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Isaac Silbermann
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I am a former analyst, now full-time investor. I may take long or short positions in companies that I write about, although my focus is on uncovering what I believe to be questionable companies and transactions. I will always provide disclosure whenever I publish a blog post. I will never... More
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  • China Agritech: A Serial Fundraiser With Negligible Fixed Assets, Ballooning Accounts Receivable and Consistently Negative Operating Cash Flow
    If one looks at the income statements of China Agritech (CAGC), a China-based producer of organic fertilizers, they seem impressive. CAGC has posted positive net income during every year of their existence as a public company, including during the recent global downturn. Yet if one looks beyond the accounting number of “net income” and engages in deeper examination of their financial statements, one can’t help but notice major red flags indicating that their stated “net income” is deceptive within the context of evaluating the overall health of their business.

    CAGC’s Serial Fundraising Activities

    CAGC has been an extremely active fundraiser during their time as a US-publicly listed company, with 4 separate major transactions to date.

    On January 13, 2006, CAGC sold 4,800,000 shares (2,400,000 adjusted for splits) of common stock to 22 investors for a total of $12,000,000 in a private placement transaction.

    On July 6, 2007, CAGC sold 5,556,000 shares (2,778,000 adjusted for splits) of common stock to 20 investors for a total of approximately $15,000,000 in a private placement transaction.

    On October 19, 2009, CAGC sold 1,392,768 shares of common stock, and warrants to purchase up to 928,514 shares of common stock at an initial exercise price of approximately $10.77 per share, which is subject to adjustment.  The total aggregate purchase price was $15,000,000. 

    The most recent quarter was CAGC’s largest transaction to date. From the June 2010 10-Q

    “Net cash generated from financing activities increase of $30.8 million, which is principally attributable to the cash proceeds from the public offering of 1,243,000 shares of our common stocks and the exercise of the warrants 186,450 shares with exercise price $16.10 per share with total consideration $20.1 million and on June 21, 2010, the Company received net proceeds $10 million from the exercise of the 2009 warrants, with 1,857,024 shares (928,514 Pre-stock split) at exercise price $5.385 per share.”

    From the beginning of 2006 to the middle of 2010, CAGC raised over $72 million. Yet startlingly little of this money actually went to fund any type of growth in physical assets...

    CAGC’s Property, Plant and Equipment Account (Book Value)

    From 2005 10-K
    – They had $1,398,987 in BV for PPE (Pre-amortization)
    From 2006 10-K – They had $3,017,164 in BV for PPE (Pre-amortization)
    From 2007 10-K – They had $4,692,738 in BV for PPE (Pre-amortization)
    From 2008 10-K – They had $6,014,282 in BV for PPE (Pre-amortization)
    From 2009 10-K – They had $8,194,176 in BV for PPE (Pre-amortization)
    From June 2010 10-Q – They had $8,694,113 in BV for PPE (Pre-amortization)

    Piecing this all together, we see that from the end of 2005 until the middle of 2010, a time period in which CAGC raised $72 million, they invested a mere $7.3 million, or approximately 10% of funds raised in fertilizer manufacturing equipment, facilities and supporting physical assets. The majority of the money that they raised was instead used to fund ever-increasing accounts receivables. Contrast the growth in physical assets to the growth in receivables.

    CAGC’s Accounts Receivable Growth

    From 2005 10-K
    – $8,525,185 in AR (Net Allowance for Doubtful Accounts)
    From 2006 10-K – $12,239,073 in AR (Net Allowance for Doubtful Accounts)
    From 2007 10-K – $22,695,039 in AR (Net Allowance for Doubtful Accounts)
    From 2008 10-K – $34,773,115 in AR (Net Allowance for Doubtful Accounts)
    From 2009 10-K – $39,256,098 in AR (Net Allowance for Doubtful Accounts)
    From June 2010 10-Q – $51,203,710 in AR (Net Allowance for Doubtful Accounts)

    For the time period in question, CAGC invested $42.7 million, or almost 60% of the total funds raised into accounts receivables growth. The problem with allowing such unrestrained growth in accounts receivables is that although it allows the company to post a “net profit” based on its income statement, it prevents the company from ever actually generating operating cash flow. This means that the company will never truly be able to fund its own “growth” and will continuously need to return to the financial markets in order to make up the difference, continuously diluting shareholders in the process.

