Tom Konrad CFA
Last year, I brought Chinese off-road vehicle and electric vehicle (EV) manufacturer Kandi Technologies (NASD:KNDI) to readers’ attention. I like Kandi because the company was already profitable and trades for a tiny fraction of what a US-based EV maker would.
I also like Kandi’s electric vehicle strategy, which focuses on inexpensive commuter vehicles combined with battery-swapping. While this sounds a lot like the the strategy of recently bankrupt Better Place, Kandi’s strategy avoids one of the biggest problems with Better Place’s strategy: Kandi does not have to bear the expense of extra sets of batteries or swapping infrastructure. The batteries are owned by the local utility, which can use them when they are not in cars to provide stabilization and ancilliary services to the grid. Kandi just (profitably) manufactures the cars and licenses the battery swapping IP.
With the Chinese government in Beijing pushing hard for more “New Energy Vehicles” as the Chinese call EVs in order to cope with its horrific problem of urban pollution, even China’s largest privately owned automaker, Geely (HKEx: 175, OTC:GELYF) got religion, and has signed a 50-50 joint venture to produce EVs with Kandi.
With Kandi already profitable based on its legacy ATV business, I and other Kandi shareholders have long been frustrated that Kandi does not trade at a much higher multiple of earnings and revenue. Kandi has a trailing P/E ratio of 20, and trades at less than 2 time trailing revenue. Meanwhile EV high-flyer Tesla (NASD:TSLA) is trading at 13.5 time revenue, and 100 times next year’s expected earnings (Tesla lost money last year, and is expected to only break even in 2013.)
The China Price
There are several factors contributing to Kandi’s low valuation:
- Kandi got its Nasdaq listing through a reverse merger, a strategy which was followed by a number of other Chinese companies, many of which were later found to have fiddled their books, absconded with shareholder funds, or otherwise been frauds.
- As a result of its small market capitalization and the general wariness of Chinese stocks, no analysts follow Kandi.
- A number of negative articles, many of which were written by investors who were short the stock, have highlighted irregularities in Kandi’s listing process and past reporting.
Although the negative articles about Kandi have been disturbing, none of them have turned up anything wrong with Kandi’s financial accounting. I’ve generally taken this as a good sign. When the same group of people who made good profits by shorting Chinese stocks and then exposing their accounting frauds have been unable to turn up anything so serious about Kandi, I have to wonder if there is anything to find.
With this in mind, I set out last month to parse through the novel-length and rather dense Kandi-bashing articles to demonstrate that there was nothing there for investors to worry about. I failed, and instead found myself doubting the judgement and/or honesty of Kandi’s management. I’d like to emphasize that there is no proof of wrongdoing, but investors who wish to hold on to their money don’t have the luxury of waiting until their suspicions are confirmed beyond a reasonable doubt.
The most in-depth articles looking into irregularities surrounding Kandi were written by Chris Cary of Sharesleuth. Carey is a former reporter for the St. Louis Post-Dispatch. Sharesleuth is funded by Mark Cuban, who often trades on the information Carey digs up before he publishes his articles. Some people find this business model distasteful but as Carey puts it, “If Sharesleuth.com exposes fraudulent companies and Mark Cuban uses profits from trades to finance more investigative reporting, then I’m OK with that.” I’m also OK with it. I don’t see the difference between Sharesleuth and any mutual fund manager who goes on CNN to talk about his portfolio. Or between Sharesleuth and a blogger writing about stocks he owns on Forbes or Seeking Alpha, for that matter.
The controversy about Sharesleuth’s business model mostly seems to arise because most of Cuban’s trades are on the short side. But in the case of Kandi, Cuban was never short. I asked Carey about this in an interview, and he responded that Kandi is a very difficult stock to short. For a billionaire like Cuban, the money he could make shorting a tiny stock like Kandi is hardly enough to move the needle. Carey uncovered the information in his articles in the course of investigations into the people who brought it public, along with ten other Chinese reverse merger companies, including New Oriental Energy (OTC:NOEC), Telestone Technologies Corp. (Nasdaq: TSTC); and Orsus Xelent Technologies Inc. (OTC: ORSX). Many of these have since been delisted, and Kandi is virtually alone among them for not trading well below its initial offering price.
Clearly, Kandi should not be indited based on guilt by association, and the scrutiny the company has been under because of these associations should give us some confidence that any past misdeeds are either very well buried or have already been revealed. Nor do any of those misdeeds reach the level of the outright accounting fraud found in many of the Kandi’s reverse-merger brethren. Kandi has not been accused of anything illegal.
My distillation of the Sharesleuth revelations is:
- A number of people made millions off Kandi’s reverse merger, and these people were never properly identified in the company’s SEC filings.
- From 2009 to 2011, Kandi significantly overstated the number of EVs it sold. After Sharesleuth showed that Kandi’s claimed sales of EVs were not supported by the number imported or sold by Kandi’s dealers, the company quietly revised its financial statements, revealing that many of its claimed EV sales were actually sales of gas powered vehicles.
Kandi’s defenders dismiss the first point as old news, saying that what should really matter to investors is Kandi’s current prospects. To the second point, they say that Kandi has admitted its mistake, and the miscategorization of sales of gas powered cars as EVs made no difference to Kandi’s revenue or earnings in any of the affected years.
They also emphasize that Kandi is not accused of any criminal act or fraud, and attempt to undermine the credibility of Kandi’s detractors by calling the negative articles paid hit pieces. Of course, Kandi’s defenders are long the stock (as am I), which is at least as much of a bias as being short.
