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  • AutoChina - The Beginning of the End

    AutoChina - The Beginning of the End 

    After the markets closed on June 30th, 2011, AutoChina announced that they were delaying their 20F filing among a litany of other admissions. The press release also disclosed that the Securities and Exchange Commission was investigating the company and an accounting restatement was likely. They also confessed that in addition to the Company, an officer had also received subpoenas from the SEC. Finally, AutoChina disclosed that it had "a material weakness in its internal control over financial reporting as of December 31, 2010, due to a lack of requisite internal U.S. GAAP experience." Despite management's crafty reassurances, "neither the existence of the investigation nor the service of subpoenas means the SEC has concluded that any violations of law have occurred," we believe that these festering problems may be the tip of the iceberg for AutoChina, the "Dependent" Board of Directors, and sadly for shareholders. With the SEC and PwC presumably examining the multitude of unusual accounts and related party transactions (disclosed and perhaps undisclosed), it would not surprise us to see future inquiries and problematic disclosures. The unwillingness of the Board of Directors to even investigate our original alarming analysis speaks volumes about its cozy composition and indifference towards U.S. investors. While it may be a coincidence, a recent call Oppenheimer hosted with two partners from PwC China (AUTC's auditor) on "The State of Accounting for Chinese Companies," seemed to cherry pick the prominent warning signs from its own client, AutoChina.   

    While the rampant and system-wide fraud accusations (and confessions) of Chinese RTO's has surely desensitized many investors, the complacency among AutoChina investors could is shocking. Despite management reassuring and misleading commentary about the business, and attempt to downplay the SEC investigation, we believe there is a high probability that AutoChina's stock will get halted, delisted, and ultimately be another sub-five dollar tragedy. We have tremendous confidence in the SEC, and despite some media criticism, their actions suggest they are aggressively addressing the RTO mess to ensure investors are protected. As the SEC and PwC continue their investigations, we are hopeful that they will consider the concerns that have been raised in past reports, as well as new areas of concern that are discussed below. Given our belief that AutoChina's Board of Directors does not possess one truly Independent member, we were relieved to learn that the SEC has now joined PwC as the last line of defense for U.S. investors. 

    Did AutoChina commit blatant, unabashed Securities Fraud?
    Since our original report on AutoChina, we believe that AutoChina's management team has misrepresented material facts to the investment community.[1] In our original report, as well as our follow-up report, we spent considerable time discussing the unusual earn-out for the CEO. Aside from creating horrific incentives for management to use aggressive accounting tactics to meet earn-out targets, it was our belief that the earn-out was "not currently treated in accordance with GAAP."  

    AutoChina's management wrote a lengthy response to our report.[2] We believe that statements contained in AutoChina's response were either fabricated or knowingly erroneous. In its response, management stated emphatically that the earn-out (underlined is our emphasis) "has been discussed and confirmed with our current auditing firm, PricewaterhouseCoopers (and predecessor auditor Crowe Horwath)." We believe that based upon the Notification of Late Filing (NT 20F), AutoChina's statements regarding the sanctity of the earn-out accounting, and explicit blessing from PwC, were untrue.[3] In the late filing notice, the company clearly states that they were adjusting the earn-out accounting "after consultation with PwC during its annual audit process." This confession directly contradicts the earlier assurances that PwC had already "confirmed" the earn-out accounting treatment. Given the sterling reputation of PwC, we believe it would be highly unorthodox for an incoming accounting firm to "confirm" an accounting treatment before conducting an audit - yet AutoChina's management clearly stated otherwise, and did so in a public forum. 

    Secondly, we would question whether AutoChina was timely and forthright with ALL investors as it relates to the SEC investigation. AutoChina filed its 6K for Q1'11 on June 6, 2011. In that filing, we were unable to find any disclosures of the SEC investigation under the risk section or under subsequent events.[4] So we must assume that AutoChina only became aware of the SEC investigation and subpoenas AFTER June 6th (otherwise they have a major disclosure issue on their hand). The lack of a disclosure in the 6K would suggest that AutoChina received the correspondence from the SEC between June 6h and 30th. While AutoChina only chose to disclose the SEC investigation and subpoenas on June 30th, we believe that they may have selectively disclosed certain "issues" earlier to analysts with banking ties.  

    We had previously highlighted an ominous research report on April 21 that foreshadowed problems with the financials. In that report, an analyst at a firm with very strong banking ties to AutoChina (as well as banking ties to a recent SPAC that has significant management overlap with AutoChina) suspended his rating and price target after discussions with management concerning the 20F. We have no reason to suspect any wrong doing by the analyst, but it is a logical concern the selective disclosure was the impetus for the rating and price target suspension. If AutoChina knew about the SEC investigation well in advance of June 30th, why was it not disclosed earlier for all investors? It would seem logical that investors would have viewed such information as material.

    An additional disclosure problem may exist if insiders were selling stock before the SEC investigation was disclosed. We believe any stock sales by insiders, disclosed or undisclosed, while having knowledge of an unannounced SEC investigation would constitute a material securities violation ("Examples of insider trading cases that have been brought by the SEC are cases against corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments").[5] In fact, we were able to find two filings for proposed insider sales within two weeks of the public disclosure of the SEC investigation. Ignoring the odd pencil filing, and the illegible signature, we would openly ask whether the company knew of the SEC investigation while Jinyu Peng filed to sell stock to U.S. investors that were unaware of the SEC investigation[6]:

     


    As a foreign filer, insider sales do not need to be disclosed. However, AutoChina's management team had publicly committed to disclose any stock sales greater than $200,000 by members of management. We would encourage the SEC to confirm that this public disclosure commitment has been upheld. Further, we think investors should be informed if members of management or the Board sold any stock subsequent to our initial report and prior to disclosing the SEC investigation.
     

    The misrepresentation of the earn-out fits a pattern of misrepresentations that have been made by AUTC management. AutoChina announced in mid-February that they would have AUDITED financials filed in March, "We look forward to announcing our fully audited 2010 fourth quarter and year-end financial results next month."[7] This timeframe for filing audited financial results would have been consistent with the filing of 2009 annual results, which occurred on March 22, 2010. In March, not only were no audited financials filed, but AutoChina seemed to retract the previous reassuring statement by issuing a new timeframe with no explanation, "The Company anticipates filing before June 30, 2011."[8]  

    In its most recent earnings release, we believe AutoChina's CEO severely misrepresented the message from the research by China Automotive Review by attempting to characterize the end markets as healthy. Mr. Yi appears to have either misinterpreted the articles, or he brazenly painted a picture for investors in the press release that didn't appear to exist in the source he cited. The two articles cited by Mr. Li don't highlight the recent strength of the heavy-duty truck market. To the contrary, they actually describe the deterioration of the heavy truck market in China (production down 16% in April, 31% in May and forecasted to decline 26% in June).[9] There is a dramatic contrast in tone from the two negative articles and the positive commentary AutoChina used in its earnings press release (underline is our emphasis).  

    Yong Hui Li, Chairman and CEO of AutoChina on June 6, 2011

    "Since the latter half of 2010, we have seen demand in the heavy-truck market normalize from its previously high growth levels. In 2010, heavy truck sales in China rose by roughly 60% when compared to heavy truck sales in 2009. We feel this was an extraordinary jump over the historical growth in the market, driven in part by the effects of the government's stimulus program. However, we are still seeing steady growth in our sector. According to China Automotive Review, sales of heavy-duty trucks, including chassis and semi-tractor trailers, in the first quarter of 2011 totaled 299,436 units, up 8.4% from the first quarter of 2010. We believe that China’s continuing economic development will keep driving demand for commercial vehicles in the long term"

    China Automotive Review article referenced above

    China's heavy-duty market in danger of negative growth by Wayne Xing  

    According to the latest data available, China’s heavy-duty truck market is slowing down significantly compared to the robust performance in 2010. Sales of heavy-duty trucks (including chassis and semi-tractor trailers) in the first quarter of 2011 totaled 299,436 units, up only 8.4 percent from the same period last year. Semi-tractor trailers, the star and fastest growing segment last year, saw sales drop 21.2 percent to 76,726 units. Another sign that the heavy-duty truck as well as the entire automobile market may be in for a difficult time is rising interest rates and tightening of credit by the central government to rein in inflation.

