UPDATE: In March 2011, CFO Jacky Lam of China Media Express and the auditors (Deloitte) resigned. Deloitte said they could no longer rely on the representations of management, and they suggested an investigation was in order. Ping Luo, the analyst from Global Hunter who gave CCME rave reviews resigned. Maurice Greenberg’s Starr Investments sued CCME for fraudulently inducing it to invest $13.5 million. The stock was delisted from the NASDAQ in May 2011.

Deloitte raised the following issues: questionable authenticity of bank statements, supicioius bank confirmation procedures, existence of advertisers/customers, undisclosed bank accounts and bank loans, financial filings with the State Administration of Industry and Commerce differing from information provided to auditors, questionable authenticity of tax filing documents, cash payments to employees, and double counting of buses.

As I have found out all too well in the last two years, those who are critical of public companies risk retaliation. Retailing failure Overstock.com (NASDAQ:OSTK) has spent years perfecting their methods of stalking and intimidating anyone who dares to criticize their perpetual losses, their wackadoo CEO Patrick Byrne, the gross incompetence of management, and (most importantly) their fraudulent financial reporting.

I have a particular interest in multi-level marketing (MLM), and in publicly voicing my dislike of this bogus “business model,” have been subjected to retaliation from the companies themselves as well as individuals associated with the companies. The most vicious attack is by Medifast and its MLM division, Take Shape For Life (TSFL). I first became aware of Medifast via a small project for a client, but became interested in the company and how it was achieving extraordinarily good financial results.

For criticizing Medifast and TSFL (because of their use of multi-level marketing, which I believe is an abusive model designed in such a way that 95% to 99% of participants lose money), I got sued for $270 million. But the fun doesn’t stop there. Throughout the lawsuit, Medifast and its lawyers have been blatantly dishonest about what I have written about the company, and have made unfounded disgustingly false allegations about me, my company, and my work. All this is being done to damage my professional reputation, trash my business, and scare anyone else who might even think about criticizing Medifast and Take Shape For Life.

The latest company to threaten critics is China MediaExpress (NASDAQ:CCME).  Last week the company was accused of being a fraud by both Citron Research and Muddy Waters. The company has responded by claiming that these research companies are simply short sellers who have a vested interest in the stock price going on, and that they are considering their options. (That sounds like a threat of litigation to me.) Let’s take a look at what is being written about China Media Express, and whether those saying bad things about the company deserve the criticism and threat of litigation.

Citron Research Report

Citron begins its report on China Media Express with a simple idea: If it sounds too good to be true, it is. They go on to lay out a case that if the business of CCME was truly as they are reporting it, this would be simple to verify. After all, the business is purported to be the largest television advertising operator on inter-city and airport express buses in China.

But the company’s numbers don’t make sense. It has spent little on infrastructure, yet allegedly has grown profits from $2 million to an expected $85 million (on revenue of $200 million). Citron says that makes no sense given the Chinese advertising market. Even more important, says Citron, is the fact that “no one in China has ever heard of them.”

Citron then goes on to detail how using Google or Baidu to find information on CCME’s operating company yields no results. It makes no sense that a highly profitable advertising company (we’re talking off the charts profitable compared to the industry, apparently) is nowhere to be found in the major search engines.  Citron continues with a listing of various reports on outdoor media companies, and cites CCME’s obvious absence on the lists.

The CCME website is curiously short on actual information about the company’s operations and partners. It is alleged by Citron that the real business of CCME is pushing stock, rather than conducting business in its industry. They give more information on how CCME lacks substance, and then state:

In preparing this report, Citron has come across a plethora of information pointing to CCME being a fraud.   These include but are not limited to:  SAIC documents, Credit Rating Agency Documents, fake awards and accolades, quotes from industry professionals, and more financial analysis than this company even deserves.  The purpose of this report was to look at CCME using simple common sense to understand that the company does not exist at the scale that they are reporting to the investing public.  We are not saying that they do not operate any buses, but if you believe that the company operations are truly reflected, or even close to their stated financial disclosures, than you must go to Taco Bell for some filet mignon.

Muddy Waters Report

The Muddy Waters Report on China MediaExpress is not flattering either. The allegations are harsh and include:

• Management is perpetrating a massive pump-and-dump
• Revenue for 2009 was not the $95.9 million report, but is only $17 million
• While CCME tells investors that they have 27,200 buses in their advertising network, the materials supplied to advertisers says they have only 12,565
• More than half of the buses actually in the CCME network don’t play CCME content, but play movies
• The company is lying about an agreement between itself (via its website www.switow.com) and Apple or an Apple distributor. Apple denies that there is any such agreement.

The primary documentation for these damning allegations includes a research report from CTR Media Intelligence that CCME commissioned. This data was compared to the kits given to advertisers, and this is where the discrepancies were found. The CTR report shows the much higher figures and appears to be a main source of information on its website. The advertising kits are apparently distributed only to potential advertisers.

