NVC Lighting (tkr: 2222 HK) and Yurun (tkr: 1068 HK) Founders Depart

Not a good sign when the founder of a company decides to quit (read here for NVC Lighting and here for Yurun).  I don't have much to add as both are widely suspected frauds.  Founders tend to step 'up' (not 'down') during difficult environments, they will do anything to turn the company around (if real and salvageable).  Stepping down is not a good sign.

There seems to be more founders/CEOs running away/stepping down in China recently.  I wonder if it is due to the rapid economic slowdown in China - companies are finding it harder to keep up the facade as liquidity dries up.  Founders/CEOs are trying to create more distance between themselves and the listed entities.  Keep an eye on whether more board members resign for 'personal reasons'.

ps. The respected Webb-site.com keeps a tab on directors resignation/change for listed companies in Hong Kong.  Always a good place to check.

Carpenter Tan (tkr: 837 HK) - Would you buy these combs?

Carpenter Tan is a 'high end' wood comb manufacturer and retailer in China/Hong Kong with combs  marketed under the brand 'Carpenter Tan' (譚木匠).  

I've walked by their retail outlets at least a few dozen times (they have outlets located in the Hong Kong MTR which I frequently walk by) and I have been counting the number of customers each time.  So far I've seen no paying customers and a grand total of 4 'window shopping' customers in their stores.  Usually the store attendant is just sitting around.

Are combs brandable?  Because these are some of the most expensive combs I've seen:

(from their homepage www.woodencomb.co.uk)

To be clear, this is denominated in USD.  Out of the nine samples from their homepage three combs are priced above USD90 and one at USD78!  (I am not selectively choosing samples.  But you should take a look at their retail outlets as well)

In 2011 they had sales of RMB244mm with 50%+ EBITDA margins.  Seriously, how many companies can you name globally with that sort of EBITDA margins?  Real world business is very competitive and to make 50%+ EBITDA margins require selling something quite differentiated/high value-add/competitively protected.  These are generally not features of the comb industry.

Is this a fraud?  Your call.

Evergrande Real Estate (tkr: 3333 HK) - Anecdotes to a Pre-IPO Fiasco

Another fairly well known fraud (at least among Asia HY/distressed debt guys) was written up by Citron Research yesterday (read here and download their research here).

No point flogging a dead horse.  I just wanted to highlight the reason Evergrande is well known among the investment community is because Merrill Lynch and Deutsche did a pre-IPO investment in Evergrande in 2006/7 based on the company's business plan to acquire and develop specific plots of land and 'guarantee' of returns.  What happened thereafter was a complete fiasco.  The company took the money and acquired completely different land parcels.  The paperwork was incomplete and the company could not deliver financial statements.  At that point, the pre-IPO investors knew it was a fraud and had pretty much written it off.  Amazingly, Evergrande pulled the IPO off and now we know how.  If Citron (or anyone interested in further investigation) is reading this, I would recommend speaking with some of the former Merrill and Deutsche investment team members (or HY sellside brokers), the backdrop is very entertaining.

It is shameful Merrill was one of the IPO bookrunners.  No way they were not aware of the fraud.  They sold a lousy deal to their clients to get them off the hook on a bad investment.

PS.  Evergrande is another China high yield bond issuer.  I've written before (here) why this is particularly dangerous.

China - More Problems with Fiat Currency and a Government that wants Inflation!

I've been thinking about China's M2 money supply problem (read here and here) for quite some time.  The following graph illustrates the current trend (borrowed from Also Sprach Analyst):

This is the result of a fiat currency and a government that wants inflation, as posted before (here).  Exacerbated by distorted incentives and poor capital allocation by policy banks (here).  It is too easy and tempting to hit that printing press, they just can't help themselves!

How is it healthy an economy half the size of U.S. is 40%+ higher in M2 money supply, with the gap widening by the day?  It is no wonder cost of living in 2nd tier cities in China is comparable to the U.S. according to a survey (here).  Let's not forget the income of an average Chinese family is not comparable to the U.S.

Keep this going and you have high inflation (translating to increasing cost of living, real estate prices and lost of manufacturing competitiveness), a currency with unsustainable value and social instability.  Turn off the spigot and you have banking system and real estate collapse and...social instability as well.  That is between a rock and a hard place.

China - The Problem with Fiat Currency and a Government that wants Inflation!

I've always enjoyed John Hempton's blog.  I found his recent entry (here) on Chinese kleptocracy opinionated and entertaining as usual.

