China Sky One Medical (OTCPK:CSKI) has been accused by some short sellers of numerous instances of fraud. Unfortunately, when false ideas are repeated often enough, many investors and some financial writers accept them as facts. As a long-term investor in CSKI (see my disclosure below), I decided to investigate the allegations as part of my effort to decide whether to sell, hold, or add more shares to my already expanded original position in CSKI. I offer my findings in the hope that my research will motivate others to undertake similar analyses.
First a little background. Through its subsidiaries, China Sky One Medical develops, manufactures and sells over-the-counter branded nutritional supplements and plant- and herb-based traditional Chinese medicines (TCMs), proprietary drugs, diagnostic kits and other health related products in China and elsewhere. The company currently offers more than 120 products and services with more in the pipeline as regularly discussed in is quarterly reports. The company went public through a “reverse merger”.
The consummation of any such merger requires extensive disclosure and is subject to close scrutiny by the U.S. Securities & Exchange Commission (SEC). The surviving company is then subject to the SEC's reporting and auditing requirements. The major factors that led officers of the American corporation, Comet Technology, to see great potential value in the company that became CSKI were:
- Its proven success selling TCMs;
- Its forward-thinking exploration of a variety of potentially highly profitable medicinal drugs, products, and services; and
- Its ability to fund its R&D efforts using working capital rather than by incurring debt or diluting stockholders’ equity.
These expectations have been exceeded since the merger. For example, the company’s revenues increased more than 1,000% since it went public and it has received citations for excellence and grants of research funds from various governmental agencies in China (see here for an example). Reflecting these achievements, when the price of CSKI stock was in the high teens, several investment advisors gave it ratings of “buy” (e.g. EVA Dimensions on 12/07/09, the Street on 6/11/10, and Ativo on 8/6/10) or “strong buy” (Thompson Reuters and First Call on 12/09/09). The stock price rose after these recommendations at which point short sellers intensified their attacks and fueled a climate of panic selling that depressed the stock to its current $2-$3 range.
In examining the allegations against the CSKI it was immediately evident that some were patently absurd, e.g. that the company does not exist, that its property and equipment and manufacturing plants do not exist, or that it has no products or patents. Others appeared to magnify trivial points completely out of proportion or to introduce irrelevancies that distort the facts. I offer my review of the six that appeared to have at least a grain of truth.
1. It has been alleged that the CSKI’s financial reports are false because there were certain discrepancies between the financial data it filed with the China State Administration of Industry and Commerce (SAIC) and its reports to the SEC. In approaching this issue, it should be understood that the principal function of the SAIC is the renewal of licenses to do business in China. It is not a taxing authority and does not base its fees on the earnings generated by a company (for further discussion, see here).
Therefore many Chinese companies just routinely report sufficient assets to warrant license renewal based upon financial information from the past year. CSKI has acknowledged a discrepancy between its filings with the two agencies. The company accordingly implemented certain internal control steps to reconcile the two reports despite the fact that the SAIC does not have an efficient mechanism for such restatement. It is important to note that the SAIC did not penalize CSKI for the discrepancy.
In the future, the same financial data will be reported to both agencies despite the fact that this is not common practice in China. The company announced its reconciliation of the SAIC and SEC reports for 2007, 2008, and 2009.
Short sellers used this discrepancy as the basis for filing a complaint about the company with the SEC. In response, that agency did open an investigation but in two years it has not assessed any fines or penalties against CSKI for illegal or fraudulent acts. Unfortunately, although the SEC has a formal mechanism for opening an investigation, it rarely formally notifies subject public company, or the public at large, that the investigation is closed. The fact that the investigation remains open has been construed incorrectly by some short-sellers as “proof” of various unrelated false accusations against the company.
Terming this discrepancy a fraud is best explained as the accusers’ failure to understand differences between the functions of the two reports. Citing an SEC investigation as proof reflects accusers’ failure to understand that agency’s practices.
Parenthetically it is useful to point out the differences between the functioning of the SEC and the courts. One of the short sellers sued CSKI’s auditor alleging intentional fraud in its review of the company’s filings. After judicial review, this suit was dismissed in a publicly discoverable ruling by the United States District Court of New Jersey.
