China Taifeng Bedding Holdings Limited

Done by: Lin Liye Singapore Management University School of Economics

A case study on a potential fraud SEHK: 0873

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Executive Summary Warning Signs Available in the IPO Prospectus 1.  Poor reputation of “independent” directors and affiliations with other fraudulent or

failed companies 2.  Heavy reliance on an “independent” third party Taifeng Textile Group (“TTG”) for

majority of sales and supplies as well as multiple connected transactions between Taifeng and TTG

Methods Used to Tunnel Out Wealth 1.  Use of finance lease agreements and loan agreements 2.  Use of prepayment to suppliers 3.  Multiple transactions with TTG since IPO 4.  100m shares investment in Combest Holdings Limited soon after IPO Other Warning Signs 1.  Resignation of Deloitte as auditor in December 2013 2.  Various clues in financial statements for the analyst to spot misbehaviour

–  Large increases in prepayments to suppliers and a large restatement in 2013 –  Restated bank borrowings in 2013 matching increase in prepayments –  Unreasonable selling expenses as a % of sales and net margins that do not

reflect the commodity nature of Taifeng’s products 2

Introduction Focus of the presentation 1.  To allow readers to understand the clues available in the prospectus to avoid

treating Taifeng as a cheap play on Chinese domestic growth 2.  To spot financial and non-financial clues that point to misbehaviour in the company 3.  To recognize the techniques used by the managers in tunneling out wealth from the

listed entity.

Key Takeaways 1.  You can do it too!

–  All information obtained in this report are from public sources from the HKEx website and online forums

–  Knowledge of the fluctuations of the bedding industry and cotton prices and how these trends translate to revenue growth are not necessary, simply because there are many other “common-sense” red flags and many other ways to tunnel out wealth.

–  Any investor will be able to reach the same conclusions easily with thorough research.

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Business Description

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One of the largest cotton producing provinces and a major cotton textile producing area in the PRC as stated in prospectus

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Taifeng’s bedding products business began in 2003

Branded bedding products sold under “TAIFENG” brand

Since IPO, OEM sales have stopped

Ranked 8th by Euromonitor in PRC in 2008 with 0.4% market share

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Section 1 – The IPO: Drawing first blood from minority investors

Cheap valuation at IPO draws in investors who screen for low PE, low PB stocks

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Taifeng was a value trap with 8.3x – 12.4x ttm PE in IPO range

The valuation appeared too cheap for a company that was growing top line at 28% and net profit at 132% YoY. Caveat Emptor!

Would-be IPO Investors would have been fooled by the “value stock” that seemed so attractive and cheap on quantitative measures.

Birds of a feather flock together – directors with links to other fraudulent companies in Taifeng

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Warning sign from poor performance of “independent” director’s other listed companies

Certain “independent” directors and executives were also on the boards of other failed or fraudulent companies. These executives and directors lend their names easily to such companies for compensation or profit-sharing schemes unknown to the public.

Mr. Chan Kin Sang, an “independent” director with a streak of joining failed companies

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Chan was a director on several listed companies in Singapore and Hong Kong that have all performed badly or entangled in fraudulent activities.

The streak continues. Mr. Chan joined Tianhe Chemical as an “independent” director in May 2014! Tianhe Chemical was subsequently accused by Anonymous Analytics for overstating sales and profits

Poor track record of Mr. Chan Kin Sang, an “independent” director

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Delisted

Delisted

S$0.02 share px

HK$0.08 share px Fell 66% since Taifeng’s IPO

HK$0.145 share px Fell >70% since Taifeng’s IPO Fell >70% since Taifeng’s IPO Fell >50% since Taifeng’s IPO

Delisted

HK$0.06 share px

Mr. Pang Wai Hong, the company secretary and an accomplice of Mr. Chan?

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Pang was a former CFO of People’s Food Holdings Limited from 2000 to 2008, a company which was delisted from the Singapore Stock Exchange on 6 Jan 2014

He was also an independent non-executive director of China Renji Medical Group Limited, a company listed on the HKEx but which had seen its stock price performance from its peak of nearly HK$300 to its current HK$0.212

“Independent third parties” disclosed in the prospectus were actually related

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Multiple transactions between these entities provided many opportunities for insiders to tunnel out wealth from Taifeng through inflated sales prices or prepayments to suppliers etc.

The close working relationship with Taifeng on suspicious terms made it hard to believe that these two companies were “independent third parties” as disclosed in the prospectus

Taifeng Textiles Group (“TTG”) and Combest appeared regularly in transactions involving Taifeng

Could it be that TTG was really an independent third party during the IPO?

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TTG was simultaneously Taifeng’s largest customer and supplier from 2007 to 2009 in the IPO track record period

Taifeng also leased from TTG two properties for 20 years commencing from 22 May 2009 and expiring on 21 May 2029 at a monthly rent of RMB350,000 and RMB775,000, respectively

Investors should ask themselves if they are willing to take on such risks before investing in the IPO

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With so many connected transactions, there are many inherent risks involved and investors are unable to fully decipher the materiality of the transactions because TTG is a private entity without public disclosures of its financials.

