Hao Tian Development (0474) has confirmed our view by dumping 9.06% of CIFG at a 61.9% discount, still well above the net tangible asset value of $0.099. CIFG should trade below NTAV due to its appalling governance and membership of what we call the "Chung Nam Network". The purported profits of its leasing division are largely illusory and depend heavily on 1 customer in which CIFG has invested. HTD has also been allowed by HKEX to skirt the Listing Rules on corporate transactions.

China Innovative Finance (0412) bubble
26 September 2016

China Innovative Finance Group Ltd (CIFG, 0412) is a bubble stock, not just in our view, but apparently in the view of its largest shareholder, Hao Tian Development Group Ltd (HTD, 0474). How do we know this? Well on Friday (23-Sep-2016), HTD sold 1,737,940,350 shares (9.06%) of CIFG to an unnamed "independent third party" at HK$0.297 per share, or $516.2m in total. That's a 61.9% discount to the closing price of $0.78 per CIFG share, but even that discounted price looks generous when you consider that the net tangible assets of CIFG at 31-Mar-2016 were just $0.099 per share. In our view, CIFG shares should trade at a substantial governance discount to that NTA.

The brief "voluntary" announcement makes no mention of the discount to market or the reasons for the sale, which cuts HTD's stake from 27.32% to 18.26% of CIFG, below the 20% level at which a company would normally account for its holding in another as an "associate", including its share of net assets in the holder's balance sheet rather than the market value of the shares.

HTD is not normal though. It first acquired a disclosable stake in CIFG in Jul-2014, and in its accounts since 30-Sep-2014, it has made the somewhat ridiculous claim that although it held almost 29% of CIFG:

"the Group has irrevocably undertaken to [CIFG] that the Group shall not participate or otherwise exercise any influence over the management or the operating and financial policy decisions of [CIFG] and shall not nominate any directors to or remove any directors from the board of directors of [CIFG]"

We have not found any mention of this irrevocable undertaking in the announcements or annual reports of CIFG. Perhaps they are unaware of it. As a result, HTD has always held most of the investment in its balance sheet under "current assets - investments held for trading" at market value, rather than at the much lower value of the share of net assets.

At 31-Mar-2016, HTD held 5241.5m shares (then 27.14%) of CIFG, in the books at HK$4979.4m, or $0.95 per share, accounting for 74.8% of its net tangible assets. Of this stake, 2.33% (acquired in the year to 31-Mar-2014) was held as long-term "available-for-sale" assets and 24.81% acquired in Jul-2014 was held as "investments held for trading". The latter stake, valued at $4550.5m, accounted for 93.6% of the "investments held for trading" at the year-end.

Despite having almost a single-stock portfolio, the Stock Exchange has allowed HTD to claim that it is "in the business" of investing since it made an announcement to that effect on 9-Jul-2014, just 19 days before it bought 26.2% of HTD in two off-market transactions for a total of HK$710m. Consequently, the acquisition of the stake in CIFG, and now its disposal, have not been treated as notifiable transactions under the Listing Rules, apparently because the Stock Exchange considers that it is in the "ordinary and usual course of business" of HTD under Listing Rule 14.04(1)(g) to buy a 26.2% stake in another listed company.

As we said in our article The bubbles in CNN on 8-Jan-2015, HTD's acquisition of 28.87% of CIFG should have been treated as a "Very Substantial Acquisition" under the Listing Rules. Similarly, Friday's disposal should have been a "Disclosable Transaction" under the Listing Rules and this is another good example of why the Stock Exchange, owned by Hong Kong Exchanges and Clearing Ltd (0388), needs to be relieved of its regulatory function entirely.

On Friday's sale alone, HTD will book a loss of $0.653 per share, or $1135m relative to the price at 31-Mar-2016. The other shares, having declined in value since the year-end, will likely also result in a fair value loss, depending on where they end on 30-Sep-2016, the next accounting date of HTD.

Acquisition of HK Leasing

On 8-Apr-2015, CIFG agreed to buy Hong Kong Leasing Ltd (HKL) from China Hover Dragon Group Ltd (CHD, 96.77%) and Mr Gao Chuanyi (Mr Gao, 3.23%) for a base consideration of HK$1558.334m payable in new CIFG shares at $0.66. Mr Gao had been allotted his HKL stake on 12-Feb-2015. CHD was 50% owned by Ji Kewei (Mr Ji) and 50% by Ms Wang Zi Yi. We don't know whether this is the same Wang Ziyi who was appointed as an Executive Director of Hao Wen Holdings Ltd (8019) on 17-May-2016.

HKL had assembled a mainland financial leasing business starting in 2013. According to the Accountant's Report in the circular dated 30-Jul-2015, HKL made a net profit of just HK$6.96m in 2014 and a loss of $8.91m in the first quarter of 2015. So the 2014 P/E on the deal was 224. The deal was also priced at 4.006x net asset value at the completion date.

