More On The (Alleged) Telestone Technologies (TSTC) Fraud: Is The Wolf About To Shed Its Clothing?

Ten days ago, we ran a story in conjunction with The Forensic Factor "Is Telestone Technologies (TSTC) A "RINO" In Sheep's Clothing?", in which we presented TFF's thesis on why Telestone Technologies (TSTC) may be simply the latest Chinese fraud stock, the latest in a list of companies so long that very soon it will be impossible to trade any Chinese company (no matter how pristine) without allegations of fraud swirling all around it. Immediately following the publication, the stock plunged by 20%, confirming that these companies are truly nothing but story investments, and when even the slightest whiff of impropriety appears, everyone bails in droves. TSTC's management team was forced to go public with an attempt at refutation, which however has achieved in doing nothing for the stock price. Today, TFF presents its follow up thesis on TSTC. As usual, the smoke certainly appears is here. We leave it up to regulators to determine if there is fire...

Telestone Technologies (Part II): The Great Wall of Deceit

What is three cents, or less than one-half of one percent?  That was the impact on the stock price of Telestone Technologies (NASDAQ: TSTC) from the highly anticipated investor update call, the second unsuccessful call management has held in the past two months.  The Forensic Factor (TFF) first wrote about Telestone on January 11th with our report Telestone Technologies - A "RINO" in sheep's clothing.  In
that report, we identified a myriad of concerns that were the
foundation of our request for the NASDAQ to halt trading in Telestone (seekingalpha.com/instablog/790526-thefor...).  Despite the gravity of the questions we raised, Telestone has failed to address many of our concerns.  Further,
an investor update call held on January 24th by Telestone management
was replete with incriminating commentary that raised more questions
than were answered.  In this brief follow-up, TFF will
highlight (a much more comprehensive final report will examine
manufacturing relationships and provincial branches):

• A
  blatant violation of Sections 10(b) and 20(a) of the Securities
  Exchange Act of 1934 and Rule 10b-5 that should provide sufficient
  ammunition for class action lawyers and the SEC.
• An accounts receivable balance, and associated DSO level, that defy logic, and arguably GAAP accounting.
• A
  definitive admission from Telestone management that revenue is
  indeed being recognized on a percentage of completion basis,
  confirming TFF's suspicion that a restatement is necessary
• Sixteen additional questions that the company failed to address, ranging from: a distributor that was incorporated fifteen months AFTER Telestone claims to have started the relationship, to
  an unusual interest free loan from a related party that
  represented nearly 50% of the company's cash at 9/30/10, and a
  history with an entity that appears to have had accounts frozen
  with large quantities of Telestone stock.

Based on the action of the stock, the investing public appears to have voted with TFF.  This
morning, TFF will again ask the NASDAQ to explore the facts in our
first article, as well as examine additional brazen misrepresentations
from Telestone's call on January 24th (http://www.mzcan.com/cancast/us/register.php?id=usTSTC_3&version=e).

Abraham Lincoln once said, "No man has a good enough memory to make a successful liar."  Fortunately
for the NASDAQ, the SEC, and TFF, a good memory is not required in the
age of public filings and recorded conference calls.  In
our previous write-up, TFF was extremely careful to highlight the facts,
opting to leave any fraud declaration to the class action attorneys and
the regulators.  In addition to the quote above, Abraham
Lincoln also said, "It is better to remain silent and be thought a fool,
than to speak out and remove all doubt."  TFF believes that Telestone management would have been better off remaining silent.  Instead
they spoke out yesterday, and essentially sealed their fate as a
reverse Chinese merger that stands for everything regulators need to fix
to restore confidence in the capital markets. 

On
the update call, Telestone management chose NOT to address many of the
more heinous issues that we raised in our first article - a fact that
was clearly not lost on the investment community.  Instead,
Telestone management chose to wait nearly two full weeks to confront
the growing conflagrations that should jeopardize their public listing.  In
addition to refusing to address many of our concerns, management also
disconnected one investor that appeared to raise valid questions that
TFF will recap below.  To top it off, management blatantly
misrepresented the circumstances of the auditor changes - a fact that we
believe will be picked up on by many of the class action firms
currently investigating Telestone.

