Sunday, April 1, 2012

Lession / Tutorial 14: CAST Chinacast Education Fraud

This is a step by step guide of how to protect yourself from investing in fraudulent companies. Chinacast will be the specimen for this tutorial. Maybe you can dispute that it's not fraud since they're not trying hard at all to hide it. After all, it's not fraud when a beggar asks for money without giving you anything in return. Read along with me while I point out warning signs and red flags in easily available public documents. I've included page numbers and quotes from the text to help you along. I shall first give a brief summary of what I predicted based on the financial statements, and then I will go into the 10-K filing to confirm my suspicions. Enjoy!!

Below are links to the 10K filing from Edgar and financial statements from Google Finance. You can use these to follow along.
CAST 10-K for 2010 from Edgar
Financial Statements for CAST

All monetary amounts in RMB

Initial thoughts before opening the 10-K ending year 2010 from glancing at financials
Operating cash flow for 2008, 2009, 2010 were 213m, 135m, 325m, totaling 700m. Shareholder 

equity went from 1026m to 1754m from 2008 to 2010, an increase of 726m. Goodwill rose from 1.7m from 2007 to 774m in 2010. This is a concern to me because there have been only small inflows and outflows of cash via issuance/retirement of stock and debt. An increase of shareholder equity so closely aligned with the value obtained by operating cash likely implies that

  • There may have been little or no depreciation of assets, meaning CAST may be accounting aggressively by deprecating  assets too slowly.
  • Depreciation was properly accounted but some other assets may have increased in value. I find this unlikely since CAST is not an investment company.  
  • Increase in shareholder equity may be due largely to acquisitions, reflected in the increase of goodwill vs the total operating cash flow.
  • There have been significant increases in shares outstanding without corresponding cash flows from issuance of stock. Considering the large increases in goodwill, this may due to the use of stock to pay for significant portions of acquisitions. If this is the case, I’m worried about the potential ability to introduce borderline accounting.

10-K for 2010, page numbers included with points made
Business summary -
  • CAST has two main operations, ELG and TUG
  • ELG, E-learning Training Group - provides a satellite service which broadcasts education programs to schools. Schools pay for the hardware to receive signals and then pay a subscription fee every month for content.
  • TUG, Traditional University Group - Universities FTBC, LJC, HIUBC with over 30k students.
  • Acquisitions were made using significant amounts of share issuances, confirming my initial guess
  • p10 - CCLX owns a VSAT license, for which foreign ownership is forbidden.
  • p11 - CCLX pays CCT Shanghai for service
  • p12 - CCT Shanghai can buy CCLX for RMB 1 when VSAT may be owned by a foreign entity. Sounds like CCLX was set up for the sole purpose of VSAT.
  • p12 - CAST funds all of CCL, interest free, and will take ownership of CCL’s assets when regulation allows.
  • p12 - CCL is a variable interest entity and CAST is not considered to be the primary beneficiary of CCL. CCL has never been included in consolidated financial statements. CAST does not have the power to direct activities of CCL and does not have the obligation to absorb losses and does not get to receive benefits of CCL.
  • p12 - In consideration of CCL's service in assisting the Company to obtain the renewal of the license, the Company shall pay an annual service fees to CCL in the amount of RMB 8.1 million during the service term of the Service Agreement and RMB60 million remaining balance of the noncurrent advances, after deducting the purchase price of NCI in CCLX, will be used as a prepayment for this service. However, given that the annual renewal of VSAT license needs to be approved by a government agency and the result is not under the control of neither CCL nor CCLX, the Company believes that the fair value of the VSAT license renewal service to be provided by CCL cannot be reasonably estimated.  In addition, CCLX undertakes to CCL in the Service Agreement that it will not take back nor to recover any amount of the prepayment even though it subsequently does not require the service of CCL during the entire service term. As a result, the Company decided to write off the RMB60 million for the prepayment for VSAT license renewal service. The impairment loss of RMB60 million is included in the operating income. This section worries me. CCL operates as a as a variable interest entity and this sounds like it allows the funneling of money from CAST out of the company via a writeoff.
  • 10-K basically explains the complicated structure of the company as a result of operating laws in China preventing foreign ownership and control of particular key business components.
Management’s Discussion and Analysis
  • p31 Revenue recognition policy looks ok
  • p32 Impairment of non-current advances - CAST pays for all of CCL’s assets. This payment increase the non-current advances balance. Every year, CAST pays 8.1m to help renew the VSAT. CAST will also write off 60m of the non-current advances, regardless of services received. My understanding is that CAST has given 60m to CCL which never has to be paid back.
  • p34 Total ELG revs from 196m to 208m in 2009 to 2010, cost of materials from 8.5m to 18m in 2009 to 2010. Sounds like they have minimal profit from selling equipment.
  • p35 impairment loss of non-current advance of 59.8m was the freebie that CAST gave to CCL.
  • p39 Net cash generated from operating activities was RMB352.6 million (US$53.4 million) in 2010 as compared to RMB135.1 million (US$19.9 million) in 2009. Mainly, it is due to the net cash generated from operating activities for 2009 was depressed because after the acquisition of LJC on October 5, 2009, there was a payment of RMB27.3 million (US$4.0 million) to Guangxi Normal University as fee payment under the affiliation agreement for revenue received before October 5, 2009. The revenue received before October 5, 2009 was not consolidated into the operating cash flow of the Company, but the fee payment under the affiliation agreement payment after October 5, 2009 was included in the operating cash outflow. As such, the operating cash flow would be reduced accordingly. This is an open admission of recognizing future revenue in the current accounting period. As a result, 2009 showed higher revenues than it should have had. 2010 showed less revenue than it should have. This is a common aggressive accounting tactic.
  • p40 On January 5, 2010, the Company issued 692,520 restricted shares of our common stock to Thriving Blue Limited, a British Virgin Islands company that is 100% owned by Ron Chan Tze Ngon, the Company’s Chief Executive Officer (“Thriving Blue”) pursuant to a Subscription Agreement dated December 21, 2009 between the Company and Thriving Blue for a purchase price of US$7.22 per share or an aggregate purchase price of US$4,999,994.40. The shares are beneficially held on behalf of Ron Chan Tze Ngon, Michael Santos, and Antonio Sena.Thriving Blue for a purchase price of US$7.22 per share or an aggregate purchase price of US$4,999,994.40. The shares are beneficially held on behalf of Ron Chan Tze Ngon, Michael Santos, and Antonio Sena. CEO issues himself 692,520 shares of stock. Agreement was made right before end of year and stock was exchanged after the start of next year. I expect this to show a healthier than normal balance sheet for 2009 at the cost of a weaker one in 2010.
  • p41 CAST uses non-cancelable leases for office space. However, it is classified as an operating lease. CAST’s debt obligations is potentially higher than displayed on its balance sheets.
  • p43 CAST Fails Independent Audit Report given by Deloitte - For the sake of this tutorial, I've gone through more than I needed before reaching a confident decision that this is fraudulent accounting. The Independent Audit is so to pass that any company which fails is guaranteed to be a scam. Even without putting the time that I have into research, it's a good idea to at least skip to the Audit Report to make sure it has passed.


  1. Thanks for posting the tips. With all the scammers these days, it definitely pays to be safe.

    1. You're welcome. There are a lot of easy ways to avoid getting caught in traps. The research above took no more than simply opening the 10-K for about an hour.