Zhongpin: Overstated Income, Excessive Capex and Deceptive SAIC Filings

Aug.17.11 | About: Zhongpin Inc. (HOGS)

We recently conducted thorough due diligence on Zhongpin Inc. (NASDAQ:HOGS). Based on our work and the observations of our investigators who have visited HOGS facilities on various occasions, we conclude that: HOGS is in fact processing and selling pork products in China. However, while HOGS is clearly not an "empty shell" we did find clear and substantial evidence of possible fraudulent activities.

Summary of Findings

  • Overstatement of SEC net income vs. SAIC filings by nearly 500% in 2009.
  • GEO estimates 2010 net income of $10-20 million vs. $58 million reported to the SEC.
  • Deliberate manipulation of SAIC filings.
  • Likely diversion of almost $150 million of reported capex.
  • Inconsistent trends between inventories and sales.
  • Repeated capital raisings, despite assurances to investors that none were needed.
  • Capex concerns already noted by Roth Capital resulting in downgrade.

What Is Zhongpin Inc. Hiding From Roth Capital?

In its 2011 second quarter conference call, Zhongpin (HOGS) refused to respond to Roth Capital's questions, posed in an earlier research note, concerning the accuracy of the average capex and land use rights spent for the average slaughtering facility alleging costs are high relative to peers in the industry.

We find HOGS refusal as a blatant disrespect for an Investment Bank, which is attempting to proactively bring clarity to the ChinaHybrid space, as a huge and obvious red flag that leads us to question the legitimacy of HOGS' operation. The reasons that HOGS gave to ignore Roth's request were unacceptable.

Reason 1: HOGS said it had concerns about 'selective disclosure.' We find this mind boggling since this is what analysts do. They ask questions and then disclose their findings. Regardless, we hardly find Roth's questions to justify capex as classified in nature.

Reason 2: Risks to competitive advantage if the information gets out. We believe this is just a ridiculous boiler plate answer. This is the same answer that many fraudulent ChinaHybrids used when they were attempting to explain why they did not report accurate numbers to the SAIC, even as they bragged that being a U.S. listed company gave them increased exposure, and basically belittling the fact that any legitimate competitor could easily access public SEC filings. HOGS, we have a little secret for you. You are not operating in a covert environment where your formidable competitors do not have access to the same information you do.

Reason 3: Professional auditing standards and precision that might or might not be applied by Roth. Talk about getting punched in the face. HOGS, are you really claiming that Roth is unqualified to interpret answers to simple CAPEX and land use rights issues?! You had no problem with them building forecasting models based on information you provided to them. You also had no problem raising money through IBanks, but now that it seems you feel they may not be qualified to fully understand the 'complicated' swine business. Are you telling us that we should take analyst financial estimates with a grain of salt? Please enlighten us on the complexity of the accounting issues regarding land use rights and use of capex. Educate us.

Red Flags Flying Over HOGS

In evaluating HOGS, there are an abundance of red flags indicating the high likelihood of deceptive practices, including:

  • As reported to the SEC, over 6 years HOGS' revenue has increased 20 fold (2,000%) to nearly $1 billion in 2010 from $42 million in 2004. During that time, store count has only roughly doubled.
  • Zhongpin has often misled investors by repeatedly stating in its filings that it could fund its expansion through access to lines of credit and internally generated cash flows. Ensuing actions to quickly proceed to raise equity capital contradicted these statements.
  • Zhongpin's debt/equity capital raises since its reverse merger in 2005 have been excessive - raising $432 million in debt and equity capital so far.
  • Substantially all of the capital raised has been poured into capex to expand new facilities, with the result that the company has been able to generate very little if any free cash flow in its history.
  • This massive capex expansion has aggressively continued despite consistently low profitability with a net income margin of only 6%.
  • Zhongpin has misrepresented its business using the term "stores" to describe simple one man, 6 foot wide meat counters located within open air vegetable markets. Few of the "branded stores" are even free standing buildings.
  • Zhongpin has misrepresented its focus on higher income customers. Zhongpin sales counters ("stores") are located within low cost open air vegetable markets which are frequented by low income Chinese. In addition, the majority of these "stores" are located in China's poorest provinces such as Henan, with only a minority located in higher income areas such as Shanghai and Tianjin.
  • Zhongpin only recently disclosed its list of store locations on its website, and the list was unusable since it did not contain actual business addresses. Instead, the company used district names or names of entire cities to identify many stores. Moreover, the list was in a format that could not to be printed and was subsequently removed from the website. Visibility is the lifeblood of retail stores, so the reluctance to reveal their locations is highly concerning.
  • Zhongpin's claims in a recent press release that it operates at higher standards and efficiencies than its industry peers:
    • "Zhongpin's "advanced" processes produce higher yields of carcass meat and all pork products than are typical." (1)
    • "Zhongpin's advanced industrial cluster concept usually results in more rapid improvement in capacity utilization for new plants than is typical." (1)
    • "Zhongpin's capital investment intensity is intentionally higher than is typical". (1)
    • "Zhongpin's gross profit margins are significantly higher than Chinese industry peers".(1)