2. Another issue arose in June, 2009, when CSKI received a comment letter from the SEC concerning its audited annual financial statements for the years 2008 and 2009. At issue was the way in which the company accounted for certain outstanding warrants in its 10-K. These instruments were originally issued in 2008 to raise $25M of equity. The SEC reclassified these instruments as “derivatives” for which the accounting rules are very complicated and subject to different legitimate interpretations. The company and its auditors did not initially share the SEC’s valuation perspective.
At issue were the use or non-use of certain key assumptions incorporated within the pricing model used to calculate the estimated fair value of the warrants. Subsequent to this discussion, new guidelines were adopted effective January 1, 2009 and the 2009 financial statements were revised accordingly.
The terms of these warrants included the reset of the exercise price during their four-year term only if the company issued additional common shares below $10.50 per share (the January 2008 subscription price) while the warrants were outstanding. As a result of the 2009 restatement:
- The consolidated balance sheet reflected a reclassification of $6.6 million from stockholders’ equity to derivative-warrant-liability effective January 1, 2009; and
- The recording within the consolidated statement of operations included a charge of $4.8 million related to the annual change in 2009 of the fair value of this liability.
Due to the continued decline in the market price of CSKI common stock in 2010, the company recorded $8.9 million of additional income in its consolidated statement of operations to reflect the annual change in 2010 of fair value of the derivative warrant liability. This correction did impact the company’s consolidated financial statements, but had no effect on its income from operations or cash flows. Restatements of this nature are common for U.S. companies and these changes were clearly not an indication of fraud by CSKI as has been alleged.
3. In blogs by short sellers, CSKI has been accused of fraud for allegedly reporting inventory levels that were too low to permit the rate of reported sales. To determine whether this, too, was a specious issue, I undertook my own analysis of the data. Some bloggers simplistically calculated the inventory turnover days for CSKI by dividing its inventory on a given date by the average daily cost of goods sold, e.g. seven days in some misleading reports. More sophisticated investors understand that well-managed companies control their inventory levels to maximize profitability based on factors such as the cost of goods sold, the shelf-life of raw materials, and expected revenues. They recognize that it makes no sense to amass inventory when prices are high, to hold inventory long enough for the material to spoil, or to freeze capital when revenues are low.
CSKI discloses its inventory turnover days in the Liquidity and Capital Resources section of its filed quarterly Form 10-Q and its annual Form 10-K report to the SEC. CSKI calculates its inventory turnover days by using the average daily cost of goods sold and average inventory for each quarter. Historically, the inventories of CSKI are at their lowest levels at the end of each calendar year and during the first fiscal quarter. Management draws down inventory levels in December of each year to meet pre-holiday demand for its products and to avoid high inventory carry costs during the first quarter when sales are traditionally low. Inventory levels are then ramped up at the end of the first quarter to prepare for increased demand during the coming stronger selling periods in the second and third quarters.
Variations in inventory management occur in response to such factors as suppliers’ willingness to retain inventory-on-call for the company (as was the case in 2008 and 2009) and management’s estimate of the cost of the materials (which increased in 2010). These forces naturally lead management to lower or raise inventory levels respectively. The table below reflects data from the Form 10-Qs for the years 2008, 2009, and 2010, calculated on a quarterly basis.
Average Daily COGS
($ in thousands)
($ in thousands)
March 31, 2008
June 30, 2008
September 30, 2008
December 21, 2008
2008 Annual Average
March 31, 2009
June 30, 2009
September 30, 2009
December 21, 2009
2009 Annual Average
March 31, 2010
June 30, 2010
September 30, 2010
December 21, 2010
2010 Annual Average
In summary, rather than an indication of fraud, these statistics reflect CSKI’s best practices management of its inventory through adjustments in accord with expected sales and the cost of raw materials.
