annonymous report 2012

8/11/2019 Annonymous Report 2012

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Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimatesare for illustrative purpose only and should not be taken as limitations of the maximum possible loss orgain. Any information contained in this report may include forward-looking statements, expectations,and projections. You should assume these type of statements, expectations, and projections may turnout to be incorrect.

All facts, figures, and opinions are as at the last practicable date. This document has been prepared forinformational purposes only. This document is not an offer, or the solicitation of an offer, to buy or sell asecurity or enter into any other agreement. We have made every effort to ensure that all informationcontained herein is accurate and reliable, and has been obtained from public sources we believe to beaccurate and reliable, and who are not insiders or connected person of the stock or company coveredherein or who may otherwise owe any fiduciary duty to the issuer. However, we do not represent that itis accurate or complete and should not be relied on as such. Anonymous Analytics is not a registered

investment advisors.

Do not assume that any company mentioned herein has reviewed our report prior to its publication. Wemake no representation or warranty, expressed or implied, in respect to the information contained inthis report and accept no liability whatsoever for any loss or damage arising from any distribution orreliance on this report or its contents.

Anonymous Analytics holds no direct or indirect interest or position in any of the securities profiled inthis report. However, you should assume that certain contributors to this report, as well as theirmembers, partners, affiliates, colleagues, employees, consultants, muppets clients and investors, as wellas our clients have a short position in the stock of Huabao International Holdings Limited (HK:336,Huabao or the Company) and/or options of the stock, and therefore stand to gain substantially inthe event that the price of the stock declines. You should further assume that following the distributionof this report, the aforementioned individuals and entities may continue transacting in the securitiescovered therein, and may be long, short or neutral at any time hereafter regardless of this reports initialrecommendation.

We waive our right to copyright protection laws as they pertain to redistribution. Accordingly, any partof this report may be reproduced in context without our consent.

Disclaimer


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We see Huabao International as a pump and dump scheme with the primary objective of enriching itsChairwoman, Chu Lam Yiu and her proxies at the expense of shareholders. Since the inception ofHuabao, Ms. Chu has sold nearly US$1.2 billion in stock, bringing her ownership of the Company from97.6% to 37.7%

News searches prior to the founding of Huaba in 2004 reveal no history of Ms. Chu, yet her suddenaccumulation of wealth has not gone unnoticed. Last year Ms. Chu was ranked the 8 th richest woman inChina at th e age of 41 on Huruns list of Self -Made Women Billionaires. Notably, Hurun also published aCashout List, which lists billionaires who have been cashing out of their own companies. The list placesMs. Chu at No. 2, having cashed out of US$549 million last year alone. The sum was so large that shewas dubbed the Queen of Cashout by the Shanghai Daily.

As detailed in this report, Huabao International came public via a reverse merger into a defunct

company ( Leaktek Ltd.) which had failed due to fraud. Shortly thereafter, Huabaos auditor (DeloitteTouche Tohmatsu) resigned. Among its peers, Huabao reports the highest margins and the highestrevenue growth, while maintaining some of the industrys lowest R&D expense. W hile all industry peersreport gross margins in the 40-50% range, Huabao reports consistent margins upwards of 70%. Further,following the shell entitys acquisition of the core Huabao business in 2006, the margins of the targetincreased dramatically despite there being no notable synergies or change in management.

From inception until August 2011, Huabaos Audi t Committee Chairman was Mr. Mak Kin Kwong.Mr. Mak was forced to resign following a trifecta of fraud charges and investigations from securitiesregulators in each of mainland China, Hong Kong, and the US. In each case, Mr. Mak was involved as adirector or CFO of a publicly listed company which was delisted or halted due to fraud. The companiesinclude: A-Power (formerly Nasdaq: APWR) delisted due to fraud; Chengdu Unionfriend (formerlySHZ:000693) delisted due to fraud; Real Gold Mining (HKG:0246) halted due to fraud.

Huabao has made efforts to conceal its operations by using such tactics as substantially reducing itspublic disclosures in financial reporting and using Photoshop to hide the location of one its facilities.

Undeniably , Huabaos gre atest shield against market scrutiny has been its large dividends. Managementmakes a point of noting that Huabao has paid out HK$2.4 billion in dividends since inception. Whatmanagement declines to mention is that throughout this period, half of all dividends have circled backto the Chairwoman due to her interest in Huabao. With the Chairwoman having sold out the majority ofher stake, Huabao has managed dividend expectations significantly lower by entering a highly capitalintensive industry.

Reducing dividend expectations was crucial because we have evidence that Huabao is not nearly asprofitable as it claims. Huabaos Chinese filings show large discrepancies from Hong Kong filings. Manyof Huabaos supposed customers do not consider themselves custo mers or have simply never heard ofHuabao. Furthermore, as evidenced in this report, we believe Huabao has undertaken massively inflatedrelated party transactions in an attempt to avoid paying dividends when possible and to explain toauditors why their bank account is empty.

Executive Summary


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Huabao International is undisputedly Chinas largest flavour & fragrance (F&F) company. With grossmargins of 75%, some have quoted its dominance of the Chinese industry as a near monopoly.

The F&F industry supplies flavours and fragrance that are used in a wide array of products: foods &beverages, cosmetics, detergents, and tobacco products, to name a few.

As presented in Exhibit 1, there are several major or otherwise relevant F&F companies we have used ascomparables in this report.

Exhibit 1Peer ComparablesCompany Ticker Market Cap (US$) Geography FocusHuabao International 0336:HK 2,000M China TobaccoChina Flavors & Fragrances 3318:HK 95M China TobaccoInternational Flavors & Fragrances IFF:NYSE 4,740M Global F&B, ConsumerSymrise SYX:GER 3,341M Global F&B, ConsumerGivaudan GIVN:VTX 8,870M Global F&B, Consumer

As shown, International Flavors & Fragrances (IFF), Symrise, and Givaudan are global industry playersthat primarily supply flavouring to the consumer market, specifically food & beverages, cosmetics, andhousehold products. On the other hand, Huabao and China Flavors & Fragrances (CF&F) are domesticcompanies that primarily su pply Chinas tobacco industry .

Flavours & Fragrances in Cigarette Manufacturing

While F&F in consumer products should be intuitively understood, its use in tobacco products may notbe. So, here we give an overview of the tobacco flavoring application and process, specifically as itpertains to cigarettes:

The manufacturing of a cigarette stick goes through several stages. One of these stages is called casingor topping. In the casing process, loose tobacco leaves are sprayed with flavoring agents such as cocoa,licorice, glycerin, and other additives. This process helps mask the smell of tobacco, enhances overallflavour during smoking, and can provide the distinctive signature of a brand. Sometimes cigarettefilters can also be dipped in flavouring, but these are generally considered specialty cigarettes and are avery small portion of the overall cigarette market.

In China, the manufacturing of tobacco products is strictly controlled by the State Tobacco MonopolyAdministration (STMA). The STMA is a government body that is responsible for enforcing the tobaccomonopoly in China. Under the STMA, there are several state-owned enterprises (SOE) that manufacture,market, and distribute all the cigarettes and tobacco products consumed in China. As a res ult, Huabaosprimary customers are government-controlled entities.