Probably the worst allegation however, is the one that says none of the major media buyers they spoke to (not even the ones who represent the supposed customers of CCME) have ever heard of CCME. Ouch.

Muddy Waters says the reason for this fraud is simple: So management can cash out. Management owns more than 54% of the outstanding stock, equal to about $312 million.

If there’s any good news (or if you can even consider this good), Muddy Waters says that CCME actually does have a business. It’s just a small fraction of what they say it is.

What do I think of the Muddy Waters report? They sourced their information, and the research seems credible. At the very least, there are legitimate questions about CCME’s numbers. I suspect it’s much worse, and that Muddy Waters is right that the numbers reported by CCME are fraudulent.

What Else is Out There?

Michael Anderson writes at SeekingAlpha that China Media Express is credible and there has been plenty of due diligence on the company. He cites Starr International’s work before investing $30 million, but doesn’t say what they did. He also cites Global Hunter Securities, which reports:

During our recent trip to China, we conducted extensive due diligence and channel checks on CCME’s business. We met with the company’s entire management team including six regional managers, checked CCME’s sales contracts and bank statements, and interviewed advertising agencies, direct advertisers and bus operators. We took buses in Beijing, Fuzhou and Guangzhou to view the company’s operation and advertising programs. In addition, we met with a representative from CTR, a market research firm, and two directors at Starr International. Our due diligence results reinforce our thesis on the company and we continue to believe that CCME is a leader in its niche market. We believe the fundamentals of the business remain solid. Thus, we reiterate our Buy rating.

Anderson also cites an audit by Deloitte Touche Tohmatsu, and the fact that they are one of the four largest auditing firms worldwide. Unfortunately, audits are not designed to detect fraud, so there is no comfort in the audit results, no matter who the auditor was.

In contrast, Chimin Sang strongly criticizes China MediaExpress at Seeking Alpha. He previously wrote a three part series praising the company, but has now changed his mind.  He points out two major lies the company has been caught in, and says that those are enough to confirm for him that CCME is a fraud.

First, he says that CCME claims  it has an “exclusive license from the Chinese Ministry of Transport to install nationwide TV system on buses.” This verbiage comes from its website and promotional materials. What Sang says the company really has is not any sort of license, and certainly is not with the Ministry of Transport. Instead, CCME has a “cooperation agreement” with an “affiliate” of the ministry, and this affiliate has no power and there is no license or advantage for CCME.

Second, Sang says the company is discredited because it claimed it won the “National Prize for Progress in Science and Technology” in 2006 for its patent on “automatic control device technology of passenger car audio/ video playback equipment.” However, records of the Ministry of Science and Technology (“MOST”) and the National Office for Science and Technology Awards (“NOSTA”) do not show CCME as winning any awards in any year.

A second article critical of CCME by Sang appears even more serious. He compares revenue and tax numbers reported to the Chinese government and to the U.S. SEC, and finds serious discrepancies. In 2008, CCME reported revenue of $63 million to the SEC, but only reported $0.3 million to the Chinese government. In 2009, CCME reported revenue of $96 million to the SEC, but only reported $0.8million to the Chinese government. In 2010, it is estimated that CCME will report revenue of $214 million to the SEC, but only report $0.6 million to the Chinese government.

Which numbers are right? According to Sang’s explanation of the Chinese system of “Fa Piao” makes the numbers reported to the Chinese government pretty reliable. Basically, Fa Piao is an invoicing system that companies must use to invoice those they do business with. When an invoice is generated through this system, the company providing the services (in this case, CCME) is taxed on the income, and the company receiving the services (and paying the invoice) is allowed to deduct the invoice as a business expense. Because the company receiving the services wants to be able to take the deduction (and can’t if there isn’t an invoice in the Fa Piao system), there is a pretty good chance that CCME will have to use the system, making their income reported to the Chinese government more reliable. (Please excuse me if I’ve explained this system incorrectly in any way, as I am unfamiliar with it and therefore I am only repeating what I understand from Sang’s article.)

One writer explains why this difference exists, and claims that the reason is that most of the revenue for CCME is really generated by Fuijan FenZhong Media Co., which has some sort of agreement with CCME so that CCME “controls the activities receives the economic benefits” of it operations.” He says that one would have to check the Chinese revenue figures of Fuijan FenZhong Media Co. to explain the discrepancy in CCME’s Chinese and U.S. revenue figures.

If this explanation is true, why didn’t Zheng Cheng explain this in his letter (discussed in the next section)? He simply noted the allegation of discrepancies in revenue figures, and said it was due to different accounting rules in China and the United States. Why not provide more information if this explanation about Fuijan FenZhong Media Co. is indeed true?

