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CMFO and Xianghe: A Dubious Acquisition 17 comments
This article discusses a questionable acquisition that China Marine Food made in January 2010 that was used to justify a $30mm equity capital raise.
As I wrote in my last post, the financial statements that CMFO files with the SEC are substantially different from the audited financial statements that it files with the Chinese government. Whereas companies like YUII, FUQI and SOLF have matching financials when comparing US and Chinese audited financial statements, CMFO’s revenue in its Chinese filings for 2008 were 85% lower than in its SEC filings. Other financial line items were smaller by similar orders of magnitude.
The company is falsifying one set of financial statements – that’s an obvious fact. The question facing investors is whether CMFO is falsifying the SAIC financials that they file to seven branches of their own government, or whether they’re falsifying the SEC financials that they used to raise $30mm of cash from U.S. investors in January 2010.
In this article, I explain why an acquisition that the company made in January 2010 provides strong evidence that CMFO is engaged in fraudulent activities. Specifically, I believe that the company which CMFO acquired is fraudulent itself.
A Questionable Acquisition
In January, CMFO raised equity capital partly to fund an acquisition of Shishi Xianghe Food Science and Technology Co., Ltd. (“Xianghe”). Xianghe is a manufacturer of algae-based soft drinks. The purchase price was $27.8mm.
Here is the description of Xianghe’s product:
“Xianghe is a Fujian based manufacturer of the branded Hi-Power algae-based soft drinks. Hi-Power was developed by the Yellow Sea Fisheries Research Institute Chinese Academy of Fishery Sciences in coordination with the founder, Qiu Shang Jing. Hi-Power is marketed as a high-protein content drink, low in calories and fat, which provides the consumers a combination of immune system benefits, improved digestion and reductions in hyperglycemia and hypertension. Hi-Power’s target market focuses on health conscious consumers in China’s fast-growing beverage market.”
Here is a link to an informative 8k dated March 16, 2010 about the Xianghe acquisition. Most of the following discussion is disclosed in this 8K. In this link, we discuss specifically where in the 8K we get supporting material for the statements we make below.
From the 8k, we learn that Xianghe’s product actually originated in January 2009, when Qiu Shang Jing paid Yellow Sea Fisheries Research Institute (YSFRI) $8,776 for “know-how” regarding the development of an algae-based drink. To repeat, Xianghe basically began 1.5 years ago, when Mr. Qiu purchased “know-how” on how to make a certain algae-based drink for eight thousand seven hundred and seventy six dollars.
In April 2009, Mr. Qiu leased office space from CMFO (CMFO waived the rent beginning in July) to set up his new algae-drink company. On July 28, 2009, Mr. Qiu incorporated Xianghe as a legal entity with $43,979 (that’s forty three thousand, nine hundred and seventy-nine dollars). On October 2009, Mr. Qiu contributed an additional $689,504 for a total registered capital of $733,483.
Xianghe was then purchased by CMFO for $27.8mm in November 2009, through a 2-step acquisition that was completed in January 2010.
I’ll repeat the key points. Xianghe began when Mr. Qiu bought “know-how” regarding how to make an algae-based beverage for ~$9k in January 2009. Over the following 9 months, Mr. Qiu contributed an additional ~$733k (with 90% of that in October, one month before the acquisition).
In November, CMFO purchased 80% of Xianghe for $27.8mm.
Based on my calculations, Mr. Qiu achieved a 139,160% annualized return on his investment in the algae drink.
For the avoidance of doubt, here is a graphic representation of what happened:
I find it extremely implausible that a company essentially begun in January 2009 and that received less than $750k of capital in its first 11 months of operation (with 90% of that in the 10th month) would be worth $28mm at the end of the 11th month, unless it had a truly unique patent or technology. Xianghe is a maker of an algae-based beverage. I doubt that this qualifies as a sufficiently unique product that’s worth $28mm purely because of the inherent attractiveness of the product.
Equally absurd is the fact that the “know-how” which Mr. Qiu purchased for $9k is now valued on CMFO’s balance sheet at $23.5mm.
Incidentally, Li Xiaochuan is “the researcher” of YSFRI and also an independent director of CMFO.
More Dubious Financial Statements
Xianghe was begun when “know-how” was purchased in January 2009 for $9k. The company wasn’t actually incorporated until July 28, 2009.
So one would think that Xianghe would have negligible revenue and profit in its first 5 months of operations, correct?
Not according to Xianghe’s financial statements. Keep in mind that Xianghe was audited by CMFO’s same poorly qualified auditor: ZYCPA Company Ltd. ZYCPA, according to its website, has 2 partners and 25 personnel. It received its PCAOB designation in December 2008.
Between July 28, 2009 and December 31, 2009, Xianghe claims to have generated $7.6mm in revenue, $3.0mm in gross profit, $1.7mm of net profit and $1.2mm of cash flow of operations.
With approximately $742k of equity capital (comprised of $9k for know-how in January 2009, $44k of cash contribution on July 28, 2009 and $689k of cash contribution on October 8, 2009), Xianghe was somehow able to generate $7.6mm of revenue and $1.2mm of cash flow from operations in its first 5 months of operations, from selling an algae-based beverage.
