What Was Said: From an October 22, 2008 South China Morning Post article titled “Chaoda Eyes Additional Farmland”:
“Chairman Kwok Ho said Chaoda would use internal resources to fund the expansion of 100,000 mu amid the global financial crisis. It currently has 494,800 mu of vegetable land, tea gardens and fruit orchards. One mu is one‐fifteenth of a hectare.
‘It’s impossible to raise funds right now, so our plan is mapped out in accordance with our own ability,’ Mr Kwok said.
The Fujian‐based company had enough cash to redeem its convertible bonds, worth 1.37 billion yuan, due in May 2009, he said. At the end of June, Chaoda had cash and equivalents of 1.28 billion yuan, down from 1.67 billion yuan a year earlier.
‘I am a very conservative man,’ said Mr. Kwok. ‘We have adequate financial resources for the bonds redemption.’”
What Was Done: Four months later, Chaoda netted ¥341 million through a gypsy swap. Right before the announcement, two executive directors, Kuang Qiao and Ip Chi Ming sold their entire holding of 3.2M shares and 0.7M shares, respectively.14
What Was Said: During the 2008/2009 interim conference call in March 2009, Mr. Kwok stated, “we are confident that with internal resources we will be able to repay the CB as well as the high‐yield bond and maintain a proper growth rate.”15
What Was Done: In June 2009, the Company raised ¥1.5 billion through a share placement. Two weeks before the announcement, Ip Chi Ming dumped 80,000 of his 90,000 shares.16
What Was Said: During the 2009/2010 interim conference call in March 2010, the CFO (Andy Chan) explained that even after retiring the high yield bonds, there was enough cash on hand and funds from operations to internally finance any growth activities. This position was reaffirmed to one of our contacts as late as June, 2010.
What Was Done: Two months later, Chaoda raised ¥2.4 billion through a combination of bonds, shares, and options. The Company also tried to raise another ¥1.3 billion in April, 2011, but failed citing ‘market conditions’.
We find the sudden nature of these capital raises bizarre given Chaoda’s growth model. Management states that it takes approximately 6 to 12 months from consideration and planning to actually leasing farm land. During this period, a team examines the climate, water source, and land to ensure cultivation is economic and viable. Once the lease is signed, Chaoda has to wait for the farmers to harvest what they have already grown. This step can take another 12 to 18 months before Chaoda begins cultivating the land. The entire process is slow and takes approximately two to two and a half years. Accordingly, management would know far in advance of its financial position and capital requirements.
Exhibit 3 shows the standard deviation of Chaoda’s gross margins is approximately 1.3%, compared to 4.7% for China Green. Based on these parameters, Chaoda will report gross margins within a 65.7% ‐ 68.5% range 99% of the time. THIS RANGE SPANS A MERE 3.2%.
As a point of reference, China Green’s 99% confidence interval is a much more reasonable 48.6% ‐ 59.0%. This range spans Chaoda’s three fold. Save for the largest multinational conglomerates, Chaoda’s reported margins are not just unlikely for a vegetable producer, they are unlikely for any company, in any industry. These numbers are even more improbable when you consider the Company’s long operating history. It appears that Chaoda is unaffected by supply, demand, droughts, quality issues, bad harvest seasons, or any form of natural disaster.
From inception to Fiscal 2010, Chaoda has spent over ¥9 billion (US$1.4B) on capital expenditures. This figure includes irrigation systems, greenhouses, processing centers, office buildings, and machinery. To that date, the company claims a production base of 664,225 mu. This translates to capex spending of approximately ¥13,700 per mu.
If we use the average figure of ¥10,055 as a reference point, the amount of total capex spending needed to establish and maintain Chaoda’s production bases should have at most cost ¥6.7 billion (~US$1B).
We say ‘at most’ because we are giving the benefit of the doubt to Chaoda. Even ignoring points (i) and (ii) above, this number is still questionably high. We note that China Green and Minzhong both have higher greenhouse coverage than Chaoda. Greenhouses can triple the yield of open fields, and produce higher quality products. However, the costs associated with establishing them are generally four times higher than open fields. Greenhouse coverage for China Green and Minzhong stand at 12% and 10% respectively, as opposed to only 7% for Chaoda21. This is why even our ¥6.7 billion estimate is likely too generous. Based on this comparison, there is an ¥2.3 billion (~US$350M) unexplained black hole on Chaoda’s balance sheet. We believe this amount (and likely much more) has been siphoned out of the Company by certain managers and third‐parties under the guise of capital spending.
