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Sunday, April 02, 2006

China Expert Technology (CXTI) 2005 10-K

CXTI posted their 10-K on Friday. The market didn't like what it saw. It's kind of funny because the market is reacting to the same information as late last year when I was able to buy the stock for 85 cents (thank you for that one Mr. Market). Let's look at the 10-K. I'll be comparing the 2005 10-K with the 2004 10-K.


Year ending Dec 31, 2005.
Incorporated in Nevada, offices in Hong Kong.
28 million shares outstanding on March 24, 2006.
$ means "US$" in all instances below.

Oct 31, 2005: completed closing a securities agreement for $6 million face value of 7% convertible debentures, payable after 1 year, quarterly payment of interest via cash or stock. Owners have the right to convert to stock at 75% of the average stock price in the previous 5 days (but no greater than $1.80). These debentures will end up causing a $4.24 million hit to earnings in Q4, which is what I think the market is reacting to... again! I made money off the silly market the first time it reacted (and the price fell to 85 cents) and I might be able to make money off the market again for the exact same transaction. Heh. I covered the transaction here.

Along with this agreement, CXTI issued three types of warrants:
  1. short term warrants (18 months after Halloween 2005) to purchase up to 3.9 million shares at $1.53.
  2. long term warrants (5 years) to purchase up to 2 million shares at $3.06.
  3. "platinum" warrants issued to Platinum Partners Advisors (lead investor who did the due dilligence etc.) to purchase up to 392K shares (18 months or 5 years) at $1.53 and 196K shares at $3.06 (5 years).
Nov 7, 2005, CXTI issued 2.3 million shares on a conversion.
Dec 29, 2005, CXTI registered (SB-2 statement) to sell up to 16 million shares of stock underlying the Debentures and Warrants.


Differences from Q3 2005:
There was $110.5 million in contracts in Q3 (most was done), $47.7 million was still outstanding. They burned through about $9.5 million in revenue in Q4, so that should leave $38 million in old contracts remaining, about $30 million should be done in 2006. (more details below on this)

At the end of the year, we add the following to the list:
Jinjiang, maintenance, starts 2/06, ends 1/09, total contract $3.9 million
Jinjiang, training, starts 2/06, ends after 2 years, total contract $1.8 million
Quanzhou, starts 11/06, ends after 3 years, total contract $35 million
Jinjiang, unified command system, starts 12/05, ends 3/06, $680K
Dehua, unified command system, starts 3/06, ends 7/06, $660K

Seems like there's about $13 million for this year in new contracts (that's just a guess). That would bring the total of contracts for 2006 to $43 million (vs $35 million in 2005).

It's worth noting that at the start of 2005, they had only $55 million in total contracts (see page 5 of the 2004 10-K) vs over $106 million at the end of the year.

More details on the contracts in the Management's Discussion (I'm moving it to here).



ProjectsStart DateDateSumin 2003in 2004in 2005Sum
Jinjiang (1st Phase)Apr 03Jan 0524.74.717.82.2--
Jinjiang (2nd Phase)May 05Aug 069.9----7.92
Jinjiang (3rd Phase)May 05Aug 0612.5----6.75.8
Dehua (1st Phase)Apr 04Aug 0615.6--8.96.7--
Dehua (2nd Phase)Jan 05Nov 0511.8----11.8--
Nan'anAug 05Mar 0714.5------14.5
HuianJan 06Jul 0816.6------16.6
Jinjiang Unified

Command SystemNov 05Mar 060.7------0.7



O T H E R - S T U F F

57 employees (26 permanent, 31 contract, all full-time). Back in 2005 they had 50 employees.

The Jinjiang City Government completion is still listed as a model for 82 cities in Fujian province.

The Hong Kong property details are unchanged from last year: same location, same rent.

The Shenzhen property was previously bundled with the Jinjiang property and both were provided by Mr. Lai Man Yuk for $14K/month, the area was unspecified. This year, the Shenzhen office (still provided by Mr Lai Man Yuk) cost $11K/month for 19K sq ft.