Flavours and Fragrances: Industry Primer


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Over the last five months, we have expended considerable resources and time analyzing Huabao. Wehave pored over every public filing since Huabaos r everse merger. We have pulled 23 sets of SAICdocuments covering all of Huabaos relevant subsidiaries. We have made over 150 phone calls to theSOE dominated tobacco industry, resulting in conversations with representatives from all the majorcigarette manufacturers. We have spoken with customers, competitors, and industry experts. We havegone to unbelievable lengths to locate facilities and shadow figures that management had hoped tokeep secret. We have dispatched teams to multiple locations spanning three continents. We have abetter understanding of Huabao, its operations and its associates than any bank, analyst, or institution.

This is not a statement of opinion. This is a statement of fact.

This report presents our evidence and conclusion. We review Huabaos backdoor listing, its history ofrelated party transactions, massive insider selling, and suspiciously strong financial metrics. We also

detail our business diligence findings gathered from a large number of calls and site visits. Altogether,we present evidence of a pump and dump operation that is misleading its shareholders and grotesquelyexaggerating its business.

Introduction


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We lay the groundwork for our analysis by providing a summary of Huabaos colorful history.

April 30, 2004 Huabao International goes public through a backdoor listing.

It should be noted that backdoor listings, by definition, are designed to circumvent listing rules andavoid independent scrutiny of business operations and corporate governance. They are also significantlymore prone to issues of fraud and corruption. It is utterly inappropriate for a company that dealsprimarily with state-owned enterprises (SOEs) to go public in such a manner.

It should also be noted that Huabao went public through Leaptek Limited, a company whose businessoperations primarily consisted of consumer electronics, computer products, and fraud. To be perfectlyclear, Leaptek was not merely a shell entity or capital pool company type vehicle awaiting a backdoorlisting. It had a highly questionable history consisting of auditor resignations, director resignations,management firings, and cooked books deserving of its own investigative report. Despite all this, it tookHuabao over two years to slowly wind down Leapteks phantom business before eventually discardingit for HK$1.

March 28, 2006 Deloitte Touche Tohmatsu resign as the firms audito rs.

The Event: Within two years of the backdoor listing, Huabaos auditors resign.

Managements Response: In a released statement, management claims the resignation of Deloitte wasa result of fee disputes. 1

The Truth: As we mentioned in a previous report, auditors rarely resign as a result of fee disputes. Thereis sufficient competition among the Big Four and second tier audit firms to ensure they dont nickel anddime clients. Fee disputes are almost exclusively used as a means for auditors to resign without beingforced to bring attention to uncovered financial irregularities.

In fact, a paper released in 2010 by the Hong Kong Institute of Certified Public Accountants states thefollowing:

The Stock Exchange of Hong Kong Limited (SEHK) and the Securities and Futures Commission (SFC) haveraised concerns with the Hong Kong Institute of Certified Public Accountants concerning announcementsmade by listed issuers of the SEHK of the reasons for changes in auditors. In many cases, fee disputes are

stated to be the reason for the change. Concern has been expressed that certain auditors have beenrelying on purported fee disputes to disguise the real reasons for the change. As a result, potentiallysignificant and fundamental matters about the listed issuer may not be disclosed to investors andcreditors and the market is not therefore being kept fully informed. It is important that the situationconcerning the change of auditors should be disclosed in full to avoid the possibility of the market beingmisled. 2

1 http://www.hkexnews.hk/listedco/listconews/sehk/2006/0329/LTN20060329082.pdf 2 http://app1.hkicpa.org.hk/ebook/HKSA_Members_Handbook_Master/volumeI/COE.pdf

History [sec 1]
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Clearly, Huabaos origins are consistent with excellence in corporate governance and transparency.

But a backdoor listing and questionable auditor resignation are not the only red flags in Huabaosopaque history, which also involves absurd related party transactions, massive insider selling, andawkward executive resignations. A discussion of these issues follows:

Related Party Transactions 1.1

August 1, 2006 Huabao acquires substantial assets through the Chairwoman, part I

The Event: Huabao, as a shell company, acquires Chemactive Investments Limited, a flavor andfragrance supplier to the tobacco industry.

The acquisition price was HK$4 billion (US$513M) in convertible preferred shares, based on 13.6 timesthe targets net in come of HK$294 million (US$37M) 3. To put that number in perspective, the net

income for Huabao during the same time period was a loss of HK$7 million (US$0.9M). This massiveacquisition of a highly profitable company was by way of an asset injection through its then 36 year-oldCEO and Chairwoman, Ms. Chu Lam Yiu.

Our Take:

(i) The share dilution and new convertibles effectively gave Ms. Chu 97.57% ownership of thecombined entity.

(ii) Based on its financials, Chemactive claimed net income of HK$294M, total assets ofHK$869M, and net equity of HK$498 M. Thats a n ROA of 35% and ROE of 61%.

Okay, well play along.

(iii) We certainly do believe Chemactive had a legitimate operating business in tobaccoflavoring, as is evidenced by their JV with Hongta Tobacco Group, a prominent SOE tobaccocompany. But as we show in this report, we also believe that the extent of the business was,and continues to be, exaggerated.

(iv) Chemactive was in the business of providing flavoring to the tobacco industry, a verymature, very established field controlled entirely by SOEs. We find it improbable that a 36year-old was able to break into this field and build a multi-billion dollar empire. In fact, asearch on Factiva and Lexis-Nexis for Chu Lam Yiu displayed no articles or news informationprior to 2004, the year she purchased Leaptek.

(v) As part of the acquisition, Ms. Chu signed a non-compete agreement. This agreementstipulated that Ms. Chu no longer owned any business or interest that would compete withHuabao.

3 http://www.hkexnews.hk/listedco/listconews/sehk/2006/0629/LTN20060629078.pdf
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The acquisition of Chemactive provided the backbone of Huabaos current business operations. As wedemonstrate throughout this report, we also believe this acquisition was the basis of what wouldbecome a materially exaggerated business operation designed to benefit insiders and their proxies.

July 30, 2007 Huabao acquires substantial assets through the Chairwoman, part II

The Event: Huabao acquires Win New Group Limited and its subsidiaries, a flavor and fragrance supplierto the tobacco and food industry. The acquisition price was HK$652 million (US$84M) in cash, based ona whopping 21 times the targets net income of HK$31 million (US$4M) . This acquisition was also by wayof an asset injection through Ms. Chu.

Our Take:

(i) Remember the non-compete clause that was signed by Ms. Chu 11 months earlier when shesold Chemactive to Huabao? The one that stated she had no interest in a competingbusiness? Well, within 11 months she managed to buy this tobacco flavor company from a

third party only to resell it to Huabao for HK$652 million. No lack of transparency here.

(ii) There is absolutely no legitimate reason for the Chairwoman to privately buy a companyonly to resell it to Huabao. Acquisition by asset injection through a related party rather thanM&A through independent parties is completely inappropriate and should immediately raisered flags with investors.

