Vimicro Investors Hold A Worthless Bag

| About: Vimicro International (VIMC)
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Summary

Over the past four years, assets worth over $600 million (4x the market cap of VIMC) we believe were embezzled from VIMC into privately-held related parties controlled by VIMC's co-founders.

After looting VIMC of all its intrinsic value, insiders further enriched themselves by falsifying VIMC's financials and issuing numerous press releases to pump and dump the worthless US-listed shares.

Consequently, VIMC's US investors unwittingly hold shares of a worthless company, with no legal recourse to claim what we believe was embezzled from them since it is now privately owned in China.

US investors will never recover what is rightfully theirs, but justice may be served as the family of VIMC's chairman is being investigated in a famous case of government graft.

We believe Shen, who is close to VIMC's chairman, was one of several government sugar daddies used to illegally obtain valuable assets from the government to transfer to the co-founders.

A PDF copy of this report can be downloaded here.

1. Introduction

It is no secret that corruption runs rampant within the Chinese government where many senior officials have historically used their positions of power to enrich themselves and their cronies at the expense of the Chinese populace. One of the hallmarks of PRC President Xi Jinping's first two years in office is a solemn campaign to crack down on the highest levels of corruption. Even senior government officials have not been immune to this crackdown, as evidenced by the recent investigation of Zhou Yongkang[1]. Many companies affiliated with corrupt government officials have lost much of their value as anti-graft investigations reveal the use of such companies as vehicles for embezzlement, bribery, and financial fraud.

In this report, we unveil how insiders of Chinese video semiconductor and surveillance camera manufacturer Vimicro International Corporation (VIMC), led by co-founders Deng Zhonghan and Jin Zhaowei (the "Co-Founders") systematically gutted over $600 million worth of government funding, government-granted real estate assets, and proceeds from commercial government contracts from the NASDAQ-listed VIMC for personal gain. We believe much of this value was derived by bribing government officials such as recently sacked Shen Weichen, former Party Secretary of China's Association for Science and Technology. Deng, VIMC's Chairman, is among the numerous businessmen implicated in the bribery and general corruption charges that resulted in Shen's sudden ousting.

The premeditation and callousness with which VIMC's Co-Founders built a company to serve as a vehicle for their exclusive enrichment makes VIMC the worst case of what, to us, is clearly embezzlement (from both their company and the government) we have ever found.

We discuss our findings in the following sections:

  1. The Government Giveth. We discuss how the Co-Founders used their government connections to obtain hundreds of millions of dollars in valuable assets for VIMC.
  2. Insiders Taketh Away. We examine the privately-held vehicles used to transfer VIMC's assets to the Co-Founders. We reveal how the Co-Founders proceeded to loot VIMC of all its worth, transferring to themselves at nominal cost VIMC's only profitable business, its valuable real estate assets, and much of the cash over a three-year period. Accounting red flags were raised many times throughout the transfer of value to the Co-Founders of the past few years, but the management team was able to cover them up by firing CFOs and auditors who posed a threat to their accounting trickery.
  3. Pump and Dump. Not content with their enormous personal gains, the Co-Founders then used a clever scheme involving related parties to maintain the appearance of VIMC as a valuable going concern, pumping its shares with inaccurate press releases and overstated financial reports. Predictably, they have been dumping their shares aggressively as duped US investors buy the pump.

2. The Government Giveth

Government Corruption in the Chinese Technology Sector

Having declared the technology sector a key investment area for the growth of the Chinese economy, the government has invested hundreds of billions of dollars (trillions of RMB) over the past two decades to support domestic entrepreneurship, research and development in the sector. This government support, which is allocated through several regional and national government bodies managed by a select few, often takes the form of tax breaks and grants of funding, land for commercial use or commercial contracts with the government.

As is typical within the Chinese political system, when that much responsibility and capital is left at the hands of an unmonitored few, the results are predictably corrupt. As reported on October 31, 2013, by China Youth Daily[2] investigations by China's Ministry of Science and Technology into the allocation of RMB 2.42 trillion from 2006 to 2012 revealed "shocking corruption" that has triggered a revamping of the way the government monitors its research spending. It turns out the vast majority of research funding ultimately went not to the intended projects, but to corrupt cronies and accomplices of the government officials issuing the grants. The article reviews cases of bribery, embezzlement, accounting fraud to cover up missing funds, secret expense accounts to fund everything from everyday expenses such as meals to cars, and more.

(Source: China Youth Daily)

Shanxi, a Hotbed of Political Corruption

Shanxi, a province located in China's northern region, is the country's most infamous area for political corruption. Shanxi was one of the areas targeted by President Xi's anti-corruption crackdown, especially this year. As noted on Wikipedia:

Since Xi Jinping's ascendancy to power at the 18th Party Congress, numerous highly ranked officials in Shanxi have been placed under investigation for corruption-related offenses, including four members of the province's highest ruling council, the provincial Communist Party Standing Committee… They were all removed from office around August 2014... Shanxi was therefore the 'hardest hit' province during the anti-corruption campaign of 2013-2014. Targeted corruption investigations on such a massive scale were unprecedented; it amounted to a wholesale 'cleansing' of Shanxi's political establishment.