(1)Source: HOGS press release Dates June 6, 2011

We believe a HOGS price per share of over $5.00 does not take into account the probability of materially overstated net income or the possible diversion of capex. Investors should note that other Chinese small cap companies with similar circumstances have suffered auditor resignations, trading halts and even delisting of their shares.

Given our findings and despite the share price of HOGS hovering near its 52 week low, we have initiated a short position in the company's shares.

Key Findings: Overstated Income, Excessive Capex and Deceptive SAIC Filings

Based on examination of SAIC filings, HOGS overstated net income in its SEC filings by 500% in 2009 and manipulated SAIC filings to ensure they matched SEC filings

The pattern of discrepancies in HOGS' SAIC filings vs. its SEC filings is notably consistent with recent China small cap frauds.In particular, SEC net income was irrefutably overstated by nearly 500% in 2009 vs. SAIC filings and by nearly 200% in 2008. Moreover, when observing the separate 2009 and 2008 SAIC filings for HOGS' Wholly Owned Foreign Enterprise ("WOFE"), it appears the numbers have been manipulated to match SEC filings even though they should not for reasons we discuss in this report. In fact, our estimate of 2010 net income of $10-$20 million is a fraction of the $58 million reported by HOGS in its SEC filings.

High likelihood of almost $150 million in questionable capex based on apparent overpayment for capacity

Effectively most of the $432 million net debt and equity capital raised from 2006 through the first half 2011 has been plowed into capital expenditure on a massive scale, with the result that HOGS has been able to generate very little if any free cash flow in its history. Of much greater concern is the fact that for competitors, additional or incremental slaughter capacity (i.e., capex) costs are around $330 per ton while HOGS claims to be spending around $515 per ton for current initiatives through 2012 which is about 56% higher than the average of its industry peers, and already spent $682 per ton for its initiatives between 2006 and 2010, more than double its industry peers' capex. This led us to surmise that HOGS' slaughter assets are either highly underproductive in generating sales or that HOGS is paying nearly double the price of their industry peers for identical capacity. Even staying on the conservative side, we conclude that HOGS has overpaid for its capex by over $150 million. If not in capex, where did the money go?

Blatantly misleading investors regarding liquidity and capex needs

HOGS has repeatedly disclosed in SEC filings that internally generated cash and access to lines of credit , "will be sufficient to finance our investment in new facilities, operating requirements and anticipated capital expenditures". Despite such assurances, the company has a pattern of raising excessive debt and equity ($432 million since 2005, about half coming from equity) in short order following public assurances that equity capital would not be necessary. (Appendix I)

HOGS' excessive dependence on external financing has led it to become one of the most prolific self-promoters in the China space. The company attends numerous investor conferences promoting its stock and recently announced a stock buyback of up to $10 million. When management was asked on a recent conference call about the purpose of the buybacks their candid response was to "increase confidence in the stock price".

We don't view buy backs representing less than one day's trading volume for HOGS as adequate to boost investor confidence in the stock. In fact, the opposite happened as indicated by the decline in stock price during the days preceding the call.

It's not what they say but what they do!

HOGS raised over $150 million in Q1 2011 alone (over 1/3 of current market cap). The massive fund raisings will likely continue as long as the market allows the company to perpetuate and sell its apparently embellished story. What does HOGS have to say for itself? Investors clearly don't believe it!

