Another Auditor Blow-Up - Digging through the Chinese RTO Jungle

Davis Accounting Group

As of November 4, 2010, the independent registered public accounting firm of two OTC-quoted Chinese microcaps has ceased to exist. Davis Accounting Group P.C., the current auditor on file for both Jade Art Group (JADA) and BioPharm Asia (BFAR), has to be licensed with the state of Utah to work as a certified public accountant. But a recent filing with the Utah Department of Commerce's Division of Occupational and Professional Licensing reveals that the principal of the firm, Edwin "Ted" Reese Davis Jr., "has engaged in unlawful conduct by continuing to practice as a certified public accountant and otherwise hold himself out to be a CPA after his license had expired on September 30, 2008."

Ted Davis's license has been revoked, and with that the license for his Davis Accounting Group is gone as well. "Respondent's expired license to practice as a CPA FIRM was revoked effective the date of the Order (November 4, 2010). Respondent was also ordered to cease and desist from engaging in any acts or practice which constitute the practice of public accountancy unless Respondent is duly licensed in that regard." (Source: State of Utah Newsletter, December 1, 2010)

Digging deeper into this story reveals that Ted Davis has been arrested in December on suspicion of issuing bad checks and a Montana-issued warrant. We don't have a statement from either JADA or BFAR on this matter, and both companies are still registered with Davis Accounting Group as their auditor. Attempts by Trading China to contact the companies have been unsuccessful so far, but we will keep trying.

In 2009, the Public Company Accounting Oversight Board (PCAOB) issued a report on Davis Accounting Group. According to this report, the firm had a total of one partner (Ted Davis?) and 3 employees, but 13 clients. And the report reads like this: "pervasive failure to plan, perform, and document performance of the audit and inappropriately taking responsibility for the work of another auditor when the other auditor performed substantially all of the audit procedures that served as the basis for the Firm's opinion." So, additionally to Davis signing off audits without a license for more than two years, the PCAOB report suggests that no actual audit work had been done by the firm.

BioPharm and Global Pharm

BioPharm Asia (BFAR) engaged Davis Accounting Group on February 21, 2010, after their previous auditor, Sherb & Co., resigned on February 11, 2010. Sherb had been engaged for just a couple of months (since June 30, 2009), following the dismissal of BFAR's previous auditor, Moore & Associates Chartered. A reason for Sherb's resignation was not given in the filing, but the firm declined to re-issue its report on BFAR's 2008 Financial Statements, and Davis was engaged to perform a re-audit. On May 10, 2010, Davis Accounting Group signed off on both the 2008 and 2009 financial statements (10-K Filing).

There is an interesting connection between Davis, BioPharm Asia, and another recent Chinese reverse merger, Global Pharm Holdings Group (GPHG). Global Pharm, known until September 2010 as Top Flight Gamebirds, Inc., is a Shenzen-based wholesaler and distributor of pharmaceutical-related products. Two of the company's three executives come directly from BioPharm Asia: Chairman, CEO, and sole director Yunlu Yin served as BFAR's CEO until April 2010, while Secretary Dan Li was assistant to President in BioPharm Asia until late 2009. Li was also director of China US Capital Holding Group. The third executive, Chief Financial Officer An Fu, was employed as an auditor at Davis Accounting Group until May 2010.

China US Capital Holding and Subsidiaries

Now this China US Capital Holding Group has several wholly-owned subsidiaries: China US Venture Capital Group Limited, China US Bridge Capital Limited, China Finance Inc., and Giant Fortune Investment Management Limited.

China US Venture seems to have changed its name to "China US Strategy Capital Group", advertising its services as "paving a way to US capital market for excellent Chinese enterprises, enabling them to become international excellent enterprises as soon as possible." Among the clients presented on their website are Home System Group (HSYT), Jade Art Group (JADA), Gulf Resources (GFRE), China Organic Agriculture (CNOA), Universal Travel Group (UTA), and China 3C Group (CHCG). The company is partnering with several U.S. accounting firms, among them two small firms with a strong presence in the Chinese RTO space: Kabani & Co. and Weinberg & Company. Davis Accounting Group is not mentioned as a partner.