Again, I'll demonstrate my points with a graphical representation:
Conclusion
The financial statements for Xianghe provided in the 8K that is “audited” by ZYCPA appear to be fraudulent. The Xianghe story is implausible, and any investors who think otherwise simply didn’t take the time to read the March 8K. Xianghe does exist and does make algae-based drinks. But I believe that it is not worth remotely close to $28mm and it did not generate remotely close to $7mm of real revenue in its first 5 months of operations. I think that Xianghe's numbers, like those of CMFO, are fabricated.
The acquisition of Xianghe served as a way for the creators of CMFO to justify a $30mm equity capital raise in January 2010. I believe that the vast majority of the $28mm that was used to purchase Xianghe was either redirected to personal bank accounts or used for some other dubious purpose.
Disclosure:
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. 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 them.
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This post has 17 comments:
I am only starting to look at this piece of work thanks to your efforts; but there are 2 items that I would like to bring to your attention. A capital contribution does not have to be in cash. The Chinese allow a company to start with cash infusions as low as 15% of the Registered Capital. In other words the Oct 09 Capital Contribution was most likely ~$100,000 cash and a promise to provide the balance of the capital within the statutory time limits. (3 years I think)
The second issue is that the fictional revenue and earnings have to be spent. The only assets you can buy with fictional earnings are equally fictional assets. It is implausible for a company with $30mm in cash to float a secondary asking for expansion money. CMFO most likely did not actually pay the money discussed. They made a deal at a far lower price but are able to show a plausible (barely) use for the fictional profits. They have also created an asset on the books and another opaque (fictional) revenue source.
Keep up the good work.
John
By the way, several members of the auditing firm you attack are from Big 4 firms. Could CMFO use a bigger auditor? Yes. But you have absolutely no basis for smearing the one they have, other than it's an easy ad hominem attack.
Why don't you disclose your name and affiliations, by the way? Afraid WE WILL DO SOME RESEARCH ON YOU? Funny how it's easy to seem credible when no one get you in their sights.
messages.finance.yahoo...
Note that the Ghost had no idea the Xianghe acquisition even existed when he wrote his first article, where he wondered what CMFO had spent its proceeds from a share offering on. Um, they spent it on this acquisition. You might want to consider the Ghost's lack of understanding of this company, its history or any of its businesses before swallowing his "analysis."
messages.finance.yahoo...
Thanks for pointing out to the 8-K, which is quite self-explanary. For people who are not reading it, they don't deserve any explanation.
It is amazing how this document is almost self-incriminating. I can hear the sound when my jaw dropped to the floor. LOL.
What does common sense tell us? That CMFO committed fraud and detailed it so completely in public filings that even our anonymous short-seller -- who didn't even know CMFO had MADE this acquisition a week ago when he wrote his first article (now abandoned) -- could piece it together? Or that this transaction, included the related-party nature, was so fully disclosed because it was legitimate? The answer is obvious. Or at least obvious to anyone without an agenda and an increasingly expensive short position.
You can draw your conclusion that it was merely a $28mm acquisition where CMFO overpaid by $27mm. Or that it's believable that an algae-drink company can generate annualized revenue of $17.7mm based on its first 5 months of operations, after receiving $53k of startup capital, and $690k of secondary capital in its 3rd month of operations. Or that an "algae-based drink know-how" that cost $9k to acquire in January 2009 deserves to be valued on CMFO's books at 23.5mm today.
I instead draw the conclusion that the Xianghe numbers are fabricated. Given that the company's accounting firm is as unreputable as they come, this isn't hard at all to believe. I believe that Xianghe merely served as an excuse to justify a $30mm capital raise that was pocketed by CMFO insiders or used for other dubious purposes.
The investing community can decide which is the more believable story.
There's nothing expensive about my short - the short interest is quite low and the borrow is very cheap right now.
Disclosure: short CMFO
I read the 8-K independently and drew the same conclusion that CCA did. I am more than certain that either you haven't read it or you are completely impotent in reading financial statements and the attached annotations.
For anyone who has some working knowledge of accounting, this 8-K just reads shocking, like watching the dumbest thieves on TV.
My bet against you is on.
Disclosure: Short CMFO.
(I know, our Ghost doesn't trust analysts, he only trusts himself. I guess I think a track record you can measure is important when making investing decisions based on someone else's conclusions, but I'm picky that way.)
We all agree on one point: the market will be the ultimate arbiter of whether our Ghost friend's allegations are accurate. Until then, I'll stay comfortably long.
Brean Murray, we all make mistakes. Differentiating between real and fraudulent Chinese RTO smallcaps is a very difficult task. I applaud you for tackling this space and trying to provide capital to small Chinese companies. And as you try to help investors cross this minefield, you're going to occasionally step on some landmines. CMFO is one of those landmines. Many investors overlooked the March 16 8K, which clearly lays out in stark terms how fraudulent Xianghe and CMFO actually are. It's excusable that you also overlooked the 8K. Research analysts are overworked and underpaid, and are subject to pressure from investment bankers to hype companies that provide investment banking revenue.
But over the next few weeks, if not months, increasing scrutiny is going to be given to the Xianghe acquisition and the issue of CMFO being a fraudulent company. This will not be a case of some anonymous internet analyst writing two posts, and then all being forgotten. As the issue gets broader exposure, you'll be faced with two choices: either stand by your Buy recommendation or to suspend coverage on CMFO.
It's a tough decision. I wish good luck to the Brean Murray analyst and/or research committee that decide how to respond to the allegations. Naturally, I think that Brean Murray should do the right thing and suspend coverage. But I'm short the stock, and so am obviously biased in my opinion.
Disclosure: short CMFO
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