Results of Zungui Investigation

http://www.theglobeandmail.com/globe-investor/osc-accuses-chinese-company-executives-of-mishandling-audit/article2229223/

E&Y Suspends the Audit of Zungui (waiting for the other shoe to drop)

Does E&Y read The Truth is in the Details?  I doubt it, however less than one month after I first raised red flags regarding Zungui in my post here and here, E&Y has suspended the audit of the Company’s financial statements for the year ended June 30^th 2011.

Shares of Zungui finished down 77% on the day after the stock was halted pending a news release.

“Ernst & Young LLP ("EY") has advised the Audit Committee of the Company's Board of Directors that it has suspended procedures with respect to the audit of the Company's financial statements for the year ended June 30, 2011 until the Company clarifies and substantiates its position with respect to issues pertaining to the current and prior year which EY has identified in the course of EY's audit work. EY recommended that the issues identified be addressed by an independent investigation.”

For now we will wait on the results of the independent investigation but if Sino-Forest is any indication we may be waiting a while.

Graham

The Truth is in the Details (and one of the details has just been removed)

I have never participated in stock discussion boards, but the discussion about this blog and Zungui at Stockhouse.com is becoming increasingly entertaining.

http://www.stockhouse.com/Bullboards/SymbolList.aspx?s=ZUN&t=LIST

So apparently someone has emailed the CFO Shelly Gobin about the comments made on this blog and this is Shelly’s alleged reply.

I have seen the blog. I cannot answer if this is impacting the stock (which are very volatile these days) but the comments made in the blog are not accurate. Our business model is different than LiNing's and we operate in lower end segment of the market. This has been clearly communicated in our prospectus from December 2009. Our capital expenditures have also been detailed out in the MDA's we have disclosed. There are inaccuracies in the blog on these matters as well. Unfortunately, people are allowed to blog whatever they like without any verification or even reading of our public documents.


The Chinese website is not used for day to day business. We do not sell our products online - they are only sold in ZUNGUI stores. The article is correct that the website is out of date and some links are not working. This is a valid point and I will follow up with the IT department in China to correct that. I believe the logo that the article highlights is not accurate - all of our products are branded with the ZUNGUI logo. The picture appears to have been altered from the catalog that is available on the website.www.zunguihaixi.com that is used for investor relations. This website is also being update to provide some more information on Zungui but does contain all of our corporate documents, press releases, etc.

Zungui Haixi Corporation has a very high standard for corporate governance and I would be happy to answer any questions you may have. I did leave you a message at the number you provided below. I would be happy to discuss further with you if there is a convenient time to reach you.

Thank you.
Shelly

 

Of course the picture I posted on my blog earlier was not altered and enough people have seen the picture on the website to know that I did not alter it.

But regardless, I have just checked the Zungui website and the Diesel logo has just been removed and Zungui’s high standard for corporate governance has been restored. We can all sleep easy now.

Graham

P.S

This still has to be the ugliest shoe I have ever seen.

Response to Comment on Migao

In the comment section below on my last post on Migao someone has raised two valid arguments in defence of Migao. I am happy that someone has brought these points forward because as I will point out although these arguments appear valid at first, upon deeper investigation, they are not really valid at all.

The first argument is that the potash deal is ‘legit’ because the CEO has pledged $95M in his own shares to restore investor’s confidence in the potash agreement and to protect against possible default from the mystery supplier

There are two things fundamentally wrong with this however.

1)      We will never know whether or not the potash supplier did default on the agreement. It is not the auditor’s duty to confirm where supplies of potash came from and therefore Migao could tell us that supplies of potash came from this mystery supplier and we would never be able to prove it one way or the other.

2)      The second reason why this pledge means essentially nothing is that as discussed in the post below if the transaction is fraud then the shares are essentially worth nothing anyways and therefore the CEO’s pledge is essentially worth 0.

The second argument in defence of Migao is that insiders have bought over $1.4M shares in the last month.

