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Expect it: Massive Asset Impairment and Devaluation Risk
Ticker: Market Cap: Recent Price: Conclusion:
JOY:NYSE US$6 billion US$57.24 Strong Sell
This report provides substantial evidence that Joy’s recently acquired IMM subsidiary was committing fraud since its IPO days, dating back to 2009. Five of the six largest customers disclosed by IMM appear to be shell entities or related parties controlled by IMM insiders. We sent teams to the registered address of these customers which turned out to include vacated buildings, residential compounds, or simply did not exist.
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Joy Global is a US$6 billion company that trades on the New York Stock Exchange (“JOY:NYSE”) and is a major manufacturer of heavy equipment and machines for the mining industry. Between 2011 and early 2012, Joy spent US$1.4 billion acquiring a Chinese company name International Mining Machinery Holdings, Ltd. (“IMM”) in an effort to expand its reach in China’s massive coal mining machinery market. Relative to its size, Joy’s US$1.4 billion acquisition of IMM was substantial in scope. IMM bills itself as a leading designer and manufacturer of underground longwall coal mining equipment in China.1 IMM was originally a publically traded company listed on the Hong Kong Stock Exchange before it was acquired by Joy Global. Recently, concerns regarding the integrity of IMM’s financial information have surfaced in the media and amongst investment professionals. The genesis of these concerns is an announcement made earlier this year by global heavy equipment manufacturer Caterpillar that a recently acquired Chinese subsidiary had engaged in “accounting misconduct” and would write down the value of this subsidiary. As it turns out, there are deep connections between the subsidiary where Caterpillar uncovered “accounting misconduct” and IMM, as both originally shared some of the same key owners and directors. As a consequence of these connections, some in the financial community were worried that just like Caterpillar, Joy Global would find accounting issues at IMM and likewise be forced to take a write-down – a painful process given the relative size of the IMM acquisition. We have conducted months of analysis and field work which shows that the concerns expressed by a chorus of media outlets, analysts, and critics were well-founded. The evidence we have gathered suggests that from its very beginning as a Hong Kong listed company, IMM was committing fraud. Most of IMM’s biggest customers appear to be nothing more than shell entities set up solely to transaction with IMM on paper, or inter-related parties owned and operated by IMM employees. Moreover, the address listed for most of IMM’s largest customers are either residential compounds, vacated buildings, or simply do not exist. Indeed, IMM has gone to great lengths to obscure the identity of its customers, including deliberately omitting the Chinese names of its customers in the Chinese version of its IPO prospectus. In the wake of Caterpillar’s announcements regarding the accounting misconduct that it discovered at its own newly-acquired Chinese subsidiary, Joy has publically stated that the financial information coming out of IMM is reliable. Yet despite these reassurances, Joy’s disclosures in its most recent 10-K filing confirm that Joy did NOT evaluate the internal controls over financial reporting at IMM.2 Finally, we show that one of IMM’s founders and his business partners have attempted to avoid necessary regulatory disclosures and also violated a non-compete agreement, potentially breaking securities and contract law. Based on the evidence presented in this report, we have every reason to believe IMM has engaged in prolonged fraud dating back to its IPO days. Accordingly, we are confident Joy Global will book a substantial write-down of its assets and faces considerable devaluation risk.
http://www.hkexnews.hk/listedco/listconews/SEHK/2012/0427/LTN20120427076.pdf pg. 2 http://www.sec.gov/Archives/edgar/data/801898/000119312512505211/d413371d10k.htm#fin413371_2 pg.F-4
On 18 January 2013, global equipment maker Caterpillar issued a surprising press release warning that it had uncovered a “deliberate, multi-year, coordinated accounting misconduct” at a Chinese subsidiary and would take a US$580 million impairment charge as a result. An internal investigation at Caterpillar had revealed that certain senior managers at the subsidiary had engaged in conduct that was “purposely designed to overstate the profitability of the *subsidiary+.”3 The term ‘fraud’ was not used – but that’s what it was. The subsidiary in question was ERA Mining Machinery Ltd. (“ERA”) (formerly “8043:HK”), a company that previously traded on the Hong Kong Stock Exchange before being acquired by Caterpillar in mid2012 for approximately US$677 million.4 At the time, ERA described itself as a designer, manufacturer and seller of underground coal mining equipment in China through its trade name and subsidiary, Siwei. Caterpillar is the global leader in the design and production of mining and construction equipment. With the acquisition of ERA, Caterpillar had hoped to expand its footprint in China, and “expand its leadership in the Chinese coal mining equipment industry.” That was then. And this is now. With the US$580 million impairment charge, Caterpillar effectively wiped out 86% of ERA’s US$677 million acquisition price, showing that ERA was more fiction than a real company. Many in the investment community found it surprising that such a conservative and reputable company could have been duped into acquiring a fraud. And this brings us to Joy Global. Joy Global is a US$6 billion company listed on the New York Stock Exchange (“JOY:NYSE”) that manufactures industrial machines with a focus on mining equipment, and is a competitor to Caterpillar. Around the time that Caterpillar was mulling its ill-fated acquisition of ERA, Joy was evidently looking to expand its own market share in China. Accordingly, between 2011 and early 2012, Joy acquired a company named International Mining Machinery (“IMM”) (formerly “1683:HK”) for approximately US$1.4 billion.5 Like ERA, IMM was a Hong Kong listed company that billed itself as a major designer and manufacturer of coal mining equipment for China’s coal industry. But that’s not where the similarities between ERA and IMM end. ERA was originally an obscure SOE (State-Owned Enterprise) that was transformed into a private company by two individuals named Mr. Rubo Li and Mr. Emory Williams – both entrepreneurs with prior interest in China’s construction industry. The two built ERA into an apparently profitable business and eventually listed the company on the Hong Kong Stock Exchange.
