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Release Date: April 24, 2012

Huabao International
Smoke and Mirrors

Ticker: Recent Price:

0336:HK HK$4.33

Target Price: Implied Return:

HK$7.80 80.0%

Market Cap:
Dividend Yield:

HK$14 billion

Strong Sell

You should have expected us

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Executive Summary
We see Huabao International as a pump and dump scheme with the primary objective of enriching its Chairwoman, Chu Lam Yiu and her proxies at the expense of shareholders. Since the inception of Huabao, Ms. Chu has sold nearly US$1.2 billion in stock, bringing her ownership of the Company from 97.6% to 37.7% News searches prior to the founding of Huaba in 2004 reveal no history of Ms. Chu, yet her sudden accumulation of wealth has not gone unnoticed. Last year Ms. Chu was ranked the 8th richest woman in China at the age of 41 on Huruns list of Self-Made Women Billionaires. Notably, Hurun also published a Cashout List, which lists billionaires who have been cashing out of their own companies. The list places Ms. Chu at No. 2, having cashed out of US$549 million last year alone. The sum was so large that she was dubbed the Queen of Cashout by the Shanghai Daily. As detailed in this report, Huabao International came public via a reverse merger into a defunct company ( Leaktek Ltd.) which had failed due to fraud. Shortly thereafter, Huabaos auditor (Deloitte Touche Tohmatsu) resigned. Among its peers, Huabao reports the highest margins and the highest revenue growth, while maintaining some of the industrys lowest R&D expense. While all industry peers report gross margins in the 40-50% range, Huabao reports consistent margins upwards of 70%. Further, following the shell entitys acquisition of the core Huabao business in 2006, the margins of the target increased dramatically despite there being no notable synergies or change in management. From inception until August 2011, Huabaos Audit Committee Chairman was Mr. Mak Kin Kwong. Mr. Mak was forced to resign following a trifecta of fraud charges and investigations from securities regulators in each of mainland China, Hong Kong, and the US. In each case, Mr. Mak was involved as a director or CFO of a publicly listed company which was delisted or halted due to fraud. The companies include: A-Power (formerly Nasdaq: APWR) delisted due to fraud; Chengdu Unionfriend (formerly SHZ:000693) delisted due to fraud; Real Gold Mining (HKG:0246) halted due to fraud. Huabao has made efforts to conceal its operations by using such tactics as substantially reducing its public disclosures in financial reporting and using Photoshop to hide the location of one its facilities. Undeniably, Huabaos greatest shield against market scrutiny has been its large dividends. Management makes a point of noting that Huabao has paid out HK$2.4 billion in dividends since inception. What management declines to mention is that throughout this period, half of all dividends have circled back to the Chairwoman due to her interest in Huabao. With the Chairwoman having sold out the majority of her stake, Huabao has managed dividend expectations significantly lower by entering a highly capital intensive industry. Reducing dividend expectations was crucial because we have evidence that Huabao is not nearly as profitable as it claims. Huabaos Chinese filings show large discrepancies from Hong Kong filings. Many of Huabaos supposed customers do not consider themselves customers or have simply never heard of Huabao. Furthermore, as evidenced in this report, we believe Huabao has undertaken massively inflated related party transactions in an attempt to avoid paying dividends when possible and to explain to auditors why their bank account is empty.

Flavours and Fragrances: Industry Primer

Huabao International is undisputedly Chinas largest flavour & fragrance (F&F) company. With gross margins of 75%, some have quoted its dominance of the Chinese industry as a near monopoly. The F&F industry supplies flavours and fragrance that are used in a wide array of products: foods & beverages, cosmetics, detergents, and tobacco products, to name a few. As presented in Exhibit 1, there are several major or otherwise relevant F&F companies we have used as comparables in this report. Exhibit 1 Peer Comparables Company Huabao International China Flavors & Fragrances International Flavors & Fragrances Symrise Givaudan


Market Cap (US$) 2,000M 95M 4,740M 3,341M 8,870M

Geography China China Global Global Global

Focus Tobacco Tobacco F&B, Consumer F&B, Consumer F&B, Consumer

As shown, International Flavors & Fragrances (IFF), Symrise, and Givaudan are global industry players that primarily supply flavouring to the consumer market, specifically food & beverages, cosmetics, and household products. On the other hand, Huabao and China Flavors & Fragrances (CF&F) are domestic companies that primarily supply Chinas tobacco industry. Flavours & Fragrances in Cigarette Manufacturing While F&F in consumer products should be intuitively understood, its use in tobacco products may not be. So, here we give an overview of the tobacco flavoring application and process, specifically as it pertains to cigarettes: The manufacturing of a cigarette stick goes through several stages. One of these stages is called casing or topping. In the casing process, loose tobacco leaves are sprayed with flavoring agents such as cocoa, licorice, glycerin, and other additives. This process helps mask the smell of tobacco, enhances overall flavour during smoking, and can provide the distinctive signature of a brand. Sometimes cigarette filters can also be dipped in flavouring, but these are generally considered specialty cigarettes and are a very small portion of the overall cigarette market. In China, the manufacturing of tobacco products is strictly controlled by the State Tobacco Monopoly Administration (STMA). The STMA is a government body that is responsible for enforcing the tobacco monopoly in China. Under the STMA, there are several state-owned enterprises (SOE) that manufacture, market, and distribute all the cigarettes and tobacco products consumed in China. As a result, Huabaos primary customers are government-controlled entities. </primer> 3

Over the last five months, we have expended considerable resources and time analyzing Huabao. We have pored over every public filing since Huabaos reverse merger. We have pulled 23 sets of SAIC documents covering all of Huabaos relevant subsidiaries. We have made over 150 phone calls to the SOE dominated tobacco industry, resulting in conversations with representatives from all the major cigarette manufacturers. We have spoken with customers, competitors, and industry experts. We have gone to unbelievable lengths to locate facilities and shadow figures that management had hoped to keep secret. We have dispatched teams to multiple locations spanning three continents. We have a better understanding of Huabao, its operations and its associates than any bank, analyst, or institution. This is not a statement of opinion. This is a statement of fact. This report presents our evidence and conclusion. We review Huabaos backdoor listing, its history of related party transactions, massive insider selling, and suspiciously strong financial metrics. We also detail our business diligence findings gathered from a large number of calls and site visits. Altogether, we present evidence of a pump and dump operation that is misleading its shareholders and grotesquely exaggerating its business.


[sec 1]

We lay the groundwork for our analysis by providing a summary of Huabaos colorful history. April 30, 2004 Huabao International goes public through a backdoor listing. It should be noted that backdoor listings, by definition, are designed to circumvent listing rules and avoid independent scrutiny of business operations and corporate governance. They are also significantly more prone to issues of fraud and corruption. It is utterly inappropriate for a company that deals primarily with state-owned enterprises (SOEs) to go public in such a manner. It should also be noted that Huabao went public through Leaptek Limited, a company whose business operations primarily consisted of consumer electronics, computer products, and fraud. To be perfectly clear, Leaptek was not merely a shell entity or capital pool company type vehicle awaiting a backdoor listing. It had a highly questionable history consisting of auditor resignations, director resignations, management firings, and cooked books deserving of its own investigative report. Despite all this, it took Huabao over two years to slowly wind down Leapteks phantom business before eventually discarding it for HK$1. March 28, 2006 Deloitte Touche Tohmatsu resign as the firms auditors. The Event: Within two years of the backdoor listing, Huabaos auditors resign. Managements Response: In a released statement, management claims the resignation of Deloitte was a result of fee disputes.1 The Truth: As we mentioned in a previous report, auditors rarely resign as a result of fee disputes. There is sufficient competition among the Big Four and second tier audit firms to ensure they dont nickel and dime clients. Fee disputes are almost exclusively used as a means for auditors to resign without being forced to bring attention to uncovered financial irregularities. In fact, a paper released in 2010 by the Hong Kong Institute of Certified Public Accountants states the following: The Stock Exchange of Hong Kong Limited (SEHK) and the Securities and Futures Commission (SFC) have raised concerns with the Hong Kong Institute of Certified Public Accountants concerning announcements made by listed issuers of the SEHK of the reasons for changes in auditors. In many cases, fee disputes are stated to be the reason for the change. Concern has been expressed that certain auditors have been relying on purported fee disputes to disguise the real reasons for the change. As a result, potentially significant and fundamental matters about the listed issuer may not be disclosed to investors and creditors and the market is not therefore being kept fully informed. It is important that the situation concerning the change of auditors should be disclosed in full to avoid the possibility of the market being misled.2
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Clearly, Huabaos origins are consistent with excellence in corporate governance and transparency. But a backdoor listing and questionable auditor resignation are not the only red flags in Huabaos opaque history, which also involves absurd related party transactions, massive insider selling, and awkward executive resignations. A discussion of these issues follows:

Related Party Transactions

August 1, 2006 Huabao acquires substantial assets through the Chairwoman, part I The Event: Huabao, as a shell company, acquires Chemactive Investments Limited, a flavor and fragrance supplier to the tobacco industry.


The acquisition price was HK$4 billion (US$513M) in convertible preferred shares, based on 13.6 times the targets net income of HK$294 million (US$37M)3. To put that number in perspective, the net income for Huabao during the same time period was a loss of HK$7 million (US$0.9M). This massive acquisition of a highly profitable company was by way of an asset injection through its then 36 year-old CEO and Chairwoman, Ms. Chu Lam Yiu. Our Take: (i) The share dilution and new convertibles effectively gave Ms. Chu 97.57% ownership of the combined entity. Based on its financials, Chemactive claimed net income of HK$294M, total assets of HK$869M, and net equity of HK$498M. Thats an ROA of 35% and ROE of 61%. Okay, well play along. (iii) We certainly do believe Chemactive had a legitimate operating business in tobacco flavoring, as is evidenced by their JV with Hongta Tobacco Group, a prominent SOE tobacco company. But as we show in this report, we also believe that the extent of the business was, and continues to be, exaggerated. Chemactive was in the business of providing flavoring to the tobacco industry, a very mature, very established field controlled entirely by SOEs. We find it improbable that a 36 year-old was able to break into this field and build a multi-billion dollar empire. In fact, a search on Factiva and Lexis-Nexis for Chu Lam Yiu displayed no articles or news information prior to 2004, the year she purchased Leaptek. As part of the acquisition, Ms. Chu signed a non-compete agreement. This agreement stipulated that Ms. Chu no longer owned any business or interest that would compete with Huabao.




The acquisition of Chemactive provided the backbone of Huabaos current business operations. As we demonstrate throughout this report, we also believe this acquisition was the basis of what would become a materially exaggerated business operation designed to benefit insiders and their proxies.

July 30, 2007 Huabao acquires substantial assets through the Chairwoman, part II The Event: Huabao acquires Win New Group Limited and its subsidiaries, a flavor and fragrance supplier to the tobacco and food industry. The acquisition price was HK$652 million (US$84M) in cash, based on a whopping 21 times the targets net income of HK$31 million (US$4M). This acquisition was also by way of an asset injection through Ms. Chu. Our Take: (i) Remember the non-compete clause that was signed by Ms. Chu 11 months earlier when she sold Chemactive to Huabao? The one that stated she had no interest in a competing business? Well, within 11 months she managed to buy this tobacco flavor company from a third party only to resell it to Huabao for HK$652 million. No lack of transparency here. There is absolutely no legitimate reason for the Chairwoman to privately buy a company only to resell it to Huabao. Acquisition by asset injection through a related party rather than M&A through independent parties is completely inappropriate and should immediately raise red flags with investors. We believe the absurd acquisition price combined with the nature of the acquisition was simply a way to transfer fake earnings/cash out of the Company. More on this later.


July 7, 2008 Huabao acquires substantial assets through the Chairwoman, part III The Event: On March 26, 2008, Ms. Chu privately acquired Wealthy King Investments and its subsidiaries (a tobacco flavoring company) from a third party. She paid for the acquisition by transferring HK$451 million (US$58M) worth of her share holdings in Huabao to the vendor, plus an undisclosed amount of cash.4 Three months later (July 7, 2008), she turned around and resold Wealthy King Investments to Huabao for HK$871 million (US$112M). This price was based on 12 times the targets unaudited net income of HK$70 million (US$9M). Our Take: (i) (ii) It speaks volumes that such a significant, yet opaque, transaction went through unaudited. We challenge investors and the analysts that are promoting this stock to answer the following questions: Is this how a transparent management team operates? Is there any legitimate reason for these types of transactions to be taking place?

November 20, 2009 Huabao acquires substantial assets through the Chairwoman, part IV The Event: Huabao acquires F&G Botswana, an African-based raw materials supplier to Huabao, which is 100% owned by Ms. Chu. The acquisition price was HK$29 million (US$3.8M) in cash, implying 7.3 times multiple on the Targets approximate net income of HK$4 million (US$0.5M).5 Our Take: We found this acquisition somewhat peculiar given managements modus operandi. The acquisition price seemed reasonable enough to not raise any attention, but we found it strange that Huabao would establish such a remote base which management claims is in the business of production and sales of natural extracts and provides the Company with an established upstream raw material extraction base. Our initial thoughts were that perhaps Botswana was home to a unique species of flora which Huabao used extensively in its flavouring business. But this theory began to make little sense when one considers that importing raw materials would likely be much less costly than establishing and manning an extraction base in such a remote location. Furthermore, it appears that management has gone to great lengths to hide the location of the Botswana base. We say this for several reasons: First, as shown in Exhibit 2, management provides country and city locations of all their facilities in their annual report. They even provide the city where their German R&D base is. However, they make no mention of the city where F&G Botswana is located. Exhibit 2

Source: Company report

Second, as shown in Exhibit 3, management went through the unusual step of photoshopping the only publically available picture of the Botswana facility (shown in the 2009-2010 annual report). This photoshop job removed the address of the facility again, an unusual move given that management was more than willing to provide the exact facility addresses in the circulars they released as part of their acquisitions of Win New Group and Wealthy King Investments.

Exhibit 3 Altered picture from Huabaos annual report

Picture we took

As we said, it appears management has gone to extreme lengths to hide the facility. But thats okay, we found it anyway. This operation was not an easy task. But perhaps the only thing more difficult than finding the location, was traveling to it, which took us three days of air travel. And our commute only happened to be so short because the construction of a domestic airport had recently been completed. So, what reason would management have to build a raw material extraction base in such a remote location and go to unusual efforts to hide its coordinates? As we found out, the business of natural extracts has little to do with it. The base is used for a different sort of business entirely, which we will forego discussing in this report. Instead, we will leave the details to Huabao and allow management to explain. Moreover, it might be more interesting to hear from Huabao who their end clients are. That said, we believe if management were forthcoming with the operations of the Botswana facility, it would very likely throw into questions Huabaos margins, and possibly cause investors to re-risk the Company.