Company Sponsored Investors' Day at Production Facilities in May 2011 Falls Flat and Market Responds

On May 30 and 31st, when the share price was $15.25, HOGS held an investors' day providing a tour of its production facilities in Tianjin and Change. In the first three days following the tour, the stock price dropped by over $2.00 to close at $13.19 on Friday, June 3rd, a new low for the year. In response to the share price drop, HOGS issued a press release on Sunday, June 5th to address investor concerns. The company also announced a proposed share buyback of up to $10 million. Since then, the stock has fallen another 35%, and currently trades at $8.6 (as of business close on August 15, 2011)

The issues that HOGS 'self-disclosed' in its June press release (after the investor tour) are as follows:

  1. "Zhongpin's gross profit margins are usually higher than Chinese industry peers."
  2. "Zhongpin's advanced processes usually produce higher yields of carcass meat and all pork products than are typical."
  3. "Zhongpin's advanced industrial cluster concept usually results in more rapid improvement in capacity utilization for new plants than is typical."
  4. "Zhongpin's capital investment intensity is intentionally higher than is typical."
  5. "Zhongpin has chosen to focus on high income markets and provide the highest product quality and safety to its customers."

The answers to these questions were also provided by HOGS, and in each case the company was somehow "special" or "unique" compared to its industry peers in this very competitive space. Specifically, HOGS stated that it is focusing on "high income markets" and is catering to customers who require the "highest quality and highest value products". These claims are clearly contradicted by the location of HOGS' stores that are typically in lower priced, open air vegetable markets frequented by lower income Chinese in the poorest provinces.

Investor Conference Call - The More Investors Learn, the Less They Like (i.e., Believe) the Story

On July 19th, when HOGS was trading at $10.25, management held a conference call to address 'share price volatility' following a negative report on the company written by China Economic Review. The report questioned, among other things, the existence of HOGS' retail stores. Management's presentation during the call included the posting of a list of over 1,300 retail stores.

Upon examination of the list, investors came to realize that it was in Chinese only and that actual store addresses were not provided. Instead, in many cases investors were given names of entire towns or districts. The share price fell by more than 20% to as low as $8.18 during the two days following the call. That price represented a new low for the year, down by 47% since the investor tour was conducted in May.

Of concern is that the list of retail stores was posted on the HOGS website in a format that could not be printed or saved, and even more concerning is that the list has since been removed from the company's website. Now, we cannot find the list of HOGS' retail stores on its website.

SAIC Filing Patterns Consistent With Confirmed China Small Cap Frauds

In evaluating HOGS' SAIC filings, we took a comprehensive approach, evaluating the SAIC financial statements of both the individual subsidiaries and the parent company or "WOFE".

Consolidated SAIC filings of operating subsidiaries do not match SEC filings

In 2008 and 2009 HOGS had 13 and 14 operating subsidiaries, respectively. Two more subsidiaries were added in 2010 and therefore are not relevant to 2009 and 2008 SAIC documents. We obtained 2008 and 2009 SAIC filings for most of the subsidiaries that were operating in those years and several, including the largest (39% of 2009 revenues) subsidiary, were audited. Specifically, we obtained SAIC data for 11 of 14 of Zhongpin's 2009 subsidiaries and 11 of 13 of the company's 2008 subsidiaries (Appendix IV).

We consolidated the financial data filed by the operating subsidiaries with local Chinese authorities and compared it with what was filed with the SEC and the differences are striking. SAIC vs. SEC revenues were in line with SEC documents which dramatically increases the legitimacy of the SAIC filings. However, net income reveals a completely different story. We are willing to attribute some of the revenue discrepancies to differences in Chinese and US GAAP but we believe the net income discrepancies are just too great to be explained away. The cumulative net incomes reported for 2008 and 2009 by the majority of HOGS subsidiaries in their SAIC filings are a fraction of what was reported to the SEC.