We believe the absurd acquisition price combined with the nature of the acquisition wassimply a way to transfer fake earnings/cash out of the Company. More on this later.

July 7, 2008 Huabao acquires substantial assets through the Chairwoman, part III

The Event: On March 26, 2008, Ms. Chu privately acquired Wealthy King Investments and its subsidiaries(a tobacco flavoring company) from a third party. She paid for the acquisition by transferring HK$451million (US$58M) worth of her share holdings in Huabao to the vendor, plus an undisclosed amount ofcash. 4

Three months later (July 7, 2008), she turned around and resold Wealthy King Investments to Huabaofor HK$871 million (US$112M). This price was based on 12 times the targets unaudited net income ofHK$70 million (US$9M).

Our Take:

(i) It speaks volumes that such a significant, yet opaque, transaction went through unaudited.

(ii) We challenge investors and the analysts that are promoting this stock to answer thefollowing questions: Is this how a transparent management team operates? Is there anylegitimate reason for these types of transactions to be taking place?



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Second, as shown in Exhibit 3, management went through the unusual step of photoshopping the onlypublically available picture of the Botswana facility (shown in the 2009-2010 annual report). Thisphotoshop job removed the address of the facility again, an unusual move given that managementwas more than willing to provide the exact facility addresses in the circulars they released as part oftheir acquisitions of Win New Group and Wealthy King Investments.

Exhibit 3Altered picture from Huabaos annual report Picture we took

As we said, it appears management has gone to extreme lengths to hide the facility.

But thats okay, we found it anyway.

This operation was not an easy task. But perhaps the only thing more difficult than finding the location,was traveling to it, which took us three days of air travel. And our commute only happened to be soshort because the construction of a domestic airport had recently been completed.

So, what re ason would management have to build a raw material extraction base in such a remotelocation and go to unusual efforts to hide its coordinates?

As we found out, the business of natural extracts has little to do with it. The base is used for adifferent sort of business entirely, which we will forego discussing in this report. Instead, we will leavethe details to Huabao and allow management to explain. Moreover, it might be more interesting to hearfrom Huabao who their end clients are.

That said, we believe if management were forthcoming with the operations of the Botswana facility, itwould very likely throw into questions Huabaos margins, and possibly cause investors to re -risk theCompany.


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Chairwomans Share Disposal 1.2

As will become evident throughout this report, Huabao is surrounded by a level of opacity rarely seen ina public company. But one point that the public filings make perfectly clear is the tremendous amount ofmoney that Ms. Chu has made by selling out of Huabao.

Ms. Chu initially held 97.6% of Huabaos outstanding shares following the backdoor listing. After years ofshare placements, share transfers and even an acquisition completed personally by Ms. Chu and paid forby Huabao stock, her interest has dwindled to 37.7%.

Below is a summary and timing of Ms. Chus share disposition:

Ms. Chus starting stake: 97.6%

August 3, 2006 The Chairwoman disposes of her shares, part I

The Event: Within two days of closing the Chemactive acquisition, Ms. Chu converts and dumps hernewly acquired shares. This disposal was of 690 million shares at HK$2.20 per share, a 22% discount tothe previous days closing price .6 The disposal represented 23% of the Companys issued share capitaland netted Ms. Chu proceeds of HK$1.5 billion (US$195M).

Ms. Chus remaining stake: 74.89%

January 17, 2007 The Chairwoman disposes of her shares, part II

The Event: Ms. Chu converts and dumps another 277 million shares at HK$4.56 per share, at a 7.51%discount to the previou s days closing price .7 The disposal represented 9.1 % of the Companys issuedshare capital and netted Ms. Chu proceeds of HK$1.3 billion (US$162M).


April 7, 2009 The Chairwoman disposes of her shares, part III

The Event: Ms. Chu converts and dumps another 191 million shares at HK$6.10 per share, at a 12.5%discount to the previous days closing price. 8 The disposal represented 6.2% of the Companys issued

share capital and netted Ms. Chu proceeds of HK$1.2 billion (US$149M).


6 http://www.hkexnews.hk/listedco/listconews/sehk/2006/0804/LTN20060804024.pdf 7 http://www.hkexnews.hk/listedco/listconews/sehk/2007/0117/LTN20070117030.pdf 8 http://www.hkexnews.hk/listedco/listconews/sehk/2009/0403/LTN20090403003.pdf
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October 8, 2009 The Chairwoman disposes of her shares, part IV

The Event: Ms. Chu converts and dumps another 150 million shares at HK$7.75 per share, at a 5.7%discount to the previous days closing price. 9 The disposal represented 4.2% of the Companys issuedshare capital and netted Ms. Chu proceeds of HK$1.2 billion (US$149M).


April 12, 2010 The Chairwoman disposes of her shares, part V

The Event: Ms. Chu converts and dumps another 204 million shares. 10 Curiously, the required noticefiled by the Company does not provide information on the disposal price, but based on market activity,we suspect Ms. Chu netted HK$2 billion (US$250M) from this transaction.

Ms. Chus r emaining stake: 44.24%

January 28, 2011 The Chairwoman disposes of her shares, part VI

The Event: Ms. Chu converts and dumps another 200 million shares at HK$11.00 per share, at a 7.8%discount to the previous days closing price. 11 The disposal represented 4.2% of the Companys issuedshare capital and netted Ms. Chu proceeds of HK$2.2 billion (US$282M).


For those keeping count, the cumulative proceeds of her disposals amount to approximatelyHK$9.4 billion (US$1.2 billion). Its unclear why Ms. Chu has decided to drastically reduce her stake inHuabao. For the past five years, revenue, profit, and book value have steadily trended higher with aweinspiring gross margins. Management commentary shows no decline in optimism, projecting confidencein Huabaos Big customers, Big brands strategy. We have difficulty imagining Ms. Chu was short ofcash following her initial share placement in 2006 which yielded HK$1.5 billion.

In light of the research presented in this report, we are confident the drastic decline in her holdings wasmotivated by her desire to cash out of Huabao before the share price reflected the organizations truevalue.

9 http://www.hkexnews.hk/listedco/listconews/sehk/2009/1008/LTN20091008013.pdf 10 http://www.hkexnews.hk/listedco/listconews/sehk/2010/0412/LTN20100412693.pdf 11 http://www.hkexnews.hk/listedco/listconews/sehk/2011/0128/LTN20110128017.pdf
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Executive Resignations 1.3

So far, we have a backdoor listing, an auditor resignation, absurd related party transactions, and acompany founder who cant sell off her shares fast enough. The only box left to check on our list of redflags is executive resignations:

December 5, 2007 The Corporate Secretary resigns

The Event: Mr. Henry Chu resigns as the Company Secretary and Authorized Representative of theCompany.

Managements Response: In a released statement, management claims the resignation is due topersonal career development. 12

The Truth: Mr. Henry Chu is a fellow member of the Association of Chartered Certified Accountants andan associate member of the Hong Kong Institute of Certified Public Accountants with a career spanningseveral auditing positions.

