Friday, February 15, 2008

Blowing Hot Air At China Wind Systems

In order to operate legally in China, offshore entities need sidestep substantial uncertainties regarding the proper interpretation and adherence to current laws and regulations of the PRC, including foreign ownership restrictions.

Investing in shares of the common stock of China Wind Systems (CWSI-$2.10), a provider of industrial equipment for use in the textile and energy related industries in the People’s Republic of China (PRC), represents the complexity and the high degree of risk found in most small-capitalization companies doing business—and based—in China.

To comply with foreign ownership restrictions, China Wind operates its businesses in the PRC through contractual arrangements with affiliates of the Huayang Companies, Huayang Dye Machine and Huayang Electrical Power Equipment, both of which are limited liability companies organized under the laws of the PRC, and each of which has the licenses and approvals necessary to operate in China.

As China Wind [allegedly] has the ability to substantially influence/control these companies’ daily operations and financial affairs, appoint their senior executives and approve all matters requiring stockholder approval, the Company is considered the primary beneficiary of the Huayang Companies.

Under the present business structure, as most of the Board and all of the Company’s Named Executive Officers reside in the PRC--and, substantially all of Company’s assets are located in the PRC--management consolidates the results, assets and liabilities of the Huayang Companies in its financial statements.

It is unclear if extradition treaties now in effect between the United States and the PRC would permit effective enforcement of criminal or civil penalties of federal U.S. securities laws—which begs the question of effective corporate governance.

PIPE Transaction

Prior to a series of complex exchange agreements in November 2007 with Fulland Limited, China Wind was no more than a publicly reporting blind pool company with nominal assets.

Fulland was incorporated under the laws of the Cayman Islands on May 9, 2007, by the owners of the Huayang Companies, Jianhua Wu and Lihua Tang, as a special purpose vehicle for raising capital, in accordance with requirements of the PRC State Administration of Foreign Exchange, known as "SAFE."

The reverse acquisition of Fulland Limited, resulted in end-control by the Company of the business and operations of the Huayang Group in the PRC.

To secure the equity financing sufficient to finance its growth, working capital, and acquisitions, China Wind found it necessary—like most early stage companies—to sweeten its initial PIPE with re-set mechanisms. To wit:

On February 14, 2008, the Company announced a shelf registration related to the public offering of an aggregate of 6.50 million private placement shares of common stock, to be sold from time to time by certain initial stockholders of China Wind. These shares are issuable upon the exercise of previously granted warrants.

China Wind will not receive any proceeds from the sale by the selling stockholders of their shares of common stock, save for the exercise price of the outstanding warrants (if and when the warrants are exercised). Based on the present exercise price of $0.58 per share, if warrants to purchase a total of 6,500,000 shares of common stock were to be exercised, the Company would receive gross proceeds of approximately $3.8 million.

Potential investors ought note, however, that in its eagerness to come up with earlier financing for its reverse acquisition, the Company issued "death spiral warrants." The toxic terms provide that if China Wind does not meet certain levels of pre-tax income for 2007 and 2008, then the exercise price shall be reduced by the percentage shortfall, up to a maximum reduction of 90 percent!

If pre-tax income per share is 20% below the threshold for each of 2007 and 2008 (a “20% shortfall”), 50% below the threshold for both years (a “50% shortfall”), or 90% or more below the threshold for both years (a “90% shortfall”), the adjusted exercise prices would decline to 37 cents a share, 14 ½ cents a share, or $0.006 a share, respectively!

The warrants provide that the exercise price of the warrants may be reduced by up to 90% per year if pre-tax income per share of common stock, on a diluted basis, is less than $0.08316 per share for 2007 and $0.13131 per share for 2008.

On November 13, 2007, concurrently with the closing on the reverse acquisition, China Wind also entered into a securities purchase agreement with the same selling stockholders. Pursuant to the agreement, China Wind issued and sold to the selling stockholders, 3.0% convertible subordinated notes. The notes are automatically converted into an aggregate of additional warrants of 5,588,252 shares of common stock at $0.83 per share, and 2,065,000 shares at $0.92 per share—with the same toxic, dilutive terms!

