Investors Short Shares Of China Medical Continue Taking Significant Risk

| About: China Medical (CMEDQ)
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Some of the most important tools an active investor has are being confident that you have all of the relevant facts and that you have objectively analyzed all of the information that you could find. This is true whether an investor is considering taking a long or short position.

When it comes to China Medical Technologies (CMEDY), a handful of articles have been written on SeekingAlpha since the company's shares were halted and subsequently delisted. Of them, three were positive, two were negative and one (written by myself) was neutral. The positive articles have been focused on the fact that there has been significant volume in the company's shares which have sent them up from $0.60 when trading resumed in shares to greater than $5.00 today. Also mentioned was the fact that China Medical's auditor should be considered reputable based on its audit history. In addition, the author believes that both the positive news flow and sheer accumulation of a significant number of shares by AER and related parties should be enough to send the stock higher. Finally, short sellers, with over 4 million shares at this point, could conceivably "melt up" the stock if they are stopped out of it.

Negative articles, on the other hand, point to more tangible data. The author pointed to the following main points:

  • Management has not communicated in any capacity to investors since December 13, 2011, when the company announced it was exploring a potential debt restructuring
  • The company missed coupon payments on two convertible bond issuance's, resulting in an effective default
  • When Nasdaq communicated to management that the company's shares would be delisted, there was no objection

In short, China Medical has become a story about analyzing bits and pieces of scattered data instead of a story about company fundamentals. As a reality check, any time management ceases to communicate with its investors, it is a significant breach of fiduciary duty. Many of the investors that are negative on China Medical have regularly shorted other Chinese companies that turned out to be frauds. In fact, a light was cast on China Medical by a Glaucus report issued late last year that accused the company of a great number of less than arms length transactions. I reported in an article at the time that the author was not well versed in medical technology, and as a result, made false assumptions about the company's business. A valid concern brought up was the high level of DSO's, however, most China medical device companies will tell you that if they sell direct to hospitals, payment terms are over many months. At the time, I also pointed out that the CEO owned 20% of shares. I have no idea if he still does, but for this and many other reasons, I concluded that the business itself was a legitimate business.

But today, with a market capitalization of at least $150 million and $400 million in convertible debt, investors have no other verifiable information source other than a monthly 13G/D that AER files in the first two weeks of each month. At this point, the new joint filer, Deutsch family, AER Advisors and as of his latest filings, Chairman and CEO Xiaodong Wu, collectively own greater than 90% of shares. Investors that are short and/or negative on shares have been insistent that institutional ownership does not matter at all, but clearly, it has moved shares of CMEDY. It matters because these filings are the only information on file with the SEC in 2012. With the stock price continuing to rise, the significant daily volume is becoming even more significant on an absolute dollar basis. Today, over 600,000 shares and $3 million changed hands.

As I've stated in my previous articles, whenever this story culminates, management will have angry shareholders and bondholders to manage. However, between Cayman, China and American law, a strong group would have to form in order to strike any monetary justice in this situation. It would likely take the work of millions of dollars in legal fees to put a case together in this instance. We can see from filings on the equity that there are not more than a handful of institutional investors left. Additionally, investors are not fully aware of who owns the bonds. For all investors know, insiders, AER and/or the Deutsch family could also own a substantial dollar amount of the bonds.

The point of this article is not to encourage investors to put money to work in China Medical. However, I think being short in this case is dangerous. I'm willing to disregard the notion that bond investors are paying to bid up the shares in order to convert them into shares and then dump them on the market. The problem with that thesis is that they would be taking a big leap of faith that there would be buyers, when in fact, they have been the primary drivers of the stock. It's clear in this case that short sellers and those negative on the stock have valid concerns, but they should be more concerned with the elephant in the room: the mystery of the significant accumulation of shares by two previously little regarded entities. These entities have upwards of $100 million invested in the equity alone. The shorts could be correct in saying that they are just regular investors making a bet. But the size of the position relative to this type of investing from these two investors is suspect. The only other company AER Advisors has acted in this capacity with appears to be ZST Digital Networks (NASDAQ:ZSTN) and I cannot find record of the Deutsch family engaging in this type of investing previously. I can't imagine being long any significant dollar amount of a stock where management has gone dark, however, I see being short as a huge risk, knowing that there are more than 4 million shares short and two entities aggressively accumulating shares.

Disclosure: I am long CMEDY.