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Sunday, October 30, 2005


See the next post for summary and details (and Q2 results).
see here for a Nov 2006 update.

I keep trying to figure out what to tackle and how to tackle it with HQSM. Every time I look at a company that's not really simple, I run into the same problem. I need to get a better understanding of the business and there are two major directions that could be taken.
  1. Walk the process. In other words, simply go through all the documents in some rational order, taking notes. At the end, hopefully I'll have the understanding I'm looking for. If this is going to become an investment, this is definitely the quickest and most effective direction to take because I need to go through all the stuff anyway. The downside is that I might not find an obvious showstopper until nearly all the work is done. And it could be something that would be easy to find (and quickly found) using method #2
  2. Search through the documents looking for answers to specific questions. This is good for weeding out bad investments quickly. However, at the end of the process, I still have to do method #1 anyway.
I use method #2 for the earlier phases of analysis and method #1 for the later phases. So I guess in this case, I'm just concerned that there's some fairly blatant showstopper here. Usually when I start the final phase, I already have a good mental picture of the business. Right now, I can't say that for HQSM. I've tried looking for obvious ways to find "the big problem" without much luck. So I'm just going to dive in to method #1.

Incorporated in Delaware. Executive offices in NYC.
NOTE: Transitional Report for May 1, 2004 to Dec 31, 2004.
Incorporated as Sharon Capital Corporation in 1989 (Nevada) as a blank check company. 1990 changed to PEI, Inc. Then changed to Process Equipment Acquisition Corp (Nevada) (PEQM.OB). March 17, 2004, the Company merged with British Virgin Islands company Jade Profit Investment Limited. Company thus ended up with an 84.42% ownership in the subsidiary Hainan Quebec Ocean Fishing Company Ltd, a PRC llc ("HQOF") also here. April 2004, Company changed its name to HQ Sustainable Maritime Industries, Inc. and incorporated in Delaware, all effective in May 2004.

August 17, 2004, HQSM acquired Sealink Wealth Limited, which was a subsidiary of Sino-Sult Canada Ltd. Sealink was incorporated in British Virg. Isl. Sealink is sole owner of Hainan Jiahua Marine Bio-Products Co ("Jiahua") a limited liability company in PRC. They sell stuff like seal genitals (mmmm... seeeaaal genitals).

This purchase of Sealink (contract contract) was a related party deal (same people involved in both HQOF and SSC):
SSC [was] owned by Harry Wang Hua (51%), Lillian Wang Li (25%), and Norbert Sporns (24%) (collectively, the "SSC Owners"). Lillian Wang Li [Chairman of HQSM] and Harry Wang Hua [COO of HQSM] are brother and sister. Lillian Wang Li is married to Norbert Sporns [CEO of HQSM]. The SSC Owners are current directors and executive officers of HQSM, as well as, collectively, indirect beneficial owners of the majority of its capital stock.
The terms of the deal were:
The consideration of the acquisition is $20 million in terms of 12,698,078 shares (equivalent to $8,888,655), $11,011,345 promissory note convertible to 15,732,493 Class A shares and $100,000 promissory note convertible to 100,000 Series A preferred stock with par value at $0.001 per share. Both promissory notes accrue interest at the rate of 5% per annum. 12,698,078 shares were issued to SSC on August 17, 2004 after the Purchase Agreement was signed. And $11,011,345 of promissory notes were converted to 15,732,493 Class A shares on November 18, 2004.
Also on August 17, 2004, they bought out the rest of HQOF, with appropriate PRC government approvals. Cost was $5,695,145 cash paid on Halloween 2004.

Analysis: HQSM paid a total of $26 million for Jiahua. In the first half of 2005, Jiahua earned perhaps $1.2 million. If this can be extrapolated, then Jiahua would be worth $36 million. Jiahua requires less capital, has higher margins, and is a more profitable business. So why screw around with HQOF?

In April 2004, HQSM US was formed and registered, but was dormant. In June 2004, HQSM Canada was formed and started business development operations (sales and mktng).

