Sky People – fraud or bargain?

Sky People Fruit Juice (NASDAQ:SPU) is a Chinese reverse merger stock that makes and sells fruit juices in China. The company sells for below net cash yet is profitable and has return on invested capital of over 20%. Bulldog Investor’s post on this company initially got me interested. The financial ratios pretty much make this a no brainer from a ‘bargain’ perspective, if the company is legit it is definitely too cheap.

But the reason for the low valuation is that this Chinese company gained a listing in the US by merging with an existing shell company, so avoided the usual regulatory burden of an IPO. Several of these reverse mergers from China have turned out to be frauds over the last few years, and SPU has several red flags which suggest it could also be one.

1. Auditor has changed several times over the last few years
2. Large cash balance, but these have been faked by companies before
3. Operations and sales could be fake, or overstated
4. The company has a large volume of accounts receivable – a classic warning sign
5. Operating margins are well above larger Chinese peers, how can a small company operate so much better?
6. The company has been issuing debt, yet it has a large cash balance. Why?
7. Despite its share price crashing, it hasn’t bought back any shares with its cash pile.
8. The company is accused of taking domestic investors money in China and not returning it to them when such money raising was deemed illegal by authorities.

I contacted the management and asked them to explain these issues. It has also defended itself against some of these criticisms publicly. Here are the results of my research into each of these flags.

• Auditor has changed several times over the last few years

The change in auditor was actually due to criticism of the existing auditor. Note that it was the company that dismissed its auditor, not the other way around. The new auditor is in the U.S. and travels over to verify the companies accounts. It thought that using a U.S. auditor would add more authority to the accounts.

• Large cash balance, but these have been faked by companies before

This assessment of the current auditor, Paritz & Co, has a very worrying criticism on page 7

• “(7) the failure to perform sufficient audit procedures to test the existence of cash;”

But the company has faced accusations of faking cash before and has been very forthcoming in verifying its cash balances whenever asked, giving breakdowns of exactly where it is located. There isn’t much more the company can do to prove this cash exists and it has certainly gone further than other Chinese companies to try and reassure shareholders.

• Operations and sales could be fake, or overstated

The companies products are real, available even in Wal-Mart and people have visited the company’s factories and distributors, even saying the inventory level looked about right. Unless you have your own team of private investigators there isn’t much more that can be done. However, I would note that Chinese companies have been known in the past to make operations ‘look good’ in order to give tours to investors.

• The company has a large volume of accounts receivable – a classic warning sign

This has historically been the cash and been getting worse, but the latest quarterly filing actually shows a large decrease in accounts receivable, but a large increase in an ‘other asset’. The filing gives the explanation of it as “deposits to land use rights”. But if it is land use rights, why would it not be accounted for under the line for ‘Land use rights’ on the balance sheet?

The company gave no explanation of this, and said it would ‘look into it further’. If I ever hear back I will update the post.

• Operating margins are well above larger Chinese peers, how can a small company operate so much better?

Haisheng Juice is a large Chinese company operating in the same market as SPU, and its 2012 annual report shows gross margins of 10-25% in the prior couple of years.  SPU’s gross margin in comparison is 33% and very stable. Haisheng is mainly a concentrate business however, and SPU’s apple juice concentrate segment shows a gross margin of 20% which seems consistent with Haisheng. SPU’s high margins seem to come from the fresh juices segments.

Huiyuan Group is another large juice company, which has gross margins of 25-28%, so again makes SPU’s margins look suspect given it has significantly higher sales and therefore bargaining power with distributors.

The company noted to me that it compares itself to other companies as well however did not name them but did say they would get back to me with a comparison analysis. To date I haven’t received this.

• The company has been issuing debt, yet it has a large cash balance. Why?

For me this is the biggest worry. The company did give an explanation of this; it said it is trying to maintain optimal liquidity given its new project initiatives. The kiwi project in Mei County is estimated at $72 MM and the orange project in Hubei Province is estimated to be $48 MM. It also said it is important that the company maintain good relationships with lending sources, as is the practice in China, so that when the time comes and the company does need to access additional capital it will be available for them.

Perhaps this is true and westerners are having a hard time understanding something which is more the norm in China, to take out debt to maintain good relationships with lenders even when not required, but in anticipation of needing debt in the future.

• Despite its share price crashing, it hasn’t bought back any shares with its cash pile.

The most likely explanation for this is the company has already earmarked the money for increased capital expenditure to move into orange and other juices. The planned investment already exceeds available cash so they don’t really have any to spare. But the company did also say that buybacks by other Chinese stocks hadn’t helped the share price in the long term. I think they are missing the true purpose of a buyback though.

• The company is accused of taking domestic investors money in China and not returning it to them when such money raising was deemed illegal by authorities.

There isn’t much information on this and the company didn’t comment. Institutions like Morgan Stanley owns 8.8%, but large investment institutions have owned stakes in frauds in the past.

Conclusion

It is impossible to say with any certainty whether SkyPeople is 100% genuine or not. I am inclined to think that the company has reasonable explanations for most of the criticisms against it however there is one red flag which I cannot reconcile and that is the change in accounts receivable and this ‘other asset’. This is the kind of thing that happens when someone is financially engineering their accounts – I’m not saying that’s what they’re doing but I have heard no reasonable explanation for it so for safety’s sake must pass on this investment.

It’s up to investors to make up their own minds on this, just don’t forget Warren Buffett’s first rule of investing – “Don’t lose money”.