    CAGC’s Operating Cash Flows – Consistently Negative Despite Positive Net Income

    CAGC consistently reports impressive net income numbers, however their cash flow statement tells a starkly different story. Net income is an accounting figure while operating cash flow much more accurately reflects the health of a business.
    From 2006 10-K – Net income was reported as $5,349,338, while total operating cash flows based on the cash flow statement were ($3,161,889).

    From 2007 10-K
    – Net income was reported as $8,528,625 while total operating cash flows based on the cash flow statement were ($4,647,180). 

    From 2008 10-K
    – Net income was reported as $8,641,741 while total operating
    cash flows based on the cash flow statement were ($893,416).

    From 2009 10-K
    – Net income was reported as $5,689,647 while total operating cash flows based on the cash flow statement were ($3,535,258).

    From June 2010 10-Q
    – Net income was reported as $11,790,296 while total operating cash flows based on the cash flow statement were $1,048,159.

    In summary, we see for the 4.5-year period in question, CAGC reported $39,999,647 in net income, yet their operations actually had negative cash flow of $11,189,584. Something troubling about this use of cash, especially in CAGC’s case, is that investment in accounts receivable vs. investment in fixed assets seems particularly subject to potential catastrophic loss due to droughts, frosts and poor harvests. They even admit as much in their 2009 10-K:

    “We typically extend our liquid fertilizer’s customers credit for their purchase of our products to allow them use the proceeds of their harvests to repay us for their purchase of our products…If customers responsible for a significant amount of accounts receivable were to become insolvent or otherwise unable to pay for products and services, or to make payments in a timely manner, our business, results of operations or financial condition could be materially adversely affected. A natural disaster, such as a wildfire, flood or drought, or an economic or industry downturn could materially adversely affect the collection of these accounts receivable, which could result in longer payment cycles, increased collection costs and defaults in excess of management's expectations.”

    This is not even beginning to address the potential for management to manipulate sales and net income figures by extending credit to parties who are not credit-worthy and will never have the ability to settle their accounts. Considering that management has already been shown to withhold material information from shareholders in order to boost their income figures as recently as Q1 2010, and considering management as already shown that they are willing to manipulate income figures by withholding information and the numerous other questionable activities of CAGC’s management, both past and present, investors should not discount this possibility.

    In conclusion, while CAGC has reported impressive numbers in terms of “accounting net income” the real picture is that CAGC’s earnings quality during their entire existence as a publicly listed entity has been remarkably poor. CAGC has not generated positive operating cash flow for a single year of their operations as a public company. It certainly begs the question as to why they are even “expanding” their business in the first place. It probably would have been better off for shareholders if CAGC had never subjected them to massive dilution in order to expand their business and had instead focused on true value creation via generation of operating cash flow.   

    Disclosure: short CAGC
    Oct 11 4:28 AM | Link | Comment!
  • China Agritech: The Case of The Missing Receivables and Factory Space
    China Agritech, a China-based manufacturer of organic fertilizers, has extremely high levels of accounts receivables (“AR”). In fact, based on the figures in their 2009 10-K, as of the end of 2009, accounts receivable represented almost 40% of their overall assets, while days of sales outstanding (“DSOs”) stood at 188 days, meaning that China Agritech had not received payment for over half of the revenue that they booked in 2009. While this should be viewed as a red flag itself, there is something that may be even more troubling to investors than the high DSOs. What I am referring to is the almost $1 million worth of receivables that simply vanished without explanation between the end of 2007 and the end of 2008.

    Inconsistent Numbers for Accounts Receivable From 2007 to 2008 – What Happened to Almost $1M in Accounts Receivable?

    Examining Note 2 (d) of the 2007 10-K, it is stated that the CAGC had AR of $22,695,039 net of allowance for doubtful accounts of $227,981. Moving on to 2008’s 10-K, Note 4 reports the number for 2008's accounts receivable $34,773,115 net an allowance of $448,606. But a taking a closer look at Note 4, one will also notice that there is also a figure given for 2007’s accounts receivable. Examination of this number and the number on the comparative balance sheet filed with the 2008 10-K reveals that this number has changed to $21,876,368, net of the same allowance of $227,981. This accounting inconsistency represents $818,671 worth of receivables, or about 4% of 2007's overall AR, and deserves further attention.
    There is no mention of any write-down of $818,671 in accounts receivable in the 2008 10-K. Had this been the case, CAGC's 2008 operating expenses would have increased by over 12% and net income would have decreased by approximately 10%. Such a large write-down of receivables should certainly have been noted in the 2008 10-K if it had occurred, especially since it would have represented 360% of 2007's stated allowance for doubtful accounts and almost 200% of 2008’s allowance. This would have been an indication that CAGC had been seriously mistaken in their estimate regarding bad debt expense. But again, based on the 2008 10-K, no such write-down occurred.
    No 10-K/A amendment was ever filed for the 2007 10-K to correct the original AR number, so this can also be ruled out as a possible explanation. Additionally, the allowance for doubtful accounts remained exactly the same in US dollar terms, which rules out that this adjustment is simply due to a change in the USD/RMB conversion rate.
    This begs the question, what exactly happened to the $818,671 worth of accounts receivable from 2007 that seems to have disappeared between 2008 and 2007? Is it just a coincidence that these receivables curiously went missing in 2008, the year that current CFO Yau Sing Tang was appointed to the position? Perhaps, but considering his past financial history, this incident deserves serious attention by CAGC investors.

