Pullet surprise? Tiny U.S. investment firm bests large Chinese company in chicken flap

Yuhe International Inc., a Chinese chicken breeder whose business model is based on quick turnaround, took only three days to acknowledge it had been bested by two short sellers in rural Pennsylvania. The investors, who run GeoInvesting LLC, issued their first negative report about the firm on June 13, saying an announced acquisition of 13 breeder farms never happened and that a $12 million down payment may have been misappropriated. Yuhe, which says on its website that it's the largest supplier of day-old broiler chickens in China, denied the report the next day. Three days later, on June 17, after GeoInvesting posted recordings of its phone calls with the man who supposedly sold the breeder farms, Yuhe executives admitted on a conference call that disclosures weren't accurate and said the $12 million ended up in a separate private firm, where it was used to buy other farms. Yuhe shares plunged 71 percent to $1.21 on the Nasdaq Stock Market before trading was halted that day. “Rarely do you see that Perry Mason effect, when a company just gives up,” said Joe Giamichael, an analyst at Global Hunter Securities LLC in New York, who had a “buy” rating on Yuhe. “I had taken for granted that those breeder-farm transactions took place. GeoInvesting did an excellent job.” The company, founded three years ago in Skippack, Pennsylvania, about 30 miles northwest of Philadelphia, has gained attention in recent months, along with research firms such as Muddy Waters LLC and Alfredlittle.com, for challenging the accounting practices and business transactions of Chinese companies listed on U.S. exchanges. Shift in Direction That marked a shift in direction for GeoInvesting President Majid Soueidan and Vice President Dan David. The firm profited over the past few years, they said, largely by taking long positions in Chinese companies that gained U.S. listings through reverse mergers. The booming Chinese economy offers investment opportunities, and GeoInvesting had been upbeat on Yuhe because of growing demand for chicken, they said. “We had high hopes for Yuhe, and our aim had been to reinforce a long position,” said Soueidan, 41, the son of Lebanese immigrants, who wore a kung fu t-shirt during an interview at a Skippack restaurant. “We wrote a positive report on them last summer. But the more we looked, the more questions we had about the acquisitions. We had no choice. I don't like being a short. I despise it. I just don't like being that guy.” Research for Subscribers Short investors typically bet against a stock by selling borrowed shares with the hope of repurchasing them at a lower price. GeoInvesting, which provides research on Chinese and U.S. stocks to subscribers who pay $9.99 a month, had written positive comments about Yuhe since 2010. The company, based in Weifang, about 500 kilometers (311 miles) south of Beijing, had $67.5 million in revenue last year and a $34.3 million net loss, according to filings. The partners, who also manage The Market's Edge Ltd., a 17- year-old investment fund with about $10 million in assets, said they held a long position in Yuhe until April, when they went short. They changed their position and issued a critical report after evidence of questionable accounting mounted. Yuhe is one of an increasing number of U.S.-listed Chinese firms facing questions about their financial disclosures. The U.S. Securities and Exchange Commission revoked the registrations of eight Chinese companies since December, and more than 24 have disclosed auditor resignations or admitted accounting misstatements since March, SEC Chairman Mary Schapiro wrote in an April 27 letter. Reverse Mergers Many of the companies, like Yuhe, obtained their U.S. listings through reverse mergers, in which a closely held business buys a publicly traded shell. The maneuver lets companies avoid the vetting process that occurs during an initial public offering. On June 9, the SEC urged investors to be careful when buying shares in reverse-merger companies. The Bloomberg Chinese Reverse Mergers Index of 78 U.S.- listed stocks has fallen 43 percent this year. Yuhe's auditor, Salt Lake City-based Child Van Wagoner & Bradshaw PLLC, resigned after the June 17 conference call, citing “the company's management's misrepresentation and failure to disclose material facts surrounding certain acquisition transactions and off-balance sheet related party transactions,” Yuhe said in a June 20 regulatory filing. ‘Become Pandemic' Fraud at U.S.