Even at present, Chaoda’s costs seem to be unjustifiably high. In a recent call to Chaoda, our representatives were told that management expects capex spending to be 28,000 per mu. Calls to peers gave us a range of 13,000 to 20,000 per mu.
We suspect management has made it a policy to grossly inflate capex costs as a cover to transfer money out of Chaoda.
Management was dodgy in discussing the pricing mechanism but has previously stated that Chaoda purchases fertilizer for approximately ¥1,500 per metric tonne (MT). Again, we have no confidence in this number, but quotes from other agricultural companies and suppliers gave us an average range of ¥700 to ¥1,300 for very high quality organic fertilizer, shipping included. Even if management’s figure is to be believed, then at minimum Chaoda has to date overpaid by at least ¥500 million (~US$77M) for its fertilizer purchases ‐ and almost certainly much more, as we show next.
Fujian Fertilizer, a company majority owned by Mr. Kwok is the exclusive manufacturer and supplier of fertilizer to Chaoda. Mr. Kwok is also a major supplier to Asian Citrus, an associate company we discuss on page 22. If these claims were true, Fujian Fertilizer would be one of the biggest organic fertilizer companies not only in China, but globally. It is neither.
We have proof that Fujian Chaoda Agricultural Produce Trading Company is nothing more than a shell company used to transfer money from Chaoda. Our sources have acquired Fujian Fertilizer’s SAIC documents, complete with official seal.22
Far from being a major player in organic fertilizer, Fujian Fertilizer only has ¥477,284 (~US$72K) worth of obsolete inventory on hand. How this company supplies the numbers Chaoda claims is beyond us. Whatever amount of fertilizer is being supplied to Chaoda is likely through local animal farms with Mr. Kwok only acting as an intermediary. Of course, the irony here is that the Chaoda model was built on the premise that intermediaries are an unnecessary cost and add little value to the supply chain.
Supporting our hypothesis is the fact that Fujian Fertilizer reports net fixed assets of ¥11,559 (~US$1,750). Either this company can manufacture, process, package and ship hundreds of thousands of MT of fertilizer using US$2,000 worth of equipment, or it’s a shell company feeding the CEO’s pockets. We’ll let investors decide.
As an added kicker, shareholders will likely appreciate that over the last decade, as Mr. Kwok was dumping his stake in Chaoda, he was buying out his partners in Fujian Fertilizer. Clearly, Mr. Kwok knows where the money is going.
Modern Orange Farm – Really?
In 2001, Asian Citrus was anything but a ‘modern orange farm’. The company consisted of a single plantation (Hepu Plantation) that was neglected and only had young orange trees (the yields provided by young orange trees are uninspiring).
In fact, Hepu Plantation was originally owned by Tropicana. In 1998, Pepsi Co. acquired Tropicana from Seagram for US$3.3 billion. The following year, Pepsi Co. sent a team to Hepu Plantation to analyze the property. The team concluded that the operations required additional investments which were not economically viable and that the project was too risky. Accordingly, they abandoned the operation and handed the plantation over to the Hepu government for free. As late as 2000, the Hepu government was looking for investors to develop, manage, and operate the plantation.24 Modern orange farm? We don’t think so.
Furthermore, upon acquisition, Chaoda had to write down ¥162 million (US$23M) or over 50% of its share of net assets. We find it hard to believe such a ‘modern orange farm’ would incur so much negative goodwill.
Attractive Investment Opportunity – Compared To What?
We question management’s claim that Asian Citrus provided an attractive investment opportunity. The graph below shows an ROE comparison between Chaoda and Asian Citrus.
Chaoda’s return on equity has trumped Asian Citrus’ by leaps and bounds since the acquisition. If management was looking for an attractive investment opportunity, why did they not invest the funds in Chaoda? Why did management instead invest in a company that even Pepsi Co. considered too risky? Given Chaoda’s numerous rounds of financing, there clearly were lucrative internal investment opportunities available. It’s hard to believe that management had shareholders’ best interests in mind when they acquired the stake in Asian Citrus. So if shareholders didn’t benefit from this acquisition, who did?
Related Party Transactions, Part II
The 49% stake gave Chaoda significant influence over Asian Citrus. This influence was cemented when Ip Chi Ming, one of Chaoda’s executive directors was appointed Vice President of Asian Citrus. If that name rings a bell it is because as we mentioned on pages 10 and 11, he was the same director who on more than one occasion dumped his shares of Chaoda ahead of material news releases. Instead of being reprimanded and possibly facing charges of insider trading, he continues to act as the Vice President of Asian Citrus.
