China Agritech: a follow up

THIS POST HAS IMPORTANT QUALIFICATIONS - SEE THE POST SCRIPT.  PLEASE READ THE QUALIFICATIONS AS AN IMPORTANT PART OF THIS POST.

China Agritech is a NASDAQ listed Chinese company that is – according to its SEC filings - in the business of manufacturing and distributing organic fertilizer.

The annual filing lists their capacity as follows:

... annual production capacity as of December 31, 2009 was approximately 13,000 metric tons of organic liquid compound fertilizers whereas ... annual production capacity for granular fertilizers as of December 31, 2009 was approximately 200,000 metric tons, consisting of 100,000 metric tons in Anhui, 50,000 metric tons in Harbin, and 50,000 tons in our newly completed plant in Xinjiang.

In my last blog post I noted that:

(a) A hitherto unknown shortseller (Lucas McGee Research) had released a report that suggested that key plants either did not exist or were entirely incapable of producing at the levels indicated in the annual filings.  Lucas McGee research - as company promoters have been keen to point out - operates out of a virtual office and have a very limited history.

(b). The biggest shareholder is the world's most powerful private equity firm (Carlyle). I did not note – but Carlyle has filed a prospectus to register (and hence sell) their stock.

(c). The company has issued a denial of the shortseller report and claimed that all their plants and distribution centers are as listed in the annual filing.

I have a short position in the stock. I am keen to verify or reject the claims in the short seller report. (If I rejected the claims I would switch and go very long the stock.  The stock is on-face cheap - and it is liquid enough that I could change my position in minutes.)

I wrote to Carlyle – and to Anne Zheng (a staff member of Carlyle and Carlyle's representative on the board of CAGC) – to see if Carlyle would confirm or deny the shortseller report. Alas I got no answer.

That makes research a little harder.  This post is a summary of my research efforts.

The research efforts of course wound up against the normal epistemological problems of proving the existence or non-existence of things.  In this case, if you find the plants and you count the trucks entering and leaving the plants with amounts of fertilizer on them consistent with the company filings you have proved the existence of the company and disproved the short case.

If however you do not find the plants you have not proved the short case - the plants could be somewhere else - or closed for a reason - or you could have the address wrong or any other similar snafu.  It is hard - nay impossible - to prove a negative.

So - if the short case is right - the best I could expect to do is find data consistent with the short case.  I did not expect to be able to prove the fraud.

The key shortseller allegations

Here are the key shortseller allegations as stated by Lucas McGee (the shortseller):

Sinochem (a claimed large customer) has told us that it does not sell any Agritech products 

Government officials in China told us that Agritech does not have a license to manufacture granular fertilizers, which the company claims are its largest product line. 

After visiting Agritech’s reported manufacturing facilities in Beijing, Anhui, Xinjiang, and Harbin, we found virtually no manufacturing underway. The single exception was the facility in Pinggu County on the outskirts of Beijing, where the plant was not in operation on the Friday when we (Lucas McGee) visited but local people told us that it has sporadically produced some liquid fertilizer over the last year. 

Plants in Bengbu, Anhui (supposedly the largest), Harbin, and Xinjiang were completely shuttered.

Obviously these are allegations that go right to the heart of the company.  Instead Lucas McGee suggests that money is being stripped out of the company by inflated rents to related parties.  

If the Lucas McGee allegations are correct then the company will probably trade well under a dollar at some future date.  

The company has categorically denied these allegations. Firstly it has pointed to a contract with Sinochem previously filed with the SEC (I will get to that contract later).  Further the company has photographs of bags of granular fertilizer and some liquid fertilizer. And it has said that “the company and its subsidiaries are operating normally.”

As stated – after repeated requests – Anne Zheng (the Carlyle executive on the China Agritech board) did not confirm or otherwise vouch for the company's position.

Doing the work myself

Given that I could not rely on Carlyle, I employed a lawyer in China to visit the plant and see what they could find. This was made somewhat more difficult than usual because of Chinese New Year celebrations. You would not expect the plant to be operational during the holiday – and hence you could not check the volume of the plant by, say, counting trucks visiting.

The Anhui plant

I chose the China Agritech plant in Anhui because (a) it is listed as the largest plant run by the company – doing 100 thousand tonnes per year of fertilizer, (b) the Lucas McGee report suggested that it was shuttered and (c) it was fairly close to Shanghai and hence possible to visit.

