Chinese Solar Companies - Analysis

Now that we have the third quarter results for all the Chinese solar companies, let's have a closer look at the performance, numbers and developments in the industry.

Third Quarter 2011 Results:

Revenue

For our group of ten companies, third quarter revenue declined both sequentially and year-over-year. Revenue for the traditionally much stronger third quarter declined on average by 9.6% from the second quarter of 2011. Only four companies - Canadian Solar (CSIQ), China Sunergy (CSUN), Suntech Power Holdings (STP) and Yingli Green Energy (YGE) could keep the same level from last quarter, while three companies posted hefty declines of 20% or more: Hanwha Solarone (HSOL), JinkoSolar (JKS), and ReneSola (SOL).

Those are disastrous numbers, especially if compared to what happened just one year ago. For the third quarter of 2010, ReneSola posted sequential revenue growth of 41.3%, compared to a revenue decline of 24.2% this year. For Trina Solar (TSL) those numbers are 37.1% growth versus 16.8% decline, but we can pick any name in the group to illustrate the unusual downtown in the traditionally very busy third quarter this year.

If we compare the Q3 revenue numbers with those of 2010, the picture looks slightly better with a year-over-year decline of "just" 3.8%. Most of this decline comes from the primarily upstream (solar wafers and cells) companies in the group: LDK Solar (LDK), ReneSola, and JA Solar (JASO), which on average lost 36.4% of their 2010 revenue. If we take those three out of the group, the rest - primarily module producers - managed to post year-over-year revenue growth of 10.2%.

The big exception among the downstream Chinese solars is Hanwha Solarone (HSOL) with year-over-year revenue decline of 34.4%. This might be a huge warning sign, as five out of seven of HSOL's direct peers managed to grow their revenue over the same period. Please review the numbers for all ten companies in the table above.

POSITIVE: CSIQ, CSUN, STP, YGE
NEGATIVE: HSOL, JASO, JKS, LDK, SOL, TSL

Gross Profit and Margins

In the third quarter of 2010 all ten of our Chinese solar companies posted double digit gross margins, ranging from the high teens to well into the 30 percent area. Just twelve months later those margins have collapsed for 90% of the group, with five companies reporting negative gross margins. As to be expected, the smallest module vendors, China Sunergy and Hanwha Solarone, suffered the most, as the solar industry is - and will always be - an industry of scale.

Only three of the ten companies still posted worthwhile gross margins last quarter, the market and cost leaders among the Chinese module producers: Trina Solar, Yingli Green, and Suntech Power. Especially STP is standing out here. The company moved from last to first place in the group, as its margins only moderately declined, from 17.9% in 2010 to 13.3% this year.

Those numbers stand in stark contrast to two other downstream companies. JinkoSolar's margins collapsed from 25.4% in Q2/2011 - the highest of the group at that time - to 3.7% in just three months, the direct effect of a 21.4% sequential decline in revenue. And while Canadian Solar managed to actually grow revenue sequentially, its gross margins (2.4%) are no longer acceptable which suggests that the company's strategy was to generate revenue at all cost.

POSITIVE: STP, TSL, YGE
NEGATIVE: CSIQ, CSUN, HSOL, JASO, JKS, LDK, SOL

Net Income and EPS

One year ago, all ten companies in our group were nicely profitable with operating margins ranging from 8.4% (STP) to 26.4% (JKS) and positive earnings per share. In Q2/2011, half of the group was already posting losses, and for the third quarter only Yingli Green Energy managed to break even on an operating level. These are disastrous results for the industry, especially if we consider that half of the group posted significant year-over-year revenue growth.

All ten companies were forced to write off some inventory which impacted the bottom line. However, if we adjust reported net income for these inventory write-downs, nine out of ten companies have still reported negative EPS. Only Yingli Green Energy reported positive numbers on an adjusted basis with $0.08 per share excluding write-downs and $0.14 per share as reported by the company on a non-GAAP basis. Yingli's business development trends look far better than those reported by its direct peers.

POSITIVE: YGE
NEGATIVE: CSIQ, CSUN, HSOL, JASO, JKS, LDK, SOL, STP, TSL

Company Guidance Revisions: (since June 30, 2011)

Official company guidance and what the company says about its business prospects can be very telling about how well management understands its market. Assumed management actually intends to tell the truth and give a realistic business outlook. If they have been utterly wrong several times in the past, why should we put too much weight on their current outlook?

We have evaluated the officially published FY2011 guidance for all ten Chinese solar companies, and the only one that actually raised its guidance at some point this year was LDK Solar. In January, LDK raised its full year revenue outlook by an astonishing $600 million and guided for gross margins in the 23.0% to 28.0% range. In mid-March Chairman Peng addressed the investment world with "we have made great strides in positioning LDK Solar to take advantage of the growth in the global PV industry. We remain excited about the multiple growth drivers we see for our business and believe we are well positioned for success." LDK reiterated its revenue guidance and raised the low end for gross margins by another percentage point.

Management kept this guidance until well into the third quarter when it was already very obvious that nothing of this will materialize. And for the third quarter the company reported a 30% decline in revenue with negative gross margins. Consequently, LDK's current FY 2011 guidance has been lowered by almost 40% from levels that were still official company outlook in August.

While the industry downturn forced nine of our ten companies to lower FY2011 guidance in the second half of this year, it is important to note that several names have not lost their credibility and have given a more or less realistic outlook at the beginning of the year. The only one that kept its original shipment guidance unchanged is Canadian Solar (CSIQ), while both Suntech Power and Yingli have lowered it only moderately. Those three are also the largest module vendors, based on Q3 revenue, while the small players in the group, CSUN and JASO, were forced to slash their guidance by at least 25%.

POSITIVE: CSIQ, STP, YGE
NEGATIVE: CSUN, HSOL, JASO, LDK, SOL

Debt Situation:
Net Debt (Debt): Total Liabilities - Total Current Assets (ex Inventories)
Debt to Equity (D/E): Total Liabilities - Total Shareholders' Equity

The debt situation is rapidly deteriorating for all 10 companies, and as the outlook for the industry is very negative for at least another 2-3 quarters, this is not going to become even worse. Further EPS losses are very likely for Q4/2011 to Q2/2012, probably even into the third quarter next year. While Trina Solar (low net debt) and Yingli Green Energy (large cash position) both look safe at this point, its huge debt burden could turn out to be a bigger problem for Suntech Power.