I believe that this is just a little bit window dressing. As per this article, the amount of purchases compared to sales is clearly insignificant and the article states that the ratio of shares sold to shares purchased was 65 to 1 back in March. So clearly these share purchases are insignificant when looking at the whole picture.

The same thing could be said about their share buyback program that they announced. It will be interesting to see how many shares they actually buyback. This wouldn’t be the first time an alleged Chinese fraud has announced a share buyback program.

Setting the Stage on Migao

I want to thank everyone for the support after my first post. I wasn’t sure if I would have the time to keep up with this blog, but the support definitely motivates me to try.

This will be my first post on Migao “TSE:MGO”. I have many more half written posts in the pipeline on Migao; however I thought that instead of taking a while and having one large post I would do smaller more frequent posts.

The Russian Deal

In this first post I thought I would highlight the largest and most blatant red flag of all. From a March 15, 2011 Migao press release:

“As part of the terms of the agreement, Migao will prepay USD $100 million, with further payments to be negotiated and advanced prior to the initial potash delivery in January 2013. Migao will receive preferential pricing on up to 500,000 tonnes of potash per year for 10 years.”

It is not common business practice to write a cheque for $100 million USD for delivery of potash over a year away and then not disclose ANYTHING about the company with which the money was given.

As per this article, Migao cites that the reason for lack of disclosure is that they do not want to give away any competitive information. This sounds awfully similar to Sino-Forests excuse for not disclosing some of their transactions.

The concern with this transaction is that the Russian company with which the agreement was made could be an undisclosed related party that Migao is using to funnel money out of the company. In almost every RTO that has been halted so far, a vast majority of them have failed to disclose related party transactions.

However it should not be too difficult to find out who this Russian company is, because there are only two producers of potash in Russia. So you would assume that it would have to be one of these two companies. However as per this article, both of these producers have denied involvement in the transaction.

If you’re not already concerned, it gets better. I was reading a few of the earlier filings (April 13^th 2006 information circular) by Migao prior to them going public and noted two things of concern.

1)      The company has a history of purchasing raw materials from related parties.

“During the year, the Company purchased $NIL (2004 - $3,659,001 and 2003 - $751,202) of raw

materials from Dandong Development District Yongfeng Agriculture Development Co. Ltd.

(“Yongfeng”). Yongfeng is related by being controlled by a person related to the shareholder of Yongcheng.”

The shareholder of Yongcheng is Mr. Liu Guocai and he is the Chairman of the Board, General Manager and CEO of Migao.

2)      Prior to Migao being publically traded in 2006 via a reverse takeover of Fox Mountain, Migao was owned 75% by the CEO Mr. Liu Guocai and 25% by a company called Russia Liumix Chemical Co. The 25% ownership was eventually converted into equity of Migao. I have not been able to find any other information about Liumix, but the fact that 25% of Migao used to be owned by a Russian company and the other 75% by the current CEO certainly doesn’t ease the concern that Migao is using this Russian contract for illegitimate purposes.

Disclosure:  Short Migao

Some Thoughts on Zungui Haixi

Zungui Haixi “ZUN” is a maker of footwear, athletic apparel and accessories. Zungui was awarded the 30^th most valuable sports brand in China in 2010 and is China’s 8^th largest domestic sportswear brand by revenue.

Zungui is not actually a reverse takeover (RTO), however I don’t believe that that offers any extra assurance, especially given the association this company has with other TSX listed RTO’s, to be discussed in a future post perhaps.

In the following post I have raised several questions that can be and have been indicators of fraud on other Chinese listed RTO’s.

IPO

A common red flag with many Chinese RTO’s is that they will be constantly raising cash in the capital markets despite having operating cash flows that exceeds capital expenditures. The reason for this is that it will later be shown that the operating cash flows were non-existent or overstated.

In December of 2009 Zungui raised approximately $36M CAD in an IPO. The IPO was to expand future growth through increasing store locations, increasing marketing expenditures and building a new manufacturing facility.