This year, they apparently moved the Jinjiang office and it's provided by the Jinjiang Gongcheng Management Services Co. Ltd. (no search results) which is associated with the Jinjiang E-Government project and the rent is deducted from the last installment of the government's payment for the project (I calculated that it's 2.4% of the maintenance contract). Rent went up to $2.4K (from $1.8K) since the area went up by 538 sq ft (the increase is overall a bit more per sq ft). 39 month lease ending Dec 31, 2006, cancelable by both parties.

Legal Proceedings
First Montauk Securities Corp claims that CXTI owes them $660K under a fee dated 9/8/04. CXTI claims it's without merit and will fight it. According to this cached web page, First Montauk was fined and suspended from issuing research reports for 3 months for securities fraud. They have other issues as well: a guy left the company, but continued to operate out of the same office and got people to invest in "Tech-Vest"...
Apparently, "Tech-Vest" was a largely fictitious entity; at any rate, all of the claimants lost all of the money they had invested.
So First Montauk has some smelly stuff surrounding them.

M A N A G E M E N T ' S - D I S C U S S I O N

All the 2004 financial statements have been restated due to issues with compensation for consultants in the reverse merger: they were incorrectly classified and should have been charged to operations. So net income took a $2.9 million hit while additional paid-in capital was increased by the same amount. It means nothing going forward except to call into question their accounting skills and more importantly, the auditors' capabilities. Chinese reverse mergers cause acid reflux to their investors.

Also, stockholder's equity was off by $24K due to the par value of the stock. Sheesh!

$500K of pre-paid expenses that were classified as non-current should have been current.

The amount due from a former officer has been restated at $2,022,525 and the amount due to a former officer was restated as $2,137,881. When I compare the 2005 10-K's results for 2004 against the 2004 10-K, here's what I see as being different:

There is a new entry in current assets of $2,022,525 as "Amount due from a former officer". There is a new entry in current assets of $500,000 for current portion of prepaid expenses. The non-current prepaid expenses is now $1,562,500. Previously, this amount was $2,062,500. So $500,000 went from non-current assets into current assets. Current assets (and total assets) increased by the sum of these two new entries. Ok, now let's look at liabilities.

Accruals were split into two categories: Accrued payroll and employees' benefits is now $29,315. Other payables and accruals is now $219,241. If you add these together, you end up with $248,556, which is the amount of "Accruals" that was on the 2004 10-K. All of this stuff is current liabilities.

We see that the "Amount due to a former officer" increased from $115,356 to $2,137,881.

Original Statement:
Amount due from a former officer: $0
Amount due to a former officer: $115,356
Net owed: $115,356

Amount due from a former officer: $2,022,525
Amount due to a former officer: $2,137,881
Net owed: $115,356

Total equity is unchanged, but the amounts of each subcategory of equity have changed:

In the equity section, we see that the par value of the common stock adds up to $24,414 (oops, shouldn't that be $24,415?) where it was previously listed as $3,879,727 which is blatantly wrong if you just look at the definition on the left (24,414,679 shares at $0.001 par value).

They had showed paid-in capital as $3,598,854 which was increased to $10,394,167. Retained earnings was $5,166,597 and was decreased to $2,226,597.

The previous statement would have been misleading if you hadn't gone into enough detail and just used shortcuts.

Now let's jump directly to Note 7 of the 2005 10-K which has a lot of explainin' to do.

Mr. Lai Man Yuk is the former officer in question.

"CEN" is China Expert Network Company Ltd, a limited liability company incorporated in Hong Kong. This was the reverse acquisition (not the shell) of Feb 9, 2004. The shell company acquired all 30 million shares of CEN from CEN's shareholders in exchange for 19,935,000 shares of the shell's common stock. The shell also issued 1,400,000 shares as compensation for services to various people involved in the reverse merger. April 12, 2004, the shell changed its name to China Expert Technology, Inc. and is the entity represented by the shares of CXTI.

"CXTI" refers to the overall holding company China Expert Technology, Inc. mentioned in the previous paragraph, with shares of stock trading on the US market.

"ENS" is Expert Network Co. Ltd of Shenzhen (and Fujian) which is a wholely owned subsidiary of CEN defined above. ENS was established in 1999 and has the 12 contracts mentioned above. ENS is a limited liability company established in PRC.

