US-listed Chinese firms are on thin ice

After Luckin Coffee’s spectacular admission of fraud, more Chinese companies are finding themselves in the crosshairs of regulators and short sellers. Some are trying to get out in front of them.

TAL Education, an online tutoring platform, said last Tuesday that one of their employees may have inflated its sales figures. This has thrown a bombshell into capital markets by setting off the second accounting scandal in a week of US-listed Chinese companies.

The Beijing-based company has seen most of its share gains since the beginning of this year wiped out after the revelation. TAL shares traded down 6.74% to close at $52 per share on Wednesday.

Also on last Tuesday, Iqiyi, a Netflix-like Chinese video platform was accused of overstating sales. Muddy Waters, the short seller behind Luckin’s downfall, tweeted a link to a report by 11-month-old short-seller Wolfpack Research, alleging that iQiyi inflated its 2019 revenue by 27% to 44% and overstated user numbers by 42% to 60%. 

Bottom line: The reputation of Chinese tech firms on US markets is suffering as a fresh wave of accounting wrongdoings linked to Luckin. TAL Education revives investor concerns over corporate malpractice among US-listed Chinese firms. These simmering accounting fraud scandals create more uncertainty for Chinese companies seeking to raise funds on US markets and opportunities for short-sellers. But read each short report on its own merits.

What happened: TAL writes that, based upon a routine internal audit, the company suspects that an employee of the company’s “Light Class” segment may have “conspired with external vendors to inflate sales of the business by forging contracts and other documentations.”

Sales of “Light Class,” an after-school tutoring platform for primary school students, accounted for approximately 3% to 4% of the company’s total estimated revenues for the fiscal year 2020, which ended Feb. 29, 2020.

The company says the employee has been taken into custody by the local police while emphasizing a “zero tolerance” stance towards illegal acts.

Safe Luckin distancing: TAL’s decision to out its own accounting faults is among the signs that Chinese companies are readying themselves for post-Luckin impact. Although the two cases are both accounting fraud, TAL’s revelation appears to concern a smaller figure and could be a voluntary move from the company to minimize negative impact.

• TAL’s revenue for the fiscal year ended February 2020 is expected to be around $3.35 billion to  $3.37 billion. Based on the 3% to 4% estimation made by the company, Light Class accounts for $100 million to $135 million. The company did not say how much of this figure it attributes to fabricated sales.
• By comparison, Luckin’s falsified sales concern around 75% of the total revenues for the first three quarters of 2019, a whopping $310 million. This is a serious fraud accusation the company was probably forced to reveal under the pressure of independent directors.
• TAL likely feared that US regulators will undertake wider-scale investigations of US-listed Chinese firms, Shen Meng, executive chairman of Chanson Capital told local media. The same report observed that TAL’s situation would be worse if the issue had been first discovered by regulators or short-sellers.
• Muddy Waters, the short seller also involved in the Luckin case, also went short on TAL in 2018 for allegedly fabricating data as early as 2016. TAL denied the allegations at that time, but the company’s shares slumped before recovering over the following years.

When it rains it pours: Many of China’s fast-growing companies have come under scrutiny since the beginning of this year.

• February 2020: Short-seller Grizzly Reports releases a report, calling China’s Craigslist 58.com an “accounting house of cards with little economic substance.” The short seller says the company failed to disclose that its biggest acquisition Ganji, which the company acquired for $2.8 billion, has seen revenue plummet by over 95% since the acquisition by 58.com in 2015..
• That same month: Another Grizzly report says GSX, a Chinese e-learning company, has drastically overstated its profitability. GSX founder Chen Xiangdong calls the report “groundless” in an interview with local media.
• April 2020: Wolfpack Research releases a short-selling report accusing iQiyi of exaggerating revenue. iQiyi’s share prices fall 11.2% Tuesday morning before bouncing back to gain 3.2% by market close. 
• Shares of TAL competitor New Oriental Education & Technology Group also fell 2.4% on Wednesday.

Bad company: Luckin-related firms have also seen disturbing share fluctuations since last week.

• Car Inc., a Hong Kong-listed firm that shares the same funding network and whose executives went on to found Luckin, saw its shares halved since Luckin’s Friday announcement. 
• Luckin’s China mainboard-listed partners also come under fire. Shares of Focus Media, a major advertising partner of Luckin, took a hit after the data tracked by CTR Market Research showed that Luckin overstated its advertisement spends. Other companies related to Luckin include logistics partner SF Logistics, and cheesemaker Milk Ground. 

What’s next: China is no stranger to financial irregularities. Previous scandals have resulted in low valuations as well as low market liquidity of US-listed Chinese firms.

• All foreign companies that list in the US must have their financial statements audited by an independent firm. The fraud cases point to a particular weakness in audit procedures and raises questions to the credibility of reports from audit firms.
• Projected tightening regulation and weak investor confidence in the US might push Chinese companies to the Hong Kong stock market, which is already the largest IPO destination in 2019, or even mainland markets.
• Chinese tech giants like JD, Baidu, Trip.com are reportedly planning dual listings on the Hong Kong market, following Alibaba’s blockbuster $13 billion listing in November.

Past performance does not guarantee future results: However, corporate credit should be evaluated based on the individual companies, say analysts from online brokerage platform Tiger Brokers. “There’s no point to short on all US-listed Chinese firms,” the analysts said.

• Just because a bunch of short-sellers have been right doesn’t mean you should believe the next one. Short sellers sometimes place their bets wrong—even Muddy Waters has had whiffs, like its 2012 attack on New Oriental.
• At the same time, Luckin has created an opportunity for small-time shorts to get traction. Wolfpack, the short seller that gained attention after the iQiyi report, was less than one year old. The firm was founded by Dan David, a featured protagonist of finance documentary The China Hussle,  in May 2019. 
• Its previous reports on SMART Global Holdings, a provider of specialty memory, storage and hybrid solutions, communication and network service GTT Communications, and Chinese news aggregation app Qutoutiao, weren’t well received.