And the news about Shanxi's widespread corruption keeps flowing. Last week, China.org.cn reported about some of the very recent political cleansing in Shanxi[3] and this week, Caixin Online[4] reported the highest-profile case yet about corrupt tie-ups between government officials and companies that bribe them for all types of illicit political favors. This was not an isolated case, as Caixin reports: "a string of corrupt officials and former government employees have been uncovered recently."

One of VIMC's Government Sugar Daddies Sacked

Several Chinese media outlets reported earlier this year that Shen Weichen, a long-standing senior official in Shanxi who held various government posts such as Mayor of Taiyuan City, Secretary of Taiyuan Municipal Party Committee, Secretary of Shanxi Provincial Party Committee, and Party Secretary and then Vice Chairman of China Association for Science and Technology, is one of the numerous officials who fell from grace this year. Throughout his long tenure as influential politico, Shen was apparently happy to do political favors for his cronies so long as he received considerable kickbacks from those who greased his palms.

One news article[5] dated 4/17/2014 concludes that more corrupt businessmen will be investigated and caught now that their government sponsor Shen has been sacked:

有境外媒体引述北京政界人士说,申维辰落马的原因,和较早前被抓的山西人大副主任金道铭一样,是涉嫌在山西的贪污腐败。金道铭是在今年2月因涉嫌严重违纪违法而被查。还有分析认为,接下来将会有更多山西官商被抓。

(Translation: Politicians say Shen Weichen was arrested due to corruption, the same reason as Jin Daoming, the Deputy Director of Shanxi People's Congress. Jin Daoming was arrested in February due to corruption. Some analysts believe that, then there will be more officials and businessmen in Shanxi province to be arrested).

The article's prediction has come true, and one of the businessmen affected is none other than VIMC Chairman and CEO Deng, who has been implicated with Shen's corrupt practices now that his wife Tan Jing (a famous singer from Shanxi who was also Shen's mistress while he was in power) is under investigation[6][7]:

京城有传言:中纪委在调查另一宗案件时,一名有国家一级演员名衔的山西籍著名女歌手因涉案被问话时,交代曾与申有过一段"私情"。

(Translation: Early this year… a Shanxi singer (Tan Jing) got involved in the corruption case and was investigated by China's Investigation Bureau…)

刚刚落马的中国科协党组书记申维辰,是今年首名受查的正部级官员,亦是首名落马的中纪委委员。网传申维辰情妇是山西籍著名女歌手,网友她猜测演过《乔家大院》。同时,网友们还翻出谭晶的个人资料,称她老公叫邓中翰,中星微电子有限公司董事长。

(Translation: Tan Jing is close to Shen Weichen. Internet users have pulled up Tan Jing's profile and said her husband named Deng is Vimicro's Chairman).

It is also noteworthy that Deng used to work with Shen as a senior officer at the state-run Association for Science and Technology that Shen used to oversee.

Hidden Assets

VIMC's corporate history makes clear that the company was built in large part through government relationships from which funding, land rights, commercial contracts, and joint ventures were obtained. A careful read of VIMC's past eight 20-F annual reports shows that the company has been a beneficiary of government generosity since 2007, a watershed year for VIMC. Eight years after its founding in 1999, for seemingly no valid reason, VIMC became a favorite of the government. Starting that year, VIMC received grants of land at ultra-low prices in Shenzhen, Shanghai, and Nanjing (Jiangsu province); received follow-on funding (outright grants or loans) to develop that land; collaborated in two joint ventures (JVs) with the local governments of Tianjin and (no surprise) Shanxi province; and received R&D-related funding in Qingdao and Wuxi. The details are shown below in Exhibit 1.

Exhibit 1: VIMC's Major Dealings with the Government[8]

Although we looked beyond the SEC filings to find some of these dealings, we think it is most likely the company had more such dealings that we were unable to find throughout our research process. We found the cash grants from the city of Wuxi (in Jiangsu province) and the cash grants from the city of Qingdao[9] shown in Exhibit 1 not in SEC filings but from our own research of Chinese SAIC filings and local city governments' public disclosures.

Interestingly, none of the government asset grants were disclosed in the types of highly promotional (and, as we show later, misleading) press releases that VIMC loves to issue whenever it signs a new contract with the government. This year alone, VIMC has announced 11 such stock-pumping press releases promising hundreds of millions of future orders from the government[10]. We note that several of these deals were done with the infamous Shanxi government in the city of Taiyuan, no less, where most of the cases of graft and government-baked corporate fraud have been discovered this year by the Chinese central government. These press releases would have you believe 2014 was quite a year for VIMC in spite of the fact that both the CFO and the auditor were inexplicably replaced.