Our search indicates that after resigning from Huabao, Mr. Chu joined Westminister Travel Ltd., anoperator of a travel agency. Westminister Travel is listed on the Singapore Exchange (5OF:SES) with amarket cap of US$22 million. We are hesitant to believe personal career development was the realreason Mr. Chu resigned as an executive of a purported multi-billion dollar tobacco enterprise to join apenny stock company offering discount travel.

It is more plausible that as Corporate Secretary, Mr. Chu found irregularities with Huabaos books andresigned to distance himself from the Company.

July 31, 2011 An independent director is forced to resign due to fraud charges

The Event: Mr. Mak Kin Kwong was one of three independent directors at Huabao. He was also theChairman of the Audit Committee as well as the Chairman of the Remuneration Committee before beingforced to resign in disgrace.

In addition to being investigated by the SEC, he was recently charged with fraud by the China SecuritiesRegulatory Commission. These charges relate to his work as an independent director of ChengduUnionfriend , a company listed on the Shenzhen Exchange. The charges included overstating revenue,

non-disclosure of related party transactions, and false and misleading disclosures.13

Unfortunately, these events were not isolated incidents. Mr. Mak was also

12 http://www.hkexnews.hk/listedco/listconews/sehk/2007/1204/LTN20071204270.pdf 13 http://www.hkexnews.hk/listedco/listconews/sehk/2011/0802/LTN201108021068.pdf
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the CFO of A-Power (NASQ: APWR), a company that until recently traded on the Nasdaqbefore being delisted last summer due to issues of fraud. 14

an independent director and Chairman of the Audit Committee of Real Gold Mining(HK:0246), a company that in May 2011 was halted on the Hong Kong Stock Exchange relating toallegations of mass fraud and auditor resignations. 15

Our Take: It does not inspire confidence that this legendary character not only served as an independentdirector at Huabao, but has been in charge of its audit committee since inception.

Its almost like management is playing a game of chicken with analysts, like theyretrying to see how many red flags they can raise and still get buy recommendations.

-Associated Analyst

14 http://online.wsj.com/article/BT-CO-20110926-710598.html 15 http://www.hkexnews.hk/listedco/listconews/advancedsearch/search_active_main.asp
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In this section, we look at Huabaos financial stat ements and compare the Company to industry peerswith regards to gross margins (2.1), research & development spending (2.2), sales growth (2.3) andreporting transparency (2.4).

Margins 2.1

Exhibit 4 shows gross margins as reported by the industry. Note that while all F&F players reportmargins in the 40-50% range, Huabao has somehow managed to command consistent margins upwardsof 70%. In most industries, even single digit deviations are considered extraordinary. So, what happenedbetween 2005 and 2006 that helped Huabaos margins explode?

Exhibit 4Industry Gross Margin

The proximate cause seems to have been the acquisition of Chemactive. Prior to this acquisition,Huabao was more or less a shell company with de minimis operations reporting annual losses. On theother hand, Chemactive was a highly profitable company enjoying margins of 48% based on the pre-acquisition financial statements.

But still, 48% is a long way from 70+%. So what happened between the acquisition and the followingyear when management released their annual results showing margins had skyrocketed? We arentactually sure. You see, management only dedicated a few lines in their entire 2006 Annual Report toexplaining the jump in gross margins:

As the raw material structure of many of the continuous developing products were being optimized aswell as the capacity of relevant production accessories increased, the gross margin rose from 47.3% oflast year to 69.5%, which further improved the operating results. 16

16 http://huabao.todayir.com/attachment/2010122112592617_en.pdf (page 8)

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%

2005 2006 2007 2008 2009 2010

Huabao CF&F Symrise Givaudan IFF

Financial Statement Analysis [sec 2]
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From our reading of this explanation, management did two things to significantly improve margins:

1) optimized the raw material structure; and 2) Increased relevant production accessories.

If youre confused, youre not alone. We dont understand this vague explanation either. Moreover, wedo not believe that management was able to re-engineer Chemactive within a year to become some sortof super-profitable money machine.

First, this transformation didnt even take a year. As presented in the interim 2006 report, gross marginshad already improved to 65.4% within 6 months of the Chemactive acquisition. Just s o our readers dontthink they re missing something:

March 31, 2006 (Chemactive prior to acquisition): Gross Margins 48.0% September 30, 2006 (Huabao interim report post-acquisition): Gross Margins 65.4% March 31, 2007 (Huabao annual report post-acquisition): Gross Margins 69.5%

Second, what type of re-engineering/cost cutting/synergies could management possibly have pulled outof their hat? Prior to acquiring Chemactive, Huabao was just a shell. Its n ot like there was a secondmaterial operating business that was merged with Chemactive to cut costs or increase efficiencies. Infact, the same person who had run Chemactive prior to the acquisition was still running Chemactiveafter the acquisition Huab aos Chairwoman, Ms. Chu.

Given managements dubious explanation, we turned to the most obvious source of confirmation documents Huabao filed with the SAIC. 17 It took nearly three months , but we didnt just get documentsrelated to the Chemactive acquisition, we got documents related to the entire Company nearly all ofits principal operating subsidiaries representing 99.5 % of Huabaos production capacity . In total, we arein possession of SAIC documents for 23 different Huabao subsidiaries.

Based on our analysis of these documents, it appears that the overwhelming majority of Huabaossubsidiaries report gross margins around 40-50%, in line with industry standards but a far cry from the74% reported by the Company in 2010. It should be noted that since these results are not consolidated,it becomes difficult to calculate an exact gross margin figure. But in either case, 40%+ and 70%+ are aworld apart.

To get more clarity on industry margins, we contacted several private F&F companies located in China.In our discussions with them, no representative was able to understand how gross profit margins of70%+ could be achieved in this industry. Moreover, one representative mentioned that his companysupplies tobacco flavors and fragrances for several foreign brands and that the gross profit margin oftheir business is quite low. When pushed further, he relented that it *may* be possible for the grossprofit margin of some new products to reach up to 70 or 80%, but was unlikely for older products.Looking back at Exhibit 4, a simple analysis of China Flavors and Fragrances gross margins confirms thisstatement. This point was also reaffirmed by a contact at a different F&F company, who went on tostate that potentially better margins on new products is why all of the companies in the industrycontinue to develop new products through R&D.

17 All businesses operating in China must file annual financial statements with the State Administration for Industryand Commerce (SAIC).


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Research & Development 2.2

And so it seems that R&D is vital to the industrys profitability and staying power. However, as Exhibit 5shows, for Huabao this issue raises more questions than it answers simple questions such as:

How is Huabao able to maintain its leadership position and gross margins by spending less on R&D thanmost of its peers?