CNS owns 100% of ENS and also 100% of Hong Zhong Holdings Ltd., a limited liability company incorporated in the British Virgin Islands.

Ok, getting back to the original issue, Mr. Lai Man Yuk made cash advances to CEN for operating expenses. However, Mr. Lai obtained cash advances from ENS.

On Dec 30, 2005, Mr. Lai and ENS and CEN signed an agreement regarding the outstanding balances among the parties involved as of Dec 30, 2005. Mr. Lai owed $1,840,192 to ENS. This amount was transferred and settled against the amount Mr. Lai paid to CEN.

In 2005 (unspecified date):
ENS owes Mr. Lai nothing.
Hong Zhong Holdings Ltd owes Mr. Lai $24,229
Mr. Lai owes CXTI $1,977
Mr. Lai owes CNS $848,195
The net result is that Mr. Lai owes $825,943

In the restated 2004 financial statements:
ENS owed Mr. Lai $2,022,525
Hong Zhong Holdings Ltd. owed Mr. Lai nothing
Mr. Lai owed CXTI nothing
Mr. Lai owed CNS $2,133,691
Mr. Lai owed Hong Zhong Holdings $4,190
The net result is that Mr. Lai owes $115,356 (this matches the result above)

This stuff is due to cash advances from Mr. Lai, leases of office space from Mr. Lai in Shenzhen, and a car Mr. Lai sold to CXTI for $23,136.

The increase in debt owed by Mr. Lai from 2004 to 2005 is $710,587.

Here's my opinion about why it's important to show both the assets and liabilities rather than just the net amount owed, consider two scenarios: 1) let's say Mr. Lai goes bankrupt. In that case, CXTI has assets on the balance sheet that are now worthless but the liability owed to Mr. Lai is legally still there. CXTI loses big time. That's an important possibility that needs to show up with accurate amounts on the balance sheet. 2) let's say CXTI goes into bankruptcy. In that case, Mr. Lai still owes the same amount to CXTI, but the amount owed to Mr. Lai might be reduced by the court. If you were buying CXTI stock knowing the company would be going into bankruptcy, you need to know these two amounts and not just the net amount.

Results of Operations
Gross margins are roughly the same as last year. Advertising and marketing is down (but I expect it to be wildly random going forward). The reverse merger costs were about 11% of revenues in 2004. The "Change in fair value of derivatives" was about 12% in 2005.
The Company accounts for all freestanding warrants to purchase the Company’s common stock as well as embedded conversion features that have been bifurcated from the convertible debentures at fair value and marked-to-market at each reporting period, with the adjustments of fair value reflected on the statements of income. For the year ended December 31, 2005 the change in fair value of warrants was $3,393,000 and the change in fair value of embedded conversion features was $851,186.
The accounting for the warrants, options, convertibles from the financing of $6 million late last year doesn't seem correct GAAP treatment, but I could be wrong* (I generally rely on my own "blunt-instrument" estimates for options and other dilution). It seems odd to be doing a fair value estimate, as the market price can swing wildly skewing the results. And it's that 12% charge that was most of why the market killed the stock price. Humorously, the drop in stock price should cause the fair value to drop, making the next earnings statement look wonderful, causing the stock to go up, causing the fair value to go up.... The stock would oscillate up and down. The market killed the price back around Halloween last year when the company announced the terms of the $6 million deal, even though the made it very clear what they were going to do. I had roughly guesstimated that it cost them $8 million worth of stuff to get $6 million in cash. Not good, but not worth driving the price to 85 cents (I made a ton of money on this stock because of it). So here's the market once again seeing the same information it saw last year and going into a panic driving the price down... again.

So from my perspective, CXTI has had two years in a row with one-time charges masking their real operating earnings.

* I was wrong, here's the detail:
The Company accounts for non-hedging contracts that are indexed to, and potentially settled in, its own common stock in accordance with the provisions of Emerging Issues Task Force 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”).
EITF 00-10 says that "This Issue does not address the accounting for either the derivative component or the financial instrument when the derivative component is embedded in and not detachable from the financial instrument." The examples they give are written put options, written call options (and warrants), purchased put options, purchased call options, forward sale contracts, and forward purchase contracts.

