China MediaExpress: Past Lessons

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

BEIJING ( TheStreet ) -- Investors are said to have short memories and this seems to be the case with CCME. I have put many hours of work into China MediaExpress Holdings ( CCME) CCME and I am now very concerned that we will see a restatement.

We have seen this many times in the past, and each time there was some excuse why investors never saw it coming, including cash verifications, audits of 10Qs by Big 4 auditors as well as too much faith in research analysts and the supposed due diligence done by institutional investors.

I have given concrete examples from the past on why these things should not be overly relied upon.

Back in November, China Education Alliance ( CEU) was the subject of a short report claiming that the company was an empty shell.

This report took the share price down to $2 from over $5 in preceding weeks. I noted a number of flaws in the short report. In particular, I noted that the short sellers never spoke with management, never visited the company and never even went to China. Instead they made use of paid "investigators" whose credentials were never stated.

As a result, I hopped a plane to Harbin. During four days of viewing every possible classroom and student that were presented to me in the best light by management, I saw fewer students in total than attended my high school.

After some technical difficulty we were able to download the company's online product, which cost only 1 RMB (about 15 cents). In contrast to the short report, there were in fact classrooms, students and a functioning Website. However there was clearly no conceivable way that the business that I was seeing was generating over $30 million in revenues as stated in its SEC filings and very recent investor presentations.

Prior to my visit, CEU's auditors announced that they had performed "enhanced procedures" to verify the company's cash balance and the stock jumped by 60% to $3.50 under the theory the company must be real if the cash is real. However, after a disappointing conference call, the stock dropped straight back to $2 where it still sits today. This represents a 20% discount to reported cash per share. Those who bought on the bounce due to the verification of the cash lost around 45%.

What did I learn from CEU? First, despite the fact that the short report was conducted with flimsy (at best) due diligence and clearly overstated its case, it was in fact about 80% correct in its ultimate conclusions. Second, "verifying" the cash balance, even when done by an auditor, in no way validates the business. Third, a company can (and often does) trade at a discount to its reported cash balance. This is particularly true of Chinese small caps which are VIE structures because there is no way for any investor to take control of the assets and claim whatever cash is there.

Duoyuan Printing ( DVP) was a stock I liked and owned and which had a distinct lack of "red flags". It was an IPO (not an RTO), it is a NYSE listed company and it had Deloitte as an auditor.

Deloitte signed off on every 10Q since the DYP came public, but when it came time for the 10K, Deloitte was suddenly "dismissed" (a.k.a. resigned), sending the share price from $7 to $2 in days - a 72% drop. DYP has not yet found another auditor and has yet to file a 10K or subsequent 10Q and currently trades at a 30% discount to its last reported cash per share.

What did I learn from DYP ? First, the amount of work performed by the auditor on a 10Q is quite minimal. It is far less than most people would imagine and does not provide any meaningful comfort as to whether or not the auditor will sign off on the 10K. The 10K is the only place where the real work is done. This applies to all auditors, Big 4 and otherwise.

Second, I observed once again that companies can and do trade at steep discounts to their reported cash per share. Finally, when investors rush for the exits, stocks can easily drop by more than 50% in a day.

Rino International (RINO.PK) was the subject of a Muddy Waters report in November. The stock was halted and then delisted within three weeks of the report, despite the fact that much of the report was overstated and despite the fact that "only" one-third of its contracts had "problems." The stock currently trades on the pink sheets at a price of $1.67.

In the weeks preceding the short report, there were multiple China analysts who had share price targets as high as $40. When the stock was in the $20's, RINO raised over $100 million in an equity offering which presumably involved considerable due diligence by analysts and institutional investors.

What did I learn from RINO.PK ? First, short sellers always overstate their claims, but as in CEU, that doesn't mean that their ultimate conclusion is incorrect. Second, it only takes a minimal amount of "problems" such as Rino had for a company to be deemed a complete fraud -- even when there is legitimate activity going on. At the current price, no one seems to be giving much credit to the two-thirds of RINO's contracts that are (potentially) legitimate. Third, despite significant attention and due diligence by top institutional investors and multiple analysts, and despite an investment of over $100 million, the small details that mattered the most were somehow missed -- by everyone! RINO's market cap is now $47 million despite the $100 million equity raise. Finally, analysts often have very high share price targets.

I could provide a much longer list of former high-fliers gone bust, but the conclusions would be largely the same as those above.

By now, nothing that is said by anyone (myself included) should be affecting the share price of China Media Express. The positive report by Global Hunter failed to have a sustainable effect on the price. Repeated attacks by Muddy Waters, Citron and Bronte Capital are now no longer effective. So the purpose of this article is not to serve as another ineffective "hit piece" on CCME.

That said, I have sold my shares of CCME but I am now buying puts because I believe that a substantial restatement of 2010 earnings is highly probable. I have put in a tremendous amount of time evaluating both the arguments of longs and shorts, and I actually don't feel that either side is entirely correct. The problem is that the burden is on CCME to be absolutely 100% correct on everything and if it is only 90% correct, the consequences will be very significant. Longs therefore are at a significant disadvantage.

Similar to FUQI, CCME's financials are simply too good to be true. They are too good vs. its competitors and good vs. virtually any other business one can find. We have seen this before. Exactly 1 year ago, FUQI was a crowd favorite by both institutions and individuals simply due to its stellar SEC financials. The company raised over $100 million from institutional investors at a price of over $20 and had multiple analysts covering it. After a restatement FUQI now trades at $4.12 (a 40% discount to cash), down from over $30.

Detailed on-the-ground work by analysts and individuals has currently verified only about one-half of CCME's business, leaving substantial room for restatement. I have spoken with numerous China based investors, including long only investors, who have repeatedly found inconsistencies with CCME's business after conducting in person due diligence with bus operators and mid-level CCME employees (i.e. intentionally avoiding senior management). This was well prior to the recent Muddy Waters report which describes an employee interview and which is the subject of some debate.

Based on the examples above, I take no comfort from the quarterly audits conducted during 2010. This is not intended to be any slight to Deloitte. It is simply a matter of fact that quarterly audit procedures are quite minimal and leave substantial room for restatement. Don't take my word for it, ask any auditor. I have.

Based on the examples above, I also take no comfort in the verification of cash or the theory that CCME should trade at a value above reported cash per share. There are simply too many examples which keep me from putting full faith in a cash verification.

Again, this is not intended to be a "hit piece" and I am not by any means suggesting "empty shell". However, as demonstrated by FUQI, DYP, CEU and RINO.PK, if any portion of CCME's story does not hold up, the consequences will be very significant.

I believe that CCME does have some legitimate business and it may in fact be quite substantial, but I also believe that some portion will not hold up simply because of the number of inconsistencies found by both long and short investors. The burden of proof is on CCME to be 100% valid, not 80% or 90% valid.

Disclosure: The author is long put options on CCME

The author 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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