Of particular note is that the differences are not only massive but increasing. We can't think of any plausible explanation for the disparities between the filings other than the SEC filings are apparently inflated:

Table 1.1 - 2008 Revenue, Net Income & EPS - SAIC vs. SEC

2008 (11 of 13 subs)

SEC

SAIC

Percent Difference*

Revenues

$ 539.8 m

$ 421.2 m

28%

Net Income

$ 31.4 m

$ 10.6 m

196%

EPS

$1.05

$0.36

192%

Click to enlarge

*SAIC numbers used as the base values.

Table 1.2 - 2009 Revenue, Net Income & EPS - SAIC vs. SEC

2009 (11 of 14 subs)

SEC

SAIC

Percent Difference*

Revenues

$ 726.0 m

$ 574.4 m

26%

Net Income

$ 45.6 m

$ 7.6 m

500%

EPS

$1.46

$0.24

508%

Click to enlarge

*SAIC numbers used as the base values.

Notice that from 2008 to 2009, EPS reported in SAIC filings actually fell from $0.36 to $0.24, a 31% decrease. During the same period HOGS reported a 39% EPS increase to the SEC.

We need to stress that the subsidiaries for which we do not have SAIC files would not materially impact the results of our findings. Given that SEC revenues are only about 25% more than SAIC revenues it does not seem plausible using HOGS' margins that the revenues from the 2 or 3 subsidiaries we did not obtain would come close to bridging the significant income gap. In fact, assuming the missing subsidiaries could bridge the revenue differences, those entities would have to earn after tax margins of around 18% in 2008 and 25% in 2009 to ensure that overall SEC and SAIC net incomes match. We don't believe even HOGS management could paint such a scenario. For more supportive evidence on why these subs should not influence our findings, please see Appendix IV.

Based on the analysis above, we conclude that 2009 net income was less than $8 million, in contrast to the $46 million reported to the SEC. For 2010, HOGS reported net income of $58 million; however, we estimate HOGS 2010 net income as being no greater than $10-20 million. We believe that the HOGS story confirms a wildly held belief by ChinaHybrid skeptics that many U.S. listed Chinese firms grossly inflate SEC margins. The HOGS case parallels that of delisted company Fuqi Intl, a real company that embellished its story and fabricated margins.

Apparent manipulation of parent company's or WOFE's SAIC filings to ensure they match SEC filings

ChinaHybrid management teams are by now well aware that investors are examining their SAIC filings. US analysts and investors are no longer willing to take SEC filings and audit reports at face value. They now look for corroborating evidence to validate SEC filings that is provided by filings Chinese companies are required to make with local government agencies, especially SAIC filings which are easy for US investors to access.

In response to this, the managements of some Chinese companies are taking measures to avoid the issues raised by mismatched filings by not only ensuring new filings are consistent with SEC filings (i.e., by forcing filings to match) but by also amending previously filed reports. We are not yet sure how they are doing this or who is aiding in this deceptive practice, but we intend to investigate further.

What is particularly noteworthy with HOGS' SAIC filings is that while the consolidated net incomes of the company's operating subsidiaries do not come close to matching the SEC filings, the financial statements of the WOFE do in fact match what was filed with the SEC. So, it seems the consolidated net income reported by the WOFE is dramatically greater than the sum of its operating subsidiaries.

That is simply not possible and makes little accounting sense since consolidation would result in less cumulative net income, not more. That's because related party balances are eliminated in consolidation which reduces consolidated net income.

Furthermore, the WOFE, as clearly stated in SEC filings, has no meaningful operations. It basically exists to aid in capital raising goals and receives cash flows, such as potential dividends, from its subsidiaries. In the end, it would be much more convenient to amend/compromise one filing (the parent/WOFE) than to coordinate the amendment of many (11 or 12 in HOGS' case) subsidiaries. HOGS; where are the true financial statements of your WOFE?

Given this odd set of circumstances we can only conclude that HOGS' management amended the filings of its WOFE apparently for no other purpose but to ensure the financial statements reported to the SAIC are consistent with what was filed with the SEC.

We have seen cases where the parent company (WOFE) filed its own financial statements with the SAIC along with separate consolidated financial statements including its subsidiaries but have not seen another case like HOGS where the parent company filed only consolidated financial statements.

There are other apparent issues associated with the SAIC filings of HOGS' WOFE that go beyond the suspicious matching of the financial data in those filings with the data reported to the SEC. First, annual inspections are performed by various PRC government agencies (SAIC, SAT, SAFE, Customs and others). Those agencies require the financial statements of the WOFE to complete their inspections.

