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Kandi's Annual Report Raises Red Flags

Summary

On Monday, Kandi Technologies Group reported what was perceived by the market to be excellent annual results and a solid forecast.

However, closer examination of the annual report released by its questionable auditor raises more questions than it seems to answer.

Numerous red flags related to a convoluted ownership structure and related party transactions remain.

Other issues such as poor cash flow persist due to the opaque financials of the company's joint venture.

Suspiciously low operating expenses despite large increases in sales also remain unexplained, as do why sales prices continue declining even as higher price models are introduced.

As I disclosed in a comment on an article titled "The Big Short Movie And My Kandi Big Long", prior to Kandi's (NASDAQ:KNDI) earnings report on Monday, I bought both puts and calls on the stock. While this might seem to be a strange strategy for someone who is bearish on Kandi and maintains that it is probably worth exactly zero, my rationale stems from a strategy that was actually outlined in the book "The Big Short". One of the hedge funds featured, Cornwall Capital, placed bets on longshots, including the mortgage meltdown, where the odds weren't quite as long as the market was pricing them at.

Even though I'm skeptical that Kandi is a legitimate company, I recognized that if it was, then clearly where the stock was trading last week at around $7 was not the "correct" price. I felt it was most likely either worthless or should trade much higher after what was supposed to be a stellar earnings report. So, in anticipation of this, I bought what is called an options strangle, which consists of both puts with a strike price of $6 and calls with a strike price of $9.

Paradoxically, one of the reasons I bought calls on KNDI is also a reason I am very suspicious about the company. It is audited by a tiny firm called Albert Wong & Co., which was rebranded as AWC CPA Limited last year, probably either to appear more legitimate or hide from its horrible track record. Of the 19 companies that appear on its most recent client list, only KNDI remains listed on a major exchange or trades for over a dollar, and 11 trade for 1 cent.

With such a questionable penny stock auditor, I felt fairly certain that Kandi could report basically whatever numbers it wanted, and sure enough, it did not disappoint with the headline numbers from the earnings report, with its JV selling 24,220 EVs in 2015, an increase of over 120% from the 10,935 it sold in 2014. Moreover, the company projected sales of 35,000 for this year, which while not quite the doubling pace that it had been maintaining, is still 45% unit growth, on par with Tesla (NASDAQ:TSLA).

With the JV expected to sell almost half as many cars as Tesla, Kandi clearly looks mispriced at less than 1/65th the market cap. Obviously, Tesla is more advanced in terms of cars and as a business, but the relative valuation gap is still vast and could start to close if investors start to buy into the Kandi story the way they have with Tesla.

However, after closer examination of the annual report, I maintain that it may be just that, a story. True to form for its auditor, it took it all day to release the 10-K, due to a mistake in some of the calculations in the initial 8-K. To miss such an obvious miscalculation doesn't exactly engender confidence in its ability to audit the labyrinthine structure that Kandi has evolved into. While an EV manufacturer in China, which is embracing EVs as part of its effort to fight a pollution problem, sounds great, I still don't think Kandi is what it purports to be.

For starters, the company is not exactly an EV manufacturer; that falls to the JV it set up with Geely in 2013, which assembles and sells the finished products. Kandi just provides EV parts to it, but it doesn't exactly manufacture the EV parts either. In 2015, battery sales made up the majority (83.5%) of total sales, and Kandi doesn't make batteries either. KNDI just buy the cells from battery manufacturers and assemble them into the final battery packs that are sold to the JV. This does not sound like a high value added technology company, but rather just a middleman.

Why can't the battery manufacturers sell directly to the JV, since they are already ostensibly doing most of the additional assembly anyway? Kandi claims it is necessary, as "[d]ue to various Chinese auto industry regulations, we hold the necessary production license to manufacture battery packs to be exclusively used in the EV products manufactured by the JV Company under the Kandi brand."

As it elaborates in another section of the 10-K:

"Kandi New Energy currently holds battery packing production rights (license), and supplies the battery pack to the JV Company. It also holds the Special-purpose vehicle production rights (license) on manufacturing Kandi brand electric utility vehicles, However, according to the JV Agreement, EV products (sic) should only be manufactured by the JV Company, Kandi New Energy need not to keep the Special-purpose vehicle production rights (license). In order to avoid the maintenance fee for this license, the Company plans to sell it to others."

In my last article on Kandi, I pointed out that its Chairman and CEO, Hu Xiaoming, directly owns 50% of Kandi New Energy. While he has theoretically granted Kandi 100% of the economic benefits from it, it should be somewhat disconcerting that the CEO owns half of what appears to be the only thing...


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