For LDK Solar the picture looks very bleak. With negative gross profit, a low cash position and rapidly deteriorating revenue, LDK is already running low on working capital, and if we consider the interest expense on its gigantic debt load something will have to happen next year to resolve this situation. If the company wants to survive this downturn, a debt to equity swap seems unavoidable, which means there is very little value in LDK's stock.

POSITIVE: JASO, TSL
NEGATIVE: CSUN, CSIQ, JKS, LDK, STP

Summary:

Third quarter earnings results for our group of 10 Chinese solar companies were generally weak, with only YGE (and to a lesser degree STP) providing some positive headlines. End markets are supposed to remain challenging for at least another 2-3 quarters with an unresolved debt crisis in Europe, massive overcapacity issues in the industry, high inventory levels, and ASP's rapidly declining. Despite collapsing end prices there was no meaningful demand uptick in the traditionally strong third quarter, and the near future brings us unfavourable weather conditions for all of the industry's strongest markets.

All signs point to a period of painful consolidation in the industry that is coming much earlier than anticipated. The weak players will be shaken out and eventually the industry will turn into oligopoly where only a handful of players will dominate the market. Third quarter results are a good indication of who will make it and who might eventually vanish over the next few years. With no positive catalysts to be expected over the next few months, it is probably to early to jump back into the sector, but the survivors will most likely come out stronger than before, in an industry that is here to stay.

Based on this analysis of business metrics and third quarter results, here is my take on the survival chances for all ten Chinese solar companies:

GOOD: YGE
NEUTRAL: CSIQ, STP, TSL
BAD: CSUN, HSOL, JASO, JKS, SOL
VERY BAD: LDK

A Close Look at Gulf Resources

Gulf Resources (GURE) is currently trading at $3.80, down 64.46% for the year. The Trading China Tracker Score is 19 (Strong Buy), the Trading China Safety Score is 36% (High Risk).

Let's have a detailed look at Gulf Resources, a producer of bromine, crude salt, and specialty chemicals in China. The company has two operating subsidiaries, one for the chemicals, and another for salt and bromine. The stock has lost two thirds of its value since the beginning of the year, despite record results for FY2010 and positive pricing developments for its core products. Is it worth putting some money at risk here? Let's start with a detailed timeline of the past 18 months to see what exactly has been going on with this stock.

Gulf Resources Timeline

2010, February 10: Gulf Resources dismisses Morison Cogen and engages BDO Limited as its new auditor.

2010, April 14: The company raises guidance for fiscal year 2010 to revenue between $146 million and $150 million and net income between $44 million and $46 million. It says that "in addition to strong demand, a shortage of bromine supply is supporting prices."

2010, May 11: Gulf Resources reiterates revenue and net income guidance for 2010 with the release of First Quarter earnings.

2010, June 8: GURE announces the acquisition of bromine and crude salt manufacturing assets for $13.9 million, paid in cash (95%) and stock.

2010, August 6: The company files a mixed securities shelf for $120 million with the SEC.

2010, August 16: Gulf Resources reiterates revenue and net income guidance for 2010 with the release of Second Quarter earnings.

2010, September 10: Deloitte Touche Tohmatsu is engaged to perform an independent assessment over the Company's internal controls.

2010, September 14: The company defends the shelf registration in a press release, but clarifies that while it plans to use its common stock as currency for acquisitions, it will only happen at levels that are accretive to existing shareholders."

2010, September 15: Due to its depressed stock price, management announces that it has decided not to raise capital during 2010. The shelf registration remains effective.

2010, September 15: The company raises guidance for fiscal year 2010 to revenue between $151 million and $155 million and net income between $48 million and $50 million, as a result of a further increase in bromine prices.

2010, September 27: A $10 million Share Repurchase Program is announced. "We are confident that this is an optimal opportunity to leverage our strong balance sheet and invest in Gulf Resources."

2010, November 6: Independent director Biagio Vignolo resigns without stating a reason. He is replaced with Mr. Nan Li who works as financial controller at Global Pharm Holdings Group (GPHG.OB).

2010, November 16: Gulf Resources reiterates revenue and net income guidance for 2010 with the release of Third Quarter earnings.

2010, December: The company is anonymously accused of falsifying its financial statements filed with the SEC. Allegedly, there are discrepancies between data filed with Chinese authorities (SAT) and the Securities and Exchange Commission.

2010, December 8: Xiaobin Liu, CEO of Gulf Resources, responds to those allegations, says they were completely without merit and that all financial statements are accurate.

2010, December 14: The company follows up with a detailed response, confirms that its 2009 Annual Report is consistent with its 2009 SAT filings, and provides proof in form of an official letter from the local SAT bureau, which is confirming that there are serious discrepancies between GURE's subsidiaries' actual tax filings and the figures provided in the anonymous report. CEO Liu reassures investors that "our financial statements are accurate and we do not expect any adjustments to them. Our business has maintained its momentum and we do not expect any changes in business conditions in the foreseeable future."

2011, January 4: Gulf Resources announces the acquisition of a crude salt field from a state-owned company for $10.6 million in cash.

2011, March 2: Independent director Richard Khaleel resigns from GURE's Board, as the company he recently joined has requested that he resigns as a director of any public company. Khaleel's replacement is Mr. Yang Zou, a senior accountant with a Beijing-based CPA firm.

2011, March 4: Deloitte has issued a final report regarding the internal control assessment performed. Management believes that the Company's internal control is improved after implementing the recommendations made by Deloitte.

2011, March 16: GURE files its Annual Report for 2010. Reported revenue of $158.3 million and net income of $51.3 million both exceed the high end of the company's official financial guidance, which had been raised twice in 2010. Gulf Resources provides a favourable outlook for 2011, without giving specific guidance at this time. Internal control over financial reporting, as audited by BDO Limited in the 10-K filing, is still ineffective due to a "material weakness regarding management's failure to maintain effective controls over the identification of related parties and the disclosure of related party transactions in the company's consolidated financial statements."