Instead of getting caught up in the pomp and circumstance of these announcements of government orders that never amount to much in audited financial performance, investors must take a closer look at the hidden value in the minimally disclosed government asset grants. We are happy to serve as your guide since this hidden value is obfuscated by a complex organizational structure that makes it hard to track what is going on.

Exhibit 2 (below) shows an organizational chart that maps all the business entities either currently or previously owned and controlled by VIMC. We denote those that received government aid in yellow.

Exhibit 2: VIMC Organizational Chart of All Historically Owned and Controlled Entities[11]

How and why VIMC, a nondescript hardware company with no real strategic value to China, managed to get so much from the government is not where we will focus, however. That investigation is better left to President Xi and his anti-graft campaign. As previously noted, having sacked the criminal Shen this year, the government is already on the case.

What the Co-Founders did after VIMC received the government grants is considerably more interesting and worth a closer look. Note that Exhibit 2 (above) is backwards-looking and therefore does not represent VIMC's current organizational structure, which is shown in Exhibit 3 (below).

Exhibit 3: Current VIMC Organizational Chart[12]

To state the obvious, Exhibits 2 and 3 are not the same… Where did all the government aid go??

3. Insiders Taketh Away

It's (Related) Party Time!

VIMC's 20-F annual reports are chock full of potential conflicts of interest and governance-related red flags. Trying to follow the related party transactions and the interrelationships between VIMC and its various related parties is dizzying. What is crystal clear is that every significant business venture, divestiture, disposal, or dealing with the government appears to involve some private vehicle controlled by the Co-Founders and other insiders. If you muster up the patience to sort through all the transactions and the fine print in the disclosures, you can find the Co-Founders' fingerprints all over the place - not solely through VIMC itself, as you would expect at a respectable company, but through a shady network of private vehicles controlled by the Co-Founders.

Below are the disclosed related parties from the past four 20-F annual reports.

Exhibit 4: Related Parties Disclosed in 2010-2013 20-F Filings

And below are the corresponding disclosed related party transactions since 2010.

Exhibit 5: Related Party Transactions Disclosed in 2010-2013 20-F Filings

Especially confusing are the related parties named Vimicro something-or-other. Why are there so many related parties also named Vimicro? Isn't Vimicro the name of the company listed on the NASDAQ whose shares and assets investors supposedly own when they buy VIMC?

The answer to what should be a simple question to answer is both yes and no, and therein lies the rub.

Yes, the name of the NASDAQ-listed company with ticker VIMC is Vimicro International, that much is true. But no, VIMC investors most definitely do not own the assets they were entitled to when they bought VIMC shares. What duped VIMC investors fail to realize is that all the other Vimicros listed in the 20-Fs, which they should own but in fact no longer own at all, were likely embezzled by Co-Founders and their complicit insiders. The various Vimicros marked in the 20-Fs as "owned by certain executives of the company" are nothing more than vehicles for the transfer of VIMC's assets to the insiders.

Bear with us, because understanding the role of each major related party is the key to seeing how clever and crooked the VIMC scheme to transfer shareholder value to insiders really is.

EmbezzleCo

There are two related parties in particular that should make the hair on the back of any US regulator's neck stand way up: VMF and VMF Consulting Company, an affiliate of VMF.

VMF first makes its appearance in VIMC's filings in the 2010 20-F. Page 29 of that document describes VMF as follows:

Vimicro Management Foundation ("VMF"), a limited partnership established by certain members of our management to provide investment, charity and consulting services.

That looks benign enough, doesn't it? Especially with the "charity" thrown in there. How good of the management team... Except that, page 30 of the same 20-F raises multiple huge red flags about this VMF company:

Vimicro Wuxi was formed in July 2009 as our regional headquarters to conduct research and development radio frequency chips and develop related businesses. In December 2010, we injected our analog integrated circuit, MP4, advanced multimedia and Bluetooth businesses (the "Non-core IC Businesses") into Vimicro Wuxi, and entered into definitive agreements to transfer 95% of our equity interest in Vimicro Wuxi to VMF Consulting Company for cash consideration. We also expect to transfer all of our equity interest in Vimicro Jiangsu, Vimicro Shenzhen and Vimicro Shanghai to VMF Consulting Company for cash consideration, subject to government approvals.

Why were all these Vimicros (Wuxi, Jiangsu, Shenzhen and Shanghai to be exact) transferred out of VIMC? If Vimicro Wuxi was formed in July of 2009 and was important enough to warrant injecting four different businesses into it just a year later (analog IC, MP4, advanced multimedia and Bluetooth), why is it being sold? And what about the three other Vimicros? Why are they too being sold?

Most importantly, who is VMF Consulting Company, the buyer? According to page 30:

VMF Consulting Company is a company established by several management members of our company to implement the business restructuring plan on behalf of VMF. Both VMF and VMF Consulting Company are managed by Mr. Xiaodong (DAVE) Yang. As a result of the foregoing transfer, we currently own 5% of Vimicro Wuxi. We expect to complete the registration of the transfer of our equity interest in Vimicro Jiangsu, Vimicro Shenzhen and Vimicro Shanghai in 2011 or 2012. Upon successful registration with relevant government authorities, we will no longer hold any equity interest in Vimicro Jiangsu, Vimicro Shenzhen, and Vimicro Shanghai.