Here is what the shortseller report said about the plant.

In Anhui, which Agritech calls its principal production facility, $400,000 worth of plant and equipment would seem slim for 100,000 tons of production capacity. We visited and found a small plant on a rutted road outside Bengbu, completely deserted.

Lucas McGee give a photograph.

This (surprisingly) was not the plant we found.  We found the plant we photographed  from following SEC filings.  

The annual filing gives the addresses of the plants as follows:

The Anhui plant is giving as  Changzheng East Rd, Gaoxin District, Bangfu City. The plant is (according to this part of the annual filing) large (3,400 square meters) and the rent is USD32,488 per month. (You can calculate the rent per square foot and my knowledgeable China contact suggests that this is high for low end industrial rent in China.)

Changzheng (the street name) translates as “Long March”.

There is another SEC filing (a quarterly) which gives a lease agreement for a plant in Bangfu City.

The address is consistent (1188 Changzheng Road Gaoxin District, Bengbu.)  I am presuming that these are the same plant - as there is only one plant listed as rented in Anhui in the property section of the annual report.  

We have however had problems with this in translation.  Some translations have it as "Long Road" Gaoxin District – rather than “Changzheng Road” or “Long March Road”. You can see that translation in using a Google translation of this 2007 job advert.

The lease gives the space as 1338 meters squared – considerably smaller than the 3400 meters square in the annual report. The rent is also considerably less than the annual report (commensurate with size) but the rent per square foot was higher - and high according to my (knowledgeable) contact.

Anyway my contact visited this site – and it is clearly an industrial site – but there is no large fertiliser plant on the site. The ground floor is held by the Bengbu Yi Machinery Factory and the Bengbu Equipment Factory. These are metalworking shops – and their sign is on the front door.

Here is the photograph.

THERE IS AN IMPORTANT CAVEAT REGARDING THIS PHOTO AT THE END...

There were not a large number of people on site. That was not surprising as it was Chinese New Year. There was however a security guard – and my contact talked to the security guard. He had never heard of China Agritech – or even Anhui Agritech. However it turned out that they did have premises on the second floor of the building – though nothing as large as the amounts indicated in either the lease or the annual.

There were no smells associated with organic fertiliser. Organic fertiliser as most people would know smells somewhat.

Moreover – and this is an obvious point – a fertilizer plant that processes 100 thousand tonnes of fertilizer per year is vanishingly unlikely to be on the second floor. 100 thousand tonnes of fertilizer is 2.5 million 40kg bags of fertilizer.  Moving this requires trucks and loading docks and the like.

The Security Guard said that the Bengbu Equipment Factory moved here approximately 3 months ago. He was not aware of either China Agritech or Anhui Agritech having any other premises. A cursory online check with the Administration of Industry and Commerce database showed Anhui Agritech only at this address. My lawyer-contact in Shanghai noted that it would be breaking the law to be operating from a second address without including that address in the database.

This all sounds consistent with the Lucas McGee report, however I note a glaring inconsistency.  This appears to be a different premise to the one photographed by the shortseller report. 


The shortseller premises are a small plant on a rutted road whereas my contact suggested that this was a more urban plant.  It would be sensible to have a fertiliser plant at an address closer to the outskirts of town, after all fertiliser is a bulk commodity and organic fertiliser smells. Moreover it is used outside towns – so premises on the outskirts of town make more sense than this site.

It is possible then that the premises are different from the ones mentioned in the annual report. However our contact visited the premises in the annual report and they did not find a fertiliser plant capable of producing 100 thousand tonnes per annum.

Moreover - considerable digging on the internet has meant that we have found an advert for a plant lease for 1338 square meters at the same address as the Anhui Agritech lease.  The same address and the same plant size to the square meter suggests that the plant was released.  This is consistent with Bengbu Equipment Factory moving into premises previously occupied by China Agritech - however we have no information that the premises were ever occupied by China Agritech.  The security guard did not know China Agritech...  

The Sinochem contract

China Agritech has claimed Sinochem as a major customer. Lucas McGee says that they talked to Sinochem and Sinochem denied being a customer. The company in their defence has pointed to an SEC filing that details a contract with Sinochem. Here is that filing.

