Cabeza's Blog of = Two-in-One Stocks

Monday, April 20, 2009

Uncovering=20 China Sky One Medical's Shoddy Practices

In a previous=20 post I raised questions about China Sky One Medical Inc. (Nasdaq GM: = CSKI),=20 including an unusual insider stock transaction, past accounting = irregularity,=20 use of dubious auditors, frequent changes of auditors, and the = appointment of a=20 non-financial graduate student as a director and =E2=80=9Caudit = committee financial=20 expert.=E2=80=9D

Here I=E2=80=99m trying to unveil China Sky = One=E2=80=99s despicable,=20 fraudulent business practices with hard facts. (Note: some of the = links=20 provided below can be slow or not functioning occasionally. If that = occurs to=20 you, just try again at a later time. In some cases, I provided double = links.=20 Note also that many of the links given here had their origin in = government or=20 quasi-government websites.)

A = =E2=80=9CFlagship Product=E2=80=9D=20 that Rips Off Consumers

Weight-loss products account for 24.3% of = CSKI=E2=80=99s total=20 revenue in the first nine months of 2008. And most of the weight-loss = revenue=20 came from company=E2=80=99s flagship product: Sumei Slim Patch.

CSKI=E2=80=99s operating company Harbin TDR (short = for Harbin Tian Di=20 Ren) promotes Sumei Slim Patch as an effortless, fast-track =E2=80=9CSleep & = Slim=E2=80=9D=20 weight-loss panacea. The Sleep & Slim patch (=E2=80=9CShui-shui = Shou=E2=80=9D or

In 2007, company=E2=80=99s ad for Kangxi hemorrhoid = ointment was found (see here = also) by Hebei=20 Province=E2=80=99s Food & Drug Administration to have illegally used = absolute=20 language to exaggerate its=20 efficacy.

Here=20 and here<= /A>=20 you can also see a consumer sharing his experience with this product. = He/she=20 wrote on January 9th this year: "The American Kangxi hemorrhoid magnetic = ointment is a scam. I was swindled 600 Yuan. After I used it for a = month, not=20 only didn't it cure my illness, it actually has made it worse. ... ... = Hope=20 everybody learns a lesson from me, and not get swindled again."

(Harbin TDR promoted its products as American = products in=20 China because its holding company CSKI is registered and traded in U.S. = Some=20 other U.S.-registered Chinese companies also have this practice. = Sometimes this=20 caused confusion among consumers, like this consumer also complained: "I = found=20 it to be produced by Harbin TDR; not an American product at = all.")

In 2004, seven of the company=E2=80=99s Kangxi = brand products=20 (covering genital cleaning, skin care, throat care, and nasal care) = showed up in=20 a banned=20 list of illegal products which were linked with exaggerated ads.

In 2003, Tianjin Bureau of Health include= d=20 company's foot care product Kangxi Jiaoshuangling in its blacklist of 68 = illegal=20 products.

In 2003, Qingdao Wanbao (Evening News) counted = Harbin TDR=E2=80=99s=20 skin care product Kangxi Fushuangling in one of the city=E2=80=99s top 10 = cases=20 of violation of national food & healthcare law. It charged the = product as=20 exaggerating treatment effectiveness.

Master in = Exploring=20 the "Gray Area"

The management=E2=80=99s = =E2=80=9Ccreativeness=E2=80=9D in marketing strategies lies=20 in its bold exploration of the "gray area" of TV shopping, a relatively = young=20 and loosely regulated area in China.

TV shopping programs usually do not have a public = address.=20 Products are sold via telephone hotlines, delivered to = consumers=E2=80=99 doorsteps, and=20 often without receipts. Post-sale services are virtually nonexistent, = with=20 service numbers constantly busy or not answering.

Sometimes consumers are required to contact = manufacturers=20 directly for post-sale problems. A lot of consumers simply do not have = the time=20 and/or knowledge to pursue manufacturers. This creates an ideal = condition for=20 sales with extra low product return rate.

In such shoddy marketing setups, marketers are = often willing=20 to bear the major share of blame when regulators show up. This way, the=20 manufacturers can continue its business almost as usual.

To a short-sighted management team, the only loser = in this=20 game seems to be the consumer. Now that regulators do not force them out = of=20 business, this same strategy always has the hope of revival in the = future.