A friendly banker in Laishang Bank

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The chairman of Taifeng was one of the directors of Laishang bank, and had resigned in 2010 right before Taifeng’s IPO so as to avoid a conflict of interest.

¥¥

However, looking at the large cash balance of Taifeng from its IPO in 2010 till 2014 and its failure to pay wages to its workers, investors should ask if the cash is really in the bank.

There are many clues within the financial statements of the prospectus

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With its cotton yarn products bulky and of low value, it is difficult to imagine how Taifeng has such great cost controls on transportation and advertising with selling expenses less than 2% of sales

18% net margins earned by Taifeng for a commodity product unrealistic

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For a business selling a commodity-like product like blankets and cotton yarn, it is indeed very difficult to achieve such high net margins that Taifeng had achieved.

For such products, we do not expect much pricing power given 1.  cotton yarn is a low value-added product which is easily sourced

from other competitors and 2.  the pricing power for blankets is difficult to imagine as there is little

to differentiate between brands.

More on the analysis of the current assets will be shown in later slides… but clues were available

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More on the analysis of the prepayments and other receivables will be shown in later slides…

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Taifeng was not being fully honest with minority shareholders by calling TTG an independent party

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In the footnotes of the prospectus, Taifeng disclosed that it had also given RMB60m of guarantees in 2009 to banks for TTG, which was supposed to be an “independent” third party. Even though the company disclosed that the guarantees would be released upon listing, the question is why Taifeng insisted on calling TTG an “independent” party when it clearly was not.

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Section 2 – Clues to avoid getting attracted by the share price momentum in

2010

Non-financial clues 1.  Relationship with Combest, a company listed through a reverse takeover a few

months before Taifeng subscribed 100m shares at HK$0.40 2.  Acquisition of land and properties above book value on 19 Nov 2010 from TTG,

Taifeng’s largest supplier and customer and an “independent third party”

Taifeng was a value trap despite good earnings and cash balances

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Implied 4.4x trailing PE and 4.6% dividend yield on 26 Apr 2012, when its FY2011 annual report was published

The investment in Combest was either a poor investment or a fraud partnership

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Taifeng disclosed in its IPO that it had entered into a cooperation agreement with Combest, a PRC healthy bedding product chain management company with over 2,000 franchised stores in China in late December 2009.

On 31 Oct 2010, 6 months after its IPO, Taifeng disclosed that it had conditionally subscribed 100m Combest shares at HK$0.40, or a total net consideration of HK$39.5m. The subscription was termed as a “strategic investment” for the “long term business development” of Combest.

Was the transaction with Combest a fair one?

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There were few clues available as to whether this was a fair transaction for Taifeng

However, investors should look at Combest’s financials and its short listing history through a RTO as a clue.

Acquisition of land and properties on 19 Nov 2010 was expensive and involved TTG again

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Taifeng had also acquired land use rights of a parcel of land in Laiwu City, Shandong from TTG soon after IPO at a total consideration of RMB68.8m.

This is further compounded by the fact that the land use rights was obtained from the “independent third party” TTG. There begins to appear a pattern of repeated collaboration with TTG throughout Taifeng’s listed history with significant transactions

In addition, the original purchase cost of the lands to TTG was approximately RMB2,760,000 and the book value of the buildings built on the lands and the fixtures attached to the lands is approximately RMB44,590,000, giving a premium of over RMB20m from book value, or 1.5x book value

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Clues to detect mischief within financial statements

Clues from financial statements 1.  Large, expensive current bank borrowings despite ample cash balance 2.  Lack of long term loans from banks and heavy reliance on short term borrowings 3.  Suspicious loan from Chairman despite huge cash balances 4.  Resignation of Deloitte as auditor 5.  Alleged unpaid wages found on online forum

Large, expensive bank borrowings despite ample cash balance

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One thing that stood out was the large bank borrowings recorded in the balance sheet, which was guaranteed by “independent parties”

Why would Taifeng pay so much for loans when it has so much cash?

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In comparison, its cash was only earning 0.01% to 0.5% interest! If Taifeng were able to fund its operations without any debt, the company would have saved RMB14m in interest expenses in 2011.

Were banks unwilling to lend LT loans to Taifeng due to its credit risk?

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Some possible reasons could be that the company required short-term liquidity, that Taifeng wanted cheaper loans and hence it took only short-term loans, or that banks were unwilling to lend longer-term due to Taifeng’s credit risk.

However, the first two reasons are easily countered with the argument that the RMB843m in the balance sheet was more than enough to fund short-term needs, unless the “cash balance” is non-existent. The third reasons sounds plausible, and is an important clue to readers who see similar large cash balances coupled with short-term bank loans in other listed companies.

Questionable loan from major shareholder majority owned by Chairman

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Given the huge surplus of cash, it is questionable why Taifeng still required a loan from its largest shareholder as disclosed in its 2011 annual report. Up to the latest interim report in 2014, the same amount of loans was still on the books.

