I am short ChinaCast Education (OTCPK:CAST) for the following reasons:
1. ChinaCast has engaged in several dubious transactions with seemingly related parties.
2. It's quite possible that ChinaCast investors' funds were misused or misappropriated during these unusual transactions.
3. Several of ChinaCast's important subsidiaries were not audited by Deloitte, but rather, by largely unknown auditing firms.
4. There appear to be numerous errors and omissions in past ChinaCast filings with the SEC and communications with investors.
5. ChinaCast is highly reliant on creating future transactions to keep up its reportedly strong rate on growth.
6. ChinaCast's questionable management team is rapidly losing investors' confidence.
ChinaCast Education wants you to believe that it, a tiny Chinese company, has managed to create a prosperous education business by purchasing private universities at great prices from, among other people, a peasant farmer and the owner of a tiny printing shop. This outstanding company has managed to outmaneuver huge international, university-operating players, such as KKR and George Soros-backed Laureate Inc., along with all the Chinese competition. This fantastic company has managed to find hidden deals the big players missed among the small pool of 250 Chinese private universities and leveraged them to create a rapidly growing and tremendously profitable business.
But there are numerous problems with this laughable pitch. It appears that ChinaCast's major acquisitions have all been with related parties, the company's management appears to have lied when questioned about these transactions, and the company has not disclosed numerous seemingly important pieces of information. ChinaCast has argued that its deals are too complicated to be understood by ordinary investors, and as such, it chooses not to release numerous pieces of crucial information because it claims that we, the general public, just wouldn't get it. I think there is a better explanation: ChinaCast is hiding some dirty laundry. Let's dig in.
Dubious Transaction #1
ChinaCast allegedly purchased the Hubei Industrial University Business College (HIUBC) from an independent party in 2010. But, all signs point to this purchase being a related-party transaction. ChinaCast purchased HIUBC from a wholly-owned foreign enterprise (commonly shortened to as WOFE or WFOE) named Rubao. Here's what we know about Rubao.
Rubao listed its contact phone number as 68644666 in its 2008 annual inspection report. This phone number is identical to ChinaCast's phone number. In the same 2008 Rubao inspection report, ChinaCast's CEO, Mr. Ron Chan, was listed as Rubao's corporate contact. Also, in Rubao's 2007 financial statements, we see (.pdf) that ChinaCast is documented to be a major debt holder/shareholder. If Rubao shared the same phone number and corporate contact prior to ChinaCast's purchase of Rubao, and Rubao's major creditor was ChinaCast, it logically follows that Rubao was a related party to ChinaCast. How can ChinaCast claim that Rubao wasn't a related party?
Rubao also had an unlikely owner. Mr. Wu Shi Xin, a middle class print shop owner (according to page 3 of this (.pdf) OLP Research report), somehow came up with the funds to establish Rubao and purchase the HIUBC university. Mr. Wu also managed to purchase $29.3 million of ChinaCast stock despite his middle class background and lack of any apparent means. I've never heard of any middle class person purchasing either a university, or $29.3 million of private placement in stock. How did Mr. Wu possibly come up the funding for these purchases? It would seem more likely that Mr. Wu was merely a front man for ChinaCast's related-party dealings.
Dubious Transaction #2
ChinaCast's purchase of Lijiang College (LJC) also raises concerns. ChinaCast purchased Lijiang from a WOFE named Xijiu. Xijiu appears to have been created and managed by ChinaCast employees. Ms. Hu Xiaolei, a longtime ChinaCast employee, has been responsible for filing Xijiu's annual reports. She served this role both before and after ChinaCast's purchase of LJC.
Mr. Song Hongtao, a former ChinaCast employee, served as Xijiu's legal representative from Xijiu's creation in 2005 onward. With ChinaCast employees filing annual reports and serving as legal representatives for Xijiu for years before ChinaCast acquired Xijiu, it would seem that ChinaCast clearly purchased a related party. At no point does it seem that Xijiu was an independent entity from ChinaCast. It appears ChinaCast purchased an entity that it had previously created. This acquisition definitely raises eyebrows.
Follow The Money
While undisclosed related-party transactions are pretty bad, the story gets worse when we try to figure out who benefited from these seemingly related-party transactions. The WOFEs involved in ChinaCast's transactions made large sums of money in a very short period of time. While it is unclear where this money went, it is unlikely that ChinaCast shareholders are the ones benefiting.
According to ChinaCast's recent 8-K, Xijiu paid 235 RMB ($36 million) for Lijiang College, and three weeks later, ChinaCast purchased Lijiang for 365 RMB ($56 million), 130 RMB more than what Xijiu paid. How can ChinaCast possibly justify this huge increase in Lijiang College's price in a mere three weeks? If ChinaCast were as shrewd as it claims, you'd think it would have simply paid $36 million for Lijiang three weeks prior and not involved a middleman. It seems ChinaCast shareholders got ripped off. Xijiu made 130 million RMB ($20 million) in just three weeks of owning Lijian -- at the expense of ChinaCast owners. Strangely, the buyer (Xijiu's owner) who supposedly pocketed this $20 million windfall with the presciently timed purchase and resale of Lijian University was a poorly educated peasant farmer (according to this (.pdf) OLP Report, page 3). I find that unbelievable.
Furthermore, as established previously, it seems that the middleman, Xijiu, was set up and operated by ChinaCast. Why would ChinaCast create a company to purchase a university and then have the related party sell it back to the parent company at a grossly inflated price? It would seem that the company is either playing games to filter money or it is directly misappropriating investors' funds. Regardless of which of these possibilities is correct, the implications are very bad for ChinaCast investors.