    China Automotive Review’s more recent findings:

    Heavy-duty truck sales down 31 percent in May

    China’s heavy-duty truck market declined further in May, as sales plummeted 31 percent to about 74,000 units compared with the same month in 2010, reported cvworld.cn, a leading Chinese truck and bus news portal on June 7. Sales over the first five months were estimated to be around 470,000 units, which is about a 4 percent drop compared with the same period a year ago, when the market soared 120 percent. The heavy-duty truck sector is expected to further drop in June, with volume estimated to be less than 60,000 units, down about 36 percent from June 2010. The market may see a decline this year of as much as 15 percent, according to some analysts

     If we assume that the financials and operating assumptions are accurate, it does beg the question, why would AutoChina's management go to such lengths to distort the health of its end markets? We think the answer may be very straightforward. They need money. In past reports we have provided analysis detailing the massive hole AutoChina would appear to have in its 2011 funding plans. In the 6K issued on June 6, 2011, they clearly state the possibility of additional "borrowings from financial institutions and/or the sale of equity." Given that most of the company's incremental borrowings have come from related parties, our analysis would require the company to raise substantial amounts of equity from NEW investors. For this to occur, PwC's audit would need to play an integral role blessing the company's financials. We believe that this is another reason PwC must get the audit 100% right - it will serve as the key safety net for U.S. investors that would invest in any future offerings. However, the comments directly from PwC partners may suggest that they are not 100% comfortable with the characteristics of AutoChina.

    Did PwC use AutoChina as a "Red Flags" case study the same day it was halted?On June 30th, 2011, Oppenheimer hosted a call entitled "The State of Accounting for Chinese Companies." The call was hosted by two audit managing partners of PwC China, Laura Butler and Stephen Ducker. Coincidentally, PwC China also happens to be AutoChina's newest auditor (although we would not be surprised to see them resign before completing an audit). On the call, Ms. Butler and Mr. Ducker outlined red flags for U.S. investors that have been harbingers of fraud. After listening to the call, it seemed to us that the PwC auditors may have been using AutoChina as their case study. Below we compare the red flags that PwC discussed and the parallels that we would illustrate at AutoChina. 

    Red Flag

    Comment on Red Flag From PwC

    AutoChina

    Dominant Chairman and CEO

    Chairman and CEO plays a dominate role at the company. Typically a founder and owns a large percentage of the company. There is no natural checks and balance with other members of the management team and audit committee. Management and audit committee are not willing or able to challenge senior management.

    Yong Hui Li, AUTC's Chairman and CEO, is also its founder. He owns roughly 58% of the company and controls the operating companies through a VIE structure.

    Weak Audit Committee

    Audit committee lacks experience and members are not located in China or do not speak Chinese. Committee members often have no power to confront senior management with issues.

    **We discuss AUTC's weak board and lack of checks and balances below. We do not view AUTC's three "external" directors as independent. None of the three directors live in China (they instead live in the United States, Canada and Hong Kong).

    Weak CFO

    CFO hired around IPO and not part of the inner-circle of management. CFO does not live in China or does not speak Chinese. CFO has limited CFO experience or accounting experience at publically traded companies and does not have a CPA.

    Jason Wang, AUTC's CFO, lives in the United States and is not a CPA. Based on his resume, it appears that he had no relevant accounting experience prior to his appointment after the reverse merger.

    Other Issues

    Manipulation and collusion with cash balances. Transactions with related parties were specifically mentioned, as was accounts receivable that were never collected.

    **See details below on related party transactions and the alarming alterations of these transactions.

     

    Tax documentation

    Disconnect between GAAP tax provisions and cash taxes

     

    Employee expenses

    Questionable expense base. Possible shared expenses with affiliated companies and rent free arrangements.

     

    VIE ownership

    AUTC has a convoluted VIE ownership structure where the shareholders do not own the operating companies.

     

    Use of IPO Proceeds

    This remains an open question as the original business model was focused on new and used car lots - a segment that was sold less than one year after the proceeds were raised.

     On the call, Ms. Butler discussed a specific example where the SEC was focusing on a CFO and finance team's lack of experience with U.S. publicly traded companies. She also alluded to problems with CFO's that are not CPA's. While it may have been a mere coincidence, only several hours after the PwC call concluded, AutoChina disclosed that it "identified a material weakness in its internal control over financial reporting as of December 31, 2010, due to a lack of requisite internal U.S. GAAP experience" (underline our emphasis). As we have discussed in past reports AutoChina's CFO is not a CPA, and it appears that he had no relevant accounting experience prior to his appointment as CFO. The CFO also joined AutoChina from PEMGroup, where he was the Director of Research. While AutoChina's CFO may have been completely unaware while he was Director of Research, PEMGroup turned out to be one of the largest ponzi schemes in U.S. history. Given the extensive similarities between AutoChina and the "red flag" examples PwC used, we would be shocked if PwC is willing, or even able, to complete the audit and required restatement. But this does beg the question, if there are problems, why have we yet to see Board resignations and the lack of cooperation from management that ultimately leads to an auditor resignation? 

    Management's $100 million incentive and the InDependent Board
    Unlike many Chinese frauds that were discovered AFTER the money had already been misappropriated, AutoChina is unique in the sense management needs the audit to make approximately $100 million in an earn-out. Upon completion of the audit (the lone remaining hurdle for the earn-out), AutoChina's CEO will be issued approximately $100 million of stock. As such, management is highly motivated to "cooperate" with PwC, and do anything it can to ensure the audit gets completed. Given the monetary amount at risk, there is zero incentive for management to "take the money and run" as so many Chinese companies have done by refusing to work with auditors or special committees. But what about the Board of Directors; where have they been during the last four months since the original research was made public questioning so many elements of the AutoChina story? Shouldn't the "Independent" Directors have taken their fiduciary responsibility seriously enough to at the very least form a special committee to investigate very reasonable claims?  

    We believe that a prudent Independent Director would have viewed an SEC investigation and associated subpoenas as cause for concern, providing a reasonable backdrop meriting an investigation. But given the unusual nature of AutoChina's Board, which arguably has no truly independent directors, it has not been surprising to see the Board look the other way. In fact, AutoChina's Board is one of the most "dependent" Boards we have ever come across. AutoChina's Board of Directors is made up of only five members. Of the five, three are labeled external directors. It would appear to us that the external directors are actually incredibly related in nature. The table below highlights the three outside directors and why we believe a reasonable person would question their independence. 

     

     

    Committee

     

     

     

    Director

    Audit

    Governance

    Comp

     

    Independent?

    Diana Liu

    Member

    Member

    Chair

     

    Former AUTC President. Current CEO of Prime Acquisition. AUTC's Chairman and CEO is Chairman of Prime Acquisition. AUTC's third largest shareholder.

    Thomas Lau

    Member

    Chair

    Member

     

    Co-owner with AUTC CEO of two businesses that have been AUTC's largest funding provider.

    James Sha

    Chair

    Member

    Member

     

    Former Chairman and CEO of AutoChina until April 9, 2009. AUTC's second largest shareholder.

    ****As a reminder Prime Acquisition Corp was the recently capitalized SPAC that shares six members of management with AutoChina, including Mr. Li who is the Founder and Chairman of both companies. 

    Areas of Focus (beyond the potential financial chicanery such as the earn-out)
    There is no doubt in our mind that the SEC and PwC (although we would guess they'll resign) will conduct an intense and rigorous investigation into the previous operational and financial concerns that have been raised. In addition to the nonsensical financial claims that AutoChina has presented to-date, we would encourage the SEC and PwC to scrutinize other areas of potential misappropriation that we list below. Following the PwC conference call on June 30th (highlighted above), we feel reassured that the auditors are intensely focused on these issues and flags.

     

    1) Related Party Funding and Transactions
    Muddy Waters has been the gold standard for exposing Chinese fraud. An incredibly powerful tool that Muddy Waters has consistently used to identify fraud has been focusing on "accounts that we consider high risk because they are primarily evidenced by paper documentation, rather than their physical presence (as in machinery and equipment). The abundance of paper accounts on the balance sheet was one of the early signs to us that Rino International Corp. was a fraud. It is clear that auditors in China are having significant problems evaluating the veracity of documents" (underline is our emphasis). We believe the same "paper documentation" verification is where the SEC and PwC could face the most significant challenges.

