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Chinese RTO: Greed and Fraud?



May 20, 2011 – Comments (1) | RELATED TICKERS: YONG.DL

Board: Deranged Monkey Criticism

Author: LeKitKat

Chinese RTOs are starting to be interesting to those of us who simply love a good tale of greed, self-serving management and fraud disguised as concern for shareholder welfare

One that has caught my fancy is Yonge Biotech. YONG started life around 2008 as a reverse merger via a suntan oil shell

They sell a soil augmentation product akin to peat moss. it is an organic molecule that enhances a plants capability of binding ions that a plant needs like magnesium, calcium, phosphorous etc.

It is made from a cheap throw away weathered [leonardite] coal product that sells for $10-$30 per ton

The company has historically used a product from the leonardite coal as a starting raw material called humic acid. They further process this to fulvic acid and that is the basic substrate they have used to make their amazing fortune. Bottom line it is a commodity easily duplicated cheaply by just about anyone and there are hundreds of similar products pushed out by competitors across China. YONG pays $100-$300 per ton for the humic acid. It is about 1/3 the cost of goods.

The predecessor company was plugging away at $5 to $9 million in sales until they went public and magically that increased to $48 million with no added capacity or apparent change other than a US listing their very first year out of the starting gate. Very impressive to shareholders!

The increases in revenue are fantastic--more than doubling every year.

With that brief background, am I crazy to think this commodity can offer a company such stupendous growth without some tinkering with the books? They are audited by KPMG Hong Kong and claim this as a good housekeeping seal of approval on their books. since their operations are in Inner Mongolia, their office in Beijing and KPMG is in Hong Kong is there any reason to suppose that KPMG actually knows anything about YONG other than the books they review at the end of a quarter and a year? This is a small fish that pays $700,000 in fees with a market cap of $226 million. Would KPMG spend any actual time and money to do an onsite in depth forensic audit? I don't think so. If the papers and invoices and bank statements add up, I think they call it good.

Here is a list of red flags that make me highly suspicious:

They make 4X to 5X more for their commodity-style product than competitors with nearly identical product. Business just does not work that way.

They claim 100% growth almost every quarter.

They give distributors 180 days credit and yet DSO is around 40 days this Q. Was 27 days for 2010.

They bought 25 cars for employees at an average cost of $50,000 per vehicle. Loans were taken out by the car owners and the company pays off the car loans for the employees. Interest is up to 14% . Nice waste of shareholder cash. They do the same for around 350 of their favorite distributors--buy them cars. Maybe they should buy $50,000 cars for long-suffering shareholders.

They have raised around $150 million in PIPEs warrants and equity issue and have only ended up with $22 million in PP&E.

$60 million of this went to buy two capex items: a meaningless customer list and rights to look for coal on the property of what looks to be just a pass through business for their raw material.

There was $25 million paid for the customer list that was paid in part with 3 million shares that never showed up on the DEF 14A along with every other major shareholder in the company. It would have been at least a 5% beneficial ownership. Did this distributor even exist or did they buy the list from themselves and management makes $25 million [sells the shares, splits the cash.]

The $35 million went to a supplier for just the rights to look for coal and produce it. They do not have any mining equipment or any experience in digging for coal. The supplier they bought the rights from was organized at the same time YONG was reverse mergered, ostensibly to supply them with the humic acid [not coal]. YONG's footprints are all over the paperwork submitted to form the distributor. The supplier may sell some of their own production, but the company says they also supply material from third parties. Sounds like a shell to pass through invoices for product that YONG can now recirculate $35 million back through to themselves for capex. Ditto for the customer list. Doubt the distributor even existed.

Here is how YONG defended the "mistake" when the supplier was set up:

According to our knowledge, our previous supplier, Wuchuan Shuntong was established in 2008 by Wuchuan Sanda, which had been, prior to that time, the main supplier of humic acid for Shengmingsu production. Sanda’s establishment of Shuntong was meant to coincide with our becoming a U.S. public company, which all anticipated would, and did in fact, bring about a significant increase in the demand for humic acid. Our staff assisted Shuntong’s business registration, and, earlier this year, we learned that because of that assistance our contact information was mistakenly left on Shuntong’s local business registration form. As for the accuracy of Shuntong’s AIC filings, we are, of course, not in a position to comment. AIC filings are notoriously inaccurate, and many commentators use those inaccuracies, falsely, to try to make unwarranted broader points. What we do know is that Shuntong does provide us quality product and that our own filings, in both China and the U.S., are accurate. We cannot comment on the conclusion drawn by some “researchers” that Shuntong is not large enough to supply us. We also have Wuchuan Government document showing that Shuntong was authorized for the lignite coal resource project we subsequently purchased. We know that in addition to their own production, they also source humic acid from third parties to supply to us.

OK--they set up a company that basically already existed but used a different name and the documents have YONG's name on them. And the new company has to buy product from third parties to supply YONG. Is this a shell owned by YONG to pass through invoices that make it appear product is bought from the shell with the end-game investment of $25 million for only the "right" to look for coal. Of course the $25 million would go back to the officers. Leonardite coal is dirt cheap. Why do this? Buying coal is cheap; investing in infrastructure to produce or hiring another third party to mine it is stupid and a total waste of shareholder cash.

The CEO sold his PP&E to the company for $16 million YONG had just built a brand new plant second plant supposedly with 4X the capacity for a little over $3 million. The cash to the CEO included an astounding $10 million in goodwill and a $4 million charge for land use.

Does the fraud sound plausible, or am I just dreaming of a juicy blow-up that would be a big disappointment for shareholders, but would pay off in spades for shorts and those of us who just love a good story of deceit and malfeasance?

1 Comments – Post Your Own

#1) On May 21, 2011 at 8:17 AM, nanoguy (< 20) wrote:

Business in emerging countries may be conducted quite differently from business as we know it in the U.S.   Even countries like Mexico and India have "special" rules when it comes to business that must obtain government licenses and approvals.   "Arrangements" must be made that particularly benefit certain principals.

So, the pass through of cash may simply be the "price" of establishing YONG as an approved national distributor of the product.

 That said, the real question then is "how does the company restore shareholder confidence and establish long term value for its external shareholders?"

Part of the answer may be that it can't.

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