    CAGC's Curiously Inconsistent Reporting of Factory Space  

    Accounts receivable isn't the only thing that has gone missing from CAGC’s financial statements. CAGC has also been remarkably inconsistent in the reporting of factory floor space at their Harbin facility, which is leased in a related-party transaction from CEO Yu Chang and director/former COO Xiao Reng Teng. 
    From the 2006 10-K:

    “We currently lease 9,878 square meters in the aggregate for office space and manufacturing facilities in Harbin, China where our subsidiary Pacific Dragon is located. The lease has a 10-year term which runs from January 1, 2004 to January 1, 2014. Our current rent due under this lease is approximately $450,000 (RMB 3,600,000) per year.”

    In the 2007 10-K, the floor space reported decreased to only 7,018 sq. M, while the rent paid to Mr. Chang and Ms. Teng has remained the same. What happened to the other 2,860 sq. M? No explanation is given.

    In the 2008 10-K, the number increases again to 9,878 sq. M, and again, no explanation is given for the increase.

    In the 2009 10-K, this number has decreased again to 7,018 sq. M. Yet again, no explanation is given for the inconsistency.

    As of the June 2010 10-Q, this number has remained at 7,018 sq. M, while there has still been no explanation offered as to what occurred to the other 2,860 sq. M that is presumably covered under the original lease mentioned in the 2006 10-K.

    My understanding of how industrial leases typically work is that the lessee pays the lessor based on the amount of space that they rent. Yet despite the factory footprint inexplicably shrinking by 29%, the rent has stayed consistent throughout the period of the lease from 2006-2010. This is also suspicious, especially due to the related-party nature of the lease itself.

    In conclusion, CAGC has been inconsistent in their reporting of both accounts receivable and factory floor space covered under their related-party lease with CEO Yu Chang and director/former COO Xiao Rong Teng. The case of the vanishing receivables should be particularly disconcerting to shareholders because receivables comprise such a large portion of CAGC’s asset base. These accounting inconsistencies represent further red flags that investors should consider carefully prior to investing in CAGC.

