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Saturday, 03/05/2011 6:44:49 PM

Saturday, March 05, 2011 6:44:49 PM

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Rames · 2011-03-05T23:44:49.9600000Z

Carson Block in Barron's Just in case you haven't seen this yet Bearish Bets On Chinese Reverse Mergers (From BARRON'S) By Dimitra DeFotis [Interview with Carson Block, Founder, Muddy Waters Research] Carson Block has spent the past five years seeking his fortune in China. With some Mandarin under his belt, he practiced law for a year, conducted research for hedge funds and for his father, a U.S. investor, and even started a self-storage venture. But Block, 34, seems to have hit his stride with Muddy Waters Research, an online service he launched in June 2010 to expose what he describes as misstatements and fraud at small Chinese companies trading in the U.S. Typically, these companies secure listings on U.S. exchanges by merging with U.S.-listed shell companies, a maneuver that enables them to fall between the regulatory cracks. The poor performance of many so-called reverse-merger stocks was scrutinized by Barron's last summer ("Beware This Chinese Export," Aug. 30, 2010), and the Securities and Exchange Commission now is investigating possible abuses in this market. After Block published his first research report last summer, claiming Orient Paper (ticker: ONP) had overstated revenue and misappropriated funds, investors lambasted his tactics and credibility, and the company disputed his findings. Undaunted, he has since issued negative reports on two more Chinese companies. Investors who sold shares of these companies short after each report was published have reaped double-digit returns. RINO International (RINO), the subject of Block's second report, has admitted to some of the irregularities Muddy Waters cited. Its stock was delisted last fall. During a recent visit to New York, Block met with Barron's to discuss his recommendations and the outlook for the reverse-merger market. Barron's: In a sentence, what do you do? Block: I am exposing what I believe are substantial frauds before they suck up more money from investors. Barron's: Why did you decide to work in China, and eventually focus on Chinese reverse-merger stocks? Block: At the outset of law school, I didn't think I would practice for one day. I ended up enjoying law school so much that I decided it would make me a better business person, a better entrepreneur. After law school in 2005, I went to China because I figured it would offer me more entrepreneurial opportunities. I chose Shanghai because I thought the post-legal opportunities would be better. I came across a stock that was a substantial fraud. It happened to be a reverse merger, and that is how the whole Muddy Waters saga started. Barron's: How do you define fraud? Block: I am exposing companies in which less than 50% of their claimed revenue actually exists. That is well beyond the realm of mistake. Fraud is a willful, material deception [entered into] for the sake of a theft. This is not just aggressive accounting. If a company is doing $100 million a year in revenue, claiming it is a manufacturer but in actuality is outsourcing production, that's also a form of fraud. And that may indicate profit margins may be different than what the company is claiming. What we are talking about here is egregiously incorrect statements about the business, like multiplying the revenue by a factor of two or more in order to raise money from shareholders, much of which will somehow be stolen by management. Or, in certain cases, the fraud will support artificially inflated stock prices that management will take advantage of in selling their stock. Barron's: Do you sell short the securities you write about? Block: Yes, I do invest ahead of my reports, as I disclose. Barron's: What do American investors need to know about Chinese reverse mergers? Block: If it sounds too good to be true, even in China, it often is too good to be true. Understand there are conflicts of interest. Some of the legal, banking and accounting gatekeepers who are supposed to protect us from malfeasance are receiving fees from companies that could be committing malfeasance. Be skeptical. I wouldn't, per se, avoid Chinese reverse takeovers, but if you aren't in a position to do your own checks on analysts' research, I wouldn't make major bets in the space. Not only is the business far away from you, it is an entirely different culture, language and legal system. Many analysts don't get it right in the microcap China space. We take two to three months to look at a company. The conventional investment-bank-analyst model doesn't really support doing that depth of research. When you are an analyst covering 20 names, you just don't have the ability to dig deeply. It's no different than any emerging market. U.S. investors are used to controls not yet there in a developing market. Barron's: Your most recent report is on China MediaExpress Holdings [CCME], a media company that installs televisions on buses and sells advertising. What did your legwork in China uncover, and why are you skeptical on the stock? Block: Our research showed that the company in its SEC filings has been roughly doubling the number of buses that it has under contract, and that its largest purported operator contracts don't exist. The media kit as of January showed fewer than half the buses the company claimed to have. We followed up with a call to a salesperson who confirmed CCME doubled the number of buses when reporting to the