Exhibit 5R&D as a percent of sales

This chart is baffling when one reads through Huabaos annual reports and sees the following gem:

The R&D capability of a flavours and fragrances company reflects its overall strength. After continuousinvestment, the Group has set up a leading R&D team which is top-notch in China and up to internationalstandards. The State-recognized technology centre, the overseas R&D centre in Germany and the professional R&D departments in Yunnan, Guangdong and Fujian together formed a vertically integrated platform for R&D in areas ranging from fundamental research to application. The R&D strategy of theGroup is market-driven so as to closely follow the latest global industry trends and to accelerate themastering of technologies in key raw materials. With such strengths, the Group is able to develop products and technologies that meet market demands, deliver comprehensive technical services tocustomers and remain dedicated to maximizing value for clients, while the Groups overallcompetitiveness is greatly e levated. 18

Based on these type of statements, Huabao seems quite dedicated to cutting-edge, international caliberR&D. So much so that to aid its efforts in internationalizing its R&D capabilities, in 2006, Huabao set upan R&D center in Holzminden, Germany, a town famous for its F&F industry and the proud headquartersof Symrise, an industry powerhouse.


0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

2005 2006 2007 2008 2009 2010

Huabao CF&F Symrise Givaudan IFF


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The German research facility stands out as an important jewel in Huabaos R&D initiative, because:

Its located in a logistically out -of-the-way place for a company that does all its business inChina.

Internationalized R&D seems to be a key strategy for the Company .

Management considers it a world -class R&D center. Huabaos Chief Technical Officer for Tobacco Flavors, Mr. Alan Davies , is posted at theHolzminden facility.

Given the apparent importance of this facility, we decided to give it a closer look to get a better feel forHuabaos R&D work.

At the prompting of our contacts, our sources at Anonymous Germany agreed to take a road trip toHolzminden and put the R&D center under surveillance for three days.

Minimal Activity

Our contacts told us that during their investigation several points struck them as notable, especially incontrast with activity at the Symrise facility, which they also visited:

Most of the lights in the complex were off. There was minimal noticeable staff activity. There was no security protecting the research facility. When neighbours were questioned, they either did not know what business was being carried

out at the facility or assumed the facility belonged to Symrise.

It should be noted that the R&D center is not actually located in Holzminden, but in a very small village

called Neuhaus, which is a twenty minute drive out of town. We were told there was no publictransportation to speak of and it was during the winter season, making it difficult to ride a bicycle. This isrelevant because over the three days, our contacts did not see more than six vehicles in the parking lotof the research center.

We are not sure what type of multi-billion dollar, research driven enterprise operates like this, but itseems that the Holzminden facility has no more than half a dozen staff members.


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Concluding on R&D Expenses

So, here we have a company with questionably low R&D spending that reports absurdly high margins,which industry sources say should not be possible. How do we bridge this divide?

We have come across various explanations. However, the best ones can be summarized as follows:

Huabao has established relationships with several prominent SOE tobacco manufacturers. Cigarettesmokers are sensitive to their preference of cigarette brands and manufacturers are hesitant to changeingredients/suppliers in their blend. Accordingly, there is no need for major R&D as once Huabao iscontracted to supply flavoring to a brand, that relationship will continue until the tobacco brand isterminated. Consumer preference for their favorite brand creates a natural moat for Huabao, ensuringlofty margins and low R&D expenditure.

This is actually a very logical, very good explanation.

The idea behind this explanation is that in a mature industry, there really is no need for R&D. TheCompany already has its flavours, it already has its connections, and it already has its committedcigarette brands. All the work is done.

And this makes sense. Except when it doesnt.

The problem with this explanation is that the math cuts both ways. It may be possible for low R&Dexpenses to co-exist with high profit margins in a mature industry, but then we should be seeingcorrespondingly low revenue growth. Growth implies new markets, new opportunities, and thereforenew R&D initiatives. If a company is not incurring substantial R&D costs because it benefits from being

the leading player in a mature industry, we should not then be also witnessing high revenue growth thatappears to be far surpassing the growth of its customer base.

Despite this, Huabao has also inexplicably experienced the fastest sales growth in the industry, as wediscuss next.


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The Uniformity Problem

Over the last decade, there has indeed been some significant industry consolidation. However, thisconsolidation was a long-tailed event, with most of the activity occurring during the first part of thedecade. Exhibit 7 presents data from Huabaos own annual report. Whats evident here is that by 2005,industry consolidation had slowed considerably as most of the obscure cigarette brands had alreadybeen crowded out or discontinued.

Exhibit 7Consolidation

Source: 2007 Annual Report

Between 2005 and 2010, the industry continued to consolidate, but at a markedly decreasing rate. Toshow this, we have presented the growth rate of the top five Chinese cigarette brands in Exhibit 8,which we have used as a proxy for industry consolidation. Side by side, we have also presented theorganic growth rates reported by Huabao.

Exhibit 8Market Dominance of Top Five Chinese Cigarette Brands

Source: Euromonitor, analyst estimates, our estimates*Note that no organic growth rate is available for 2006

What is evident here is that while industry consolidation slowed rapidly in the latter part of the decade,Huabao continued to post relentless growth over the same time period. Against this b ackdrop, Huabaosreported growth is highly suspect, especially when you consider the next issue.

0.0%

10.0%

20.0%

30.0%

40.0%

2006 2007 2008 2009 2010

Growth Rate of Top Five Brands Huabao Organic Growth Rate


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The Cannibalization Problem

Huabao supplies flavouring to approximately 50% of the top ten cigarette brands. In terms ofconsolidation, this is a positive factor for the Company. As the top brands consolidate smaller players, byproxy Huabao increases its market share and grows accordingly.

However, Huabao also supplies approximately 50% of the overall market, which implies that on averageit also supplies 50% of brands and suppliers that are being or have been phased out. And as surely asHuabao gains from its biggest customers consolidating the industry, it also loses equally as its smallerclients are squeezed out. The result is a near zero-sum game.

Given these factors, we question Huabaos growth story as a result of industry consolidation . Insections 3 and 4 , we follow up this macro analysis by providing a granular look at Huabaos revenuestreams and client relationships.


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With the removal of this information, analysts cant get a clear picture of personnel changes, nor whothe Companys customers are. Far more concerning however is that management decided to combinethe Tobacco Flavours and Food Flavours segments into one opaque segment simply called Flavours.While the first two omissions should raise eyebrows, it pales in comparison to the egregious act ofcombining two of the Companys biggest and distinct businesses into one reporting segment. Frankly,we cant bel ieve the auditors (PricewaterhouseCooper) have been so docile as to allow this grossviolation of Hong Kong reporting standards to continue. 21

This simple, but crucial change has made it impossible for analysts and investors to determine whererevenue and sales growth is coming from. It has turned the whole due diligence process into a joke of aguessing game. Because now, instead of getting a clear picture of the Huabaos revenue break -down,you get something like this:

Exhibit 10New Segment Reporting

What is the purpose of changing the reporting so that one segment effectively accounts for all of theCompanys sales? What is achieved by a change like this? What is the net benefit?

Make no mistake these changes were implemented with the intent of limiting proper analysis ofHuabaos operations and revenue streams, a topic we discuss next.

21 PwC would be wise to freshen up on HKFRS 8 and relearn the meaning of substance over form.http://www.hkiaat.org/images/uploads/articles/Operating.pdf
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The Food Flavouring segment contributes to approximately 15% of Huabaos revenue. This segmentsupplies flavouring to various food, beverage, and cosmetic products. In fact, Exhibit 11 presents someof the segments customers as at Fiscal 2009. We presented this list earlier in the report, with an explanation that this was the last list Huabao made public before management stopped providing thename of its clients.