China US Bridge says it were dedicated "to strengthening the integration between fast-growing China enterprises and US capital market." As partners they have listed the same accounting firms as China US Venture, and the same reverse merger "cases" are advertised with additionally New Energy Systems (NEWN). US Bridge is also partnering with several investor relations firms, among them well-connected Hawk Associates. AMI Research, a division of Hawk Associates, initiated paid coverage of Jade Art Group (JADA) in June of 2008, and recommended the stock with a $7.49 price target. JADA is currently trading at $0.08. Among AMI Research's 2011 Top Microcap Picks are two Chinese companies: Tri-Tech Holding (TRIT) and China Kangtai Cactus (CKGT). Both are current clients of Hawk Associates.

Giant Fortune again presents the same auditing and investor relations partners as the previous two entities. Three U.S.-listed Chinese companies are presented as "successful cases" on their website: BioPharm Asia (BFAR), Universal Travel Group (UTA), and China 3C Group (CHCG). Giant Fortune's Zuhong Xu still is the largest independent shareholder of BioPharm Asia as of its latest annual report, holding 8.50% of outstanding shares.

Mr. Xu served as Chairman and CEO of the fourth company on our "subsidiary list": China Finance Inc., which was quoted on the Bulletin Boards under CHFI, before it went dark in 2009, became delinquent and subsequently demoted to the pink sheets. As of March 31, 2009, China Finance still held sizable positions in Jade Art Group (JADA, 8.87%) and Gulf Resources (GFRE, 5.46%), additionally small leftover shares in Home Systems Group (HSYT) and China Organic Agriculture (CNOA, 1.30%). Previous holdings of CHFI include Universal Travel Group (UTA, 2008), Orient Paper (ONP, 2008), and the failed RTO stocks China 9D Construction Group (CNAG.PK), Beijing Logistic (BJGL.PK), Guilin Paper (GUPR.PK), and China Ivy School (CIVS.OB).

Doubts about Jade Art Group

Jade Art Group (JADA) engaged Davis Accounting Group on July 13, 2009 after dismissing Chisholm Bierwolf, Nilson & Morrill. Davis has been engaged "for all audit and permissible non-audit services," and the firm signed off on JADA's 2009 financial statements on April 12, 2010. JADA is currently not delinquent with its filings, and the most recent balance sheet shows cash and cash equivalents of $16.27 million or 250% of their current market capitalization. The company went dark again, all attempts to contact anyone there have been unsuccessful for weeks, and the stock price keeps collapsing on extremely high volume. With the recent developments regarding their auditor the market does apparently not believe JADA's financial statements, questions that all that cash even exists. We will see if (and what) they file their 2010 annual report - due by March 31, and who will sign off on the numbers (can't be Davis anymore).

Colatteral Damage?

Both BFAR and JADA have not yet shown any reaction on the developments at Davis Accounting. They will both have to engage a new accounting firm for the 2010 report, and I have my doubts that this can be a quality name. I am also not sure about further legal implications. Will a re-audit be required by the SEC for the fiscal years of 2008 and 2009 when Davis illegally practiced as a CPA firm? If so, then another Chinese firm that had connections with China US Capital Holding and China Finance might be affected:

Orient Paper (ONP) engaged Davis Accounting Group on November 27, 2007, replacing Moore & Associates Chartered (similar to BFAR). Davis signed off on Orient Paper's 2007 results on March 28, 2008, and on the 2008 numbers on March 19, 2009. Davis resigned as ONP's auditor on December 1, 2009 and was replaced by BDO Limited. On November 29, 2010, Orient Paper presented the findings of an independent investigation, assisted by two law firms and Deloitte & Touche Financial Advisory, into several issues which also covered the period when Davis was engaged. ONP said this investigation found no evidence for falsely reported revenue, inventory turnover, and gross profit in previous financial statements.

Late Filers Set to Report This Week

A large number of Chinese Small Caps, mostly OTC-traded companies, filed an extension to their annual reports by the end of March. All of them are now set to report by April 15, and there might be some good opportunities coming out of this. Remember that many of the following companies do not have a history of publishing a press release with earnings, so it would be wise to monitor SEC filings in the next 2 days.

Asia Cork (AKRK.OB)

Manufacturer and distributor of cork and cork products. I am expecting EPS of $0.09 for the year. Watch out for more detailed growth plans (incl. acquisitions) and news about the planned share offering. I like the stock at current levels.

BioPharm Asia (BFAR.OB)

The company is selling traditional Chinese medicine and other drugs. Very cheap at current levels, the company reported EPS of $0.15 in the last two quarters alone. High growth rates in the past two years. Watch out for hidden guidance in the 10-K as there probably won't be a press release.