    The table below highlights the list of related party transactions that we have been able to ascertain. There may be other material related party transactions that have not yet been fully fleshed out. Given the sheer volume of dollars shifting back and forth between these related parties, there is ample opportunity for impropriety (such as hiding expenses and credit losses). Through nine months of 2010, the combined dollar amount of the related party transactions equated to a shocking $865 million. We believe the SEC and PwC are determined to reconcile the paper and money trail relating to the unprecedented related party transactions that we have found at AutoChina. While we are still working though the transactions, we would agree with PwC's assessment from the Oppenheimer call concluding that extensive related party transactions present huge red flags….

    Account / Related Party

    Nature of Related Party

    Nature of Related Party

    Capital and trading transactions

     

    Honest Best

    Parent of AUTC, owned by CEO & wife

    Loan provided

    Hebei Kaiyuan

    Owned and controlled by CEO & wife

    Bank guarantee

    Kaiyuan Shengrong

    Owned and controlled by CEO

    Bank guarantee

    Kaiyuan Shengrong

    Owned and controlled by CEO

    Bank guarantee

    Hebei Ruihua Real Estate Dev

    Owned and controlled by CEO & wife

    Bank guarantee

    Kaiyuan Doors

    Owned and controlled by CEO & wife

    Deposits for inventories for the purchase of trading materials

    Kaiyuan Shengrong

    Owned and controlled by CEO & wife

    Loan provided

    Beiguo

    CEO and Director owns ~40% combined

    Customer deposits received for the purchase of automobiles

    Beiguo

    CEO and Director owns ~40% combined

    Deposits for inventories for the purchase of trading materials

    Wantong Longxin

    CEO's Brother owns 40%

    Deposits for inventories for the purchase of trading materials

    Renbai

    CEO and Director owns ~40% combined

    Customer deposits received for the purchase of automobiles

    Ruituo

    Owned and controlled by CEO

    Sale of automobiles to the Company

    Kaiyuan Shengrong -

    Owned and controlled by CEO

    Interest expenses incurred

    Hebei Kaiyuan

    Owned and controlled by CEO & wife

    Purchase of trading materials

    Kaiyuan Doors

    Owned and controlled by CEO & wife

    Sale of trading material

    Kaiyuan Shengrong

    Owned and controlled by CEO & wife

    Interest paid

    Wantong Longxin

    CEO's Brother owns 40%

    Sale of trading material to the Company

    Beiguo

    CEO and Director own ~40% combined

    Sale of automobiles to the Company

    Beiguo

    CEO and Director own ~40% combined

    Purchase of automobiles from the Company

    Beiguo

    CEO and Director own ~40% combined

    Purchase of trading materials from the Company

    Beiguo

    CEO and Director own ~40% combined

    Interest paid or expensed by the Company

    Renbai

    CEO and Director own ~40% combined

    Sale of automobiles to the Company

    Renbai

    CEO and Director own ~40% combined

    Interest paid (or expensed) by the Company

    Renbai

    CEO and Director own ~40% combined

    Purchase of automobiles from the Company

    Deposits for inventories, related party

     

    Beiguo Commercial Building

    CEO and Director own ~40% combined

    Beijing Wantong Longxin Auto

    CEO's Brother owns 40%

     

    Hebei Kaiyuan Doors & Windows

    Owned and controlled by CEO & wife

    Due to affiliates

     

     

    Hebei Kaiyuan

    Owned and controlled by CEO & wife

    Honest Best

    Parent of AUTC, owned by CEO & wife

    Kaiyuan Shengrong

    Owned and controlled by CEO

     

    Hebei Shengrong

    Owned and controlled by CEO & wife

    Mr. Li

    CEO himself

     

    Accounts payable, related parties

     

    Beiguo

    CEO and Director owns ~40% combined

    Renbai

    CEO and Director owns ~40% combined

    Hebei Ruituo Auto Trading Co.

    Owned and controlled by CEO

     

     Additionally, we are concerned that related parties appear to be shifting and morphing as well. AutoChina director Thomas Lau may have become uncomfortable with the related party activities between AutoChina and Beiguo Commercial Building Limited and Shijiazhuang Beiguo Renbai Group Limited (both partially owned by Mr. Lau and AUTC's CEO Yong Hui Li). This could be the motivation for AutoChina attempting to shift their related party debt to firms 100% controlled by Yong Hui Li (including Honest Best, the parent company of AutoChina, and Hebei Ruituo Auto Trading Co.). On May 31, 2011, AutoChina announced it had transferred its related party debt to a company 100% controlled by the CEO. The debt was transferred on March 29th, two full months prior to the disclosure, and just two days before quarter end. Was this transfer related to the audit? Was it related to the SEC? Why was Mr. Lau's exposure to AutoChina suddenly removed? 

    Disclosed related party transactions leave plenty of room for comingling of funds and cash exchanges that are beneficial to management. Unlike most troubled RTO's, AutoChina actually needs to receive cash to keep the machine going because funding is needed - unless loans are fabricated, but we trust that the loans do exist. So what should be made of cash infusions from related parties at massive discounts, in some cases at a zero percent interest rate? We aren't entirely sure, but we do know that the CEO stands to make $100 million in earn-out shares should the game last through the 2010 audit. 

    Additionally, we would love to be a fly on the wall when PwC and the SEC carefully examine Hebei Chuanglian Trade Co, Hebei Xian Real Estate, and Mr. Yong Hui Li. Also, we would guess the SEC will look at the ownership structure of Changjie and Chuangshend Auto Trade and any cash acquisitions that those entities may have made with loans from Hebei Chuanglian Trade, to verify that AutoChina paid a financing charge of approximately 4% in 2010 in excess of the cost to Beiguo and Renbai for the funds obtained due to the financing arrangement guaranteed by Mr. Li.

    The payable balances of each loan from Beiguo and Renbai will also be interesting (the cash payments) as both were due within 180 days on Dec 31, 2009 (were payments ever made?). Similar issues may exist between Honest Best and Hebei Ruituo Auto Trading balances. Further any undisclosed vehicle purchases by ACG through Chuanglian Trading from parties related to Mr. Li or Mr. Yong would be a material problem. Additionally, we wonder who represented the ownership of Xinjiang? Was this a truly independent purchaser of the auto dealerships? Was the full purchase amount of $68.8 million ever received by AutoChina subsidiaries in cash? Did the ownership structure of Xinjiang qualify as a related party transaction that was not disclosed? Was there ever a physical delivery of materials in the sum of $1 million (NYSEARCA:USD) that AutoChina paid Kaiyuan Doors, or was the cash simply transferred to a company owned by the CEO and his wife? Further, Beiguo (the grocery story) purchased $19 million of "trading materials" from AutoChina - what were these materials? Why was a grocery store owned by the CEO buying materials from an auto leasing company? In addition, we would guess the SEC will perform a similar exercise with the accounts relating to Wantong Longxin (owned by Mr. Li's brother).  

    2) Credit
    We have not been shy in noting our extreme skepticism towards AutoChina's credit quality. Given the myriad of related party transactions, it would appear to be very easy to hide repossessed vehicles and losses inside of related party entities. Management claims to have experienced fewer than 20 defaults (versus 23,000 leases) and cumulative losses of roughly 15 basis points since inception. We believe this would represent one of the greatest accomplishments in modern finance, defying all conventional laws of lending. As such we would implore the SEC and PwC to verify (beyond paper documents) the purported loans AutoChina has made to confirm that they have only had 20 defaults. We would also guess that PwC will insist on verifying the trail of cash interest payments from every loan all of the way through third party bank statements. 