The filing is interesting. It is for liquid fertiliser and in surprisingly small quantity. The contract is for liquid fertiliser in tiny bottles. I quote:

Name		Package Size			Number				Volume (L)				Unit Price (Yuan /L)				Purchase Amount (Yuan)
organic condensed liquid compound fertilizer (Broad Spectrum Type)		15ml *300 packages/piece				5,000				22,500				60				1,350,000
organic condensed liquid compound fertilizer (Broad Spectrum Type)		180ml *50 bottle/piece				100,000				900,000				55				49,500,000
organic condensed liquid compound fertilizer (Anti-disease Type)		20 mil * 300 bag/piece				25,000				150,000				66				9,900,000
Total (RMB)		60,750,000

Note: the prices above include packaging price, Party B shall pay transportation fee.

These are tiny bottles – sometimes only 15ml and always less than one fifth of a litre. The contracts include packaging.  A 15ml packet is probably enough for one to five shrubs - not a commercial farm.  The instructions (in Chinese on China Agritech's website) suggests that the liquid be diluted 1000 to 1 before watering plants.  A 15ml packet would do a watering can.  

The total contract is for just over a million litres – or just over a thousand tonnes. This is tiny for a company that produces (or claims to produce) over 200 thousand tonnes per year of fertilizer - and indeed the main product appears to be packing and handling.  

This Sinochem contract is probably real (contrary to the suggestions of the shortseller).  But the contract is tiny and unlikely to be financially relevant. 

Moreover, the contract is not agricultural supply (which is done in bulk) rather a packaging contract for the sort of product someone use to fertilize their home flower patch. I might buy a small bottle of fertilizer for my (postage stamp size) backyard.

Moreover this contract is consistent with what the shortseller said about the company – they said that the company produced small quantities of liquid fertiliser at Pinggu County on the outskirts of Beijing. Indeed the contract was signed in Beijing. 


The company's photographic evidence 

The company has presented several photos to prove the plants are there.  The photos show plants but without loading docks or the like.  They also show liquid fertilizer packing.  They show a total of five 40kg bags of mixed organic/NPK fertilizer.

They are however not supportive of the proposition that this company produces 200 thousand tonnes (5 million 40kg bags) of dry fertilizer annually.

Several of the photos are of packaging and distributing very small quantities of liquid fertilizer.  Here is one example.

Summary

I sent a researcher to the company's stated main premise to see if I could find a plant capable of producing 100 thousand tonnes per annum of bulk fertiliser. We did not find that plant.

The company has protested there is one there. The premises appear different from the one the shortseller visited – but I found stuff consistent with what the Lucas McGee report and inconsistent with what the company says.

The Lucas McGee report said that no contract with Sinochem existed. I am satisfied that Lucas McGee is wrong on that point. A small contract for liquid fertiliser for retail use exists – and the company is capable of bottling such a product. However it is entirely possible that no bulk-dry-product contract with Sinochem exists.  The contract in the SEC filings does not support the proposition that Sinochem is a meaningful customer relative to China Agritech’s claimed sales.

China Agritech has produced photos to support the existence of their main business. These photos are alas entirely consistent with the shortseller claims - in that they do not support the proposition that there is a business capable of distributing 5 million bags of fertilizer.  Moreover none of the photos is labelled or geo-tagged in any way that helps verify the existence of the company.

I am staying short.




John

Some people have noticed - that unbeknown to me - my Chinese contact took the photo of the gate from a website.

I have attached the document the Chinese contact sent me.  Here it is

http://www.calameo.com/books/0005679007df8943103d9

I agree the document is IDENTICAL to the one taken from the website.  I instructed him clearly to TAKE photos -

He just says "Here is a picture of the gate".  He never told me he TOOK the picture of the gate.  Though my instructions to him were clearly TAKE PHOTOS.

I will follow up with photos HE TOOK.

----------------

The current state of play is this:  The lawyer in the states had a colleague swing by the factory on her way home.  She was visiting her family in Anhui for Chinese New Year and SHE provided photos including photos of the metalworking.  She also provided the photo of the factory gate - a photo that perplexed me because it was NOT a photo that matched the photos in the Lucas McGee report.

My lawyer in Shanghai cannot explain why the photo came from the website and was not taken on her phone.

He is trying to follow this up.  I will have a further follow up details when available.

Flagrant breach of copyright by TeacherSoft

There is a really fine company out there – we will call it TeacherSoft.  TeacherSoft wants to build the best possible education platform and market it globally.

