It Doesn’t Take a Microscope to See What’s Wrong with China-Biotics (NASDAQ:CHBT)

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It Doesn’t Take a Microscope to See What’s Wrong with China-Biotics (NASDAQ:CHBT)
Citron Probes the Obvious:  Where are the Stores?

Amazing how fraud is like water, it just finds the path of least resistance.  When Citron started this column nine years ago this week, the frauds were OTCBB stock promotions run out of boiler rooms.  The progressed to internet campaigns and mailers, and now most recently to the greatest promotion of ’em all:  CHINA.   In this past weekend’s Barron’s Magazine, Bill Alpert does a fine job in describing the web of fraud that exists in small cap Chinese stocks that were brought to market via reverse merger.

http://online.barrons.com/article/SB50001424052970204304404575449812943183940.html?mod=BOL_hpp_mag

In the article, Barron’s observes:

“The SEC’s enforcement staff can’t subpoena evidence of any fraudulent activities in China, and Chinese regulators have little incentive to monitor shares sold only in the U.S. Many reverse-merged companies admit in prospectuses that they haven’t gotten required approvals under China’s financial regulations.”

Citron has written about a reversed merged China stock in 2007  (Xinhua Finance Media NASDAQ:XFML).  When we published, it was $10.00 and now it is .18 cents (ticker now XSEL).   After reading this weekend’s Barron’s, we thought we would share the interesting case of China-Biotics as it seems so timely and relevant.

While the world “biotics” might sound impressive, it really is nothing more than a food supplement that in this case comes in the form of an acidophilus pill.  Worldwide, there are literally dozens of manufacturers of the bacteria concentrate in these supplements.  It is a mature and stable low-margin industry.

We could probably write 10 pages on what stinks about this China Biotics and what raises the red flags for fraud.

  • It would be easy to look at the gross discrepancies between the company’s SAIC and SEC filings.
  • It would also be possible to show pictures of the half-finished over-budget manufacturing facility side-by-side with company claims that it was already in production, or the photos of their current production facilities the size of a “bathroom” where the acidophilus pills drop out of a machine two by two.
  • Most compelling, it would be simple to question how a company who sells the bulk of their product though distributors, who then purportedly resell them to Wal Mart (so they claim) can generate EBIDTA margins of 40-45% when their competition is at 27% max.  (Multinational companies in the business include Danisco, Yakult, Perrigo, Cargill and others.)   The company claims its high margins are due to its “retail channel”.
  • Or, as if one needs any more of a red flag, we could discuss how the company has been through 5 CFOs in only 4 years
CHBT CFO History Start Date End Date
Song Jinan 3/22/2006 11/13/2006
Li Chi Yuen (Raymond) 11/13/2006 03/06/2009
Lewis Fan 03/06/2009 10/21/2009
Yan Yihong (Eva) 10/21/2009 01/22/2010
Travis Cai 01/22/2010 Present
  • We could discuss the company’s $50 million plus financial commitments due in 2010 or its looming potential tax liability from questionable past financial transactions that could also be as high as another $50 million.

But all of those arguments would either require Citron to prove a negative or use arguments of inference.  Or it would require shareholders to actually use some form of skepticism and analytics when judging the numbers.  So instead we will ask an easy question that the company and shareholders should have no problem answering:

China-Biotics  –  Where are your stores?????

According the CHBT’s SEC filings,

“As of March 31, 2010, we had 111 Shining branded outlets in Shanghai and 12 other major cities in China where we sell our products directly to the end users.”

Below is a chart showing the company’s alleged retail store growth since the company completed its reverse takeover in March 2006.

chbt4.gif

CHBT disclosed that “about three quarters of these outlets are located in Shanghai and the rest are located in 12 other cities in China.” As a result, we should expect that the company has at least 70 outlets in Shanghai.

Amazing that a company that is not at all shy in its use of PR’s had this explosive store growth without one: ribbon cutting, new store pr, or notice of opening.

Extensive web searches through http://map.baidu.com/ http://shanghai.aibang.com/ , and http://www.mapbar.com/ using the company’s disclosed brand names reveal only a handful of stores.  We can find only 6 or 7 stores in Shanghai, and one each in Xeitu, NanMatou, Jingyu, Zhang YangLu, LingNan, FengZhuang.

In going through the corporate filings, it appears that the company’s retail outlets go under the brand  益生有益.  That is also the name that we can see on the sign of the few stores that we actually could identify.  Put that into http://map.baidu.com/ and see if your results differ.

Citron has heard from a handful of investors who all report that they have been unable to find any sign of even 25 locations, let alone over 100.

The company claims there are more than 100 retail outlets, with at least 70 of them in Shanghai. Proving that should be fairly easy: management should simply publicly disclose the addresses for every one of the company’s retail outlets.

Since a picture is worth a thousand words, here’s a look at the store China-Biotics identifies as its “flagship”.  There’s very scant inventory, but a lot of photos of what looks like a sales meeting for an MLM organization, a business model the company denies being a part of.   Yet the excuse made by the proprietor of this store for the obvious lack of sales is that “most of the sales are generated through a ‘buying club’ “.

NOTE:  MLM sales organizations are strictly prohibited in China.   See what happened to Avon:   http://www.chinaretailnews.com/2009/07/06/2798-avon-china-investigated-for-multi-level-marketing/

OK, OK … those used to our stringent US disclosure standards may be asking…”What about the auditors..– certainly they have seen or have knowledge of all of the stores, no ? ”

The auditors of CHBT are BDO Limited…..who should not be confused with BDO Seidman, as all they really share with that big-name firm are 3 letters in their name as explained in this article by China Company Analyst.

http://seekingalpha.com/article/213213-orient-paper-not-all-bdos-are-the-same

BDO seems to have become the auditor du jour for questionable Chinese public companies.

“Well Citron, what about just going to the corporate website and getting the locations there?”

You do it.  If you try it on one of those days where the corporate website actually works ( http://www.chn-biotics.com/ ), you will not find a list of store addresses.  How can any company claiming to be in the retail business (with over 100 stores) not even list store locations on their site…anyone, anyone??

Conclusion

Investors need to be wary of the growing scrutiny that Barron’s and other investigative reports will bring upon these shenanigans.  Citron doesn’t believe the current regulatory “enforcement-free zone” for US-listed China-based companies is in the best economic interests of either the US or China, and it is not sustainable.

Within China, the country’s credibility in the international marketplace is regarded as a national strategic priority.  It may seem that China’s culture has different standards when it concerns of questionable business ethics, but when the state becomes aware of a real economic threat, they come down hard.  Just look at what happened to the CEO’s of companies involved in the melamine in milk scandal, the lead in toys scandals, etc.  Its no wonder that the first sign a US investor may get of trouble in a Chinese company is when the CEO “disappears”.

There’s no need to get embroiled in “shorts vs longs” battleground rhetoric here.  It’s a very simple matter:  where are the stores?  If there are no stores, there’s no margins, no profit and nothing credible about this company or its management to hang an investment thesis on….period.

Alpert’s article shows how bad the odds are for investors in these poorly documented and regulated reverse-merger entities.  But at the bottom of the class is a company whose entire operation is based on fiction.

Cautious investing to all.