Please read the disclosures at the bottom of this article.
In my previous two articles, I’ve written about how several Seeking Alpha contributors have used locally filed Chinese financial statements to provide compelling evidence that certain U.S.-listed Chinese companies may be frauds.
All foreign-invested enterprises must file financial statements with the State Administration for Industry and Commerce branch of the Chinese government. These documents are not available electronically; rather, a local Chinese citizen must go to the appropriate local branch to access these documents. Fortunately, certain third-party credit agencies provide this service to foreigners for a fee.
In previous articles, I compared the SAIC and SEC financial statements of YUII, CSKI and LIWA. The numbers for YUII matched, whereas they did not for CSKI and LIWA.
In this post, I compare the SAIC and SEC financial statements for China Marine Food Group Limited (OTCPK:CMFO). The numbers do not match.
This provides evidence that China Marine Food Group Limited may be a fraud. In addition, I note additional data points that raise questions about whether CMFO’s financial statements accurately represent the financial condition of the underlying business.
I also present the response of the chief financial officer of CMFO to a question on why the SAIC and SEC documents don’t match, and provide my opinion on his response.
Before discussing CMFO’s SAIC statements, let’s discuss the legal organizational structure of CMFO. This is important because each subsidiary files separate SAIC financial statements. Chinese GAAP does not consolidate subsidiaries, and therefore it’s important to determine which subsidiary generates most of the company’s revenue. We can then compare the SAIC financial statements of this main operating subsidiary with the SEC filings.
Here is CMFO’s legal organizational structure, from an annual report. We use the 2008 org structure, because we are comparing their 2006, 2007 and 2008 financials. 2009 SAIC filings are typically not filed until midyear.
The U.S.-based, publicly listed entity is China Marine Food Group Limited. Nice Enterprise Trading H.K. Co., Limited, its subsidiary, is based out of Hong Kong. Nice Enterprise has one subsidiary, Shishi Rixiang Marine Foods Co., Ltd (“Rixiang”), which is based out of China. Rixiang is a foreign invested enterprise that owns two other subsidiaries: (1) Shishi Huabao Mingxiang Foods Co., Ltd. (“Mingxiang”)and (2) Shishi Huabao Jixiang Water Products Co. Ltd (“Jixiang”).
Where are the operations primarily held? Rixiang. We know this by the following disclosures in the 10K:
"With effect from January 1, 2005, Rixiang acquired the business operations of Mingxiang, which subsequently became a property holding company. Rixiang was incorporated as a FIE and was granted the tax incentives for FIEs, and was exempted from income tax for 2005 and 2006... Jixiang is also a property holding company and is not subject to tax."
Elsewhere throughout the report, the Company also makes clear that Rixiang generates all of the Company's operating revenue, such as "All of our production is undertaken by our subsidiary, Rixiang" in the "Our Products" section.
From the above disclosure, we also know that Rixiang is an FIE. As an FIE, Rixiang must file accurate annual financial statements with the Administration for Industry and Commerce branch of the Chinese government.
SAIC vs. SEC financial statements
I have had a local third-party credit agency go to the local AIC office in Rixiang’s jurisdiction and photocopy their financial statements.
The figures in the attached documents are in Remnimbi. In the chart below, we convert the Remnimbi to US dollars, and compare key financial line items with CMFO’s SEC financials:
As we can see, CMFO reports much higher numbers in its SEC filings than its SAIC filings. In its SAIC filings, the company generated only $2mm of revenue in 2007 and $7mm in 2008. In its SEC filings, it allegedly generated $36mm in 2007 and $49mm in 2008.
Compare that with Yuhe, which generated $21mm and $34mm of revenue in 2007 and 2008 in its SAIC filings, compared to $22mm and $36mm of revenue in 2007 and 2008 in its SEC filings.
As we discussed earlier, Rixiang is the primary operating subsidiary of CMFO. It is also an FIE. As a result, Rixiang’s financial statements should accurately reflect CMFO’s SEC financial statements.
But they don’t.
The CMFO’s response to the discrepancies is the following, based on an email:
"It's a formality in China to file the operating figures with SAIC on an annual basis. We used to hire an independent agent firm to do the filing on our behalf as the process itself is quite tedious though. Guess the agent firm has used kinds of outdated figures to do the filing and thus discrepancies appeared as a result.
