Reasons to Avoid China-Biotics

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

On Friday, China-Biotics' (OTC:CHBT) stock price took a dive on apparently no news. A news search in the China media, however, yields a piece of news (original, and Google translation) charging that the company may have fabricated its revenue numbers. Coming from The First Financial Daily, an influential Chinese financial newspaper owned by the second largest news group in China, SMG, the news did not evade the shrewd eyes of some smart investors and made an impact on the capital market.

This investigation was sparked by some original financial analysis done recently (original, and Google translation) by Xiacao, a.k.a. Summer Grass, a famous independent Chinese financial analyst.

Xiacao, nicknamed “Fraud Killer,” is a former teacher in Shanghai's national accounting college and a member of that institute's Fraud Research Center. Having exposed a famous fraud case in 2001, and since then exposing hundreds of fraud cases in China, he has published eight books covering his research results. By all means, he is an expert in cracking hard-to-detect frauds in China.

The findings listed below are explosive for the fraud-plagued company, which struggled in a recent scandal finding that it did not own hundreds of retail stores that it claimed to have.

The company exaggerated its retail outlet number.

While the company's 2010 10-K (Its financial calendar ends in March 2010) claimed that it had around 70 dedicated retail outlets in Shanghai, the First Financial Daily reporter confirmed with the outlet staff that only six outlets exist in Shanghai: One in Pudong and five in Puxi. One mid-level manager in its manufacturing department was surprised by the quoted high outlet number when interviewed.

China-Biotics' executive VP, Eva Yan, informed the reporter that only 60% of the outlets are true outlets, the rest being counters in supermarkets. Even with that shrunken account, the outlet number, which comes up to 40, is still far above the six quoted by the store staff and verifiable by external investigation.

Legou, a supermarket, informed the reporter that the sale of China-Biotics' pro-biotics powder was so low that it suspended sales from July 2010 and only resumed them recently. Some supermarkets confirmed that they have never carried Double Gold pro-biotics, CHBT's main product.

The company's retail sales seem to be extremely weak.

The reporter stayed at the two flagship stores for half an hour each and did not see any customers. The sales book the staff showed to the reporter contained sales as early as 2008. The reporter found some out-of-date products in a supermarket, where the staff confirmed that there were rarely sales.

The company's bulk additive business seems grossly exaggerated.

China-Biotics made $81m in its 2010 fiscal year, but according to Dachao Zhang, chairman of the Consulting Committee of China Healthcare Association, there are no large-scale probiotics domestic manufacturers. The known market leaders are Danisco (OTC:DNSOF), a Danish company that was recently acquired by DuPont (NYSE:DD), and Grape King, a Taiwanese company.

Danisco China headquarters' marketing department staff commented to the reporter that the market share of China-Biotics is "ignorable" when compared to Danisco. The same personnel were also puzzled by China-Biotics' claimed revenue of $81m.

China-Biotics also claimed that it provides bulk additives to large diary companies like Yili, Mengniu and Bright. Yili denied that China-Biotics was its supplier and quoted Danisco and Hansen, the largest two in the world, as the only pro-biotics suppliers. Bright claimed that it used mostly its own pro-biotics. In responding to that, Eva Yan claimed that China-Biotics has not signed with Yili and had a limited co-operation with Bright in 2007.

China Biotics' FY2010 10-K shows 26.8% of its revenue came from bulk additives and 73.2% from retail. Eva Yan now believes 40% of the revenue comes from bulk additives and 60% comes from retail.

China-Biotics' tax payable seems to indicate exaggerated revenue and profit.

Xiacao found that the company accumulated $31m in tax payable, nearly 60% of all its tax to date (see table). He argued that it was unlikely for the tax authority to keep such a high amount on the book. The company's claim of exemption of value-added tax also was unheard of for health care product companies. The only logical explanation is that the company was massively exaggerating its revenue and profit and did not pay tax appropriate for the exaggerated number.

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Eva Yan's explanation is that these are tax-accrued in case that the tax-exempt case for the company five years ago is not approved. "These are not real tax liabilities," he emphasized. But an employee of a Big Four accounting firm doubted such a claim: "What is the basis for accrual? How did the company calculate it? Why did not increase year over year?"

China-Biotics has an abnormally low inventory.

The following table shows that China-Biotics had inventory at merely 12 days in the most recent quarter and only nine days for 2008, which does not fit its manufacturing business model. Xiacao argued that this was also a primitive error left by revenue exaggeration.

Conclusion: Local sources in China helped raise more red flags on China-Biotics.

The local financial analyst was convinced that the company exaggerated its revenue numbers, as otherwise he could not explain the high tax payable and fast inventory turnover. The local reporter was able to talk to its customers and its employees, and found that the annual revenue numbers of $81m was unlikely, given the few retail stores and no visible business, both in retail and bulk additives.

Thus I suggest that readers avoid investing in this phantom company.

Disclosure: I am short CHBT.