The Accountant's Report also reveals that the 2014 profit was boosted by the following means. On 21-Nov-2014, HKL and China Hover Dragon Investment Ltd (a sister company of HKL) agreed to pay interest at 17% p.a. on amounts advanced by HKL from May-2013 to Nov-2014. In other words, interest of $6.69m was added in arrears and all of that was booked in 2014. Without that, HKL's profit for 2014 would have been only $0.27m. Furthermore, the 2014 profit includes a one-off gain on disposal of trading securities of $4.55m, so without those two effects, HKL would have been loss-making.

The rich valuation of 4x NAV was built on narrow foundations. Of the HK$856.0m of loans receivable at 31-Mar-2015, $600.5m or 70.1% was due from a single customer, 中國雲南路建集團股份公司 or "Yunnan Lu Jian". This also appears to translate as "China Yunnan Highway Construction Group Co Ltd" (Yunnan Highway). The same construction company also agreed on 23-Dec-2013 to take over debts of RMB41.8m due to HKL from various parties but on an interest-free basis.

The acquisition of HKL completed on 1-Sep-2016, and it can't be a coincidence that in note 22 of the CIFG annual accounts at 31-Mar-2016, we see that during the second half of the financial year, CIFG subscribed 30m shares (8.33%) of an entity it calls 雲南路建集團 or "Yunnan Highway Construction Group", for HK$39.604m. So apparently CIFG has been investing in its largest customer and debtor. For the year-end, CIFG has obtained, from an unnamed valuer, a valuation of $96.010m for this unlisted investment, booking a gain of $56.406m or 142% in 6 months or less.

During the period from the date of acquisition (1-Sep-2015) to 31-Mar-2016, HKL purportedly contributed a segment profit of $69.655m to CIFG, but this included a gain on investments of $56.709m, presumably including the gain on the Yunnan Highway stake, which in our view has nothing to do with the leasing business. Note 5 shows segment revenue of $88.8m, but note 6 shows that actual revenue from financial leasing was only $48.3m, while "consultancy services income" was $39.0m. It is unclear what the consultancy services are or how they relate to financial leasing.

Stripping out the gain on Yunnan Highway, the segment profit was not more than $12.95m, even including the consultancy services income. The Management Discussion and Analysis, in our view, contained a false and misleading statement:

"The financial leasing business recorded a positive result of approximately HK$70 million for the year ended 31 March 2016".

The true figure matters, because the acquisition agreement contains a clause that if the audited net profit for the 12 months after completion is less than HK$100m, then the vendors will return CIFG shares equal to 4.006 times the shortfall (at $0.66 per share) which will be cancelled. That period runs to 31-Aug-2016 and has now ended, so CIFG should announce whether the net profit, excluding the investment gain, has reached that figure. Shareholders could not have expected to be paying 4 times the future gains on investments to buy HKL. There is a similar clawback if the second 12-month period (to 31-Aug-2017) produces a profit of less than HK$200m.

On 11-Sep-2015, Mr Ji was appointed Deputy Chairman and CEO of CIFG. He claims to hold an MBA and a "Doctor of Philosophy degree in Economics (Finance)", but he doesn't say where from, and we've been unable to find the degree-awarding institution(s) in earlier biographies. Mr Ji was first appointed to a HK-listed board on 12-Apr-2006, when he became Deputy Chairman and CEO of what is now China Finance Investment Holdings Ltd (0875) and became non-executive on 29-Dec-2011, leaving the board on 1-Apr-2012. In 2007, he and his private firms pleaded guilty to 12 disclosure of interest offences and were fined a total of HK$24,000.

Concentrated ownership of CIFG

The holders of CIFG that we know of are:

Those 11 holdings add up to about 79.42% of CIFG, and there may be others that we have not found within the balance sheets of what we call the "Chung Nam Network", which includes HTD, CIFG, GT, Enterprise Dev, Enerchina, CSPT, China Opto and many more, as well as several unlisted hubs jointly owned by the network members. As of Friday night, 88.26% of CIFG was held in CCASS, and the top 10 brokers/custodians held 91.25% of the shares that are in CCASS.

The involvement of CCB

For unknown reasons, HTD and CIFG seem to have developed a close relationship with China Construction Bank Corp (CCB, 0939).

On 19-May-2015, HTD announced a non-binding term sheet proposing that it would (i) borrow US$30m by issuing loan notes to CCBI Investments Limited (CCBI), (ii) that its subsidiary, HTF would issue unlisted warrants to subscribe US$15m worth of shares in HTF at NAV, and (iii) that HTD would grant a call option over shares in CIFG with a value of US$15m based on an exercise price of $1.44 per share, being 115% of the 15-day average price. HTD failed to say who owned CCBI or where it was incorporated.