At
the 15:20 mark of the call on 1/24/11, Telestone management addressed
the juggling auditors - a major concern raised by TFF in our previous
report.  As we highlighted, Telestone had two auditors resign within one year, the second of which was not disclosed until months after the resignation.  Telestone disclosed that Mazars had resigned on July 13, 2009 in an 8K filing (http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHtmlSection1?SectionID=6736766-1159-7337&SessionID=WMJMH6nEJqubgA7), "On July 8, 2009, Mazars CPA Limited resigned as the independent registered public accounting firm for Telestone Technologies Corporation (the “Company”)."  Buried in Telestone's 10K, they disclose auditor resignation number two (bold/underlined is TFF emphasis)(http://yahoo.brand.edgar-online.com/DisplayFiling.aspx?TabIndex=2&FilingID=7159133&companyid=64423&ppu=%252fDefault.aspx%253fcompanyid%253d64423):

During
the Company’s fiscal years ended December 31, 2008 and 2007 and through
July 8, 2009, the Company engaged Mazars CPA Limited previously as the
independent registered public accounting firm prior the engagement of QC
CPA Group, LLC on July 9, 2009 through January 14, 2010. QC CPA Group,
LLC performed the interim reviews of the Company’s financial statements
for the period ended June 30, 2009 and September 30, 2009.  QC CPA Group, LLC resigned
on January 14, 2010 and the Company engaged Mazars CPA Limited as the
Company’s new independent registered public accounting firm on January
18, 2010 to audit the Company’s financial statements for the year ended
December 31, 2009.

It
is the opinion of TFF that management lied and misrepresented the
resignations by proclaiming that the auditor changes were in fact
voluntary.  On the 1/24/11 call, Mr. Wu, who TFF devoted several paragraphs to in our last report, stated (bold emphasis of TFF):

In the third quarter of 2009, some of our shareholders recommended that we switch from our long-standing auditor Mazars to a U.S.-based firm called QC CPA Group.  But
soon we found out that this new auditor was not as familiar with our
business and was treating some of our ordinary receivables as long-term
ones.  Due to our high comfort level with our long-time auditor we switched back to Mazars. 

First, the decision to switch to a U.S.-based audit firm is understandable.  However, the decision to use an unknown firm out of Beaver Creek, Ohio does not pass the smell test.  Secondly, this statement by management is fraught with deceit with the clear motive of misleading investors.   The decision to switch auditors was not benign and voluntary as management seems to suggest.  Instead, Telestone's public filings clearly state that both auditor changes were driven by existing auditor resignations.   TFF
believes that this statement is a violation of Sections 10(b) and 20(a)
of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated there
under (http://taft.law.uc.edu/CCL/34Act/sec10.html) and (http://taft.law.uc.edu/CCL/34ActRls/rule10b-5.html). 

While the scope of management's discussion was quite limited, there were other noteworthy issues.  In
a press release that hit the wires around the time the call commenced,
Telestone management announced unaudited preliminary results (finance.yahoo.com/news/Telestone-Technol...).  The numbers are impressive when viewed in a vacuum.  But
the P&L lives outside of a vacuum, with the balance sheet and cash
flow statements providing a complete picture of financial health.  As TFF asserted in our last report, Telestone's results are meaningless without cash flows that approximate net income.  Based
on Telestone's guidance for revenues of $131.5 million at the
mid-point, this implies Q4'10 revenues of $60.6 million ($70.9 million
for first 9 months).  Additionally, Telestone announced net
income for 2010 of $30.75 million at the mid-point, implying Q4'10 net
income of $18.5 million ($12.6 million for first 9 months).  Amazingly, the company confessed on the call that DSO's and accounts receivables increased dramatically.  A major focal point of the call was again DSO's, which Mr. Wu admitted climbed to 374 days from 358 days in 2009.  Equally
concerning was the disclosure on the call that accounts receivable
increased sequentially by $47 million (from $134 million to $181
million).  To put this lunacy into perspective, using
the mid-point of guidance, the company's revenue only increased $17.5
million quarter-over-quarter (from $43.1 million to $60.6 million),
which compares to a jump of $47 million in accounts receivable. 

At
the 33:20 mark of the call, an exchange took place between management
and an investor that illustrated management's inability to reconcile any
of their numbers.  We would encourage any potential
investors to listen to that segment of the call that ended with
management disconnecting the caller mid-question (http://www.mzcan.com/cancast/us/register.php?id=usTSTC_3&version=e).  Additionally,
TFF found it very odd that management placed the entire conference call
on hold/mute for 15 seconds at the 35:20 mark and confessed multiple
times that they could not explain the trend in the numbers that they had
just provided in their prepared remarks.  Management
finally capitulated at the 39:55 mark, admitting "we can not reconcile
those [numbers] over a phone call like this" and said they would file an
8K to reconcile the discrepancy between the 10Q disclosures. 