http://www.caterpillar.com/cda/components/fullArticleNoNav?m=393518&x=7&id=4326216 http://www.sec.gov/Archives/edgar/data/18230/000001823013000075/a10kpdfwithexhibits.pdf pg A-87 5 http://www.sec.gov/Archives/edgar/data/801898/000119312512505211/d413371d10k.htm pg F-16
As it turns out, while Mr. Li and Mr. Williams were promoting ERA for listing – a company which years later would be acquired by Caterpillar and be found to have engaged in accounting fraud – they were also busy building another company: IMM. A reading of IMM’s IPO prospectus tells of the deep connections between IMM and ERA. For example, Mr. Rubo Li and Mr. Emory Williams are mentioned 122 and 101 times, respectively.6 Moreover, the prospectus reveals a slew of inter-related loans between IMM, Mr. Li, Mr. Williams, and more interestingly, HK Siwei (the subsidiary of ERA where Caterpillar uncovered fraud). Exhibit 1 Transactions between IMM, ERA, and their mutual co-founders
Source: http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129037.pdf pg. 99
And so when Caterpillar announced in January 2013 that it had uncovered fraud at ERA, concerns started being expressed in the financial media and amongst investment professionals over Joy’s acquisition of IMM.7 After all, both companies had the same founders: Mr. Li and Mr. Williams. But on 15 February 2013, a month after Caterpillar’s announcement, the CEO of Joy Global came out and assured investors that Joy hadn’t found any need to write down the value of its IMM acquisition, stating that “we don’t see that there are any issues with that.”8 Back at base, our team wasn’t entirely convinced. It made little sense to us that of two related companies, one had engaged in “deliberate, multi-year, coordinated accounting misconduct” and the other was a completely clean business. Months of analysis and field work shows that the concerns expressed by a chorus of media outlets, analysts, and critics were well-founded. As outlined in this report, we believe that from its very beginning as a Hong Kong listed company, IMM was committing fraud. Most of IMM’s biggest customers appear to be nothing more than shell entities set up solely to transaction with IMM on paper, or interrelated parties owned and operated by IMM employees. Moreover, the address listed for most of IMM’s largest customers either do not exist or are the locations of questionable sites. Based on the evidence presented in this report, we are confident Joy Global will book a substantial write-down of its assets and faces considerable devaluation risk.
http://seekingalpha.com/article/1126641-joy-global-when-will-we-see-the-1-billion-write-down http://www.andrewjohns.ca/sites/default/files/JOY_20130128%20Coal%20and%20IMM%20Two%20Killjoys%20T rigger%20Downgrade.pdf 8 http://online.wsj.com/article/SB10001424127887323478004578305994088796074.html
In its filings, IMM described itself as the leading designer and manufacturer of underground coal mining equipment in China. As per the 2011 annual report, IMM operates through four subsidiaries:
Jiamusi Machinery: this subsidiary designs and manufactures roadheaders. A roadheader is a piece of excavating tunneling equipment that digs underground tunnels to the coalface in order to access the minable area.
Jixi Machinery: this subsidiary designs and manufactures shearer products. Shearers ride atop special conveyors and are used to cut coal from coal seams. Jixi Machinery and Jiamusi Machinery are IMM’s core subsidiaries and contribute to the bulk of Company-wide sales.
Huainan Longwall: IMM initially held a 75% equity interest in Huainan Longwall. The remaining 25% stake was purchased on 19 January 2010, making it a whollyowned subsidiary. Huainan Longwall designs armouredface conveyors (“AFC”). The AFC acts as an intermediate haulage system which carries the mined coal to another location where it is crushed into smaller pieces and removed from the mine.
Qingdao Tianxun: this subsidiary was acquired on 27 August 2010. Qingdao Tianxun manufactures electric control systems and related components for roadheaders, shearers, and AFCs. These control systems act as the “brain” of IMM’s other products.
IMM went public on the Hong Kong stock Exchange in February 2010, and raised approximately US$327 million in the process.9 In its IPO prospectus, the Company provided the names of its largest customers as well as a description of their relationship with IMM:
“Sales to our five largest customers accounted for 47%, 56%, 43% and 49% of our total revenue in 2006, 2007, 2008 and the seven months ended 31 July 2009, respectively… All of our five largest customers during these periods were independent third parties, and primarily consisted of distributors. None of our Directors, executive officers, associates or shareholders holding more than 5% of our issued share capital had any interest in any of our five largest customers in 2006, 2007, 2008 and the seven months ended 31 July 2009.10”
Following a celebrated tradition of avoiding transparency among Hong Kong-listed companies, IMM stopped providing customer names immediately after its IPO. As such, our analysis relies on the information provided in the prospectus. In any case, the prospectus makes clear that these customers are recurring, independent third parties and account for nearly half of IMM’s reported revenue.
http://www.youtube.com/watch?v=HmUJxuCLjb0 http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129037.pdf pg. 124
Before we analyze these customers in more detail, we want to note the same page from the Chinese version of the prospectus as presented below. This version translates the entire page into Chinese except for the names of the customers – despite the fact that they are all Chinese companies based in China:
Source: http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129038_C.pdf pg. 124
This convenient omission strikes us as odd. Indeed, it’s so odd that we have very little doubt that this was done deliberately by Management to obscure the identity of the customers. When we noticed this, one thing became immediately clear: there is a great disturbance in the force.