China Growth Development (CGDI.OB)

CGDI owns six shopping malls and plans to acquire more. Consistently profitable and trading below book value. This one could double with a good report. Watch out for leasing rates, expansion plans and operating costs (power and heating).

China Agri-Business (CHBU.OB)

Sells organic fertilizer and bactericides to Chinese farmers. Plans to establish their own direct sales network. Stock rallied last week, about doubled for the year, so be careful here. There are faster growing companies in the sector, I'm not a fan here.

China 3C Group (CHCG.OB)

Electronics retailer in trouble. Promised to do everything necessary to turn the business around. Trading below cash at current levels. A return to profitability or just positive 2010 guidance would make this a clear buy at current levels below $0.50.

China Carbon Graphite (CHGI.OB)

After a TheStreet.com induced hype in March the stock fell back below book value. I'd like to see them reporting well above $1 million in net income for the Fourth Quarter, which could bring CHGI back on the radar screen of many traders.

China Industrial Waste Management (CIWT.OB)

Expect the filing for this one in a few hours as the company announced a conference call for later this morning. A very important industry for China, but the whole sector is underperforming so far this year. Not cheap based on past numbers, it all depends on future guidance.

China Kangtai Cactus (CKGT.OB)

One of my favourite picks in the China OTC space. Very cheap, high growth rates, several promising business segments, but apparently many US investors are only reluctantly investing in a cactus farmer. I'm confident that they will deliver this week.

China Organic Agriculture (CNOA.OB)

CNOA has several seemingly unrelated business segments in the agricultural/food area. Their newest one is blueberries. Just watch out for bottom line numbers, the stock is very liquid and many people are waiting for the annual report to jump in (or not).

China Shuangji Cement (CSGJ.OB)

The stock doubled over the past few weeks and I believe that this one has to report way above expectations just to keep its current levels. It doesn't have a history of doing so, but I am looking forward to getting surprised for once.

GC China Turbine (GCHT.OB)

Wind turbines manufacturer just coming out of development stage. Their press releases with project agreements have been frequent, their guidance is astronomical, any reassurance that their business plan will be achievable could propel this one to much higher levels.

Huifeng Bio-Pharma (HFGB.OB)

Huifeng supplied the pharmaceutical industry with rutin and related plant-derived chemicals. The company issued very bullish guidance in February and is very cheap at current levels with a P/E of less than 5. Also plans to uplist this year. Watch out for guidance confirmation.

Jade Art Group (JADA.OB)

They are selling jade. We hear nothing from the company outside of earnings filings, so key here is to watch out for new sales contracts, and ideally for new customers. If they report any of that the stock should trade much higher, if not then I would avoid it here.

New Energy Systems (NEWN.OB)

Lithium-ion battery producer on the verge of uplisting to Nasdaq. Crazy cheap here compared to its peers. We get the first consolidated earnings report with their two big acquisitions. Expectations seem to be low.

Songzai International (SGZH.OB)

Another one of those Chinese companies that leave shareholders in the dark most of the year. A coal miner that was ignored in the Chinese coal rally. Huge potential with a good 10-K, even bigger potential with reignited uplisting chatter.

Earnings Previews, Part 2

Another bunch of China Small Caps that are set to report next week. Part 3 and 4 of this post will be up tomorrow.

China Medicine (CHME.OB) will report Monday, March 29, before the open. CHME is trading in the $4 range for most of the year and positive news on Monday could propel it above its 52-week-high at $4.89 which had been reached in January. The company has already applied to list on Nasdaq, it is nicely profitable and reported $3.36m net income for the Third Quarter 2009. Keep an eye on the share count which should increase significantly with the $69.6m private placement that was announced in January.

Changda International (CIHD.OB) is also set to report next week. The stock clearly underperformed in its sector and is currently trading at its year low (down 35% since January). All metrics for CIHD are negative but there is some hope for a surprise quarter as the company is heavily in the snow melt agent business and the hard winter seems to have paid off for Changda as the company announced in January that orders in this segment have more than doubled in 2009. Watch out for liquidity issues.

China Industrial Waste (CIWT.OB) is a player in a very interesting industry that is set for explosive growth. CIWT has yet to prove that their business model works as growth in 2009 has been weak so far. I have no opinion on what Fourth Quarter numbers might look like, but watch out for bullish guidance especially for their sludge processing business.