After digging through the September 10Q (http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?ID=7556714&SessionID=rpAvHj8AoL5mF27), TFF believes it has discovered the smoking gun that management was unable to reconcile.  As
TFF stated in our last report, Telestone is either booking unbilled
receivables or is misclassifying long-term A/R as short-term.  The recent management call validated our suspicion.  On
the call, Mr. Wu discussed the payment process of the big 3 and stated
(10:00 into the call),"once their payment process is activated usually
we can collect 90% of the customer volume except for warranty related
receivables that isn't due for 24 months."  This appears to
be a consistent statement with the language in the most recent 10Q,
"Approximately 10% of our professional services revenue are settled
after 24 months of our warranty period."  HOWEVER, THESE STATEMENTS DO NOT RECONCILE WITH THE DISCLOSED AMOUNT IN THE 10Q. 

TFF
believes that management's stated policy of 10% of services settling
after 24 month, as well as the policy language in the 10Q does not
reconcile with the disclosed amount of A/R that is expected to be
collected after one year. The September 10Q states,
"Of the retentions balance as of September 30, 2010 and December 31,
2009, approximately US$3,023,000 and US$903,000 respectively are
expected to be collected after one year" (Note 6 - Accounts Receivable).  If
the company has $3 million that represents 10% of the professional
service revenues booked over the last 12 months, then that would imply
that the maximum service revenue that Telestone could have recognized
over the past 12 months was $30 million.  However, the
trailing 12 month services revenue through Q3'10 was $66.2 million
($41.9 million first 9 mo's of 2010 and $24.3 million in Q4'09).  This
level of service revenue, which comes with 10% of revenues collected
after 24 months, would imply at least $6.62 million of receivables to be
collected after one year (this doesn't even include the amounts from
Q1'09 - Q3'09 which would still be under the 24 month collection period
and make the numbers even more challenging to reconcile).  Given the fact the Big 3 purportedly represent 99%^ of revenues, TFF sees no explanation for these inconsistencies.  TFF
is convinced that Telestone's reported financial are irreconcilable,
and management's inability to answer basic questions on the call,
solidifies our perspective.  As TFF asserted in our last
report, we are nearly certain that Telestone is recognizing revenues
without invoicing customers and/or is recognizing revenues under a
percentage of completion methodology without the necessary disclosures
(unbilled receivables). 

While
we were unable to find conclusive evidence that Telestone was not
invoicing customers at the time of our last report, we believe
management unwittingly provided confirmation on the investor update
call.  At 8:08 into the call, Mr. Wu defended their ballooning accounts receivable balance by stating, "A delay in customer inspection reduced our ability to issue invoices."  There
is no way to interpret this statement other than Telestone has
recognized revenues, booked a receivable, and has not been able to
collect said receivables because no invoice was issued because of a
delay in inspection (approval).  WHAT MR. WU DESCRIBED IS THE EXACT DEFINTION MOST COMPANIES USE FOR UNBILLED RECEIVABLES -“Unbilled Receivable”
means any Receivable for goods sold or services performed for the
related Obligor, and with respect to which no invoice has been submitted
to such Obligor for payment of the amount thereof" (www.secinfo.com/d14D5a.22xj6.d.htm).

TFF believes this statement is a confession that Telestone is in fact recognizing revenues without invoicing customers.  If we are correct, we believe Telestone investors could face significant consequences that should start with a restatement.  While
there is nothing wrong with percentage of completion accounting,
Telestone has never disclosed this revenue recognition policy and would
need to restate past periods disclosing unbilled receivable.  Further, as TFF has suspected, investors would be investing with incomplete and inaccurate information.   If
this is the case, and Telestone is not a fraud (which TFF will again
leave to lawyers and regulators to determine), then this could explain:
the astronomical accounts receivable, the lack of associated cash flows,
the ability to recognize revenues with significant discretion, and the
unusual warranty period when revenues are recognized, but apparently no
invoice is issued until some inspection occurs.

In
addition to the significant and material misstatements that were
gleaned from the update call, TFF is equally concerned about the areas
that Telestone failed to address:

1)       Why
did Telestone claim to work with Quell Corp a full 15 months before
Quell Corp was formed (despite being discussed at length in out first
report, TFF does not believe Quell was referenced in the prepared
remarks)?

2)       Why are they not complying with applicable Chinese tax laws as disclosed in their financial filings?

3)       Why did allowance for doubtful accounts decline by such a large percentage in Q3'10?