Predictably, Mr. Kwok has used this influence to position his fertilizer company as one of the main suppliers to Asian Citrus. Over the last 9 years, Asian Citrus has bought ¥238 million (US$37M) worth of fertilizer from another of Mr. Kwok’s fertilizer companies. We note that these lucrative contracts have the same questionable pricing mechanism that was entered into with Chaoda, as per page 19.
We believe Mr. Kwok understood the economics of Asian Citrus not from shareholders’ perspective, but from his own. When Chaoda leases land from farmers, the land is in relatively good condition since its being maintained. However, the Hepu plantation was on neglected, poor land that lacked minerals. To get the land fertile enough to grow healthy oranges, the soil had to be revitalized and injected with nutrients. As shown in Exhibit 9, this translated into large amounts of fertilizer dumping, which probably had Mr. Kwok popping a few bottles of Cristal as he penned the deal with shareholder money.
One final note regarding Asian Citrus: Concerns have previously surfaced that Chaoda has exaggerated its land bank and does not grow all the produce it claims. In fact, it may be buying its produce from third parties and reselling them. Management has systematically denied these allegations. However, buried in Asian Citrus’ 2005 AIM listing document, we see that in 2002 and 2003, ¥69,000 and ¥11,000 of oranges were purchased from Asian Citrus by one of Chaoda’s operating subsidiaries.25 While the sums are small, these related party transactions were never disclosed in Chaoda’s financial statements. This glaring omission does not inspire confidence that management has been honest with investors regarding its production bases.
Historically, Chaoda has had difficulty securing bank loans. This is primarily due to the issues with land ownership, and its corporate structure.
At the beginning of our report, we mentioned that Chaoda doesn’t actually own any of the land it cultivates. It’s all leased from farmers. In a liquidation scenario equity holders and creditors would not be able to claim this land. In fact, the Company would be on the hook for the significant long term contracts it signed with the farmers. Moreover, the bulk of Chaoda’s long term assets are attributed to farmland infrastructure, such as irrigation systems. Without ownership of the land, this too is lost.
Then there is the issue of Chaoda’s corporate structure. Often mistaken for an H‐share company, Chaoda is actually a P‐chip stock and technically not recognized by China as a national enterprise33. As shown on the next page, the organization consists of a labyrinth of PRC subsidiaries and offshore BVI entities. If current senior convertible bond holders carefully read through the CB Proposal, they will notice that all the guarantors to their holdings are BVI entities. Not a single one of them is a PRC operating subsidiary. We doubt this is a coincidence. Even if Chaoda had the cash balance it reports, it would be nearly impossible for creditors to collect. A lawyer we consulted explained to us, “I’ve had these types of cases before. It’s not about collecting 10 cents on the dollar. It’s about collecting 0 cents on the dollar.”
These are the reasons even Chinese banks refuse to lend to Chaoda.
The one asset Chaoda holds that we can confirm is its stake in Asian Citrus, which over the years has slipped from 49% to 13.4% interest. However, with a VP who loves trading on insider information, questionable related party transactions with Mr. Kwok’s fertilizer company, and discrepancies we found in its listing documents (which are beyond the scope of this report), we have our own concerns with Asian Citrus. But assuming recent market prices, Chaoda’s stake is worth approximately HK$870 million or HK$0.57 per share. Of course, this type of theoretical valuation still leaves investors with the very practical issue of collectability. What happens if management continues to sell the stake and abscond with the proceeds?
Chaoda’s long history as a public company is mired in lies and corporate fraud. Under the cover of inflated capex spending and related party transactions, management has transferred more than US$400M out of Chaoda. In so doing, the Company has overstated its cash balance and falsified its financial statements. The CEO, with the support of the board of directors has invested in risky projects that have robbed shareholders of returns in order to line his own pockets. In an attempt to cover their egregious actions, management has paid a fraudulent company to provide Chaoda positive marketing exposure.
Corporate fraud has become problematic in both the Mainland and Hong Kong. Both governments have wisely renewed calls for tougher action in the face of this growing epidemic. The fact that the HK Exchange and the SFC have allowed this obvious fraud to operate under their watch will not go unnoticed. To maintain market confidence, we expect in the coming weeks and months for the SFC to conduct their own investigation into Chaoda’s operations and business activities. In addition to what has been presented here, we have reason to believe Chaoda will not be able to survive scrutiny. Accordingly, we expect this Company to eventually be delisted.