    3) Hidden expenses
    Given the limited expense growth and extremely low ratio of expenses per employee at AutoChina (which we have documented in the past), we believe AutoChina could have offloaded expenses to affiliated companies. This would include rent free transactions, as well as services and employee expense burdens being passed to related party companies. If this is true, it is not disclosed and would severely alter the expense structure at AutoChina. As a result, it would be prudent to review and audit the expense structure and payroll of related party companies that share employees with AutoChina (for example Mr. Li who hypothetically could be highly incentivized to shift expenses to Hebei Kaiyuan to remove said expenses from AutoChina's P&L - to hit the EBITDA targets stipulated by the earn-out). Also, for example, Hebei Kaiyuan Real Estate Development - formerly Shijiazhuang Kai Yuan Auto Trade Co.,Ltd. - 86 311 8382 - should not be able to transfer a caller to an AutoChina employee.

     

    4) Size and Scope of Operations
    We would encourage the verification and authenticity of the 318 AutoChina branch locations. A common theme in Chinese RTO frauds has the exaggeration of the actual size and scope of the operating company. We are confident that PwC has requested documentation at the branch level for the leases that AutoChina has claimed to underwrite for their normal audit procedures. We would be thrilled if management would release the addresses for each of the 300+ branches. 

    We also believe there are several other accounting issues that could cause material restatements at the company (beyond the earn-out). We are concerned about other accounting issues including sales-type lease accounting (AUTC is not a captive finance company so this treatment does not apply to them), credit reserve accounting (credit reserves against their accounts receivable which represent their delinquent loans does not conform to GAAP, in our opinion), interest expense (debt with below market interest rates must be discounted), and stock compensation. In the first quarter 2011 the company restated part of their reserves for the first quarter 2011 and the fourth quarter 2010, shifting a portion against the "Current maturities of net investment in sales-type leases." There was no mention of this shift in accounting policy or notification of the restatement that we have been able to find.  

    5) Things that common sense would say aren't so common
    *It defies common sense that that AUTC has only 20 defaults out of more than 23,000 leases
    *It defies common sense that a $1.7 million reserve is sufficient to cover over $850 million of leases
    *It defies common sense that a grocery store has provided hundreds-of-millions of dollars of funding to AutoChina
    *It defies common sense that the expense base is virtually non-existent for a national network of 300 stores and thousands of employees
    *It defies common sense that AutoChina can account for its delinquencies as "account receivables" and its related party debt as "accounts payable" and "due to affiliates 

    U.S. investors in AutoChina are investing at their own peril. The stock is currently more than fairly value on reported financials and has seemed to completely discount any risk from the SEC investigations. If the SEC or PwC were to find more problems at AutoChina, there is no reason to think it will not suffer the same fate as so many halted Chinese scams once they reopen - a quick trip to a few bucks per share. But, even if AutoChina somehow manages to get through its audit and escape unscathed from the SEC investigation, the company could face a severe funding gap. The company claims to have $242 million of book value at March 31, 2011. This amount will be materially lower after the earn-out restatement.  When one considers that AutoChina has recognized significant earnings upfront through gain on sale accounting and has a mere $2.4 million of reserves, we think book value is likely materially overstated.  At 50% of stated book pre-restatement, the company would be worth $5 to $6 per share. In run-off, we think there would be little to no value for equity holders.

     

    Disclosure:

    *** The author of this article is short AutoChina stock. TFF goes to great lengths to ensure that all information is factual and referenced. All facts that we present herein are true to the best of our knowledge. All opinions presented are our own and accurately reflect our opinion on the relevant subject being discussed. We recommend that investors perform their own extensive due diligence before buying or selling any security.

     

     

     

    Tags: F, China, Short Idea, RTO
    Jul 11 2:23 PM | Link | Comment!
  • Dear PwC - Do AutoChina's financials pass the smell test?

    Dear PwC - Do AutoChina's financials pass the smell test?


    Investors in U.S. listed Chinese companies have suffered sizable losses over the last three months. There has been no shortage of blogs that have correctly highlighted the widespread fraud in the Chinese RTO space. Had auditors initially examined many of the publicly raised concerns, the irreparable reputational damage may have never occurred. Ironically, the impetus for the recent crescendo of losses seems to be the newfound sense of responsibility by many auditors. With regulators demanding accountability, auditors appear unwilling to put rubber stamps on Chinese financials. As a result, countless Chinese companies have no auditor, no reliable financials, and huge uncertainty about what actually exists. With the Bloomberg Chinese Reverse Mergers Index declining over 40% since November 2010, it is no longer a shock to see exchanges halt trading in Chinese stocks due to new accounting scandals, auditor resignations, or accounting restatements. However, investors appear to be extra vigilant to ensure they don't own the "next halted stock." Many of these halted securities have experienced share price declines of at least 60% once trading resumes. We continue to be mystified by the complacent shareholder base in AutoChina, which very well could be the next implosion if PwC refuses to certify the financials by June 30th.

     

    In two past reports, The Forensic Factor (TFF) highlighted our concerns about AutoChina's (AUTC) accounting and financial profile. With the foreign filer deadline fast approaching, we want to again go on public record stating our belief that AutoChina's new auditor, PwC Zhong Tian, has some major questions that need to be diligenced. In this brief follow-up, TFF will NOT focus on the shady related party transactions, the complicated organizational structure, the absurd financial guidance and origination outlook, or the massive and inexplicable funding gap the company currently faces. Instead, TFF wants to revisit AutoChina's accounting issues in front of its year-end audit deadline. As PwC, and other auditors, face massive liabilities (from large investor losses and the appearance of negligence, malpractice and breach of fiduciary duty), we implore PwC to focus on our past reports and the issues below.[1],[2] TFF's research serves as public record that concerns were raised to PwC regarding AutoChina's accounting and business model, and we hope PwC will take their responsibilities seriously…. and it is not unreasonable to assume that recent delays in filing audited financials are reflective of problems PwC may have found.

     

    AutoChina announced in mid-February that they would have AUDITED financials filed in March, "We look forward to announcing our fully audited 2010 fourth quarter and year-end financial results next month."[3] This timeframe is consistent with the filing of 2009 results, which occurred on March 22, 2010. Yet, in March, not only were no audited financials filed, AutoChina seemed to retract the previous reassuring statement by issuing a new timeframe, "The company anticipates filing before June 30, 2011."[4] While no explanation was provided for the delayed audited financials, TFF would highlight an ominous research report from Chardan Capital on April 21 that may forebode problems with the financials.

     

    Red Flag: Lead Underwriter "Suspends" Coverage

    TFF is not the only voice that has expressed concern over AutoChina's audit. Boutique investment bank Chardan Capital was the lead underwriter for the IPO of the SPAC "Prime Acquisition Corp" on March 31, 2011. As the table below highlights, Prime Acquisition and AutoChina have almost the EXACT same management team.[5]

     

    Shared Management - AUTC and Prime Acquisition

     

     

    AUTC

    Prime Acquisition

    Yong Hui Li

    Chairman & CEO

    Chairman / Director

    Diana Chia Haei Liu

    Former President; Director, Member of Audit, Governance & Nominating, and Compensation Committee

    CEO / Director

    William Tsu-Cheng Yu

    Former Director, Husband of Ms. Liu

    CFO / Director

    Hui Kai Yan

    Corporate Secretary & Director

    COO

    Gary Han-Ming Chang

    "Special Advisor" to AutoChina

    CIO & Director

    Jason Wang

    CFO

    Director

     

    As one of its marquee investment banking clients, Chardan Capital faces an understandable conflict of interest in covering AutoChina. Most investment banks would never publish a negative report on a banking client unless something was very wrong. As such, TFF was surprised to learn that Chardan, only a few weeks after the Prime Acquisitions IPO, suspended its rating and price target on AutoChina the day before a three day weekend.[6] After reviewing the research report, it appears Chardan was not comfortable with the 2010 audit following a discussion with management. There were no details in the report explaining what management said to generate this concern, but the analyst felt compelled to suspend his rating and price target after previously defending AutoChina.

     

    Halted Chinese Companies

    Dozens of Chinese companies have been halted since early March, with a handful already getting delisted. The auditor quality of these halted and delisted stocks runs the gamut. Big 4 firms Deloitte & Touche and KPMG have the not-so-distinguished pleasure of being involved with seven of these companies. To date, AutoChina's auditor, PricewaterhouseCoopers Zhong Tian, has only been involved with one (although PwC's affiliate in Hong Kong was involved in one also). It is unclear if PwC has a higher quality audit client list or if they are more complacent than Deloitte and KPMG in identifying accounting issues.