Indeed, if you know Chinese and have read th= is=20 report carefully, the top sales representative of the Sumei Sleep = & Slim=20 Patch Ms. Lin has made it clear that similar TV promotion is going to = resume in=20 2009.

Why were the fraudsters so confident about their = comeback?=20 Simply put, they are familiar with China=E2=80=99s regulatory = environment. Policy=20 enforcement comes in pockets and waves. Tight periods are followed by = loose=20 ones. Even during periods of enforcement, punishment is often little = more than=20 forced suspension of the shoddy marketing programs. There can be fines. = But=20 often the punishment is "worth the while."

Besides, local governments often race to promote = and protect=20 businesses in their own jurisdictions. So, even though an officer of=20 Heilongjiang=E2=80=99s provincial FDA to= ld=20 reporters that any promotion of Sumei Slim Patch is illegal beyond = its=20 registered indication of Simple Obesity, there do not seem to be reports = on any=20 disciplinary action from Harbin TDR=E2=80=99s provincial or municipal = government.

(Some observers have questioned if Sumei Slim = Patch=20 qualifies as a weight-loss product at all. As some of the reports above, = e.g.,=20 this= =20 and this,=20 pointed out, the patch actually has to be used in combination with = weight-loss=20 medicines to be =E2=80=9Ceffective.=E2=80=9D)

Then, there also comes the Chinese business culture = of=20 "Guanxi" (connection). If a management has good Guanxi in the = government, it=20 becomes relatively easy for them to survive regulatory troubles.

As the ultimate victims, Chinese consumers = apparently might=20 not agree to this lenient regulatory environment for enterprises. But it = is hard=20 to blindly blame the government. Recall all the actions mentioned = previously=20 that the various government organizations have taken in this Sleep & = Slim=20 scam?

Apparently Chinese government is trying to strike a = balance=20 between protecting consumers and having too rigid and restrictive rules = that=20 might stifle entrepreneurial creativity altogether. For Sleep & = Slim,=20 authorities in several provinces have issued consumer alerts, launched = consumer=20 education campaigns, and solicited consumer complaints actively.

It appears that the government prefers these soft = measures=20 over hard ones. After all, if consumers know what products to avoid,=20 perpetrators will have received some punishment through loss of sales = and=20 tainted brands. Many violators will also have learned a lesson and be = given a=20 chance to take corrective measures and seek lasting prosperity by = remaking=20 themselves.

Sadly this inevitably leaves plenty of = opportunities for=20 recidivists. They constantly tweak their skills of deception and test = government=20 and consumers=E2=80=99 limits. They aim to get = =E2=80=9Cstronger=E2=80=9D after each cycle, much like=20 how viruses work.

However, no matter how handy they can hide behind = marketers=20 and lenient regulatory environment, it is unlikely that fraudulent = business=20 practices can thrive over the long term.

Consumers always wake up and revolt, particularly = in this=20 information age when bad news can travel by the speed of light. When the = time of=20 reckoning comes, investors would be the ones to pick up the bill.

Or maybe that is of the least concern to this = management?=20 Anyhow, if a "clarification" ever needs to be given to the investors, it = would=20 be "the company does not have control over how our marketers behave." = Are you=20 feeling sympathetic already?

Questionable=20 Financial Control

Asensio, a trading firm specializing in = short-selling, has=20 published a report=20 about CSKI=E2=80=99s auditors. It has found that all four (previous and = current)=20 auditors were investigated or sanctioned by SEC, PCAOB, or other = regulators.=20 CSKI=E2=80=99s current auditor, MSPC, was at the center of a scandal and = was sanctioned=20 by SEC in 1999.

Aside from Asensio's findings, on November 30th = 2005, PCAOB=20 issued an inspection=20 report on MSPC. PCAOB found six areas of audit deficiencies and = concluded=20 that =E2=80=9Cthe deficiencies identified in three of the audits = reviewed included=20 deficiencies of such significance that it appeared to the inspection = team that=20 the Firm did not obtain sufficient competent evidential matter to = support its=20 opinion on the issuer's financial statements.=E2=80=9D

As an update to my last=20 post, Mr. Jiang Qi Feng, a young graduate student (now 26) with no = prior=20 financial background, is still serving (as of April 15th) as an = =E2=80=9Cindependent=E2=80=9D=20 director and =E2=80=9Cfinancial expert=E2=80=9D on company=E2=80=99s = Audit Committee, Compensation=20 Committee, Executive Committee, and Finance Committee.