To do this it inserts in 100 thousand classrooms a classroom recorder.  The recorder records everything the teacher does.  TeacherSoft of course has the consent of 100 thousand teachers to insert the recording equipment.

The recording equipment is very powerful.  Not only does it record what the teacher says – but using speech recognition software it converts all of that material to text and it uses that text in its own business.  

TeacherSoft also – in building the best possible education platform – uses many other signals.  For instance it uses exam results sometimes adjusted for the socio-economic status of the kids.  

The teachers are of course informed about TeacherSoft – and they endorse its programs.  TeacherSoft of course shares some of the benefits of that program with the teachers.  The teachers in the process pass the information freely knowing it will be shared.  That is of course the deal.

Now one particularly fine teacher gets a little stroppy when her teaching technique is featured heavily in TeacherSoft's lucrative platform.  She thinks she should be entitled to share in the wealth.  Alas she does not have a leg to stand on – she consented to the use of any copyrights she owned.

Joe the novelist

Joe is a children's novelist.  The novels are not long – a couple of thousand words at most.  They are a length that a teacher can read them to a kid on a hot Friday afternoon – when the kids are a little rowdy and are not really up to arithmetic lessons. 

Joe's novel is of course incorporated into TeacherSoft's database.  A teacher read it aloud – and through sophisticated speech recognition software the whole novel got included in TeacherSoft's teaching kit.

It's not an exact copy of Joe's novel though.  The teacher read it but mispronounced a few words and took breaths at the wrong places and hence the punctuation is slightly incorrect.  Also – because TeacherSoft's systems are not perfect the spelling is incorrect in a few places.

But it is a copy of at least a part of Joe's novel.

Joe objects

Joe doesn't like TeacherSoft making profits from Joe's novel.  Joe owns the copyright – and he politely asks that whenever TeacherSoft notices Joe's novel in their database they exclude it.

TeacherSoft does not accept Joe's claim.  They say they did not copy Joe's novel.  They just watched the “teacherstream”.  They don't see one part of the teacherstream – the part based on novels – should be prioritized or not prioritized over any other part of the teacherstream.  The novel is just a small part of a teacherstream.

Joe is upset.  His novel has been – in part – copied.  He seems to have no redress other than issuing a cease-and-desist.

Is it copyright abuse?  

I think this is obviously copyright abuse.  The copy of Joe's novel – or even parts of it (as long as those parts do not fit into a fair use exemption in the copyright law) are breaches of copyright.

TeacherSoft argues that it has not breached Joe's copyright.  It has permission from classroom teachers to use their teacherstream.  They just got the material from the teacherstream and they have permission to use that.

So what.  They don't have Joe's permission.  And Joe has sent a cease-and-desist letter.

And if TeacherSoft were to continue to ignore the cease-and-desist then TeacherSoft would be liable for breach of copyright.  If this were a case of a lot of little Joe's and one big nasty corporation I would even go as far as to suggest that a visit from criminal regulators would be appropriate.  Of course it would never get to that – but if done on a grand scale and with flagrant disregard for copyright it would be criminal.  

The Microsoft analogy

This is – of course – a direct analogy to Google's claim that Microsoft is breaching their copyright.  This is a claim that almost all my readers have disagreed with – but which I think is a lay-down.  

Ed Harrison (from the wonderful Credit Writedowns) refers me to an article by Danny Sullivan.  Sullivan writes more about Search than anyone else on the web – and knows his way around.  His argument is this:

The Search Signal Doesn’t Overrule Other Signals

Let’s step back. There’s no “Google signal” but rather a “search signal” that Google activity is mixed into. That search signal is further mixed in with other ranking signals, a dilution that is crucial to why Bing so strongly rejects Google’s claim that it is copying its results.

Most of Bing’s searches — popular so-called “head” searches — are not heavily influenced by the search signal, Bing says. There are many other signals that come into play.

“Movies” would be an example of a head search. That’s a search that’s done by thousands of people each day, and a search topic with lots of “signal” to measure. Bing can determine if pages are relevant to that term based on the words that appear on the page itself; how many people link to some of these pages with the word “movies” in the link; how authoritative those links seem to be, and more.

Bing can also examine how people click on its own results that it lists in response to that search. If a page doesn’t get as many clicks as would be expected, it might get dropped further down on the list. Pages that get more clicks than expected can be a sign that users find them more relevant than Bing’s ranking algorithm did originally, and so that can be used to boost them.

