Enlightening Potential Investors on Shengkai Innovations

| About: Shengkai Innovations, (VALV)
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In the short amount of time I have been following Shengkai Innovations (NASDAQ:VALV), I have received a lot of questions and concerns from individuals about several factors involving the company in my previous articles here and here.

I have taken a little time to do some further research into the company and these are the results of those findings. If there are any concerns that you have that are left unaddressed, or are not answered in a manner that is satisfactory, then please feel free to leave a comment about it.

1) General discomfort with the reverse-IPO listing of the company:
Many individuals have expressed negative opinions towards the reverse merger process. Their arguments are that the IPO process is meant to weed out the companies that are not ready to list publicly. The IPO process also adds confidence to the legitimacy of the company, its management, and its product lines because the underwrites of the IPO are held liable if they endorse a fraud. You can imagine that they do their due diligence. The argument against a reverse merger is that this due diligence is never done by an underwriter. Also, without a large firm underwriting an IPO, you find that several reverse-mergers never get the public exposure they seek from listing on markets and eventually trade with low liquidity because they are unknown. Essentially, they are a privately owned public companies.

I have spoken with an individual involved in the initial structuring of the deal to bring Shengkai public through a reverse merger. The explanation given to me was because IPOs are often expensive, time consuming, and make little financial sense for smaller companies only seeking small amounts of capital. If you think about it, Shengkai only needed $30 million dollars for the new facility (and I'm not certain all of that even came from the initial financing, they may have had money on hand from operations too). This is not a lot of money to warrant the time, effort, and expense that would typically go into an IPO. A reverse-merger gave the company the financing that it needed to move into its new factory and still have access to equity markets for future capital needs. In fact, you will be hard pressed to find IPOs of this size from American companies; this is not a phenomenon limited to Chinese companies.

2) Little legal recourse for investors:
Since the company operates in China but is only traded in the US, several individuals have expressed that it would be impossible for investors to have any recourse against Shengkai or its auditors in the event of fraud. Investors would not be able to press charges against Shengkai or its auditors and there is little the American justice system could do to subpoena records and etc.

This is only partially true. Investors have little direct recourse against Shengkai itself. It is unlikely that the Chinese government would do anything about the company if they were only defrauding American investors, though the penalty for defrauding Chinese investors is pretty steep. However, it was explained to me by someone who has experience underwriting issues that for a company to trade in the US, their auditing firm has to have representation in the US. This means that records should be able to be subpoenaed in the event of a criminal investigation and its auditing firm could be held partially responsible. How likely this is though is beyond my realm of knowledge. We will have to watch and see how the recent Chinese reverse-merger frauds turn out and see if any action is taken against their auditors.

Their are a few other disadvantages to doing business in a country like China. First of all, cash deposits in banks are not insured so it is possible that in the event of an economic downturn that companies may sustain substantial losses from bank failures. This is something to keep in mind as a few economists have suggested that China's real estate market is in a similar bubble the one the US experienced in the early 2000s. I will not definitively say that the Chinese markets are not in a bubble, but it seems that their Real Estate market has a much better reason for being inflated than the simple speculation that was going on due to yield starved investors searching for returns in the US.

Secondly, as mentioned above, it will be far more difficult for investors to seek recourse against the company itself. That would be something that we would have to rely on the Chinese government to step in. I do not believe that this will end up being much of an issue either but it is important to keep it in mind when investing.

3) The fact that it only trades in the US is a little shady:
Why does Shengkai trade only in the US and not in China? This would seem to point to the possibility that they are trying to evade Chinese regulations and authorities in an attempt to defraud American investors; an action that may make some individuals very rich while shielding them from any potential litigation.

Chinese companies have few options available to them in the event of becoming publicly traded. They can trade on the local Chinese exchange which lacks liquidity and other attractive features, they can list in Hong Kong, or they can list in the US. According to someone who has experience with Chinese regulation, there are some laws/regulations in place to limit American ownership/investment in domestic Chinese companies. This is part of the reason Shengkai is a wholly owned subsidiary of the parent company that is based in Bermuda. Evidently, there are no regulations involving American investors who invest in the wholly owned subsidiary by investing in the foreign parent company or some convoluted loophole like that. Thus, this is the reason Shengkai trades in the US. It would not have nearly the same exposure to American investors if it traded in Hong Kong or China. The only question that is left unanswered is why Shengkai found the American capital markets to be a place more desirable to raise money than the capital markets found in Hong Kong. After all, it was this desire for American investors that let to the creation of this opaque business structure to circumvent Chinese regulation.

4) Legitimate business?:
Several readers have questioned the legitimacy of the business given that many Chinese companies are being exposed as frauds and have little to actual business or revenue. I have spoken with an individual from one of Shengkai's institutional investors who has been actively involved in researching the company. This individual had been to the factory and confirmed its existence. There was also a reference made to a Financial Times article that reported on Shengkai where pictures were taken within the factory. This article can be found here. Keep in mind that any institutional investor in the company has an interest to "sell" the company so the price of the stock will rise so a look into the reputation of the institution is also in order. I found nothing to be too terribly suspicious or a cause of worry when researching the institutional investor. (They asked that I not quote them directly due to company policy which is the only reason I have not disclosed who this institutional investor is).

