You have to live under a rock not to know that there is widespread fraud in the China RTO small cap space. There is no reason to even reiterate the news coverage as the story has been flogged over and over. There are, however, plenty of reasons to look for the next company that will fall victim to increased scrutiny. Citron believes that this is an easy one: the case of China Valve Technology. (NASDAQ:CVVT)
Frazer Frost has become the poster child for bad auditing of Chinese names. They were just sanctioned by the SEC for their lack of oversight of China Energy http://www.sec.gov/litigation/admin/2010/33-9166.pdf Frazer was also the auditor for the now infamous, recently delisted RINO. All of Frazer’s clients have been forced to find new auditors, which for the reasons described below, puts CVVT in an untenable position — between a rock and a hard auditor.
The fact that CVVT had one of the lowest corporate governance scores (ranked 63rd out of 70 companies) on a recent Piper Jaffray China investment study and has had a revolving door of CFO’s is not surprising in light of what we discovered. And worse, the company made three acquisitions in 2009 and 2010, with some of the most unimaginably bizarre disclosures we’ve ever seen.
The company recently teased with news it was close to finalizing a “big 4” auditor – but hasn’t said which one. It is Citron’s opinion that there is no way the company can pass an annual audit of any reasonable professional scrutiny. Citron believes that the company will execute a secondary prior to attempting to provide an audit for these acquisitions.
Citron further predicts the company will get delisted to the world of the pink sheets when it inevitably fails to produce a credible audit of its 2010 acquisitions.
Case in Point
A year ago, if you asked “what’s the cleanest, best disclosed example of a China RTO, the name Tongxin (NASDAQ:TXIC) would invariably get props. This model truck body manufacturer with state-of-the-art facilities was one of the first – and the cleanest – reverse merger companies to list on NASDAQ. Yet, when the company hired a “big 4” auditor to “get legit” in 2010, the auditor was unable to produce the audit because of concerns over related party participation in the acquisition transaction. When it failed to file annual audited financials, the company lost its listing, 85% of its market cap, and now trades for 1.20 on the pink sheets.
Our research reveals a picture of China Valve much worse than TXIC — consistently misrepresenting their business and more importantly their acquisitions, which appear to be nothing more than an instrument for insiders to extract money from the company….so sit back relax and here we go….
Acquisition History of China Valves
China valves completed 3 major acquisitions in 2009 and 2010.
Able Delight – The Myth
The Company first reported its intention to acquire the assets of Able Delight for 15 million USD on January 12,.2010, a few weeks after closing a 22 million USD private placement. The press release described Able Delight as a leading producer of valves. The transaction was completed on February 3rd, 2010. In CVVT’s February 8-K, the assets purchased in this transaction included 4.94 million USD of Inventory and 10.11 million USD of PP&E. ….which seems simple enough.
But then something happened in November. Whether an SEC inquiry or pressure from the auditors we don’t yet know, but the company amended the 8-K and disclosed something closer to the truth.
In the amended 8-K on November 18th, 2010, the company reveals for the first time that Able Delight was in fact a subsidiary of billion-dollar Watts Water Technologies, (NYSE:WTS). The SEC filings of Watts paint a very different picture of the operating profile of the company than described by CVVT. According to Watts’ 10-Q and 10-K, Able Delight (Changsha) Valve lost 5.3 million USD in 2009. Worse, the subsidiary was under foreign corrupt practices investigation and Watts shut it down as a result of that.
However, under ownership of China Valves, we are to believe an instant turnaround had happened. CVVT estimated the subsidiary to contribute 20.5 million USD of revenue, twice of the previously reported revenue number by Watts, and 5 million USD of net income, instantly turning around a 5.3 million USD loss in 2009….Good luck getting that past an auditor.
Worse, we learn in the amended 8-K filed in November that only 6.07 million USD was paid for the “assets” of Able Delight to Watts (who filed that they received 5 million) and an additional 8.93 million USD went to the owner of Able Delight, purportedly for a list of other tangential expenses listed as “(approx)’. So who is this mystery owner who received the bonanza?
Now this would get you “locked up” in the United States:
The November 8-K states the CVVT bought Able Delight from a “third party” Qing Lu, and the company lent Lu the money to buy the subsidiary. Yet what was not disclosed is that Qing Lu shares the same residential address and co-owns the same house as Bin Li, who’s the first cousin of Siping Fang (Chairman of CVVT) and 34% owner of the Company.