Chairwomans Share Disposal


As will become evident throughout this report, Huabao is surrounded by a level of opacity rarely seen in a public company. But one point that the public filings make perfectly clear is the tremendous amount of money that Ms. Chu has made by selling out of Huabao. Ms. Chu initially held 97.6% of Huabaos outstanding shares following the backdoor listing. After years of share placements, share transfers and even an acquisition completed personally by Ms. Chu and paid for by Huabao stock, her interest has dwindled to 37.7%. Below is a summary and timing of Ms. Chus share disposition:

Ms. Chus starting stake: 97.6%

August 3, 2006 The Chairwoman disposes of her shares, part I The Event: Within two days of closing the Chemactive acquisition, Ms. Chu converts and dumps her newly acquired shares. This disposal was of 690 million shares at HK$2.20 per share, a 22% discount to the previous days closing price.6 The disposal represented 23% of the Companys issued share capital and netted Ms. Chu proceeds of HK$1.5 billion (US$195M). Ms. Chus remaining stake: 74.89%

January 17, 2007 The Chairwoman disposes of her shares, part II The Event: Ms. Chu converts and dumps another 277 million shares at HK$4.56 per share, at a 7.51% discount to the previous days closing price.7 The disposal represented 9.1% of the Companys issued share capital and netted Ms. Chu proceeds of HK$1.3 billion (US$162M). Ms. Chus remaining stake: 65.78%

April 7, 2009 The Chairwoman disposes of her shares, part III The Event: Ms. Chu converts and dumps another 191 million shares at HK$6.10 per share, at a 12.5% discount to the previous days closing price.8 The disposal represented 6.2% of the Companys issued share capital and netted Ms. Chu proceeds of HK$1.2 billion (US$149M). Ms. Chus remaining stake: 56.46%

6 7 8


October 8, 2009 The Chairwoman disposes of her shares, part IV The Event: Ms. Chu converts and dumps another 150 million shares at HK$7.75 per share, at a 5.7% discount to the previous days closing price.9 The disposal represented 4.2% of the Companys issued share capital and netted Ms. Chu proceeds of HK$1.2 billion (US$149M). Ms. Chus remaining stake: 51.28%

April 12, 2010 The Chairwoman disposes of her shares, part V The Event: Ms. Chu converts and dumps another 204 million shares.10 Curiously, the required notice filed by the Company does not provide information on the disposal price, but based on market activity, we suspect Ms. Chu netted HK$2 billion (US$250M) from this transaction. Ms. Chus remaining stake: 44.24%

January 28, 2011 The Chairwoman disposes of her shares, part VI The Event: Ms. Chu converts and dumps another 200 million shares at HK$11.00 per share, at a 7.8% discount to the previous days closing price.11 The disposal represented 4.2% of the Companys issued share capital and netted Ms. Chu proceeds of HK$2.2 billion (US$282M). Ms. Chus remaining stake: 37.71%

For those keeping count, the cumulative proceeds of her disposals amount to approximately HK$9.4 billion (US$1.2 billion). Its unclear why Ms. Chu has decided to drastically reduce her stake in Huabao. For the past five years, revenue, profit, and book value have steadily trended higher with awe inspiring gross margins. Management commentary shows no decline in optimism, projecting confidence in Huabaos Big customers, Big brands strategy. We have difficulty imagining Ms. Chu was short of cash following her initial share placement in 2006 which yielded HK$1.5 billion. In light of the research presented in this report, we are confident the drastic decline in her holdings was motivated by her desire to cash out of Huabao before the share price reflected the organizations true value. 11



Executive Resignations


So far, we have a backdoor listing, an auditor resignation, absurd related party transactions, and a company founder who cant sell off her shares fast enough. The only box left to check on our list of red flags is executive resignations:

December 5, 2007 The Corporate Secretary resigns The Event: Mr. Henry Chu resigns as the Company Secretary and Authorized Representative of the Company. Managements Response: In a released statement, management claims the resignation is due to personal career development.12 The Truth: Mr. Henry Chu is a fellow member of the Association of Chartered Certified Accountants and an associate member of the Hong Kong Institute of Certified Public Accountants with a career spanning several auditing positions. Our search indicates that after resigning from Huabao, Mr. Chu joined Westminister Travel Ltd., an operator of a travel agency. Westminister Travel is listed on the Singapore Exchange (5OF:SES) with a market cap of US$22 million. We are hesitant to believe personal career development was the real reason Mr. Chu resigned as an executive of a purported multi-billion dollar tobacco enterprise to join a penny stock company offering discount travel. It is more plausible that as Corporate Secretary, Mr. Chu found irregularities with Huabaos books and resigned to distance himself from the Company.

July 31, 2011 An independent director is forced to resign due to fraud charges The Event: Mr. Mak Kin Kwong was one of three independent directors at Huabao. He was also the Chairman of the Audit Committee as well as the Chairman of the Remuneration Committee before being forced to resign in disgrace. In addition to being investigated by the SEC, he was recently charged with fraud by the China Securities Regulatory Commission. These charges relate to his work as an independent director of Chengdu Unionfriend, a company listed on the Shenzhen Exchange. The charges included overstating revenue, non-disclosure of related party transactions, and false and misleading disclosures.13 Unfortunately, these events were not isolated incidents. Mr. Mak was also

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the CFO of A-Power (NASQ: APWR), a company that until recently traded on the Nasdaq before being delisted last summer due to issues of fraud.14 an independent director and Chairman of the Audit Committee of Real Gold Mining (HK:0246), a company that in May 2011 was halted on the Hong Kong Stock Exchange relating to allegations of mass fraud and auditor resignations.15

Our Take: It does not inspire confidence that this legendary character not only served as an independent director at Huabao, but has been in charge of its audit committee since inception.

Its almost like management is playing a game of chicken with analysts, like theyre trying to see how many red flags they can raise and still get buy recommendations. -Associated Analyst

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Financial Statement Analysis [sec 2]

In this section, we look at Huabaos financial statements and compare the Company to industry peers with regards to gross margins (2.1), research & development spending (2.2), sales growth (2.3) and reporting transparency (2.4).



Exhibit 4 shows gross margins as reported by the industry. Note that while all F&F players report margins in the 40-50% range, Huabao has somehow managed to command consistent margins upwards of 70%. In most industries, even single digit deviations are considered extraordinary. So, what happened between 2005 and 2006 that helped Huabaos margins explode? Exhibit 4 Industry Gross Margin
80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2005 Huabao 2006 CF&F 2007 2008 Symrise 2009 Givaudan 2010 IFF

The proximate cause seems to have been the acquisition of Chemactive. Prior to this acquisition, Huabao was more or less a shell company with de minimis operations reporting annual losses. On the other hand, Chemactive was a highly profitable company enjoying margins of 48% based on the preacquisition financial statements. But still, 48% is a long way from 70+%. So what happened between the acquisition and the following year when management released their annual results showing margins had skyrocketed? We arent actually sure. You see, management only dedicated a few lines in their entire 2006 Annual Report to explaining the jump in gross margins: As the raw material structure of many of the continuous developing products were being optimized as well as the capacity of relevant production accessories increased, the gross margin rose from 47.3% of last year to 69.5%, which further improved the operating results.16

16 (page 8)


From our reading of this explanation, management did two things to significantly improve margins: 1) optimized the raw material structure; and 2) Increased relevant production accessories. If youre confused, youre not alone. We dont understand this vague explanation either. Moreover, we do not believe that management was able to re-engineer Chemactive within a year to become some sort of super-profitable money machine. First, this transformation didnt even take a year. As presented in the interim 2006 report, gross margins had already improved to 65.4% within 6 months of the Chemactive acquisition. Just so our readers dont think theyre missing something: March 31, 2006 (Chemactive prior to acquisition): Gross Margins 48.0% September 30, 2006 (Huabao interim report post-acquisition): Gross Margins 65.4% March 31, 2007 (Huabao annual report post-acquisition): Gross Margins 69.5%

Second, what type of re-engineering/cost cutting/synergies could management possibly have pulled out of their hat? Prior to acquiring Chemactive, Huabao was just a shell. Its not like there was a second material operating business that was merged with Chemactive to cut costs or increase efficiencies. In fact, the same person who had run Chemactive prior to the acquisition was still running Chemactive after the acquisition Huabaos Chairwoman, Ms. Chu. Given managements dubious explanation, we turned to the most obvious source of confirmation documents Huabao filed with the SAIC. 17 It took nearly three months, but we didnt just get documents related to the Chemactive acquisition, we got documents related to the entire Company nearly all of its principal operating subsidiaries representing 99.5% of Huabaos production capacity. In total, we are in possession of SAIC documents for 23 different Huabao subsidiaries. Based on our analysis of these documents, it appears that the overwhelming majority of Huabaos subsidiaries report gross margins around 40-50%, in line with industry standards but a far cry from the 74% reported by the Company in 2010. It should be noted that since these results are not consolidated, it becomes difficult to calculate an exact gross margin figure. But in either case, 40%+ and 70%+ are a world apart. To get more clarity on industry margins, we contacted several private F&F companies located in China. In our discussions with them, no representative was able to understand how gross profit margins of 70%+ could be achieved in this industry. Moreover, one representative mentioned that his company supplies tobacco flavors and fragrances for several foreign brands and that the gross profit margin of their business is quite low. When pushed further, he relented that it *may* be possible for the gross profit margin of some new products to reach up to 70 or 80%, but was unlikely for older products. Looking back at Exhibit 4, a simple analysis of China Flavors and Fragrances gross margins confirms this statement. This point was also reaffirmed by a contact at a different F&F company, who went on to state that potentially better margins on new products is why all of the companies in the industry continue to develop new products through R&D.