-listed Chinese companies has “become pandemic,” Giamichael said. “It's gotten incredibly difficult. You doubt everything a company says.” GeoInvesting said the disclosures are part of a necessary culling of weak companies from an otherwise promising market. “We're saving this market,” said David, 42, a former manager at a jewelry-store company. “We were very uncertain about starting the short process. It's so against the grain for us. We're still basically long investors. Ultimately, we believe you make more money that way.” Soueidan said he became obsessed with investing as a teenager and grew more serious about it while majoring in finance at Temple University in Philadelphia. After college, he worked as an analyst at mutual fund company Vanguard Group Inc., he said. When he learned it would take years to manage his own portfolio, he quit to trade full- time for himself. ‘Hate Weekends' Soueidan said he is a value investor who pores over financial statements to select stocks with strong balance sheets that are undervalued by the market. At 19, he said, he started calling executives to quiz them before buying shares. “I wouldn't say I'm a trader,” Soueidan said. “I'm an investor. I love what I do. I hate weekends. I get bored.” He said he invested only his own capital until 2005, when he started thinking about building a subscription-service website and tried to lure David, a social acquaintance, to join him as a partner. David, a flag football enthusiast who wore shorts and a button-down shirt during the interview, said he worked as a manager at Finlay Enterprises Inc., which operated jewelry concessions in department stores before filing for bankruptcy in 2009. He declined Soueidan's offer at first, then agreed to join him in 2006. The partners began seeking investors in the fund and launched the website in 2008. They first took an interest in U.S.-listed Chinese companies in 2006, David said. ‘Investing on Steroids' “With the growth we were seeing, it seemed like value investing on steroids,” David said. Their Market's Edge fund returned almost 50 percent a year in 2006 and 2007, David said. It invested as much as 15 percent of its capital on long positions in Chinese companies, he said. He declined to disclose what percentage of the fund he and Soueidan own. The fund tumbled about 70 percent during the 2008 financial crisis, David said. It surged more than 200 percent in 2009, when it increased its holdings of Chinese stocks to about 70 percent, still all long positions. The gains continued into early 2010 before returns leveled off. The fund ended the year unchanged and is up about 12 percent this year, David said. Among GeoInvesting's biggest winners, David said, was China MediaExpress Holdings Inc., a Hong Kong-based company that sells television advertising on intercity buses in China. The fund bought warrants starting in July 2009 for less than 20 cents each. It began selling the securities, which give the owner the right to purchase common stock at a set price, in December 2009 for as much as $8 and later converted some warrants into common stock, which they sold for as much as $15 in mid-2010. Organic Fertilizer They also scored with China Agritech Inc., a Beijing-based producer of organic fertilizer. The fund started acquiring the shares for less than $5 apiece in August 2009 and sold in March 2010 for about $26, David said. GeoInvesting put Yuhe on its GeoSpecials list for attractive shares in 2010, Soueidan said. He also wrote articles for TheStreet.com, the flagship website of New York-based TheStreet Inc. One report in February 2010 carried the headline: “A Bullish Case for Chinese Stocks.” Soueidan and David said they became concerned in mid-2010 that some Chinese stocks were dropping without news developments. Then a report on June 28, 2010, by Muddy Waters, an investment firm founded by Carson C. Block, questioned the accounting of Orient Paper Inc., a Baoding, China-based maker of paper products. Orient plunged 40 percent to $5.09 on July 1. It closed last week at $4.20 in the U.S. Turned a Profit In July 2010, GeoInvesting removed all Chinese companies from its GeoBargains list because Soueidan was concerned that the firms' financial data may be inaccurate, he said. Soueidan and David also learned that some of the companies in which they had invested and turned a profit, including China MediaExpress and China Agritech, had been accused of making misstatements. Shares of China MediaExpress plunged 33 percent to $11.09 on Feb. 3, then the biggest drop since its 2007 initial public offering, following a report by Muddy Waters saying the company inflated revenue and profit. The stock was delisted by the Nasdaq Stock Market in May and closed last week in over-the-counter trading at $1.61. China MediaExpress said at the time that it “strongly disagrees” with the claims. Lucas McGee Research, another investment website, called China Agritech a scam in a Feb. 3 report. The shares, which closed at $10.78 a day earlier, dropped to $6.88 on March 14, when trading was halted. The company was delisted