Clues Suggesting China Medical Technologies Has A Solid Balance Sheet

| About: China Medical (CMEDQ)

The following are clues and indications that China Medical Technologies (CMEDY.PK) has correct financial numbers on its annual reports. None of these clues are conclusive in themselves, but as a whole provide a very strong argument supportive of the stock. Unfortunately, I didn't act on these clues enough when the stock was trading under $1 after being unhalted. However, I was short the stock at the time, and did cover between $1-$1.80, so that reflected some of my doubts that the stock will go back down.

The stock keeps moving higher, and if you're a momentum player, you might want to take a position. However, keep in mind that the management isn't communicating with the shareholders, which makes this stock a wild card. I myself don't have a firm enough understanding of the situation to be comfortable in taking a position. Though I would wager that it will keep going up rather than down, possibly reaching $5.00+.

Most Chinese stocks RTOs that have been halted and removed from an exchange to the Pink Sheets never recover. Stocks like Wonder Auto (OTCPK:WATG), A-Power (OTC:APWR), and China Media Express (OTCPK:CCME) are good examples. So why has China Medical rebounded so strongly? Why would a stock that its management has gone dark and still ignores the shareholders continue going up? Because of a short squeeze? That answer is clearly no. There were only around 6.5 million shares short before the stock was halted in February. That's only about 25% of the float, and the majority of those shares have long been covered.

Because of dumb money pushing it up? That's very unlikely.

At its current price of $3.50, CMEDY.PK has more than tripled since the day it started trading on the Pink Sheets. That's about a $60 million rise. It would take about that much money to make it go up to where it is now and settle there. Why would dumb money, ie retail investors, suddenly invest so heavily in a delisted Chinese company where management has gone silent? The answer is they wouldn't.

The following are some interesting pieces to the CMEDY.PK puzzle:

1. AER Advisors

AER Advisors has shown to have been accumulating a very large position in CMEDY.PK.

  • Here, AER filed a 13G/A on 1/27/12 that it holds 1,948,006
  • shares or 6.04% of the shares outstanding.
  • Here, AER filed a 13G/A on 1/30/12 that it holds 2,026,506 shares or 6.28% of the shares outstanding.
  • Here, AER filed a 13G/A on 2/02/12 that it holds 3,889,177 shares or 12.05% of the shares outstanding.
  • Here, AER filed a 13G/A on 2/21/12 that it holds 4,889,177 shares or 15.15% of the shares outstanding.
  • Here, AER filed a 13G/A on 3/20/12 that it holds 6,040,886 shares or 18.72% of the shares outstanding.

AER Advisors seemed to have gotten greedy when others were fearful with China Medical.

On its website, AER Advisors describes itself as a registered investment advisor that follows a proprietary research methoodology. Founded by Carol and David O'Leary, it seems like a solid, small investment firm. David O'Leary is a CFA and a graduate of Harvard. He is the "mastermind behind AER Advisor's proprietary stock selection methodology". Graduating from Harvard and getting his CFA suggest that this guy is no investment slouch. He wouldn't be the type to make impulsive investment decisions.

Apparently the company only has about $25 million under management as shown here. It manages Powershares Active Fund (NYSE:PQY), which is a small actively managed ETF of only $8.27M in net assets. So why would this seemingly conservative investment advisor put the majority of its assets under management into a crazy-acting microcap Chinese reverse merger?

These were all questions I wanted to know, so I called up AER Advisors and spoke with a guy named "Eric". He has a junior analyst position with the company. He said he wasn't allowed to give me much information about their motives for accumulating such a large position in CMEDY, but he was willing to talk. He seemed a little bit embarrassed about their large position, but upon reflection I don't think that means much. He has no reason to convince me, a random caller, whether it's a good investment or not. He said they have gotten some calls from bondholders asking similar questions. He said they have some kind of an "umbrella" arrangement with a third party about their holdings. Maybe they bought all those shares and are holding onto them for an insider or related party to the company? I'm not sure what the legalities are for that but I assume a company like AER Advisors is up to par with regulations. I asked him if his company had any more information about China Medical than anyone else, and he said no. I also mentioned that the company's auditor, PWC Zhong Tian, has a very good track record for staying away from fraudulent companies. Eric responded with something similar to what I said in my previous article, that an auditor's job is just to make sure the numbers are correct, but the auditor doesn't look deep into the company's actions.

2. Bond Action

China Medical's bond price movements are a bearish sign for the company. They have been trading at a wide range of bankruptcy prices, from $15 to $50.

There were several 13G filings for CMEDY in February with bondholders converting their shares to common stock. My cynical side thought that they were doing that to then dump the stock on the open market since the company wasn't making the bond payments. However, it's apparent that the investment companies aren't dumping their shares, they're holding onto them. This is a sign that the company is still solid, but it's hard to say. Does anyone understand what the motive is for these investment companies behind the bond conversions?

3. The Auditor

China Medical's auditor, PWC Zhong Tian, is trustworthy as I showed in this article. If China Medical has fraudulent financial statements, then it will be the first time that PWC Zhong Tian has ever signed off on a fraudulent annual report.

4. Dr. Crum's Response

In February, I emailed and spoke with one of the company's independent directors, Dr. Lawrence Crum. On CMED's annual report for the fiscal year ended June 30,2011, Dr. Crum has served on the board of directors since February 2005, and was a member of the audit committee, compensation committee, and nomination committee. In response to my email, he simply wrote: "I am no longer a Director. L Crum"

In an attempt to try to get more information, I called him on the phone, and was able to reach him. He told me he quit being a director of the company a couple months ago because management hasn't returned his calls. He said he: "hasn't heard from the company, doesn't know what's going on, and doesn't care."

Now at first that might seem like a bad sign for the company. However, on closer analysis, one has to question Dr. Crum's motives. If he has been a part of the company since 2005, he should have an idea if the company is involved in fraudulent activities. Since he was a director, he would most likely be a part of those activites and know if the numbers are reliable to some extent. Would he really respond with a resounding "I don't care" if he was guilty of fraud and at risk of being sued? That seems like the talk of someone who has nothing to worry about, and therefore he truly doesn't care.

5. The Glaucus Report Was Weak

From reading the Glaucus Research Group's report against China Medical, there didn't seem to be much meat to it. This is apparent after reading the company's response to the allegations. The company's response to each of the five allegations make a lot of sense and often makes the Glaucus report look amateurish and full of holes. For example, Glaucus talks about CMED's former auditor resigning after an investigation by the audit committee. This is a baseless accusation. The company switched auditors based on cost and quality of service.

Despite the above positive signs for the company's financials, I really can't recommend it a buy. It's one of those situations that being on the sidelines is best in my opinion. The drawback of investing in the company is no one really knows what management is doing. The company might also be losing market share to its competitors and not be profitable in the future, and management might be trying to cover that up. But whatever is going on internally in the company, there's a strong argument to be made that the financial numbers are real and so is the cash on the balance sheet.

Trade recommendation: Buy (with caution)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.