All businesses operating in China must file annual financial statements with the State Administration for Industry and Commerce (SAIC).


Research & Development


And so it seems that R&D is vital to the industrys profitability and staying power. However, as Exhibit 5 shows, for Huabao this issue raises more questions than it answers simple questions such as: How is Huabao able to maintain its leadership position and gross margins by spending less on R&D than most of its peers? Exhibit 5 R&D as a percent of sales
10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2005 Huabao 2006 CF&F 2007 2008 Symrise 2009 Givaudan 2010 IFF

This chart is baffling when one reads through Huabaos annual reports and sees the following gem: The R&D capability of a flavours and fragrances company reflects its overall strength. After continuous investment, the Group has set up a leading R&D team which is top-notch in China and up to international standards. The State-recognized technology centre, the overseas R&D centre in Germany and the professional R&D departments in Yunnan, Guangdong and Fujian together formed a vertically integrated platform for R&D in areas ranging from fundamental research to application. The R&D strategy of the Group is market-driven so as to closely follow the latest global industry trends and to accelerate the mastering of technologies in key raw materials. With such strengths, the Group is able to develop products and technologies that meet market demands, deliver comprehensive technical services to customers and remain dedicated to maximizing value for clients, while the Groups overall competitiveness is greatly elevated.18 Based on these type of statements, Huabao seems quite dedicated to cutting-edge, international caliber R&D. So much so that to aid its efforts in internationalizing its R&D capabilities, in 2006, Huabao set up an R&D center in Holzminden, Germany, a town famous for its F&F industry and the proud headquarters of Symrise, an industry powerhouse.



The German research facility stands out as an important jewel in Huabaos R&D initiative, because: Its located in a logistically out-of-the-way place for a company that does all its business in China. Internationalized R&D seems to be a key strategy for the Company. Management considers it a world-class R&D center. Huabaos Chief Technical Officer for Tobacco Flavors, Mr. Alan Davies, is posted at the Holzminden facility.

Given the apparent importance of this facility, we decided to give it a closer look to get a better feel for Huabaos R&D work. At the prompting of our contacts, our sources at Anonymous Germany agreed to take a road trip to Holzminden and put the R&D center under surveillance for three days.

Minimal Activity Our contacts told us that during their investigation several points struck them as notable, especially in contrast with activity at the Symrise facility, which they also visited: Most of the lights in the complex were off. There was minimal noticeable staff activity. There was no security protecting the research facility. When neighbours were questioned, they either did not know what business was being carried out at the facility or assumed the facility belonged to Symrise.

It should be noted that the R&D center is not actually located in Holzminden, but in a very small village called Neuhaus, which is a twenty minute drive out of town. We were told there was no public transportation to speak of and it was during the winter season, making it difficult to ride a bicycle. This is relevant because over the three days, our contacts did not see more than six vehicles in the parking lot of the research center.

We are not sure what type of multi-billion dollar, research driven enterprise operates like this, but it seems that the Holzminden facility has no more than half a dozen staff members. 17

Concluding on R&D Expenses So, here we have a company with questionably low R&D spending that reports absurdly high margins, which industry sources say should not be possible. How do we bridge this divide? We have come across various explanations. However, the best ones can be summarized as follows:

Huabao has established relationships with several prominent SOE tobacco manufacturers. Cigarette smokers are sensitive to their preference of cigarette brands and manufacturers are hesitant to change ingredients/suppliers in their blend. Accordingly, there is no need for major R&D as once Huabao is contracted to supply flavoring to a brand, that relationship will continue until the tobacco brand is terminated. Consumer preference for their favorite brand creates a natural moat for Huabao, ensuring lofty margins and low R&D expenditure.

This is actually a very logical, very good explanation. The idea behind this explanation is that in a mature industry, there really is no need for R&D. The Company already has its flavours, it already has its connections, and it already has its committed cigarette brands. All the work is done. And this makes sense. Except when it doesnt. The problem with this explanation is that the math cuts both ways. It may be possible for low R&D expenses to co-exist with high profit margins in a mature industry, but then we should be seeing correspondingly low revenue growth. Growth implies new markets, new opportunities, and therefore new R&D initiatives. If a company is not incurring substantial R&D costs because it benefits from being the leading player in a mature industry, we should not then be also witnessing high revenue growth that appears to be far surpassing the growth of its customer base. Despite this, Huabao has also inexplicably experienced the fastest sales growth in the industry, as we discuss next.


Revenue Growth


Exhibit 6 shows Huabaos compounded average growth rate (CAGR) between 2005 and 2010. Compared to its peers, a 30% annual growth rate is nothing short of awe-inspiring.

Exhibit 6 5-Year CAGR Sales Growth Huabao 29.6% CF&F 25.0% Symrise 6.5% Givaudan 8.8% IFF 5.6%
Source: Company financials

To deliver this revenue growth, management has targeted 10% growth through acquisitions, and 20% organic growth. To be perfectly clear, growing revenue 20% organically year after year is no small feat, especially when one understands that Chinas tobacco industry as measured by volume has only grown 4% per annum between 2005 and 2010. 19 So, how was this growth rate achieved? Management attributes most of this to industry consolidation: Over the last decade, Chinas tobacco industry has been undergoing a major restructuring that includes the consolidation of cigarette producers. The number of cigarette companies under the STMA has dropped from 185 in 2001 to 30 in 2010, while the number of brands has decreased from more than 1,800 to 133 over the same period. The STMA reduced the number of cigarette factories and brands in an effort to create economies of scale and to focus production on a limited number of Chinese brands that could better compete on the international market.20 Management explains that as a key supplier to the top cigarette brands, Huabao stands to benefit from industry consolidation as popular brands replace obscure ones. On the surface this might make sense, and certainly we believe Huabao has experienced some benefits found in industry consolidation but a steady 20% organic growth over five years? We dont think so. There are two mathematical issues with Huabaos explanation of its organic growth: (i) the uniformity problem, and (ii) the cannibalization problem, as discussed next.

