I propose a short position in Yongye International (YONG) via March put options. I expect KPMG to resign as Yongye’s auditor by the March 15th 10-K deadline. This trade has a binary outcome and I estimate the payoff is 9:1. I believe the actual probability of success is much higher than the price-implied probability of 10%. Yongye is yet another Chinese RTO fraud
Yongye’s product is based on fulvic acid, a “snake oil”. Fulvic acid has been heralded as a magical, cure-all type of product. Yongye itself uses fulvic acid for both its fertilizer and for a cow medicine. A quick Google search turns up snake-oil salesmen suggesting that fulvic acid has anti-aging properties when consumed by humans. What that search does not turn up, however, are any reputable companies selling fulvic acid, nor any reputable scientific research supporting the magical properties of fulvic acid.
Fulvic acid is a commodity product whose prices do not support Yongye’s claimed revenue. I found several Chinese sellers of fulvic acid: http://www.alibaba.com/showroom/fulvic-acid-fertilizer.html -- These sellers are charging around USD 300-600 per metric ton. At $450/ton and 18,800 tons of production in 2010, fertilizer revenue should have been significantly lower than the $207 million reported by Yongye. (Note: Yongye’s Shengmingsu product is a mixture of fulvic acid and NPK fertilizer which sells at a similar price of USD 300-600/ton). Even if Yongye had some magical ability to place a huge markup on a commodity item, the market prices are significantly below even what Yongye claims are its raw material costs.
Yongye claims to have expanded from 200 branded stores in 2007 to over 29,000 currently. This figure is, on its face, not believable. Put into perspective: Starbucks had only 17,000 worldwide stores in its latest 10-K. Starbucks sells an addictive product which hundreds of millions of people drink every day. Yongye sells fertilizer!
At the same time, Yongye’s number of employees dedicated to sales and support has only grown from 91 to 114. In 2007, each sales employee covered on average 2.2 branded stores, and in 2010, each sales employee covered 210.8 stores. This is how Yongye described these employees’ function in its May 15, 2008 prospectus:
“Our sales staff is trained to work with our branded stores, banner stores and distributor network to ensure that our customers receive the right product and after-sales support. We overlay this sales and support network on top of our store and distributor network in a way that our sales and support staff are project managers who oversee 3 – 10 stores each depending upon their region and capability level. They will in turn hire contractors to assist them in various areas to ensure enough coverage exists in each area.
Our staff shares its knowledge base by walking through farming communities, organizing training courses, inviting local agricultural experts and university professors to speak on proper agricultural techniques as well as the use of our product. We ended 2007 with sales staff of 80 and support staff of 11 and project that in 2008 we will have 100 sales and 20 support staff and in 2009, 120 sales and 25 support staff. Our management in Beijing work with these staff to coordinate all marketing and sales activities.”
Reported revenue per employee has grown from $70,000 in 2007 to $520,000 in 2010. Fraud is more likely than a 7.4-fold increase in per-employee productivity in a commodity manufacturing business over a 3 year period.
Yongye previously did not disclose the identities of its largest customers, but upon the SEC’s insistence, finally did. Of Yongye’s 5 largest customers, 1 no longer buys from Yongye; 2 others appear to be related parties, despite Yongye’s claims to the contrary.
Yongye’s largest claimed supplier is a shell company and its second largest claimed supplier was shut down by the government. OLP Global issued a report stating that Wuchuang Shuntong, accounting for 58% of Yongye’s raw materials purchases, “is nowhere to be found in any business directories and is completely unknown to its competitors”, while its AIC filing contains contact information that leads back to Yongye and shows a shell company with minimal assets and revenues nowhere near what Yongye claims to pay them. Absaroka issued a report confirming this and also showing that Yongye’s other supplier was shut down by government decree.
Yongye’s COO wrote a book claiming that Yongye never sells on credit, contradicting YONG’s SEC filings. Richard X Roe, on Seeking Alpha, revealed a book available in China written by Yong’s COO with the approval of Yongye and its CEO, which says that Yongye never sells on credit. This directly contradicts SEC filings which show accounts receivable of $200M and six-month payment terms. It is highly unlikely that these receivables really exist.
Timing the Short - KPMG
Yongye is purportedly growing at 100%, yet trading at a P/E under 3. The market has already spoken on the question of whether Yongye is a fraud. To me the only question is timing. While it is not a certainty, I believe it is highly likely that KPMG HK will resign as YONG’s auditor before the March 15th 10-K deadline. Big 4 auditors have resigned many fraudulent RTO clients since March 2011; specifically, Deloitte resigned CCME and LFT, E&Y resigned CAGC, and KPMG resigned CBEH. KPMG had signed off on CBEH’s and YONG’s 10-Ks in March 2011, but was forced to resign the CBEH account after Alfred Little released time-lapse video showing almost no production activity at CBEH’s plant.
The reason for these resignations is a heightened understanding of the sophistication of fraud among Chinese issuers, and growing concerns about legal and reputational risk to auditors. I believe that among all the remaining RTO frauds, YONG is the most likely to face auditor resignation. KPMG is the highest reputation auditor that continues to audit RTO frauds, and it is located in Hong Kong rather than the mainland, meaning that it is exposed to a reliable judicial system. BDO Limited (HK), even after signing several 10-Ks for RTOs in March 2011, ended up resigning them all by the end of 2011, with many of those clients switching to BDO affiliates in mainland China. In doing so, BDO Limited’s stated reason was that it was unable to obtain insurance to cover litigation risks. KPMG is facing a similar calculus but has even more to lose on the reputation front.
The Big 4 auditors are more tightly integrated than the smaller auditors and KPMG International will be able to exert significant influence over the outcome of the audit to obtain its desired result. I cannot see how it can be in KPMG International’s best interest to allow KPMG HK to continue auditing this client. The new chairman of KPMG International, Michael Andrew, is based out of Hong Kong, and while I don’t know the extent of his involvement in the YONG situation or how much his being in HK will help, it certainly couldn’t hurt.
No matter how “obvious” the fraud may seem to me, the fact remains that the incentives of the individuals involved are opaque. While KPMG International and KPMG HK have institutional incentives to resign, there is a significant risk that KPMG’s engagement partner for Yongye or other KPMG HK personnel are corrupted. After all, KPMG HK did sign off on YONG’s 2009 and 2010 10-K reports, as well as other frauds and potential frauds (CBEH, COGO, FSIN). Carson Block stated in a Bloomberg interview that he was aware of complicity by Big 4 auditors, and while I have no direct evidence to support this claim, I find it highly credible as it is difficult to otherwise understand how so many absurd RTO frauds have been given clean opinions by Big 4 auditors. So while a resignation here is likely, it is far from a certainty.
Buy March puts on YONG. March $3.5s were asking $0.20 and March $4.0s were asking $0.30 this morning.
If KPMG resigns, NASDAQ will halt the stock prior to expiration. You can then exercise through positive instructions (as “automatic” exercise will be suspended) and a few months later the stock will reopen on the Pink Sheets at a much lower price, perhaps between $1.00 and $1.50. Assuming the stock resumes trading at $1.50 post-halt, the payoff is 9:1.
The author of this report is short YONG, and may buy or sell the securities of YONG without disclosure. This report was prepared for the Value Investors Club for use only by investment professionals. Securities trading involves a high degree of risk, and should only be undertaken by investment professionals.