Interestingly, after this whopper of a disclosure, the 20-F for the following year, 2011, describes VMF a little differently (on page F-10) than in previous years:

Vimicro Management Foundation ("VMF") which is a venture capital fund managed by certain members of the company's management.

It took only a year, after all those Vimicros were divested, of course, for VMF to go from charity, investment and consulting services to managing insider money in a privately-held VC fund.

VMF and its affiliate VMF Consulting Company are the keys to transferring shareholder value out of VIMC and into the Co-Founders' pockets. To simplify some of the related party complexity and confusion caused by various similarly named entities, we refer to VMF and VMF Consulting Company as "EmbezzleCo" and refer you back to Exhibits 2 and 3. Remember when we asked where all the government aid went? Now you know: EmbezzleCo.

Exhibit 6: Flow Chart of Asset Transfers Disclosed in 2010-2013 20-F Filings

Exhibit 7 (below) lists all major disposals of VIMC subsidiaries.

Exhibit 7: VIMC's Major Disposals, 2010-2013

The counterparty to VIMC for all these disposals was EmbezzleCo. Why are insiders, and never a third party, so keen on buying these assets presumably not worth keeping around at VIMC? Why wasn't a commercial auction process used to dispose of them instead of defaulting to insiders as exclusive bidders every time?

Step 1: Carve the Operating Value Out of the Business

Page 25 of the 2011 20-F has the following rationale for the disposal of Vimicro Wuxi to EmbezzleCo:

In December 2010, in order to focus on our growing surveillance and security businesses, we disposed of our loss-making non-core IC businesses (which forms part of our multimedia processor business) to VMF Consulting Company, a related party controlled by certain members of our management team and managed by Dr. Xiaodong Yang, one of our directors, for cash consideration.

The Co-Founders would have you believe Vimicro Wuxi was disposed of because it was "loss-making" and therefore presumably not worth the bother. But filings with the Chinese government paint a completely different picture. Exhibit 8 (below) shows a table summarizing key financials from the SAIC filings in English. Below that, Exhibits 9-11 show the supporting evidence: photos of Vimicro Wuxi's SAIC filings for 2010-2012 in Chinese.

Exhibit 8: 2010-2012 Summary Financials for Vimicro Wuxi from SAIC Filings

Exhibit 9: Vimicro Wuxi's 2010 Financials Filed with the SAIC

(Income Statement)

(Balance Sheet)

Exhibit 10: Vimicro Wuxi's 2011 Financials Filed with the SAIC

(Income Statement)

(Balance Sheet)

Exhibit 11: Vimicro 2012 Wuxi's Financials Filed with the SAIC

(Income Statement)

(Balance Sheet)

Not only was Vimicro Wuxi profitable when it was sold - and therefore not loss-making, as falsely alleged in the 20-F - it had a 66% profit margin in 2011 and grew revenue a whopping 8.2x year on year in 2011, immediately after it was sold in December of 2010. It then proceeded to nearly double revenue in 2012.

A year after disposing of Vimicro Wuxi to EmbezzleCo, VIMC also sold them Vimicro Qingdao. Again, the rationale for this sale was the disposal of a non-core, unprofitable business, and EmbezzleCo paid VIMC $2.9 million (see Exhibit 7) for it. Why would EmbezzleCo pay anything for a worthless unprofitable business, you ask? Because it is anything but worthless and unprofitable, as you will see in the next section. For starters, shortly after buying Vimicro Qingdao for $2.9 million, EmbezzleCo received $6.9 million in funding from the government (refer to Exhibit 1)!

Step 2: Relist the Valuable Operations Where US Investors Can't Find You

If the SAIC filings are not proof enough that the Co-Founders stole VIMC's only valuable businesses for their personal gain at the expense of shareholders, then what do we make of the Co-Founders' plan to IPO Vimicro Wuxi, the allegedly unprofitable non-core business not fit to be public anymore?

This news article discusses Vimicro Wuxi's IPO plans in some detail. The article states Vimicro Wuxi, a company so valuable that it recently received a national industry award for technical achievement, is planning an IPO in China's domestic A-share market after continuing its exceedingly strong financial trajectory, growing 50% year on year in 2013 to roughly RMB300 million in sales.

Throughout our due diligence we learned that Vimicro Wuxi had been consolidated in 2013 with Vimicro Qingdao (as discussed, also transferred to EmbezzleCo), which explains the substantial difference in revenue between Vimicro Wuxi's 2012 SAIC-reported financials from Exhibit 12 (RMB 75.7 million) and those announced by the media article, i.e. 50% year-on-year growth to RMB300 million in 2013, which implies RMB200 million in 2012 revenue.

