China Natural Gas (NASDAQ: CHNG) – Management Leaving Investors Stuck at the Pumps - PART ONE

Our due diligence investigation into China Natural Gas (NASDAQ: CHNG) uncovered some very serious concerns, most importantly that there is strong evidence that company management stole or misappropriated $20 million from public investors through an undisclosed related party acquisition. Additionally, it is highly likely the company’s Q4 and Q1 revenue will fall short of guidance and expectations due to the ongoing natural gas shortage as a result of the unusually cold winter. Furthermore, the frequent CFO turnover (five in the past three years), inexperience and significant internal control weaknesses identified by its auditor leave us with grave concerns over the reliability of CHNG’s financial reports. 

Background info on CHNG’s long delayed LNG project

Fundamentally, China Natural Gas is a simple business operating compressed natural gas fueling stations for buses and taxis in the Shaanxi province of China with profit margins controlled by the government. In order to better attract investment, management for the past three years touted a liquefied natural gas central station project. In its SEC filings dating back to March of 2007 management claimed the project would cost $40-$45 million to complete and take approximately six months to build. Funding for the project was completed in early 2008 through a financing lead by Abax Lotus. However, management then immediately diverted $20 million of the proceeds to the questionable Lingbao Yuxi acquisition (detailed below) and announced the delay of the LNG project until 2009. In November 2009 following a hugely dilutive $50 million financing management announced a further significant delay in the completion of the LNG project until May 2010.

The $20 million Lingbao Yuxi acquisition appears to be a related party transaction and may have enriched management at the expense of public shareholders

CHNG announced the surprise acquisition of Lingbao Yuxi Natural Gas Co (Yuxi) for RMB 134 million (USD $20 million) in January 2009. The funding of this acquisition left CHNG with insufficient cash to complete its LNG project. The merits of the acquisition are impossible to calculate since management does not disclose the subsidiary’s performance, though according to a December 5, 2008 article in Sanmenxia Daily (link here or PDF version here) the recently completely pipeline had only 3,000 customers. According to SEC filings Yuxi was purchased by CHNG’s subsidiary Xi’an Xilan Natural Gas Co (Xilan) in October 2008. The company did not bother to file an 8K to disclose the acquisition until December 31, 2008. What made us more puzzled about this deal was the inconsistency we found from information on local government websites. According to this August 2007 news release from the SME webportal of Lingbao government (Link here or PDF version here), Yuxi was actually an existing subsidiary of CHNG (Xilan) over a year prior to the announced “acquisition”. Another record from the RFP information portal of Chinese government (link here or PDF version here) dated May 2007 again states that Yuxi was a subsidiary of CHNG (Xilan) and was selected to construct the pipeline infrastructure in the city of Lingbao. Assuming the records from the government are accurate, why would CHNG claim that it acquired 100% of the equity in a company they already own or control without disclosing it as a related party transaction?

 

The acquisition became even more questionable after we reviewed the detailed “Equity Ownership Transfer Agreement” attached with the 8K filed on Dec 31st, 2008. The agreement mentioned two shareholders in Lingbao Yuxi owning 99% and 1% of the equity interest respectively (inconsistent with the 90% and 10% mentioned in 10K). But the real danger lies in the payment details quoted here: 

Party C will wire agreed payments to the bank account appointed by Party A. Party A will distribute the payment according to their respective equity ownership percentage. The accounts is: Industrial and Commercial Bank of China, Sanmenxia Xiaoshan Ave. Branch, account holder: Sanmenxia Yuxi Investment Co., Ltd.; account number: 1713022909200034327

 

Party C in the agreement is CHNG’s Xi’an Xilan subsidiary. Party A’s shareholders are identified as Zhang and Hu. However, the payee account, Sanmenxia Yuxi Investment Co (notice the same word Yuxi as in Lingbao Yuxi) has CHNG CEO Qinan Ji himself named as its legal representative according to State Administration of Industry & Commerce records (web link here or PDF version here). So the CHNG CEO himself controlled the $20 million funds disbursed to purchase Lingbao Yuxi and could use the proceeds however he saw fit, even to pay part or all of the proceeds to himself. The failure to disclose that the Yuxi acquisition was in fact a related party transaction is a major violation of securities regulations.

