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News for the aggregate Chinese small cap sector couldn’t get much worse. On March 11, 2011, shares of China Media Express Holdings (OTCPK:CCME) were halted on account of "pending news" regarding accusations the company has been misstating revenue and earnings. CCME use to be the underground "darling" of sophisticated individual investors in small cap China because of its reported cheap valuation, boasted a top 4 auditor (Deloitte), the CFO (Jacky Lam) had made a recent "market" purchase of $1.5 million dollars of stock, and CCME had the financial backing in the form a $13.5 million dollar equity investment by the fund (Starr International CO.) ran by ex-Wall Street Titan Hank Greenberg. CCME was "reportedly" growing its business on the top and bottom line 30-40% and was trading for 5 or 6 times earnings.

That all changed when on January 30 Citron Research issued a report detailing accusations that CCME was fraudulently reporting earnings, revenue, and business. Since that time Deloitte Touch Tohmatsu (CCME’s auditor) and Jacky Lam (CCME’s CFO) have severed ties with the company, the stock price has been sunk by some 50%, trading on the stock has been halted, and Starr International has filed suit against CCME and Deloitte Touch Tohmatsu saying it was fraudulently induced into investing $13.5 million. This has subsequently led to a more severe broad market sell-off within the small cap Chinese space has investors scramble to try and figure out the next fraud [Deer Consumer Products (OTC:DEER), China Integrated Energy (OTCPK:CBEH), China Biotics (OTCQB:CHBT), China Agritech (OTCPK:CAGC), the list goes on] that will possibly be exposed while the "shorts" pile on winning trades.

I have no doubt there will be more corpses to uncover within the small cap China space and many more profits to be made on the "short" side but LONG TERM I also see an incredible opportunity to get long a select few of these Chinese RTO names pending ACTIVE management involvement. Winning for the longs in the Chinese RTO space will take a bit of luck, lots of patience, some thorough due diligence, and a management team hell bent on proving they run a legitimate business that confines to IFERS or GAAP accounting standards (anything legitimate) and WILL take some sort of action when their equity reaches ridiculously cheap levels.

One of those companies that I’ve made an investment in that finds themselves at this crossroad is Longwei Petroleum (LPH). A month ago I wrote a piece on here detailing the company’s valuation and questions I had regarding the future of the business, validity of the financial reporting, and management’s competency with respect to shareholder value. On March 14 Longwei issued a press release announcing that it has entered into a letter of intent to purchase a third fuel storage facility with a 100,000 metric ton storage capacity (roughly doubling current capacity levels) for roughly $106.5 million. Longwei has reportedly already made a $20 million down payment towards the facility leaving $86 million up in the air to finance. On the press release Longwei stated it intends to use its cash on hand, bank and other financing, and working capital assets to finance the acquisition but has yet to disclose anything further.

Per the press release the company expects the third facility to contribute approximately $300 million to revenues and $40 million to net income during the fiscal year ending June 30, 2012. Assuming Longwei will need an extra $40 million to finance initial inventory for the new storage facility I come up with a rough all-in cost estimate of $146 million. This rough estimation means the facility is projected to produce a 27% return on investment in the first year — great numbers for any investment.

The LOOMING question now becomes how the company is going to finance such an expansion while its shares trade for "reportedly" just above 3x earnings with no debt. If LPH wants to sell equity to finance such an acquisition you don’t have to be a Finance professional to realize that IF the company is truly legitimate then buying back their own shares trading at 3x earnings is more accretive to shareholders then financing a project by selling equity with a projected 27% ROI. The flipside to that scenario is that if LPH would try to buy back $100 million worth of stock PPS would undoubtedly shoot up making financing expansion by selling equity more attractive on a return basis.

An EVEN GREATER question is why would a company that has "reportedly" $182 million in working capital assets, around $230 million in total assets, and NO DEBT look at financing a $106 million dollar expansion with a projected 27% return on investment in the first year by selling equity that is trading BELOW "reported" net asset value and less than 3x earnings? LPH is still reeling from the last round of dilutive equity financing undertaken in October 2009 for the second storage facility "Gujaio" that has left the company with millions of dilutive warrants outstanding that kills GAAP EPS quarterly when the share price rises above the $2.25 strike.

