Educating over a billion people can be a daunting task for any nation. But ChinaCast Education (OTCPK:CAST), a Hong Kong-based operator of for-profit universities and online degree programs, seems to have found a way to lure everyday Chinese people into institutions of higher learning and make a handsome profit in doing so.
The problem is, ChinaCast has built up its business with a pair of complex and baffling deals that should raise red flags for any investor, especially because they make up about one-third of the company’s $78 million in annual revenue. According to details buried in Chinese filings, ChinaCast appears to have had a major interest in two holding companies that owned colleges it later bought.
The prospect of self-dealing should be troubling enough for any investor, especially when ChinaCast’s CEO made $472,000 last year and its chief marketing officer took in $561,000.
The two deals in question were completed with the help of at least two front men who, by all accounts, aren’t your typical owners of for-profit colleges worth tens of millions of dollars. One is a small print shop owner from Shanghai and the other is a small farmer from Fujian province. Not only were the printer and the farmer owners of these colleges, they were involved in such complex deals with ChinaCast that one could view them as some of the savviest dealmakers in China.
If you ask Ned Sherwood, the chair of ChinaCast’s audit committee, there was zero corporate connection to the schools before they were purchased. Sherwood argues passionately that ChinaCast is one of the good guys in the scandal plagued world of Chinese small caps and that credible U.S. institutions have carefully vetted their every move.
Sherwood readily pins the blame for the company’s stagnant share price on a conspiracy between short-sellers and OLP Global, a New Jersey-based China stock research firm that has released a large amount of critical research on ChinaCast. In a recent conversation with the Financial Investigator, he described what the research shop does as “Illegal” and did not dismiss the possibility of future legal action.
Still, critical questions remain: How did these two deals came together, why did one college double its value in less than two months and who are real buyers and sellers?
The Farmer’s Deal
The tale of these deals all starts with something called a wholly owned foreign enterprise, or a WOFE for short. These shell companies are often used in China for navigating rules prohibiting direct foreign ownership of Chinese companies. American investors dabbling in China have used them without a hitch in numerous transactions. But the use of WOFEs by ChinaCast in the two aforementioned deals served to obscure a lot of crucial details about the transactions.
Here’s where the drama begins: On August 3, 2009, a man named Xie Jiqing, a 34-year-old farmer from a remote part of Fujian province, suddenly became the legal representative of a British Virgin Islands domiciled holding company called East Achieve (which in turn owned a WOFE called Xijiu.) Shortly after, Xijiu purchased Lijang College for 182 million RMB, or just under $27.7 million.
With a junior-high education and a low-wage agricultural job in a rural village called WangKang, Xie Jiqing doesn’t fit the mold of the typical corporate dealmaker. He’s also never appeared in U.S. or Chinese corporate filings. About three weeks after buying the school, Jiqing got out of the WOFE business altogether when he sold Lijiang College to ChinaCast for 365 million RMB, netting a paper profit of just under $28 million. Then he disappeared.
The WOFE that Jiqing legally controlled had actually been set up in 2005 by a then-ChinaCast employee named Song Hongtao. After he departed in 2007, his colleague, Hu Xiaolei, continued to sign the AIC filings. (ChinaCast’s statement on the WOFE issues was released in an 8-K filing available here and here.)
It may well be the case that Hongtao set up the WOFEs on his own and disclosed it to no one. In conversations with a pair of investors (the notes and transcripts of which were provided to the Financial Investigator) ChinaCast chief executive Ron Chan said signing the WOFE’s filings were done as “a favor” to Hongtao by Hu Xiaolei. Pressed by one investor as to why this went on for several years, his response later evolved to, “I have thousands of employees and can’t keep track of everything everyone does.”
Chan, in other words, has trouble explaining why a former employee would set up a WOFE for his own gain and then have a ChinaCast employee continue to sign all the legal papers for him. Consistent with the 8-K explaining the company’s position on this, Chan takes great offense at an obvious inference: That Song Hongtao no longer signed the filings once he left ChinaCast because the company itself actually owned the WOFE.
The Printer’s Deal
Last August, another WOFE set up by Song Hongtao was used to purchase Hubei Industrial University Business College. Unlike the Xijiu WOFE, the audited filings show that ChinaCast had several financial connections to this WOFE, which Hongtao had named Rubao.
Not only is Ron Chan’s email address listed as the contact on Rubao’s official filing form, the phone contact is ChinaCast’s main phone number and its 2007 audited financial statements (done by a firm that audited some of ChinaCast’s subsidiaries) listed ChinaCast as a shareholder and creditor.