Main business is
The Hainan aquatic products processing plant was designed in Canada. The plant had 2 production lines, but that was expanded to 6: 2 filleting lines (3,000 tons/year), 2 hole fish lines of tilapia gutting, scaling, gilling (10,000 tons/year), 2 shrimp lines (3,000 tons/year). The plant has 2 shifts. They are HACCP certified for export to the US and Japan (but some other Hainan producers also have these certs*). They also have an EU Code for exporting to the EU. Only two Hainan Province producers have a code, which are supposedly difficult to get. Restricted trade is good for business insiders while free trade is good for consumers. Thank you, EU. Also acknowledged as "eco-friendly" by the Canadian International Development Agency (CIDA) which provides government-to-government aid for developing countries like China. They provided technology transfer to the business in Hainan (this one?) in exchange for "detailed environmental and social (gender) impact studies." [yeah, sure, we'll tap dance for you evangelists in exchange for your technology]

* HQSM claims that they know of no other competitor in Hainan that has a similar scale and production capacity or that has the vertical business model. Note that Hainan is the best place in China to farm tilapia because of the year-round climate.

Jiahua Marine subsidiary provides capacity to make nutraceuticals to enrich feed for tilapia and shrimp in Hainan. They're working with the US to improve the feed (health, feed conversion, meat quality, and boost their immunity to disease).

Jiahua marine bioproducts factory. Located in Wenchang City of Hainan. 180K sq ft and a construction area of about half that size. Two production lines: powder line, oil line. Jaihua has HACCP ceritification from China Entry-Exit Inspection and Quarantine Bureau.

Jiahua sales in 2003 were over $7 million, $2.7 million net profit. Sales in 2004 were higher (unspecified). Looks like only $3.2 million of the 2004 Jiahua sales were to external customers.

Jiahua research and development: Marine Organism Research Institute. Clinical trials, lab testing have resulted in National Certification for "various healthcare products". Won some awards in China. This group has a long-term relationship with Qingdao University of Oceanography (intro) (enterprises) (alumni for searching).

Chinese patents:
460000X340-2001: shark cartilage health benefits (suspicously high number of unrelated benefits).
460000x131-2001: more shark catilage stuff (same red flag)
460000x338-2001: shark liver oil
460000x342-2001: shark liver oil for nursing mothers
"The above products have been shown to be effective."

Jiahua has adopted a sales strategy of large scale tours in popular tourist areas. Products started selling in Hualian Supermarket Co. (1200 outlets, $2 billion in sales)

March 2005, Jiahua finalized an agreement with American River Nutrition providing HQSM with technology (for boosting immune system of shrimp). ARN is also into stuff like this (which, in March 2005, is HQSM's entry into the North American market for voodoo medicines... that's just what I call it)
DeltaGoldĀ® is a registered trademark of American River Nutrition, Inc. and is protected by US Patent no: 6,350,453 and patent pending application No: US 2005037102.
Nine people in Jiahua sales and marketing, led by Harry Wang, COO [you were thinking of some culturally insensitive snide joke, weren't you?].

There are some barriers to competition due to the high cost of infrastructure (but it's clearly not all that high).

In 2001, HQOF was recognized as a "Leading Agriculture Enterprise" by Hainan Provincial Government, which helps at trade shows such as the Boston Seafood Show (which I just missed, it was in October).

There are "significant" economies of scale with HQSM. R&D and QA can monitor larger operations without new hiring. Larger buy orders can be made with long term supply orders. They made an odd statement: "Large buyers are able to sole source instead of having to group supply from various producers...."

April 2001, they received the "New/high tech Enterprise of Hainan Province" award by Hainan Provincial Technology Authorities.

Jan 2003, they received the "Industrial Enterprise of the Province"

2002, they were named "Leading Agriculture Enterprise" for both Hainan and Wenchang provinces.
[Googling these things only shows HQSM's statements]

March 2005, they received the "prestigious China Excellence Award" for health product excellence and advancement of of China business practices, by the China Association of Entrepreneur Foreign Investment (CAEFI), can't verify.

HQOF and Jiahua together have 434 employees, all full-time, mostly in Haikou, PRC. The rest are in Wenchang, PRC.

The land is rented from PLA Haijun No. 4802. Lease expires in 2009. Rent in $26K per year. The health and bio-product processing factory costs $81K for 50 years (from 2000). There's a coconut producer on the same road as the factory.

No material legal proceedings.

Stock transactions:
The fiscal year has been changed from April 30 to Dec 31 (reason for the transitional report).