    Disclosure: short CAGC
    Oct 11 4:17 AM | Link | Comment!
  • China Agritech: More Related-Party Corruption
    In my first article about related-party transactions at China Agritech, I established that CEO Yu Chang and director/ex-COO Xiao Rong Teng are siphoning money away from the public company CAGC and into their own pockets via significantly above market price related-party leases. However, these leases are not the only transactions in which Mr. Chang and Ms. Teng are using their positions as officers/directors of the public company CAGC in order to enrich themselves at the expense of CAGC shareholders. This article will examine another instance of corrupt self-dealing on the part of Mr. Chang and Ms. Teng, the buyout of their 10% minority interest in one of CAGC's operating subsidiaries, Pacific Dragon.
    When CAGC went public via a reverse merger transaction in 2005, CEO Yu Chang and director/ex-COO Xiao Rong Teng did not vend their entire interest of the Harbin-based operating subsidiary, Pacific Dragon, into the public company. They decided to keep 10% of the subsidiary under the ownership of their personal company, Yinlong. Over the years, as CAGC expanded their operations they also created more operating subsidiaries to hold the various new interests of the company. Beijing Agritech was formed for the Beijing operations, Anhui Agritech was formed for the Anhui operations and Xinjiang Agritech was formed for the Xinjiang operations. From the 2009 10-K:
    "Corporate Structure
    China Agritech, Inc. is a holding company with no operations. We are the parent company to our operating subsidiaries, Pacific Dragon, Anhui Agritech, Beijing Agritech and Xinjiang Agritech, which are located in the PRC.
    On June 29, 2006, the Company established a wholly owned subsidiary, Anhui Agritech.
    On November 1, 2006, the Company and the stockholders of CAI Investment, Inc (the “CAI stockholders”) entered into an equity transfer agreement whereby the CAI stockholders transferred 100% equity interest in CAI Investment, Inc. (“CAI”) to the Company in exchange for $1,000. CAI holds 100% equity interest in Beijing Agritech.
    On December 23, 2008, the Company formed Xinjiang Agritech, a PRC entity. Beijing Agritech and Anhui Agritech hold 75% and 25% of the equity interests, respectively, in Xinjiang Agritech."
    Four years after the initial reverse merger, Mr. Chang and Ms. Teng decided that it was time to sell their remaining 10% interest in Pacific Dragon. According to Note 15 of the 2009 10-K:
    "On February 12, 2009, Tailong entered into a share purchase agreement with Pacific Dragon and Yinlong and a supplemental purchase agreement among Yinlong, Pacific Dragon, Mr. Yu Chang and Ms. Xiao Rong Teng pursuant to which Tailong agreed to acquire Yinlong’s 10% interest in Pacific Dragon for a cash payment of $1,000,000 and issuance of 1,745,000 shares (as retroactively adjusted the 1-for-4 reverse split on September 8, 2009 and the 2-for-1 forward split on February 1, 2010) of the Company’s common stock in the Company. On the same date, Tailong completed the acquisition and Pacific Dragon has since become a wholly-owned subsidiary of the Company.”
    By any measure, the public company China Agritech significantly overpaid Mr. Chang and Ms. Teng for the acquisition of the minority interest, as I shall demonstrate. According to the 2009 Q1 10-Q, the annual production capacity as at the end of 2008 was 13,000 MT of liquid fertilizers, and 100,000 MT of granular fertilizer. Based on CAGC's own press release from 4 months later, we can determine that the production capacities of the Pacific Dragon operation as at February 12, 2009 were as follows:
    Harbin (Pacific Dragon) – 5,000 MT of liquid fertilizer
    We can see that at the date of the acquisition, the Pacific Dragon portion of CAGC's overall production capacity is 38.5% of liquid fertilizer capacity and 0% of granular capacity. This means that the 10% minority interest in Pacific Dragon represented 3.85% of CAGC's liquid fertilizer production.
    Looking at the balance sheet of the Q1 2009 10-Q, we see that at the end of Q1 2009, CAGC had 12,349,808 shares outstanding (adjusted the 1-for-4 reverse split on September 8, 2009 and the 2-for-1 forward split on February 1, 2010).
    After the issuance of the new shares to Mr. Chang and Ms. Teng, CAGC had 14,094,808 shares outstanding (split-adjusted). The new shares now represented 12.4% of CAGCs shares outstanding, while the actual acquisition only represented 3.85% of CAGC's liquid fertilizer production and 0% of granular fertilizer production. In addition to the new shares, Mr. Chang and Ms. Teng personally received $1M in cash from the public company CAGC. Even if the Pacific Dragon minority interest had represented 10% of CAGC’s entire production, which it did not, Mr. Chang and Ms. Teng could not justify the price paid.
    What should be plain and obvious from all of this is that CAGC grossly overpaid for the acquisition of the 10% interest of Pacific Dragon. CAGC probably overpaid CEO Yu Chang and Director/ex-COO Xiao Rong Teng by about 3-4 times for this acquisition, based on the amount of additional production it received. Perhaps this is why no independent fairness assessment was done on this acquisition. An additional interesting piece of information is that the new shares were issued to Sammi Holdings, an offshore holding company owned by Mr. Chang and Ms. Teng. Why might Mr. Chang and Ms. Teng choose to place these new shares into this entity instead of directly under their own names?
    In conclusion, Yu Chang and Xiao Rong Teng clearly used their positions as officers and directors of the public company CAGC in order to pay themselves a grossly inflated price to acquire the 10% minority interest in Pacific Dragon. This represents yet another in a long line of documented instances, based entirely on publicly available information, in which CAGC’s management has acted in an unethical and corrupt manner. Management has proven on numerous occasions that they will seize opportunities to enrich themselves at the expense of common shareholders. This disposition should be carefully considered by all potential and existing CAGC shareholders. 

    Disclosure: short CAGC
    Oct 11 3:09 AM | Link | Comment!
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