His basic premise:

• Chinese government is corrupt, driven by personal interest
• One child policy and limited investment options drive high savings rate
• Banks (and deposit and borrowing rates) are regulated.  Deposit rates below inflation creates negative real rates
• Negative real rates fund SOEs and politically connected entities
• Borrowing at low cost (from deposits) and investing in a highly inflationary environment is effectively looting the public

His conclusion:

• The 'undiscussed' serious threat is deflation (or low inflation).  Low inflation (or deflation) creates positive real rates, and stops SOEs from 'looting' the public and paying back the banks
• And unless the Chinese can get the inflation back up, expect major social problems

While I think his premise is correct - the conclusion is rushed.  His assumption that it is difficult to increase inflation, in my opinion, is misguided.

Herein lies the problem of a fiat currency, particularly under China's currency controls.  Inflation can almost 'always' be manufactured (also known as money printing, much easier in today's digital world).  It is easy to maintain negative real  rates when you control the banking system and the currency. Deflation is not a 'threat', as they can always create inflation (the opposite is not true). And since they control the currency, they can always push money directly/indirectly to SOEs - funding is never a 'real' problem. Which would lead one to question the value of the Renminbi, but that is a separate story.

The real issue, in my view, is whether the government can maintain negative interest rates (keeping deposit rates below inflation), while maintaining social stability/the facade of wealth creation (in an inflationary environment) among the public.  Definitely a very tough balancing act!

PS.  The only way to maintain/balance this in the long term is to drive productivity growth.  Which is very difficult in today's environment. 

China Banks - Is the Weakness its Deposit Base?

While the fragility of the Chinese banking system is increasingly acknowledged by people as the system experiences more strain (read here), it is not completely clear what the 'trigger point' of a collapse is.  Even though bad loans continue to build up, my contention is it is unlikely to be on the asset side of the balance sheet.  The simple reason is banks will simply manipulate the accounting principles and keep the bad loans at face value (never write it down).  If it really becomes unsustainable, the central government will ultimately buy the bad debt from the banks to bail them out, like they have in the last Chinese banking crisis of 2002/3 to keep the system stable.

The trigger point ought to be something outside the bank and central government's control.  My guess is it will be on the funding side of the bank balance sheet, ie. deposits.  Deposits have never been a problem for Chinese banks as deposits have grown rapidly in the last few years due to the gradual appreciation ('expected' appreciation) of the RMB (among other reasons) as people convert their USD (or another currency) and deposit it in RMB with a Chinese bank.  But the continued revaluation of the RMB is no longer clear (and few viable RMB investment alternatives other than real estate), and deposits are escaping the system as people convert RMB back to USD (or another currency).  This could create a painful unwinding process if it triggers a classic bank run.

The central government has to keep 'slowly' appreciating the RMB to ensure the bank's deposit base is stable (or growing).  Yet, due to the lack of investment alternatives, banks end up lending money to real estate developers, local governments and SOEs, which the central government is trying to clamp down on!  And the juggling act continues...

Fook Woo (tkr: 923 HK) - Does this Sound Suspicious?

In a recent release (read here) dated 2nd December, 2011, Fook Woo Group announces:

In the course of preparing its interim results for the six months ended 30 September
2011, it has come to the attention of the board of directors of the Company (the
“Board”) on 25 November 2011 (after trading hours) that an amount of RMB 100
million was paid out by a subsidiary of the Company in September 2011 and the
Company has not been able to confirm the remittance with the recipient(s). On 29
November 2011, an equivalent amount was remitted to the Company’s bank account, the
source of which is yet to be ascertained.

In the meantime, there has been several resignations at the Board level.  This is to hoping their auditor, PWC, will take a closer look into the company (not holding my breath though).

Broken Myth of Reputable Sponsors

An excellent article (read here) on Neil Shen of Sequoia Capital, and his involvement in various accounting schemes and related party transactions to dupe public investors.

I can't emphasize this enough, but many private enterprises in China are established for the sole purpose of being taken public.  Many (if not most) VC/PE firms in China are in bed with these private enterprises to add 'credibility' to the IPO.  They want the same thing: (1) exit through an IPO via aggressive accounting (sponsored by complacent accountants and underwriters), and (2) funds raised are eventually siphoned off through acquisitions and related party transactions.

Public investors are duped by the shiny 'brand name sponsors' and are left holding the bag...

Bank of Communication (tkr: 3328 HK) - 60% Dividend Withholding!

I was just complaining the other day of the 10% dividend withholding tax in China.  But Bank of Communication ('BoCom') really took that up a notch and inflicted a 60% dividend tax on itself (read here). 

Maybe David Webb got it all wrong - BoCom is just trying to generate more tax revenue (ie. value) for the government, its ultimate shareholder.  Good job creating shareholder value!

China Zhongwang (tkr: 1333 HK) - More Corporate Governance Issues

Apparently I missed this little account on Zhongwang in my earlier post (read here).  Zhongwang disclosed in the footnotes of its 2009 annual announcement (read here) it borrowed RMB2.3billion from two Liaoning banks and gave it to a local government construction entity.  The company claims it is not on the hook to repay the debt (read here).