The Rubao transaction also featured another unlikely front man named Wu Shixing, a printer from Shanghai whose shop has all of five employees (several of whom are relatives.) Wu Shixing lives with a modest house with extended family and rents his printing space. Filings list him as the owner of a British Virgin Islands shell company called Wintown, which, not surprisingly, purchased the Rubao WOFE.
Last May, before the deal for Hubei Industrial University, Wu Shixing spent $29 million to buy 3.7 million ChinasCast shares at $7.85 each. Understandably, a press release was issued proclaiming, “[ChinaCast is] very pleased Mr. Wu shares our passion and vision to build a significant enterprise…” the same day. It is now gone from their website.
We were assured by ChinaCast investor relations advisor Ted Haberfield that detailed questions posed to the company would be handled on a forthcoming conference call with management. Despite repeated attempts to contact the firm, the call never materialized.
When it comes to the second WOFE transaction, things get even murkier. Instead, Haberfield’s boss, Matt Hayden, sent this email to an investor last week in response to questions he had posed.
It is very difficult to reconcile this statement with standard business practices. In one sense, the statement tries to say that Chan’s email was used in the Rubao filing because Song Hongtao couldn’t think of anyone else besides Ron Chan to record as the corporate contact.
In another sense, it asks investors to ignore the fact that a seller of a WOFE printed a potential buyer’s professional contact information on official filings more than one year before the sale occurred. Regardless, how ChinaCast came to be a shareholder and creditor of this WOFE is not even addressed.
Chan, according to the notes and transcripts of portfolio managers who have recently met with him at length, openly brags about the complexity of ChinaCast’s deals and has told one investor, “Apollo [Group] won’t do these deals,” referring to the giant American for-profit education company.
In the same conversation, Chan told the portfolio manager, “Sellers want to hide assets all the time” and that an equity transaction was done through Roth Capital Partners in December 2009 solely to get research coverage.
“I know how the game is played,” said Chan, of doing the Roth deal.
Sherwood and the Shorts
If ChinaCast management won’t answer questions about Rubao with a reporter, Ned Sherwood of the ZS fund is happy to go on the attack. Sherwood has a distinguished track record to be sure and much of his defense of the company was centered around it.
He blames all the controversy on nitpicking by Adele Mao [OLP Global’s research chief] so short sellers can gain. “The audit committee hired PriceWaterhouseCoopers to go over the sequencing of the deals and everything is fine,” Sherwood said. He declined repeatedly to disclose what PWC found.
The company shares Sherwood’s assessment of matters, so much so that it made its primary risk to investors the threat from short-sellers who among other things, “Arrange for the publication of negative opinions regarding the relevant issuer and its business prospects,” according to its 10-K.
Much less important to the company were the material weaknesses it disclosed in the same filing. Per its auditors, they include a “Lack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses,” presumably something investors in a company that is growing by acquisitions would be interested in more than unflattering research from a firm in New Jersey. The auditors also noted a “Lack of contemporaneous documentation of certain decisions made by the Board of Directors.”
The issues over lack of controls were buried on page 20 of the 10-K yet have been disclosed for three years running. To that end, its auditor Deloitte Touche Tomatsu regularly excludes acquired assets from its audit for a full year.
For its part, OLP Global’s strategy and sales chief Cheng Lim refused to comment on Sherwood’s animosity but said that neither Sherwood nor ChinaCast (and its representatives) had attempted to point out a single mistake in their research.
That ChinaCast has attracted scrutiny from short-sellers and forensic researchers is not terribly surprising. Reconstructing the deals is very difficult — the company admits as much in its filings — and the use of front men and the sharp increases in sales prices of the colleges are practically invitations to dig deeper into their filings.
Sherwood and the company’s other major holder, Katonah, N.Y-based FirTree Partners, have certainly been putting their money where their mouths are buying blocks of stock recently. That’s largely because ChinaCast has one thing going for it that many Chinese small cap companies do not: An actual business. There are indeed universities and students do attend them.
But China has proven to be a graveyard of good intentions for high-profile investors who swore up and down that good research, big law firms and bigger accounting firms will protect their investments. Time after time, their best practices and high-priced talent have failed to detect even the most elementary red flags. Moreover, they ignored and rejected repeated suggestions that problems were afoot.
Brilliant and successful as these investors are, they might do much better if they stop looking at themselves as long term partners and started seeing themselves the way many all too many Chinese management’s see them: As potential marks.
Disclosure: I have no economic engagement with this company's securities, long or short.