There are 2 big issues with this company:

1. Creative accounting
2. Poor handling of convertible bonds

Creative Accounting

The 1Q 2010 profit and loss statement reeks of creative accounting.

The 2009 annual report states that revenue is recognised:

1. From the sale of goods when risk/reward of ownership/control has been transferred; and
2. From interest income

Obviously only #1 relates to the sale of milk, embryos and sperm. But looking at the income statement, revenue is described 2 ways: "Revenue" and "Fair Value".

"Fair Value" is a bigger number so it's conveniently used to compute the reported profits. But what, exactly, is "fair value"? The company gives 2 components:

i. value of agricultural produce i.e. milk, embryos, and sperm; and
ii. value of dairy livestock

The proportion is 90/10 so we can set aside the livestock for the time being.

In the 2009 annual report, the revenue number is quite close to the fair value, within 10%, of the agricultural produce for both FY2008 and FY2009.

But in 1Q 2010, the difference is about 30%.

2 questions:

1. Why is there such a big difference between the company's own fair value estimate for its products and the price it actually got for them in the market?

Clearly, if the company thinks the products are worth $1 but it got only $0.70 for them, the real value is $0.70, not $1. What happened to the $0.30? If it's not reflected in lower earnings in the income statement, then it may be hiding in inflated inventories or trade receivables, and will show up eventually as inventory provisions and bad debt.

2. What was the underlying profit based on actual sales revenue?

If we use the revenue figure instead of the fair value figures, and strip out interest income and the gains from repurchase of convertible bonds, and ignore the non-cash charge from the convertible bonds, we get:

Revenue RMB 111m

less:
Operating Costs RMB 85m

equals:
Profit RMB 26m

The underlying profit of RMB 26m is quite a bit less than the accounting profit of RMB 65m that the company is reporting.

Poor Handling of Convertible Bonds

The company's feeble attempts to repurchase its convertible bonds suggest that the company was only trying to put on a show. The tender for the bonds closed after just 1 day (on April Fools' Day, no less), and only 2% of the principal was bought back. The company paid 95% of par, plus 1% commission, for 96% net.

This is totally idiotic because from November 2008 through March 2009 the company could have bought the bonds on the open market without calling for a tender, and the bonds were selling at significant discounts to par.

If the company was serious about the repurchase, it could have called any investment bank and told it to buy a big block. The likes of Goldman Sachs would be more than happy to perform this service; if they were worried about payment they could have asked for a deposit, or for the payment to be escrowed in advance.

Buying on the open market using a prime broker would have easily allowed the company to cancel 20-30% of its convertible debt, at discounts of 30-40% or even more. This would have saved the company at least US$10m, about RMB 70m. Why didn't they do this?

Some possible answers:

1. The cash was fake, so the transaction could not be funded; or
2. The management was too lazy to track the prices of the convertible bonds; or
3. The management was too stupid to realize there was "free money" available.

In other words, maybe the management was dishonest, lazy, or stupid, or some combination of the three. There are of course other possible explanations, some of which may cast the management in a better light. I will leave it to forum readers to dream those up.

As usual, YMMV.