Q4 and Q1 results should disappoint due to weak natural gas sales at fueling stations during the unusually cold winter

The natural gas supply/demand situation was relatively stable through the first 10 months of 2009. However, with the extremely cold weather since November CHNG’s main market Shaanxi province experienced substantial supply shortages widely reported by local media. To manage the shortfall, the National Development and Reform Commission (NDRC) published a notice (link here), requiring various participants in the industry supply chain (including CHNG) to cooperate with the government’s effort to ensure stable supplies to local households for necessities such as heating, cooking etc rather than public and industrial uses. A Huashang Newspaper article dated Nov 20 2009 (link here) mentions multiple CHNG Xilan branded fueling stations closed for business due to lack of supply. The article went on by quoting Xilan manager Mr. Guangliang Jin who explained that more than 10 of its 24 stations in Xi’an were not functioning properly at the time since the stations’ compressors were unable to start as a result of low gas pressure and furthermore that Xilan was forced to procure gas at much higher costs from other compressing stations in order to meet its contractual obligations to supply the buses. The story includes a photo of a closed Xilan fueling station in Xi’an. CHNG has not to date publicly disclosed the closures or the inevitable shortfall in its operating results. According to its SEC filings, natural gas sold through CHNG’s fueling stations accounted for 74% of the total revenue and about 80% of its gross profit in the first three quarters of 2009. CHNG’s Q4 and Q1 operating results are certain to be adversely impacted given heavily reduced volume coupled with some gross margin pressure due to the short supply, rising costs, and government selling price controls that have so far not been lifted.

Timing and frequency of CFO turnover and significant internal control weaknesses

Including the resignation of its first CFO Xiaogang Zhu on December 10, 2007, CHNG has had 5 different CFOs, four of whom each held the title for less than a year. Three of the resignations happened within the past 16 months. Most alarming is the fact the current CFO David She (appointed on January 14) only just obtained his undergraduate and graduate degrees in 2006 and 2007 with his only previous experience as an analyst at a regional securities firm in China.

 Name Appointment Resignation
 David She 14 January 2010 --
 Veronice Jing Chen 28 April 2009 10 January 2010
 Richard Peidong Wu 23 October 2008 27 March 2009
 Lihong Guo 10 December 2007 23 October 2008
 Xiaogang Zhu January 2005 10 December 2007

We’re deeply concerned about the quality and integrity of the company’s financial reporting under such frequent CFO turnover, especially when two resignations happened while important SEC filing such as the 10K were being prepared. One of the CFOs, Ms. Guo, resigned at the time of the suspicious Lingbao Yuxi acquisition. Her successor Mr. Wu departed shortly after the next 10K was filed and amended. Furthermore as we have shown, the 8K regarding the Yuxi acquisition was filed late and was misleading plus the significant closure of numerous fueling stations in Q4 and Q1 as a result of the severe gas shortage has not been disclosed.  Additionally, we encourage investors to take a close look at the detailed disclosure on internal control because of the startling fact that the company does not even have adequate control systems on basic daily cash transactions and its treasury cycle.  All these problems are extremely unsettling to see in a NASDAQ listed company!

Recommendation

With dishonest management and Q4 and Q1 likely to significantly disappoint, we are short CHNG at $9.50. We recommend smart investors sell the shares immediately as shareholders are once again left with nothing but worthless pennies.

 

Note to readers: In the next several weeks we will publish PART TWO of our report in which we take a detailed look at CHNG’s long delayed and very suspicious LNG project and question CHNG’s unusually high reported profit margins among other concerns.