Lihua International And The Danger Of Chinese RTOs

Sep. 1.11 | About: Lihua International (LIWA)

Since October of 2010, numerous allegations of fraud have been made against U.S.-listed Chinese reverse merger companies. The publication of detailed research reports documenting significant accounting discrepancies, auditing deficiencies, undisclosed related party relationships and various other indications of financial fraud have caused the share prices of many Chinese RTOs to plummet, and has eroded investor confidence in the sector as a whole.

The dissemination of research has been spearheaded in large part by buyside fund managers and independent research firms. Fraud reports by firms such as Kerrisdale Capital, Citron Research, Muddy Waters Research and Bronte Capital exposed what appear to be widespread, systemic irregularities in the Chinese reverse merger space. Growing awareness of these issues prompted investigations by both the SEC and PCAOB, the findings of which were not reassuring. The SEC issued an Investor Bulletin cautioning investors about reverse merger companies in June, and has attempted to actively engage Chinese regulators to improve accounting transparency and investor protections.

Lihua International (NASDAQ:LIWA) has recently become the focus of heated debate between bearish and bullish investors. I would like to shed some light on LIWA and, more importantly, explain why I believe American investors should not invest in Chinese RTOs. As a native of China, I think I can contribute some unique insights into the debate.

  1. Educational Background of Company Founders & Management. The personal and educational background of key personnel is an important factor to consider before investing in a Chinese company, particularly a Chinese RTO.

As a Chinese native, I know that the majority of people born in China between 1940 and 1960 had little access to formal college education. The college education system was essentially shut down by Mao and his supporters during the brutal Cultural Revolution (1966-1976), a period defined by unrest, instability, class warfare and lawless politics. Chinese residents who grew up and came of age under this oppressive movement tend to have very different perspectives on ethical and legal issues than those who did not. They were denied formal education and learned at a young age that currying favor with corrupt state and local officials was an effective way, often the only effective way, to survive and succeed. Sadly but naturally, this generation now controls much of China's political, economic and legal system.

Many of the founders and upper management of Chinese companies are from this age group. American investors should take that into consideration and not invest in any Chinese company without first researching its key personnel. I would advise anyone looking for investment opportunities in China to seek out companies whose principals were born after 1960. These younger CEO/founders, such as Robin Li of Baidu Inc. (NASDAQ:BIDU) and Charles Zhang of Sohu.com Inc. (NASDAQ:SOHU), tend to have college educations from China and advanced degrees from the United States, and are therefore far more likely to be of a mindset that falls in line with the legal and compliance expectations of American investors.

In the case of LIWA, the company’s CEO/founder and COO both came of age during the Cultural Revolution and have no formal college education. I am certainly not suggesting that every person who was exposed to the Cultural Revolution is unethical, but I do believe this experience is often reflected in the attitudes of those who lived through it. As an investor, one needs to know the executives’ backgrounds and that company management may share a vastly different framework of ethics and legal compliance perspectives than the investor does.

  1. Location of Company Operations. Investors should be especially wary of investing in Chinese RTOs located in small cities and towns because of the high prevalence of fraud and corruption in small local governments and institutions.

China has seen tremendous economic growth over the last thirty years, but this economic boom has not been accompanied by meaningful reform and development in the political system. The country continues to be plagued by rampant corruption, particularly at the local government level.

In small towns and cities, the national government does not have the ability to effectively monitor the behavior of local officials and enforce legal compliance. Bribery is commonplace. In major cities such as Beijing or Shanghai, it is almost impossible to have government filings changed by bribing an official, but in small towns and cities, where local officials are essentially unsupervised and the risk of punishment is low, it is possible to have prior tax filings and other government documents altered for as little as $20,000.

U.S.-listed companies located in small communities are generally important players in the local economy and have the funds and influence to develop close ties to local officials. Companies whose operations are based in third-tier and even second-tier cities are able to cultivate relationships with tax collectors, recorders, local SAIC officials and local banks. In the case of Longtop Financial Technologies (LFT, now trading on the pink sheets as LGFTY), fraudulent bank statements were submitted to Longtop’s auditor, Deloitte Touche, by a local bank in the second-tier city Xiamen. Deloitte later verified these statements with the bank’s headquarters in Beijing and found they had been falsified. Deloitte subsequently resigned as auditor, stating in its resignation letter that it had experienced “deliberate interference by certain members of Longtop management.”

LIWA’s operations are based in Danyang, a tiny, fourth-tier city located in the Jiangsu Province. I’m familiar with Danyang because I’m from the Jiangsu Province and happened to have college classmates from the city, but many residents in China have never even heard of the town. LIWA is undoubtedly a major player in the Danyang economy, and likely receives favorable treatment from local officials.

In a city like Danyang, the authenticity of tax documents and bank statements can not be relied upon. Small town officials are eager to help U.S.-listed companies in their local communities, and the national government does not have the oversight to prevent local banks and officials from accepting bribes and engaging in fraud. Even verification of cash balances by independent third parties can not be considered dependable if the verification process relies on statements from local banks.

Investors should stay away from Chinese RTOs whose operations are based in small communities. Government and institutional corruption in small towns and cities is so widespread that documents issued from these locations can be unreliable to the point of meaningless. Companies located in first-tier cities are safer investments, because at least investors can be reasonably certain official government documents have not been altered.

  1. Reported Financial Results Are Too Good To Be True. Investors should not invest in companies that report exceptional financial results which can not be rationally explained.

Many Chinese RTOs report financial results that seem to defy logic. These companies are often small cap, commodity businesses with no significant technological advantage, yet they report profit margins double or triple those of their nearest competitors.

LIWA currently has a trailing 12-month P/E of 4.5 with a reported operating margin around 12% and return on equity of 29.5%. But LIWA also reports great growth in China. Why would a company that reports great growth trade at these undervalued levels? It is more likely that these numbers have been fabricated to appeal to American investors.

  1. Lack of Corporate Governance. Investors should only invest in companies that have legitimate, effectively functioning corporate governance in place.

Chinese RTOs typically hire Americans to serve as board directors, but these American board directors generally have little influence on the operations of the company. The directors are typically paid $20-50K/year and given some stock options, not a bad deal considering the low liability and minimal responsibility the position entails. These outside board directors are put in place to create the appearance of good corporate governance, but in reality they have very little oversight. In a typical Chinese RTO, the CEO/founder essentially controls the company and dictates every aspect of operations including marketing, accounting and production. LIWA appears to fit this model.

In summary, I believe that any reasonable investor should consider Chinese RTOs too risky to be considered an attractive investment opportunity. The method of entry itself is the first red flag, and the widespread fraud and false accounting that has been exposed in recent months are further evidence that investors should stay away from this sector. Chinese RTOs that lack effective corporate governance, report irrational financial results, are located in small communities and are run by principals with no college education are especially likely to be engaging in fraud. Investors should not be fooled by the reported financial results of LIWA, a company which exhibits all of these warning signs. I urge American investors to avoid Chinese RTOs that exhibit large numbers of red flags and put their money into safer, less problematic investments.

Disclosure: I am short LIWA.

Additional disclosure: I stand to benefit financially from the decline of the stock price.