     

    Selective Delisted/Halted US Listed Chinese Stocks

     

    Halt Date

    Company

    Ticker

    Auditor

    delisted

    Rino International

    RINO

    Fraser Frost

    delisted

    Duoyuan Printing

    DYNP

    Deloitte & Touche

    delisted

    China INSOnline

    CHIO

    Weinberg & Co

    delisted

    Xinhua Sports

    XSEL

    Deloitte & Touche

    delisted

    Tongxin International

    TXIC

    Malone Bailey

    3/11/11

    China MediaExpress

    CCME

    Deloitte & Touche

    3/14/11

    China Agritech

    CAGC

    Ernst & Young

    3/15/11

    ShengdaTech

    SDTH

    KPMG

    3/21/11

    China Century Dragon Media

    CDM

    Malone Bailey

    3/24/11

    NIVS IntelliMedia Tech

    NIV

    Malone Bailey

    3/24/11

    China Intelligent Lighting

    CIL

    Malone Bailey

    3/31/11

    China Electric Motor

    CELM

    Malone Bailey

    4/1/11

    HQ Sustainable Maritime

    HQS

    Schwartz Levitsky Feldman

    4/1/11

    Keyuan Petrochemicals

    KEYP

    KPMG

    4/7/11

    Subaye

    SBAY

    PricewaterhouseCoopers Hong Kong

    4/11/11

    Puda Coal

    PUDA

    Moore Stephens

    4/12/11

    Universal Travel Group

    UTA

    Windes & McClaughrey

    4/18/11

    China Ritar Power

    CRTP

    Crowe Horwath

    4/20/11

    Duoyuan Global Water

    DGW

    Grant Thornton

    4/20/11

    China Integrated Energy

    CBEH

    KPMG

    5/6/11

    Wonder Auto Tech

    WATG

    PricewaterhouseCoopers Zhong Tian

    5/17/11

    Longtop Financial

    LFT

    Deloitte & Touche

     

    There are numerous parties that will face difficult questions in the coming months from lawyers, regulators and authorities. Auditors of Chinese RTO frauds face MASSIVE liabilities due to large investor losses and the appearance of negligence, malpractice and breach of fiduciary duty. One of the more blatant examples of a Big 4 auditor breaching its fiduciary duty (or worse) is KPMG's audit of China Integrated Energy (ticker CBEH). CBEH hired KPMG in December 2010 to audit the company's 2010 results. On March 16th, 2011, CBEH filed its 10-k with a clean audit opinion from KPMG.[7] That same day, video surfaced that appeared to verify that CBEH was operating idle factories and was in fact a fraud.[8] CBEH's stock had declined 75% year-to-date BEFORE the shares were halted on April 20th. TFF has a tremendous amount of respect for the Big 4 accounting firms and the accounting profession in general. However, it appears that accountants have been complacent relating to the massive fraud that has occurred in Chinese RTOs.


    Auditor last line of defense for most investors

    Most U.S. investors do not have the time, money, or resources to perform the level of diligence required to flesh out these frauds (like video taping a facility for three consecutive weeks). As a result, the auditors provide one of the last lines of defense to protect investors. Auditing services are performed on behalf of shareholders and for the integrity of the markets. Given the documented concerns and red flags, TFF believes PwC should approach its audit with intense rigor and be in a position to provide extensive documentation and evidence related to its procedures. There have been many similar themes across the RTO frauds, but some of the most glaring have been odd financial statements that defy COMMON SENSE. Along these lines, TFF points out:

       

    *It defies common sense that that AUTC has only 20 defaults out of more than 23,000 leases

    *It defies common sense that a $1.7 million reserve is sufficient to cover over $850 million of leases

    *It defies common sense that a grocery store has provided hundreds-of-millions of dollars of funding to AutoChina

    *It defies common sense that the expense base is virtually non-existent for a national network of 300 stores and thousands of employees

    *It defies common sense that AutoChina accounts for its delinquencies as "account receivables" and its related party debt as "accounts payable" and "due to affiliates"

     

    One thing is clear: AutoChina does not look like any leasing company that we have encountered, and TFF believes the most likely reason is financial statements that PwC will not be able to support. AutoChina's reported financials are such an extreme outlier from the myriad of historical models that any prudent investor should question the numbers. TFF's work continues to support our original opinion that AutoChina has significant accounting issues and questions. Below are some of the outstanding points that PwC will need to address before any audit can be completed. This process could be the impetus for a large restatement (at best) given the company's aggressive accounting policies, or even a resignation from PwC (at worst).

     

    I) The use of gain on sale accounting by an independent finance company does not conform to GAAP

    AutoChina utilizes gain on sale accounting that dramatically overstates revenue and front-loads profits. AutoChina's accounting is so aggressive that it allows for the recognition of a profit on day one for simply providing a loan! This sales-type lease accounting generates substantial "paper" income but significantly overstates and misrepresents economic income. Sales-type lease accounting is reserved for manufacturers that have captive finance organizations (allows a company to recognize revenue and gross profit on the sale of the equipment that they manufacture). Since AutoChina's value proposition is almost exclusively providing financing, it is unclear how the company justifies this accounting treatment. AutoChina's revenue and income would look dramatically different under GAAP lease accounting standards that should be used by non-manufactures. For example, TFF has estimated in past reports that revenue may be overstated by as much as 75%.

     

    II) Credit and reserve makes little sense

    Given the myriad of related party transactions, checkered history of management and reliance on plain old common sense, TFF is extremely skeptical towards AutoChina's claims of pristine credit quality. Based on TFF's experience with leasing companies, transportation finance, auto finance, and banks, we believe AutoChina's delinquencies and reserves are too good to be true. History has shown that when a company can recognize profits by simply providing a loan, there is very little incentive to stringently underwrite a credit.

     

    A downside to recognizing profit upfront is future credit losses can provide a huge downside surprise (reversal of recognized gains, costs of repossession, and loss on collateral). TFF believes this concern is relevant given the recent jump in delinquent accounts relative to the minuscule provision for loan losses. In fact, TFF believes AutoChina has only reserved $1.7 million against nearly $450 million of GAAP loans (and over $850 million of loans provided over its history). According to the fourth quarter earnings press release, over 5.25% of AutoChina's loans were delinquent as of December 31, 2010, versus only 1.11% at June 30, 2010. This deteriorating loan book paints a different picture than the paltry reserve that represents less than 0.39% of the total lease portfolio. Management claims to have experienced less than 20 defaults (versus 23,000 leases) and cumulative losses of roughly 15 basis points. TFF believes this would represent one of the greatest accomplishments in modern finance, defying all conventional laws of lending.

     

    AutoChina's credit experience seems to be even more amazing considering recent press reports coming out of China. A recent New York Times article highlighted the "brutally competitive" independent trucking market in China, "Within China, thousands of small trucking companies, many of them family-owned, compete by promising low-cost delivery. Then they overload their 18-wheelers in dangerous ways, pay bribes to ward off highway inspectors and hope to eke out tiny profits. Now, though, with global oil prices sending the cost of fuel soaring, many truckers say they are heading toward bankruptcy. Many of the factory bosses seem to recognize that there is an oversupply of small trucking companies desperate for cargo" and "are reluctant to pay higher fees to move goods."[9] A Financial Times article echoed this deteriorating trend, "One problem is that there are so many independent truckers in China that each feels they will lose business if they raise their prices even slightly."[10]

     

    Additionally, AutoChina's accounting for reserves and delinquent loans defies financial logic and is treated differently than anything TFF has ever seen. According to management, they place delinquent loans into accounts receivable on the balance sheet and build their reserve as a bad debt expense against the A/R. The company also classifies its related party debt as "accounts payable" and "due to affiliates" on the balance sheet. TFF believes this treatment does not conform to U.S. GAAP.

     

    III) Why is the "reported" expense base so low?

