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My Case for Going Short on China's Lihua

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- By now most investors in Chinese small-caps have come to the realization that standard audit procedures are nothing close to forensic audits and, in many cases, are inadequate to detect fraud. Likewise, the opinions and price targets put out by sell-side analysts have repeatedly been proven to be disastrously wrong. In getting comfortable with a China small-cap investment, clearly something more is needed than a clean audit and a positive sell-side recommendation.

As a result, I view the recent due diligence report conducted by China 360 on Lihua International (LIWA) as a positive for the China small-cap space. Furthermore, I expect that we will see similar reports going forward.

China 360 comprises a team led by due diligence experts Thornhill Capital, run by Managing Director Alan Refkin. The firm is a "Global Hunter Approved" third-party due-diligence provider. I spoke with Refkin for about an hour to get a better understanding of China 360's scope of work and how it was conducted. The report itself was paid for by Larry Isen, a shareholder in LIWA and a regular fan of the stock on his Web site, emergingchinastocks.com, for a price of $30,000 to $50,000.

The scope of work included verification of corporate structure, an operational overview, verification of licenses and certificates, tax reconciliation, interviews with government officials, independent channel checks and a review of internal controls. China 360 visited LIWA on two occasions.

Based on my discussion with Refkin, it became clear that China 360 went the extra mile to make sure that the tasks performed were completed with a forensic level of skepticism. In contacting suppliers and customers, China 360 would independently locate the phone numbers of third parties rather than simply get these numbers from the company. In verifying SAIC filings, China 360 went directly to the local SAIC office and waited as the filings were printed out.

Some aspects were beyond the scope of China 360's mandate and some were not able to be completed. Cash verification was not performed because this task had already been assigned to a different third party. Bank statements from 2008 and 2009 were not able to be obtained. Also, the tax filings viewed by China 360 had to be obtained directly from the company rather than from the tax authorities.

Despite the fact that I am very positive on the report from China 360, I have come to a number of negative conclusions regarding LIWA itself, primarily due to factors that are beyond the scope of the China 360 report. In analyzing the company, I have tried to take a few steps back and ask myself if the numbers seem feasible using a "reality-based" analysis. In other words, if I myself wanted to run a similar business, could I achieve such results?

This was the type of analysis that led me to take a negative view of China MediaExpress (CCME.PK), despite very detailed on-the-ground due diligence by Global Hunter. In short, CCME's margins were too high and its capex and operating expenses were too low. I came to the conclusion that if such a huge amount of business could be generated with such a small amount of capital, then other competitors would surely be rushing in to compete away the potential. I myself would have jumped into that business were it truly that easy. Despite the verification of volumes of documentation by Global Hunter, auditor Deloitte resigned just a few weeks later due to company misrepresentations.

One area that China 360 was not able to analyze was profit margins. According to Refkin, such an analysis would have taken several months. But this is the most important piece of the puzzle. While it is no doubt important to verify documents and view facilities, the key question is how is LIWA able to generate double-digit gross margins in a highly competitive commodity market. In recent years, gross margins were over 20%, which seems nearly impossible in this type of business. It is worth strongly emphasizing that the market for copper wire is purely a commodity business. Customers shop their business based on price and negotiate it down to the point where it is very difficult for the supplier to maintain a reasonable profit. Simply put, if LIWA were charging prices that high, customers would simply go to a lower-cost supplier and save as much as 15%.

My second point of concern with LIWA is on capex. Since 2008, LIWA has spent les than $15 million on PP&E, yet it has grown revenue from $50 million to a whopping $370 million. This is an increase of $220 million (over 400%) in revenue with only $15 million in investment. Similar to CCME, I have come to the conclusion that if it were this easy to rack up an additional $220 million in revenue with only $15 million in investment, then surely others (myself included) would be rushing to enter this business.

My final point of concern with LIWA relates to cash. The current cash balances were not able to be verified by China 360, but are being verified by a separate third party. If LIWA is spending so little on capex, then why has it felt it necessary to tap the U.S. capital markets? For the past five quarters, LIWA has maintained a cash balance of roughly $90 million, which has not been used for any purpose. During this time, reported interest income has been negligible. The question I ask is why bother to dilute shareholders if the money isn't needed? I am also curious as to why there is little or no interest income if this cash is sitting in long-term bank accounts.

Because of the presence of $90 million in cash on the balance sheet, many investors view $3 as a floor for the share price. I believe this is wrong for many reasons. Just as a matter of fact, Chinese RTOs do not provide any investor with a direct claim on the assets of the company. Simply put, an investor could buy up 100% of the outstanding shares of any of these companies and still not be able to get control of any of the assets. As a result, many Chinese small caps trade at a significant discount to reported cash per share. The examples are numerous and include Sky People Fruit Juice (SPU), China Education Alliance (CEU), Sinoclean Energy (SCEI) and Gulf Resources (GURE). Each of these stocks trades at around $2 or less, despite having a cash balance greater than their market cap. Notably, none of these are delisted pink sheet stocks.

The release of the China 360 report led to a brief rise in the share price as longs bought in and shorts covered. Yet I have decided to take a short position in the stock because I don't feel that it even remotely passes the common-sense test, in the same way that CCME did not. In short, I don't believe it is possible for a commodity producer to sustain 20% gross margins, I don't believe that it is possible to boost revenue by over $200 million with less than $15 million in investment and I am not yet comfortable with the company's perceived desire for cash when none is needed combined with a lack of interest on that reported cash. Based on these factors, I see a high probability that the share price can drift well below its recent 52-week low of $5.19, while at the same time there is no clear catalyst for a move to the upside.

Disclosure: The author is short LIWA. He can be reached at comments@pearsoninvestment.com.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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