The WOFE is therefore required to file its own audited financial statements with the SAIC. In the case of HOGS, its WOFE submitted only consolidated financial statements and not its own making it impossible for the agencies to complete their inspections. Second, as we stated, HOGS' SEC documents clearly state that the WOFE only exists to receive cash flows, such as potential dividends, from its subsidiaries so it has no meaningful operations.

Thus, the WOFE's true financial statements (which should not be consolidated) should not reflect meaningful revenues or net income (Appendix II). So it seems HOGS can't please both the PRC government agencies and US investors seeking to validate SEC filings so they chose to please the investors.

Based on our findings concerning the SAIC filings of HOGS' WOFE, we can only conclude that the 2008 and 2009 filings were revised to match the company's SEC filings and deceive US investors who would take comfort in knowing the SAIC and SEC filings reflect the same financial data. The trap management finds itself in is that they only amended the WOFE and not its subsidiaries. We understand the practicality of forcing the WOFE SAIC filing to match the SEC filing but when the SAIC filings of the subsidiaries are also examined, as we did, the ploy becomes transparent.

Diverting Funds Via Phantom Capex - If Not Capex, Where Did the Money Go?

Between 2006 and 2010, HOGS invested capex of approximately $405 million to increase capacity by 594,000 tons.

Table 2 - Zhongpin Capex Spent from 2006 to 2010

2006

2007

2008

2009

2010

Cumulative

HOGS Capex ($US millions)

26

50

108

123

98

405

Click to enlarge

Note: so far in 2011 HOGS has spent $80.9 million bringing the total capex spent between 2006 and the first half of 2011 to $457 million.

We estimate HOGS spent an average of $682 per ton ($405mm divided by 594,000 tons) for its facilities which is three times our estimate for industry peer People's Food's most recent facilities expansion in 2006. According to a recent Jefferies research report, other peers China Yurun and Shuanghui spent around $330 per ton of new capacity in 2008/2009 - about $185 per ton less than HOGS plans to spend on new facilities through 2012.

Even allowing for wage and materials costs inflation in recent years, the difference between HOGS costs and its industry peers are just too great to ignore.If our assumptions are correct, we have to ask: Where did the 'extra' money that was supposedly spent on capex go?

Following is a list of capex per ton reported by HOGS and its industry peers in recent years:

Table 3 - Capex per Ton - HOGS vs. Peers

Company - Year

Capex per Ton

People's Food - 2005 (Source: 2005 People's Food Annual Report)*

$262

China Yurun - 2008/2009 (Source: Dec. 2010 Jefferies Report, pg. 8)**

$338

Shuanghui - 2008/2009 (Source: Dec. 2010 Jefferies Report, pg. 8)**

$328

HOGS 2006 - 2010 (Source: HOGS Annual Reports)

$682

HOGS 2011 - 2012 Est.

$515 (based on Table 4 Total)

Click to enlarge

*We only used 2005 data since it was the highest capex per ton instance for People's Food from 2002 to 2010, offering us the most aggressive number. Consequently, this was also the year of the most recent substantial capex project for Peoples Foods over this period.

**Dec. 2010 Jefferies Report on Yurun Food; Exchange rate of 7.8 used.

Table 4 - Zhongpin Planned Capacity Increases - 2011/2012 cost per ton**

Incremental Capacity (000s Tons)

Capex

(millions)

Capex per Ton

Taizhou, Jiangsu Province

130

$63

$484

Changchun, Jilin Province

125

$61.5

$492

Tangshan

102

$49

$480

Tianjin

36

$21

$583

Changge, Henan Province

100

$58.5

$585

Totals

493

$254

$515

Click to enlarge

**Source: June 30, 2011 Annual Report

We believe it is reasonable to assume that no more than 20% of the difference between HOGS' capex spending and that of its peers can be attributed to technological or geographic differences and wage and materials costs inflation. The rest of the differences are not easily explained.