The warrants have a term of five years, and expire on November 13, 2012

In parallel, on the same date, the Board unanimously adopted, too, a restated certificate of incorporation to increase the number of authorized shares of capital stock from 75.0 million to 210.0 million shares.

Business Outlook

For fiscal year 2007, the company anticipates net revenues of approximately $23 million and net income of approximately $10.4 million (including a one-time gain from the forgiveness of income and VAT taxes of $6.8 million), or share-net of about 28 cents. For 2008, China Wind Systems anticipates net revenues of approximately $40 million and net income of approximately $7 million, or 19 cents a share.

Growth Strategy

Historically, the principal source of business at China Wind was as a manufacturer of textile dyeing and finishing machines. Since August 2007, however, the Company has shifted its strategy to focus on the growing wind energy industry in China, and has begun to supply high precision rolled rings to companies in the wind energy industry.

For the nine months ended September 30, 2007, dyeing and finishing equipment division accounted for revenues of approximately $14.5 million, or 87.3% of revenues; and, the electrical equipment division accounted for revenues of approximately $2.1million, or 12.7% of revenues.

In connection with the expansion of the electrical equipment division to develop and market rolled rings and related equipment to the wind power industry, China Wind are acquiring newly-constructed buildings and the related land use rights from Wuxi Huayuang Boiler Company, Ltd., in which the Company holds a 33% interest, for $11.9 million.

As of September 30, 2007, management had made payments of $5.9 million, which are classified as deposits on long-term assets on the balance sheet. The remaining balance of $6.0 million is due in the first quarter of 2008.

Favorable tax treatment in the PRC

In 2007, the Chinese local government granted the Huayang Companies a special tax waiver to exempt certain corporate income tax and value added tax liabilities (and any related penalties). For the nine months ended September 30 2007, net income increased 415.4% to $9.4 million from $1.8 million in the prior year. Adjusting net income to exclude total tax exemptions, the non- GAAP net income fell to $2.6 million in the first nine months of 2007, up 44.5% from $1.8 million for the same period prior year.

Related Party Transactions of the Huayang Companies

The voice of parents is the voice of gods. ~ William Shakespeare

Chief executive officer and chairman of the board, Jianhua Wu, 52, beneficially owns approximately 49.7% of the outstanding common stock. Mr. Wu founded both of the Huayang Companies, too, and is presently the executive director and general manager of Huayang Dye, positions that he has held since September 2002.

Mr. Wu is the husband of Ms. Lihua Tang, 53, the secretary and a director of China Wind.

From time to time, the Huayang Companies advance funds for working capital purposes to companies in which they have partial ownership interests. These advances are non-interest bearing, unsecured and payable on demand. At September 30, 2007, China Wind had a receivable from these entities of $377,860.

Huayang Electric, Lihua Tang, and Haoyang Wu (who beneficially owns 5.5% of China Wind and is the son of Mr. Wu) beneficially own 33.33%, 40%, and 26.67% of Wuxi Huayang Boiler Ltd., respectively. [see aforementioned land rights deal]

In addition, Lihua Tang has two bank accounts in the PRC under her name that have been assigned to China Wind and are being used by the Company in its operations!!! At September 30, 2007, the balance in these bank accounts amounted to $1,215,437 (reflected as due from related parties on the balance sheet).

Would it surprise anyone that as of February 14, 2008, the Company did not have any audit, compensation or nominating committee [rhetorical]?

Indeed, given the admitted lack of internal controls currently in place at the Company (in particular, Section 404 of the Sarbanes-Oxley Act of 2002), Wu and Tang are the voice of God at China Wind.

Investment Considerations

Forget about share dilution, Wu clan influence on all movable parts of the Company, and a dearth of internal audit controls—bring onboard a PR firm experienced in realpolitik of doing business in the PRC, and China Wind will soon be promulgated on message-boards and spam e-mail bursts for its significant wind power market potential and outstanding long-term earnings growth possibilities!

“HUGE GAIN opportunities for investors who capitalize and jump on shares early enough!”

To ... not prepare is the greatest of crimes; to be prepared beforehand for any contingency is the greatest of virtues. ~ Sun Tzu (The Art of War)

Propaganda could send the stock up ten-fold in price. Nonetheless, the 10Q Detective prefers not to make a ‘bet-the-store’ gamble on China Wind and we will sit this speculative play out.

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