2011, March 28: The company provides financial guidance for 2011. It expects revenue to range from $195 million to $198 million and net income to range from $64 million and $66 million. CEO Liu says he expects "the price of bromine to stabilize at a high level and possibly reach a new historical high price during 2011."

2011, April 26: Short-selling outfit Glaucus Research Group releases an extensive 29-page report on Gulf Resources. The group "initiates coverage" with a $0.00 price target, based on its belief that investors "are likely holding worthless paper in a shell company." Glaucus claims that "the two Chinese subsidiaries that own and operate the business are privately owned by a company controlled by the chairman."

2011, April 27: John Hempton of Bronte Capital, who is also short the stock, comes out in support of the Glaucus report. He argues that an inventory turnover of 169.5 times per year is not believable in the bromine industry.

2011, April 28: The company issues a detailed response to the Glaucus Report. Explains that it produces most of its bromine and chemical products on demand, therefore does not accumulate inventory. Provides 2009 SAIC filings for both its subsidiaries and concludes that reported SAIC financials are in line with SEC filings. Provides documents that should prove ownership of subsidiaries. Explains low shipping costs with customers directly picking up their products from facilities. Reiterates that Deloitte's internal control assessment did not find major issues in the Company's corporate governance and internal control system.

2011, May 2: Gulf Resources issues a second press release in response to the allegation in the Glaucus Report.

2011, May 11: Gulf Resources issues a third press release in response to the allegation in the Glaucus Report.

2011, May 16: The company reiterates revenue and net income guidance for 2011 with the release of First Quarter earnings. Says it expects bromine prices to remain at current levels for the remainder of the year.

2011, May 19: Another short-seller, Kerrisdale Capital publishes a hit piece, supporting the April 26 Glaucus report and adding its own claims, particularly that GURE's reported profit margins "are too good to be true." Kerrisdale concludes that Gulf Resources' "business claims are not within the realm of reason."

2011, June 7: GURE announces that it intends to register a subsidiary in Daying county, Sichuan province, in order to research possible resources for bromine and crude salt in Sichuan province.

2011, June 22: BDO Limited is reappointed as the company's auditor for the 2011 fiscal year.

2011, June 23: Gulf Resources announces that the share repurchase program, announced in September 2010, has been initiated, and the company has acquired 100,500 shares of its common stock through open market transactions.

2011, June 29: Independent director Yafei Ji resigns for "personal reasons." He is replaced by Mr. Tengfei Zhang, a CPA and Chairman of the Board of Supervisors of Shenzhen Kaili Industrial Co., a manufacturer of computer cables.

2011, June 30: Gulf Resources' ticker symbol changes from 'GFRE' to 'GURE'.

2011, July 13: Chairman Ming Yang, the company's largest shareholder (38.7%), declares that he will not pledge or sell any of his shares in the next three years. The company reiterates that it maintains 100% ownership in its subsidiaries, that its corporate structure remains linear and unchanged since February 2007, and that Gulf Resources maintains full control over its operating subsidiaries. Documentation for subsidiary ownership is attached to the 8-K Filing.

2011, July 20: The company withdraws its shelf registration that was originally filed on August 6, 2010. "We decided to withdraw our registration statement because we think our share price remains undervalued and do not intend to sell any securities under the registration statement."

Evaluation

Extremely Cheap Valuation - GURE has posted Earnings per Share of $1.48 for the fiscal year ended December 31, 2010. Official 2011 guidance calls for 24.8% to 28.7% net income growth, not taking into account any impact from potential acquisitions. During 2010, the company raised its guidance twice and managed to exceed the high end of its guidance range when it posted final numbers in March. At Friday's close ($3.80) the stock is trading at a forward P/E of 2.05, based on 2011e EPS of $1.85. That is about as cheap as it gets for a Nasdaq-listed growth stock.

No Shareholder Dilution - the company did not sell any stock in the past 18 months. The shelf registration that became effective in August of 2010 has been withdrawn earlier this month. GURE paid for all its recent acquisitions almost entirely in cash. Total dilution for existing shareholders over the past year was just 2.38%, which is among the lowest with U.S.-listed Chinese stocks. If GURE were a fraud then it is certainly not very clever with monetizing its stock.

Management Continuity - Unlike most other Chinese names, Gulf Resources has not been hit with a slew of management resignations. The Chairman of the Board, CFO and CEO are all with the company for a long time. There have been three director resignations in the past 18 months, but I believe it is credible that none of them were in disagreement. I also believe that it is part of good corporate governance if a company changes its independent directors every once in a while.

Strong Responses to Short Seller Attacks - Gulf Resources has been a short seller target for more than a year, the depressed stock price clearly reflects that now. Yet, the company has always been very quick, detailed and elaborate in its response to such attacks, unlike most other names in the China space. GURE does reliably provide documents to support its position and publicly files those with the SEC so all interested parties can review them easily.

Corporate History - This is the strongest negative aspect, and it is one that will never go away. Gulf Resources' public company life began with a China Finance (CHFI.PK) shell, in connection with reverse merger specialists like China US Bridge Capital, a subsidiary of CHFI. China Finance went dark in 2009, stopped filing anything with the SEC, and is now a 2-cent zombie stock. All of the other CHFI RTO's are either complete frauds or extremely questionable at least, including CNOA, JADA, BFAR and CHCG. It is a bit of a stretch to argue that Gulf Resources is the one exception in an otherwise smelly pit of dirt.

However, and here it comes, proclaiming guilt by association has never been a good or wise strategy. Gulf does surely wish - fraud or not - they would have never been associated with China Finance, but we should judge them by their actions after all. Maybe they have cut all the ties with CHFI, as they say they have, a long time ago already? The company's communication with investors in the past 18 months certainly doesn't bear any resemblance with other former CHFI clients.

Prime Short Seller Target - GURE has been attacked several times by multiple individuals and entities. Short interest in the stock sits at about 20% of the float and has been at a very high level for most of 2011. While the company has managed to stabilize the stock price since May, none of the recent announcements led to a meaningful recovery and investors are still sitting on a loss of 64% for the year.

Half-hearted Stock Buyback - There is no better investment for a company like Gulf Resources than investing in its own stock at just 2x forward earnings. But it took the company almost nine months to initiate its buyback program that was announced in September of last year. And the number of shares (~ 100k) that has been repurchased so far is very small for a company that supposedly has more than $80 million cash on the bank.