19 20 Ibid


The Uniformity Problem Over the last decade, there has indeed been some significant industry consolidation. However, this consolidation was a long-tailed event, with most of the activity occurring during the first part of the decade. Exhibit 7 presents data from Huabaos own annual report. Whats evident here is that by 2005, industry consolidation had slowed considerably as most of the obscure cigarette brands had already been crowded out or discontinued. Exhibit 7 Consolidation

Source: 2007 Annual Report

Between 2005 and 2010, the industry continued to consolidate, but at a markedly decreasing rate. To show this, we have presented the growth rate of the top five Chinese cigarette brands in Exhibit 8, which we have used as a proxy for industry consolidation. Side by side, we have also presented the organic growth rates reported by Huabao. Exhibit 8 Market Dominance of Top Five Chinese Cigarette Brands
40.0% 30.0% 20.0% 10.0% 0.0% 2006 2007 2008 2009 2010 Growth Rate of Top Five Brands Huabao Organic Growth Rate

Source: Euromonitor, analyst estimates, our estimates *Note that no organic growth rate is available for 2006

What is evident here is that while industry consolidation slowed rapidly in the latter part of the decade, Huabao continued to post relentless growth over the same time period. Against this backdrop, Huabaos reported growth is highly suspect, especially when you consider the next issue. 20

The Cannibalization Problem Huabao supplies flavouring to approximately 50% of the top ten cigarette brands. In terms of consolidation, this is a positive factor for the Company. As the top brands consolidate smaller players, by proxy Huabao increases its market share and grows accordingly. However, Huabao also supplies approximately 50% of the overall market, which implies that on average it also supplies 50% of brands and suppliers that are being or have been phased out. And as surely as Huabao gains from its biggest customers consolidating the industry, it also loses equally as its smaller clients are squeezed out. The result is a near zero-sum game. Given these factors, we question Huabaos growth story as a result of industry consolidation. In sections 3 and 4, we follow up this macro analysis by providing a granular look at Huabaos revenue streams and client relationships.


Reporting Transparency


Public companies are obligated to provide a certain level of corporate and operational information to investors in their financial reports as stipulated by the stock exchange they trade on. Huabao is governed by the disclosure requirements of the Hong Kong Exchange, but even here Huabao appears to only be disclosing the minimum required and in at least one case, even less than that. Looking through Huabaos financial reports, we can see that starting in 2010, management stopped disclosing pertinent information which would otherwise aid analysts in the due diligence process. Specifically, management removed three key pieces of information from their annual reports as presented in Exhibit 9:

1) Departmental breakdown of personnel. 2) List of selected direct sales customers. 3) Segment information between its three business lines: - tobacco flavours - food flavours - fragrances

Exhibit 9

Source: 2009 annual report


With the removal of this information, analysts cant get a clear picture of personnel changes, nor who the Companys customers are. Far more concerning however is that management decided to combine the Tobacco Flavours and Food Flavours segments into one opaque segment simply called Flavours. While the first two omissions should raise eyebrows, it pales in comparison to the egregious act of combining two of the Companys biggest and distinct businesses into one reporting segment. Frankly, we cant believe the auditors (PricewaterhouseCooper) have been so docile as to allow this gross violation of Hong Kong reporting standards to continue.21 This simple, but crucial change has made it impossible for analysts and investors to determine where revenue and sales growth is coming from. It has turned the whole due diligence process into a joke of a guessing game. Because now, instead of getting a clear picture of the Huabaos revenue break-down, you get something like this: Exhibit 10 New Segment Reporting

What is the purpose of changing the reporting so that one segment effectively accounts for all of the Companys sales? What is achieved by a change like this? What is the net benefit? Make no mistake these changes were implemented with the intent of limiting proper analysis of Huabaos operations and revenue streams, a topic we discuss next.


PwC would be wise to freshen up on HKFRS 8 and relearn the meaning of substance over form.


Food Flavouring

[sec 3]

The Food Flavouring segment contributes to approximately 15% of Huabaos revenue. This segment supplies flavouring to various food, beverage, and cosmetic products. In fact, Exhibit 11 presents some of the segments customers as at Fiscal 2009. We presented this list earlier in the report, with an explanation that this was the last list Huabao made public before management stopped providing the name of its clients. Exhibit 11 Huabao Clients (Fiscal 2009)

Source: Company financials

Well leave it up to investors to decide why Huabao stopped providing a client list. But in the meantime, we went ahead and contacted the companies on the list, and were able to get in touch with representatives from Danone, Heinz, Totole, Yurun, Huiyuan Juice, Bright Dairy and Dali Group. Certain representatives confirmed that Huabao was indeed a supplier. But just as well, there were a number of other companies that informed us that Huabao was not a supplier of any material form. For example, we contacted Heinzs corporate office in the US and were placed in contact with the Procurement Department. We provided the department Huabaos name, along with the names of all its food and flavor subsidiaries. The department ran the names through their system and confirmed that they have no relationship with any of the names we had given them. We were informed that it may be possible that their Chinese factory sources directly from Huabao, in which case the Corporate office wouldnt be aware. They therefore provided us with the contact information of the person in charge of procurement at the Chinese factory. We contacted the individual who confirmed that they were in the best position to provide information regarding Heinzs suppliers. When asked about Huabao, the individual wasnt convinced Huabao could be classified as a supplier to Heinz because, to quote:

We didnt purchase much *from Huabao+ we didnt really use them, previously we only purchased from them once. It was very little.


Admittedly, the presented client list is dated. What about current clients? While Huabao stopped providing a client list, Shanghai H&K Flavor, one of Huabaos food and flavoring subsidiaries does have a website where it lists products that it evidently provides flavouring for. On its website ( under the tab Market > Product Information, there is a list of various products from flavoured yogourt to flavoured peanuts. This list was updated as recently as October 20, 2011, so we can assume its relevant. From this list, we picked two products at random and contacted their manufacturers to confirm a client/supplier relationship with Huabao or its subsidiary. The first product we picked was Harris Teeter Simply Clear Water, as shown in Exhibit 12. Exhibit 12

We contacted Harris Teeter, a grocery store chain based in the US. Harris Teeter put us in contact with Cott Beverages, the company that manufactures and bottles the Simply Clear product. When asked about Huabao, Cott simply confirmed that they are not using any Chinese based company to supply flavouring ingredients for this product.


The second product we picked was HyVees Vanilla Flavoured Almond Milk, as shown in Exhibit 13. Exhibit 13

We contacted HyVee who put us in touch with the account manager and the third party broker responsible for this product. Both individuals confirmed that no Chinese company is sourced for flavouring in the production of the milk. Confused, we asked our contacts if they knew any reason why their products were displayed on Huabaos website. Their simple response: No.

Bill Gates (questioning Homer Simpsons fake business): Your internet ad was brought to my attention, but I cant figure out what, if anything CompuGlobalHyperMegaNet does -The Simpsons 26

Tobacco Flavouring

[sec 4]

Huabao is exaggerating the scope of its food flavouring business this is self-evident. But food flavouring is only 15% of their revenue. The other 85% comes from tobacco flavouring. Tobacco flavouring is the backbone of the Company and the reason that at the time of writing, this company was worth over HK$17 billion. However, it also appears Huabao is embellishing their tobacco flavouring business. Straight from its 2008 annual report is a list of Huabaos customers. This impressive list not only shows that Huabao is a supplier to all of the top ten cigarette brands sold in China, but also a core supplier to nearly all of them. The Company defines core supplier as supplying more than 50% of each companys tobacco flavour purchase. Exhibit 14

Source: Company financials

The top ten cigarette brands are manufactured by 8 different companies across a spectrum of factories. Exhibit 15 presents a list of the companies and their associated top ten brands. Exhibit 15 Company China Tobacco Hubei Industrial LLC China Tobacco Henan Industrial LLC China Tobacco Hunan Industrial LLC Yuxi Hongta Tobacco (Group) Co Ltd. China Tobacco Guangdong Industrial Co. Ltd. China Tobacco Shandong Industrial Corporation China Tobacco Guizhou Industrial Corporation Hongyun Honghe Group

Brands Hongjinlong Hongqiqu Baisha Hongmei, Hongtashan Shuangxi Hatamen Huangguoshu Honghe, The Scarlet Camellia