4. Some short-sellers have disputed whether CSKI legitimately entered into a 30-year lease transaction for 78,000 acres of forest-land in December, 2010. There is simply no factual basis for disputing this transaction that has been properly documented, audited, and verified by the Chinese government. This land will be used for the cultivation of many components of the company’s TCMs. Lease fees were prepaid using approximately $36M of working capital. This money could have stayed on CSKI’s books and earned perhaps .5% interest, but was used instead to invest in the recovery of raw materials that are expected to increase in cost at many times that rate (see here). In addition, the company is likely to be able to become a distributor of the herbs and other products that will be extracted from this land, thereby creating a new profit center. Therefore, rather than being an indication of fraud, this lease is another indication of the astuteness of CSKI management.
5. Another attack against CSKI concerns the number of patents it holds, with at least one short seller alleging that it holds no patents. Patents are intellectual property rights to certain discoveries. Rather than having intrinsic value, these rights become valuable when they are used to develop, produce, and market products. Therefore the term “exercisable patent rights” is more informative than the simple term “patent”. In certain instances, CSKI disclosed under its previously recorded patent purchase transactions that it had acquired “ownership” rather the “sole exclusive rights” to use of certain patented technologies. This is the case with the cancer-drug Antroquinolol, for which CSKI owns the right to market the product in China without having had to bear the very high cost of developing the drug.
Although there were some costs associated with acquiring this right, CSKI did not record or assign any value in its financial statements for other patents that it developed internally because the cost of developing them was previously expensed. Management accordingly corrected the record in restatements in the Property section of the company’s 2008, 2009, and 2010 10K reports. Rather than a fraud, this was a technical issue that was responsibly resolved with no material impact on the net carrying value of CSKI’s intangible assets as recorded in its consolidated balance sheet.
6. Finally, some short sellers have alleged that CSK’s report of its cash and cash equivalents position is fraudulent. As has been suggested in recent business articles, some bankers in China are willing to issue false information, and United States auditors have difficulty penetrating the fraud. It is, however, very unlikely that what could be a capital crime in China is endemic in that country’s banking system. Auditors routinely obtain deposit data directly from banks using a “plea to form” to confirm bank balances.
I have been informed that this is exactly what occurred with regard to CSKI’s accounts. Any investor who is truly interested in the facts can obtain records that validate bank balances and can review the company’s financial documents to reconstruct the path through which the cash and cash equivalents were created. This is yet another inappropriate allegation of fraud that can be disproven through careful scrutiny of CSKI’s financial statements.
In conclusion, I consider all six of these accusations of fraud by CSKI to be unfounded. I believe that they are at best the result of a failure to understand the facts but at worst they could be intentional efforts to distort the facts in which case they would violate the SEC’s 10(b) rule. Contrary to what has been alleged, I believe that CSKI management has made good-faith efforts to meet the conflicting requirements of regulatory agencies in multiple countries.
That is not to say that the company is without problems. It reported the loss of its two main distributors in 2010 that resulted in a 20% reduction in sales and new distribution avenues must be found. The basis for its better-than-average profit margins has been questioned and it is important for CSKI to substantiate its claim. Current owners of CSKI stock have also been frustrated by the company’s less-than-aggressive response to short sellers’ unwarranted allegations including those reviewed here. Its evident inattention to this problem has allowed false accusations to gain prejudicial traction.
However these problems should be viewed in the context of CSKI’s success in meeting even greater challenges in the past I have great confidence that management will solve these problems as well.
From my review of the data, CSKI has made remarkable progress in the creation a highly successful business in a very competitive market. Nevertheless, parties interested in depressing the price of its shares have succeeded in depressing the price of CSKI despite the following remarkably attractive levels.
- As of March 31. 2011,it was selling at 1.3 times earnings.
- As of March 31, 2011, it had a quick ratio of 6.3.
- As of March 31, 2011, it had a book value of $10.1 per share.
- An ROAE of 25.2% for the year of 2010.
These metrics have led to a rebirth of appreciation of the underlying value of CSKI stock by independent sources (see here and here). In addition, the modest executive compensation in China when compared to the U.S. contributes to higher net revenues. It is also important to note that no officers or directors have sold any of their original stock in CSKI or shares acquired as compensation after the date of the reverse merger.
It is also worth noting that CSKI has been mentioned as one of several drug companies in China that could be acquired by an international drug manufacturer seeking a cost-effective entry into China (see here). Given these facts, I believe it is hard to find an investment of comparable value.