by the Nasdaq Stock Market on May 20. “I was embarrassed,” David said. “Luck shouldn't have that much to do with it.” Investigative Team Soueidan and David built their own investigative team in China starting in August 2010. They hired three Chinese staff members, all with business degrees, and a Chinese lawyer to conduct due diligence, David said. The team examined tax and business records, interviewed customers and conducted surveillance of company facilities. GeoInvesting grew concerned about its Yuhe investment because of delays in closing on the deal to buy the breeder farms, first announced in December 2009. Yuhe initially said the deal would be completed by March 2010. Yuhe announced two delays and said on March 31 of this year that the deal wouldn't close until December. On May 16, the company announced it had taken possession of 11 of the breeder farms, not mentioning what happened to the other two. That's when GeoInvesting's staff in China contacted Zheng Xuejiang, head of Weifang Dajiang Corp., the company from which Yuhe said it was buying the breeder farms. Zheng told them that he never seriously negotiated a sale with Yuhe and that there had been no deal, according to GeoInvesting's June 13 report, in which the firm disclosed its short position. Zheng didn't reply to an e-mail seeking comment. Financial Disclosures GeoInvesting also has written reports questioning financial disclosures by companies including Sino Clean Energy Inc., China Redstone Group Inc., Puda Coal Inc., Lotus Pharmaceuticals Inc. and China Natural Gas Inc. There was no response to phone messages and e-mails sent to China Natural Gas. Crocker Coulson, a spokesman for Puda Coal, said the company had no comment. The report by GeoInvesting questioning Lotus's financial disclosures wasn't accurate, said Xing Shen, a spokesman for the company. Sino Clean Energy, a Xi'an-based maker of a coal-slurry fuel, said it had been defamed by false reports, according to a lawsuit it filed May 9 in New York state court against GeoInvesting and Alfredlittle.com. Both firms said Sino Clean Energy had inflated its shipments and revenue. Sino Clean Energy's lawyers haven't served either research firm with legal papers, according to David and Simon Moore, who said in an e- mail that he's the editor of Alfredlittle.com. Cemetery Plots Lawyers for China Redstone, which sells cemetery plots, said it was defamed in a GeoInvesting report that questioned whether the company had a license to sell the plots, according to a March 15 cease-and-desist letter provided by GeoInvesting. The report contained “material and gross inaccuracies,” the Richardson Patel LLP law firm said in the letter. The law firm wrote that China Redstone would sue unless GeoInvesting removed the analysis from its website. As of July 8, the China Redstone reports were still on GeoInvesting's website and no lawsuit had been filed. China Redstone has declined 82 percent this year to $0.75 a share. Sino Clean Energy has dropped 79 percent to $1.37. GeoInvesting held no short positions when its investigators first found discrepancies in the companies' regulatory filings, David said. It approached the firms hoping that any misstatements could be corrected, Soueidan said. Dave Gentry, president of Maitland, Florida-based RedChip Cos., which handles investor relations for U.S.-listed Chinese companies, said GeoInvesting approached him earlier this year and presented its findings on Lotus Pharmaceuticals, a RedChip client based in Beijing. Independent Appraisal GeoInvesting questioned filings in which Lotus said it had acquired an Inner Mongolia property, valued at more than $33 million, that was to be used to build a production facility. David said his staff interviewed government officials who disputed Lotus's assertions that it had purchased rights to the land. GeoInvesting appraised the property independently and found it was worth about $6 million, David said. “There are charlatans out there, but GeoInvesting uses good evidence,” Gentry said. “They came to us with their information on Lotus. They're trying to do the right thing, like Muddy Waters. They've done a great service for the market.” RedChip no longer represents Lotus, said Gentry, who declined to elaborate. David said he became discouraged when the Chinese companies failed to amend SEC filings or change business practices after GeoInvesting accused them of shortcomings. That's when David and Soueidan said they decided to take some short positions and publish their negative findings. They said they look forward to writing positive reports again. “Even when we didn't take a short position on the companies we criticized, we were hated,” David said. “The longs all hated us for hurting their stocks, and the shorts laughed at us for not being more aggressive.” --Bloomberg News--