In addition to these and other signals, Bing can also turn to the surfstream to perhaps give a boost to pages that it sees are well visited by Internet Explorer users.
“Bombilate” would be an example of a “tail” search, a search that’s rarely done, and on an unusual topic. Here, there are fewer signals to assess. Only a few pages might be found. These pages might have few links pointing at them. Since the term isn’t searched for often, measuring clicks on Bing’s own results might not help much much. This is a case where the surfstream — as well as the search signal within it — might count more.

Microsoft is arguing that there is no “google search signal” there is just clickstream.  They don't distinguish Google clickstream from any other clickstream.  That they wind up copying part of Google's database (and a small part at that) is an accident of clickstream – it is not copying.

Ok – and TeacherSoft argues that they are not copying novels – they are just using teacherstream.

Microsoft argues it has permission to copy a “clickstream”.  TeacherSoft argues it has permission to copy a clickstream.  But they do not have permission from Google or Joe respectively – and it is Google or Joe's copyright they are breaching.

Microsoft's argument is ultimately very weak.  Google has copyrighted search results.  They wind up in Bing's search engine.  Joe has a copyrighted novel.  It winds up in TeacherSoft's education material. Both Google and Joe have a valid claim for breach of copyright.  It does not matter how technologically sophisticated the method of copying.  The novel and Google's data are copyright and they are copied.

Microsoft is also a huge hypocrite here – it regularly cooperates in criminal prosecution of people who breach copyright.  Yet Microsoft flagrantly breaches copyright – and ignores a cease-and-desist.  

I opposed the original anti-trust action against Microsoft.  But this time – and much to the annoyance of most my readers – I really do think the Justice Department should become involved.   

I know my readers disagree with me.  That is kind of nice.  Part of the joy of this blog is to find smart people who disagree with me - and I have found them here.  But I still don't think I am wrong.

John

The original Google release is here.  And Microsoft's reply is here.

China Agritech. The "sniff test" and other questions for Anne Zheng and Carlyle

China scams are becoming so - well - yesterday.  There was a lot of it yesterday - hence two long posts in a day.

I barely noticed that Lucas McGee Research had put out a note accusing China Agritech (Nasdaq:CAGC) of being a fraud.

Lucas McGee is a new name for me - but their report is a classic of the genre.  They visited the factories (addresses in the annual filings) and there was nothing there.  These are plants that supposedly generate 50 thousand tonnes of "organic fertilizer" per year.

A truck carries a bit under 20 tonnes fully loaded.  That is 2500 trucks per year - in and out of the plant - so maybe 10 per working day bringing in the "raw material" and taking out the pellets.  You think you might notice some activity - but alas there was none.

All very interesting - but most interesting is that - at least according to China Agritech's annual report -  Carlyle - the most influential private equity firm in the world - have an equity stake in this company and a nominee on the board.  Her name is Anne Wang Zheng - and she is young (33) and a VP of Carlyle Asia Growth.  She works at the Shanghai office.

Now Carlyle - again according to the filings - has actively traded and sold China Agritech stock exercising their options.

I am not going to vouch for the fraud.  I have not visited the factories so I do not know.  (I confess however to being short the stock for the usual accounting-raised-eyebrows-reasons.)

I see five possibilities - though it is possible that readers - or Carlyle - see more.  I have sent an email to Anne Wang Zheng asking for her views but have received no reply.  Here are the five possibilities:

1.  The short-seller allegations are false.  (That is the short's note is a fraud.)

2.  The short-seller allegations are true but Carlyle is not actually represented on the board of China Agritech.  The China Agritech filings that say they are represented are in error (a fraud committed by China Agritech).  It would not be the first time I have seen people named as directors or officers of a fraudulent company when they in fact have nothing to do with the company.  In this case the company is fraudulent but Carlyle/Anne Zheng are honest.

3.  Carlyle is represented on the board of China Agritech - but remain - at least until the publication of the short's note - ignorant of the fraud.  In which case Carlyle/Zheng look incompetent - but not criminal.  Zheng in fact might be competent if the deception conducted by China Agritech were very well executed.  Being actively deceived even in her role as a board member makes her gullible - but being deceived is not a criminal offence and if she took reasonable steps to acquaint herself with the situation but was deceived regardless she does not even have civil liability.

