On page nine of Harbin Electric’s 2010 annual report is a real snoozer of a paragraph, a combination of mandatory disclosure and corporate boilerplate drearily familiar to investors the world over:
No customer accounted for more than 10% of the total revenues for the fiscal year ended December 31, 2010. Two major customers accounted for approximately 22% of the net revenue for the fiscal year ended December 31, 2009, individually accounting for 12% (Daqing Xinchengtai Technology Co., Ltd.) and 10% (Jiangsu Liyang Car Seat Adjuster Factory), respectively. At December 31, 2009, the total receivable balance due from these two customers was $22,835,846, representing 24% of total accounts receivable. Three major customers accounted for 43% of the net revenue for the fiscal year ended December 31, 2008, with each customer individually accounting for 16% (Jiangsu Liyang Car Seat Adjuster Factory), 15% (Daqing Xinchengtai Technology Co., Ltd.) and 12% (Guiyang Putian Logistic Co., Ltd.), respectively. At December 31, 2008, the total receivable balance due from these customers was $26,253,907, representing 87% of total accounts receivable.
Not quite riveting to be sure, but it’s the sort of textual sludge that we wade through religiously, seeking insights about revenue concentration and potential threats to corporate balance sheets and cash-flow statements from problematic receivables.
There is an important caveat, however. Most corporations actually have the customers they disclose in these filings; Harbin does not.
Harbin has made up tens of millions of dollars of annual revenue and receivables for several years running, according to assertions made in a pair of interviews with the senior management of Jiangsu Liyang, a company that Harbin has asserted in its 10-Ks is one of its best customers.
An American investigator living in Beijing conducted the interviews last week, posing as a buyer for a fictional American auto parts wholesaler. The interviews, with Wei Shen, Liyang’s sales director, and Ms. Ma, its general manager and head of quality control (a position broader than just quality assurance, involving oversight of manufacturing and delivery processes), are here and here. The tapes are unedited, save for the removal of the investigator's name.
The interviews have both executives stating that Jiangsu Liyang barely does any manufacturing of electric car-seat adjusters, a fact contradicting Harbin’s filings. While there remains some chance that Harbin does some small amount of business with the company, both executives remarked that what little electric business they do is primarily supplied by a China-based unit of Johnson Controls (JCI).
Moreover, with approximately $27 million and $30 million in annual sales for 2009 and 2010, respectively, the Jiangsu Liyang portrayed by its executives is in no way big enough to do the business volumes Harbin’s filings claim. For example, with roughly $27 million in 2009 revenues–which, according to the executives, is 98% manual car-seat adjusters–the $19.3 million or so in motors Harbin asserts it is selling the company represents a big disconnection.
The interviews put matters into stark relief for investors: If Harbin’s SEC filings are to be believed, both Jiangsu Liyang executives would have to be profoundly incompetent, having no knowledge of their products and key suppliers. Or, alternately, they both simultaneously lied to a prospective client when it would be to their benefit to represent their company as larger and higher tech than it is.
If the Jiangsu Liyang’s executives are credible, however, then Harbin is perpetrating a financial fraud sharply larger than the many red flags already suggested in its filings. As such, the rank nature of the fraud alleged makes it difficult to imagine that this is the only customer where revenues are problematic.
Regardless, on-the-record evidence from a key customer that casts doubt on 10% or more of a company’s revenues should absolutely serve to put its auditors and regulators on notice. [Harbin’s auditor, the truly beleaguered outfit of Moore Stephens--the former Frazer Frost--has been the auditor of record for a host of frauds so spectacular they literally call out for cinematic treatment. Here is their resignation letter for Puda Coal, a company that did to its investors what the Germans did for Russian real estate values during the Second World War.]
The interviews also broadly jibe with Jiangsu Liyang’s credit report (pdf) referenced in an August 3 story on short-seller Andrew Left’s Citron Research site, estimating that the car-seat company was doing about $24 million in revenue.
Mostly, however, the interviews raise a much more fundamental question about market integrity: Exactly what does it take to get market surveillance officials at NASDAQ to start requesting documents and asking some uncomfortable questions of companies like Harbin that pay the for-profit exchange handsome fees to list there?
Based on recent history, it takes an auditor’s resignation for them to act, which is troubling since the stock regularly trades hands more than a million times daily and, as noted above, those investors have been making decisions without the faintest outline of Harbin’s actual financial condition.
Though frauds–and that is a word now fairly applied to Harbin in light of the Jiangsu Liyang executive interviews–are often shocking, there is little about Harbin that wasn’t fully foreshadowed in many, many places.
Nor should investors be faulted for taking some risk and playing what looks like the easiest arbitrage in recent memory. Where the problems arise is the American regulatory apparatus that has blown through a host of warning signs and allowed Harbin to stage its drama for going on a full year now. These tapes, if the vows made after the sub-prime and Madoff scandals are to be taken seriously, should be the script for the much overdue final act.
Disclosure: I do not have any sort of investments in the securities of any company I write about, nor for that matter, in anything at all (save for my house).