Ineffective Internal Controls - BDO attested that the company's internal controls are ineffective due to a "material weakness regarding management's failure to maintain effective controls over the identification of related parties and the disclosure of related party transactions." Gulf management hired Deloitte Touche Tohmatsu for an internal control assessment, and announced that DTT did not find major issues in the Company's corporate governance and internal control system. We don't know what issues Deloitte found, but we know that related party issues are one of the short sellers' most prominent claims.

Conclusion

Bottom line is, I don't have any conclusion - you have the choice between a "Yes, but..." and a "No, but..." approach. It is my belief that GURE's stock price will more likely appreciate from here than deteriorate, as the main reason for its low level is the general investing public's reluctance to put money in any name with a strong "but...", especially Chinese reverse mergers. We are now probably beyond the peak of "weeding out China frauds" and there are signs that investor appetite for the remaining Chinese names is slowly but steadily increasing from here.

There are compelling arguments for taking a position in GURE at the current level, however the arguments for staying away completely are also quite convincing. This is the prototype of a "high risk" stock which could easily double or even triple from here if/when market sentiment improves. But those risks are real and they are obvious to most market participants, so cautious investors should act accordingly.

China Stock Obituary 2011

China Agritech (CAGC.PK) is currently trading at $1.65, down 86.56% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 8% (Extreme Risk).

Fertilizer company China Agritech has been accused of many things, among them drastically overstating the scope of its business. Things turned fatal when CAGC did not file its annual report for 2010, and subsequently dismissed its Big Four auditor Ernst & Young with very questionable reasoning. CAGC has since engaged a new auditor, California-based Simon & Edward, and a new chairman for both the audit committee and the special committee that was formed in March to look into the matters that led to the initial Nasdaq trading halt. In late May the Chief Operating Officer of CAGC resigned. We haven't heard any details from the ongoing investigation for the past three months, and the company's stock is trading on the pink sheets since May 20, 2011.

China-Biotics (CHBT.PK) is currently trading at $1.73, down 88.27% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 7% (Extreme Risk).

Probiotics company CHBT has been under attack for more than a year until on June 22, BDO Limited, the company's auditor for more than five years, resigned. The firm found several "irregularities" that "likely constitute illegal acts", including fake documentation and being directed by the Company to access a suspected fake website for the company's bank account. One day later, the company's CFO and the Chairman of the Audit Committee resigned as well. The stock was delisted from Nasdaq on July 1 and finds itself now on the pink sheets.

China Century Dragon Media (CCDM.PK) is currently trading at $0.30, down 94.29% from it's IPO price of $5.25 (February 8, 2011). The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 7% (Extreme Risk).

On March 22, just six weeks after CCDM's IPO on NYSE Amex, its auditor found "an indication that the accounting records have been falsified, which would constitute an illegal act." The company was unwilling to let its auditor obtain official bank records directly from the bank, and MaloneBailey resigned its engagement with the company. Similar to all the other cases, the stock was halted by the exchange, delisted, and is now quoted on the pink sheets since June 21, where it is now a "zombie stock" with not a single share having changed owners in the past four weeks.

China Electric Motors (CELM.PK) is currently trading at $0.33, down 92.73% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 0% (Extreme Risk).

CELM was destined to share the fate of the other WestPark deals NIVS, CILE and CCDM (for details please see: "WestPark Capital's RTO Deals"). The auditor (MaloneBailey) found discrepancies in the bank statements, a Special Committee was formed on March 31 to investigate those issues, and an SEC investigation was launched on April 7. On May 24, all of the members of the Special Committee resigned, the company terminated the forensic audit by PricewaterhouseCoopers, and at least one independent director resigned as well. MaloneBailey finally resigned as the company's auditor on May 31, stating "management’s unwillingness to take appropriate actions" and "an unwillingness to cooperate with the Securities & Exchange Commission and Nasdaq." The Chief Financial Officer left the company on the same day, and the Chairman of the Audit Committee followed on June 3. CELM was subsequently delisted from NYSE Amex and is trading on the pink sheets since June 14, 2011.

China Integrated Energy (CBEH.PK) is currently trading at $0.69, down 90.59% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 6% (Extreme Risk).

Biodiesel maker China Integrated has been accused of significantly overstating its revenue and profits. The company's auditor, KMPG, first signed off on CBEH's annual report for 2010, then shortly after withdrew its opinion and resigned on April 26, stating that it is no longer able to "rely on management’s representations in connection with its 2010 audits of the consolidated financial statements and the effectiveness of internal control over financial reporting of the company." China Integrated launched an investigation into these matters, but on April 28 its CFO resigned and shortly after, on May 3, a member of the audit committee left the company, saying that "recent events, including but not limited to the inconsistencies between representations made by CBEH’s management to the Board of Directors, have eroded my confidence." The company has since hired a new director and CFO and says it "remains committed to identifying and engaging a new auditor as soon as possible." The stock has been delisted from Nasdaq on June 15 and is now quoted on the pink sheets.

China Intelligent Lighting (CILE.PK) is currently trading at $0.11, down 95.85% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 6% (Extreme Risk).

When CILE's auditor (MaloneBailey) resigned on March 24, it gave to protocol that it found "accounting fraud involving forging of the Company's accounting records and forging bank statements, in addition to other discrepancies identified during its testing of the Company’s accounts receivable." The Chairman of the Audit Committee resigned on the same day. China Lighting's stock was delisted from NYSE Amex on June 20 and is currently quoted on the pink sheets. It should be noted that the company hired Friedman LLP as its new auditor shortly after MaloneBailey's resignation (see also NIVS).

China MediaExpress (CCME.PK) is currently trading at $1.60, down 89.90% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 0% (Extreme Risk).

The CCME story is well-documented and I don't have to go into details again. The company lost its auditor, CFO, Chairman of the Audit Committee and independent directors through resignations in March and April, and has not hired any replacements since. It is unclear if the special committee that was formed on March 17 is still working on the internal investigation into the accounting matters, as the company has not updated the investment community in the past four months. CCME has been delisted from Nasdaq on May 19, 2011.