8 Month Results

Jiahua contributed $3.2 million to sales. Gross margins were 83%. Advertising costs were 52% of sales. Net income was $1 million. This was August 17, 2004 to Dec 31, 2004. This would annualize to sales of $8.5 million.

The original fish farming sales were $17.5 million for the 8 months of 2004 (was $10.8 million during the same 8 months in 2003). Gross margins were 14% during 2004, but 31% during 2003. They intentionally pushed gross margins down in 2004 to attract customers and make up for lost revenue, also the supply from local fishermen dropped significantly due to frequent bad weather in Hainan causing higher supply costs. Net profits were $2.8 million in 2004 ($490K in 2003). Um, where's the SG&A? Why are(n't?) gross profits higher than net profits?

Selling and distribution costs were $331K or 1.6% ($474K or 4.4% in 2003).
Advertising costs were $1.7 million or 8% (zero in 2003).
G&A was $1.9 million or 9% ($672K or 6% in 2003).
Depreciation $509K ($210K in 2003).

Provision for bad and doubtful receivables zero ($800K in 2003). Debts were slowly recovered during the shutdown but all debts were collected afterward, and all receivables are now current so they used zero provisions here. NOTE 3P boilerplate really contradicts what they're saying. Not to mention...

From Wiley GAAP 2002:
The recording of a valuation allowance for anticipated uncollectable amounts is almost always neccessary. The direct writeoff method, in which a receivable is charged off only when it is clear that it cannot be collected, is unsatisfactory since it overstates assets and results in a mismatching of revenues and expenses. Proper matching can only be achieved if bad debts are recorded in the same fiscal period as the revenues to which they are related. Since the amount of uncollectable accounts is not known with certainty, an estimate must be made.
There are two estimate techniques:
The direct writeoff method is used for income taxes, but not for GAAP accounting.

The giant increase in "other income" is due to large bad debt recovery. I'm not sure if such as large percentage should still go on other income or if it's an extraordinary event. I treat it as extraordinary, myself.

No income taxes. Deferred tax for the period was $194K (vs $120K), the increase due to timing of provision for bad debt being eliminated and recovery of bad debt.

Liquidity: financing has normally been done via operations. This should be sufficient, except for temporary periods of rapid growth. The decrease in the current ratio is mainly due to buying out the minority interest in HQOF.

Most important of the risks, in my view:
It's worth noting there that HQOF and Jiahua are Foreign Investment Entities (FIEs) and subject to restrictions in foreign exchange. They are permitted to exchange current account items and after-tax dividends. But things are never without exceptions.

Auditor Report
Auditors are Rotenberg & Co of Rochester, NY. The report is dated March 16, 2005. There are no qualifications. These auditors are not on the list of top auditors of SEC clients. They audited or are auditing CHFI (which I looked at earlier, can't find them elsewhere other than the FAQ), OZLU (OTC BB, seems ok), ZEOM (OTC BB), Epsey Manufacturing & Electronics Corp (ESP), Contact Capital Group (which seems kind of scummy).

Rotenberg & Co replaced Baum & Co who resigned. Baum had their own issues with the Public Company Accounting Oversight Board. Numerous infractions.

Balance Sheet
Current assets are half trade receivables and nearly half cash. Very low inventories. $389K due from related parties (net of provision???) So they have a provision for a related party but not for customers? You'd think that you'd know which related parties were trustworthy/solvent and which ones aren't. Another $27K advanced to an employee.

Current assets: $4.6 million
Trade receivables: $5.4 million
Deferred taxes: $1.2 million
Total assets: $21 million

Current liabilities: $9.2 million (about half accrued expenses, half bank loans)
Total liabilities: $9.3 million
Equity: $11.6 million

Income Statement
The "8 Month Results" above are really better than looking at the consolidated results. And 2004 was a weird year for them. Can't really compare 2004 with 2003 (and 2005 won't be very comparable to 2004).