4.  Carlyle is represented on the board - but found out during the time they were represented on the board that it was a fraud and did nothing about it.  In that case either Carlyle or Zheng (or both) are accessories after the fact to fraud.  Also as they sold stock they might be insider traders.

5.  Carlyle and/or Zheng knew that the company is a fraud from inception - and purchased the stock and sold the stock in that knowledge.  It could be that Zheng knows and Carlyle does not in which case Zheng has committed fraud against Carlyle (and its clients).

I have racked my brain as to which of these possibilities is the truth.  I think it is now incumbent on Carlyle to answer - and I will happily reprint their answer.

If you asked me my best guess it would be 3 above.  Zheng was an unwitting board member - and she may have been actively deceived.  I only arrive at that by applying Hanlon's razor:  "never attribute to malice that which is adequately explained by stupidity."

Of course there may be an explanation outside the 5 above.  Billy Bragg sang that "a man can spend a lot of time wondering what was on Jack Ruby's mind".  And he can.

A blogger could spend a lot of time wondering what was on Anne Zheng's mind.  I have - but I figure it is easier to ask.

So I am asking...



John

PS.  I have refrained from the (obvious) jokes comparing the company's accounts to a crock of the product (fertilizer) because I am not prepared to vouch for the fraud.  I have not wafted my nose in the product - but my guess is that if a plant did actually process tens of thousands of tonnes of chicken s--t pellets and you asked the locals about how active the plant was they would look at you as if you were strange.  Can't you smell it?

Visiting the plants and not being able to smell it would be proof enough.  In this case you should be able to smell fraud (or at least smell the absence of fraud).

If you believe Lucas McGee this one does not pass the "sniff test".



Corrections:  Carlyle did not - as far as I can tell - ever sell any shares - they purchased more - but only through the exercise of options.  I have corrected the post accordingly.  Thanks for the comment.

----------------------------

Second postscript:  The company has decided on 1 above.  I repeat their press release below.  If Anne Zheng wants to confirm this publicly as a director appointed by Carlyle I will happily post:


BEIJING, Feb. 4, 2011 (Nasdaq:CAGC - News) ('China Agritech', or the "Company'), a leading organic compound fertilizer manufacturer and distributor in China, today announced the following statements in response to the short sellers' elaborate article purposefully delivered during the Chinese New Year Holiday.

China Agritech and its subsidiaries are operating normally. A number of analysts, professional investors, industry experts, and the Company's independent accountants have toured the Company's facilities in the past. The Company has never received any challenges regarding either the existence or the scale of production of its facilities. In addition, management has confirmed that the Harbin facility has never been listed for sale.

The sales growth of the Company's organic fertilizers remains robust. In response to the short sellers' allegation that the Company's distribution centers are non-existent, there have already been 10 newly established distribution centers (including a flagship distribution center) in Henan Province alone.

In response to the short sellers' allegation that the Company's subsidiary YiNong does not exist, YiNong in fact is headquartered in Beijing with strong governmental support. In August 2010, the Company announced that it had entered into a strategic agreement with the Beijing Municipal Government to establish within Beijing the headquarters of its nationwide network of distribution centers.

In response to the short sellers' allegation that the Company does not have a license to manufacture granular fertilizer, the government-issued production license number for China Agritech's granular fertilizers is clearly marked on each of our product's packaging.

All distribution partners have signed legitimate and verifiable contracts with the Company. Sales records have been transacted per legal and accounting standards in China. Sales agreements with major distributors such as SinoChem can be viewed on the SEC's website at www.sec.gov.

Relevant evidence such as government-issued production license number and photos taken during the production process will be made available on the Company's website in the near future.

The Company appreciates shareholders' long-term support and stands ready to defend and uphold shareholders' value.

China Media Express: what disconcerted me when I read the accounts

China Media Express is a tiny company about which there is – as I have noted – major passion and drama on Wall Street.

My last post indicated that it was either (a) one of the best businesses in the history of capitalism or (b) one of the most brazen frauds in the history of capitalism.  That post was linked by Forbes (disapprovingly) or Fortune (somewhat approvingly).

I noted that extraordinary claims require extraordinary evidence – and that neither side (long or short) had presented extraordinary evidence.