Repeatedly Misleading Investors Regarding Liquidity Requirements

Zhongpin has repeatedly chosen to raise equity capital in the periods immediately following statements strongly indicating that it had sufficient cash on hand and access to lines of credit to fund operations into the foreseeable future. This is a top 3 Red Flag that we use to identify suspect companies. No additional equity capital was required as per statements in 10K 2005, Q3 2007, Q3 2009, Q3 2010 and 10K 2010 filings, after which they either filed a shelf and/or raised money shortly thereafter:

  • Q1 2006 - $23.1 million in preferred stock
  • Q4 2007 - $46.4 raised via private placement
  • Q4 2009 - $57 million equity capital raised
  • Q4 2010 - Filed for a shelf for $250 million
  • Q1 2011 - $66 million equity capital raised

Zhongpin's most recent misrepresentation of capital requirements occurred in late 2010.

  • November 9, 2010- HOGS discloses in its 10-Q for the period ended September 30, 2010 that existing funds "will be sufficient to finance our investment in new facilities, operating requirements and anticipated capital expenditures of approximately $105.8 million over the next 12 months."
  • December 11, 2010 - Within 1 month, HOGS filed a $250 million shelf filing (over 1/3 of market cap at the time), and disclosed that Selling Stockholders may sell as many as 9.5 million shares. (Nearly 25% of the total shares currently outstanding).
  • March 7, 2011 - On page 10 of its 10-K, HOGS disclosed that it intended to invest over $180 million in upcoming capex projects, roughly 80% more than disclosed in previous November 9, 2010 10-Q for the period ended September 30, 2010.
  • March 21, 2011 - HOGS announces closing a $70.5 million equity offering at $14.10 per share, and that $84 million was raised separately via a debt financing for a total of $155 million in Q1 2011 alone.

Table 5 - Zhongpin Capital Raising Activity - 2006 to 2011

Raise Type

2006

2007

2008

2009

2010

2011

Cumulative

Combined

Equity (net long term debt, millions $)

23

63

0

57

0

66

209

$432*

Debt (net long term debt, millions $)

0

12

43

32

49

87

223

Click to enlarge

Source: Zhongpin 10-K's, 2006 through 2011

*Making this number eye-opening is the $457 million that has been spent on capex through first half of 2011.

Appendix I shows a series of SEC disclosures spanning several years, HOGS explicitly notes that it will not need to raise additional equity capital. It then proceeded to do just that shortly thereafter. The information in the appendix reveals that HOGS was very clear in its filings to supposedly differentiate between when it needed or did not need to raise equity capital. This shows that HOGS' SEC filing statements were not boiler plate in nature and management knew exactly what it was saying.

Additionally, in order to sustain a multiyear financing binge, HOGS has devoted extensive efforts to promote its stock. Zhongpin has become one of the more prolific presenters at international investor conferences and has issued press releases indicating impending stock buybacks by management and the company.

Over the past 12 months, HOGS has presented at or attended the following events to promote its stock price:

  • September 13, 2010 - Rodman & Renshaw Conference, New York, NY
  • May 16 & 17, 2011 - Morgan Stanley Investor Summit, Hong Kong
  • May 23 - 26, 2011 - 2nd Annual Deutsche Bank Access Conference, Singapore
  • May 30 & 31, 2011 - Facility Tours
  • May 31 to June 1, 2011 - 2nd Annual World Meat Exhibition, Beijing, China
  • June 1, 2011 - J.P. Morgan China Conference, Beijing, China
  • June 28 - 29, 2011 - 11th Annual Oppenheimer Consumer Conference, Boston, MA
  • July 29, 2011 - Facility Tours

Finally, despite its seemingly urgent need for more capital, HOGS made the contradictory announcement on June 6, 2011 that it would be buying back up to $10 million in stock.

Unrealistically Low Inventories Implies Inflated Sales

Hogs inventory as a percent of sales has declined from 7% in 2006 to 2.8% in 2010. We believe this is strange since the business has not changed substantially. It would therefore seem logical that the inventory as a percent of sales would not change by so much unless the business has changed, which it has not.

A change from 7% of sales to 2.8% of sales is very significant, and is a red flag because it is not likely they would be able to operate on such a smaller amount of inventory in relation to sales. It is noteworthy that accounts receivable also declined as a percent of sales over time. It seems plausible that hogs was reporting its true inventory, but using inflated sales in 2010 to support the capex spending they have reported. This would account for the decline in both inventory and accounts receivable as a percent of sales.

