Our investigator visited China Ceramic’s facilities on Jan 20, 24 and 25, 2011. CCCL conducts operations through two subsidiaries: Jiangxi Hengdali Ceramic Materials Co., Ltd. (“Hengdali”) and Jingjiang Hengda Ceramic Co., Ltd. (“Hengda”). Our investigator visited Hengdali again on Aug. 24, 2011. Possible Issues Identified:
- 2009 and 2008 SAIC sales and net income from filings we originally obtained did not match SEC filings. After learning that the company claimed SAIC filings matched SEC filings, we re-pulled SAIC filings from the same source. These filings matched. Both filings were audited, but by different firms. At the time of our investigation CCCL’s main operating subsidiary was (and still is) an FIE.
- Construction cost of Hengdali facilities on billboard does not match claims on SEC documents, but could be within an acceptable estimate range.
- Hengda facilities are interspersed among facilities of another ceramic tile company (Jingjiang Tengda Ceramic Co., Ltd.). The owner of Hengda and this other company are brothers.
We were able to locate both of China Ceramic’s subsidiaries. The following observations were made, as well as information gathered:
Jiangxi Hengdali Ceramic Materials Co., Ltd.
- Information on a billboard at the front gate of the Hengdali location provided an estimate of $90 million to complete the expansions of this project. Using information in SEC documents it appears that CCCL will have spent around $110 million at the completion on this project by the end of 2012. The billboard illustrates that at full capacity, Hengdali will be capable of generating revenues of $224 million with net income of $37 million.
- At the time of our first visit (Jan 20, 2011), we observed that the CCCL Hengdali location had 8 facilities. Employees claimed that CCCL will have a total of 16 facilities upon project completion. Media reports claimed that the Hedgdali location will encompass a total of 12 production lines upon completion of the project.
- Employees confirmed that the commencement date of Hengdali operations began in late 2009. Based on the introduction of employees, at the time of our first visit (Jan 20, 2011) some of the production lines were still in test mode.
- In our second visit to Hengdali, one sales representative hosted the visit of our investigator. At that time, three production lines at Hengdali were in the regular production. The two other constructed production lines are slated to start production on Oct. 21, 2011.
- At the time of the second visit, Hengdali totally has around 700 to 800 employees.
Jingjiang Hengda Ceramic Co., Ltd
- Activity at the Hengda location (the main revenue generating subsidiary in 2008 & 2009) was busy and at full capacity.
- Employees confirmed that Hengda operates nine production lines.
- The number of employees (Hengda has 1200-1400 employees) in SEC documents matches information gathered on-site and corroborates that the production volume claimed by CCCL may be achievable.
China Ceramics Co. Due Diligence Report Introduction
The GeoTeam is like any other investor in the ChinaHybrid space. Quite frankly, we have been disappointed in and even a bit stunned by the prevalence of fraud in the China small cap space. It is not the GeoTeam’s objective to be predominantly bear-side analysts but that’s the way our recent investigative work has turned out (e.g., PUDA, YUII, SCEI, ORS). Our on-the-ground due diligence takes us well beyond SEC filings and company press releases by first reviewing local regulatory filings in China vs. SEC filings. If a case justifies the effort, we then conduct initial phases of on-the-ground due diligence to get a firsthand look at the operations of selected companies. We report the facts as we find them without a preconceived bullish or bearish bent. Lately it has been hard to find Chinese small cap companies that we have confidence are or at least close to being what they purport themselves to be in SEC filings.
Even when preliminary findings appear positive, obstacles that challenge our convictions can surface as was the case with VALV after it downgraded its auditor. Those who want to be bullish have to accept this risk of the unknown. Some Chinese companies frustrated with the U.S. public markets may choose to go dark, while others may become more sophisticated in their ability to camouflage fraudulent activities. Still we continue to forge forward creating wish lists of companies to track, monitoring their steps to substantiate their legitimacy or ultimately try to attract going private suitors. This brings us to China Ceramics Co (NASDAQ:CCCL).
A GEO investigator initially visited CCCL’s operating facilities, Jiangxi Hengdali Ceramic Materials Co., Ltd. (“Hengdali”) and Jingjiang Hengda Ceramic Co., Ltd. (“Hengda”) on Jan 20, 24 and 25, 2011. We conducted a follow up visit in August 2011 which confirmed our initial findings and revealed that CCCL appears to be a busy operation and is seeking additional workers.
On-the-Ground Due Diligence Findings -Jan 20, 24 and 25, 2011
Site Visits
CCCL has two production facilities; Hengdali, Located in Gaoan City, Jiangxi Province and Hengda, Located in Jingjiang City, Fujian Province. Our investigator visited both sites as well as a sales office.