I also noted that the basis for my short was that the numbers were too good to be true – but I did not state in what way they were too good to be true.  (Many people in the comments and by email questioned my assertion that the numbers were too good to be true.)

Finally I suggested that there was a relatively simple way of checking the bona-fides of CCME which was to check the veracity of a claim that they had contractual arrangement with Apple. Apple of course would tell the truth to the SEC if asked.

Since I wrote all this the stock is down about 40 percent. My (very small) short position is ex-post too small – but then as I noted the evidence that I had to support that short was flimsy and did not justify a large short position.

I was short simply because it was “too good to be true”. Alas really good does not mean false – so this was a tiny bet. I was (and remain) more interested in the drama than the result.

The Muddy Waters Report

Yesterday (last night my time) the stock fell a third fairly rapidly after a small China-based research outfit (Muddy Waters) released a report. Muddy Waters has released two prior reports alleging fraud – one on Orient Paper (Amex:ONP) and one on Rino International. ONP denied the charges and the results to date only marginally vindicate Muddy Waters. (The stock is down – but nobody has admitted fraud.) Rino International however is one of the great hits of all time. Rino has admitted fraud, been delisted from the Nasdaq and now trades on the Pink Sheets and have filed with the SEC to say they will no longer be filing with the SEC. It is – as John Cleese might say – pushing up daisies. (I remain short RINO.PK and will cover in the pennies.  There doesn't seem any reason to allow the longs an exit above $1 when they hold clearly worthless paper.)

Muddy Waters shoots one (and a bit) from two.

And Muddy Waters claims are extraordinary. They don't suggest the company does not exist (it clearly does – and indeed they visited them in many guises). They just suggest that it is egregiously overstated both in the number of buses used and the revenue from each bus. They suggest earnings per share are (generously) about 5c (compared to the stated $2.37 historical). These are big claims and Muddy Waters present considerable evidence to back them up. They claim that major advertisers (such as people who handle the Coca Cola account) could not verify the existence of this company. This was strange because the company claimed considerable revenue from Coca Cola.  (The company does exist.  Muddy Waters just asserts it is a minnow.)

Moreover Muddy Waters claimed to have checked the Apple contract. I quote:

We caught CCME’s management telling a particularly egregious lie. It recently announced it had created an online shopping platform that has an agreement with Apple Inc. (NASDAQ:AAPL – yes, THAT Apple) or one of AAPL’s distributors. AAPL made clear to us that it has no such relationship with CCME’s subsidiary. Further, AAPL keeps tight control over its distribution in China, with only two authorized online distributors (including Amazon.com’s China subsidiary). None of AAPL’s China distributors have authority to sub-license.

This is pretty incontrovertible. If Apple will verify this to the SEC the SEC has no choice but to suspend the stock - send it to the Pink Sheets and leave the corpse to the class-action lawyers to clean up. If Apple will not verify this to the SEC then Muddy Waters has some questions to answer. This issue alone is sufficient to say who is telling the truth.

But I am not here to talk about the Muddy Waters report (although it is an impressive piece of due diligence). I am here to explain what it was that you could check from your desk in Sydney, New York or London that made me think that CCME was a strange company.

It was the payments for media content.

How media content is paid for

TV shows are expensive to produce. The stars are paid well (sometimes very well). Scripts are expensive. Studios and their staff more so. Tens of billions of dollars annually is spent producing TV content.

People don't spend all that money on TV content and then give it away. Those tens of billions of dollars have to be recovered from somewhere. Indeed they are usually recovered eventually from either advertisers or pay TV subscriptions.

Content deals come in two forms. Either (a) I pay a fee for the content or (b) I broadcast the content on my distribution (say a TV station) and I allow you a share of the advertising revenue or give you a proportion of the total advertising time in which to sell adverts.

In the US most TV content is sold by networks to regional TV stations in exchange for “minutes” of advertising time. If a network is selling a hot show (like American Idol) it might demand 10 minutes of advertising time per hour. If its a very cool show the network might demand 4 minutes of time leaving a larger piece of the smaller pie to distribution.

But its one or the other. I either pay for the content in hard cash or I pay for it by giving up revenue.

If I pay for it in hard cash that cash outflow will show in the accounts (and reported margins will be lower).

If I pay for it in minutes then the cash outflow will not show in the accounts – but the revenue per screen will be lower.

Its one or the other. Either cash outflow shows in the accounts or revenue per screen is lower. No choice in that.

