Summary:

We recommend a short position in China Green Agriculture Inc (CGA-NYSE).  We believe CGA is a fraudulent company that went public only for the purpose of raising and stealing large amounts of funds from investors.  CGA operates in an industry with nearly no barrier to entry and sells a highly commoditized product but reports unusually fat margins compared to its competitors.  In our opinion, the company was selling hot concepts, i.e. organic fertilizer, ag stocks and China (just like the way the company’s being named), to naïve US investors who have little knowledge about China.  The stock was up again over the last couple of days on bogus rumor/speculation of an extremely remote possibility of takeover as a result of the talks of BHP/Potash bid.  Much of this write up was based on the findings of excellent 3^rd party research report detailing volumes of evidence of CGA’s overstated revenue/earnings, inconsistent financial statements and the stealing of investors’ money through a land acquisition.  We believe several recent events will likely accelerate the collapse of the scam, similar to the earlier collapses of several other reverse merger frauds.

Description:

CGA went public in the US through a reverse merger into a shell company in Dec 2007.  Simultaneous with the reverse merger, it raised $20.5MM through a private placement from a group of accredit investors, the majority of which have exited the stock a while ago.  CGA subsequently raised $28.8MM and $20MM in July and Nov 2009 in two rounds of secondary offerings underwritten by Roth Capital and Rodman & Renshaw.

Through its operating subsidiaries in China, CGA primarily sells humic acid based fertilizers.   The company’s latest guidance is for  2010 revenue in the range of $50.6-51.2MM and net income of $21.1-21.4MM.  CGA reports a fat operating margin of close to 50% and 64% gross margin on its “high-tech” fertilizer products, which dwarfs anyone else in the same industry.  The publicly stated goal of management is to grow revenue to $750MM in 3-5 years, requiring an annual CAGR of at least 70%.  Of course, this is China so some people believe anything is “possible”.  To fund its ambitious growth plan, CGA recently filed an S-3 with SEC registering $200MM worth of securities to be issued.  The sell side analysts are of course very bullish on the stock in order for their own banks to get a lucrative piece of this investment banking businesses.

Recently, we ran across a research report by written by a chinese 3^rd party due diligence outfit, providing high quality analysis and a large amount of evidence pointing to a strong possibility of CGA defrauding investors. Our local team has reviewed the report and its various supporting documents and believe these are real, credible sources that are primarily based on local government documents in China, stamped and certified by the government and the company itself.  A link to the report is here.  We suggest you take a look at the information in there along with the a few comments we have below.

Reasons we believe CGA is a fraud:

1. VAT Payable (Value-Added Taxes) in financial statements looks fishy. 

A little background on VATs: A form of consumption taxes that exists in many countries outside of the US.  It is similar but not the same as a sales tax, as it’s calculated primarily based on the value-added to a product/service in the process of manufacturing and distribution.  In China, a VAT rate of 13-17% are levied on the sales price of products and, separately, companies are allowed to take deductions on its purchase of certain raw materials, services and equipments at a rate no more than 17%. A VAT rate of 13% applies to fertilizer products sold by CGA.  Practically, given the deductions allowed to take, the amount of VAT as a % of fertilizer revenues should be a blended rate in a range of mid-high single digit %.  It’s worth pointing out, VATs are accrued and paid on a monthly basis with very little chance of getting an extension.  The understanding of our local team is VAT represents the largest category of the Chinese government’s taxation income (over 30%) and is one of the most strictly collected taxes by the tax authority.  Local governments don’t have jurisdiction on VATs and have no ability to grant any extension on the payments.

The reason we went all the way to explain the basics behind VAT tax calculation is we believe the VAT payable balances disclosed in CGA’s financial statements do not make any sense at all and indicate its reported revenues are probably inflated.  The findings by the research report have basically confirmed our thesis.  For example, CGA reported a massive VAT Payable $5,476,791 as of September 30 2008.  What does this mean?  In the most optimistic scenario in which CGA has no deduction from its COGS, $5.5MM of VAT must have been accrued based on fertilizer revenues of $42MM (5.5/13% = 42).  Bear in mind that VATs are paid off monthly, so this $5.5MM VAT payable must have been accrued on revenues over the past month.  Therefore, the financials suggest CGA must have had $42MM fertilizer sales over a very short period of time (past 1-3 months).  However, this implied $42MM revenue is higher than the $28.9MM fertilizer revenue CGA reported in that fiscal year.  Remember, our assumption of CGA having no deduction against its VAT calculated on fertilizer sales?  Realistically, CGA must have raw material and equipment purchases that can be deducted for VAT calculation, so the true sales that generated the $5.5MM VAT payable balance must be a lot higher than $42MM (conservatively $5.5MM VAT based on a 10% blended rate = $55MM).  In summary, we question how such large VAT balances could exist! These publicly available data sources alone can support our fraud thesis.