Some investors have also been highly skeptical = about CSKI's=20 reported gross margin. In a highly competitive industry, CSKI has been = able to=20 report markedly higher gross margin (in the high 70s) than competitors. = Its=20 reported gross margin also stayed amazingly steady even as its product = mix and=20 in particular, average selling prices (ASP) for key segments, changed=20 significantly (sometimes wildly) from quarter to quarter.

When so many scandals and questions surround a = single=20 company, chances are there is a major credibility crisis hidden = somewhere.=20

Disclosure:=20 Author is short CSKI as of this writing.

Table of Contents

=E2=96=BC 2009=20 (2)=20
- =E2=96=BC 04= =20 (2)=20
  - Uncovering=20 China Sky One Medical's Shoddy Practice...=20
  - Is=20 CSKI=E2=80=99s Late Filing of 10-K a Warning Sign? =

=E2=96=BA 2008=20 (1)=20
- =E2=96=BA 09= =20 (1)=20
  - Better=20 Days Ahead for China Yingxia

=E2=96=BA 2007=20 (13)=20
- =E2=96=BA 12= =20 (1)=20
  - Giant=20 Interactive=E2=80=99s Industry Leading Position and ... =
- =E2=96=BA 11= =20 (3)=20
  - Giant=20 Interactive: A Giant Cash Machine=20
  - Wall=20 Street's No Confidence Vote on TCM=E2=80=99s Manageme...=20
  - Brand=20 Protection Key to TCM=E2=80=99s Long-Term Success =
- =E2=96=BA 10= =20 (1)=20
  - A=20 Dozen Reasons Why I'm Bullish on TCM
- =E2=96=BA 09= =20 (1)=20
  - Critical=20 Moment for China Expert Technology
- =E2=96=BA 06= =20 (1)=20
  - CGG=20 Veritas, a Veritable Bargain
- =E2=96=BA 05= =20 (2)=20
  - Erratum=20 and Update on CIWT=E2=80=99s Valuation Ratios=20
  - A=20 Cute Little Cash Cow in China's Industrial Trash... =
- =E2=96=BA 04= =20 (1)=20
  - Patterson-UTI=20 Energy, to Hate or to Like?
- =E2=96=BA 03= =20 (1)=20
  - More=20 on China Medical Tech's Growth Strategy
- =E2=96=BA 01= =20 (2)=20
  - Thoughts=20 on CMED=E2=80=99s Debt and Equity=20
  - CMED:=20 a Company with a Clear Growth Path=20

=20

Featured Companies

China = Sky One=20 Medical (Short) (CSKI)

Uncovering=20 China Sky One Medical's Shoddy Practices=20

Is=20 CSKI=E2=80=99s Late Filing of 10-K a Warning Sign? =

Giant=20 Interactive (GA)

Giant=20 Interactive=E2=80=99s Industry Leading Position = and Competitive=20 Advantages=20

Giant=20 Interactive: A Giant Cash Machine=20

China=20 Medical Tech (CMED)

More=20 on China Medical Tech's Growth = Strategy=20

A=20 Company with a Clear Growth Path=20

CMED's=20 Debt and Equity=20

=20

About Me

Cabeza Howe=20: I'm a scientist, software programmer and = individual investor. When selecting my own investment, I love to dig = deep into=20 a company, its industry, and identify macroeconomic forces driving the = industry's long-term prospects. I found good use of my research, = analytical,=20 mathematic, financial, and software skills in this process. Once I = have my own=20 in-depth research report in place, I often buy and sell against the = trend. And=20 yes, I do a little short-term trading too. But focused value investing = is my=20 passion. My favorite quote is "market is designed to transfer wealth = from the=20 active to the patient," by Warren Buffett.

View my = complete=20 profile=20

=20

Cabeza's Blog of Two-in-One Stocks

Monday, April 20, 2009

Uncovering=20 China Sky One Medical's Shoddy Practices

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