We have written a 40-page report where we present compelling evidence that ChinaCast Education Corporation (CAST) has materially misrepresented itself in its SEC financial statements. Our full report is available by clicking here (.pdf).
We have also written a letter to the company's auditors discussing our findings. The letter is available here (.pdf).
ChinaCast has long occupied a special place within the U.S.-listed Chinese smallcap universe. As fraud after fraud has been exposed within this sector, CAST has been upheld as the baby thrown out with the bathwater, the one shining beacon within a sea of scams.
As such, we decided to conduct deep-level diligence on CAST, to determine whether the perceptions match reality. Our findings have led us to conclude that CAST is beset by a long list of red flags. Based on our evidence, we believe CAST has materially misrepresented itself in its SEC financial statements. We have shared our findings with senior partners at Deloitte LLP, and urge them to consider our evidence when conducting their audit for ChinaCast for the fiscal year 2011. We have also shared our report with the Securities and Exchange Commission and the NASDAQ stock exchange.
Below we summarize certain red flags we found during our diligence on ChinaCast.
SAIC Filings report that the ELG business is substantially smaller than what is claimed by CAST in SEC Filings
We acquired the SAIC financial statements for ChinaCast Li Xiang Co., Ltd. (“CCLX”) and ChinaCast Technology (Shanghai) Ltd. (“CCT Shanghai”), which are the main operating subsidiaries that comprise the ELG segment. ELG accounted for 66% of the Company’s gross profit in 2010 and for 100% of the company’s gross profit prior to CAST’s first brick-and-mortar college acquisition in 2008.
According to SAIC filings, the subsidiary accounting for the ELG segment generated revenue of less than half of that reported in SEC filings from 2007 to 2009. In our report, we include photocopies of the annual inspection reports, as well as signed attestations by the subsidiaries’ legal representatives attesting that the information in the SAIC filings is valid and accurate.
Below are links to the SAIC filings and documents for CCLX. The documents include business license issuance notifications, notices of company name registrations, company bylaws, records of shareholder meetings, regulatory infractions, leases, and records of changes in registered capital and shareholders:
CCLX SAIC Filings (Chinese) (.pdf)
CCLX SAIC Filings (English Translation) (.pdf)
Of particular relevance to us are the 2008 and 2009 Annual Inspection Reports. Companies in China undergo annual inspections by their local branches of the Administration for Industry and Commerce. Included within these annual inspection reports are financial statements, as well as attestations by the companies’ legal representatives that the contents of the Annual Inspection Reports are accurate and valid.
Below are links to photocopies of the 2008 and 2009 CCLX annual inspection reports, as well as English translations.
CCLX Annual Inspection Report – 2008 (Chinese) (.pdf)
CCLX Annual Inspection Report – 2008 (English Translation) (.pdf)
CCLX Annual Inspection Report – 2009 (Chinese) (.pdf)
CCLX Annual Inspection Report – 2009 (English Translation) (.pdf)
In these documents, we see full balance sheets and income statements for fiscal years 2007, 2008 and 2009.
Below is a table summarizing the revenue and profit reported by CCLX in 2007, 2008 and 2009 (we use average annual exchange rates):
We can see that CCLX operates a profitable operation, according to SAIC filings, and posts revenue that is materially higher than other Chinese companies we have previously alleged to be fraudulent, such as China Education Alliance (CEU) and Advanced Battery Technologies (ABAT). Nevertheless, according to SAIC filings, ChinaCast’s ELG revenue is less than half of what it claims in SEC filings. According to 2009 SAIC financial statements, the CCLX annual revenue reported in China was less than one-fifth of the SEC revenue reported by ELG.
CCLX’s annual inspection reports include attestations by its legal representative that the information included in the annual inspection report is accurate and valid. Below we paste the relevant section from the 2008 annual inspection report, as well as an English translation:
click to enlarge
On the left, we have pasted the original Chinese photocopy of the attestation, while on the right we have provided an English translation of the primary document. Note that in the signature line, we see the name of Yin Jianping, who is currently the Vice Chairman of ChinaCast and has been previously described as “responsible for [ChinaCast’s] overall management, operations and strategic direction” (see here). Mr. Yin was the legal representative of CCLX prior to 2010.
We have also acquired historical SAIC filings for subsidiaries ChinaCast Co. Ltd. ("CCL") and ChinaCast Tecnology (Shanghai) Ltd. ("CCT Shanghai"), and provide them below.