CCME Responds

China Media Express Holdings responded to the allegations with a letter posted on their website. The letter from Zheng Cheng, CEO attempts to debunk the allegations point-by-point. The highlights include:

• The authors of the reports didn’t talk to CCME management, didn’t do real due diligence, and didn’t create any financial models. (They didn’t do any of that because they’re not your friends and they’re not trying to develop a relationship with you. They’re investigating you!)
• The authors are short sellers. They have a conflict of interest. (I hear this one all the time. Management has a conflict of interest when they report anything about their company since they want the stock price to go up. I guess then management’s reports should all be ignored as well?)
• Our numbers are audited. So there.  (Again, audits don’t detect fraud, so there is really only a very small amount of comfort that should be felt because of the audit.)
• The numbers Muddy Waters claims are in the advertising kit are wrong and do not agree to the numbers that are really in the advertising kit. (I would love to know the truth on this one.)
• The claim that drivers are showing movies instead of CCME content is not true.
• CTR’s numbers and research are credible and reliable.
• CCME has a contract with Shanghai Bus Industrial Group for 1,892 buses, in direct opposition to the Muddy Waters claim that CCME does not have a contract with the largest bus operator. (I don’t know who to believe. Muddy Waters says Shanghai Ba Shi said they have never done business with CCME. Who is telling the truth?)
• The number of buses they have contracts for looks lower than it really is, because there are contracts with subcontractors, who have contracts with the operators. (This one sounds plausible, yet I don’t believe it. Something doesn’t ring true about it.)
• A contract was signed with an authorized Apple distributor, Eading Group, in December 2010. (I’d like to see independent proof of that.)
• The bus riders are not the “sub-Greyhound demographic” that Muddy Waters claimed. It is members of households with above average income.
• Competitors that Muddy Waters identified, who have not heard of CCME, are not in the same industry and not competitors. CCME has no competitors. (This one made me laugh.)
• Revenue reported in China and in the U.S. is different because of different accounting and reporting rules. (I’m very skeptical about this one. The discrepancy is way too large.)
• Claims about a lack of an exclusive license from the Ministry of Transport are simply a case of twisting words. CCME writes: “CCME has been issued a “tongzhi” by the Transportion Television Audio Visual Center, a department under the Ministry of Transport, which has binding effect on the bus operators.” (CCME seems to be playing word games of their own. This doesn’t sound anything like a license, nor does this prove that it is exclusive.)

What Next?

The issue of Chinese reverse mergers is hot right now. This article explains how and why Chinese reverse mergers are done. They are essentially a way to get smaller Chinese companies listed on American exchanges without all the hassles (and regulation) of an initial public offering.

Chris Carey over at sharesleuth.com did an extensive report on the use of Chinese reverse mergers to get listed on U.S. exchanges. CNBC stock commentator Herb Greenberg urges caution with companies doing the reverse merger dance. These are two smart people whose viewpoints and research should be considered carefully.

The SEC says it is taking a hard look at these reverse mergers, and has taken action against at least one auditing firm involved with a Chinese reverse merger. The auditors and lawyers are important to getting these deals done, and management and promoters often tout the names these firms to give credibility to these deals. The fact is that the auditors and lawyers are out to make money too, and so their involvement doesn’t necessarily mean anything good.

What do I think?

I think it’s very easy for the companies targeted by these kinds of reports to cry foul and say that the authors are just a bunch of short sellers or anonymous internet trolls. The fact is that there is no one else who is going to dig into the dirt of these companies.

Management has a vested interest in producing good numbers so the stock goes up, and there is great potential for fraud. Who is going to report the flip side of things? Of course it is going to be someone like a short seller who makes money when dirty companies are exposed.

Does that mean the dirty companies should not be exposed? Of course not. They need to be exposed, and I don’t really care who does the exposing.

I am all too familiar with the smear campaigns of companies who are upset by negative reports. I have had a hand in researching companies that had negative reports written and published about them. I have written my own negative commentary on companies like Medifast, Mary Kay Cosmetics, United First Financial, and plenty of others. I have been smeared for my efforts, and the retaliation has been harsh. I know all too well why some of the people who write these reports prefer to remain anonymous. Anonymity does not automatically make them trolls.

There are plenty of people on each side of this debate, and there are allegations that these reports have been cleverly worded to imply fraud when there really is none. Who is right?

It doesn’t matter. (Yes, I said that.) It doesn’t matter. I always believe that where there is smoke, there is fire. We are not talking about one or two allegations of impropriety, nor are we talking about some small “gray area” issue. We are talking about multiple allegations of serious problems from several different organizations. There is enough in there to make me believe things are not as management would like us to believe at  China MediaExpress Holdings.

Are some of these allegations wrong or made to appear worse than the reality? Probably. But there is still enough here that I’d be uncomfortable putting any of my own money into this company. If I were betting on them, it would be short.