China Kangtai Cactus (CKGT.OB) has already announced preliminary FY09 numbers in early March. The company is looking at revenues of $25.8 million for 2009 and is targeting 35% revenue growth for 2010. The market has been clearly disappointed by this guidance and the stock suffered to lose more than 22% for the year. However, CKGT is dirt cheap at current levels with a P/E ratio of less than 4.

China Armco Metals (CNAM) is one of the best performing stocks YTD in the China Small Caps sector with a gain of 171%. But the stock is still not expensive here and with a FY 2010 guidance in the $1 range CNAM has plenty of room to appreciate further. Most people are still not fully aware of the earnings potential that lies in the new scrap metal recycling business. China Armco announced a conference call for March 31 after the close, so expect a press release to hit the wires next Wednesday.

China Organic Agriculture (CNOA.OB) is a stock where I never know what to expect. The company is profitable, trades at book value and looks cheap at current levels. But their business model seems flawed with a crude mix of segments and recently a move into blueberry drinks and blueberry health care products(?!). I would not take a position here before earnings and watch the behaviour of the stock closely when numbers are out. CNOA has a history of making wild swings to both ends of the scale with earnings, there is always a chance of making money either way if it keeps this tradition.

China Power Equipment (CPQQ.OB) is in an interesting industry (energy saving, smart grid), has good growth prospects and seems prepared for an uplisting to Nasdaq now with the appointment of independent directors in mid-March. The stock is down slightly for the year and seems to have fallen under the radar, although it has been slowly creeping up over the past few weeks. Watch out for an uptick in volume with a break of the $4 level which the stock hasn't seen since January. It could be a potentially very rewarding investment.

China Ritar Power (CRTP), another laggard in the CSC space, will report FY09 numbers after the close on March 31. Growth prospects for the lead-acid battery industry are in the 25% range for 2010 as COO Zeng Jianjun indicated yesterday. Just like most other battery makers CRTP is down for the year and trading close to its lows. Analysts are expecting the company to report Q4/09 EPS between $0.08 and $0.15 (FY09 EPS $0.37 - $0.44) with a median revenue estimate of $33.3 million.

China Shuangji Cement (CSGJ.OB) is currently up 36% for the year and the stock roughly doubled in the past four weeks on a bullish press release the company issued on March 4. CSGJ is still trading below book value and the company earned $2.75 million in the first nine months of 2009, up 8.7% from 2008 levels despite a decrease in revenues. I would focus on revenue guidance for 2010 and some more clarity about production capacity for the new Longkou Cement plant.

China Valves Technology (CVVT) is scheduled to report earnings on March 29 before the market opens. The performance of the stock 2010 YTD has been excellent as CVVT is up more than 46% from December levels. Two weeks ago the company announced net income guidance of $23 million for 2009 and $40 million for 2010 which represents a healthy growth rate of 74%. Those numbers call for an outstanding Fourth Quarter and we will see early Monday morning if CVVT can deliver on the promise.

China Wind Systems (CWS) also preannounced 2009 numbers already. Non-GAAP net income for the year should come in at $0.34 per diluted share on revenues of $53.6 million, representing an estimated 26-33% growth. Nothing to get too excited about. Performance of the stock has been disappointing, despite big catalysts as the Nasdaq listing the stock is down for the year and down a whopping 40% from its January high at $8.20. I would look for any signs of accelerating growth, especially in the wind energy components business, to find a reason for the stock to trade at higher multiples than 10-12.

China Yongxin Pharmaceuticals (CYXN.OB) could be very interesting here. The company is currently in transition but preannounced higher net income ($5.4 million, +35%) on lower revenues ($46.1 million, -22%) for FY 2009. The company is moving away from the wholesale sector into direct retail and medical facilities. Yongxin is also actively working on uplisting to a senior exchange. CYXN is down 15% for the year but with confirmation of the 2009 guidance next week the stock could start to move with big upside. The Fourth Quarter has to be exceptionally strong for Yongxin to reach their guidance of EPS $0.16 for FY09 and at the current share price of just $0.55 this would mean the stock is currently valued with a ridiculously low trailing P/E of 3.47.

Chinese Book Value Plays

I've made a screen for Chinese Small Caps trading below BV. Of course this doesn't necessarily mean they are cheap here but there are some interesting names on this list which may qualify for further DD.

Personally I like CHCG, CSGJ, SGAS, JADA, SGTI, CCGY, CNTF, AKRK, CYXN, RCON, CDII, CNOA and CSR as speculative ideas here.