Hengdali Site Visit
Hengdali is the newer of CCCL’s two production facilities. Based on information posted at the main gate of Hengdali’s production facility, total investment in this location is RMB 600 million (around $90 million) and covers 670 mu (446,890 m2) of land. Once the project is complete, around 2,000 workers will be employed at Hengdali. Projected revenues at full capacity for the Hengdali facility will be around RMB 1.5 billion ($224 million) which should generate around
China Ceramics Co. Due Diligence Report Introduction
The GeoTeam is like any other investor in the ChinaHybrid space. Quite frankly, we have been disappointed in and even a bit stunned by the prevalence of fraud in the China small cap space. It is not the GeoTeam’s objective to be predominantly bear-side analysts but that’s the way our recent investigative work has turned out (e.g., PUDA, YUII, SCEI, ORS). Our on-the-ground due diligence takes us well beyond SEC filings and company press releases by first reviewing local regulatory filings in China vs. SEC filings. If a case justifies the effort, we then conduct initial phases of on-the-ground due diligence to get a firsthand look at the operations of selected companies. We report the facts as we find them without a preconceived bullish or bearish bent. Lately it has been hard to find Chinese small cap companies that we have confidence are or at least close to being what they purport themselves to be in SEC filings.
Even when preliminary findings appear positive, obstacles that challenge our convictions can surface as was the case with VALV after it downgraded its auditor. Those who want to be bullish have to accept this risk of the unknown. Some Chinese companies frustrated with the U.S. public markets may choose to go dark, while others may become more sophisticated in their ability to camouflage fraudulent activities. Still we continue to forge forward creating wish lists of companies to track, monitoring their steps to substantiate their legitimacy or ultimately try to attract going private suitors. This brings us to China Ceramics Co (NASDAQ:CCCL).
A GEO investigator initially visited CCCL’s operating facilities, Jiangxi Hengdali Ceramic Materials Co., Ltd. (“Hengdali”) and Jingjiang Hengda Ceramic Co., Ltd. (“Hengda”) on Jan 20, 24 and 25, 2011. We conducted a follow up visit in August 2011 which confirmed our initial findings and revealed that CCCL appears to be a busy operation and is seeking additional workers.
On-the-Ground Due Diligence Findings -Jan 20, 24 and 25, 2011
Site Visits
CCCL has two production facilities; Hengdali, Located in Gaoan City, Jiangxi Province and Hengda, Located in Jingjiang City, Fujian Province. Our investigator visited both sites as well as a sales office.
Hengdali Site Visit
Hengdali is the newer of CCCL’s two production facilities. Based on information posted at the main gate of Hengdali’s production facility, total investment in this location is RMB 600 million (around $90 million) and covers 670 mu (446,890 m2) of land. Once the project is complete, around 2,000 workers will be employed at Hengdali. Projected revenues at full capacity for the Hengdali facility will be around RMB 1.5 billion ($224 million) which should generate around RMB 250 million ($37 million) in net income. Local media reports claim that Hengdali plans to build twelve (12) production lines in three phases and complete construction by the end of 2011.
At the time of our visit, construction taking place at Hengdali was approximately 50 percent complete. Our investigator observed eight (8) completed production lines (400m*45m for each line) and three (3) additional lines being built (400m*45m for each line) at the facility. All buildings looked similar but it was not possible to determine which structures were intended for production and which for storage.
There are four six story office and dormitory buildings on the property. Our investigator also saw two paper box manufacturing facilities (2,000 m2/each) which produce packaging for finished ceramic tile products. Finally, there is an on-site gas station for fueling the company’s trucks and other vehicles.
Our investigator interviewed several employees at the Hengdali site. The employees said that in addition to the eight (8) completed buildings and three (3) others under construction, another five (5) are planned for Phase III of the project. At full capacity, Hengdali will have 16 production facilities. Local media coverage of the project confirms the company will have twelve 12 production lines and four 4 storage facilities.
A local report also confirms that Hengdali began producing tile products at the location in September of 2009, utilizing two production lines capable of producing 16,000 m2 per day. The employees also confirmed that Hengdali started its production in 2009. The employees said that since there are intermittent periods of production during the initial phase of the operations, the volume of Hengdali’s tile produced was not yet stable. Production has increased as more production lines were brought online. The employees also confirmed that the Hengdali site’s current workforce stands at around 600 employees.
Hengda Site Visit
Hengda is an older facility. Hengda’s headquarter offices are located in a 7 story office building at this location. Our investigator learned that the facilities also house the operations of another tile company, Jiangjiang Tengda Ceramic Materials Co., Ltd. (“Tengda”). He also learned that Tengda is owned by the brother of CCCL’s CEO. Since our investigator was unable to go inside the facilities we don’t know how the two companies segregate operations from one another and to what extent activities are comingled or shared if at all (e.g., warehouse space, shipping/receiving, production lines, administrative staff, etc.). The comingling of production activities by related parties is something that bears watching and is a potential risk factor for investors to consider. Key questions:
- Do Hengda and Tengda ever share production lines? If this is the case, is this situation reflected properly in SEC financial statements. (Who is booking the revenue and related expenses)?
