAT filings are not in the public domain. With CEU, even though we have not seen the SAT filings, we have seen the bank confirmations and we can follow the cash.

The Facilities All Exist

The company explained in its 8-K shown here that the empty facility was in the process of being remodeled. The company posted many pictures of all its facilities on its website. Because company was in a rush to prove itself, it scheduled an investor day on December 21st in Harbin. That was a bad decision. Given that the investor day was right before Christmas no one showed up. I confirmed this with the company. CEU was very disappointed. They had even booked a bus to take investors to see all of the locations in Harbin. This is a classic case of an overlooked and unloved company where a lot of money can be made. The market will figure this one out eventually.

The Website Works

CEU gave a lengthy explanation regarding its website in the 8-K shown above. The company even set up trial accounts for users to use the prepaid cards it sells. If anyone is interested to test the internet in greater detail, I am sure Zack Pan the CFO will be more than willing to help.

The Valuation is Extremely Attractive

Below I provide my updated projected income statement and updated comparable valuation. I have revised my income statement slightly downward since my last report because of higher marketing expenses and because management will have probably been distracted some during the cyber smear response. I have also assumed that CEU spent $4m of the $8.6m in cash it had in the US on stock buybacks at an average price of $2.50 per share. I’ve thus adjusted the pro forma sharecount down by 1.6m shares. The stock price has come under some weakness lately, and I believe that is because the company has exhausted its available US cash for buybacks. Currently CEU is trading for less than its cash value and the cash value has been proven by bank confirmations. And it is a profitable business producing significant amounts of cash each year. If CEU were to trade in line with its peers, it would be worth anywhere from 7x-9x its current valuation or between $16.50 and $21.50 per share. Even if CEU were to trade at 15x current year earnings (plus cash), which is the multiple that Mr. Yu constantly mentions on conference calls for smaller targets sold in private transactions in China, it would be worth $11.40 per share. The current share price is $2.39. There’s only upside from here.
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Disclosure: I am long CEU.