I’m certainly happy that Kandi has not been accused of fraud, and I do prefer to focus on Kandi’s future than on events which occurred before I was ever a shareholder. On the other hand, when we’re trying to predict how management will behave in the future, our best evidence is how they have behaved in the past.
In the case of unknown individuals profiting from the reverse merger, this was at best bad judgment on the part of Mr. Hu, Kandi’s President, CEO, and largest shareholder. The reverse merger process seems to have needlessly diluted existing shareholders, and also shows Mr. Hu working with a number of unsavory characters, perhaps unwittingly. At worst, Mr. Hu and his associates may have directly benefited from the transactions in ways which were not disclosed.
Either way, the incident undermines my faith that Mr. Hu will do everything in his power to protect the equity of the company’s current small shareholders.
In terms of the misreported EV sales, the best case scenario is that it was simply a translation mistake. I find this scenario unlikely, because the exaggeration occurred repeatedly over a couple years. Nor does the fact that the mis-categorization of EV sales did not affect reported sales or revenues mean that the number of Kandi’s EV sales was not material to investors’ investment decisions. The Kandi “story” depended on the growth of its EV business even then: Here’s an article from 2010 making the link explicit: Kandi Tech Reports Strong Results, But Future Depends on Electric Car Growth.
After couple of my picks recently revealed that they would have to restate their financial accounts because of misreported revenue, I began using the Beneish M-Score as an early warning system for earnings manipulation. I calculated Kandi’s M-Score based on annual accounts from 2010 to 2012, and on quarterly accounts for the last three quarters. The M-Score combines factors which might give a company an incentive to manipulate with factors which pick up the distortions caused by common forms of earnings manipulation. Details about how to calculate M-Score and a spreadsheet can be found here. For nearly all the periods I tested, M-Score indicates that Kandi has a moderate chance of having performed some earnings manipulation. Exactly what this probability is is hard to say, but the M-Scores are a long way from giving an “all clear.”. The 2010 annual report looks most likely to have been manipulated, mainly because of a high level of receivables growth relative to sales growth. Note that this period coincides with the inflated EV sales numbers.
Companies can have high M-Scores without having manipulated earnings, but a high M-Score says “proceed with caution.” Maxwell Technologies (NASD:MXWL) had an M-Score in the third quarter of 2012 that was similar to Kandi’s annual 2010 M-Score, and the next quarter they announced that they had been misreporting revenue since 2011. (I suspect Maxwell’s mis-reporting may be greater in extent than has yet been revealed.) M-Score will not flag all earnings manipulation, but it may flag some honest companies as well.
Reading through Kandi’s filings, I noticed that Kandi’s largest shareholder at the time of its listing was ExcelVantage Group, a fund controlled by a Chinese retiree Tim Ho Man. In 2010, Mr. Tim transferred control of ExcelVantage to Kandi’s CEO, Mr. Hu, “pursuant to a Transfer of Equity Agreement” between them. Kandi’s listing documents made no mention of any connection between Mr. Hu and Mr. Tim. While it is possible that Mr. Hu bought ExcelVantage from Mr. Tim in an arms-length transaction, it seems more likely to me that the two men had an undisclosed agreement between them which gave Mr. Hu effective control of ExcelVantage all along.
Once again, there is nothing illegal about this, but it had the effect of obscuring the fact that Mr. Hu retained a controlling stake of Kandi at the time it went public. That’s something I would have wanted to know had I been considering investing at the time.
There are a number of instances and red flags about Kandi’s management that lead me to want to proceed with caution. At the very least, the company has not been forthcoming with relevant information that investors would have been interested in. A company looking to build a reputation for good shareholder relations would have disclosed this information. At worst, the company may have intentionally misled investors regarding its EV sales at a time when its accounts also showed signs of possible distortion. If that’s the case, it would be reasonable to assume that they will do something similar in the future.
On the other hand, the evidence of Kandi’s current progress at building acceptance for its EVs is based not only on the company’s statements, but a large number of articles in the Chinese press, and agreements with Geely and a number of Chinese cities and provinces. My feeling from this is that Kandi will continue to rack up good press and increasing EV sales for the rest of the year. The fact that Kandi also recently filed an S-3 to allow it to sell additional securities also leads me to believe that, if the company is likely to exaggerate its results, it will do so in the coming months in order to boost the share price.
After weighing the evidence, I no longer consider Kandi a long-term hold. That said, my concerns about management are long-term in nature, and I think Kandi’s short term trend will be up. This article itself may cause a downward blip, but Kandi’s shareholders are so used to negative articles about the stock that I doubt this one will have any long term effect, and I expect Kandi’s upward momentum will soon resume. I intend to maintain my reduced holding to take advantage of that trend.
Update 6/10/13: The upward climb I predicted above started much sooner than I thought, when a relatively minor news story about a car developed for the Kandi-Geely JV received approval from the Chinese government, and Kandi finally caught some of the Tesla (NASD:TSLA) fever. When I wrote this article 10 days ago, Kandi was trading around $3.80, today it’s trading at $6.50. I’m now mostly out of the stock, having sold covered calls at $5, but I’m not ready to call a top. As Tesla showed, once an EV stock catches investors’ imaginations, it can completely defy gravity and fundamentals. Bottom Line: If you still own Kandi, enjoy the ride, but this hot EV stock should be a rental, not a purchase or even a long term lease.
Disclosure: Long KNDI stock, short KNDI covered calls, MXWL.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.