GEO Investing

After the market close yesterday VALV released news that it had changed auditors.

“Shengkai Innovations, Inc announced that its auditor BDO China Li Xin Da Hua CPA Co., Ltd. (“BDO”) resigned on August 4, 2011 because parties were unable to agree to BDO’s proposed increase in their fee for conducting its 2011 audit.

BDO had proposed to increase its 2011 audit fee from $200,000 to $610,000, which management felt was too sizable and unjustifiable.

The Audit Committee of the Company then appointed Albert Wong Co. (“AW”) as its new independent registered public accounting firm on August 4, 2011.”

In our initial VALV alert on July 13 and ensuing DD update published on July 18, 2011 we had said that in order for VALV to ultimately achieve PE expansion the company would have to continue to build investor trust.

Unfortunately, VALV’s decision to not to come to terms with BDO and switch to a weak auditor will test investor trust. VALV claims to have $50 million on its balance sheet and is projected to earn over $30 million in net income for its June 2011 year end. Although the increase in audit fees is large, the hit to its financial statement would be minimal. The cost the company is not considering is the loss of potential market value from retaining a weak auditor in a period where the company is becoming increasingly larger.

VALV is either being stubborn (knowing that it is legitimate) and cannot justify the extra expense to appease investors, or is hiding something and assumes that BDO is stepping up its DD procedure of ChinaHybrid firms.

Yes, we are flabbergasted and angry at VALVs apparent blatant disregard for shareholder value. For a company of VALV’s size, the increase in fees translates to pennies as far as EPS is concerned, provided of course that BDO is actually performing higher quality audit services. And with the state of equity markets their decision could not come at a worse time.

As far as the GeoTeam is concerned we have placed much less emphasis on auditor selection. Virtually any auditor, ranked or un-ranked, including the infamous BDO family has been foiled by ChinaHybrid firms. In fact, we still believe the BDO family is being duped by ChinaHybrid firms. We also do not know the extra DD steps BDO “may be” implementing in the China space. In the end, if a company is legit and is providing proper documentation to the auditors, the choice of auditors takes on less importance.

Sure, VALV has now complicated our quest. However, at least our preliminary DD indicates that we can place a level of trust in some of VALV’s paper (financials). Regardless of auditor selection, we will continue our DD into the company’s story. Ultimately, this DD will form our long term investment bias in VALV shares. In the near-term we think it’s more prudent for our team to wait for the completion of the audit and more OTGDD before we continue to pound the table.

If the stock does get whacked, we may consider taking on a long trading position in VALV shares. But there certainly is short-term risk to this story. Investors must still know that we are attempting to regain some of our bullish sentiment for ChinaHybrid companies, but stubborn decisions such auditor changes will continue to pose challenges to this goal. But we won’t give up.

Disclosure: Long VALV