If one looks at the income statements of China Agritech (OTCPK:CAGC), a China-based producer of organic fertilizers, they seem impressive. CAGC has posted positive net income during every year of their existence as a public company, including during the recent global downturn. Yet if one looks beyond the accounting number of “net income” and engages in deeper examination of their financial statements, one can’t help but notice major red flags indicating that their stated “net income” is deceptive within the context of evaluating the overall health of their business.
CAGC’s Serial Fundraising Activities
CAGC has been an extremely active fundraiser during their time as a US-publicly listed company, with 4 separate major transactions to date.
On January 13, 2006, CAGC sold 4,800,000 shares (2,400,000 adjusted for splits) of common stock to 22 investors for a total of $12,000,000 in a private placement transaction.
On July 6, 2007, CAGC sold 5,556,000 shares (2,778,000 adjusted for splits) of common stock to 20 investors for a total of approximately $15,000,000 in a private placement transaction.
On October 19, 2009, CAGC sold 1,392,768 shares of common stock, and warrants to purchase up to 928,514 shares of common stock at an initial exercise price of approximately $10.77 per share, which is subject to adjustment. The total aggregate purchase price was $15,000,000.
The most recent quarter was CAGC’s largest transaction to date. From the June 2010 10-Q:
“Net cash generated from financing activities increase of $30.8 million, which is principally attributable to the cash proceeds from the public offering of 1,243,000 shares of our common stocks and the exercise of the warrants 186,450 shares with exercise price $16.10 per share with total consideration $20.1 million and on June 21, 2010, the Company received net proceeds $10 million from the exercise of the 2009 warrants, with 1,857,024 shares (928,514 Pre-stock split) at exercise price $5.385 per share.”
From the beginning of 2006 to the middle of 2010, CAGC raised over $72 million. Yet startlingly little of this money actually went to fund any type of growth in physical assets...
CAGC’s Property, Plant and Equipment Account (Book Value)
From 2005 10-K – They had $1,398,987 in BV for PPE (Pre-amortization)
From 2006 10-K – They had $3,017,164 in BV for PPE (Pre-amortization)
From 2007 10-K – They had $4,692,738 in BV for PPE (Pre-amortization)
From 2008 10-K – They had $6,014,282 in BV for PPE (Pre-amortization)
From 2009 10-K – They had $8,194,176 in BV for PPE (Pre-amortization)
From June 2010 10-Q – They had $8,694,113 in BV for PPE (Pre-amortization)
Piecing this all together, we see that from the end of 2005 until the middle of 2010, a time period in which CAGC raised $72 million, they invested a mere $7.3 million, or approximately 10% of funds raised in fertilizer manufacturing equipment, facilities and supporting physical assets. The majority of the money that they raised was instead used to fund ever-increasing accounts receivables. Contrast the growth in physical assets to the growth in receivables.
CAGC’s Accounts Receivable Growth
From 2005 10-K – $8,525,185 in AR (Net Allowance for Doubtful Accounts)
From 2006 10-K – $12,239,073 in AR (Net Allowance for Doubtful Accounts)
From 2007 10-K – $22,695,039 in AR (Net Allowance for Doubtful Accounts)
From 2008 10-K – $34,773,115 in AR (Net Allowance for Doubtful Accounts)
From 2009 10-K – $39,256,098 in AR (Net Allowance for Doubtful Accounts)
From June 2010 10-Q – $51,203,710 in AR (Net Allowance for Doubtful Accounts)
For the time period in question, CAGC invested $42.7 million, or almost 60% of the total funds raised into accounts receivables growth. The problem with allowing such unrestrained growth in accounts receivables is that although it allows the company to post a “net profit” based on its income statement, it prevents the company from ever actually generating operating cash flow. This means that the company will never truly be able to fund its own “growth” and will continuously need to return to the financial markets in order to make up the difference, continuously diluting shareholders in the process.
CAGC’s Operating Cash Flows – Consistently Negative Despite Positive Net Income
CAGC consistently reports impressive net income numbers, however their cash flow statement tells a starkly different story. Net income is an accounting figure while operating cash flow much more accurately reflects the health of a business.
From 2006 10-K – Net income was reported as $5,349,338, while total operating cash flows based on the cash flow statement were ($3,161,889).
From 2007 10-K – Net income was reported as $8,528,625 while total operating cash flows based on the cash flow statement were ($4,647,180).
From 2008 10-K – Net income was reported as $8,641,741 while total operating
cash flows based on the cash flow statement were ($893,416).
From 2009 10-K – Net income was reported as $5,689,647 while total operating cash flows based on the cash flow statement were ($3,535,258).
From June 2010 10-Q – Net income was reported as $11,790,296 while total operating cash flows based on the cash flow statement were $1,048,159.
In summary, we see for the 4.5-year period in question, CAGC reported $39,999,647 in net income, yet their operations actually had negative cash flow of $11,189,584. Something troubling about this use of cash, especially in CAGC’s case, is that investment in accounts receivable vs. investment in fixed assets seems particularly subject to potential catastrophic loss due to droughts, frosts and poor harvests. They even admit as much in their 2009 10-K:
“We typically extend our liquid fertilizer’s customers credit for their purchase of our products to allow them use the proceeds of their harvests to repay us for their purchase of our products…If customers responsible for a significant amount of accounts receivable were to become insolvent or otherwise unable to pay for products and services, or to make payments in a timely manner, our business, results of operations or financial condition could be materially adversely affected. A natural disaster, such as a wildfire, flood or drought, or an economic or industry downturn could materially adversely affect the collection of these accounts receivable, which could result in longer payment cycles, increased collection costs and defaults in excess of management's expectations.”
This is not even beginning to address the potential for management to manipulate sales and net income figures by extending credit to parties who are not credit-worthy and will never have the ability to settle their accounts. Considering that management has already been shown to withhold material information from shareholders in order to boost their income figures as recently as Q1 2010, and considering management as already shown that they are willing to manipulate income figures by withholding information and the numerous other questionable activities of CAGC’s management, both past and present, investors should not discount this possibility.
In conclusion, while CAGC has reported impressive numbers in terms of “accounting net income” the real picture is that CAGC’s earnings quality during their entire existence as a publicly listed entity has been remarkably poor. CAGC has not generated positive operating cash flow for a single year of their operations as a public company. It certainly begs the question as to why they are even “expanding” their business in the first place. It probably would have been better off for shareholders if CAGC had never subjected them to massive dilution in order to expand their business and had instead focused on true value creation via generation of operating cash flow.
Disclosure: short CAGC