Actually, CXTI explains it best this way:
As no floor price is set for the conversion price of such convertible debentures which vary with the fair value of the Company’s common stock, the Company could not be sure it had adequate authorized shares for the future conversion of convertible debentures. Therefore, all embedded derivatives and freestanding warrants are recorded at fair value, marked-to-market at each reporting period, and are carried on a separate line of the accompanying balance sheet.
Ok, that makes sense.

They attempted to acquire Shenzhen Zhong Zhou Technology Development Company Limited ("ZZTech") in March 2005, but it fell through and they received the $3.7 million back in March 2006.

NOTE: Additional contracts might require additional financing. The market might hate that, but it's the reality of the situation. The cost of that cash can be high, but overall it's a net benefit.

E-Government revenue is still recognized on a percentage-of-completion basis with the usual provisions etc. Consulting revenue is recognized as work is performed and amounts are earned based on SAB No. 101.
We consider amounts to be earned once evidence of an arrangement has been obtained, services are delivered, fees are fixed or determinable, and collectibility is reasonably assured. For contracts with fees based on time-and-materials or cost-plus, we recognize revenue over the period of performance.
Allowance for doubtful accounts is just handwaving.


Recruiters from BDO McCabe (see "photos" below)

Yes... but here are the photos, they don't want you to see. :-)

BDO McCabe Lo Limited audited the 2005 results only (not 2004). Unqualified opinion. PKF audited the 2004 results, signed on Feb 22, 2005 and the restatement Note 2 signed March 10, 2006.

BDO McCabe Lo Limited is essentially BDO Hong Kong. One of their directors was appointed as a Director of the Hong Kong Institute of Accredited Accounting Technicians Limited for 2005/2006. They're not an official standards body or anything like that. He shows up here. BDO McCabe is not on this list, but the list doesn't seem to include firms substantially outside the US?

These guys have audited:
General Component Inc. who is late with their 10-K this year. Last year they got an unqualified opinion when the company lost $1.9 million: more than half their equity. The balance sheet was fairly strong, however, and they got $2 million in contributed capital that year. Seems reasonable.

Sunrise Real Estate Development latest 10-K
unqualified opinion for 2005 and 2004, which seems reasonably well justified. As usual, it's a British Virgin Islands company Chinese reverse merger. They tossed out Whitley Penn accountants for John J. Geib and then BDO McCabe in 2005.

BBMF which switched to BDO McCabe from Kesrich.
Unqualified opinion with strong balance sheet, but losing lots of money and very negative cash flow from ops. But they issued lots of stock.

Loulan Holdings Ltd. 2003 Annual report.

Sino-Forest Corp
Sino-Forest Corp. (TRE CN) lost 42 cents, or 6.4 percent, to C$6.10, for the biggest decline in the S&P/TSX. The largest foreign-owned lumber company in China postponed to an unspecified date its fourth-quarter and annual 2005 results, saying BDO McCabe Lo & Company needed additional time to complete its first audit of the company.


Garron International Ltd. technically switched auditors when KLL was acquired by McCabe.
The Company was informed by KLL that the reason for its resignation is due
to the combination of their practice with that of BDO McCabe Lo Limited
("BDO"). For that reason, BDO will be appointed as new auditor of the
Company following the resignation of KLL upon the approval by the
shareholders of the Company by an ordinary resolution at the
extraordinary general meeting (the "EGM") of the Company and to hold
office until the conclusion of the next annual general meeting of the
Here are some photos of BDO McCabe recruiting at The School of Accounting and Finance...
The School of Accounting and Finance (formerly Department of Accountancy until 31 August 2003) is the longest established accountancy school in Hong Kong. With a history dating back to 1972....
A brief video of the founder and managing director of BDO McCabe. An interview with some more details about the company.

BDO McCabe apparently a defendent in a private securities fraud suit. It was dismissed (page 22), but on forum non conveniens which I'd call a technicality.