The choice of listing venue for Vimicro Wuxi is quite telling. Why would a team that successfully IPO'd their company in the US choose to spin off a privatized subsidiary in China? Because, once gutted of all its value, the US-listed VIMC is not worth anything and therefore the founders have nothing to lose in the US while they have everything to gain in China, where no US investor has ever successfully laid claim to assets due to them by a US-listed company, whether fraudulent or not. In China, which does not recognize US law, US investors have no legal leg to stand on.

China's domestic market values semiconductor companies growing at Vimicro Wuxi's high pace at a minimum of 3x sales, so an IPO at the low end of likely pricing would yield a RMB900 million outcome (that is over $146 million, or the entire market cap of US-listed VIMC) for the Co-Founders.

What is that in returns, you ask? To calculate returns, we must first recall what EmbezzleCo paid for the business. As Exhibit 8 shows, the net consideration for Vimicro Wuxi and Qingdao together was $1.4 + $2.9 million, or a mere $4.3 million. That works out to a 34x return for the wily Co-Founders.

Had the greedy insiders stopped there, they might have gotten away with everything unnoticed or at least unperturbed. After all, what does the Chinese government care if all the operating value was gutted from VIMC, a US-listed entity, even if a few American investors got fleeced out of a couple hundred million dollars in the process?

But remember, Vimicros Wuxi and Qingdao weren't the only VIMC subsidiaries EmbezzleCo transferred to itself. It is in dealing with the other transfers that Chairman Deng likely got into trouble, since all those other subsidiaries had very significant dealings with the Chinese government's most prized assets: the government's land. Recall from Exhibit 1 that the land granted to VIMC was specifically intended for the company's own corporate use, to build office buildings for its own use.

Isn't it interesting, then, that SAIC filings for the transferred subsidiaries show real estate rental to third parties in their newly expanded business scope?

Exhibit 12: Vimicro Shenzen's SAIC-Registered Business Scope Includes Real Estate Rental

Step 3: Pillage the Land

On December of 2012, VIMC sold Vimicro Shanghai to EmbezzleCo for $10.4 million largely for the value of its real estate assets. In doing so, it failed to run a proper auction process that involves bidders other than the insiders at EmbezzleCo. Instead, according to the 20-F disclosures, VIMC used third-party consultants to assess the value. Whether these consultants were paid shills or affiliates of EmbezzleCo we will never know, but one thing is crystal clear: they were not objective appraisers of land.

The following excerpt can be found on page 41 of VIMC's 2007 20-F:

On November 15, 2007, Vimicro Shanghai entered into an agreement with Zhangjiang Semiconductor Industry Park Co., Ltd. pursuant to which, in consideration of approximately $5.7 million, to be paid in installments, Vimicro Shanghai would acquire land use rights for approximately 20,900 square meters of land in Zhangjiang Hi-Tech Park, Shanghai.

Vimicro Shanghai's lot of land is home to a handsome commercial project that is expected to look like this when completed:

Exhibit 13: Model Picture of Vimicro Shanghai's Commercial Real Estate Project[13]

Below are some pictures we took in person that show the outstanding progress being made on the construction of this commercial building.

Exhibit 14: Current Pictures of Vimicro Shanghai's Real Estate Project

Even a quick glance at these pictures is enough to make EmbezzleCo's acquisition price for this real estate laughable, but if it is not worth $10.4 million, then what is it worth? It is not difficult to objectively assess the value of the 20,900 square meters of commercial development in Shanghai. We use two approaches to estimate the value: assessing the average price per square meter in the area and using recent listing or transaction prices of comparable projects.

According to Landvalue.com.cn, a leading online real estate industry resource, rights for the use of land in Shanghai currently averages RMB38,195 per square meter ($6,210/sq. m.). So the regional average price of land suggests Vimicro Shanghai's land use rights have a current market value of RMB798,275,500 million (approximately $129.8 million). Let us not forget, this is the value of the land itself.

When a developed project's worth is considered, the value goes up. A lot, it turns out, per reasonable comps we derived from discussions with real estate agencies in the area. The closest comp we were able to find is a little dated, having been sold in 2012, but it is a 41,000 square meter building in the exact same location, Shanghai Zhangjiang Hi-Tech Park. That building was sold almost three years ago in early 2012 for RMB700 million (approximately $113.8 million)[14]. Vimicro Shanghai's project is being erected on a considerably larger lot with a target of 76,000 square meters of commercial space (nearly double that of our comp) by its July 2015 completion. Conservative estimates from our real estate agency conversations based on a project 1.85x larger than our comp (76,000 vs. 41,000) being sold 3.5 years after our comp (July 2015) point to a value north of RMB2 billion (over $325 million).

No matter which range of estimated values you believe, there is absolutely no way Vimicro Shanghai was worth the $10.4 million that EmbezzleCo paid for it.

Let's move on to the next city. How great a deal did EmbezzleCo get in Shenzhen?