Since there won't be any anticipated influence or harm over those inaccurate historical figures with SAIC, we don’t believe it’s necessary to re-file the statements. That said, we will switch to another sizeable agent firm to do the 2009 filing and will make sure the numbers so filed are consistent with our book record going forward."
We’ve been down this road with CSKI. The CFO of CSKI said a similar thing in 2009 when asked why CSKI’s SAIC numbers didn’t match the SEC numbers. We have yet to see matching financial statements.
What is actually going on? My belief is that CMFO is fabricating its SEC financial statements. FIEs in China must file accurate audited financial statements. I’ve spoken with dozens of accountants and CFOs of verifiably legitimate Chinese companies, and they have all confirmed this. It’s understandable to have small differences between SAIC and SEC filings, due to subsidiary consolidation and Chinese vs US GAAP. But CMFO’s 2008 SAIC revenue was 85% lower than its 2008 SEC revenue. That’s not due to GAAP accounting differences.
In my opinion, fraudulent Chinese companies like CSKI and CMFO are making up numbers out of thin air. To fool their accountants, the companies are using sophisticated and undisclosed related party and off-balance sheet transactions to inflate financial statements. They are using phony bank statements to fake cash. It’s unclear how exactly they are doing it. But the differences between the SAIC and SEC numbers provides compelling evidence that they are finding a way to do it. After all, there is a lot of money to be made – companies like CSKI and CMFO have raised $25mm+ each in secondary equity offerings or private placements, all for dubious purposes. If they are indeed fraudulent, these funds are likely being siphoned to a large degree to personal bank accounts.
These are shocking allegations, yes. But the world of Chinese reverse-merger smallcaps is a shocking one, and given the very low valuation multiples, it’s clear that many other investors suspect similar wrongdoings.
Other Signs that CMFO is a Fraud
The main thrust of our argument that CMFO is a fraud is that the Company’s SAIC and SEC filings don’t match. But as we did with our two posts on YUII, CSKI and LIWA, we’re going to highlight other signs that make us concerned about trusting CMFO’s SEC financial statements.
Again, we’ll compare CMFO with YUII.
In our last post, we explained that Yuhe’s attempt to upgrade to Grant Thornton was a welcome contrast to the audit history of many other Chinese companies that have gone public via reverse mergers.
CMFO’s auditor, ZYCPA Company Ltd., is equally as questionable as LIWA’s and CSKI’s auditors. It is not listed in the top 100 global audit firms. It has 2 partners and 25 personnel, per its web site. Given that CMFO alleges to have generated $70mm of revenue and $15mm of net income in 2009, ZYCPA appears to be a woefully inadequate auditor for the company.
If CMFO is making up its numbers, it would certainly find an easier time defrauding one of the two partners at ZYCPA than a top-5 audit firm like Grant Thornton.
As we discussed in our last post, a key thing to monitor when examining whether reverse-merger Chinese companies are frauds is to see how much capital they’ve raised via secondary private placements and equity offerings.
Naturally, we have no issue with capital raises. Companies need to raise funds to grow. But with Chinese companies that have gone public through reverse mergers, we see a tendency to raise large sums of money at large discounts to current stock prices, with dilutive warrants attached, and for dubious purposes. Indeed, if a company is fraudulent, a capital raise is the primary goal of creating a China-based fraud in the first place. The funds are taken from U.S. investors and deposited in the personal bank accounts of the organizers of the fraud.
With YUII, we have not seen any dilutive and/or unnecessary secondary offerings thus far.
With CMFO, we saw a $30mm private placement on January 20, 2010. The purpose was: “The Company intends to use the net proceeds from this offering for working capital and general corporate purposes.” From its SEC filings, the company allegedly had $7mm of cash at December 31, 2009 and has generated positive free cash flow (measured by cash flow from operations less capital expenditures) for each of the past three years. It’s unclear why the company needed additional cash.
The dilution was not especially egregious though, and the new shares were issued at only a 9% discount to the prior 10-day trading average and a 12% discount to the prior 30-day trading average.
At the time of writing, I and affiliated entities have a short position in CMFO and a long position in YUII. I intend to trade in these securities subsequent to this post within the next three days. I may also initiate positions in other stocks mentioned in this article, including CSKI and LIWA.
In no part of this post do I attempt to provide false or misleading information. All facts presented in this post are true to the best of my knowledge. All opinions presented on this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please list your concerns in the comments section and I will address it.