Exhibit 11Huabao Clients (Fiscal 2009)

Source: Company financials

Well leave it up to investors to decide why Huabao stopped providing a client list. But in the meantime,we went ahead and contacted the companies on the list, and were able to get in touch withrepresentatives from Danone, Heinz, Totole, Yurun, Huiyuan Juice, Bright Dairy and Dali Group.

Certain representatives confirmed that Huabao was indeed a supplier. But just as well, there were anumber of other companies that informed us that Huabao was not a supplier of any material form.

For example, we contact ed Heinzs corporate office in the US and were placed in contact with theProcurement Department. We provided the department Huabaos name, along with the names of all itsfood and flavor subsidiaries. The department ran the names through their system and confirmed thatthey have no relationship with any of the names we had given them. We were informed that it may bepossible that their Chinese factory sources directly from Huabao, in which case the Corporate officewouldnt be aware. They therefore provided us with the contact information of the person in charge ofprocurement at the Chinese factory.

We contacted the individual who confirmed that they were in the best position to provide informationregarding Heinzs suppliers. When asked about Huabao, the individual wasnt convinced Huabao couldbe class ified as a supplier to Heinz because , to quote:

We didnt purchase much *from Huabao+ we didnt really use them, previously we only purchased from them once. It was very little.

Food Flavouring [sec 3]


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Admittedly, the presented client list is dated. What about current clients? While Huabao stoppedproviding a client list, Shanghai H&K Flavor, one of Huabaos food and flavoring subsidiaries does have awebsite where it lists products that it evidently provides flavouring for.

On its website (http://www.hbkq.com.cn/en/ ) under the tab Market > Product Information , there is alist of various products from flavoured yogourt to flavoured peanuts. This list was updated as recently asOctober 20, 2011, so we can assume its relevant.

From this list, we picked two products at random and contacted their manufacturers to confirm aclient/supplier relationship with Huabao or its subsidiary.

The first product we picked was Harris Teeter Simply Clear Water, as shown in Exhibit 12.

Exhibit 12

We contacted Harris Teeter, a grocery store chain based in the US. Harris Teeter put us in contact withCott Beverages, the company that manufactures and bottles the Simply Clear product. When askedabout Huabao, Cott simply confirmed that they are not using any Chinese based company to supplyflavouring ingredients for this product.
http://www.hbkq.com.cn/en/http://www.hbkq.com.cn/en/http://www.hbkq.com.cn/en/http://www.hbkq.com.cn/en/


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The second product we picked was HyVees Vanilla Flavoured Almond Milk, as shown in Exhibit 13.

Exhibit 13

We contacted HyVee who put us in touch with the account manager and the third party brokerresponsible for this product. Both individuals confirmed that no Chinese company is sourced forflavouring in the production of the milk.

Confused, we asked our contacts if they knew any reason why their products were displayed onHuabaos website. Their simple response: No.

Bill Gates (questioning Homer Simpsons fake business): Your internet ad was broughtto my attention, but I cant figure out what, if anything CompuGlobalHyperMegaNetdoes

-The Simpsons


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Huabao is exaggerating the scope of its food flavouring business this is self-evident. But foodflavouring is only 15% of their revenue. The other 85% comes from tobacco flavouring. Tobaccoflavouring is the backbone of the Company and the reason that at the time of writing, this company wasworth over HK$17 billion.

However, it also appears Huabao is embellishing their tobacco flavouring business.

Straight from its 2008 annual report is a list of Huabaos customers. This impressive list not only showsthat Huabao is a supplier to all of the top ten cigarette brands sold in China, but also a core supplier tonearly all of them. The Company defines core supplier as supplying more than 50% of each companystobacco flavour purchase.

Exhibit 14

Source: Company financials

The top ten cigarette brands are manufactured by 8 different companies across a spectrum of factories.Exhibit 15 presents a list of the companies and their associated top ten brands.

Exhibit 15Company BrandsChina Tobacco Hubei Industrial LLC HongjinlongChina Tobacco Henan Industrial LLC Hongqiqu

China Tobacco Hunan Industrial LLC BaishaYuxi Hongta Tobacco (Group) Co Ltd. Hongmei, HongtashanChina Tobacco Guangdong Industrial Co. Ltd. ShuangxiChina Tobacco Shandong Industrial Corporation HatamenChina Tobacco Guizhou Industrial Corporation HuangguoshuHongyun Honghe Group Honghe, The Scarlet Camellia

Tobacco Flavouring [sec 4]


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Our contact confirmed that Peony is indeed the only flavour supplier to Shanghai Tobacco Group. Whenasked about Huabao, the contact stated that Huabao is one of many suppliers but only supplies Peonyone kind of raw material for the latter to use in the manufacturing of tobacco flavours.

We should reiterate that Huabao no longer discloses who their tobacco clients are, and the client list weare relying on is several years old. However, managements claim that the tobacco flavouring industry ishighly sticky, combined with the results of our Hongyun Honghe and Peony channel checks give us greatcause for concerns regarding Huabaos reported profitability.

The Tobacco Industry in China

When we take a step back from specific purported customer relationships and focus on the overallcigarette market in China, we find it impossible that Huabao earns the revenue it claims.

In 2010, Huabao reported revenue of HK$2.9 billion (US$366M). The overwhelming majority of thisrevenue came from their tobacco flavouring segment. How does this amount compare to the tobaccomarket in China? The diagram on the next page puts the industry into context.


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So, is the realm of 2.4% a reasonable cost component of flavouring when it comes to the manufacturingof cigarettes? We had no idea, but intuitively it seemed somewhat high. Anecdotally, when you bake acake, the few drops of flavouring extract you include as part of the recipe dont cost anywhere near2.4% of all the ingredients. But then again, none of us have ever baked a cake before, just like wevenever manufactured cigarettes and anecdotes arent exactly facts.

In the absence of personal knowledge, we referred to a research paper titled Cost Analysis of Optionsfor Self- Extinguishing Cigarettes 23 which was prepared in 1987 for the US National Bureau of Standards.The paper disaggregates an earlier research paper by James Morris titled This Tobacc o Business PartXIII: Manufacturing Costs of Cigarettes 24 which was first published in Tobacco International Magazine in1980. These two research papers are the most comprehensive and granular bodies of work on cigarettemanufacturing, in what is otherwise a secretive and complex industry.

Exhibit 16 presents the relevant information for our analysis.