- Did any of the funds CCCL raised in U.S. capital markets end up at Tengda?
Please go here to see pictures of Hengda and Tengda facilities.
Our investigator did get a chance to interview one of Hengda’s employees who said he has worked for the company for three years. He said Hengda has 9 production lines. The monthly capacity of the best production line is around 210,000 m2 and 180,000 m2 for the least productive line. It takes 90-100 workers to operate a production line.
Hengda’s total employee headcount is around 1,200-1,400, including sales representative and other officers. The employee also said that Tengda is larger than Hengda. Tengda has 14 production lines and around 2,000 employees. He did not know the details of Tengda’s production.
A positive sign is that Hengda was short of workers and actively recruiting new employees. Our investigator saw posters around the factory that offered additional compensation to employees who worked overtime during the traditional Chinese New Year. This indicates strong ongoing business operations and high utilization of production capacity.
Our investigator also interviewed a woman whose husband works on Hengda’s production line. Her comments were consistent with what the Hengda employee told our investigator, but she did say the Hengda facility was old and dirty.
CCCL’s Sales Office
Our investigator also visited a CCCL sales office in Nanchang City, Jiangxi Province, which is in close proximity to Hengdali. The sales representatives said that the price points can be RMB 17/m2, RMB 20/m2, RMB 40/m2 and RMB 60/m2 for different outdoor ceramic tiles. The price for indoor ceramic tile ranges from RMB 30/m2 to RMB 80/m2. The greatest sales volume is in the RMB 17/m2 and RMB 20/m2 price range. This sales office sells tiles supplied by both manufacturing locations. Note that the product prices quoted at the sales office are in line with the RMB 25/m2 average stated in CCCL’s SEC filings.
Assessment of CCCL’s Claims in SEC Filings vs. Due Diligence Findings
Production Capacity and/or Volume
CCCL claimed in its SEC filings that:
“Our target production is 78.8 million square meters by the end of 2011. Planned expansion of and upgrades to the Hengda facility will increase its current production capacity from 28 million square meters per year to 36.8 million square meters by the end of 2011…..In January 2010, we acquired Hengdali, a new facility in Gaoan, Jiangxi Province, which has three operating production lines with current annual production capacity of 10 million square meters. Our expansion of the Hengdali facility is to be conducted over three phases. Phase I was completed in 2009 and was put into production in early 2010, bringing current production capacity after completion of phase I to 10 million square meters per year……”
The actual annual production volume reported by Hengda for 2010 was 28 million m2 which is more than our estimate of 22 million m2 (i.e., 9 production lines x 200,000 average tiles per month per line x 12 months = 22 million tiles). We think it’s reasonable to assume the company could have produced 6 million m2 more than our estimate by adding shifts during periods of peak demand. The Hengda facility appeared to be old so it is likely that CCCL needs to upgrade operations at that location as they have indicated in recent press releases.
We do not know the current production volume of Hengdali. However, based on the local news accounts, we know that two production lines were operating at the end of 2009 with the daily capacity of 16,000 m2. That implies an estimated annual production volume of around 11 million m2 (i.e., 2 lines x 16,000 tiles today x 365 days per year). Our production capacity estimate is in line with local media accounts of around 11 million m2, as well as 10 million m2 reported by CCCL for that facility in its SEC filings. Also, our investigator observed significant construction activity at Hengdali, supporting management’s claim that capacity is being expanded at the facility.
Pricing of Ceramic Tiles and Revenues
CCCL reported in its SEC filings that:
“The average selling price for ceramic tiles increased by 5.3% to RMB 25.8 ($3.8) per square meter for the six months ended June 30, 2010 from an average selling price of RMB 24.3 ($3.6) per square meter for the six months ended June 30, 2009, and sales volume increased by 3.7 million square meters to approximately 19.4 million square meters for the six months ended June 30, 2010 from 15.7 million square meters for the same period in 2009.”
Based on the prices we obtained from one of CCCL’s sales office of RMB 17/m2, RMB 20/m2, RMB 40/m2 and RMB 60/m2 for different outdoor ceramic tile products, the price range of RMB 30/m2 to RMB 80/m2 and average price of RMB 25.8/m2 claimed by CCCL appears to be reasonable.
It should be noted that CCCL reported that it sold “15.7 million square meters for the same period (first half) in 2009.” when Hengdali was not producing tile, so all of the tile would have been produced at Hengda. Implied first half production was therefore greater than Hengda’s reported annual capacity of 28 million m2. Although we have not confirmed this, it is plausible that CCCL could have made up the difference between its sales volume and reported production capacity from inventory of finished goods on hand at the end of 2008. The company could have also added production shifts to meet sales demand, making the 15.7 million m2 sales volume reasonable. Still, we need to be aware of this discrepancy.