There was a settlement in 1996 with ADT Limited for $65.0 million found here on page 22. Not much said about it. Here we see:
However, in recent years it has also been the accountancy profession that has been lobbying hard for changes to the law to allow for some limitation of personal liability. This has come about mainly as a result of a number of high profile cases in which accountancy firms have been found liable in negligence to third parties.

The case which caused the most concern was ADT Ltd v BDO Binder Hamlyn3. In this case, BDO Binder Hamlyn was found liable to ADT for £65 million as a result of a negligent audit that was carried out of Britannia Security Group Plc prior to its purchase by ADT. As the professional indemnity insurance was capped, so the partners were ultimately jointly liable for over £150,000 each.
Apparently, this was shock to the industry, mostly because of the outrageous amount of liability.

BDO McCabe merged with KLL Associates in August 2005.
am I just going through the motions here?

F I N A N C I A L - S T A T E M E N T S

Balance Sheet
Cash increased by $4 million to $7.3 million. We know this was due to the $6 million financing back in October 05 offset by probably the expected burners of cash (which is why the cash was needed).
AR increased by $11 million to $15.4 million. We knew this would happen, which is why they needed cash to support the additional business.
Cost and estimated earnings in excess of billings is $1.1 million (wasn't on the balance sheet last year): work done that's not billed yet (see Note 9)
We have the related party stuff from Note 7 (mentioned above).
Prepayments increased by around $6 million to $9.8 million. This is burned cash. Note 8 shows that it's $6 million contract prepayments, $3.7 million deposit attempting to acquire ZZtech (see above) which has since been returned, and $68K of other prepayments etc.
Deferred finance costs appear at $540K.
And we have the $500K of prepaid that was moved to current (mentioned above). Oddly it's there for two years, which makes me wonder why it was considered current? ANSWER: $500K is amortized every year, so in a sense, this is a different $500K from last year (see Note 6 below).
Current assets increased to $35 million from $17 million

The intangible assets are gone.
The prepaid expenses decreased by the $500K shifted into current assets. So none of this pre-paid account has changed from a year ago.
Deferred tax assets are gone.
Total assets increased to $36 million from $19 million. Much of this is due to switching from showing just the net amount owed by a former director to showing both the assets and liabilities (see my opinion above).

AP dropped somewhat.
Other payables went up a bit more.
There's the stuff from Note 7.
Total taxes payable is down by about 3/4 of a million.
There are now two new entries for "Embedded derivatives" ($3.6 million) and "Warrants" ($5.5 million). In my opinion at this point in time, it seems like this really distorts the financial statements apart from reality.
Current liabilities increased to $14.5 million from $6.6 million.

Here I think it makes sense to stop using a current ratio and start using working capital as a measure of the same thing. In fact, given the weirdness of the derivatives and warrants, the only good way to get an understanding of the current assets and liabilities is to look at the more tangible current assets/liabilities along with the potential dilution.

There's no non-current liabilities in either year.

Equity increased to $21.3 million from $12.6 million due to both earnings and additional paid-in capital (i.e. dilution).

Visual display of balance sheet (see the link for how to read this stuff)

Current Assets ***********************************
Cash *******
Accounts Receivable ***************
Cost/EstEarn in excess *
Related Party Stuff .
Prepayments **********
Deferred finance costs *
Current prepaid expens *
PP&E (it's depreciated) -
Deferred tax assets *
Total Assets ************************************
Liabilities (current) **************
AP *
Other payables *
Related Party stuff *
Income taxes payable *
PRC business tax *
Convertibles *
Derivatives ****
Warrants ******
Equity PPPPPPPPPPPP*********
* = retained earnings
P = paid in and other)
Total liab and equity ************************************

Income Statement
Revenue ************************************
Cost of revenue -------------------
G&A --
Advertising/Marketing -
Operating Income **************
Interest exp/finance cost -
Changed fair value deriv ----
Income tax expense ---
Net income *******
Revenue **************************
Cost of revenue --------------
G&A -
Advertising/Marketing -
Reverse merger costs ---
Operating Income *******
No derivative charges
Income tax expense --
Net Income *****