    In 2010, AUTC nearly doubled its store count (157 to 300), while growing originations by 66%. Incredibly, their "sales and marketing" expense rose by less than $1 million year-over-year. AutoChina's G&A increased $8.3 million year-over-year, but stock compensation and the small increase in provisions represented a good chunk of this change. TFF estimates that AutoChina only has $23 million of total SG&A to support: over 200 members of management, 23,000 leases, 300 branches (with 6 to 7 employees per branch), and over 2,000 employees. The level of SG&A per employee suggests that AutoChina is one of the most efficient lenders in the world. After backing out some easily identifiable expenses from SG&A (including audit fees, stock comp, depreciation and provision expense), TFF estimates that AUTC only spends $9,000 to $11,000 per employee for all overhead, salaries, rent, insurance. This level of expense (again) appears to defy common sense.

     

    SG&A per employee

     

    2010 SG&A

    $23,850

     

     

    Audit fees

    481

    Depreciation

    1,000

    Provision

    1,000

    Stock comp

    3,000

     Total

    5,481

    Total SG&A excluding above

    18,369

     

     

    Estimated average employees

    1,650

    Estimated end employees

    2,050

     

     

    SG&A per employee

    $11,133

    SG&A per employee

    $8,960

     

    Through the first nine months of 2010, AutoChina's transactions with related parties amounted to $865 million.[11] The related parties include a grocery store chain owned by the CEO and Director, and businesses wholly or partially owned by the CEO, his wife, his brother, and a Director. Given the sheer volume of dollars shifting back and forth between these related parties, there is ample opportunity for impropriety (such as hiding expenses and credit losses). TFF believes some of these related party transactions are simply unjustifiable and may represent a glimpse into more menacing activity. For example, why is Kaiyuan Doors, a company owned by the CEO and his wife, selling over $1 million of "trading materials" to AutoChina? Why is Wantong Longxin, a company owned by the CEO's brother, selling $4.6 million of "trading materials" to AutoChina? Why is Beiguo (the grocery story) purchasing $19 million of "trading materials" from AutoChina? Why is Hebei Kaiyuan providing office space to AutoChina rent free?[12]

     

    IV) Interest expense / related party debt

    Since AutoChina's inception, the largest provider of debt has been a grocery store chain by the name of Beiguo Commercial Building Limited, which is owned by AutoChina's CEO and another board member. But their grocery-store partner is just one of many strange bedfellows that include unusual interest free loans from the CEO and below market deals from a company owned by the CEO's brother. AutoChina's complicated web of related party debt financing has fluctuated wildly in recent periods. The fact AutoChina has been borrowing from related party entities interest free, or even at below market rates, significantly distorts the company's normalized income statement and overstates earnings. Management emphatically responded to TFF's past criticisms, stating a goal to reduce the reliance on related party funding. TFF is convinced that if the related party transactions slow, the future income statement will be dramatically different. But these assertions by management appear to have no substance, and in fact we believe the company's actions are in direct contradiction to their public promises.

     

    On May 31, 2011, AutoChina disclosed it had entered into a $61.57 million short-term loan with a firm called Honest Best on March 29, 2011. TFF believes that Honest Best is 100% owned by AutoChina's CEO - a fact the company failed to disclose in the 6K. If TFF is correct, and Honest Best is indeed controlled by the CEO, then AutoChina has another regulatory problem. Current reports from foreign private issuers are required to be "furnished promptly after the material contained in the report is made public." In the U.S., the SEC defines "promptly" as four days. TFF does not understand why it took AutoChina over two months to provide this disclosure.

     

    This reliance on related party transactions and debt can often be associated with unscrupulous activity and/or exchanges which are clearly not arms length in nature. TFF was not surprised to learn that "loans to related parties were the most frequent type of related party transaction" that drove SEC enforcement actions involving fraud. TFF believes PwC needs to examine how AutoChina is accounting for it interest free and sub-market debt. Under APB Opinion No. 21, debt with below market interest rates must be discounted (adjusts the principal of the debt to equivalent debt having the market rate of interest). This discount flows through the income statement. Given the large below market rate debt that is used to fund operations, AutoChina is significantly understating its interest expense.

     

    V) Compensation expense may be dramatically understated

    TFF believes that AutoChina's compensation expense is significantly understated because it does not include a realistic cash comp figure for the CEO, nor does it include the earn-out that has been offered in lieu of cash compensation. The stock compensation expense appears to be hidden from investors because it is not reflected in the company's income statement. AutoChina has used a large earnout to compensate its CEO. After examining FASB guidelines, TFF believes these earnouts should be expensed through the income statement and the existing treatment does not conform with GAAP. Although there is some ambiguity, FASB has provided a framework for expensing earnouts. Management's rationale for not expensing stock comp relies on the argument that the earnout is "based on performance that is not tied to employment," and that the "original intent" would compensate Mr. Li for EBITDA growth. TFF believes that AutoChina is incorrect. Accounting is not static, nor is it based upon intent. EITF 95-8 clearly states that earn-outs must be classified as an expense if management is not compensated at levels consistent with "other key employees." AutoChina's CEO was paid only $1.00 in salary with no bonus or other compensation in the last fiscal year. This level of compensation would clearly be defined as well below "other key employees."

    As a result, the earnout should be considered "compensation" expense under U.S. GAAP. The value of stock issued to Li in 2010 was over $57 million. If this was expensed appropriately, AUTC would have had negative pretax earnings in 2010.

     

    PwC - Is this worth the reputational risk?

    The ball is in PwC's court. TFF can only hope that PwC has checked every box and in doing so has found the magical elixir that would explain a financial and operating model that seems to defy every basic element of common sense. It is our belief that PwC will not be able to reconcile and support past financials. If this is the case, AutoChina may represent just one more RTO that makes the daily halt list, destroying investor capital and auditing reputations in the process.

     


    http://www.scribd.com/doc/56808143/Dear-PwC-Do-AutoChina-s-financials-pass-the-smell-test
     

    Disclosure:

    *** The author of this article is short AutoChina stock. TFF goes to great lengths to ensure that all information is factual and referenced. All facts that we present herein are true to the best of our knowledge. All opinions presented are our own and accurately reflect our opinion on the relevant subject being discussed. We recommend that investors perform their own extensive due diligence before buying or selling any security.

     

    Tags: F, fraud, china, short
    Jun 01 10:40 AM | Link | Comment!
  • AutoChina (Part 1.5) - Imagine if this was a U.S. company?

    AutoChina (Part 1.5) - Imagine if this was a U.S. company?

     

    Stealing from the famous scene in the wonderful book/movie A Time to Kill, we ask our readers to close their eyes (not literally) and imagine the following scenario. Imagine a company that came public through the underworld of a reverse Chinese merger. Imagine this company sold all of its auto dealerships to an entity called Xinjiang - which at the time represented the only material operations of the company. Picture the company using a controversial accounting tactic called sales-type lease accounting that overstates revenue and pulls forward profits. Now imagine a wildly dilutive earn-out that crushes existing shareholders while giving the CEO newly issued shares through fiscal 2013 that represent between 5% - 20% annual dilution. Additionally, try to picture this earn-out being set up in a manner that will still pay the CEO the maximum – while diluting shareholders by 20%, even if the company misses estimates by ~ 20% in 2011. Now imagine this same CEO, who receives ludicrous compensation based upon EBITDA metrics, well imagine him providing significant levels of related party financing at ZERO PERCENT. Try to picture a related party page of the 20-F that has 18 rows of transactions, the largest of which is a grocery store partially owned by the CEO, and partially owned by a crony Director. Picture a VIE organizational structure that appears to put equity owners in the precarious position of having no direct ownership of the operating company. Now imagine this same amoeba of risk having capital needs for 2011 of approximately $600 million in order to hit analyst estimates. Now think about the existing CEO marketing an IPO of another company, where incredibly, he is also the CEO and Chairman. Now imagine one door down from this CEO, a CFO that was the Director of Research for one of the largest ponzi schemes in U.S. history…. Now open your eyes and ask yourself: would this story be acceptable, justify a listing on a U.S. Exchange, and warrant institutional sponsorship if the company in question was from California, New York, or even Nevada?