CCT Shanghai Annual Inspection Report – 2008 (Chinese) (.pdf)
CCT Shanghai Annual Inspection Report – 2008 (English Translation) (.pdf)
CCT Shanghai Annual Inspection Report – 2009 (Chinese) (.pdf)
CCT Shanghai Annual Inspection Report – 2009 (English Translation) (.pdf)
CCL SAIC Filings and Annual Inspection Reports (Chinese) (.pdf)
CCL SAIC Filings and Annual Inspection Reports (English Translation) (.pdf)
Based on our reading of the company’s SEC filings, CCL is not consolidated into the company’s SEC financial statements and CCT Shanghai is supposed to be a non-operational shell whose revenue is merely the profit generated by CCLX. Nevertheless, an examination of the annual inspection reports of CCL and CCT Shanghai will demonstrate that even if the revenue of all entities were added together, the combined revenue would still fall substantially short of what the company reports for the ELG segment in its SEC filings.
Misappropriated Funds During College Acquisitions
Beginning in 2008, ChinaCast launched an expansion into brick-and-mortar colleges and universities in an effort to broaden its asset base within the growing Chinese education sector.
On April 11, 2008 and September 17, 2009, the company acquired The Foreign Trade and Business College of Chongqing Normal University. On October 5, 2009, CAST acquired Lijiang College of Guangxi Normal University. On August 23, 2010, CAST acquired Hubei Industrial University Business College (HIUBC). These three brick-and-mortar universities comprise the Traditional University Group (“TUG”) segment of ChinaCast.
Numerous red flags were highlighted about these acquisitions in a series of six research reports published by OLP Global LLC. As of our report’s publication date, these six reports can be found on the internet by typing the words “OLP global chinacast mailchimp” into Google.
We were impressed by the depth of diligence conducted by OLP and recommend all parties interested in ChinaCast acquire and read these reports.
The dates and titles of the report were as follows:
Date | Title |
Feb 16, 2011 | ChinaCast Education Corporation (CAST) - Show Me the Money! Questions to Management Regarding Acquisition #1 |
Feb 18, 2011 | ChinaCast Education Corporation (CAST) - Again, Show Me the Money! More Questions to Management Regarding Acquisition #1 |
Feb 28, 2011 | ChinaCast Education Corporation (CAST) - Red Flags in Acquisition #2 and Recent 8Ks |
March 7, 2011 | ChinaCast Education Corporation (CAST) - Our New Finding Directly Refutes CAST's SEC Filings |
March 16, 2011 | ChinaCast Education Corporation (CAST) - Red Flags in Acqusition #3 |
March 17, 2011 | ChinaCast Education Corporation (CAST) - 10K Reveals Material Weaknesses |
The company responded to several of the red flags raised in the OLP reports.
Their responses can be seen in the following SEC filings:
CAST Form 8-K from February 16, 2011
CAST Form 8-K from February 17, 2011
CAST Form 8-K from February 22, 2011
CAST Form 8-K from March 2, 2011
We highlight the two transactions that concerned us the most.
Allegations Regarding Foreign Trade and Business College of Chongqing Normal University
The company announced in SEC filings that it acquired a business college in 2008 for RMB 480 million. Yet, Chinese filings show that CAST paid only RMB 165 million for the asset. We question what happened to the remaining RMB 315 million, and whether it was misappropriated by insiders.
On April 11, 2008, the company acquired an 80% stake in the Foreign Trade & Business College of Chongqing Normal University (“FTBC Acquisition”). The company reported in SEC filings that it paid RMB 480 million for the acquisition. However, SAIC filings show that CAST’s wholly owned subsidiary Yupei Training Information Technology Co., Ltd. paid only RMB 165 million for the asset. When research firm OLP Global demonstrated this in a report, the company responded that the remaining amounts were paid by CCT Shanghai. However, the 2008 SAIC filings for CCT Shanghai report that no funds were paid by CCT Shanghai for the FTBC Acquisition, and that cash paid for acquisitions from CCT Shanghai was negligible in 2008. When OLP explained this in a subsequent report, CAST did not reply.
We provide links to the relevant source documents in our longer report.
Allegations regarding Lijiang College
CAST appears to have overpaid for its 2009 acquisition of Lijiang College by at least RMB 113 million, based on information from SAIC filings as well as documents filed with Chinese securities regulators that are easily accessible on the internet. We question whether the RMB 113 million was misappropriated during the acquisition.
For the acquisition of Lijiang College of Guangxi Normal University in October 2009, ChinaCast disclosed in SEC filings that it would pay a total consideration of RMB 365 million, of which RMB 295 million was paid in 2009 and the remaining contingent consideration would be paid in 2010. But Shanghai Xijiu Information Technology Co. Ltd. (“Xijiu”), the entity from which CAST purchased Lijiang, had only paid RMB 182 million to acquire Lijiang several weeks earlier, according to Chinese filings. Furthermore, Xijiu was set up by a former CAST employee and its 100% owner at the time of the acquisition was a farmer from Fujian province who did not graduate high school. It strikes us as unlikely that an under-educated farmer was the ultimate recipient of the proceeds from the acquisition of Lijiang College. The question emerges whether this acquisition was used to misappropriate funds during the acquisition of Lijiang College.