It is almost as if China Valve was trying to break a record with how many securities laws can be broken with a single transaction. From misstating ownership of a company, to an undisclosed related party transaction, to inflating revenue projections, and lastly hiding the actual name of the business, for this 4-in-1 disclosure failure … we tip our hats to their management team!
The Acquisition of Hanwei Valves
In the asset acquisition of Hanwei Valves, we see again that the Company did not do what it said in its 8-K filed on April 9th, 2010.
The “Asset Transfer Agreement” referenced in the 8-K filing contains four parties:
Party A: Henan Tonghai Fluid Equipment Co., Ltd. (Subsid of China Valve)
Party B: Shanghai Pudong Hanwei Valve Co., Ltd. (Acquired Company)
Party C: Shanghai Hanhuang Valve Co., Ltd (Owner of B)
Party D: Hong Kong Hanxi Investment Co., Ltd. (Owner of B)
In the Company’s 8-K filed on April 9th, 2010, it clearly stated several points leading to the conclusion that Party C and D, which owned Party B (from which assets are acquired) are unrelated parties. But here is a document that tells us a different story. In another seemingly undisclosed related party transaction, this document below shows in fact that China Valve owned party C prior to the acquisition.
Furthermore, the company presents this transaction as an “asset sale” and goes as far as to claim that Party C and Party D represent that the tangible and intangible assets of Hanwei Valve (including but not limited to land, buildings, equipment and intellectual property) are not subject to any collateral, pledge, lien or any third party claims. Party C and Party D will take all responsibilities arising out of any claims if the representations are not accurate. It further lays on non-compete clauses…the whole 8-K can be read here.
Yet we read as of today that CVVT did not in fact buy just the assets but rather they bought the whole company, which could easily include undisclosed liabilities. MORE IMPORTANTLY, when you buy just the assets of a company, you do not have to file financials on the acquisition but when you buy a full company, you are required to….so its another auditing nightmare….good luck. Below is proof that China Valve now owns all parties B, C, and D.
The Yangzhou Rock Acquisition
Yangzhou Rock was the smallest acquisition transaction of the three, a mere 7.3 million USD. Without diving into too many details, there are at least two points of suspicion.
1. Before even agreeing upon a price, China Valves paid 6 million USD upfront for Yangzhou Rock which simply makes no sense, unless of course you had some “relationship” with the seller.
2. Like the other transactions, China Valves paid for a mere 2.2 times PE for Yangzhou Rock which leads to the question: Why would anyone sell such a business for 2.2 times PE?
Unless of course the numbers are completely fictional as we saw in the example of Watts Water.
Through its own filings and disclosure on the three acquisitions it completed, China Valves has been claiming an annualized 94 million USD revenue and a blended gross margin of 43.4% on these three acquisitions. They are simply too good to be true. The words “too good” is not being used lightly here
Nothing about this company seems to make sense.
· They represent gross margins that are by far the highest in a commoditized sector, yet they make no investment for innovation: their R&D Budget for 2010 is around $150K.
· They compare themselves to Emerson, a company 100 times larger, yet CVVT claims they have twice the operating margins….good luck explaining that to your new auditor.
· They are able to buy a competitor at P/E of 2.
Who’s Minding the Store?
The SEC is currently wrestling an enormous and intractable problem. This entire wing of the market has gone completely off the regulatory rails. Disclosure failures that would result in immediate stock halts and criminal actions are being uncovered daily.
Yet, getting any jurisdiction for serious regulatory efforts in China is very problematic, even more so with a holding company structure in yet a 3rd jurisdiction, typical for China RTO’s. (CVVT’s holding company is in Hong Kong.) Yet nothing of an enforcement nature happens without the explicit permission of the Chinese government.
So the SEC task force’s approach is to hold the US counterparties accountable for these entities. Before the analysts rush to defend these regulatory quagmires, they are going to have to consider their own vulnerability for being held accountable for issuers’ practices that make such a joke of basic disclosure rules. A 2010 big 4 audit will not be as easy to acquire as another no-name valves maker.
This company needs substantial cash going forward – which puts it in a cynical race between a secondary and an audit.
Citron expects the secondary is going to win – and there’s no safety valve for investors who are the likely losers. Consider the rush to close this secondary in light of how difficult it will be to actually procure a real audit. This is stuff that would just never be permitted in US exchanges.
How sustainable is this picture? Citron suspects it ends with the color pink.