Sales: $21 million
Gross profit: $5 million
Selling: $331K
Advertising: $1.7 million
G&A: $1.9 million
Deprec: $509K
Finance costs: $400K
Other income (recovery of bad debt): $2.6 million
Deferred tax: $194K
Minority interest: $235K (goes away in 2005)

Share count at end of year is 95 million (it's now over 100 million).
25 million on April 30, 2004
Issued 70 million during 2004 (plus warrants, see Stock Transactions above)

A realistic bottom line would be to add at least $400K for provision for doubtful accounts, remove the $2.3 million of other income and put it into some extraordinary category. This would give them a net loss from operations of about $182K. This isn't so bad because they had shut down for part of the year.

I truly don't understand one part of the financial statements. On the equity statement, they issued 70 million shares which raised the paid-in capital by $22.5 million. Then they subtracted the exact same amount as "Adjustment from acquisition of Assets under cost basis", which essentially means they paid $22.5 million for something worth zero? It was all goodwill, but that goodwill doesn't show up on the balance sheet.

If we look at the cash flow statement for 2004, everything in operating activities looks normal except for a $22.5 million negative which results in about $18 million used in operating activities. Wait a minute, that wasn't operating activities, it was investment or at least finance.

Finance produced $20,755,288 as "proceeds from common stock". But this was wiped way by "Goodwill adjusted for reorganization process" of $22.5 million. I don't understand how operations destroyed $22.5 million. If you flush $22.5 million down the toilet, isn't that investing activities?

Capex was $6 million. But there's an entry outside of capex called Acquisition of PP&E. How is that not "capital expenditure"?

They received $1.2 million in cash from an acquisition along with $409K in PP&E.

Trade receivables on the balance sheet increased from $2.4 million to $5.4 million. In cash flow from operations, they subtracted $2.54 million as a decrease in provision for doubtful account. But there's also an entry for "trade receivables, net of provisions" of $3.8 million. I hope the "net of provisions" really applies to 2003 and that it's zero for 2004. But there's something really, really weird: the decrease in provision for doubtful account in 2004 is $2,535,047. There's also a decrease in provision for doubtful account in 2003 for $2,535,047, the exact same amount!! This is Fouled Up Beyond All Repair: FUBAR.

I can't understand this financial statement. Maybe it's just me, but how could they possibly have a change in provisions two years in a row of exactly the same amount down to 1 part per 2.5 million?

The $100,000 promissory note (which is also listed in the supplemental disclosure of non-cash investing and financing activities) is listed in the cash flow from operations. This seems like it's definitely finance. Didn't I cover something exactly like this recently? Another Chinese reverse merger had an issued note payable under operations.

I suspect it's very difficult to put together an 8-month transitional financial statement. You have to compare two different 8-month periods with a gap of 4 months in-between that you must somehow deal with. I don't see how this could pass an audit. Rotenberg & Co expressed their opinion for both periods of the cash flow statement. And NOTE 2 states that the statements are prepared according to US GAAP.

Depreciation schedules (straight line)
Taxes accounted for by liability method.
8.3 renminbi to the dollar.
revenue recognition is when merchandise is shipped, title passes, and collectability is reasonably assured.
$175K shipping and handling in 2004 ($290K in 2003), included in selling and admin expenses.

Fish farmings sales in 2004: $17.5 million
Selling: $303K
Advertising: $0
Finance costs: $156K
Profit before tax: $3.24 million
Tax: $194K
Net Profit not including G&A: $2.8 million

Health and bio-products sales in 2004: $3.24 million
Selling: $28K
Advertising: $1.7 million
Finance costs: $50K
Profit before tax: $1 million
Tax: $0
Net Profit not including G&A: $1 million

G&A: $1.9 million
Finance costs not associated with segments: $194K

Note 3Q: They mention SFAS 149 which makes changes for derivatives and hedgding. They aren't using any of this, so they should make a statement saying this has no material impact on financial statements [of the future]. But they say nothing: not even that it's being evaluated. They do say the right thing about SFAS 150 and derivatives. Also for the other accounting pronouncements.

NOTE 4: Trade Receivable
Jan 2004 starts off with $829K allowance for doubtful accounts.
$1.5 million is added to this during the first 4 months of 2004.
April 30, 2004: allowance = $2.35 million
This is entirely written off during the last 8 months of 2004.

This makes the duplicate numbers for 2003 and 2004 in the cash flows even more bogus.

Dec 2004 PP&E is mostly plant and machinery ($8.5 million) with some buildings and leasehold improvements ($2.8 million).
April 2004 PP&E is nearly all plant and machinery ($3 million).