     

    Nearly a week ago, The Forensic Factor ("TFF"), released our first report on AutoChina.[i] In that report we covered a broad array of topics that provided the foundation for our assertion that AutoChina has serious accounting concerns and a corporate structure where equity holders own NOTHING. AutoChina management published a response several days later discussing several of TFF's arguments, while completely ignoring others.[ii] It was a pleasant surprise to see such a verbose response, even if it ignored the most damaging questions, while manipulating and sensationalized others. TFF respects management's attempts to communicate - a fact that we will later explain is necessary given their sizeable funding gap for 2011. TFF has decided to provide the same courtesy to management of AutoChina with a brief response of our own. Our response will be brief in nature. TFF will save new and additional information for our next report - one that will likely require another response from management (perhaps much more damage control will be necessary). 

     

    AutoChina's management was correct when they stated it has become popular to attack Chinese reverse mergers. However, TFF would point out that it hasn't necessarily been without merit. In many cases, blatant frauds have been exposed, and at the very least, credible research has been presented highlighting substantial risks that investors have potentially been ignoring. TFF wants to be very clear that we do not believe AutoChina is a fictitious business[iii], it has not lied about its contracts and technology[iv], nor has it misrepresented its actual inventory or jewelry sales.[v] No, AutoChina actually operates a real business, and that is the problem.

     

    Lease accounting has been around for decades. As such, investors can expect, with a high degree of accuracy, a predictable range of frequency and severity metrics over time. AutoChina's reported financials are such an outlier from the myriad of historical models that any prudent investor must ask the question - how? It is the fact TFF can understand what AutoChina does that leads to the conclusion that AutoChina is a horrible investment and that no prudent fiduciary can explain how they overlooked: aggressive accounting methods that have historically been documented as overstating revenues and earnings, reliance on related party, sub-market rate financing, and an org structure that ultimately leaves equity shareholders with nothing.

     

    While we absolutely do not think AutoChina is a fraud, we do believe it possesses all of the warning signs that investors have come to associate with problematic Chinese companies. In fact, TFF recently reviewed a presentation by Paul Gillis, a Professor of Accounting at Peking University and the former PwC Asia-Pacific Managing Partner.[vi] According to Gillis, the warning signs are:

     

     


    Slide 7

     

    TFF would note AutoChina has a "check-positive" to all five bullets (at least until Gillis' old firm PwC completes an annual audit).

     

    The VIE Structure Revisited

    In our first report, TFF raised grave concerns that AutoChina shareholders owned nothing. In fact, we underlined one sentence to emphasize the severe risk that shareholders faced: " But a more concerning reality for AUTC shareholders is that based on the org structure it appears equity owners in AutoChina do NOT own the operating companies." TFF was surprised to see that management's 10-page response failed to address this seminal issue. In fact, the VIE explanation, or "Reference I" of management's response, was comprised of just four sentences. Management's evasive, and carefully chosen language towards the founding business versus the existing business, suggests they are acutely aware of the VIE grenade. It is the belief of TFF that truck leasing is NOT a protected business in China, hence there is no need for this VIE structure given AutoChina's only business is truck leasing. In fact, TFF has learned that AutoChina's PRC Counsel, Zhong Lun Law Firm, advised the company that there is no foreseeable legal impediment to the conversion of these contractual arrangements to a direct ownership structure, or to the conversion of all of AutoChina's other contractual arrangements since the applicable foreign investment restrictions have been lifted.[vii] So TFF is very confused why management would put forth this historical excuse for their VIE structure. 

     

    How dangerous is AutoChina's corporate structure, one which looks eerily similar to Rino's as illustrated in our last report? Prominent China research boutique New York Global Group recently published a report on Chinese VIE's, with forceful language that should be thoroughly examined by investors in AutoChina (underlined by TFF for emphasis):

     

    China based companies with VIE structures are the single biggest “time bombs” in the U.S. Markets. In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as cash, factories, land use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.[viii]

     

    This warning from NYGG is consistent with the concerns raised by TFF that AutoChina shareholders have no real ownership of the operating companies. In AutoChina's disclosure segment of its 20-F, a risk statement appears that validates TFF's concerns, "if there is any change of the PRC laws or regulations to explicitly prohibit such arrangements, ACG may lose control over, and revenues from, these companies, which will materially affect ACG’s financial condition and results of operations." Management did not address this issue in its response.

     

    AutoChina's Reference A & B & E - Gain on Sale Accounting

    TFF read management's response carefully and appreciated management's candor and thorough examples. With that said, TFF continues to believe a restatement will be the result of AutoChina's aggressive accounting policies. Sales-type lease accounting is reserved for manufactures that have captive finance organizations. Manufacturers have historically used sales-type lease accounting to recognize higher revenue and gross profit on the sale of the equipment that they manufacture. Since AutoChina's value proposition is almost exclusively providing financing, it is unclear how the company justifies an accounting treatment that has historically been reserved for manufacturers. Management's explanation would have been accurate… had they also been a manufacturer of the product to be leased. We believe the company's new auditor PwC, could confirm our view that the use of sales type lease accounting by an independent finance company does not conform to GAAP.

     

    The discussion about sales-type lease accounting may prove moot given the potential for it to go away. Recently, FASB identified lease accounting as an area of "weakness" and proposed merging their accounting standards with IASB (International). In August 2010, they issued an exposure draft of the standard, with the final standard set to be released in the next few months.[ix] According to the Equipment Leasing and Finance Association, "this may kill sales-type lease accounting. They want to use the finance lease accounting method in IAS 17 for all leases."[x] Even AutoChina's new auditors appear to side with TFF, "PwC Observations: The performance obligation approach represents a potentially significant change for lessors with sales-type leases under current standards because, under this model, no revenue would be recognized immediately; rather, it would be recognized over the lease term."[xi]

     

    The point is two-fold. TFF believes AutoChina is using an aggressive form of gain-on-sale accounting with its sales-type lease methodology. This accounting treatment has historically been utilized by firms with financing and manufacturing arms under the same umbrella. AutoChina does not have this structure. Second, it may be moot as oversight momentum is building to eliminate sales-type lease accounting, which should speak volumes about its overly-aggressive nature.

     

    Reference C &D - Atrocious cash flow and massive capital needs

    There seems to be no disagreement between TFF and AutoChina management that the company has atrocious cash flow characteristics today. However, management seems to massage the rationale for the cash flows in their letter by referencing a "typical vehicle lease, such as that for a passenger car." Management correctly points out that "the leasing company never reaches cash flow breakeven during the lease." We agree with this statement. While true, this statement is irrelevant and misleading when looking at AutoChina. The passenger leasing company never reaches break-even on a passenger car, nor does it really matter for the total economics of the manufacturer. The leasing company's economics must be viewed in conjunction with the manufacturing arm. This abusive sales-type accounting allows the entity to show big profits on day one of a lease. Comparing AutoChina to this model seems silly. AutoChina's sole business proposition is to make money on it leases. To state that "it is impressive that we reach breakeven at all" suggests that management is either clueless (which we do not believe), or is gently providing a comparison that is not tremendously relevant.

     

    Either way, AutoChina admits that in order to continue its game of growth, they will need to continue to ramp originations. Examining the estimates of Daiwa (we were unaware of their coverage until management's letter), the analyst appears to be assuming 20,625 new leases in 2011 for AutoChina.

    At $38,000 per lease with 20% down (very conservative, we think it is substantially lower), AUTC would need a remarkable $627 million of new funding. The company's investment portfolio will generate a small fraction of this amount. 

     

     

     

     

     

    2011

    # leases

    Ave COGS

    $ Volume (mm)

    Downpay

    Cash needs (mm)

    20,625

    $38,000

    $783.8

    20%

    $627.0

    Source: Daiwa and TFF analysis.

     

    As such, TFF believes that management desperately needs to secure new sources of funds, or growth will stall. Where will this cash come from? U.S. investors? Chinese banks that are under pressure to reduce originations? After analyzing the most recent disclosures, TFF is convinced that if the related party transactions slow, the future income statement will be dramatically different - a fact that AutoChina chose not to discuss in the numerous tables they provided.

     

    Reference K& L - Related Party Debt

    In management's response, TFF was extremely surprised to see the following quote from the CEO, "Also, I am the Company's second-largest related party lender and have provided AutoChina with capital from entities of which I own. I lend this to the Company at 0% interest cost to AutoChina, on an unsecured basis, repayable on demand."