HQ Sustainable Maritime Industries (HQSM.PK) is currently trading at $0.24, down 94.97% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 9% (Extreme Risk).

HQSM's auditor could not confirm the cash balances in the company's bank accounts nor verify the existence of customers in China. In its resignation letter dated May 26, the auditor claimed HQSM's management resisted its efforts to address these issues and became "increasingly non-responsive, uncooperative and non-communicative." The company's account of what happened paints a different picture. As of July 1 the company has only one independent director left, all the others resigned, including the Chairman of the Audit Committee. The SEC has initiated a formal investigation into HQSM. On July 11 the stock was delisted from NYSE Amex to the pink sheets after having been halted since April.

NIVS IntelliMedia Technology (NIVS.PK) is currently trading at $0.35, down 84.52% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 0% (Extreme Risk).

In its resignation letter on March 24, the company's auditor, MaloneBailey, said it found "illegal acts involving the Company’s accounting records and bank statements and discrepancies in accounts receivable." NIVS managed to engage BDO China as its new auditor shortly after, but on May 14 they resigned as well, stating the company's inability to provide "certain critical financial related documents and records." Since May 19, Friedman is the company's independent auditor, we will see how long that lasts... The special committee that was formed to look into the accounting issues broke apart on July 11 when two directors, incl. the committee's chairman, the legal counsel, and the accounting advisors (Deloitte) all resigned or terminated their engagements. The company has since hired new directors and said it "intends to engage new counsel and forensic auditors to continue its work." The stock has been delisted from NYSE Amex on June 24 and is since trading on the pinks.

Puda Coal (PUDA) is halted since April 11. Last reported trade was at $6.00, but the stock will likely open significantly lower when trading resumes. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 6% (Extreme Risk).

Apparently, the chairman of Puda Coal stole almost the entire company from U.S. shareholders, sold half of it to Chinese investors, and pledged the other half as security for a loan at 14.5%(!). The company has basically admitted fraud by stating that "although the investigation is in its preliminary stages, evidence supports the allegation that there were transfers by Mr. Zhao in subsidiary ownership that were inconsistent with disclosure made by the Company in its public securities filings." The stock has been halted since April 11 and the company completely ignored the due date for its first quarterly report of 2011. PUDA's independent auditor for six years, Moore Stephens Hong Kong, resigned on July 7, which makes it very unlikely that the stock will reopen again on NYSE Amex.

ShengdaTech (SDTH.PK) is currently trading at $0.53, down 89.19% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 13% (Extreme Risk).

When ShengdaTech failed to timely file its annual report for 2010 the stock was halted by Nasdaq. Shortly after it came to light that SDTH's auditor, KPMG, found "serious accounting and operational issues," and informed the exchange of "deliberate and ongoing efforts of the company’s Chief Executive Officer and Acting Chief Financial Officer to obstruct an internal investigation into these matters." The Acting CFO resigned on April 21, followed by the auditor on April 29. KMPG was replaced by Marcum Bernstein & Pinchuk on June 9, however a final engagement is still pending satisfactory completion of Marcum's new client acceptance procedures. For the past six weeks no new developments regarding the status of investigation and auditor have been filed, and the stock has been delisted and is trading on the pink sheets since June 10, 2011.

Subaye (SBAY.PK) is currently trading at $0.49, down 95.02% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 0% (Extreme Risk).

In my opinion this is the most outrageous of all the Chinese frauds, it is almost comical. If you are interested in a bit of cheerful entertainment you really should dig into the Subaye story - it claimed to be an entertainment company after all. Subaye is currently at its third CFO since March, its CEO resigned in May, its auditor in April and hasn't been replaced since. The stock has been delisted on June 24, and is now trading on the pink sheets.

Just one snippet to illustrate all this craziness: Subaye's last official guidance, presented in December 2010, called for earnings per share of exactly $3.12 in FY2011. If the company were not blatantly lying, a P/E of 5 were justified and the stock would be worth at least $15, a level it reached briefly in January of the current year. Now the employment agreement with SBAY's newest CFO, Jacqueline Ng, dated June 1, guarantees her the following compensation: an annual salary of $60,000, a sign-on bonus of 150,000 shares, and a minimum annual bonus of 100,000 shares of common stock. That means CFO No.3 Miss Ng would receive stock worth at least $3.75 million additionally to her annual salary as compensation for her CFO duties, if the company's representation of its net profits and prospects would have any credibility. Even at the current stock price her compensation is outrageously high. She's not alone, though. In the same filing it was revealed that SBAY's new CEO, a German national who seems to be in the IR business and doing side-jobs like serving as honorary consul for the Republic of Belize in Germany, will receive the same 250,000 shares plus $80,000 annual salary.

Wonder Auto Technology (WATG) is halted since May 9. Last reported trade was at $5.42, but the stock will likely open significantly lower when trading resumes. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 26% (Extreme Risk).

When WATG failed to file its 2010 annual report, the company announced an internal investigation into reported accounting matters, incl. that it had engaged in several transactions without properly disclosing their related-party nature. Intermediate results led to announced restatements for fiscal years 2008, 2009 and 2010, and for the quarters ended March 31, June 30 and September 30, 2009 and 2010. This investigation was originally expected to conclude by the end of July, but that is now a very unlikely outcome. On July 12, both the CEO and CFO resigned from their positions without giving a reason. Wonder Auto's auditor, Big Four firm PricewaterhouseCoopers, is apparently still with the company. Trading in the Nasdaq-listed stock has been halted for ten weeks now, and at this point it is very unlikely that it will reopen on the big boards again.

Yuhe International (YUII.PK) is currently trading at $0.97, down 89.17% for the year. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 0% (Extreme Risk).

Chicken breeder Yuhe International claimed to have acquired 13 breeder farms from a competing business in 2009, but an investigatory report from Geoinvesting proved those claims wrong and the company was lying to investors. YUII's auditor resigned on June 17 due to "management’s misrepresentation and failure to disclose material facts surrounding certain acquisition transactions and off-balance sheet related party transactions." The stock was delisted from Nasdaq on July 21, and is since trading on the pink sheets.