Equity Statement
2005 started with 24.4 million shares
1.1 million shares were issued to pay for getting a customer
1.9 million shares were cancelled, previously issued to an investor (see Note 14, seems odd, I don't remember it)
2.3 million shares were converted (convertible debenture) at 47 cents/share
2005 ended with 25.9 million shares
Cash Flow Statement
this is difficult to follow, but you can just jump to the stuff in bold below

Net Income *********************************
Intangible amortization +
Consultant fee amortiz +++
Deferred tax assets/liab ++
Stock used for expense pay +++
Interest expense/finance cost ++++
Fair value change in derivatives +++++++++++++++++++++
AR increase ------------------------------------------------------
cost and estimated earnings ------
other assets -----------
decrease in AP --
decrease in other --
PRC tax -------
tax payble +++
Deposit to acquire subcon -------------------
Repaid loan from director +++++++++++++++
Advance from former officer +++++++++++
Repayment to former officer -------
Convertible debenture fees --
Proceeds from convertible debentures ++++++++++++++++++++++++++++++

Net cash provided by finance: ++++++++++++++++++++++++++++++++++++++++++++++
Net cash used in operations: ----------
Net cash used in investing: -------------------
Net increase in cash <-------------->

Cash at beginning of year: ****************
Net increase in cash: +++++++++++++++++
Cash at end of year: *********************************

Ok, so the cash flow diagram above shows why CXTI needed to produce $6 million in cash from financing. They wanted to buy the subcontractor ZZtech [presumably] because they need to expand very fast and it's just too slow and difficult to grow that much organically.

My opinion: You can clearly see how the cash flow nature of this business is such that it's capital intensive. It needs a lot of cash up-front and it takes a long time to turn a cycle and get the return back. Yes, that's a bad feature of this business which makes it difficult to grow. The overall return, however, is pretty good. And potential competitors will have the same problem (ok, so that's not much of a benefit).


Note 1: I already covered the structure of the business above.

Note 2: This shows all the same adjustments in the 2004 restatement that I've already covered. It's a good summary.

Note 3:
The depreciation schedule is unchaged from last year's Note 3.

I covered the derivative details above in the Results of Operations section.

They added better detail to the revenue recognition details.

Income taxes are accounted for using the liability method.

New accounting pronouncements:
Listed last year: SFAS 150, SFAS 132, SFAS 123R

Listed this year:
SFAS 123 "Share-Based Payment". This stuff kicks in at next year's 10-K (it was delayed).

SFAS 153 Exchanges of Non-monetary Assets. For fiscal periods beginning after June 15, 2005 which for CXTI means Q2 2006. No anticipated effect.

SFAS 154 Accounting Changes and Error Corrections (oh boy, this one will affect just about every Chinese reverse merger company out there). Apparently new accounting standards become retroactive. For fiscal years that start after 12/15/05, i.e. 2006 for most everybody. Oh sheesh.

SFAS 155 Accounting for Certain Hybrid Financial Instruments (amending SFAS 133 Accounting for Derivative Instruments and Hedging Activities and SFAS 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities). No more need to bifurcate the derivative from the host security if the holder elects to account for the whole thing on a fair value basis. Effective for fiscal years starting after 9/15/06.

Note 4:
$579K of gross PP&E with $551K of depreciation. Wow. Last year was not much different.

Note 5:
Intangibles gross is $1.9 million. It was nearly all depreciated last year. This year it's totally depreciated. This was paid for in shares of stock before the reverse merger.

Note 6:
There are $2.5 million in pre-paid consultant fees paid for with stock on 2/18/04. Amortization is currently at $938K. Another $500K will be amortized in the next year. This is the $500K that shifted into current assets. NOW I UNDERSTAND! Each year it's a new $500K, which is why it's current but shows up every year!

Note 7:
I covered part of this earlier in the section on Mr. Lai.

3/22/05, CXTI tried to acquire Shenzhen Zhong Zhou Technology (what I called ZZtech above). See the cash flow statement above. CXTI got their money back when the deal fell through a year later on 3/3/06. The CEO of CXTI is a director of ZZtech. CXTI has paid ZZtech $3 million in 2005, $1.2 million in 2004, and $2 million in 2003.