While it is possible there is another explanation, we believe inflated sales makes the most sense in this situation. It's also curious that HOGS inventories declined in some years where sales were supposedly expanding rapidly.

Table 6 - Zhongpin Sales vs. Inventory (in millions)

Year

2006

2007

2008

2009

2010

Sales

144

291

540

726

947

Inventory

10

26

16.7

33.9

26.5

Inventory as % of sales

7%

8.91%

3.1%

4.66%

2.8%

Click to enlarge

Suspicious Loan Guarantee

See Appendix III for the suspicious loan guarantee HOGS made in 2010 as well as questions and concerns regarding this arrangement.

Rounding up the Usual Suspects: Auditors, Promoters and Management

See Appendix V for what we feel are other flags indicative of susceptible circumstances surrounding a company such as Zhongpin.

Conclusion

We view the HOGS case as a new and potentially more sophisticated form of deceptive practices than we have previously witnessed in the China small cap space. We have already exposed the more blatant and easy to identify frauds committed by PUDA, YUII and others.

We are not calling into question the viability of HOGS as a real company, but rather the company's claim to be as large and profitable as portrayed. We believe it is not. Consider, for example, that the company's 2009 SAIC and SEC documents do not match.SEC net income in 2009 was nearly 500% greater than SAIC net income. And, adding further to our concerns is that we estimate 2010 net income at no more than $10-$20 million vs. $58 million reported by HOGS to the SEC, so there are clearly issues with the company's numbers.

We believe that HOGS may have also taken the additional step to amend the SAIC filings of its parent company or WOFE. The company's SAIC filings are in line with corresponding SEC filings. This ploy, however, is readily noticed since the WOFE, by definition, should not recognize the consolidated revenue and net income of its subsidiaries. Further, management did not take the time and effort to also amend the SAIC filings of the subsidiary companies leaving the parent/WOFE exposed like the prince with no clothes.

Furthermore, in the SAIC file of the WOFE, financial statements exist for only after 2008 but the WOFE was established in 2005. We find it very odd that we could not locate 2005-2007 financial statements in the SAIC filing even though they should be included.

There is also the issue of HOGS' capex which far exceeds the costs per ton of its industry peers. HOGS claimed capex for capacity expansion of around $515 per ton for its 2011/2012 initiatives and about $682 per ton for the period from 2006 to 2010, the latter being more than double the capex costs reported by its industry peers. In fact, Roth Capital recently dropped its rating on HOGS based on capex concerns. We note that HOGS management apparently got the capex memo as the cost per ton for capacity expansion initiatives announced in its Q II earnings release are significantly less than previous expansions. The company's August 8th press release details three capacity expansion initiatives that will cost an aggregate of $183 million and add 325,000 tons capacity. That's an average cost of around $563 per ton, still well above the costs per ton reported by other major pork processors.

Finally, there is the issue of HOGS' inventory levels vs. its sales. In 2007, HOGS generated $291 million revenues and ended the year with $26 million inventory. In 2010, the company recorded revenues of $947 million and, once again, ended the year with only $26.5 million inventory. How is it possible to generate more than three times the volume of sales with the same inventory levels?

Based on our findings, we can reach no other conclusion than HOGS has consistently embellished its story since becoming a public company and that its financial results have been exaggerated to a material extent. We are therefore short this stock.

Our high end 2010 net income estimate of $20 million based on SAIC filings equates to EPS of $0.56. Applying a P/E of 5 or generous P/E of 10 on this EPS estimate yields a price target of $2.80 to $5.60.

Disclosure: I am short HOGS. Risks do exist when shorting companies where revenues between PRC and SEC filings are in line, but diverge on the net income line. Such companies still may possess some “perceived” value as a going private candidate (to institutional firms who may be oblivious to the fraud case), especially if the net income difference is related to tax avoidance schemes. Still, in the current environment, companies that may have manipulated SEC documents have left themselves open to significant risk. We will have more on the “going private games” and why we think PE firms may be making some risky bets that might not pan out. See our Terms of Service here.