All of this sounds good initially, but when we look at what the actual expenditures were related to this “funding of future growth” a year and a half after the IPO, I question whether the IPO was really necessary.

The cash balance has actually increased by $7M since the IPO and every quarter except the last two quarters the cash flow from operations has been positive and has been more than enough to cover any capital expenditures.

As at March 31, 2011 Zungui has claimed to have spent $18.7M of the proceeds from the IPO, a far lesser amount from the original $35M they claimed they needed originally.

Breakdown of the $18.7M

·         $8.7M for expanding the retail and distribution network

·         $1.8M for increasing production capacity

·         $8.2M for brand recognition and awareness

The $1.8M for production capacity appears more in line with maintenance capital expenditures and hence is not what the proceeds of the IPO were meant to be used for originally. The company has recently said they have plans to build a $4M new facility although there is very little information on this.

The other $8.2M for brand recognition and awareness appears to be normal marketing expenses and a reason for an IPO should never be marketing expenses as marketing expenses should always be covered by the operating cash flows otherwise the business is not sustainable.

The $8.7M for increasing the retail distribution network is the only amount of the $18.7M that seems like a legitimate reason for the IPO. The beginning cash balance prior to the IPO was $23M which was more than enough to cover the $8.7M.

Zungui raised far more cash than was necessary to fund the future growth and on top of that, they had a beginning cash balance prior to the IPO of $23M and since the IPO the cash balance has actually increased by $7M not decreased like would be expected.

Therefore in my opinion there was no legitimate need for an IPO, which raises red flags. In the case of other RTO’s management either raised cash from investors to fund their own pockets or to profit in the form of stock options. Neither of which is good for investors.

In the case of Zungui, I can’t comment on management’s intentions but Zungui has issued a lot of stock options to management and other related parties.

 Margin Comparison

In comparing the margins of Zungui to one of their larger competitors Li Ning HKG:2331 which has a very similar business model I have noticed a few concerns in the margins of Zungui.

The cost of sales of Zungui is 73% of revenue while Li Ning cost of sales is 53% of revenue. This indicates either that the cost of producing for Zungui is much higher than for Li Ning or that Zungui does not have the pricing power of Li Ning. Neither of which is good, but since the business models are very similar, which is that they sell to 3^rd party retailers I would suspect that the problem lies in the cost of production.

The crazy thing though is that Zungui actually has a higher profit margin than Li Ning of 19% compared to 14%. This means that Zungui has to be saving money somewhere else. Zungui is making up for their high manufacturing costs by decreasing the costs of everything else. Total selling expenses, G&A and R&D expenses as % of revenue is 8% for Zungui and 33% for Li Ning.

R&D expense and advertising expense as a % of revenue are a fraction of what they are to Li Ning. Reduced spending in R&D and advertising generally results in reduced growth in the long run. However Zungui has managed to be spending only a fraction on R&D and advertising compared to their competitors but has still managed to grow revenue at an extremely high rate of approximately 33% compared to prior year. The fact that is Zungui’s fixed costs as a % of revenue is so much less than Li Ning is suspicious.

Store Comparison

Both Zungui and Li Ning mostly rely on 3^rd party retailers 95% and 92% respectively as a % of 3^rd party stores over corporate owned stores.

Note:  I refrain from using the word franchise when referring to the third party retailers. There is almost no disclosure about these third parties but they do not appear to meet the definition of a franchise. They are however very similar to franchises as each 3^rd party store sells explicitly Zungui branded products.

Li Ning revenue per store is approximately $190,000 compared to Zungui revenue per store of approximately $104,000 per store.  This is concerning to Zungui especially since the gross profit margin of Li Ning is 47% which is significantly higher than Zungui gross profit margin of 27%.

Therefore the gross profit on selling goods to these stores is about $28,000 per store for Zungui and about $90,000 per store for Li Ning.