Note 8: (covered in Balance Sheet above)

Note 9:
$71.8 million cost and estimated earnings to date
$70.8 million has been billed to the customer
leaving $1 million which shows up on the balance sheet.

Note 10: Convertible Debentures
I covered the deal here and above. But Note 10 is a good condensed summary of the details.

Note 11:
No US tax for any year, but the rate is 35%.
CEN, being incorporated in Hong Kong, pays the 17.5% Hong Kong tax, but the total amount of tax is only $272K.
The British Virgin Islands company is not subject to taxes.
ENS is taxed in PRC at a total of 33%.

Ok, so net income is $9.3 million.
Hong Kong tax at 15% is $1.4 million
PRC additional tax is apparently $1.3 million

CXTI has some NOLs which might not be utilized. Frankly, I'm skipping over a lot of the tax stuff for now.

Note 12: I have my own diluted share count.

Note 13: Lease obligations are fairly low. And there's the First Montauk Securities threatened lawsuit mentioned above.

Note 14: Equity
2/18/04 to 2/17/09 consulting contract. CXTI issued 1.8 million shares as payment.

2/26/04 CXTI entered into an agreement with a consultant in Fujian province. CXTI to pay 15% of the gross income. Also CXTI issued 1.1 million shares for payment.

2/28/04 a consultant failed to provide services and surrendered 550K shares which were cancelled.

6/16/05 strategic services agreement with a consultant in Fujian province. CXTI to pay 10% of gross profit. Also CXTI issued 1.1 million shares for payment.

8/9/05 CXTI reached agreement with a shareholder to cancel 1,877,863 shares due to a disagreement regarding a share exchange on 2/9/04.

11/7/05 CXTI issued 2.3 million shares for converted convertible debentures.

Total warrants outstanding: 6.5 million
From the top of the document we see 28 million shares as of March 24, 2006. This could actually be double counting warrants that were converted in 2006 on or before March 24. On Dec 31, 2005 there were 26 million shares.

Note 15: Employee Benefits, not really material in my view

Note 16: No stock options outstanding

Note 17: Two local governments account for 100% of revenue.

Note 18: Subsequent Events
1/2/06: 1.2 million share being issued for a consultant to source a new project.
1/20/06: 800K shares reserved for a stock option plan.
2/11/06: 150K warrants issued to a consulting company.

8-K press release
This press release doesn't seem to have anything not already covered in the 10-K.


For a totally diluted share count, let's start with the 26 million on Dec 31. Then let's add in all of the 6.5 million warrants (some could expire, but I doubt it). We need to add in 2.2 million shares for the subsequent events stuff below. And given the way shares are used like toilet paper, I think we should add another 7 million shares. Note that this is probably on the low side, but remember that shares are issued for value received in return (which I'm not really counting very well for future stuff). So the totally diluted share count becomes 41.7 million shares which we'll round up to 42 million.

Since I'm adding the dilutive costs in the totally diluted share count, I should back out the cost of outstanding warrants from the income statement and assume a reasonable tax rate on it. So I'm adding $2.8 million to the bottom line of $6.5 million (I don't want to use the comprehensive income here since I don't want to make assumptions about future foreign currency adjustments despite my opinions about it). So I get an adjusted net income of $9.3 million or 22 cents per totally diluted share. If we were to slap a P/E of 15 onto that, we get $3.32. That assumes no significant growth going forward. I consider the growth to be gravy which is difficult to estimate, but I sure want to look for as much of it as I can get.

NOTE: My own estimate of earnings per share is actually lower than the value in the 10-K. If you simply take their 25 cents per share of earnings and slap a P/E of say 10 onto it, you get $2.50. That's not counting growth. That's not counting the benefits of potential currency revaluation.