Looking at IMM’s customer list, only one of the customers is an actual mining company: Heilongjiang Longmay. Heilongjiang Longmay is a large, SOE coal mining company operating in Northeast China, and was listed as IMM’s top customer, accounting for 14% of revenue at the time. In light of its government background and scope of operations, we had little reason to doubt that Heilongjiang Longmay is a genuine customer of IMM, and accepted this at face value without confirmation. That’s the good news. The bad news is that ALL the other customers disclosed in its prospectus – comprising 35% of IMM’s revenue – are not mining companies, but merely third-party distributors. These third-party distributors supposedly act as middlemen for IMM, buying machinery from IMM and reselling them to mining companies, presumably at a mark-up. What’s interesting about this sales arrangement is that we could find no other company in China’s heavy equipment industry that operates through third-party distributors to such extent. For example, Sany International (“0631:HK”), a Hong Kong listed company and China’s largest manufacturer of roadheaders for the coal mining industry primarily sells to end-customers. Sany does incorporate independent distributors, but these distributors constitute only a small portion of total sales.11 In fact, the most frequent mention of distributors in Sany’s filings is in its prospectus with regards to overseas sales where Sany may not fully understand the local markets. But even in these cases, the distributors are still wholly-owned subsidiaries. Indeed, IMM’s heavy reliance on third-party distributors is so far removed from industry standards that the prospectus admits as much: “Our sales model, which focuses on sales through distributors and sales agents, distinguishes us from a number of our key competitors which sell products directly to end customers.”12 A recurring theme among the wave of questionable manufacturing/material goods companies that have blown up over the years is the use of intermediaries or distributors as middlemen.13,14,15 Using distributors can allow a company to hide who its end-customers are and prevents any sort of serious due diligence or scrutiny of revenue streams. Moreover, it’s significantly easier to set up a fake distributor than it is to set up a fake end-customer that might need to show some semblance of a real, economic operation. And with that background, we’re going to provide what we believe to be overwhelming evidence that all of the distributors IMM claimed as independent customers are actually related parties that we suspect were simply set up to inflate IMM’s sales ahead of its IPO debut.
http://www.hkexnews.hk/listedco/listconews/SEHK/2011/0905/LTN20110905605.pdf pg 9 http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129037.pdf pg 122 13 http://www.thestar.com/business/2012/07/31/sinoforest_says_several_companies_that_owe_it_millions_no_lo nger_exist.html 14 http://www.citronresearch.com/longtop-financial-nyselft-final-proof-of-undisclosed-related-party-transactions/ 15 http://www.citronresearch.com/citron-updates-home-solutions-of-america-nasdaqhsoa/
Customer #2: Shanxi Guangfa Coal Mining Machinery (“Shanxi Guangfa”)
The prospectus lists Shanxi Guangfa as IMM’s second largest customer, accounting for approximately 13% of revenue at the time. We have acquired the documents that Shanxi Gaungfa filed with the SAIC.16 These documents show that Shanxi Guangfa is not a real customer but rather a subsidiary controlled by IMM. Starting at the beginning, the SAIC documents show that Shanxi Guangfa was incorporated on 15 January 2006:
This date is only three months before IMM itself was incorporated, on 12 April 2006.17 We found it somewhat convenient that IMM and its second largest customer were incorporated within three months of each other (later on we find out all the customers have been incorporated around the same time frame).
By way of background, Chinese companies are required to file annual financial and business information with the State Administration for Industry and Commerce (SAIC). SAIC filings are public documents. 17 http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129037.pdf pg. 90
Now here’s where it gets interesting – the registered address of Shanxi Guangfa is listed as: 1/F, Building 43, 35 East Jinyang Street, Xiaodian District, Taiyuan City, Shanxi Province (Chinese: 太原市小店区晋阳东街35号43栋1层)
It’s worth noting that Shanxi Guangfa has filed documents with the SAIC annually, yet maintained the same registered address. Our contacts visited this address but there was no company called Shanxi Guangfa to be found. All we found was an empty building that locals explained had been vacated due to government relocation:
So, who’s the intrepid entrepreneur that’s apparently operating a multi-million dollar distribution company out of a vacant building? Well, according to the SAIC documents, the registered controlling shareholder of Shanxi Guangfa is someone by the name of Mr. Liu Xueguang (Chinese: 刘学广):
Who is Mr. Liu Xuegang? The SAIC filings show that at the time of incorporation, Mr. Liu put himself down as an employee of Jiamusi Machinery Taiyuan Sales Subsidiary – a subsidiary of IMM.
But that’s not all – we also found Shanxi Guangfa’s corporate profile on the industry association website of China Coal Infrastructure. This profile explicitly states that Shanxi Guangfa is a subsidiary of Jiamusi Machinery (IMM subsidiary):
Moreover, this profile provides a contact number (+86351-5268377). When we called this number, we were greeted by an automatic recording welcoming us to “Jiamusi Machinery Taiyuan Sales Subsidiary… our general manager is Mr. Liu Xueguang.” This recording confirmed two findings: 1) Shanxi Guangfa, the supposed second largest customer to IMM is actually a subsidiary of IMM. 2) Mr. Liu Xueguang, the man who is registered as the controlling shareholder and legal representative of Shanxi Guangfa is actually an employee and a general manager at IMM.
But it gets better. In addition to providing a phone number, the above profile also provides a company address for Shanxi Guangfa that is different than the registered address provided in the SAIC documents. We visited this new address which is shown as: 1/F, Building 2, Happy Forest, 10 West Kangning Street, Xiaodian District, Taiyuan City, Shanxi Province (Chinese: 山西省太原市小店区康宁西街10号欢乐林栖2号楼一层) As pictured below, this address turned out to be a residential compound:
The first floor of Building 2
Hmmmm... As per the prospectus, Exhibit 2 shows that between 2006 and 2009, Shanxi Guangfa purchased tens of millions of dollars of equipment from IMM. We find it hard to believe transactions of this size were being carried out in a modest apartment complex.18 Exhibit 2 (In RMB thousands) 2006 IMM Revenue % Contributed from Shanxi Guangfa Revenue from Shanxi Guangfa 545,878 13% 70,964 2007 12% 102,916 2008 13% 166,360 2009 873,018 13% 113,492 857,633 1,279,693
Note: Fiscal 2006 is from 12 April to December 31, 2006. Fiscal 2009 is from 1 January to 31 July 2009.
But maybe Marissa Mayer was wrong about working from home.