Our conclusion is further enhanced by the 3^rd party research report’s findings that sales of organic fertilizers, a vast majority of CGA’s fertilizer, are exempted from payment of VAT since June 1, 2008 (confirmed by our own checks).  So how is it possible that CGA kept reporting such large amount of VAT payables and its financials showed the balances are regularly paid off?  In fact, the records obtained by the authors of the research report from local tax authorities in China showed little VAT payment over the past 2 years.  There has been some discussion and confusion about the reliability of the information from filings of various Chinese government agencies (such as the SAIC). We agreed on the report’s assessment that records from the tax authority in China, the Chinese State Administration of Taxation (SAT), is the most reliable source since its functions are essentially identical to the IRS in the US. The tax collector in China is not any less serious than the one United States.

There’re several possible implications from the above analysis of the unusually large VAT amounts:

1. Since VAT calculation is based off the fertilizer revenue, CGA has inflated its revenues reported to US investors through the SEC filings.
2. CGA historically has used such non-existent VAT payable balances to steal money (similar to what they did with the inflated land acquisition price).
3. CGA has been illegally avoiding its tax liability, a criminal offense that could result in substantial penalties in PRC.  We’re not aware of any disclosure of such risk in its SEC filings, so we believe the other two scenarios are more likely.

2. $8MM of shareholders’ money have probably been stolen through an inflated land purchase price.

CGA’s own excuse for their lack of free cash flow this year was the $10.8MM spent acquiring an 88 acres land for its new R&D facility (basically a bunch of greenhouses).  We’re going to be very brief in this part as the research report has detailed the background and large amount of evidence, proving that the actual cost of the land was only $2.5MM based on various local government documents.  We have our local analysts reviewed all documentations presented and believe those are indeed authentic records, stamped and signed by a number of different government agencies such Ministry of land & resources, local treasury and taxation collection office.

3.Multiple other red flags

a)     Aggressive accounting practice – large disconnect between reported earnings and cash flow and most of increases in revenue over the past 2 years ended up in large A/R.  Our channel check failed to identify any customers that have significant purchases of CGA products.

b)    In addition to the inconsistency between VAT tax records and SEC financial statements, the research reports have also pointed out a number of other alarming things such as record of income taxes and questionable accounting practice of recently acquired subsidiary etc .  SAIC records in the 3^rd party report clearly show CGA reported much less revenue and income to the Chinese commerce bureau than it does to its U.S. investors in its SEC filings.

c)     Auditor – We’re not saying there’s necessarily something wrong with a small, regional auditor such as Kabani & Co.  Our experience is small US auditors (even those with US educated, Chinese-speaking staff) typically lack of necessary local knowledge and working experience to detect a lot of the tricks used by the local management to manipulate its books.  Kabani did have a questionable history of auditing a number of Chinese small cap companies.  One prior client of Kabani was Bodisen Biotech (BBCZ.OB), which was delisted to pink sheets, attacked by various class action lawsuits alleging frauds and only miraculously made back to OTCBB recently.  The interesting thing noted by the research report is Bodisen was also in the organic fertilizer business and happens to be located in the same city of Xi’an, although we couldn’t find any other connection b/w CGA and Bodisen. 

d)    Management – The Chairman/CEO Tao Li also owns a number of unrelated businesses and seems to lack focus on CGA.  One other company of his that was taken public by Roth Capital earlier this year was a total joke and its share price collapsed (KONE-NASDAQ). Li also has a history of selling CGA shares to fund his other ventures.  Current CFO Ken Ren is a new hire at the company.  Our experience with him can be summarized as a bit disappointing, as he didn’t appear to be knowledgeable and experienced enough to be the CFO of an NYSE listed company.  He wasn’t sure about the answers to a lot of China related questions such as VAT, Chinese fertilizer industry.  It appears to us that his main function at CGA is an IR spokesperson, although our impression is that he was probably an honest person and a young man who was out from college not too long ago, w/o much knowledge of what he’s walking into by taking this job.

Catalysts:

We believe two recent events are likely to accelerate the collapse of this scam:

1. PCAOB tightening its oversight of auditors of Chinese companies.  PCAOB has recently issued an audit practice alert on July 12 questioning the practice of accounting firms (especially the small ones) issuing clean opinions on the books of oversea issuers.  The notice made specific reference to Chinese companies went public through reverse mergers and their auditors’ practice of issuing opinions based the works performed by a local consultant or without even traveling to the country where the company is located.  The direct result of such event is the delay of filing 10-Q by a large number of reverse merger Chinese companies and, in certain cases, restatement prior earnings or even resignation of auditors.  We’re not suggesting all companies with those events are fraudulent, but this certainly reduces the odds of ones like CGA to survive the increased scrutiny (assuming the auditor acts responsibly).

1. We’ve never been fans of the investment banks for their almost always positively biased rating of scam companies with insatiable need for capital.  However, recently we’ve seen some banks/analysts suspending coverage or downgrading the stocks to sell given the increasing amount of evidence of fraud, such as ONP, CHNG etc.

Risks:

Since this is a fraudulent company, they can report whatever outrageously numbers whenever they want (if the auditor keeps failing like it did before).

We’d like to end the write up with a comment by Buffett and Munger on Freddie and Fannie  – when someone tells you they can maintaining a 15% CAGR growth in earnings no matter what, they’re playing accounting tricks to you.  What happens when someone tells you they can maintain a 70% CAGR in earnings?