Refer back to Exhibit 7, which shows Vimicro Shenzhen was sold to EmbezzleCo for a consideration of $10 million. According to page 41 of the 2007 20-F filing, the Shenzhen subsidiary also had significant real estate assets:

On June 27, 2007, Vimicro Technology entered into an agreement with Shenzhen Municipal Bureau of Land Resources and Housing Management, pursuant to which, in consideration of approximately $0.9 million, we acquired land use rights for approximately 3,947 square meters of land in Shenzhen High-Tech Industrial Park. The land will be the site of a new building, which will become Vimicro Technology's office building and accommodate a research and development center. Governmental authorities require us to obtain necessary governmental approvals for the proposed project.

Although 3,947 square meters in Shenzhen does not appear to be the real estate bonanza hidden in Vimicro Shanghai's 20,900 sq. m. lot of land, appearances are deceiving. Shenzhen, also a Tier 1 city, has had one of the hottest real estate markets in China over the past five years, so much so that the region leads all of China in secondary property sales, a clear sign of real estate market maturity. EmbezzleCo's Shenzhen project is in a prime location in one of the most expensive areas of Shenzhen, in the central business district next to Changhong Plaza. Although the lot of land is not as big, its location allows for the construction of tall buildings. When the Shenzhen project is completed, it will have 48,000 square meters of commercial real estate distributed over 30 floors. Below are some of the details of this project found online and on the web site of the construction company managing this project.

Exhibit 15: Shenzhen VMC Plaza Project Details

(Translation of key items:

Project size: 48,000 sq. m.

Number of Floors: 30

Investment: RMB 65 million)

(Translation of key items:

Project start date: 5/22/2013

Size of lot of land: 3,947 sq. m.)

Right after Vimicro Shenzhen was transferred to EmbezzleCo, the Co-Founders began construction of the Shenzhen VMC Plaza project in 2013. A search on Baidu reveals the project is under construction now, as evidenced by this picture from Baidu Maps:

Exhibit 16: Construction of Shenzhen VMC Plaza, an EmbezzleCo Project

A little research on SouFun (land.fang.com), China's dominant online real estate web site, provides some comps for what this property will be worth upon completion. To provide a fair range of possible values, we looked for a building in a much less desirable location but in the same district to estimate the low end of our estimated range. It is harder to estimate the higher end, since properties near VMC Plaza are in such a desirable location that they are seldom sold. So we used rental prices, which are readily available on SouFun, to find comps for properties sold that generated similar rental income.

On the low end, we found a property that sold for RMB13,000/sq. m.[15] VMC Plaza will have 48,000 sq. m., so that comp suggests a low end value of RMB624 million, about $101.5 million.

For our high end estimate, we used the rental cost of VMC Plaza's adjacent building, Changhong Plaza. According to SouFun, Changhong Plaza rents for RMB110/sq. m./month, which is quite close to the rental cost of commercial property in Shanghai's Zhangjiang Hi-Tech Park (RMB3.43/sq. m./day[16], or RMB103/sq. m./month). Therefore, on the high end, EmbezzleCo's Shenzhen property should sell for a similar price to its Shanghai property, or about RMB2 billion (over $325 million).

Step 4: Bait and Switch US Investors

So far, we have shown the Co-Founders transferred to themselves over $146 million of business value (Vimicro Wuxi and Vimicro Qingdao), approximately $325 million of real estate in Shanghai, and approximately $213 million of real estate in Shenzhen (using the very conservative midpoint of our low and high end estimates). That totals $684 million. What can possibly be left in the NASDAQ-listed VIMC? Judging from the company's inability to ever turn a meaningful profit, probably not much, right?

The answer is zero, and in this section we will show how the Co-Founders used two JVs with the government to massively inflate revenue while reversing the company's significant net cash position to net debt in the process.

Recall from Exhibits 1 and 2 that VIMC entered into two JVs with the government. An analysis of the structure of those JVs raises the biggest of the many red flags yet, which is saying something given our analysis so far.

The first JV, Vimicro Tianjin, was established with the Tianjin government in December of 2008[17]. This JV is 49.99% owned by VIMC, 49.99% owned by Tianjin, and 0.02% owned by none other than EmbezzleCo. The combined stakes of VIMC and EmbezzleCo give the Co-Founders effective control, even though VIMC's sub-50% stake gives off the impression they don't have it.

The second JV, Zhongtianxin, was established with the notoriously corrupt Shanxi government in September of 2012[18]. This JV is 49% owned by VIMC, 49% owned by Shanxi, and 2% owned by EmbezzleCo. Again, the Co-Founders are in control without looking like they are.

The 0.02% stake in particular is downright farcical. There is absolutely no operating or business reason to organize a JV this way… But there sure is a very good accounting reason. This clever structure creates two related parties that do not need to be consolidated with VIMC for accounting purposes since VIMC ostensibly owns a non-controlling interest. In other words, the Co-Founders created two related parties they control with which they can do anything they want without having to report numbers to the SEC. And anything they want is exactly what they did.