4)       Why are the contacts listed in past Telestone press releases so inconsistent and mysterious?

5)       Why did the company fail to include Mr. Wu in any of their presentations or the management slide on their website?

6)       How
did Mr. Wu add two years of experience on his resumes in just ten
months between his employment at China Natural Gas and China Medicines?

7)       Why
have there been three people listed as Secretary of the Board, one of
whom had a New Jersey phone number and a Gmail account listed as contact
information (this is salient as well as our entire tree of oddities in
our last report)?

8)       Why
are Mr. Wu and Mr. Ballard, emailing individual investors, and
potentially providing selective disclosures that are appearing on yahoo
message boards? (http://investorshub.advfn.com/boards/read_msg.aspx?message_id=57397703) and  (http://messages.finance.yahoo.com/Business_%26_Finance/Investments/Stocks_%28A_to_Z%29/Stocks_T/threadview?bn=51264&tid=31530&mid=31530) and (http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks_T/threadview?m=tm&bn=51264&tid=34952&mid=34952&tof=44&frt=2)

9)       Given the commentary on the update call about retaining Deloitte & Touche, when can we expect an 8K on their engagement?

10)    What was/is the involvement of Paul Kelley with Telestone?  Why did he appear in pictures with Telestone's management on the podium of the AMEX in 2005 and Nasdaq Global Market in 2007?  (pictured and detailed - http://sharesleuth.com/investigations/2011/01/you-wont-find-s-paul/)

11)    Does the frozen account of Winner International own Telestone shares?  Did
the company give 200,000 Telestone shares to Winner International
without disclosing that in SEC filings as Sharesleuth suggests (http://sharesleuth.com/investigations/2011/01/you-wont-find-s-paul/)?

12)    Did MCC Group receive shares of Telestone in exchange for $50,000 loans as ShareSleuth details? (http://sharesleuth.com/investigations/2011/01/you-wont-find-s-paul/)

13)    Does CEO Han have any remaining business relationships with MCC Group?

14)    What is the nature of the loan that CEO Han has provided to Telestone and why was it necessary?

15)    What is the $536,000 related party loan and why is Telestone not collecting interest on this loan (http://www.faqs.org/sec-filings/101115/TELESTONE-TECHNOLOGIES-CORP_10-Q/)?

16)    Which Director lent the company $4.13 million and why was this necessary if Telestone is in sound financial health?

Like our last report, TFF is very concerned that investors are trading in Telestone with incomplete and inaccurate information.  This concern seems particularly germane given the rampant retail message boards and individual investor interest.  Telestone's message boards on Yahoo Finance had approximately 359 posts on January 24th alone!  This type of retail involvement is wonderful for the stock market.  However,
if regulators intend to protect the retail experience, then it is
paramount that they begin to address the massive issues that are present
with so many of the Chinese reverse mergers.  TFF is hopeful that the recent attention from mainstream publications will expedite regulatory action (www.newyorker.com/talk/financial/2011/01...) TFF has confidence that our requests to the NASDAQ and SEC will not fall on deaf ears.  And if report II does not garner appropriate attention, we are extremely confident that our final report (III) that explores the outsourced manufacturer and provincial offices will.

As we said in our last report, if it looks like a duck, walks like a duck and quacks like a duck, it probably is a duck."

*** The author of this article is short Telestone stock.  TFF
goes to great lengths to ensure that all information is factual and
referenced. All facts that we present on this site are true to ...More
the best of our knowledge. All opinions presented are our own and
accurately reflect our actual opinion on the relevant subject being
discussed at the time

Comments

[sodbuster]

>We leave it up to regulators to determine if there is fire...<

Regulators couldn't find a fire if they were standing in the middle of a burning building. No action will be taken that might be construed as negative.

[Oh regional Indian]

Industrial China = Massive fraud. it's so simple. These stocks are traded by insiders while being touted by penny-stock merchants. 

In a rigged game, there are rigs within rigs. 

It's good to know your rigging, or your sails get all fouled up. If you don't, don't sail.

You should see the crap Chinese manufacturers are unloading on India's product hungry public. No recourse, no repairs, no back-up.

ORI

http://aadivaahan.wordpress.com/2011/01/21/accidental-lives/

[trav7777]

China is Fraud, Inc.  Wall Street should move there; they'd be right at home

[Plainview]

Thanks for this coverage - it's great research and, having shorted the stock on the first report, valuable too. Cheers.

[UninterestedObserver]

Can you guys hurry up and prove that CHBT,ONP,CSKI,CGA and CVVT are also frauds?

TIA