I would assume that the mark-up by the 3^rd party retailers would be similar for Zungui and Li Ning. I question how profitable these 3^rd party owned stores are to the 3^rd parties that are selling Zungui branded products and whether they are even profitable at all. The difference in revenue and income per store between Zungui and Li Ning is somewhat suspect, which makes the revenue amount and the number of store locations suspicious.

Inventory Turnover

Another red flag that makes the inventory account suspect is the high turnover of inventory. Inventory turns over at Zungui approximately 25 times a year which is about every 15 days.

As a comparison Li Ning inventory turns over approximately 7 times a year or every 52 days. For every inventory cycle of Li Ning, Zungui has had 3.5 cycles!

The inventory turnover is very suspicious. Of course maybe Zungui is using a new type of just in time inventory production strategy to keep costs down, but that wouldn’t explain why Zungui gross margin is just 27% while Li Ning has 47% gross margin.

Website

Another common red flag for Chinese reverse mergers seems to always be their website, especially when the product is designed to be sold to individual consumers. I am referring to UTA and COGO.

The website for Zungui is no different and is full of red flags, which begs the question whether the website is designed to sell products to Chinese consumers or whether the website is designed to dupe investors.

Here is the company’s website, feel free to follow along.

1)      On the home page of the company there are 11 links, but only 3 links actually work. I would have thought the China’s 8^th largest sportswear brand would have a working website.

2)      I click on the casual shoes link and I notice only Caucasian models which I find strange given that they sell 100% to Chinese consumers. 

3)      They still have promotions from Chinese New Year’s 2011 and earlier. Chinese New Year is in January, which was 7 months ago. I had the same result with the Chinese version of the website. Is it just me or should I not expect a company of this size to be able to update their website more often.

4)      The picture of this shoe shows up twice either by going to “2011 new products” and going through the 2011 new products catalogue(they call it album) or clicking on the “life leisure” shoe on the main page of the “casual shoe link”.

I know it is hard to tell what that logo is from here so I have blown the size of the image up.

Does anybody else recognize this logo?

How about now?

For those of you not familiar with the logo, Diesel is a very popular and expensive clothing brand from Italy.

Okay, but now I am really confused.  Why is a Diesel shoe showing up in Zungui 2011 new product catalogue? Does Diesel know about this?

Maybe Zungui has some kind of arrangement with Diesel to manufacture Diesel products. But then again the company says they don’t manufacture for any other parties and I found this shoe in their 2011 new products category, so that doesn’t really make any sense either.

The only reason I can think of as to why Zungui would have a Diesel shoe in their 2011 New Product catalogue is that Zungui didn’t have any of their own shoes to put in the catalogue because the 1,000 newly designed shoes they claim to create each year doesn’t actually exist.

I noticed that some of the other shoes shown on the website have logo’s that are not the logo of Zungui that would be worth further investigation however I did not recognize the logos off the top of my head.

When something like this is so blatant, you have to question managements integrity and wonder what else there is that they might be hiding.

5)      Usually the point of a website is to search or browse through the products offered. No option to do that here. Only a very limited number of products are actually shown on the website and one of those was a Diesel product.

6)      There is also no online store. I have tried to purchase Zungui products online from anywhere but have had no such luck.

7)      So if I can’t purchase their products online maybe they can at least tell me where I can go in China if I wanted to go purchase their product. I was able to find a “store locator” section on their website but it appears as though it has never been updated or has never worked.  Clicking on the different areas of the map would result in nothing happening.

This website served almost no useful purpose for an actual consumer, but it did look pretty. This makes me think that the website was created more for investors than anything else.

Thoughts for E&Y

If the revenue is overstated than the cash balance would be overstated. All auditors of Chinese companies should do what Deloitte did here for Longtop Financial. This is a great NY Times article.

Another thing E&Y might try is a surprise visit to few of the 2,000 locations. If the locations exist and seem legitimate enough than the revenue may be plausible.

Disclosure

I wrote this post for fun. I am currently not long or short this company, however this could change in the future.