I have not personally contacted any of Shengkai's customers that were listed in the 2009 form 10-k but that is because all of them were in China and I thought that it would be unlikely for me to be able to actually get through to anyone who would be able to confirm their involvement with Shengkai.

5) Shengkai's Auditor: Is Shengkai's auditor reputable?
Many individuals may have noticed that there appears to be a common thread between Chinese companies being exposed for fraud--they have the same auditors. If Shengkai's auditor were to be linked to other frauds then one could put less trust in Shengkai's audited financial statements.

Shengkai's auditor is BDO China Li Xin Da Hua CPA Co., Ltd. It is my understanding that BDO represents a network of separate accounting firms that operate under the umbrella of BDO. I have been told that BDO is a reputable, international accounting firm; however, this does little to speak for the individual accounting firms that comprise the organization as a whole. So, it is possible for Shengkai's auditor to be less reputable than the name BDO would suggest though I have not located any information to suggest such.

6) Dilution and its Effects: Why is the company issuing so many new shares as a new company? Won't this dilution effect total investment performance? Why was the recent offering so under-priced?
The company has been issuing a lot of shares recently is relation to the their newly adopted employee compensation plan as well as for purposes of raising money. Some individuals have suggested that this unusual for companies so young. I have little experience with start-ups but it actually makes sense to me that start-up companies issuance of warrants and etc. would actually have a much larger relative effect on share price dilution then for large companies given that smaller companies have fewer shares outstanding. Technology companies and start ups are known in the US for paying executives and top talent with options. I do not know why this would be any different for a Chinese company except for the fact they are not a "tech" company by the standards most of us Americans would use. They are a high growth company though, so the issuance of warrants and options would fall under the same reasoning that tech companies use to justify their employee compensation plans.

Warrants and option are dilutive and will lower the value of each individual share that you own. Keep in mind that insiders own a large percentage of the company. I do not know the exact % after their most recent offerings but its somewhere in the neighborhood of 75-85% of the company. Any decisions that they make to dilute current shareholders has a much more substantial impact on them because they own the majority of the outstanding shares. Thus, it would not make sense for them to print themselves money through options and warrants while deteriorating the value of the 85% of shares that they already own. Also something to consider, the provisions of the most recent offering prevent any further dilution for the next 9 months and after that Shengkai has capped it's total shares outstanding to 50,000,000 which the company is approaching. Even at this 50,000,000 my previous business analysis' found here and here showed that this company was an attractive opportunity if growth continued. Now, the management could always vote to change the share cap amount because they own more than half of the shares outstanding. This is where we need to remember that anything that do that negatively affects us has a much larger negative effect on them in regards to diluting share value.

So, why was the most recent offering so under priced? I can not answer with any definitive knowledge on the subject. I have not spoken with any investment professionals on the matter but let me share my opinion. Shengkai is a little known Chinese company that is not followed regularly by anybody other than myself and it is a relatively illiquid stock. To be able to attract buyers Shengkai would have likely had to price in a large discount to get anybody to be attracted in trading it for all of those reasons. With the large discount, these individuals could easily flip the shares in the open market for a 20% gain and then Shengkai gets the money it wants and the liquidity of the stock improves. If you don't believe me, look at the current liquidity of the company. Before the offering it wasn't rare for Shengkai to only trade a couple hundred shares a day and it's 3 month volume average was something along the lines of 2,000 shares a day. Now, just a few weeks after the offering 3 month volume has jumped to 14,000 shares a day and the ten-day average volume has been 26,600 shares a day. This is hardly what I call a "liquid" security but its clear that the offering did create volume movements in the stock that are continuing today making it easier to get into and out of the stock and lowering bid/ask spreads. This is ultimately what long-term shareholders want because then it is more likely for the company's share price to reflect its intrinsic value.

7) Shengkai's Investment Relations firm: Who are they and are they reputable?
Shengkai just hired an investment relations firm named Grayling that is based out of London. Grayling is the world's second largest independent global public relations firm. I do not know a lot about how to begin investigating a public relations firm but I would think that if they have been successful enough to become the second largest firm that something could be said about their reputation (though this is not always true and there are a number of examples of bad seeds being successful). If anyone can provide more insight on Grayling in the comments below it would be much appreciated.

It is odd that Shengkai waited until after their recent offering to appoint this company. That is clearly something that should have been done before the offering and it is possible the company could have received more favorable terms as the investing public becomes more familiar with the company. What is done is done and investors cannot change what the company has already issued; what they can do is look forward to a future where there is more coverage, even more transparency, and potentially more value created from a company that they are invested in.

This article is not to definitively say that Shengkai isn't a fraud of a company. There is absolutely no way of me to be certain of that without going to China myself, visiting the company, buying it in its entirety and operating it myself. There is always the possibility for investment fraud, even in American companies (I'm sure one doesn't have to think too hard to come up with a few names just over the past decade). Chinese companies simply need more due diligence. Hopefully, this article has provided just that: enough research and due diligence to suggest that individuals can feel a little more comfortable about owning shares or to solicit the facts and opinions from individuals who feel otherwise.

If anyone is able to contact one of Shengkai's direct customers that would be great; please share the experience in the comments section. The same goes for individuals who have anything to offer about Grayling.

Disclosure: I am Long VALV.