Is the Chairman using the loan as a “risk-free” way of earning interest on spare cash?

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The RMB27m loan as of FY2011 carries an interest rate of 5.25% payable, which amounted to RMB1.4m in finance expenses in the same year. This seems like a way for the Chairman to park his money in a “safe” place to earn a higher interest than what he could have earned from the state-owned banks, which were charging much lower interest rates.

Bank of China’s deposit rates as of February 2011

Deloitte resigned as auditor of Taifeng in late 2013, a huge red flag

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On 10 Dec 2013, Deloitte resigned as auditors of Taifeng, “as [Deloitte] cannot reach an agreement with Deloitte on the audit fees payable to Deloitte for the financial year ending 31 December 2013.”

This may sound like a valid reason until we look at Labixiaoxin, which also used the same reason to justify why PwC had resigned as auditors on 12 May 2014. Anytime an auditor resigns “voluntarily”, minority investors should take this as a warning sign.

Comments on alleged unpaid wages found on Chinese online forum

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On 30 December 2011, an online forum user claimed that Taifeng had not paid wages to factory workers for six months, and urged government officials to check into the issue. While one might argue that such posts lack credibility and that the accusations could be baseless, a cautious investor should investigate further into the company that is so cash rich but yet was unable to pay wages to factory workers.

Protest on unpaid wages in 2015, 3 years after the first accusations appeared

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Workers in Laiwu City, Shandong were protesting on the streets, asking Taifeng to pay up their owed salaries from a photo taken from a Tumblr account dated 20 Jan 2015. Meanwhile, Taifeng disclosed in its 1H14 interim report that it had cash balances of RMB1.9b and a net cash position of RMB1.4b.

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Section 3 – The “murdering” and “hiding of the body”

How the “murder” was done 1.  Finance lease with CDB Leasing 2.  Loans to suppliers 3.  Prepayments to suppliers, and understating the bank borrowings and prepayments

to suppliers in the 2012 annual report

Finance lease with CDB Leasing opened up opportunity to tunnel money out

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On 29 May 2013, Taifeng reached a sale and leaseback agreement with CDB Leasing for total lease payments of approximately RMB421,723,000 (equivalent to HK$533,826,000) for a term of 5 years

Firstly, why should Taifeng enter into such a contract given they have ample cash balances to pay the entire principle sum easily, because the interest rate of 7.3% was much higher than the 0.5% that the “cash balance” was earning

The reasons that management used to justify the transaction were misleading and untrue

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Secondly, the reasons that Taifeng gave to justify the finance lease were so as to “replace the existing short-term loan facilities, which are subject to periodic renewals, with a more stable facility. The lower interest rate under the Finance Lease Arrangement compared to the interest rate under the short-term loan facilities also reduces the finance costs of the Company.” To verify the claim made by Taifeng, a quick look into the FY13 annual report would suffice.

2013 2012 2011

One can see that bank borrowings continued to increase at a rapid pace, rising from RMB316m in 2012 to RMB428m in 2013, in addition to the new finance leases. This was contradictory to what the management had said previously.

Original classification of the finance lease in 1H13 was within five years

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6 months later, Taifeng classified most of the lease as “later than five years” without any explanation

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In the 2013 AR, over RMB219m of the finance leases were booked as “later than five years”. However, the finance lease agreement with CDB Leasing was only for 5 years. This meant that all the non-current leases should be booked under “Later than one year and not later than five years”!

Suspicious loan to suppliers is a poor use of the “excess cash” in balance sheet

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On 1 April 2014, Taifeng announced that it had entered into two short-term loan agreements in December 2013 with TTG and Laiwu Fengze worth RMB237m and RMB243m respectively.

It is questionable why the company took nearly four months to disclose this transaction, especially when the maturity date of these two loans were in 11 June 2014 and 15 June 2014 respectively, just two months after the announcement. This is akin to hiding material information from minority investors

The reason that Taifeng gave to justify these two loans was to “make better use of its funds and provide [it] with a reasonably high return.” If this is indeed the case, then why did Taifeng not want to give back the excess cash through dividends to shareholders?

Were prepayments to suppliers used to tunnel out money from Taifeng?

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To illustrate how the prepayments to suppliers work, the screenshot is an extract from the FY2012 annual report, which shows how TTG purchased RMB227m of cotton from Taifeng in 2012, but received RMB210m in prepayments based on what was disclosed as of FY2012

It seemed as though Taifeng was booking revenue growth using its own money, booking increases in receivables and in retained earnings and making its earnings look good.

Was the change in classification of prepayments to suppliers done to mislead investors?

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There was a big restatement of accounts where the prepayments to suppliers nearly doubled to RMB511m for FY2012 from previously stated RMB298m.

If we include the loan receivables, then the amounts that were tunneled out of Taifeng in FY2013 increased to RMB900m, or an 80% increase YoY!

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Increase in prepayment restatements similar to the increase in restated bank borrowings of RMB200m

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How could Taifeng have not known the correct bank borrowings in 2012?

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2012 2011

2012 2011 2013

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Thank You