In our longer report, we provide source documents detailing the acquisition of Lijiang College by Xijiu from its sellers Wuhan Humanwell Hi-Tech Industry Co., Ltd. (“Humanwell”), a publicly listed company on the Shanghai Stock Exchange with the ticker 600079, and Wuhan Hengjiantong, a private company. Through Chinese filings, including documents submitted by Wuhan Humanwell to the Shanghai Securities Exchange that are publicly accessible to anyone who visits here, as well as the SAIC filings of Xijiu, we can see that Xijiu purchased Lijiang College for only RMB 182 million.
Yet while Xijiu paid RMB 182 million to acquire Lijiang College, ChinaCast paid RMB 295 million to acquire Xijiu. The RMB 113 million difference went to Xie Jiqing, a farmer from Fujian province. Let’s not forget that Xijiu is an entity set up by a former CAST employee, and that Xijiu had purchased Lijiang College only a few weeks before CAST purchased it from Xijiu.
What happened to the RMB 113 million difference between the price paid by CAST and the price paid by Xijiu for Lijiang College? Who exactly is this farmer who happened to gain control of a British Virgin Islands-based entity that purchased a college in China and then flipped it for a quick RMB 113 million profit to ChinaCast? Did the RMB 113 million end up in his bank account, or in someone else’s?
Unnecessary Capital Raises
When we come across U.S.-listed Chinese companies exhibiting red flags, such as mismatching SAIC financial information and suspicious acquisition transactions, we examine whether the companies have conducted unnecessary capital raises at low valuations.
ChinaCast has completed several secondary public offerings. They also conspicuously diluted their outstanding shares in 2008 by voluntarily reducing the strike price of their legacy SPAC warrants in order to raise $15 million from three hedge funds.
The first secondary public offering was announced on September 26, 2008. The company raised $11.1 million of capital through a secondary equity offering arranged by Roth Capital. Roth also received warrants in addition to their customary underwriting fee. The offering was priced at an 18% discount to the closing price of CAST stock on the day prior to the announcement, and a 31% discount to the average closing price of CAST stock for the 30 days prior to the announcement. These are large discounts.
At the time of the capital raise, the company was trading at an EV/EBITDA multiple of 3.9x and a P/E ratio of less than 10x. These were low multiples for a company that was supposedly growing through the recession unfazed (non-acquisition-related gross profit increased 25% from FY 2007 to FY 2008).
At the time of the capital raise, the company had $57 million of cash on the balance sheet, and according to its SEC financial statements, the company generated $11 million and $31 million of cash flow from operations in 2007 and 2008, respectively. According to the offering prospectus, the proceeds would be used to “fund product development, corporate growth and for other general corporate purposes.” The offering was completed five months after the completion of the FTBC 80% stake acquisition, and it would be nearly a year before CAST announced its next college acquisition.
In our opinion, CAST’s first secondary offering suffers from many of the red flags we have seen in the past. The company raised cash from US investors despite reporting substantial cash on the balance sheet, healthy operating cash flow and no immediate need for the cash proceeds. Furthermore, the capital was raised while the company was trading at a low valuation, and at a large discount to its prior 30-day trading average.
Chinacast’s second public offering to US investors was announced on December 2, 2009. The company raised $46.7 million in an offering arranged by Roth, Brean Murray and Global Hunter. The offering was priced at a 6% discount to the closing price of CAST stock on the day prior to the announcement, and a 4% discount to the average closing price of CAST stock for the 30 days prior to the announcement.
At the time of the capital raise, the company was trading at an EV/EBITDA multiple of 8.3x and a P/E ratio of 31x. These multiples and discounts were reasonable metrics at which to raise capital (assuming, of course, that the EBITDA and EPS figures were accurate).
At the time of the capital raise, the company supposedly had $100 million of cash on the balance sheet, and according to its SEC financial statements, the company generated $31 million and $20 million of cash flow from operations in 2008 and 2009, respectively. According to the offering prospectus, the proceeds would be used “for working capital, future acquisitions and general corporate purposes.” The company had closed its Lijiang College acquisition three months earlier, and therefore the company did not need the capital for the Lijiang acquisition. The company announced the HIUBC acquisition in April 2010, four months after the capital raise, and the total spent on HIUBC according to SEC filings was $66 million.
Again, this secondary capital raise struck us as unnecessary because the company supposedly had $100 million of cash on its balance sheet for potential acquisitions, such as the one of HIUBC announced several months later.