Jiangbo Pharmaceuticals (JGBO) is halted since May 31. Last reported trade was at $3.08, but the stock will likely open significantly lower when trading resumes. The Trading China Tracker Score is UNDER REVIEW, the Trading China Safety Score is 14% (Extreme Risk).

The Securities and Exchange Commission subpoenaed the company on March 26 and Jiangbo's audit committee started an internal investigation of the issues raised by the SEC. Elsa Sung, Jiangbo's CFO, resigned on March 31. On June 6, the independent members of the Audit Committee jointly resigned, stating that JGBO's "chairman and members of his management team have exhibited repeatedly their unwillingness to cooperate in even the most basic requests," and - among other things - the investigation "raised serious concerns regarding the veracity or correctness of banking information provided by the company."

Michael Marks, former independent director and Chairman of JGBO's Audit Committee filed a very long (22 pages) and detailed account of the internal investigation with the SEC. If you are interested in the troubles of U.S.-listed Chinese companies, you should take the time to read the full letter. You will find real gems in there, such as the manager of Jiangbo's materials department refused to leave the employee wash room in order to avoid answering Ernst & Young's questions. Or that the law firm's fee was paid from a personal account of an individual who turned out to be Jiangbo's cashier - via internet banking - when Jiangbo previously told Ernst & Young that the company did not use and did not have access to internet banking.

The stock remains halted on Nasdaq and will likely get delisted soon. Anyone out there who still believes this company has almost $150 million cash on the bank?

This was a very long account of (likely) fraudulent Chinese stocks which blew up in the first half of 2011. But it is far from complete! I did not mention several other cases, including Longtop Financial (LFT), Duoyuan Global Water (DGW), or A-Power Energy (APWR), and there are many stocks with similar problems that never made it to the big boards and are still quoted on the bulletin boards or pink sheets.

Second Quarter Summary

The Second Quarter performance of small cap U.S.-listed Chinese stocks was even worse than the already terrible performance in the First Quarter. The sectorwide sell-off spread from reverse merger stocks and bulletin board quoted names to established Chinese companies and recent tier one IPOs. Only very few stocks managed to counter this trend and ended the quarter in green territory, mostly driven by company-specific news like going private initiatives (CSR, FTLK) or large investments as Tencent and Expedia buying a stake in eLong (LONG).

Here are the highlights of the two indices we are tracking for China stocks. The Main Index holds the 40 largest exchange traded stocks with a market capitalization under $1 billion, while the China OTC Index tracks the 40 largest stocks on OTC Markets with reasonably liquid trading patterns; stocks like Tsingyuan Brewery (BEER) which traded under $500 for the last week of June are not eligible for the OTC Index.

Trading China Main Index
- 571.36 (down 24.74% for the Second Quarter)
- 8 stocks are up, 32 are down

Top Five

• eLong (LONG) +68.81%
• China Kanghui Holdings (KH) +33.63%
• Charm Communications (CHRM) +19.98%
• SouFun Holdings (SFUN) +16.18%
• China Security & Surveillance (CSR) +14.25%

Bottom Five

• China New Borun (BORN) -51.66%
• Puda Coal (PUDA) -51.03%
• SinoTech Energy (CTE) -49.50%
• ChinaCache International (CCIH) -44.77%
• Mecox Lane (MCOX) -44.39%

Trading China OTC Index
- 350.76 (down 41.23% for the Second Quarter)
- 4 stocks are up, 35 are down, 1 unchanged

Top Five

• China Health Industries (CHHE.OB) +209.80%
• Fuqi International (FUQI.PK) +38.59%
• Deyu Agriculture (DEYU.OB) +6.33%
• Asia Pacific Wire & Cable (APWC) +1.46%
• AgriSolar Solutions (AGSO.OB) +0.00%

Bottom Five

• China Executive Education (CECX.OB) -77.56%
• Sen Yu International (CSWG.OB) -75.00%
• China Shandong Industries (CSNHD.OB) -65.00%
• Lotus Pharmaceuticals (LTUS.OB) -52.78%
• China Energy Corporation (CHGY.OB) -52.13%

But there is hope!

While the OTC Index seems to be bottoming here, the Trading China Main Index has made a significant move in the past two weeks and gained 17.5% from the lows printed in mid-June.



Quarterly Revision (Second Quarter)

Both China indexes are revised at the beginning of each quarter. Stocks that do no longer meet the requirements are being removed. Reasons could be posting a loss in the most recent quarter, uplisting to a higher exchange or just a huge decline in share price. Following is a list of all changes for both indexes.

Trading China Main Index

Additions

• 21Vianet Group (VNET)
• Asia Entertainment & Resources (AERL)
• ATA Inc. (ATAI)
• China Dangdang (DANG)
• China Ming Yang Wind Power (MY)
• China Real Estate Information (CRIC)
• China Yuchai (CYD)
• China Zenix Auto (ZX)
• E-House (China) Holdings (EJ)
• iSoftStone Holdings (ISS)
• Jiayuan.com International (DATE)
• NetQin Mobile (NQ)
• Phoenix New Media (FENG)
• Taomee Holdings (TAOM)
• Xinyuan Real Estate (XIN)

Removals

• AirMedia Group (AMCN)
• Bona Film Group (BONA)
• China Hydroelectric (CHC)
• China New Borun (BORN)
• China TechFaith Wireless (CNTF)
• China XD Plastics (CXDC)
• China Xiniya Fashion (XNY)
• Cogo Group (COGO)
• eLong (LONG)
• Fushi Copperweld (FSIN)
• Lihua International (LIWA)
• Mecox Lane (MCOX)
• Puda Coal (PUDA)
• Sky-mobi Limited (MOBI)
• VisionChina Media (VISN)

Trading China OTC Index

Additions

• China Agritech (CAGC.PK)
• China Bilingual Technology (CBLY.OB)
• China Integrated Energy (CBEH.PK)
• China MediaExpress (CCME.PK)
• ShengdaTech (SDTH.PK)
• Yayi International (YYIN.OB)

Removals

• Asia Pacific Wire & Cable (APWC, uplisted)
• China Pharmaceuticals (CFMID.OB)
• China Shandong Industries (CSNHD.OB)
• Eastern Environment Solutions (EESC.PK)
• GC China Turbine (GCHT.OB)
• Lotus Pharmaceuticals (LTUS.OB)

49 China Stocks to be Dropped from Russell Indexes

Russell Investments has announced a preliminary list of additions and deletions for the annual rebalancing of its family of indexes. As expected, the weight of U.S.-listed China stocks on these indexes will be much lower in 2011 than in previous years. As the main criterion for inclusion is total market capitalization, the steep sell-off in the sector has taken its toll.