Penetrating the SOE dominated tobacco industry was a time consuming effort. We made over 150 phone calls to various factories, companies, and procurement departments in an effort to verify Huabaos business claims. We are confident this is the most exhaustive effort any researcher or analyst has undertaken in this regard. We were successful in making contact with at least one factory from each of the 8 major tobacco companies listed above. Some of the representatives were happy to speak to us but citing factory regulation were not forthcoming with regards to quantity and pricing. However, many of the representatives were willing to give us qualitative information. In our conversations, Huabao was generally acknowledged to be Chinas leading tobacco flavouring supplier. However, we found some material inconsistencies with Huabaos claims. Some factories confirmed that Huabao was indeed a core supplier, while others denied using Huabao as a supplier at all. For instance, we contacted three of the six factories that manufacture Huangguoshu cigarettes. Huabao lists itself as a core supplier to the Huangguoshu brand. Two of the factories claimed they do not purchase goods from Huabao, and the third mentioned that Huabao is one of numerous suppliers and is not a core supplier. In the case of Hongyun Honghe Group (Hongyun Honghe), we spoke with a representative at one of its key factories. The representative acknowledged that Huabao is a core supplier to the company, but said that the entire Honghe Group only purchases tens of millions of RMB of flavours from Huabao. It helps to understand that Hongyun Honghe is the second largest Chinese tobacco company and accounted for 9.4% of the Chinese retail volume, according to a 2011 Euromonitor International report22. So despite Hongyun Honghe controlling nearly one-tenth of the Chinese retail tobacco market, a representative from the cigarette maker attributed only tens of millions of RMB of purchases from Huabao, a figure that pales in comparison to the approximate HK$2.3 billion annual sales claimed by Huabao. Another notable conversation we had was with a flavouring company called Shanghai Peony Flavours & Fragrances Co. Ltd. (Peony). Peony as it turns out is a subsidiary of, and sole flavour supplier to Shanghai Tobacco Group. And who is Shanghai Tobacco Group? Well let Huabao explain. Here is an excerpt from their annual report justifying the Win New Group acquisition we introduced on page 7:

Win New Group is mainly engaged in the production and sales of tobacco and food flavours as well as fragrances in China, with its tobacco flavor and fragrance business mainly targeting at large and quality tobacco groups in Eastern and Central China, such as Shanghai Tobacco Group Corporation which is the tobacco manufacturer of various famous cigarette brands, including Panda, Chunghwa, Shanghai and Peony etc.

Huabao boasts of being a major flavour supplier to Shanghai Tobacco Group. But Peony, Shanghai Tobacco Groups own subsidiary claims to be its only flavour supplier. We contacted Peony to get some clarity on these conflicting statements.



Our contact confirmed that Peony is indeed the only flavour supplier to Shanghai Tobacco Group. When asked about Huabao, the contact stated that Huabao is one of many suppliers but only supplies Peony one kind of raw material for the latter to use in the manufacturing of tobacco flavours. We should reiterate that Huabao no longer discloses who their tobacco clients are, and the client list we are relying on is several years old. However, managements claim that the tobacco flavouring industry is highly sticky, combined with the results of our Hongyun Honghe and Peony channel checks give us great cause for concerns regarding Huabaos reported profitability.

The Tobacco Industry in China

When we take a step back from specific purported customer relationships and focus on the overall cigarette market in China, we find it impossible that Huabao earns the revenue it claims. In 2010, Huabao reported revenue of HK$2.9 billion (US$366M). The overwhelming majority of this revenue came from their tobacco flavouring segment. How does this amount compare to the tobacco market in China? The diagram on the next page puts the industry into context.


So, is the realm of 2.4% a reasonable cost component of flavouring when it comes to the manufacturing of cigarettes? We had no idea, but intuitively it seemed somewhat high. Anecdotally, when you bake a cake, the few drops of flavouring extract you include as part of the recipe dont cost anywhere near 2.4% of all the ingredients. But then again, none of us have ever baked a cake before, just like weve never manufactured cigarettes and anecdotes arent exactly facts. In the absence of personal knowledge, we referred to a research paper titled Cost Analysis of Options for Self-Extinguishing Cigarettes23 which was prepared in 1987 for the US National Bureau of Standards. The paper disaggregates an earlier research paper by James Morris titled This Tobacco Business Part XIII: Manufacturing Costs of Cigarettes24 which was first published in Tobacco International Magazine in 1980. These two research papers are the most comprehensive and granular bodies of work on cigarette manufacturing, in what is otherwise a secretive and complex industry. Exhibit 16 presents the relevant information for our analysis. Exhibit 16

23 24;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03


Based on this work, we can see that the casing process (flavouring) only accounts for $0.016 of $5.64 in material costs per 1,000 non-flavour tipped sticks25. Thats less than 0.3% of all costs! For Huabao to sell the amount of flavouring it claims, it would need to supply more than 50% of the tobacco market in China. In fact, it would need to supply more than 100% of the global cigarette market.

Cigarette Flavouring: Then and Now Admittedly, the research papers were relying on are over 25 years old, and a lot has changed during that time. And while we believe that given tar content and manufacturing capabilities, older western standards actually represent the manufacturing of Chinese style cigarettes more accurately, we decided to cover all bases. So, we contacted Altria and British American Tobacco to ask about their flavouring costs. Altria is a tobacco company that exclusively sells cigarettes within the US, so we didnt put much weight on what they had to say. British American Tobacco however, has a large market in Asia, which we were willing to pay more attention to. Regardless of their respective markets however, both said pretty much the same thing about their flavouring costs, which we have boiled down to a few key quotes presented here: Flavourings are irrelevant to us. Not very much at all. *Flavouring is+ so negligible that we dont keep track of it. Virtually irrelevant.

The more things change, the more they stay the same. You see, Huabao would have investors believe that its found a niche market that no one else has. That despite Symrise, IFF and Givaudan operating in China since the 1990s, they have overlooked a market that grows 20% year after year, with 75% margins and little need for R&D. But the truth is that all these companies have looked at the economics of the tobacco flavouring market and it sucks. There simply isnt enough demand for flavouring in cigarette manufacturing to make it a worthwhile principal market. Thats why most of the global companies focus on food and cosmetics. And thats why the only other company to focus on tobacco flavouring (China Flavours & Fragrances) has been languishing on the stock market as a micro-cap stock over the last five years. Other F&F companies dont break out a tobacco flavour segment in their annual reports because its such a small market that it doesnt matter. Huabao doesnt break it out because someone might realize their numbers cant possibly make sense.


Non-flavour tipped sticks are just regular cigarettes as opposed to specialty cigarettes that have plugs dipped in flavouring.


The Dividend Story

[sec 5]

No report would be complete without acknowledging that Huabao pays large dividends. In fact, over the last number of years, the Company has paid out between 30-50% of its earnings to shareholders. And as management notes in their most recent report, that amount to date equals HK$2.4 billion since its backdoor listing. More impressively, this was all done without the Company raising any money, either through equity or through debt. These numbers speak for themselves and paint a rosy picture. But of course, its not the whole picture. In this section of our report, we present what we believe has been managements blueprint to reap personal wealth at the expense of public shareholders and investors. We believe this section will bring full circle many loose ends, and add some sense to managements otherwise erratic behavior. We give particular attention to managements past actions, and focus on the issue of dividends. For ease of reading, we have split this section into four parts: 1) 2) 3) 4) The Chemactive Injection The Chairwomans Share Sell Down Other Related Party Acquisitions Dividend Payouts