Exhibit 16

23 http://tobaccodocuments.org/rjr/508510047-0116.html 24 http://legacy.library.ucsf.edu/tid/nfa17a99/pdf;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03
http://tobaccodocuments.org/rjr/508510047-0116.htmlhttp://tobaccodocuments.org/rjr/508510047-0116.htmlhttp://tobaccodocuments.org/rjr/508510047-0116.htmlhttp://legacy.library.ucsf.edu/tid/nfa17a99/pdf;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03http://legacy.library.ucsf.edu/tid/nfa17a99/pdf;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03http://legacy.library.ucsf.edu/tid/nfa17a99/pdf;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03http://legacy.library.ucsf.edu/tid/nfa17a99/pdf;jsessionid=B620A702E193AA125D371204AD393E34.tobacco03http://tobaccodocuments.org/rjr/508510047-0116.html


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Part 1: The Chemactive Injection 5.1

As we mentioned at the beginning of our report, Huabao did not go public through a traditional IPO. Itwent public through a backdoor listing via a shell company. In an IPO setting, you hire investmentbankers and outside consultants with their own reputations on the line to vet through your business

operations, look through your financial statements, and then sell your shares to the public. And whilethis outside scru tiny in no way guarantees that your business is legitimate, it doesnt hurt.

In a backdoor listing, you can be as shady as you want. No one is really there to question your businessor inspect it. In fact, most people will just assume youre doing somethi ng sketchy. Backdoor listingshave that certain je ne sais quoi grease-ball quality to them.

After Huabao took over Leaptek, management effectively had a shell company available. They thenbought the Chemactive assets from the Chairwoman and injected it into the shell, essentially takingChemactive public. This is when we believe management first began to misstate their financials.

As we mentioned on page 14 , Chemactives reported gross margins rose drastically immediately afterthe injection. Based on the evidence previously presented, we believe management simply fabricatedtheir numbers. But of course, if you begin to lie about your gross margins, its going to affect reportednet income as well.

Exhibit 17 shows the difference in 2010 net income between Huabaos public filings and its SAICdocuments. The net income of the SAIC documents are based on the sum of Huabaos disclosedprincipal operating subsidiaries representing 99.5% of its production capacity, plus several ancillarysubsidiaries that have some form of business operations. There appears to be a 36% difference inearnings between these two sources.

Exhibit 17

(HK$ millions) DifferencePublic Filings 1,632SAIC Documents ~1,200 36%Reported R&D Expense 122R&D Expense net of taxes 105SAIC Documents less R&D ~1,095 49%

Source: Company financials and SAIC documents

It should also be noted that in calculating the SAIC net income, we did not included any cost centers,such as R&D facilities. However, Huabao claims to have spent HK$122 million on R&D in 2010. If we

subtract this expense on an after tax basis from the SAIC net income, then we get an even largerdiscrepancy.

So, what reason did management have to inflate the financial figures?


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Part 2: The Chairwomans Share Sell Down 5.2

Better financial figures bring a higher share price. And thats exactly what the Chairwoman wanted whenshe began dumping her shares. In order to understand the Huabao story, its important to understandthat Huabao and its Chairwoman are inextricably linked. It helps to think of the Chairwoman as

Huabaos off -balance sheet entity. So yes, its true that Huabao as a company has never rai sed anymoney. But through the years, the Chairwoman has raised HK$9.4 billion (US$1.2 billion) on the back ofinflated share prices.

Exhibit 18Date (HK$ millions)3-Aug-2006 1,50017-Jan-2007 1,3007-Apr-2009 1,2008-Oct-2009 1,20012-Apr-2010 2,00028-Jan-2011 2,200

To Date: 9,400

In most instances of fraud, management will usually issue shares/debt through the company andabscond with the proceeds. However, this creates certain problems. For instance, when the auditors dotheir annual cash verification, management will need to explain what happened to the money. To coverthe theft, management has to create lies such as claiming the money was spent on expanding/improvingthe business. This lie leads to other lies, such as inflated asset balances. Unfortunately, these inflatedassets stay on the balance sheet where they can eventually be uncovered . Then theres the issue oftrust. If management repeatedly raises money to expand busin ess, people are going to start asking

questions. The market will begin to suspect foul play. The whole process can become very messy.

We believe Chairman Chu avoided these complications. Instead of raising money through the Company,she simply inflated the value of Huabao, and then sold her personal shares into the market, generating asmall fortune in the process.

The Queen of Cashout

Well, small fortune may be a bit of an understatement. Last year Ms. Chu was ranked the 8th richestwoman in China at the age of 41 on Huruns list of Self -Made Women Billionaires.

But thats not the only list that Ms. Chu made . Hurun also released a Cashout List which lists billionaireswho have been cashing out of their own companies. 26 According to the list, Ms. Chu was the secondbiggest inside-seller in China, cashing out US$549 million in the last year alone. This sum was so largethat she has been dubbed Queen of Cashout by The Shanghai Daily.

Disregarding everything in this report, at the most basic level shareholders should ask themselves: Whyam I an investor in this company when the Chairwoman cant sell her shares fast enough?

26 http://www.china.org.cn/business/2011-10/14/content_23626245.htm
http://www.china.org.cn/business/2011-10/14/content_23626245.htmhttp://www.china.org.cn/business/2011-10/14/content_23626245.htmhttp://www.china.org.cn/business/2011-10/14/content_23626245.htmhttp://www.china.org.cn/business/2011-10/14/content_23626245.htm


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So, was the Chairwoman just greedy and looking to make money by flipping these businesses toHuabao? Yes and No.

We believe that these subsequent acquisitions were carried out at inflated valuations for the purpose ofremoving fake earnings from Huabaos balance sheet. That way, management had an excuse when theauditors found Huabaos bank accounts empty. Put another way, these transactions were used to cleanup the theft that had already occurred.

And this is exactly why the Chairwoman took the awkward step of buying these assets from third partiesonly to resell them to Huabao.

We do not believe Huabao paid the reported price to acquire Win New Group and Wealthy KingInvestments from the Chairwoman. The reported acquisition price consisted of imaginarymoney/earnin gs that needed to be removed from Huabaos balance sheet. It would have beenimpossible to do this through a n arms length transaction , since a third party would be publicallyquestioned regarding the value of the transactions. However, since the Chairwoman acquired the assetsquietly from a third party, she was free to resell them to Huabao at any price with impunity.

Take the acquisition of Win New Group as an example. When Win New Group was acquired by Huabaofrom the Chairwoman, it had three operating subsidiaries as listed below:

Exhibit 20Win New Group 2007(In millions of RMB)

Subsidiaries Revenue % of Total Net Profit % of Total

Shanghai Zhezhan 35.8 18% 26.2 80%

Huasheng Qinghua 30.8 15% -0.1 0%

Zhaoqing Fragrances 134.1 67% 6.7 20%

Total 200.7 100% 32.8 100%

Huabao acquired Win New Group for HK$650 million, or 21 times earnings. Its vital to note that thisacquisition included 100% of Shanghai Zhezhan and Huasheng Qinghua, but only 72.1% of ZhaoqingFragrances. A third party owned the other 27.9% of Zhaoqing Fragrances. This is important, becauseaccording to filings, Huabao would later acquire this outstanding portion of Zhaoqing Fragrances for onlyHK$21 million. This transaction from an independent third party implied a valuation of only 10.6 timesearnings, for the same business Huabao bought at twice that valuation from Ms. Chu. Its interestinghow Huabao only pays reasonable prices for acquisitions that are not through the Chairwoman.