     

    Shockingly, TFF could only find disclosures for these "interest free" loans in a footnote in the company's quarterly filings.[xii] We may have missed the reference or disclosure, but we were unable to find this disclosure in the company's three earnings press releases year-to-date. The fact AutoChina has been borrowing from related party entities interest free, or even at below market rates, significantly distorts the company's normalized income statement and overstates earnings. While there is nothing illegal with the CEO making a decision to lend to AutoChina interest free, this should be disclosed with every financial table so that investors understand that AutoChina's financial results are not comparable to other lenders based upon the non-arms length loans.

     

    TFF would also point out AutoChina's disclosure that highlighted Mr. Yong Hui Li 21% ownership of Beiguo, a percentage that we referenced in Table 7. They failed however to even mention that he also owns 19.60% of the equity interest of Renbai. They also neglected to mention that Thomas Luen-Hung Lau, a director of AutoChina, is the indirect beneficial owner of approximately 21.71% and 20.33% of the equity interest of Beiguo and Renbai. Additionally, as a teaser for our next report, TFF has learned that Yong Hui Li’s brother has a company that began extending credit to AutoChina in 2011, a fact that was also left out of management’s response. According to the most recent annual report, approximately 60-70% of the total commercial vehicle purchases made by AutoChina were made pursuant to arrangements with Beiguo and Renbai.[xiii] TFF is currently waiting on more information on the crony Board that we look forward to sharing in our next report.

     

    To illustrate why the related party loans are such distorting factors, TFF analyzed the P&L impact on AutoChina if related party rates adjusted to market rates. The 4% interest rate that the company discloses in their 20-F, should result in roughly $16 million in annualized interest expense. At "market rates," generously assumed to be 7% by TFF (200 basis points below recent securitization financing of 9%), the pre-tax difference based on our analysis would equal $0.74 per share, or over 40% of the company's 2010 earnings estimate.

     

     

     

     

     

    Annualized Interest Expense MM

    Annualized Int Expense @ 7% MM

     

     

     

    Amount Financed 9Ms MM

    Amount Annualized MM

    Interest Rate

     

    EPS Impact

    Related Party

    Delta

    Beiguo

    $296.70

    $395.60

    4%

    $15.80

    $27.70

     

     

    CEO

    $85.90

    $114.50

    0%

    $0.00

    $8.00

     

     

    Total

    $382.60

    $510.10

     

    $15.80

    $35.70

    $19.90

    $0.74

     

    TFF believes AutoChina's disclosure that it has only recognized $4.8 million of "related party interest expense" year-to-date raises other questions. At a 4% interest rate, this implies only $158 million of average related party debt. We could be missing something, but thus far, we have not been able to reconcile this figure. TFF believes the company is either significantly understating their related party debt or has found a way to inexplicitly pay off the "$382.6 million" of debt it discloses in its financial statements. Given the fact management also used the $382.6 million figure in their letter (reference L), we wonder out-loud how their related party interest expense would seem to imply a much lower rate than that which has been disclosed. 

     

    Reference F & G - Minimal loan loss reserves

    Management was a stickler when they asserted TFF contradicted itself when we decried the company's lack of reserves. TFF did not literally mean the company had no loss reserves, although the actual number (which we clearly cited) is not far from zero. We apologize if this was confusing, and hope it does not blur our point. Based on TFF's experience with leasing companies, transportation finance, auto finance, and banks, we believe AutoChina's delinquencies and reserves are beyond abnormal. TFF estimates a loan loss provision equal to just 50% of delinquencies would be worth $0.28 per share, or over 15% of 2010 earnings per share. Again, we look to the perverse earn-out as a possible explanation for the aggressive assumptions management has utilized. 

     

    TFF does believe that loan-to-liquidation value is well north of 100% BEFORE the company lends fuel, tires and insurance. It is widely accepted that any new car or truck loses a significant percentage of its value the second it is driven off of the dealer's lot.  Additionally, the reposition of a truck is expensive and time consuming, while the losses generated by selling a truck in the secondary market can be significant. As a result, TFF is skeptical about AutoChina's statement that it is providing "secured" financing for fuel, tires, and insurance. 

     

    Finally, history has generally shown that when a company can recognize profits by simply providing a loan, there is very little incentive to stringently underwrite a credit. This should sound familiar to anybody that followed the mortgage catastrophe over the last decade. With that said, TFF concedes it is possible AutoChina's lending policies, and claims of advanced screening tools, could be the driver of their unique credit quality. TFF admits that we could be wrong and this time it may indeed be different. However, the phrase “this time it’s different” is usually another way to say “sell.”

     

    Reference J- Restatement Likely

    We were critical towards the earn-out that AutoChina has endowed upon its CEO. We would note that we have no opinion towards Mr. Li; he may very well be a wonderful person and CEO. Our disdain is directed towards the egregious nature of the earn-out, the unfavorable incentives and dilution it has created, and the fact the treatment of the earn-out does not appear to conform to GAAP accounting. Management’s defense of the earn-out seems to imply that it is merit based. TFF reads the earn-out very clearly, and this statement is true for determining the range of dilution (5% - 20%).  However, TFF believes it is very misleading for management to state “Fact – The earn-out is subject to certain EBITDA targets,” when in fact the earn-out seems to stipulate a minimum of 5% dilution in new shares regardless of performance.

     

    Further, TFF believes management was not entirely sincere by failing to discuss the absurdly low bogeys that the earn-out is based upon.  AutoChina’s earn-out is not based upon EBITDA targets that are reset annually. Instead, the earn-out is calculated off of an abnormally low level of projected EBITDA from 2009. With the initial bar set at artificially low levels, 2011 EBITDA could come in $19 million below consensus expectations (Daiwa) and still result in the maximum benefit for CEO/dilution for shareholders of 20%. This 19% miss of expectations that would still create 20% dilution does not exactly register as a Herculean (or fair) bar for performance.[xiv]

     

    AutoChina's management claims that the $57 million of stock issued to the CEO in 2010, and the $100 million of stock about to be issued to the CEO is not compensation expense. Their rationale relies on the argument that the earnout is "based on performance that is not tied to employment," and has an "original intent" that would compensate Mr. Li for EBITDA growth. TFF continues to believe that AutoChina is incorrect. Accounting is not static, nor is it based upon intent. EITF 95-8 clearly states that earn-outs must be classified as an expense if management is not compensated at levels consistent with "other key employees." Young Hui Li's compensation of $1.00 per year is clearly not inline with other employees. TFF believes that AutoChina's compensation expense is significantly understated because it does not include a realistic cash comp figure for the CEO, nor does it include the earn-out that is offered in lieu of cash compensation.

     

    We'll be back with much more in Report 2…

    While we respect the open dialogue AutoChina has demonstrated with the investment community, our thesis still holds. TFF believes that when the dust settles, AutoChina will be a single digit stock. As of January 24, 2011, the 72 companies in Roth Capital's Chinese Investment Universe Publication traded at 7.7x earnings. If AutoChina simply traded inline with the broad Chinese universe, it would be $14 per share based upon consensus estimates. Taking into consideration the possible 50% dilution, the stock would be closer to $7.00 with an inline multiple to the peer group. However, given the quantity of issues that TFF has discussed, it would seem logical that investors would value AUTC at a discount to its peer group (assuming the earnings do not vanish in a restatement). TFF would point out that should bad debt increase, or funding dry up, there are ample scenarios where AUTC equity could go to zero. We believe the serious issues TFF has raised warrant investor skepticism. It is the opinion of TFF that investors will suffer at least 50% downside from current levels.

    [xv]



    [vi] Seminar: China's Auditing and Financial Statements - Risks and Realities

     

    Disclosure:
    *** The author of this article is short AutoChina stock.  TFF goes to great lengths to ensure that all information is factual and referenced. All facts that we present herein are true to the best of our knowledge. All opinions presented are our own and accurately reflect our opinion on the relevant subject being discussed.  We recommend that investors perform their own extensive due diligence before buying or selling any security.

    Feb 07 1:23 PM | Link | 1 Comment
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