That's not all. I also have grave doubts about ChinaCast's acquisition of Foreign Trade and Business College of Chongqing Normal University (FTBC). ChinaCast's subsidiary Yupei Training Information Technology purchased FTBC in 2008. According to ChinaCast, Yupei paid 480 million RMB ($73 million) to acquire 80% of FTBC. According to Yupei's audited financial statements (which can be found here (.pdf), appendix 1), Yupei paid 165 million RMB ($25 million). What's the explanation for the $48 million difference?
ChinaCast tried to explain this difference by saying that a different ChinaCast subsidiary (ChinaCast Technology) paid the other $48 million. However, the audited ChinaCast Technology statement for 2008 shows (.pdf) a cash outflow of only 7,000 RMB ($1,069). It appears that ChinaCast lied when it published the 8-K with this piece of apparently errant information. The question remains: What happened to the unaccounted for $48 million?
There are several other significant cases of financial transactions that don't make sense and money that seems to disappear unaccounted for. But for the sake of brevity, I'll move on to the big problem that arises from these transactions: Management is unable to reasonably explain these bizarre dealings.
Baffling Corporate Response
I can accept complicated and unusual financial transactions, provided that management can clearly explain them to investors. But ChinaCast has failed to explain itself. Its CEO has repeatedly taken pride in the sophistication of its dealings. According to the Financial Investigator's report, CEO Ron Chan has stated about its complex transactions that: "Apollo [Group] won’t do these deals." When questioned about these deals, ChinaCast refused to provide crucial details, in essence saying that the deals were too complicated to be understood. For example, take this quote from ChinaCast's 8-K that sought to explain the deal:
Once again, these transactions are complicated and, to the extent that you are trying to follow the cash, you need to be careful to understand how the transaction works. We obviously cannot in this short statement provide a thorough explanation of the transaction.
Since this is an 8-K, the company has an unlimited space to explain itself. It is bizarre to claim that management cannot provide a thorough explanation of the transaction. ChinaCast stated that in the end, a sum of money was paid to acquire each university, and that these transactions were audited. But ChinaCast has left out all the details about the multiple levels and layers of these transactions. As noted previously, ChinaCast appears to have dealt with many undisclosed related parties. Since this is the case, the details of how these transactions occurred are relevant and ChinaCast should disclose this information rather than claiming that the deals are too complicated to be understood. ChinaCast's behavior leads me to ask: "What are they hiding?" Investors are supposed to be partners with management, but ChinaCast's management is acting as if it is superior to its investors.
ChinaCast has made a point of noting that it is audited by a Big Four auditor (Deloitte) and that Deloitte has not raised concerns about the acquisitions. In reality, however, there are two big concerns about ChinaCast's auditing. The first of these is that Deloitte has noted problems with ChinaCast's lack of effective financial controls as reported in ChinaCast's 2011 10-K. Deloitte stated that:
The following material weaknesses have been identified and included in management's assessment:
1) Lack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses which resulted in a delayed closing process.
2) Lack of contemporaneous documentation of certain decisions made by the Board of Directors.
I am curious as to what the Board of Directors has been doing recently. While the Board was unable to document its decisions to Deloitte's liking, a certain board member, Ned Sherwood, recently purchased two million shares of CAST in the following week after the latest 10-K was filed. Why was Sherwood in such a rush to acquire stock (he accounted for nearly 40% of the volume in the days he bought stock) while the public was dumping their stock following the worrisome 10-K?
The second auditing-related problem is that Deloitte did not audit ChinaCast's acquisitions when they occurred. For example, I noted the missing $48 million in Yupei's acquisition of FTBC. Deloitte didn't audit the seller of this transaction (Hai Lai), instead, Hai Lai's books were audited by Jimmy C.H. Cheung & Co. In addition, the Yupei subsidiary that purchased FTBC from Hai Lai was also audited by yet another firm, Shanghai Hongzheng, rather than Deloitte. Here is ChinaCast's comment on the auditing of this acquisition from a recent 8-K:
This acquisition has been fully disclosed in our 2008 annual report (10K), which includes financial statements audited by our auditor, Deloitte Touche Tohmatsu CPA Ltd., and filed with the SEC.
For statutory purpose, local auditors were engaged each year to audit all of our local subsidiaries on a standalone basis. The local auditor for Yupei only considered payment made directly by Yupei as long term investment and the consideration paid by other companies within our Group were not included in Yupei’ s accounts.
Numerous other acquired parties and ChinaCast subsidiaries were audited by smaller, less reputable auditors and were excluded from Deloitte's audits. Deloitte's role, as the China MediaExpress (OTCPK:CCME) scandal clearly showed, is merely to make sure the books add up. Since ChinaCast excluded the dubious transactions from Deloitte's audits, Deloitte would miss any fraud that ChinaCast may have committed in these unusual transactions.
I believe ChinaCast's past acquisitions are largely unexplained to investors, and as such, there are potentially grave problems buried within them. I also doubt that ChinaCast will be able to secure future acquisitions at prices beneficial to shareholders as ChinaCast is competing with far better financed and far more reputable operators in a small and fiercely competitive marketplace.
Also, ChinaCast's management has little credibility since it has been unwilling to frankly and forthrightly explain these questionable acquisitions. ChinaCast has been unable to answer OLP Global and the Financial Investigator's questions about the company's unusual dealings. ChinaCast is running out of time before investors lose confidence in it. ChinaCast shares will likely collapse unless the company reverses course and starts openly communicating with shareholders regarding the labyrinthine structure of its dealings.
Disclosure: I am short OTCPK:CAST.