Part 1: The Chemactive Injection


As we mentioned at the beginning of our report, Huabao did not go public through a traditional IPO. It went public through a backdoor listing via a shell company. In an IPO setting, you hire investment bankers and outside consultants with their own reputations on the line to vet through your business operations, look through your financial statements, and then sell your shares to the public. And while this outside scrutiny in no way guarantees that your business is legitimate, it doesnt hurt. In a backdoor listing, you can be as shady as you want. No one is really there to question your business or inspect it. In fact, most people will just assume youre doing something sketchy. Backdoor listings have that certain je ne sais quoi grease-ball quality to them. After Huabao took over Leaptek, management effectively had a shell company available. They then bought the Chemactive assets from the Chairwoman and injected it into the shell, essentially taking Chemactive public. This is when we believe management first began to misstate their financials. As we mentioned on page 14, Chemactives reported gross margins rose drastically immediately after the injection. Based on the evidence previously presented, we believe management simply fabricated their numbers. But of course, if you begin to lie about your gross margins, its going to affect reported net income as well. Exhibit 17 shows the difference in 2010 net income between Huabaos public filings and its SAIC documents. The net income of the SAIC documents are based on the sum of Huabaos disclosed principal operating subsidiaries representing 99.5% of its production capacity, plus several ancillary subsidiaries that have some form of business operations. There appears to be a 36% difference in earnings between these two sources. Exhibit 17

Public Filings SAIC Documents Reported R&D Expense R&D Expense net of taxes SAIC Documents less R&D

(HK$ millions) 1,632 ~1,200 122 105 ~1,095

Difference 36%


Source: Company financials and SAIC documents

It should also be noted that in calculating the SAIC net income, we did not included any cost centers, such as R&D facilities. However, Huabao claims to have spent HK$122 million on R&D in 2010. If we subtract this expense on an after tax basis from the SAIC net income, then we get an even larger discrepancy. So, what reason did management have to inflate the financial figures?


Part 2: The Chairwomans Share Sell Down


Better financial figures bring a higher share price. And thats exactly what the Chairwoman wanted when she began dumping her shares. In order to understand the Huabao story, its important to understand that Huabao and its Chairwoman are inextricably linked. It helps to think of the Chairwoman as Huabaos off-balance sheet entity. So yes, its true that Huabao as a company has never raised any money. But through the years, the Chairwoman has raised HK$9.4 billion (US$1.2 billion) on the back of inflated share prices. Exhibit 18 Date 3-Aug-2006 17-Jan-2007 7-Apr-2009 8-Oct-2009 12-Apr-2010 28-Jan-2011 To Date:

(HK$ millions) 1,500 1,300 1,200 1,200 2,000 2,200 9,400

In most instances of fraud, management will usually issue shares/debt through the company and abscond with the proceeds. However, this creates certain problems. For instance, when the auditors do their annual cash verification, management will need to explain what happened to the money. To cover the theft, management has to create lies such as claiming the money was spent on expanding/improving the business. This lie leads to other lies, such as inflated asset balances. Unfortunately, these inflated assets stay on the balance sheet where they can eventually be uncovered. Then theres the issue of trust. If management repeatedly raises money to expand business, people are going to start asking questions. The market will begin to suspect foul play. The whole process can become very messy. We believe Chairman Chu avoided these complications. Instead of raising money through the Company, she simply inflated the value of Huabao, and then sold her personal shares into the market, generating a small fortune in the process. The Queen of Cashout Well, small fortune may be a bit of an understatement. Last year Ms. Chu was ranked the 8th richest woman in China at the age of 41 on Huruns list of Self-Made Women Billionaires. But thats not the only list that Ms. Chu made. Hurun also released a Cashout List which lists billionaires who have been cashing out of their own companies.26 According to the list, Ms. Chu was the second biggest inside-seller in China, cashing out US$549 million in the last year alone. This sum was so large that she has been dubbed Queen of Cashout by The Shanghai Daily. Disregarding everything in this report, at the most basic level shareholders should ask themselves: Why am I an investor in this company when the Chairwoman cant sell her shares fast enough?


Part 3: Other Related Party Acquisitions


Of course, overstating a companys earning power has its own issues. For instance, auditors expect to see a commensurate cash balance as proof of income. Sales receipts and expense receipts can easily be forged or faked. However, bank cash balances are slightly more difficult to fake slightly. We know that Ms. Chu disposed of a large portion of her shares two days after the Chemactive acquisition, and once more before fiscal year end. Together, these two share sales gave her proceeds of approximately HK$2.5 billion. With this amount, it would have been easy enough to pad Huabaos bank accounts, which at the end of Fiscal 2007 (one year after the Chemactive acquisition) were reported to be approximately HK$ 900 million and still have enough money left over to grease the palms of third parties and their proxies working behind the curtain and as a result of our investigation we certainly have reason to believe there are a multitude of outside players who are involved in this game Huabao is playing. Of course, one does not perpetuate a scheme to simply leave money in the bank for the auditors. Moreover, as each year goes by and fake earnings continue to accumulate, it becomes more difficult to maintain sufficient cash in the bank. Ms. Chu could have sold down her holdings at a faster rate to continue to pad Huabaos bank account, but then that would likely attract scrutiny. So what to do? The answer was to transfer these earnings out of Huabao. Enter Win New Group and Wealthy King Investments. Recall from the beginning of this report that these two companies were injected into Huabao through Chairwoman Chu as related party transactions. More dubiously, the Chairwoman acquired these assets from third parties and resold them to Huabao within months. Not only that, but the price paid for these acquisitions were absurdly high, as shown in Exhibit 19. Exhibit 19 Win New Group Wealthy King Investments Average P/E Xiamen Amber Maoming Kebi Qingdao Qingda Yunnan Huaxiangyuan Average P/E
Source: Company disclosures

Net Income 31 70 101 5.7 20 2.5 0.4 29

Acquisition Price 652 870 1522 62 117 12 4.3 195

P/E Ratio 21.0 12.4 15.1 10.9 5.9 4.8 12.2 6.8

Acquisitions through the Chairwoman

Acquisitions through third parties

This Exhibit contrasts the valuation of the transactions between Huabao and the Chairwoman, and the transactions between Huabao and third parties. What is evident here is that the transactions involving the Chairwoman were valued at more than twice the transactions involving third parties. 36

So, was the Chairwoman just greedy and looking to make money by flipping these businesses to Huabao? Yes and No. We believe that these subsequent acquisitions were carried out at inflated valuations for the purpose of removing fake earnings from Huabaos balance sheet. That way, management had an excuse when the auditors found Huabaos bank accounts empty. Put another way, these transactions were used to clean up the theft that had already occurred. And this is exactly why the Chairwoman took the awkward step of buying these assets from third parties only to resell them to Huabao. We do not believe Huabao paid the reported price to acquire Win New Group and Wealthy King Investments from the Chairwoman. The reported acquisition price consisted of imaginary money/earnings that needed to be removed from Huabaos balance sheet. It would have been impossible to do this through an arms length transaction, since a third party would be publically questioned regarding the value of the transactions. However, since the Chairwoman acquired the assets quietly from a third party, she was free to resell them to Huabao at any price with impunity. Take the acquisition of Win New Group as an example. When Win New Group was acquired by Huabao from the Chairwoman, it had three operating subsidiaries as listed below: Exhibit 20 Win New Group 2007 (In millions of RMB) Subsidiaries Shanghai Zhezhan Huasheng Qinghua Zhaoqing Fragrances Total

Revenue 35.8 30.8 134.1 200.7

% of Total 18% 15% 67% 100%

Net Profit 26.2 -0.1 6.7 32.8

% of Total 80% 0% 20% 100%

Huabao acquired Win New Group for HK$650 million, or 21 times earnings. Its vital to note that this acquisition included 100% of Shanghai Zhezhan and Huasheng Qinghua, but only 72.1% of Zhaoqing Fragrances. A third party owned the other 27.9% of Zhaoqing Fragrances. This is important, because according to filings, Huabao would later acquire this outstanding portion of Zhaoqing Fragrances for only HK$21 million. This transaction from an independent third party implied a valuation of only 10.6 times earnings, for the same business Huabao bought at twice that valuation from Ms. Chu. Its interesting how Huabao only pays reasonable prices for acquisitions that are not through the Chairwoman. Over the years, Huabao has continued to grow and overstate its earnings. The share price has continued to grow as well, giving the Chairwoman more opportunities to sell down her stake. However, this growth has come with a price: Huabao is so large now that it has become difficult to conduct additional related party transactions of significant size to be meaningful in removing earnings from its balance sheet. Moreover, as Huabaos reported cash balance grew, calls from investors and analysts to declare dividends intensified. And so, management began declaring dividends. 37

Part 4: Dividend Payouts


Here we return to the stated amount of HK$2.4 billion the cumulative amount Huabao has paid out in dividends all these years, the amount that regardless of how shady management has been in the past, should remove any doubts about Huabaos brilliant and legitimate business. But theres a problem with this number: its a red herring. Over the relevant period, the Chairwoman has had anywhere between 66% to 38% ownership in Huabao. Due to this interest, a significant amount of the dividends that have been paid out have never actually been paid out they have just circled back to the Chairwoman. In fact, as Exhibit 21 shows, only half of the HK$2.4 billion has actually made it to public shareholders.