Lastly, in June and July of 2008, the company voluntarily reduced the strike price of its warrants to allow several hedge funds to exercise their otherwise out-of-the-money warrants. The company even issued additional shares to the hedge funds as part of the warrant amendment. Press releases announcing these warrant amendments can be found here and here.
To understand the nuances behind this action, which we consider highly dilutive and essentially equivalent to a capital raise, it’s important to provide some background. ChinaCast was originally a Singapore-listed company that switched to a U.S. exchange by being acquired by a U.S.-listed Special Purpose Acquisition Company (“SPAC”) in December 2006. This SPAC had warrants outstanding at the time of the 2006 acquisition that were exercisable at $5.00 and expired in March 2009. In 2006 and 2007, no warrants were exercised. In 2008, the Company’s shares fell below $5, rendering the warrants out-of-the-money.
Intuitively, the potential removal of CAST’s large warrant overhang should have been a boon and welcomed as a silver lining to the company at the time. The legacy SPAC warrants would constitute more than a third of the company’s outstanding shares upon exercise, and if they expired worthless, the intrinsic value of the common shares would increase substantially.
Yet, when the company’s stock price declined below $5, ChinaCast voluntarily entered into an agreement with three shareholders in June and July of 2008 to reduce the exercise price to $4.25 in order to allow the hedge funds to exercise their warrants. Even more conspicuously, ChinaCast issued additional restricted shares to entice the hedge funds to participate in the transaction. In total, three hedge funds exercised 3.5 million warrants, increasing the Company’s outstanding shares by 13%. The 537,311 newly issued restricted shares increased the share base by another 2%.
The warrant exercise resulted in $15 million of new cash being sent to CAST’s bank accounts.
This transaction effectively functioned as a capital raise. When the hedge funds exercised their warrants, the company essentially raised $15m of new capital by issuing shares.
As with the two public offerings, let’s examine the company’s financial metrics at the time of the warrant amendment. As of the day of the first announcement, the company was trading at an EV/EBITDA multiple of 4.4x, pro forma for the acquisition of the 80% stake in FTBC made two months prior to the warrant amendment.
As with the first capital raise, we note again the low company valuation at the time of the warrant amendment.
Prior to the warrant exercise, the company supposedly had a cash balance of $57 million, if we use the cash balance as of June 30, 2008. We question why the company needed the cash receipts from the warrant exercise, and why they were willing to reduce the strike price of the warrants when the company was trading at such a low valuation.
Conclusion
We believe that ChinaCast Education Corporation is misrepresenting itself in its SEC financial statements. Based on our evidence, we believe that the actual underlying ELG business has historically generated materially less revenue and profit than what the company has reported in SEC filings. We also provide evidence that funds may have been misappropriated during two of the company’s college acquisitions; when faced with these allegations, the company’s unwillingness to publicly address these issues in a clear, straightforward manner made us further concerned about CAST.
Below, we summarize some of the most serious red flags that we found when researching ChinaCast:
The SAIC filings for the main operating subsidiary of the company’s ELG segment show materially less revenue and profit than what the company reports in SEC filings. In our report, we include photocopies of the annual inspection reports, as well as signed attestations by the subsidiaries’ legal representatives attesting that the information in the SAIC filings is valid and accurate.
SAIC filings provide evidence that shareholder funds were misappropriated during the company’s acquisition of a business college in 2008. The company announced in SEC filings that it acquired a business college in 2008 for RMB 480 million. Yet Chinese filings show that CAST paid only RMB 165 million for the asset. We question what happened to the remaining RMB 315 million, and whether it was misappropriated by insiders.
Filings with Chinese Securities Regulators and the SAIC provide evidence that funds were misappropriated during the acquisition of another college in 2009. During CAST’s 2009 acquisition of Lijiang College, Chinese filings show that CAST paid at least RMB 113 million more than what the sellers of the college sold it for. The RMB 113 million difference appears to have been pocketed by a farmer from Fujian province through an intermediary holding company previously set up by CAST. We question whether the RMB 113 million was misappropriated during the acquisition. We are furthermore concerned by CAST’s unwillingness to directly address these specific allegations in a public manner when it had the opportunity to do so.
The company has repeatedly raised cash through secondary equity offerings and unnecessary warrant amendments, despite having a large amount of cash on its balance sheet. In multiple situations, capital was effectively raised at low valuations, diluting shareholders in what we believe would be an irrational manner if the company’s SEC financial statements were accurate.
We urge officials at Deloitte, NASDAQ and the Securities and Exchange Commission to review our report. In our opinion, CAST is providing misleading financial information to one set of regulators, given that SEC and SAIC financial statements diverge by a material disparity. We believe it is the American regulators and investing public that are being misled.
Disclosure: I am short CAST.
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