Finally, according to the SAIC filings it seems that Shanxi Guangfa experienced a balance sheet reduction right before IMM was wholly acquired by Joy Global. As the following income statement shows, in 2011, Shanxi Guangfa recorded revenue of RMB290 million and loss of RMB2 million versus revenue of RMB372 million and net profit of RMB3 million in 2010. This drop in business isn’t the most positive sign for a company, but at least the company seemed operational on the income statement.
However, what is highly unusual is that on its balance sheet, Shanxi Guangfa was disappearing. In 2011: Inventory decreased from RMB6 million to 0 (zero) Accounts receivable decreased from RMB139 million to RMB9 million Cash decreased from RMB17 million to RMB0.3 million Total current assets decreased from RMB188 million to RMB10 million Accounts payable decreased from RMB175 million to RMB0.2 million Total current liabilities decreased from RMB180 million to negative RMB0.2 million (negative liability).
We don’t know what to make of Shanxi Guangfa’s disappearance at the end of 2011, but we suspect it had to do with Joy’s acquisition of IMM which closed in early 2012.
Takeaway from Shanxi Guangfa
IMM listed Shanxi Guangfa as its second largest customer in its prospectus. It was also listed as an independent distributor. Shanxi Guangfa was incorporated a mere three months before IMM was incorporated. Furthermore, it was incorporated by an IMM employee (Mr. Liu Xueguang) who continues to work at IMM today. An industry association profile states that Shanxi Guangfa is actually a subsidiary of IMM and not an independent entity as claimed in the IMM prospectus. The number listed on the profile leads to a recording that confirms Shanxi Guangfa is a subsidiary of IMM and that Mr. Liu Xueguang is the general manager of the subsidiary. The address Shanxi Gaungfa has registered with the government is a vacated building. The address that Shanxi Gaungfa has on its public profile is a residential apartment complex. At the end of 2011, Shanxi Guangfa seems to have disappeared on paper – right before IMM was wholly acquired by Joy Global.
So, here we have Shanxi Guangfa, a company that IMM claimed in its prospectus as an independent customer that turned out to be controlled by an IMM general manager. Not only that, on its own corporate profile Shanxi Guangfa states that it’s a subsidiary of IMM and provides a phone number with a recording that further confirms this. Furthermore, site visits to Shanxi Guangfa’s listed addresses turned out to be dead ends. And if all of this wasn’t bizarre enough, right before IMM was acquired, Shanxi Guangfa seems to have simply disappeared on its balance sheet. Poof! We suspect that Shanxi Guangfa was always a subsidiary of IMM. However, IMM decided to claim that Shanxi Guangfa was an independent customer to fabricate sales and boost reported revenue ahead of its IPO on the Hong Kong Stock Exchange. Prior to the acquisition by Joy, Shanxi Guangfa was “cleaned up” to hide all of this. There are more holes, inconsistencies and untied ends in Shanxi Guangfa’s story than the season finale of Lost. We are REALLY looking forward to hearing those responsible put together a coherent explanation for all these contradictions.
Customer #3: Diaobingshan Jiamei Machinery Sales (“Diaobingshan Jiamei”)
The prospectus lists Diaobingshan Jiamei as IMM’s third largest customer, accounting for approximately 9% of revenue at the time. We have acquired SAIC filings which show that Diaobingshan Jiamei was in fact a related party, and not an independent distributor as stated in the IMM prospectus. According to the filings, Diaobingshan Jiamei was incorporated on 10 February 2006 and eventually deregistered in September 2011. As was the case with IMM’s second largest customer, it appears that Diaobingshan Jiamei was incorporated around the same time IMM was incorporated, and then simply disappeared in the months leading up to the Joy acquisition:
Additionally, the above filing shows Diaobingshan Jiamei’s registered address is listed as: Store 3, Building 6, Zhenxing Complex, Zhenxing Road, Diaobingshan City, Liaoning Province (Chinese: 调兵山市振兴路振兴小区6楼3号门市) Our contacts visited this address and here’s what they found:
As IMM’s third largest customer, Diaobingshan Jiamei supposedly dealt in tens of millions of dollars worth of machinery each year, as presented in Exhibit 3. How much worth of heavy mining equipment do you figure they could have stuffed behind that garage door?
Exhibit 3 (In RMB thousands) 2006 IMM Revenue % Contributed from Diaobingshan Jaimei Revenue from Diaobingshan Jaimei 545,878 6% 32,753 2007 8% 68,611 2008 9% 115,172 2009 873,018 9% 78,572 857,633 1,279,693
Note: Fiscal 2006 is from 12 April to December 31, 2006. Fiscal 2009 is from 1 January to 31 July 2009.
Moreover, the SAIC filings show that Diaobingshan Jiamei’s legal representative and controlling shareholder is a man by the name of Mr. Xing Shiguang (Chinese: 邢士光). And who is Mr. Xing Shiguang? We found the answer to that question through Jiamusi Machinery’s website. As we mentioned at the beginning of this report, Jiamusi Machinery is one of IMM’s four operating subsidiaries and thus has its own website. On this website is a map that provides location and contact information for Jiamusi’s various sales subsidiaries throughout China:
As it happens, Jiamusi Machinery has a sales subsidiary located in the city of Diaobingshan, the same city where Diaobingshan Jiamei (IMM’s third largest customer) would have been located before it was deregistered. A click on the link brings up the following organizational chart showing a Mr. Xing Shiguang as the general manager of an IMM sales subsidiary located there:
This Mr. Xing Shiguang appears to be the same Mr. Xing Shiguang that was registered as Diaobingshan Jiamei’s legal representative and controlling shareholder. This finding throws into question IMM’s claims that Diaobingshan Jiamei was an independent distributor. 21
Presumably, the argument can be made that Mr. Xing Shiguang only recently became an employee of IMM, but wasn’t associated with IMM when he was the running the Diaobingshan Jiamei distributor. Well, we also have proof that Mr. Xing Shiguang was an IMM employee during the all-important years spanning 2006 to 2009 – the years that the IMM prospectus says its third largest customer was an independent third party. Here is an SAIC filing for an IMM subsidiary that was deregistered in July 2007:
For the sake of simplicity, the only relevance of this filing is that it shows that when this IMM subsidiary was deregistered in 2007, Mr. Xing Shiguang was listed as the legal representative. Therefore, it’s pretty clear that Mr. Xing Shiguang was an employee of IMM smack-dab in the middle of the 2006 – 2009 period, showing yet again that IMM’s third largest “independent” customer was actually controlled by IMM insiders. And boom goes the dynamite.
