Why I Sold My Position in China-Biotics

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

Using the little resources and time that I have at my disposal, I recently tried to perform a mini-DD (due diligence) on China Biotics (OTC:CHBT). Up until that point I had been unimpressed with the management in term of capital allocation (see my article here), but I also had been having troubles determining the validity of the allegations that have been posted on the company on Seeking Alpha.

I was especially perplexed with Mr. Nevander´s fierce defense of the company (link). To my knowledge, Mr. Nevander is someone who has a reputation to protect; he is putting his name on the line. If China Biotics were indeed a fraud, why would he do that? There were also these two excerpts from the 2010 annual report that concerned me:

On risk factors:

Because our executive officers and directors are Chinese citizens, it may be difficult, if not impossible, to acquire jurisdiction over them in the event a lawsuit is initiated against us or our management by a stockholder or group of stockholders in the United States. We anticipate that future members of our management will also be Chinese citizens. Because the majority of our assets are located in China, it would also be extremely difficult to access those assets to satisfy an award entered against us in U.S. court. (China Biotics Annual Report 2010)

Also, on page 26:

As of June 7, 2010, Mr. Song, our President and Chief Executive Officer and a director, owned, directly and indirectly through his family, approximately 37.1% of our issued and outstanding common stock on a fully diluted basis. As a result, Mr. Song has the ability to exert substantial influence or absolute control over all matters requiring approval by our stockholders, including the election and removal of directors, any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. (China Biotics Annual Report 2010)

The DD

What I did was, basically, read through the material that China Biotics has already made public and collect statements that were refutable. I tried to verify statements made by sending emails to third parties connected with those statements. This included Unilever (NYSE:UL), Wal-Mart China, Bright Dairy, Nestle (OTCPK:NSRGY) (all mentioned as clients or business collaborations in Seeking Alpha articles by Mr. Nevander (link) and Mr. Wright (link)), Shanghai Sunrise Trading Limited, Shanghai Lian Hua Quik, Beijing DBN Technology Group Co. Ltd. (all mentioned as top clients in the 2010 annual report (.pdf)), Chr. Hansen (on the cost of building a probiotics manufacturing plant in China and on sales margins in the China market place), Danisco (on an alleged formal visit of the president of Danisco China at the Qingpu facilities (link)), DSM (on a formal visit to the Qingpu facilities (link)), Morishita Jintan Co., SINE Pharmaceutical Co. Ltd, Shanghai Jiaoda Onlly Co. Ltd. (China Biotic´s main competitors according to its 2010 annual report (.pdf)), International Probiotic Association (about China Biotic´s membership), Northwest A & F University (about an alleged joint R&D program), TÜV Rheinland/Berlin-Brandenburg Group (about production certificates such as ISO) and Shanghai Food and Drug Administration (on the GMO license). All of these efforts were unsuccessful. An email from Nabi Pharmaceuticals, however, confirmed that Dr. Hui S. Chang is indeed a former employee of the Nabi.

I have tried to contact China Biotics´ CFO, Mr. Travis Cai three times by email. The first time I asked to arrange a meeting with a representative of mine at China Biotics headquarters. I received no answer. The second time I sent him the following mail:

I’ve been looking through CHBT reporting for the past few days and there are two items that I am trying to figure out. I haven’t had any responses yet, but maybe you know something about this.

First of all, I was trying to look up the patents that you have registered at the moment in the SIPO database but without success. Could you help me out with that, perhaps by sending me links to the SIPO registrations?

Secondly, at the investor day the R&D presentation talked about 10 papers that had been published with China Biotics as collaborator. Would you be able to send be the corresponding ISBN numbers of the articles?

Needless to say I received no answer. The third email I sent was this one:

"I’ve been looking through CHBT reporting for the past few days and there are two items that I am trying to figure out. I haven’t had any responses yet, but maybe you know something about this.

1. In their latest annual report the company claims:

“For the fiscal year ended March 31, 2010, we had one customer, Beijing DBN Technology Group Co. Ltd, that accounted for 13.0% of our sales revenue. For the fiscal year ended March 31, 2009, we had one customer, Shanghai Lian Hua Quik Convenience Store Limited, that accounted for 11.5% of our sales revenue. For the fiscal year ended March 31, 2008, two of our customers, Shanghai Lian Hua Quik Convenience Store Limited and Shanghai Sunrise Trading Limited, accounted for 15.5% and 10.5% of our sales revenue. These three customers are independent third parties.”

To the best of my knowledge Shanghai Sunrise Trading Limited is a company that exports hats and caps mainly to the States. Do you know anything about this?

2. In the same report they state:

“Our primary competitors in the Chinese domestic probiotics market are two Chinese companies, Shanghai Jiaoda Onlly Co. Ltd. and Shanghai Pharmaceutical Group Co. Ltd. – SINE Pharmaceutical Co. Ltd. and one Japanese company, Morishita Jintan Co. Ltd. These competitors produce similar probiotics products and have similar market share to ours in the Chinese domestic market. In addition to these primary competitors, there are approximately four other domestic competitors that compete with us in the Chinese market.”

To the best of my Morishita is a capsule maker with no operations in Shanghai. Do you know anything about this?

I’m sending this to you personally as I do not want to stir things up with information that is not backed up.

I sent a fourth email to remind him of the previous ones, but I have yet to receive an answer. There is one last thing that bothers me. If you go to the news page on the China Biotics home page (link) you can see a short piece about a formal visit of DSM N.V. Now, take a look at the pictures of the visit. Why is there the American flag there on the table, as DSM is a Dutch company?

I’m inconclusive whether China Biotics is indeed a fraud or a rose bud amongst cabbages, but what I do know is that I have a huge information disadvantage. That is why I disposed of my position in China Biotics.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I recently dropped my position in CHBT.