Behold Exhibit 17 (below), which shows what happened to VIMC's accounts receivable (AR) from related parties and net cash, starting in 2013, right after the JV with the crooked Shanxi government was established.

Exhibit 17: VIMC's Quarterly AR and Net Cash after Establishment of Zhongtianxin

In case the important trends are not obvious, here they are in chart format.

Exhibit 18: VIMC's Revenue and Sequential Increase in AR from Related Parties, Q1 2013-Present

Exhibit 19: VIMC's Net Cash Position, Q1 2013-Present

VIMC ended 2012 with $28.8 million of AR, or 40% of its $71.2 million in revenue. Not exactly world-class, but it doesn't scream fraud either. By the time Zhongtianxin was in place, VIMC ended 2013 with $50.8 million in AR, almost double that of 2012, or 79% of its $64.5 million in revenue! And the trend goes on. More than all of last quarter's $27.6 million in revenue was attributable to an increase in AR ($31.1 million), and 89% of it was attributable to AR from related parties. A collection problem with this AR would nullify all Q3 sales and then some.

If that is not alarming enough, since Zhongtianxin was established, nearly $51 million of VIMC's net cash has evaporated and turned into over $2 million of net debt. Is it any wonder VIMC had to find both a new CFO[19] and a new auditor[20] this year?

In former auditor E&Y's defense, they did provide the accounting smoking gun in the 2013 20-F they signed off on before they hit the road in 2014. There is a major difference between the 2013 and the 2012 20-Fs. When Zhongtianxin was established in late 2012, it flew under the auditor's radar for the 2012 20-F because it was just ramping up, and its pernicious impact on VIMC's financials had not fully kicked in yet. E&Y was not on to the 49%+2% accounting chicanery that the Co-Founders used to keep Zhongtianxin's numbers off of VIMC's financials.

Obviously, 2013 was a whole different story. By then, it was beyond obvious that something was going on with Zhongtianxin. We interviewed industry executives familiar with this matter and learned that the reason behind this year's downgrade in auditor from E&Y, a Big 4 firm, to Grant Thornton was E&Y's insistence that the 49%+2% scheme was not going to pass muster for the 2013 20-F. E&Y's "mea culpa" for not reporting Zhongtianxin's financials in 2012 can be seen in Exhibit 15.3 all the way in the back of the 2013 20-F, where the offending Zhongtianxin's financials are reported for the first time.

And when you look at the numbers, is it any surprise that there are $19.4 million of accounts payable to related parties?

Exhibit 20: Zhongtianxin's Liabilities and Equity[21]

Note the ominous note at the bottom of Exhibit 20, which leads us to NOTE-12, where the truth is finally told.

Exhibit 21: Zhongtianxin's Related Party Transactions

100% of Zhongtianxin's accounts payable is to VIMC. Exhibit 17 shows that VIMC had $25.8 million in AR from related parties at the end of 2013, and now we know that $19.4 million (or 75%) of them are Zhongtianxin's. Moreover, of VIMC's roughly $50 million of revenue in 2013, over $27 million of it (a whopping 54%) was from purchase of inventories by none other than Zhongtianxin. What's more, having purchased $27 million worth of product from VIMC, Zhongtianxin generated all its $26.4 million of revenue from VIMC, the vast majority of which has yet to be collected. In case you do not follow, that revenue is not revenue and the AR from Zhongtianxin is not "receivable" - it will never be collected. It's fake! How else can it be possible that one year after its establishment, Zhongtianxin (which is really just another name for VIMC, which controls it) is by far VIMC's biggest customer, a customer so big that it accounted for 54% of VIMC's 2013 revenue and 89% of its revenue last quarter, and most of that revenue has yet to be collected. Would any investor knowingly invest in a company who is its own biggest customer and generated nearly all of its sales last quarter from itself, failing to collect most of that revenue?

So if 54% of VIMC's 2013 revenue was generated from itself (Zhongtianxin), what do we make of the rest of the 46%? Is it legit? In other words, is the glass just 54% empty… or completely empty?

We answer that question by reminding you that Zhongtianxin was only one of two JVs structured in the shadiest of ways, using the 49%+2% technique to try to divert attention from what was going on. E&Y was diligent enough to force the inclusion of Zhongtianxin's financials in the 2013 20-F, but E&Y was also negligent enough to not force the same treatment on Vimicro Tianjiin, the other JV. After all, VIMC's 49.99% stake in it combined with EmbezzleCo's 0.02% stake does in fact add up to exactly 50.01%, which, like the 51% stake the Co-Founders have in Zhongtianxin, is a number greater than 50%.

The obvious reality of this situation is that after gutting VIMC, the Co-Founders bait-and-switched the valuable assets that belonged to US investors with fabricated financials courtesy of related party transactions with the likes of their shady partnership with Shanxi, the most corrupt local government in China.