Takeaway from Diaobingshan Jiamei
Diaobingshan Jiamei was listed as IMM’s third largest customer in its prospectus. It was also listed as an independent distributor. Diaobingshan Jiamei was incorporated a mere two months before IMM was incorporated. Furthermore, Diaobingshan Jiamei’s legal representative and controlling shareholder was and continues to be an employee of IMM. We visited the address Diaobingshan Jiamei had registered with the government. We are not sanguine that a real business of the size claimed in IMM’s prospectus could have ever operated out of a location better suited for a small convenience store. Diaobingshan Jiamei was deregistered on September 2011, a few months before IMM was acquired by Joy Global.
Diaobingshan Jiamei seems to have been a fake customer set up by IMM insiders for the purpose of transacting with IMM on paper. This would have allowed IMM to inflate its income ahead of its IPO. Moreover, Diaobingshan Jiamei seems to have been deregistered ahead of Joy’s acquisition of IMM. It makes very little sense for a customer of Diaobingshan Jiamei’s purported size to simply deregister and disappear right before an acquisition unless it was set up to perpetuate a fraud.
Customer #4: Shandong Jiamei Roadheader Sales (“Shandong Jiamei”)
The prospectus lists Shandong Jiamei as IMM’s fourth largest customer, accounting for approximately 7% of revenue at the time. We have acquired SAIC filings which show that Shandong Jiamei was controlled by an IMM insider, and not an independent distributor as stated in the IMM prospectus. According to the filings, Shandong Jiamei was incorporated on 5 February 2005 by a legal representative and controlling shareholder named Mr. Lian Shuiqing (Chinese: 廉水箐):
Who is Mr. Lian Shuiqing? As we noted previously, Jiamusi Machinery (IMM subsidiaries) has its own website, with a map that provides location and contact information for Jiamusi’s various sales subsidiaries throughout China:
This map shows that Jiamusi Machinery has a sales subsidiary located in the province of Shandong, the same province where Shandong Jiamei (IMM’s fourth largest customer) would be located. A click on the link brings up the following organizational chart which shows a Mr. Lian Shuiqing as the general manager of an IMM subsidiary located there:
This Mr. Lian Shuiqing appears to be the same Mr. Lian Shuiqing that was registered as Shandong Jiamei’s legal representative and controlling shareholder. As with the previous customer, this finding throws into question IMM’s claims that Shandong Jiamei was an independent distributor and customer. 25
Once again, the argument can be made that Mr. Lian Shuiqing only recently became an employee of IMM, but wasn’t associated with IMM when he was the running the Shandong Jiamei distributor. And once again we have proof that Mr. Lian Shuiqing was an IMM employee during the all-important years spanning 2006 to 2009 – the years that the IMM prospectus says Shandong Jiamei was an independent third party. Here is the SAIC filing of an IMM subsidiary which was incorporated in November 2003, and deregistered in October 2006, showing Mr. Lian Shuiqing as the legal representative at the time:
Again, to keep things simple, the only relevance of this filing is that it shows that when this IMM subsidiary was deregistered in 2006, Mr. Lian Shuiqing was listed as the legal representative. This proves that Mr. Lian Shuiqing was both an employee of IMM as well as the legal representative and controlling shareholder of Shandong Jiamei during the 2006 – 2009 period in which IMM claimed Shandong Jiamei was an independent distributor and its fourth largest customer.
Now, we get to Shandong Jiamei’s address which is listed as: 679 Xingye Road, Zoucheng District, Jining City, Shandong Province (Chinese: 山东济宁市邹诚市兴业路679号) We sent a team to this location on a weekday and here’s what they found:
Of all the customer addresses our teams visited, this location was the closest thing to a real, commercially viable facility. That said, despite several hours of observation, our team noticed that:
The front gates of the facility were locked. No movement was seen inside the facility, no one came in or out, no lights were on, no sound was heard. The facility was observed to be small and our contacts were confident that if work was being undertaken at the factory they would have seen and heard it. Our contacts spoke with workers at nearby factories who claimed that the facility had not been operative for a “long time”.
On a follow up visit to the facility on a Sunday morning, our contacts observed a few people inside the property standing around in the area near the gate. But again, there was no evidence observed of any machinery or vehicles coming in or out of the facility or that the facility was otherwise engaged in any business related to heavy mining equipment.
Takeaway from Shandong Jiamei
Shandong Jiamei was listed as IMM’s fourth largest customer in its prospectus. It was also listed as an independent distributor. Shandong Jiamei’s legal representative and controlling shareholder is also a general manager of an IMM subsidiary, having been employed by IMM since at least 2006. Our contacts visited Shandong Jiamei’s registered address and found a real, commercially viable facility. Unfortunately, nearby neighbours told our contacts that the facility had been nonoperational.
Following tradition, Shandong Jiamei appears to be yet another customer established by IMM, and not an independent third party as claimed in the IMM prospectus. Furthermore, there does not appear to be any business activity at Shandong Jiamei’s registered address.