The answers I hear regarding these issues are always vague and talk about how the company is located in China and that the culture is adverse to debt and companies like to build conservatively for the "long-term". I’m not in LPH for a "quick trade" so I believe in building conservatively for the long term but only up to a certain point, when your equity reaches such low levels and you have profitable projects to invest in it doesn’t become a "conservative" play to sell your own equity to finance expansion it becomes stupidity. After seeing the reported numbers for the Gujaio storage facility vs. the capital structure used to finance the acquisition (cheap convertible preferred shares attached with warrants on a project that was "reportedly" immediately profitable) one has to wonder about LPH (and yes I know the Gujaio facility was financed in October of ’09 when the financial markets were still in a disarray).

The market is clearly done with vague answers to tough questions surrounding small-cap China, the sector is clearly in crisis mode. Redchip/CFO Toups/Directors Cai Yongjun & Xue Yongping need to realize the stock is getting crushed by fraudulent accusations for merely existing in the small-cap Chinese space. If LPH is a legitimate company (reporting accurate figures on its financial reports) it is time for its management to take some sort of action to help rise above the rest of the accusations surrounding the Chinese small-cap space:

  • Come up with some sort of Action Plan and communicate with shareholders on how it is going to build shareholder confidence, move past the fraudulent accusations surrounding small-cap China, and rectify your stock’s valuation using internally generated cash/action instead of trying to "sell" the stock to the average Joe in the U.S. who has NO idea who to trust in regards to buying a business ran halfway around the world while its sector (small-cap China) is currently mired in fraud.
  • Pay a small token dividend (very small amount that will still allow the company to grow with internally generated cash) etc.
  • Hire a top tier auditor.
  • Pull debt out to fund its new storage facility that has a projected 27% return on investment — if it's have trouble finding debt financing, it knows it can also collateralize that loan with its "reported" $182 million in working capital assets mostly tied up in the form of oil contracts and/or physical oil otherwise known as BLACK GOLD.
  • Bring Mr. Cai Yongjun and Xue Yongping to America for an investor conference … Q&A session with them in person would go a long way since they own over 60% of the company and control it (you can bet I’ll be there if it’s anywhere in the continental U.S.).
  • Go on a road show with Mr. Cai Yongjun and Mr. Xue Yongping showcasing Longwei Petroleum’s business model and financials to smaller institutions and hedge funds and allow them one on one access with the directors, especially if it's truly going to be a $925 million revenue business in FY2012.
  • Show shareholders that it is taking steps to strengthen above and beyond what is required in corporate governance and internal controls.

Management needs to take some sort of action to show investors they are not the equivalent of CMME, Rino International (OTC:RINO), or Orient Paper (NYSEMKT:ONP) etc. (all small cap China stocks listed in the U.S. that have been accused/guilty of fraud). Simply doing nothing but releasing Redchip research reports claiming Longwei’s stock has a price target on it of $5.50 is a useless endeavor at this point. If it's a legitimate small cap company in China, it is time to rectify valuations with actions initiated internally instead of trying to "sell" its stock to Joe the Average U.S. investor at 2 and 3 times earnings. Selling equity at prices below reported net asset values to finance a 3rd fuel storage facility with a projected 27% ROI is not a winning strategy for a legitimate business. I am actively monitoring LPH and the Chinese small cap space but remain invested in Longwei because of its simple business model and the "reported" numbers below:

Current Market Cap = $200 million

Net Assets = $230 million

FY 2011 Earnings Projection ending June ’11 = $70 million

FY 2012 Revenue Projection = $925 million

FY 2012 Earnings Projection = $125 million

Projected Net Assets end of FY2012 = +$400 million

NOTE: Congrats to Andrew Left of Citron Research and Carson Block of Muddy Waters for exposing CCME. While I remain long with a Chinese small cap name whose value has been hindered by the association with CCME (small-cap China), I believe shorts that expose fraudulent companies play a VITAL role in our financial markets.

Source: Seeking 'Legitimate' Value in China Small Cap Longwei Petroleum