On 6-Jul-2015, this was distilled into a binding agreement between Sea Venture Investments Ltd (Sea Venture, BVI) and HTD, in which Sea Venture would subscribe US$30m of 2-year 9% loan notes, secured by a pledge of 550m shares (then 3.25%) of CIFG. HTD also granted a 3-year call option over 80,729,170 shares (then 0.48%) of CIFG at $1.44 per share, a total exercise price of US$15m at an exchange rate of US$=HK$7.75. Sea Venture also received warrants to subscribe US$15m of shares in HTF, or about an 8.8% stake, which would dilute HTD from 75.2% to 68.6% of HTF. The notes subscription was completed on 16-Jul-2015.

The announcements failed to say who owned Sea Venture. A disclosure of interest by HTD on the same date hints that the actual size of the share pledge was 720m shares (then 4.25%) of CIFG, not 550m shares as announced. At the closing price that day of $1.15, the 720m pledged shares were worth HK$828m (US$106.8m), so HTD was getting a margin loan of about 28% of that. In the Webb-site CCASS Analysis System we can see the shares moving from Haitong International Securities Co Ltd (Haitong) to CCB International Securities Ltd (CCBIS) on 15-Jul-2015.

The ownership structure of Sea Venture only became clear because on 19-Aug-2015, CCB acquired a "security interest" (normally a pledge of shares for a loan) of 440m shares (then 2.59%) of CIFG, increasing its overall security interest to 1160m shares (6.85%) of CIFG. Having risen above 5%, On 27-Aug-2015 it made a disclosure of interest filing which showed that Sea Venture is owned by CCBI and that CCBI is incorporated in the Cayman Islands and is a 100% subsidiary of CCB. We can infer from the HTD interim report at 30-Sep-2015 that all of the 1160m pledged CIFG shares were owned by HTD, because at the market price of $0.67 on that date they were worth $777.2m in total, matching the figure for pledged investments. Again, we can see the 440m shares moving from Haitong to CCBIS on 19-Aug-2015.

On 16-Dec-2015, the pledge was reduced by 250m shares to 910m shares worth $728m at the closing price of $0.80. We can see the released shares moving from CCBIS to Haitong the next day.

On 24-Dec-2015, Sea Venture subscribed US$40m of 2-year 7% bonds in CIFG, convertible at $0.72 per share into 433.3m shares (2.20%) of CIFG. The conversion price was a 14.29% discount to the closing price of $0.84. The bonds were secured not by assets of CIFG but by a pledge by Mr Yau's private company over 1.5bn shares (7.77%) of CIFG. CIFG also failed to say who owns Sea Venture, but as we already know, it was owned by CCB and this was confirmed by a subsequent disclosure of interest filing. The issue was completed on 31-Dec-2015. We can see Mr Yau's 1.5bn shares moving from HEC Securities Ltd (HECS) to CCBIS on 30-Dec-2015.

6 months later, on 30-Jun-2016, CIFG issued a redemption notice to Sea Venture, and on 27-Jul-2016, CIFG agreed to issue to Sea Venture US$40m of 2-year 8% bonds convertible at $0.72 per share, swapping the old bonds for the new bonds. This extended the maturity date by 6 months but increased the interest rate by 1%. The board of CIFG claimed that the new bonds were:

"on more favourable terms to the Group as compared to the Previous Convertible Bonds in terms of maturity period and effective interest rate."

How can 8% be more favourable than 7%? The redemption and new issue was completed on 16-Aug-2016. By this stage, CCB had a security interest in 2710m shares (then 14.03%) of CIFG. This appears to be 910m shares pledged by HTD and 1800m shares pledged by Mr Yau (up from 1500m) to meet the required 400% coverage of the bonds. At the closing price of $0.72, his pledged shares were worth HK$1296m (US$167.2m). We can see 300m shares moving from Haitong to CCBIS on 7-Jun-2016.

Meanwhile, on 13-Apr-2016, CIFG announced that "the Company and its related companies" had received "approval of a comprehensive credit facilities" of up to RMB 1.1bn from the Shenzhen branch of CCB, although no actual facilities had yet been granted.

Apart from HTD's pledge of 910m CIFG shares to CCB, at 31-Mar-2016 it had also pledged shares worth $1422m to secure a bank loan facility of HK$450m. Since HTD holds little else, most of these shares must also be CIFG shares.

Other convertibles

CIFG has two other convertible bonds outstanding:

Index inclusion

Hilariously, CIFG, at its inflated market value, has recently been admitted as a member of the Hang Seng Composite LargeCap & MidCap Index, effective 2-Sep-2016, as well as being in the MSCI Small Cap Index since 31-May-2016. CIFG's board trumpeted this in an announcement, opining that this:

"represents capital markets’ recognition and confidence in the market capitalization and trading liquidity of the Company"

We'll see about that.

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