Customer #5: Ningxia Jiamei Machinery Sales (“Ningxia Jiamei”)
The prospectus lists Ningxia Jiamei as IMM’s fifth largest customer, accounting for approximately 6% of revenue at the time. We have acquired SAIC filings which show that Ningxia Jiamei is controlled by IMM insiders and is in fact not an independent entity. Moreover, our investigation shows that the address supplied by Ningxia Jiamei does not exist. According to the SAIC filings, Ningxia Jiamei was founded on 4 August 2005, and controlled by three shareholders: Ms. Li Yuexia (Chinese: 李跃霞) – with 50% ownership Mr. Li Yuetang (Chinese: 李跃堂) – with 30% ownership Mr. Ma Xianlong (Chinese: 马宪龙) – with 20% ownership
We do not know the identities of the first two shareholders, but it appears that Mr. Ma Xianlong, the 20% shareholder of Ningxia Jiamei is also a general manager of an IMM subsidiary...
Another visit to the Jiamusi Machinery website shows that IMM has a distributor listed in the Ningxia region – the same area that Ningxia Jiamei (IMM’s 5th largest customer) is located.
A click on the link provides the following organizational chart of the subsidiary:
This chart shows that the general manager of this IMM subsidiary is a Mr. Ma Xianlong – the same Mr. Ma Xianlong who has a 20% ownership interest in IMM’s fifth largest customer. As seems to be the running theme, these connections throw into question IMM’s claims that Ningxia Jiamei was an independent distributor and customer.
Adding an even seedier element to this whole drama is that the address for Ningxia Jiamei doesn’t seem to exist. The below filing shows that that the registered address of Ningxia Jiamei is listed as: Family dormitory building of National Taxation Bureau, East Donghuan Road, Lingwu City, Ningxia Autonomous Region (Chinese: 灵武市东环东侧国税局家属楼)
We dispatched two different teams to this address and neither team was able to locate any such address. It’s not so much that the company didn’t exist at the address – but that the whole address doesn’t exist. But even if such an address did exist, it would not be housing a heavy equipment distributor. This address as stated is of a “Family dormitory building of National Taxation Bureau.” If real, this would be the location of a dormitory that houses the staff of a government tax authority, which would almost certainly not allow a private commercial enterprise to operate in the building. Whoever submitted this address is clearly new to lying. 31
Takeaway from Ningxia Jiamei
Ningxia Jiamei was listed as IMM’s fifth largest customer in its prospectus. It was also listed as an independent distributor. Mr. Ma Xianlong is the 20% shareholder and legal representative of Ningxia Jiamei. He is also a general manager at an IMM subsidiary. The address Ningxia Jiamei has registered with the government does not exist.
These customers seem to get more and more elusive. Not only does Ningxia Jiamei not appear to be an independent customer as stated in IMM’s prospectus, but the registered address doesn’t even seem to exist.
Ningxia Jiamei IMM’s 5th largest customer
Last seen in the IMM prospectus
Customer #6: Shuozhou Longmay Coal Mining (“Shuozhou Longmay”)
The prospectus lists Shuozhou Longmay as IMM’s 6th largest customer, accounting for approximately 6% of revenue at the time. According to the SAIC filings, Shuozhou Longmay was incorporated on 8 March 2006, which is one month before IMM was incorporated:
This filing also shows that Shouzhou Longmay’s legal representative and controlling shareholder is a Mr. Chen Ziliang (Chinese: 陈子良). We could not find Mr. Chen Ziliang’s name on the Jiamusi Machinery website as we were able to do with previous names. However, we can still show that Mr. Chen Ziliang was an IMM insider during the 2006 – 2009 period in which IMM claimed Shouzhou Longmay was an independent distributor.
Here is a filing of an IMM subsidiary which had its business license revoked by the local SAIC office in March 2008. The legal representative listed at the time was Mr. Chen Ziliang:
As was the case with the other “independent” customers, this filing shows that Shouzhou Longmay’s legal representative and controlling shareholder was also an employee of IMM as early as 2008.
But in the case of Shouzhou Longmay, a connection between IMM and its customer are the least of worries. According to the prospectus, Shuozhou Longmay contributed to 7% of IMM’s RMB546 million revenue in 2006, which translates to RMB38 million, as presented in Exhibit 4: Exhibit 4 (In RMB thousands) 2006 IMM Revenue % Contributed from Shouzhou Longmay Revenue from Shouzhou Longmay 545,878 7% 38,211 2007 16% 137,221 2008 6% 76,782 2009 873,018 0% 0 857,633 1,279,693
Note: 2006 and 2009 reported numbers are not for the full year.
However, according to the SAIC filings, this is impossible. As per its income statement, Shuozhou Longmay only recorded RMB1.2 million in sales and RMB1.1 million in cost of goods sold in all of 2006:
Moreover, according to its balance sheet, Shuozhou Longmay only had RMB2.7 million worth of inventory at year-end 2006:
If we combine the cost of equipment sold, plus what Shouzhou Longmay still has in inventory, we get (1.1 + 2.7) = RMB3.8 million in total purchases. That’s only 10% of the RMB38 million IMM claimed it sold to Shuozhou Longmay in 2006. Either Shuozhou Longmay lied to the government, or IMM simply fabricated the revenue numbers for its IPO listing. In any case, we find it pretty sloppy that despite having control of Shuozhou Longmay, IMM didn’t even bother making the SAIC financials match the prospectus.
But perhaps there’s a reason that Shuozhou Longmay’s SAIC filings show it barely made any money in 2006, despite claims by IMM. The registered address of Shuozhou Longmay is listed as: No. 9, Cuifengyuan Complex, East Pingshuo Road, Shuozhou City, Shanxi Province (Chinese: 山西省朔州市平朔路东翠丰苑小区9号) We sent a team to this address and found that it’s a residential complex. Moreover, there was no “No. 9”. But here’s a picture of building No. 5:
Just look at this pit of despair – no wonder Shuozhou Longmay had a rough year in 2006. But what’s even funnier about Shuozhou Longmay’s registered address is that they don’t provide a unit number for this imaginary “No. 9.” So even if this building did exist, would Shuozhou Longmay occupy the entire apartment complex? This is grade-school intrigue at its finest.