The most important of the Russell indexes, the Russell 2000, has lost almost all its China stocks by now. This year we have three deletions and zero additions. For the Russell Microcap Index we have two additions - NEP was not eligible last year, because at the time of index reconstitution the stock was halted by the exchange - and four deletions. And the Russell Global, the only one of the three that allows non-U.S. headquartered companies to be included, dropped 46 U.S.-listed China stocks, while only eight - most of them recent IPOs - have been added.

The final reconstitution of these indexes will take place on Friday, June 24, after the market close. Until that day, Russell can make changes to this preliminary list.

Russell 2000 Additions (U.S. Companies)

None

Russell Microcap Additions (U.S. Companies)

NEP - China North East Petroleum
NEWN - New Energy Systems Group

Russell Global Additions

CNTF - China Techfaith Wireless Communication
ZX - China Zenix Auto International
DQ - Daqo New Energy
LONG - eLong
FTLK - Funtalk China Holdings
QIHU - Qihoo 360 Technology
RENN - Renren
CTE - Sinotech Energy

Russell 2000 Deletions (U.S. Companies)

ABAT - Advanced Battery Technologies
AXN - Aoxing Pharmaceutical
CHINA - CDC Corporation

Russell Microcap Deletions (U.S. Companies)

CADC - China Advanced Construction Materials
CNAM - China Armco Metals
HQS - HQ Sustainable Maritime
UTSI - UT Starcom

Russell Global Deletions

APWR - A-Power Energy Generation Systems
ABAT - Advanced Battery Technologies
AMCN - Airmedia Group
AMBO - Ambow Education Holding
AOB - American Oriental Bioengineering
AXN - Aoxing Pharmaceutical
CHINA - CDC Corporation
CPC - Chemspec International
CHBT - China-Biotics
CAAS - China Automotive Systems
CO - China Cord Blood
CFSG - China Fire & Security Group
CHOP - China Gerui Advanced Materials Group
CGA - China Green Agriculture
CHC - China Hydroelectric
CNIT - China Information Technology
CBEH - China Integrated Energy
BORN - China New Borun
CSKI - China Sky One Medical
CVVT - China Valves Technology
CXDC - China XD Plastics
XNY - China Xiniya Fashion
COGO - Cogo Group
DEER - Deer Consumer Products
DGW - Duoyuan Global Water
EDS - Exceed
ADY - Feihe International
FSIN - Fushi Copperweld
GEDU - Global Education & Technology
GFRE - Gulf Resources
CTC - Century 21 China Real Estate
JST - Jinpan International
KONG - Kongzhong
LIWA - Lihua International
MCOX - Mecox Lane
SEED - Origin Agritech
SHP - Shangpharma
SDTH - Shengdatech
SCOK - Sinocoking Coal & Coke
SVA - Sinovac Biotech
HEAT - Smartheat
SORL - Sorl Auto Parts
UTSI - UT Starcom
WATG - Wonder Auto Technology
WH - WSP Holdings
XIN - Xinyuan Real Estate

Auditors Not Licensed to do Fieldwork in China?

A stunning Form 8-K, filed last night by currently halted Chinese food company HQ Sustainable Maritime Industries (HQS), suggests that most U.S.-based auditors of Chinese companies are not even allowed to perform the necessary fieldwork, if they are not officially licensed to conduct auditing services in China. The text explicitly mentions "collection of information directly from the sources of such information, such as vendors, customers and financial institutions."

During the course of the audit work relating to the Company's consolidated financial statements for the fiscal year ended December 31, 2010, the Company learned that Schwartz Levitsky Feldman LLP (SLF) was not licensed to provide auditing services for the Company and its PRC subsidiaries in the People's Republic of China (the PRC). This information came to the Company's attention when SLF insisted upon application of certain heightened, more stringent procedures than those utilized by SLF in prior audits of the Company's financial statements. Specifically, those procedures related to confirmation and verification procedures that involved the collection of information directly from the sources of such information, such as vendors, customers and financial institutions in connection with the 2010 audit work. SLF's attempt to implement these new direct collection procedures raised the issue of SLF's lack of PRC licensing since such licensing is a legal pre-requisite for direct collection of information in connection with an audit in the PRC.

The Company also learned that the PRC Ministry of Finance has reconfirmed its policies regarding the performance of fieldwork by foreign auditing firms auditing the financial statements of companies with operations in the PRC. The PRC rules and regulations governing licensing matters require, among other things, that foreign accounting firms obtain administrative permits to conduct auditing services in the PRC, comply with PRC laws regulating the confidentiality and secrecy of information, and keep audit working papers within the PRC. Violators of the foregoing requirements could be subject to legal sanctions in the PRC, ranging from fines and suspension of business licenses to criminal prosecution. Notwithstanding repeated inquiries by the Company, SLF neither confirmed nor denied that it was not properly licensed to provide auditing services in the PRC.

As an alternative to SLF's more stringent confirmation procedures and a safeguard against violating applicable PRC rules and regulations, the Company proposed that SLF and the Company employ certain "chain of custody" procedures in the confirmation and verification procedures to be utilized in the audit, which the Company believed would satisfy Generally Accepted Auditing Standards. Those proposed procedures involved the proposed collection of the requisite information by the Company in the presence of SLF. Notwithstanding SLF's initial agreement to utilize such procedures, SLF subsequently and without explanation elected not to utilize this alternative and reverted to its demand to utilize the more stringent confirmation procedures. Thereafter in early May 2011, SLF requested that the Company (and its subsidiaries') provide certain written representations to be submitted by SLF to the PRC Ministry of Finance in connection with an application SLF intended to make for a Temporary Practice Permit for Offshore Accounting Firm in accordance with the PRC Ministry of Finance's Interim Provisions on Temporary Auditing Business Activities Carried Out in China Mainland by Offshore Accounting Firms. The Company and SLF apparently have conflicting understandings of those regulations. The Company believes that the subject legal scheme precludes SLF from obtaining such a temporary permit by virtue of SLF's prior activities in the PRC, and the Company has continued to press SLF to utilize alternative procedures. SLF disagreed with the Company's view of that regulatory scheme. If the Company's assessment is correct, the written support that SLF requested that the Company (and its subsidiaries) provided could have subjected the Company to administrative sanctions in the event that the PRC authorities determined that SLF engaged in unpermitted auditing business activities in Hainan Province. The Company, therefore, declined to provide the written authorizations sought by SLF. Subsequently on May 26, 2011, SLF tendered its resignation letter filed as an exhibit to this Current Report.