So lets look at the accounts to see which:

Here is the cost-of-revenue section in the last annual report. To quote:

CME’s cost of revenue increased to $25.1 million for the year ended December 31, 2008 from $13.2 million for the year ended December 31, 2007 due to the following reasons:

Concession fees.  Concession fees charged by inter-city express bus operators increased to $20.0 million for the year ended December 31, 2008 from $10.7 million for the year ended December 31, 2007. The substantial increase was attributable to the concession fees payable to the group of bus operators participating in CME’s network through the execution of long-term framework agreements for the year ended December 31, 2008 as well as an increase in the number of inter-city express buses carrying CME’s network to 15,260 as of December 31, 2008 from 10,053 as of December 31, 2007.

Depreciation.  Depreciation for CME’s digital television displays and hard disk drives increased to $2.8 million for the year ended December 31, 2008 from $1.6 million for the year ended December 31, 2007. The increase was attributable to installation of new equipment and control systems in connection with the increase in the number of inter-city express buses in the CME’s networks.

Business tax.  Business tax increased to $2.1 million for the year ended December 31, 2008 from $0.7 million for the year ended December 31, 2007. The increase was primarily attributable to business taxes arising from consulting services Fujian Express provided to Fujian Fenzhong in the year ended December 31, 2008.

Salary.  Salaries increased to the amount of $203,000 for the year ended December 31, 2008 from the amount of $156,000 for year ended December 31, 2007. The increase was primarily attributable to the increase in number of staff in production and maintenance department in 2008.

Other operating costs.  Other operating costs decreased slightly to approximately $9,000 for the year ended December 31, 2008 from approximately $13,000 for the year ended December 31, 2007. The decrease was primarily attributable to the decrease in production costs in 2008.

Now lets add this up.  Concession fees were 20.0 million dollars, depreciation another 2.0 million, business tax 2.1 million.  Salary was a paltry 0.2 million.  Other expenses were trivial.  That adds up to 24.3 million.  Total cost of revenue is 25.1 million. There is $800 thousand unexplained.

That $800 thousand must include all content payments. There is no other place that content payments in cash can go.

That is not much – relative to huge revenues to pay for content.

So we can presume they are not paying much for content.

That is OK of course. Regional TV stations don't pay much cash for content - they yield minutes of advertising time instead. Its entirely possible that CCME yielded minutes of advertising time.
Indeed I questioned one of the stock brokers pushing the stock about this and they told me – after discussion with the company – that the low payments for content were explained by yielding minutes of advertising time.

Alright – then you would expect revenue per screen to be lower than the competition because – after all – the company does not own all the advertising time on the screens.

I did the calculation – and it is repeated in the Citron Research blog post. Advertising revenue per screen was roughly double the competition.

No cash outflows for content are visible in the accounts and revenue per screen is higher than the competition (suggesting but not proving that they are not paying much for content by yielding minutes).

As I note: this is not proof of fraud. Checking fraud is difficult: though physically checking say the contract with Apple exists would probably constitute proof of fraud.

I did not try to check fraud.  My standard of proof was low - but then so was my position size.

After all, it is possible that CCME had worked out how to sell adverts for 4 times what the competition sell them (thus producing double the revenue per screen whilst sharing half the advertising time with the suppliers).

But I thought that was “too good to be true” so I shorted the stock.

Was I confident about this? No. That is one reason why my position was small.

Does the Muddy Waters research surprise me?

No. I was kind of expecting an end game somewhat like that – and it makes sense of my observations.

Does the Muddy Waters research constitute proof?  Not directly - you would either need to confirm some of their observations yourself or wait for the SEC to do it for you.

However confirming the claim about Apple would be pretty convincing. The SEC should do this and – with that proof – they should suspend the stock.

I am not holding my breath. The SEC are regulators with a reputation for being slow.

If the short case is right (and I have a small bet on that it is right) then some prominent people have some egg on their face. Starr Asia - associated with Hank Greenberg - looks really stupid.  They have repeatedly purchased stock in this company and claim to have done due diligence.  That I guess will further tarnish Hank's reputation.  Deloittes is the auditor.  Knock one more failure up for a major audit firm - albeit a particularly embarrassing failure.

At this point you know my (weakly held) view.  I still welcome criticism in the comments.

Finally to the new readers who came from Forbes or Fortune.  Welcome.



John