And if all of this wasn’t enough, in 2012, the Shuozhou City SAIC revoked Shuozhou Longmay’s business license because the company failed to file an annual inspection for the year 2010. It appears that Shuozhou Longmay only existed between 2006 and 2009 – the track period that IMM used in its prospectus to get listed on the Hong Kong Stock Exchange:
Takeaway from Shuozhou Longmay
Shuozhou Longmay was listed as IMM’s 6th largest customer in its prospectus. It was also listed as an independent distributor. Shuozhou Longmay was incorporated one month before IMM was incorporated. Furthermore, the company’s legal representative and controlling shareholder was and continues to be a manager of a core IMM subsidiary. The financial information provided by Shuozhou Longmay to the government shows that it could not possibly have bought anywhere near the amount of equipment IMM claims in its prospectus. The IMM prospectus claims that Shuozhou Longmay bought 10 times more equipment in 2006 than what the SAIC filings show. Shuozhou Longmay’s registered address = LOL!! Shuozhou Longmay was suspended in 2012 by the government after failing to submit its 2010 annual inspection forms. This means that Shuozhou Longmay was only active between 2006 and 2009.
Shuozhou Longmay appears to be yet another fake customer established by IMM. Government records show that Shuozhou Longmay was only an active company between the 2006 and 2009 tracking period that IMM used to get listed on the Hong Kong Stock Exchange. Shouzhou Longmay’s only reason to exist seems to have been to inflate IMM’s profitability before going public since the SAIC filings show that Shuozhou Longmay could not possibly have bought anywhere near the amount of equipment claimed by IMM.
Conclusion: IMM Customers
When Caterpillar announced that it had uncovered a “deliberate, multi-year, coordinated accounting misconduct” at ERA and its Siwei subsidiary, it disclosed that the nature of this misconduct involved improper revenue recognition practices and cost allocation that resulted in overstated profits. Moreover, the announcement put the blame on the senior managers in charge, stating that “Caterpillar’s investigation determined several Siwei senior managers engaged in deliberate misconduct beginning several years prior to Caterpillar’s acquisition of Siwei.” In response, Caterpillar removed those senior managers responsible for the misconduct and installed a new leadership team. 19 Based on all the evidence presented in this report, it would hardly be a stretch to conclude that IMM has used the exact same playbook in committing its own fraud. From the very beginning, IMM’s sales structure of relying primarily on third-party distributors was dubious and at odds with the industry standard of selling straight to end-customers. Five out of six of the Company’s largest customers were apparently “third-party distributors” incorporated around the same time, who by all indications are nothing more than subsidiaries or shell entities set up by IMM insiders to inflate revenue numbers. Not a single address our teams visited appeared valid and operational – vacated buildings, apartment complexes, addresses that don’t exist – what multi-million dollar heavy equipment distributors operate like this? Moreover, the Chinese version of the prospectus deliberately omitted the Chinese names of IMM’s customers, obscuring their identities. Nothing IMM has done in regard to its customers appears honest and transparent. These are not the actions of a company that purports to be one of China’s leading manufacturers of coal mining equipment. But they are the actions of a company seeking to obfuscate the truth.
The Qingdao Tianxun Acquisition
For all the looming questions surrounding ERA and IMM, very little scrutiny has been put on their founders, Mr. Rubo Li and Mr. Emory Williams. We expect this to change in the coming months as Caterpillar and Joy Global beef up their litigation teams and extract answers using China’s fair and robust legal system. In any case, our own investigation shows that at least one founder – Mr. Rubo Li – has a very relaxed definition of securities and contract law. In this section, we focus on IMM’s acquisition of Qingdao Tianxun, which as we briefly mentioned at the beginning of this report is one of the four operating subsidiaries which comprise IMM. Qingdao Tianxun manufactures control systems which are used as the “brains” of IMM’s other products, and was acquired by IMM in mid-2010 for RMB539 million.20 According to the press release announcing the acquisition, Qingdao Tianxun was owned by four people: Mr. Deng Kefei, with a 30% interest Mr. Deng Kelong, with a 60% interest (presumably Mr. Deng Kefei’s brother) Mr. Ma Fuqian, with a 5% interest Mr. Wang Dongxing, with a 5% interest
Besides naming the owners of Qingdao Tianxun, the press release made it clear that these four individuals were “a third party independent of *IMM+ and connected persons of *IMM+.” Of course. In researching Qingdao Tianxun, we also came across a different company named Qingdao Tianxin Electric (Chinese: 青岛天信电气有限责任公司) (“Qingdao Electric” for the sake of clarity). These companies have very similar names, but are entirely different entities. In fact, not only are the names similar, but so are their lines of business. Here is the business description of Qingdao Tianxun (acquired by IMM): “Qingdao Tianxun is a manufacturer and supplier of electric control systems and related components for roadheaders, shearers, armoured-face conveyors, and other mining equipment”
And here is the business description of Qingdao Electric (random company we ran into): “[Qingdao Electric] specializes in developing and manufacturing mining electric and automation solutions. The company manufactures high and low voltage frequency converter, and contactor set for mining usage, both of which are explosion-proof”21
http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0715/LTN20100715268.pdf http://www.tianxindianqi.com/en/info/?2-1-1.html (we are ecstatic that their equipment is explosion-proof)
Curious to learn more about Qingdao Electric, we pulled its SAIC filings. Surprisingly, the filings show that this company is owned 90% by two shareholders that our readers should by now be familiar with: Mr. Deng Kefei, and Mr. Rubo Li. The filings show that several rounds of capital injections had been made by early 2010, with each individual contributing RMB22.5 million to Qingdao Electric for a combined 90% ownership of the company:
Recall that the acquisition announcement by IMM stated that Qingdao Tianxun was owned entirely by independent third parties with no connections to IMM insiders. One of these individuals was Mr. Deng Kefei with a 30% stake. However, the above documents show that Mr. Deng Kefei was (and is) a business partner of Mr. Rubo Li, with each owning 45% of Qingdao Electric – a previously undisclosed company we stumbled upon. This brings up a burning question: why did IMM’s acquisition announcement of Qingdao Tianxun state that all of the vendors were independent third parties when in fact one of them (Mr. Deng Kefei) was the business partner of Mr. Rubo Li, a founder and then-Director of IMM?
