In our experience with the Chinese reverse merger sector, capital expenditure shenanigans are frequently used to cover up accounting fraud. One of the most commonly employed techniques involves overpaying for assets, or making up expenditures, in order to disguise the booking of fictitious profits. For readers unfamiliar with this type of CAPEX fraud here is a simple example.
Company A claimed to earn $10 million, but in reality only earned $1 million. During the audit process, the auditor will attempt to verify the $10 million in profits at the bank. Obviously the company does not have $10 million and will have only $1 million, so what do they do? Make up a $9 million capital expenditure to explain why the money is not there.
We see dozens of variations of this basic scheme, and nearly all of them are fooling the auditors in China. That is why it is imperative for investors to check a potential investment's claimed CAPEX and verify that the assets were actually acquired and the claimed price is equivalent to market price. If a claimed capital expenditure doesn't make sense, it is an excellent indicator of the booking of fictitious profits or that management is siphoning money away from investors.
Exceed Company Ltd. (NASDAQ:EDS) is a company we have written about before. Since our initial publication the CFO has resigned, board changes have occurred, and stock analysts have declared EDS "a failed first attempt as a public company." EDS provides a case study of the CAPEX fraud depicted above. EDS recently claimed to spend approximately RMB 198,000,000 on acquiring 600 acres of land for a new production facility. While EDS does not disclose the exact location of the project, some Baidu searches determined the land is located in the Ruichang Industrial Park. An article on the Ruichang Government's website and an article on the Industrial Park's website confirm this.
EDS claimed to spend approximately 330,000 RMB per acre (Note: we are discussing Chinese acres, which are 1/6th the size of a U.S. acre). However the Introduction (translated version here) to the Ruichang Industrial Park states the land is priced at the national benchmark 80,000 RMB per acre.
We then contacted the Ruichang Industrial Park posing as a company wishing to acquire land there. They referred us to contact the Ruichang Commercial Bureau. However the operator told us that the land would cost 80,000 RMB per acre. The transcript and recording can be found under "Land Transaction," on our website.
We then called the Commercial Bureau who transferred us to the Section Chief. The Section Chief actually told us we would have a difficult time hiring workers. Once again he told us the land is the official national price of 80,000 RMB per acre. In fact he stated it would not cost more than 80,000 RMB per acre and that it could even become cheaper depending on the conditions of the deal. The transcript and recording are also under "Land Transaction."
Land in the Ruichang Industrial Park costs 80,000 RMB per acre, we confirmed this via the Introduction to the Industrial Park document, talking to an employee of the Park, and by interviewing the Section Chief. Why then is Exceed Company Ltd. claiming to pay 330,000 RMB? In our opinion Exceed Company paid 80,000 RMB per acre, which leaves the question; where is the missing 150,000,000 RMB, or did it ever exist?
Disclosure: I am short EDS.