Warren Buffett's investment in Arcata Corporation is, to me, an excellent way of looking at investments (you can see it in Berkshire's 1988 letters to shareholders).
Finally, we had to ask ourselves what the redwood claim might be worth. Your Chairman, who can't tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.
and later on, he reveals a bit more about it:
Encouraged, we raised our stake, buying at around $38.00 per share [even though the offer was only for $37 plus the redwood claim] and increasing our holdings to 655,000 shares, or over 7% of the company. Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward "a whole lot" rather than "zero" for the redwoods.
In that one example (you have to read it all), you can see how Buffett keeps various aspects of the investment in mind simultaneously, some of which are very fuzzy, some have a range of dates, some have a range of dollars, and overall you want a good sense of a minimum value. It seems to me that arbitrage would be a good exercise for doing valuations.

Now in my opinion, what Buffett probably did back then was to go check the prices on redwood lumber, ask someone roughly how much lumber would come from one average tree. Get a lower bound on the number of trees involved in the redwood claim. Make some conservative estimate of how much profit+costs would be taken up by various people between the tree and the retailer. And then just do the math.

The last trade of CXTI was at $1.93. Is this a sufficient margin of safety, given the various issues about CXTI? I believe it is. So I may choose to buy more stock on Monday, but at the very least I won't be selling any.

Update early Tuesday 3/4/06:
See this post for more details. I'd have to lower my valuation to something probably around $2.55. However, with the valuation lower, it's forcing me to have to put more thought into the less easily determined part of the value of the stock.

Bruce, many thanks for your insightful and in-depth take on these OTC:BB stocks. The writeup for CXTI was fantastic, and I laughed out loud at the pics of the auditors.

Keep up the great work!
I'm wondering how long until someone starts making a TV series "The Office" for Hong Kong/China. When you consider all the pictures, you get a sense for who these people are and their organization.

The [apparently] new rules for accounting for stock options are a major hassle. I'm going to really hate that crap. If I understand it correctly, it could essentially cause stock prices to oscillate since a high stock price causes a hit against earnings which will cause a low stock price which will benefit earnings which will cause a high stock price which will....

Anyway, I essentially just backed that stuff out and used my own accounting for dilution from options/warrants. It's not very pretty but I trust it to give me a conservative estimate of valuation.
Bruce, is your sense here that most investors will back out all these non-cash charges from the income statement? The mark-to-market stuff renders the income statement virtually worthless, so we'll have to have some kind of adjustment process to a new standard. PRZ is another example of a company that got caught up in the restatement issue surrounding treatment of warrants that were exercisable at less than market prices.

One quick comment on CXTI's revenue projections. The 30MM figure you come up with could be high IF they don't recognize a huge chunk of the Nan'an and Huian contracts in 2006. Its really hard to estimate when the milestones will be achieved so they can book the revenue, but I think you might be a bit high on your rev estimate. Either way, it represents a drop in revenue from FY05, and thus could be something that is holding buyers from coming in....yet. We have a long way to go in FY06, and not much in catalysts from the sales side. Earnings could be another matter if the stock continues to tank. They'll look tremendous! Seems pretty wacky to me.....but then that's accounting for you.

The cash flow looks pretty crappy too, and that might be holding off the value crowd that likes to see decent (or at least positive) cash flow from ops. Bottom line, I think the low PE is justified, and I don't see a 15x multiple on the horizon. Of course, anything is possible with Mr. Market.


I base investments entirely on my estimate of NPV of future free cash flow combined with how the return is handled (returned to shareholders or re-invested at reasonable returns). If the market doesn't want to give this company a high P/E, then I'm OK with sitting on it for a long time. Given the accounting issues, that could easily be the case.

The stuff I try to do is to gauge for myself whether I think the business has good characteristics. If it does, then in my view it deserves a P/E of 15. The market may not see it, but I believe it will over time as the compound returns accumulate. And that's not just cash, but also experience of the management team, development of the market, establishment of their (hopefully good) reputation, etc.
Aren't the convertibles with no floor price toxic? If so, couldn't the bond holders drive the stock price down and exchenage their bonds for an obscene number of shares thereby wiping out the equity of the other shareholders?

Amazing stuff. But I'm a dunce. How does CXTI calculate the fair value of the warrants they have issued? How does the 75% of stock price/$1.80 max debenture conversion price figure into the derivative profit/loss equation?
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