Gross PP&E increased by $8.2 million during the last 8 months of 2004 to $11.5 million.

Depreciation is nearly all plant and machinery.

Three expired bank loans (all secured by fixed assets):
  1. $1.8 million (6.588% interest)
  2. $964K (6.588% interest)
  3. $1.7 million (5.04% interest)
Currently negotiating with bankers to extend these loans.

PRC Taxes (no tax benefit or burden for US):
Statutory rate: 15%
Tax holidays and concessions: (7.5%)
Effective rate: 7.5%

Deferred tax asset (liability method):
Jan 2004: $1.426 million
April 2004: $1.403 million
Dec 2004: $1.209 million

PRC reserves: $1.1 million (vs $957K in April 2004). Can't make any cash distributions until these are satisfied at the discretion of the board of directors as per PRC GAAP. If the statutory reserve reaches 50% of the registered capital of the company, then the reserve doesn't increase any more.

Stock option plan:
Dec 2, 2004 non-qual plan approved
$0.28 strike price, 10 year expiration, immediate full vesting
Norbert Sporns: 500K
Lillian Wang: 500K
Harry Wang: 500K
Fusheng Wang: 1 million
CFO Dallaire: 200K, 1/3 vested per year
5 million more reserved
Total dilution from stock options is 7.5 million

Credit Risk:
Top 5 customers accounted for 57% of AR (15.9% of sales, 12% of sales, 10% of sales), aggregate of 38.5% of sales.

No legal proceedings

Executives and Directors
Norbert Sporns <== married ==> Lillian Wang Li <== sister/brother ==> Harry Wang Hua
Fusheng Wang == father ==> Lillian and Harry Wang

Fusheng Wang is Honorary Chairman and received 1 million options

Lillian Wang Li, 47, Chairman of the Board ($187K) owns 18.3% of the company via Red Coral Group Ltd. (no website)
HQSM founder. 25 years in management of Chinese and Canadian businesses. Graduated Beijing Univerisity (Euro and Chinese lit), Certificate of BA Concordia University in Canada.

Harry Wang Hua, 41, COO, Director ($150K) owns 37.3% of the company
HQSM founder (esp operations). Civil engineer, Beijing University. 15 years in startup company management in China and Canada. Also many years training Chinese middle managers in Western standards.

Norbert Sporns, 50, CEO, Director ($150K) owns 17.6% of the company
HQSM founder (from 1997). University of British Columbia (philosophy), bachelor of civil law degree and bachelor of English common law from McGill. Certificate of Tax Law, Certificate of Condominium Law, Diploma of Notarial Law from University of Montreal.

Jean-Pierre Dallaire, 53, CFO, Director
Fusheng Wang, 71, Honorary Chairman, Director
Jacques Vallee, 52, indpendent Director
In charge of business development and financing with Altitude Consulting Group (no website). MBA Sherbrooke. Advanced Certificate in BA from University de Quebec a Trois Rivieres. Post-grad level Advertising Mgmt Diploma from Ecole des Hautes Etudes Commercialese (Montreal). 30 years mgmt experience. Bank of Montreal and other places.

Fred Bild, 67, independent Director
Visiting professor at University of Montreal's Centre of East Asian Studies. Private consultant on political and economic relations with China and East Asia. Has been Ambassador to various countries from Canada.

Daniel Too, 52, independent Director
Grad of Hong Kong University and Polytechnic. Managing Director of Delta Elevator Far East. Director of Voker Chemical Paint Ltd. (no website)

He Jian Bo, 37, Manager Finance Dept.
Bachelor's and Masters in economics from Southwestern University of Finance and Economics, PRC. Joined HQSM in 1999.

Liam Haniffy, 37, Sales and Quality Production Mgr

Wang Fu Hai, 60, Chief Production Controller
Chief Production Controller and Engineer at HQSM. Joined HQSM in 1997.

Barron Partners LP owns 3.6% of the company.

All executives and directors own 73.28%.

UPDATE: Rotenberg and Co. gave an unqualified audit opinion on what seems like either outright fraud or else extremely unethical.

UPDATE Dec 21, 2005: There's just too much red here, too many red flags.

hi,thanks for such information. Reverse merger consultant
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