This is the company's account of the situation, and I haven't confirmed this with a third party. However, if this representation is correct, then it further devalues the opinion of any small U.S.-based accounting firm providing services for U.S.-listed Chinese companies. We can safely assume that not even basic fieldwork, like confirming the cash balance directly and independently with a Chinese bank, could have been performed if the firm is not licensed to work as an auditor in the PRC. Furthermore, if Chinese law demands that audit working papers are to be kept within China, then an American accounting firm with no direct presence (offices) in China will have a hard time to comply.

HQS was the only remaining Chinese client of Ontario-based Schwartz Levitsky Feldman, but in the past the firm was registered as the auditor for more Chinese firms, including China Botanic Pharmaceutical (CBP) and China Automotive Systems (CAAS). China Automotive replaced SLF last December with PricewaterhouseCoopers, since the day of PwC's engagement the stock lost 53% of its value. You can use our comprehensive list of auditors for U.S.-listed Chinese companies to find other names that currently use small U.S.-based accounting firms.

A Short History of Short Attacks, Part Two

China Marine Food Group (CMFO) has come under pressure from short sellers several times throughout 2010. A person posting under the alias "Chinese Company Analyst" on Seeking Alpha repeatedly called the company a fraud: "The main thrust of our argument that CMFO is a fraud is that the Company's SAIC and SEC filings don't match." (June 1, 2010) and "Investors ... should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements." (June 16, 2010).

ZYCPA, China Marine Food's auditor at that time, is a small Hong Kong firm that has several U.S.-listed clients, including NF Energy Savings (NFEC) and China Sun Group (CSGH). The firm had repeatedly been accused of participating in alleged frauds, and whenever that happened the auditor changed its name: from Zhong Yi (Hong Kong), to ZYCPA, and now they use the moniker "HKCMCPA" - the original firm is no longer recognizable. China Marine Food engaged BDO China as its new auditor in October 2010 and is no longer connected with ZYCPA/HKCMCPA.

Another Seeking Alpha author attacking the company was Chimin Sang, when he wrote in June 2010 that CMFO's "business itself is nearly impossible. It has $400 fixed assets, little inventory, zero finished product inventory, but it has a magic ramp-up of sales." None of those attacks had an immediate effect on CMFO's stock price. The stock traded in a relatively narrow range for the remainder of 2010, and closed the year unchanged from the levels of mid-June. However, the performance for 2011 is terrible and CMFO printed new lows this Friday, to close at $2.92, down 45.93% for the year.

Muddy Waters Research, perhaps the most famous of all China short-selling outfits, emerged on June 28, 2010, with its initial "Sell Short" report on Orient Paper (ONP): "We are confident that ONP is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars." The company swiftly responded by stating that it "categorically denies these allegations and has instructed its legal counsel to contact Muddy Waters and explore all legal options against it for publishing and distributing such a report." However, the stock lost some 20% of its value within three days from the release of Muddy Waters' report.

A whole battalion of short sellers jumped on Muddy Waters' bandwagon and published further attacks over the next few weeks. Again we have "Chinese Company Analyst" - whose website is no longer active today - questioning the integrity of Orient Paper's auditors BDO Limited, the Hong Kong member firm of BDO International. He also published another article where he claims to "provide compelling evidence that Orient Paper is falsifying its financial statements." And Chimin Sang, a very vocal China bear who posted negative articles on a growing number of Chinese reverse mergers (FUQI, CCME, CHBT, ZSTN, SCEI), meant to let the world know that he "side[s] with Muddy Waters: ONP has more likely than not committed fraud."

Orient Paper initiated an internal investigation of these fraud allegations, which, according to the company, did not find any evidence for fraud. Drew Bernstein, the head of ONP's audit committee and a partner in the New York-based accounting firm Marcum Bernstein & Pinchuk, concluded that: "When you look at Muddy Waters' allegations in totality, you'd have to say they are false." He said that ONP is "by now perhaps the most vetted company in China."

Muddy Waters hasn't admitted defeat, instead they questioned the validity of the company's internal investigation. And Orient Paper's share price? The stock recovered nicely after the investigation concluded, yet it is now trading at lower levels than any time in 2010, printing new lows last week and sitting on a 44.34% loss for the year.

Sharesleuth picked on Chinese telecom equipment company Telestone Technologies (TSTC) in an article published on August 11, 2010. The article focused on TSTC's growing accounts receivable issue and concluded that "investors who are considering the company because of its sharp increase in sales and earnings and its attractive profit margins might want to know more about the underlying numbers." The article was explicitly "not alleging any wrongdoing by Telestone," but it set the tone for further negative articles this winter.

On January 10, 2011, The Forensic Factor called Telestone "a RINO in sheep's clothing," stating that they are "nearly convinced that Telestone has misrepresented its prospects, size, and business to the investment community." TSTC swiftly rejected all allegations and called the article "an unjustified swipe at a reputable and successful Chinese business." The Forensic Factor remained unimpressed and posted a follow-up two weeks later with the telling title "The Great Wall of Deceit".

TSTC suffered its steepest losses in 2010 already, when the share price was roughly cut in half. Most of these losses can in fact be attributed to the accounts receivable issues, unrelated to any specific short-selling attack. For 2011 the stock is down 29.67%, yet it has recovered almost 50% from its early April low. It is one of the very few Chinese reverse merger stocks that seems to be in an uptrend for the past four weeks. But TSTC is not for the faint of heart, the Trading China Risk Model suggests that this is one of the highest risk stocks in the China small caps universe.

To be continued...