Over the years, Huabao has continued to grow and overstate its earnings. The share price has continuedto grow as well, giving the Chairwoman more opportunities to sell down her stake. However, this growthhas come with a price: Huabao is so large now that it has become difficult to conduct additional relatedparty transactions of significant size to be meaningful in removing earnings from its balance sheet.Moreover, as Huabaos reported cash balance grew, calls from investors and analysts to declaredividends intensified.

And so, management began declaring dividends.


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Part 4: Dividend Payouts 5.4

Here we return to the stated amount of HK$2.4 billion the cumulative amount Huabao has paid out individends all these years, the amount that regardless of how shady management has been in the past,should remove any doubts about Huabaos brilliant and legitimate business.

But theres a problem with this number: its a red herring.

Over the relevant period, the Chairwoman has had anywhere between 66% to 38% ownership inHuabao. Due to this interest, a significant amount of the dividends that have been paid out have neveractually been paid out they have just circled back to the Chairwoman. In fact, as Exhibit 21 shows,only half of the HK$2.4 billion has actually made it to public shareholders.

Exhibit 21In HK$000 )

2007H1 2007H2 2008H1 2008H2 2009H1 2009H2 2010H1 2010H2 2011H1 2011H2 2012H1 Total

Dividends per share 1.80 3.80 2.30 6.00 5.00 8.80 8.80 12.28 7.20 7.98 12.98

Declared dividends 54,773 116,382 70,451 184,147 154,100 271,463 274,970 384,219 226,789 251,374 409,467 2,398

Chairwoman's stake 65.78% 65.35% 62.96% 62.80% 62.64% 51.28% 50.87% 44.10% 37.71% 38.43% 38.40%

Dividends paid out 18,743 40,326 26,095 68,503 57,572 132,257 135,087 214,767 141,267 154,776 252,232 1,241

To put this all into perspective:

Over the last six years, the Chairwoman has raised HK$9.4 billion from the public. Over that same timeperiod, Huabao has paid HK$1.2 billion back to the public in the form of dividends. Thats 13% of what

was raised over six years.

Based on our time weighed calculation, the Chairwoman could have put the money she raised in a bankaccount earning 5.00% interest and still made those payments to public shareholders. And despiteofficial statistics, anyone who actually lives in China will know that 5.00 % doesnt even cover the cost ofinflation.

With some perspective, suddenly Huabaos dividend story doesnt seem so compelling anymore.

People assume that financial schemes can be successful as long as money doesnt needto be paid out. In fact, financial schemes are successful precisely because they appear to

pay so well.

-Forum Post


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The Dividend Story


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Its never easy to value a company where ther e is little faith in management or the numbers theyprovide. Applying a multiple to questionable numbers to arrive at a share price is an exercise in futility.The truth is, we have no idea how much Huabao is worth. The Company certainly has an underlyingbusiness, but as we have presented here, we believe that business is grossly exaggerated.

SAIC net income adjusted for R&D is ~40% less than the net income of HK$1,632 reported in Hong Kongfilings. Our discussions with the tobacco factories indicated a smaller tobacco business than thatreported in the Companys public filings. We found customers in the food business that denied beingcustomers. The margin profile is unbelievable.

The truth is that we have no idea what the real earnings of this business are. While we cant discern the true earnings of the Company and thus cant provide a confident valuation, we can speculate as to thelong term prospects of Huabao.

We do not believe that management will be able to maintain the current growth trajectory of revenueand by extension, dividends. Over the last few years, it was relatively inexpensive for management todeclare robust dividends, given that a large portion of the payout circled back to the Chairwoman.However, with the Chairwoman significantly selling down her shares in the last two years, we believe ithas become more and more unmanageable for Huabao to continue to declare dividends.

In the future, we suspect management will have to significantly curb the growth rate of Huabao to easethe growing dividend burden. In fact, we believe this gearing down has already started to occur. Forexample, when management released the most recent half-year results on November 22, 2011, theshare price dropped 10% the following day on the back of an unexpected slowdown in growth. Lookingfurther back to June 17, 2011, this same slowdown surprise caused the stock to crash 23% over the nextthree days when the full-year 2011 results were released.

Exhibit 22Report Release Date Price Before Price After Change in ValueH1 2012 22-Nov-11 4.67 4.19 -10.3%

FY 2011 17-Jun-11 10.56 8.07 -23.6%

H1 2011 26-Nov-10 12.50 12.88 3.0%

FY 2010 18-Jun-10 9.86 9.90 0.4%

H1 2010 2-Dec-09 8.76 8.29 -5.4%

FY 2009 18-Jun-09 8.50 8.54 0.5%

H1 2009 2-Dec-08 5.08 5.14 1.2%

FY 2008 16-Jun-08 7.50 7.50 0.0%

H1 2008 29-Nov-07 7.30 8.03 10.0%

FY 2007 13-Jul-07 7.10 7.44 4.8%

As Exhibit 22 shows, these consecutive and large earnings misses are highly unusual for a company thathas managed to hit or meet market estimates going back to 2007.

Valuation [sec 6]


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Equally of interest is that this unexpected slowdown in growth follows the Chairwomans significantshare disposals. We recall that Ms. Chu was dubbed Queen of Cashout after decreasing her holdings inHuabao from 51% to 37% between April 12, 2010 and January 28, 2011. This is right before Huabaobegan missing consensus targets.

We suspect in future reporting periods, shareholders will continue to see more of these earnings missesas management reigns in on the burgeoning dividend problem.

Furthermore, Huabao has recently started expanding into a more capital intensive business by enteringthe Reconstituted Tobacco Leaves (RTL) business through a HK$1.3 billion acquisition. Managementbelieves RTL will consume an additional HK$370 million in capital expenditures over each of the nexttwo years, or 8x the HK$45 million in capex Huabao spent last year. Analysts had started believing in asustained 50% payout ratio, but with the move in RTL, Huabao was able to manage these expectationsback down to a 30% payout, as was detailed in reports from Deutsche Bank on June 22, 2010 andNomura on August 5, 2010.


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In preparing this report, we have been aided by various parties. These parties worked independently ofeach other and were unaware of the nature of the end product. This was both for their protection andours. While well compensated, we would like to take this moment to thank those who helped us. At thispoint, you probably know who you are.

Through our investigative process, we have come across additional information which we have decidedagainst releasing. There are several reasons for this. One, we tried to provide this report with a certainflow and ease of reading, which additional information would have only obstructed. Second, we believepeople should be allowed their own personal privacy. And finally, we have no financial interest inHuabao, which gives us no reason to overstate our case.

However, we have an immense interest in the safety and well-being of our people. This is why all theinformation withheld from this report has been encrypted and stored online. This information pertains

to Huabaos business, along with the personal information of the individuals who run Huabao behindthe scenes and their associated proxies (y ou didnt actually think a 36 year old woman was the truerunning force behind one of Chinas largest public tobacco enterprises, did you?)

Management is more than welcome to address concerns in this report. In fact, we encourage it.However, should we find that any individuals associated with this report has been threatened, or isotherwise in danger, we will release the encryption code into the public domain.

Cascade: tek / SynTehTek

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