SEC. [In a Feb. 7 statement, CCME disputed Block's research.] Our research also showed that the demographics of China MediaExpress' audience are unattractive for advertisers. The target customers have among the lowest incomes in China and are very price-sensitive. [CCME's annual report stated that many passengers have higher-than-average income.] Barron's: Any chance there was a miscommunication between Muddy Waters representatives and the media buyers they interviewed? Block: We queried based on the name of China MediaExpress' operating subsidiary, on its trade name and also on a description of the business model. This company puts LCD TVs on inter-city buses and sells ad space. And none of the media buyers with whom we spoke, who were all familiar with the major outdoor digital-media companies in China, were familiar with China MediaExpress by name, or even with the concept of putting video ads on inter-city buses. They were familiar with [other] intra-city bus advertising networks in China. Barron's: China Media shares have fallen about 21% since Feb. 2, the day before your report was published. What is likely to happen next? Block: Where the stock goes depends on what its auditor does. If the auditor signs off on the financials, then most likely the stock returns to its prior level above 20. Barron's: And if not? Block: It is likely the stock price will drop a decent bit. Barron's: What role do auditors play generally in reverse mergers? Block: In many cases, the U.S.-listed company and its subsidiary in China don't have ownership of the operating company in China. They just have a contractual arrangement that mandates that the operating company in China transfer profits in the form of regular payments to the China subsidiary of the U.S.-listed company. If payments don't occur, the consequence is that cumulative profits have not been transferred into the corporate structure that encompasses the U.S. shareholders. That should raise red flags with the auditor. It could be a signal that management intends to drain money from the company. But the U.S. Public Company Accounting Oversight Board doesn't appear to be ensuring that auditors are verifying these payments. That is a major problem that hasn't even come to light yet. Barron's: The SEC has talked to you about your research and strategy. What can the SEC do to protect investors from reverse-merger fraud? Block: China's State Administration Industry & Commerce has business-registration files, including those of Chinese companies listed in the U.S., that contain financial statements, records of the shareholders, capital contributed to the business, information on leased or purchased real property and permits. They are a treasure trove of history about a business and its connection to other people and businesses. Nongovernmental entities -- any company or individual investor from another country -- can engage a Chinese law firm to pull an SAIC file, but the SEC's ability to do so is limited. Barron's: Is fraudulent behavior common among Chinese companies that trade in China or Hong Kong? Block: In general, the problems would be fewer. Maybe far fewer. There is a pretty strong disincentive that we don't have in the U.S.: capital punishment for financial crimes. If you are listed in China or you are scamming Chinese investors, if you are Chinese, there is a much higher degree of risk then if you are scamming U.S. investors. Barron's: Why not look for great stocks to buy? Why focus on shorting small companies' shares? Block: There are good companies in China that are listed in the U.S., and I expect to issue some Buy recommendations. But, for the time being, there is a lot of fraud being committed among U.S.-listed Chinese micro-caps and it is time to clean them up. Doing so will benefit the real companies. Barron's: So who will "clean them up," as you say? Block: Short sellers. The SEC is investigating. At one point, Congress was going to hold hearings. There isn't a small number of people in both the U.S. and China who collaborated to bring these seemingly empty boxes public in the States. Those days could be over. Barron's: Detractors have accused you of being a part of a larger short-selling scheme. Block: Some of the assertions regard collaborating with other publishers of short-side research. I haven't collaborated with any other publishers of short-side research. I don't discuss what clients retain me for. Barron's: Are you a one-man show? Block: I have a lot of people I work with in China, though not on every project. We are attempting to prevent managements from making tens of millions of dollars in illegal profits. And that's not the kind of money that people usually have a sense a humor about. Protecting [researchers] is top priority, because they are more exposed in many ways than I am. Barron's: What lessons have you learned about capitalism in China? Block: I used to think that when you have some sort of political change -- maybe the government fails or starts to open up -- we go over there with money and economics and MBA textbooks and teach them how to do business like capitalists. And then we can make some money too. That's not how it really works. There are factors that are embedded within societies that explain the relative primacy of nations or economies. I expect to make more short calls and some long calls out of China this year, but I am also looking to expand my understanding of other emerging markets, including Latin America. Barron's: Thank you, Carson.

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