Margins
Claimed operating margins generated by other tile companies appear to be in line with the 32% reported by CCCL in 2009:
- Dynasty Ceramic Pub Co Ltd. reported 44.3% gross and 26% operating margins.
- Arab Ceramics reported 34.2% operating margins and a 31.27% net income margin.
Number of Employees
CCCL claimed that “on June 30, 2010, China Ceramic’s subsidiaries had 2,029 employees.” The reported employee headcount is in line with the total employees of the two locations reported to our investigator of 1,200 – 1,400 at the Hengda facility and 600 at Hengdali.
Hengda’s SAIC documents
The first SAIC documents we obtained revealed 2009 revenue of RMB 59 million for the Hengda facility, which was not in agreement with the RMB 273 million revenues reported in SEC filings. However, armed with what we now know about the annual production volume and product pricing, half glass full investors could deduce that the revenues reported in that SAIC filing seem understated and are not consistent with what one would expect if CCCL was operating at full capacity.
Since Hengda is an FIE, the SAIC reports must be audited by a CPA firm (Quanzhou Xiangrui Xinlian CPA Co., Ltd.) and the same financial reports must also be submitted to the SAT.
When we pulled CCCL’s SAIC filings a second time a few months later, they did in fact match the SEC filings. Possible explanations for the initial mismatch and the subsequent match based on our due diligence findings include:
a) Initial SAIC filings we obtained were not authentic and cannot be relied upon.
b) The initial SAIC is correct and company committed either tax fraud or misrepresented SEC margins in the past. The company may have found a way to amend AIC flings at the local level. (We have not obtained SAT documents).
c) The company did something else with regards to its VAT planning and joint-inspection which we cannot explain.
Since CCCL’s main subsidiary Hengda is an FIE and the original SAIC filings were audited, we believe that “b” or “c” above are the most plausible scenarios. If tax avoidance schemes are the reasons for SAIC vs. SEC discrepancies then the market might embrace the possibility of a going private transaction, assuming this is a direction CCCL would want to take. We currently have no opinion on this topic.
Conclusion
Since CCCL’s main subsidiary Hengda is an FIE and the original SAIC filings were audited, we are unable to render a conclusive internal investment opinion on shares of CCCL. Investors seemed to be troubled over the belief that CCCL has not been more loud and clear regarding their reason for not entertaining the going-private discussions recently initiated by certain interested parties.
Putting these issues aside, our overall impressions of CCCL based on our on-the-ground findings suggest that CCCL is capable of generating substantial revenues if it truly was operating at full capacity. Hengda appears to be a real company with well-established and ongoing operations. Hengdali is a newly established company with substantial potential production capacity. Generally speaking, the revenue information reported in the SEC filings appears to reflect what CCCL’s true business operations and performance could be at full capacity.
The possibility does exist that CCCL reported slightly higher revenues (within 20%) to the SEC in 2009 compared to what CCCL may be able to produce at full capacity. However, we cannot be certain of this point since the production volume estimates provided by the company’s employees may not be as accurate as is needed to make this estimation. Also, there are other possible explanations such as meeting demand from existing inventory or extra production shifts.
We would encourage CCCL to work with GeoInvesting to devise a plan to establish credibility with market participants, if in fact CCCL is who it claims to be. We believe that CCCL would ultimately attain a higher valuation as a public company if the market was convinced of its legitimacy vs. the valuation it would receive in a going private transaction.
The GeoTeam is keenly aware of the limitations of OTGDD proceedings when formulating a bullish case to include a ChinaHybrid in our portfolios. We must all be aware of the challenges we face when attempting to go long in this space (see commentary). More layers of due diligence will be needed in order for our team to be more comfortable in embracing our initial OTGDD work. We do not consider our limited margin analysis to be comprehensive enough to render an opinion on the validity CCCL’s SEC margins. Investors also have to be aware that:
- Legitimate companies may soon decide to go dark as opposed to dealing with uncooperative U.S. capital markets.
- Risks to near term growth could be impacted by a China economic slowdown.
- Investors do not yet seem convinced that the company will take meaningful measures to increase shareholder value.
In the case of CCCL, potential related party and SAIC vs. SEC issues may have to be explored further. The obvious concern here is with the possible Hengda/Tengda connection and if this creates a misappropriation of money between these two unrelated operations that occupy properties in such close proximity to one another. To be fair CCCL has stated on a number of occasions that no related party transactions exist between CCCL and Tengda. We feel that a brief but more comprehensive question and answer discussion should take place given the current market environment. We will be making questions available to CCCL’s management shortly, some of which are from GeoInvesting’s members.
Disclosure: None at the time of report.
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