4. Pump and Dump

VIMC's Co-Founders must love the famous Gordon Gekko quote, "Greed is good." Not content with EmbezzleCo's enormous gains, they went to the seemingly endless VIMC well one final time with the clever scheme we just discussed involving JVs they controlled. After all, if you can hide it, what better customer is there than yourself, especially if you never have to pay yourself for the revenue you generated by selling products to yourself? Using these JVs, whose financials they thought they could get away with not disclosing, the Co-Founders successfully duped US investors and maintained the appearance of a valuable going concern at VIMC for a while until your friends at Trinity Research Group caught on.

Zhongtianxin established in 2012, the Co-Founders revved up the old PR machine and let her rip. To see how aggressive they were, examine the progression of press releases before and after Zhongtianxin was established.

Exhibit 22: 2011 Press Releases

In 2011, only one government deal was announced[22] and it was completely benign since it announced a non-profit alliance to promote a technical standard. 2012 was more interesting.

Exhibit 23: 2012 Press Releases

Two government deals were announced. The first[23] with Fuzhou, involved an allocation of land (3,000 square meters), some free cash (RMB30 million) and an interest-free loan (RMB60 million). We all know where those assets are going, don't we?

The second deal was the announcement of the Zhongtianxin JV on 9/12/2012. Very interesting indeed is the fact that just a month later, when you would think executives would be celebrating the big deal, CFO Richard Wu quit. David Tang, a long-time colleague of the Co-Founders had to take his place.

The fun begins in 2013.

Exhibit 24: 2013 Press Releases

On 4/3/2013, CFO Tang's role was changed to Chief Strategy Officer and Jimmy Dong was hired as Chief Controller, presumably to oversee VIMC's books in the absence of a CFO.

By Q3, the PR machine was ready for action, and two large government deals were announced. The first[24] was a deal for the offensive Zhongtianxin with an unnamed government customer (a vague reference to "a large Chinese city" is all we got) and was worth $20 million. The second[25] was with Sichuan province and was worth $14.5 million.

2013 ended with a bang when Zhongtianxin delivered a $41 million order from Baoding City[26], and in 2014, the PR machine went into overdrive.

Exhibit 25: 2014 Press Releases

The government really delivered for VIMC this year, with 11 deals and one huge line of credit and the year is not even over. Things were so exciting that nobody seemed to care that the CFO position changed again with the hiring of Peter Li and that E&Y was replaced as the auditor.

But what is a good pump without an even better dump?

Exhibit 26: USD Value of Insider Sales, 2008-Q3 2014

If VIMC insiders were excited about the future of their business due to all those government deals, they certainly failed to put their money where their mouth was.

5. Conclusion

There are very few zeros in investing. Nevertheless, we believe VIMC is one of them. Somewhere north of $600 million of hidden value, the majority of which was likely obtained from corrupt government officials, was systematically transferred to the Co-Founders over a four-year period through what we clearly view as an embezzlement scheme that clever accounting tried to hide. After being gutted of all its worth, all that is left of VIMC is the illusion of VIMC as a going concern. That illusion is propped up by falsified financials derived from clever accounting trickery that attempts to hide the fact that VIMC itself became its own biggest customer once all its business value was transferred out of it for the exclusive benefit of insiders. VIMC is not only its own biggest customer, generating most of its own revenue (through corrupt JVs), but it is also its own worst customer since the majority of that revenue it generates by selling product to itself has not been and likely never will be collected.

If you are long VIMC, we sincerely feel for you. You have no legal recourse to claim the assets you were rightfully entitled to when you bought your shares. As painful as it may be to admit that you were duped, we remind you that pride is an investor's worst enemy and even a penny is worth more than zero.

If you are short VIMC, congratulations. You were right.

If you are not involved but want to make money, we strongly recommend shorting VIMC in size. While borrow may not be available (believe us, we know), you are in luck because VIMC is an optionable security. We recommend buying puts or selling calls to short VIMC all the way down to zero.

Footnotes:

[1]: diplomat.com

[2]: China Youth Daily

[3]: china.org

[4]: Caixin Online

[5]: news.163.com

[6]: ymysw.cn

[7]: blogchina.com

[8]: Source: 2010 20-F, 2010-2012 SAIC Filings, Qingdao City government web site

[9]: Qingdao

[10]: corporate-ir.net

[11]: Source: 2010 20-F, 2010-2012 SAIC Filings, Qingdao City government web site

[12]: Source: 2013 20-F

[13]: jiangs.com

[14]: finance.ifeng.com

[15]: land.fang.com

[16]: zhangjiangruanjianyuan.fang.com

[17]: Source: 2013 20-F, page 30

[18]: Source: 2013 20-F, page 32

[19]: corporate-ir.net

[20]: corporate-ir.net

[21]: Source: 2013 20-F, page F-3 of Exhibit 15.3

[22]: corporate-ir.net

[23]: corporate-ir.net

[24]: corporate-ir.net

[25]: corporate-ir.net

[26]: corporate-ir.net

Disclosure: The author is short VIMC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.