This apparent puzzle can be explained through a crafty maneuver captured by an analysis of the SAIC filings. On 6 July 2010 – just nine days before IMM announced the acquisition of Qingdao Tianxun – Mr. Deng Kefei transferred his entire holdings in Qingdao Electric to a woman named Ms. Wang Yanxia (Chinese: 王衍霞). This transfer technically disassociated Mr. Deng Kefei from Mr. Li. 11 months later, after the IMM acquisition of Qingdao Tianxun was completed, Mr.Deng Kefei had his entire stake of Qingdao Electric transferred back to him by Ms. Wang Yanxia:
By “parking” his shares of Qingdao Electric with Ms. Wang Yanxia, Mr. Deng Kefei was free to sell Qingdao Tianxun to IMM without having to reveal that he was in fact the business partner of Mr. Li. Such is the spirit of the law, no doubt. One can only speculate as to what kind of side arrangement Mr. Li and Mr. Deng Kefei had regarding this sale.
As a side note, Mr. Li had signed a non-compete agreement with IMM promising not to “compete, directly or indirectly, with our business during the period from 16 May 2006 and ending 16 May 2011.”22 Yet, it seems that he was already competing with IMM via his undisclosed other company, Qingdao Electric. One industry source even told us that after Qingdao Tianxun was sold to IMM, Mr. Li used his contacts to shift clients and key personnel over to Qingdao Electric.
http://www.hkexnews.hk/listedco/listconews/SEHK/2010/0129/LTN20100129037.pdf pg. 124
When Caterpillar notified the public of accounting misconduct at ERA and the removal of its management team, the executives at Joy Global should have immediately announced a thorough investigation into IMM and the executives in charge – not issued statements to the press that everything was sunshine and rainbows. It’s not like ERA and IMM are completely unrelated enterprises – they are sister companies and Mr. Rubo Li and Mr. Emory Williams were the architects of both companies! There is no substitute for management integrity, and that goes for both IMM as well as Joy. Joy spent US$1.4 billion of shareholder money on an acquisition that has a very real possibility of being a fraud. That’s not pocket change. With so much at risk, the management team at Joy owed it to shareholders to proactively investigate IMM further – not be forced into it because we did their diligence work for them. Throughout, Joy has maintained the integrity of the financials reported by IMM, even going as far as to call their due diligence on IMM “substantial”. 23,24,25 Yet for all this confidence, Management disclosed in the most recent 10-K filing with the SEC dated 17 December 2012 that Management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did NOT include the internal controls of International Mining Machinery Holdings, Ltd.: “[W]e conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework. As allowed by the SEC guidance, management excluded from its assessment International Mining Machinery Holdings, Ltd., which was acquired in 2012 and constituted 27.1% and 55.4% of total and net assets, respectively, as of October 26, 2012 and 3.9% and 0.8% of net sales and net income, respectively, for the year then ended.” 26
Wow... seriously?! May we humbly suggest that Joy’s Management fulfill its most basic fiduciary duties to its shareholders and proceed to conduct a thorough evaluation of the internal controls over financial reporting of IMM?
http://www.bizjournals.com/milwaukee/blog/2013/02/joy-global-might-avoid-caterpillars.html?page=all http://seekingalpha.com/article/1230561-joy-global-management-discusses-q1-2013-results-earnings-calltranscript?page=2 25 http://online.wsj.com/article/SB10001424127887323478004578305994088796074.html 26 http://www.sec.gov/Archives/edgar/data/801898/000119312512505211/d413371d10k.htm pg. F-4
Recently, there have been talks of Joy being acquired by a competitor. In fact, in a February 2013 note to clients, CLSA analysts cited a possible acquisition as one reason to buy shares of Joy. Are you fucking kidding? The IMM subsidiary accounts for nearly a quarter of assets, half of shareholders equity, and a whopping 20% of Joy’s market cap. What kind of potential acquirer with an instinct for self-preservation would touch Joy without a sweeping audit of IMM? What would that boardroom pitch sound like?: “You know, we haven’t made an offer for Joy Global yet, but with the black box that is IMM and the possible litigation costs, not to mention the overall industry being in the shitter, this is exactly what we’ve been waiting for. We would be crazy not to acquire Joy right now! [Smashing Jim Cramer’s ‘BUY BUY BUY’ button]” Head of M&A at some random Company
There are a lot of questions surrounding IMM, its management team, and its founders – but very few people willing to actually dig for the answers it seems. We focused our team’s resources to analyzing IMM’s disclosed customers, their government filings, their owners and legal representatives, and conducting on-site visits to the customers disclosed by IMM in its IPO prospectus – often multiple times. We didn’t rely on IMM’s representations nor previous audit work which is notoriously shoddy in Hong Kong and China. How many auditors, investment bankers, and analysts charged with verifying IMM’s operations and financial information can say the same thing? If IMM turns out to be a fraud, Joy will join a long and distinguished list of investors and superstar hedge fund managers who have been duped in China. And for the sake of everyone, we hope that there is a coherent, logical explanation for everything we have presented here. We just don’t expect that to be the case. In the end, we want our readers to understand this and understand this well: It would have been about impossible for us to uncover so many inconsistencies, holes, and red flags if all was well at IMM. The individuals behind IMM have a lot to answer for.
“But China has proven to be a graveyard of good intentions for high-profile investors who swore up and down that good research, big law firms and bigger accounting firms will protect their investments. Time after time, their best practices and high-priced talent have failed to detect even the most elementary red flags. Moreover, they ignored and rejected repeated suggestions that problems were afoot.” -Roddy Boyd, The Financial Investigator
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