Exhibit 21 (In HK$ 000)

2007H1 Dividends per share Declared dividends Chairwoman's stake Dividends paid out 1.80 54,773 65.78% 18,743 2007H2 3.80 116,382 65.35% 40,326 2008H1 2.30 70,451 62.96% 26,095 2008H2 6.00 184,147 62.80% 68,503 2009H1 5.00 154,100 62.64% 57,572 2009H2 8.80 271,463 51.28% 132,257 2010H1 8.80 274,970 50.87% 135,087 2010H2 12.28 384,219 44.10% 214,767 2011H1 7.20 226,789 37.71% 141,267 2011H2 7.98 251,374 38.43% 154,776 2012H1 12.98 409,467 38.40% 252,232 1,241,625 2,398,135 Total

To put this all into perspective: Over the last six years, the Chairwoman has raised HK$9.4 billion from the public. Over that same time period, Huabao has paid HK$1.2 billion back to the public in the form of dividends. Thats 13% of what was raised over six years. Based on our time weighed calculation, the Chairwoman could have put the money she raised in a bank account earning 5.00% interest and still made those payments to public shareholders. And despite official statistics, anyone who actually lives in China will know that 5.00% doesnt even cover the cost of inflation. With some perspective, suddenly Huabaos dividend story doesnt seem so compelling anymore.

People assume that financial schemes can be successful as long as money doesnt need to be paid out. In fact, financial schemes are successful precisely because they appear to pay so well. -Forum Post


The Dividend Story



[sec 6]

Its never easy to value a company where there is little faith in management or the numbers they provide. Applying a multiple to questionable numbers to arrive at a share price is an exercise in futility. The truth is, we have no idea how much Huabao is worth. The Company certainly has an underlying business, but as we have presented here, we believe that business is grossly exaggerated. SAIC net income adjusted for R&D is ~40% less than the net income of HK$1,632 reported in Hong Kong filings. Our discussions with the tobacco factories indicated a smaller tobacco business than that reported in the Companys public filings. We found customers in the food business that denied being customers. The margin profile is unbelievable. The truth is that we have no idea what the real earnings of this business are. While we cant discern the true earnings of the Company and thus cant provide a confident valuation, we can speculate as to the long term prospects of Huabao. We do not believe that management will be able to maintain the current growth trajectory of revenue and by extension, dividends. Over the last few years, it was relatively inexpensive for management to declare robust dividends, given that a large portion of the payout circled back to the Chairwoman. However, with the Chairwoman significantly selling down her shares in the last two years, we believe it has become more and more unmanageable for Huabao to continue to declare dividends. In the future, we suspect management will have to significantly curb the growth rate of Huabao to ease the growing dividend burden. In fact, we believe this gearing down has already started to occur. For example, when management released the most recent half-year results on November 22, 2011, the share price dropped 10% the following day on the back of an unexpected slowdown in growth. Looking further back to June 17, 2011, this same slowdown surprise caused the stock to crash 23% over the next three days when the full-year 2011 results were released. Exhibit 22 Report
H1 2012 FY 2011 H1 2011 FY 2010 H1 2010 FY 2009 H1 2009 FY 2008 H1 2008 FY 2007

Release Date
22-Nov-11 17-Jun-11 26-Nov-10 18-Jun-10 2-Dec-09 18-Jun-09 2-Dec-08 16-Jun-08 29-Nov-07 13-Jul-07

Price Before
4.67 10.56 12.50 9.86 8.76 8.50 5.08 7.50 7.30 7.10

Price After
4.19 8.07 12.88 9.90 8.29 8.54 5.14 7.50 8.03 7.44

Change in Value
-10.3% -23.6% 3.0% 0.4% -5.4% 0.5% 1.2% 0.0% 10.0% 4.8%

As Exhibit 22 shows, these consecutive and large earnings misses are highly unusual for a company that has managed to hit or meet market estimates going back to 2007. 40

Equally of interest is that this unexpected slowdown in growth follows the Chairwomans significant share disposals. We recall that Ms. Chu was dubbed Queen of Cashout after decreasing her holdings in Huabao from 51% to 37% between April 12, 2010 and January 28, 2011. This is right before Huabao began missing consensus targets. We suspect in future reporting periods, shareholders will continue to see more of these earnings misses as management reigns in on the burgeoning dividend problem. Furthermore, Huabao has recently started expanding into a more capital intensive business by entering the Reconstituted Tobacco Leaves (RTL) business through a HK$1.3 billion acquisition. Management believes RTL will consume an additional HK$370 million in capital expenditures over each of the next two years, or 8x the HK$45 million in capex Huabao spent last year. Analysts had started believing in a sustained 50% payout ratio, but with the move in RTL, Huabao was able to manage these expectations back down to a 30% payout, as was detailed in reports from Deutsche Bank on June 22, 2010 and Nomura on August 5, 2010.


We believe management is materially overstating Huabaos earning power. The genesis of this overstatement was the Chemactive acquisition dating back to 2007, when management reported a questionable explosion in gross margins. In the early years, management was able to cover Huabaos fake earnings by acquiring assets from the Chairwoman and removing fake cash off the Companys balance sheet. However, as Huabao grew larger, it became more difficult to make sizable acquisitions and continue this practice. In the absence of material acquisitions, management was forced to declare dividends. Initially, the dividends were not a concern since the Chairwoman owned most of the shares and was able to reclaim the bulk of the dividends herself. However, over time the Chairwoman began selling down her shares and raised a fortune in the process. For her, that was the good news. The bad news was that with the share sell down, she lost her ownership in Huabao. This meant that as dividends continued to get paid out, more and more of the cash outflow left the Chairwoman and fell into the hands of public shareholders. This normally wouldnt be a concern, except that Huabao is paying out a larger portion of its income than it claims a result of its exaggerated business. Given this problem, management needs to significantly curb current growth to alleviate its committed dividend burden. Based on the results of the last two reporting periods, we believe this slow-down process has already started to occur and expect to see more moving forward.


Last Words
In preparing this report, we have been aided by various parties. These parties worked independently of each other and were unaware of the nature of the end product. This was both for their protection and ours. While well compensated, we would like to take this moment to thank those who helped us. At this point, you probably know who you are. Through our investigative process, we have come across additional information which we have decided against releasing. There are several reasons for this. One, we tried to provide this report with a certain flow and ease of reading, which additional information would have only obstructed. Second, we believe people should be allowed their own personal privacy. And finally, we have no financial interest in Huabao, which gives us no reason to overstate our case. However, we have an immense interest in the safety and well-being of our people. This is why all the information withheld from this report has been encrypted and stored online. This information pertains to Huabaos business, along with the personal information of the individuals who run Huabao behind the scenes and their associated proxies (you didnt actually think a 36 year old woman was the true running force behind one of Chinas largest public tobacco enterprises, did you?) Management is more than welcome to address concerns in this report. In fact, we encourage it. However, should we find that any individuals associated with this report has been threatened, or is otherwise in danger, we will release the encryption code into the public domain.

Cascade: tek / SynTehTek