This is another example of poor corporate governance in China.  As local governments are prohibited from borrowing debt, this is also an example of how local governments get around this policy restriction.  Perhaps more importantly, as this article points out (read here), how will this continue as central government clamps down on various 'shadow lending' schemes?

Chinese Banks - "These Things Aren't Banks"

An oldie but a goodie.  Interview with Victor Shih and Carl Walter (watch here) on the distorted banking system and incentives of China and how it may unravel.

Here is a partial picture (in very simplistic terms) of how I see it:

1. China has gone through years of economic growth (productivity improvement) through introducing capital equipments to China's cheap labor force.  This process has slowed in the last few years with growth driven by fixed asset investment (ie. infrastructure and real estate).
2. Fixed asset investments have been productive in the early years.  Urbanization has driven the need for real estate.  Better ports, roads, transport systems, etc. is important to furthering productivity.
3. Local government, SOEs and government ministries (with distorted incentive system and corruption) found that it was easy to drive GDP growth through fixed asset investment.  Land sales were easy as real estate prices kept going up and real estate developers were able to get relatively cheap borrowing from the banks.  Infrastructure construction was a function of borrowing from the banks and throwing money at the projects.  Everyone was making money!
4. How is this possible?  The key is that banking system in China is not structured to make commercially viable loans (ie. allocate capital wisely).  Loans are made primarily through relationships (fueled by corruption) and directed towards SOEs and local governments (indirectly, as local governments are generally prohibited from borrowing).
5. As productivity of various fixed asset investments decline, the massive credit binge (bank lending) is leading to rampant inflation throughout the system.
6. The central government is attempting to contain the issue through imposing various restrictions and mechanisms on banks (eg. changing capital requirements, reserve requirements, limiting total loans made available, etc.).  Problem is these policy 'tweaks' don't fixed the underlying problem - *distorted incentives* throughout the system!
7. Local governments and banks have found ways around the central government policy restrictions by setting up various trust vehicles to obtain funding directly/indirectly from banks (read here).
8. As the central government starts to close in on these trust vehicles, we see a sudden surge in local financing companies and credit guarantee companies prop up around the country that charge exorbitant interest rates (well north of 20-30%+).  Many of these local financing companies are setup by SOEs (like China Mobile, read here) which can still borrow cheaply from the banks, but able to lend out at exorbitant rates (what a great scheme!).
9. Bad loans are on the rise (read here), but banks are more than willing to roll them over and not take a loss.  Now the central government is asking banks to *not* roll over the debt (read here).
10. This is like plugging a leaking dam.  We shall see how it unfolds.

This is obviously an oversimplification of the current situation.  I can write a book on this.  But hopefully this suffices to describe things in broad strokes.

Angang Steel (tkr: 347 HK) - Useful Life of Fixed Assets

What do you do when you can't hit your target earnings?

In the case of Angang Steel (tkr: 347 HK), just change the depreciation schedule (read here and here for corporate announcement)!

Estimated Useful Life (years)

Category of fixed assets   Before revision    After revision

Buildings                  20                 30

Structures                 20                 30

Conductor facilities       15                 15

Machinery                  10                 15

Power equipment            11                 10

Reason for the change as follows:

"The Company has been endeavouring to enhance the value of its fixed assets in recent years by carrying out continuous renovation and upgrading and regular examination and maintenance of its production facilities. As a result, the actual useful life of certain fixed assets of the Company, in particular, the buildings, structures, machinery and equipment used in production, has been prolonged."

As mentioned with Nine Dragons (tkr: 2689 HK) here, having low (under) depreciation seems to be pretty common with capital intensive industries in China.  It is a quick and dirty way of increasing earnings and margins.  The need for maintenance capex exceeding depreciation is evident, but masked by what many companies claim to be 'growth capex'.

A quick tour of a steel mill (or paper mill) in China will convince anyone there is little chance any fixed asset gets its useful life 'prolonged' in China.

--
ps. I have no idea why useful life of power equipment is shortened by one year.  Seems awfully precise.

Chaoda (tkr: 682 HK) - Last Breath?

As mentioned before in the blog - is this finally the end of Chaoda Modern Agriculture as it goes to Hong Kong's Market Misconduct Tribunal (read here) and exposed as a fraud (for the 'x'th time), this time by Anonymous Analytics (read here)?

Anonymous Analytics mentions sibling / affiliates, Asian Citrus (tkr: 73 HK) and Le Gaga (tkr: GAGA).  I would keep a close eye on and stay away from them.

--
ps. sry about the slow postings, it has been a very hectic few weeks.

Shenguan Holdings Group (tkr: 829 HK)

I'll keep this short.  Shenguan Holdings Group is a collagen sausage casing manufacturer listed in Hong Kong with a market cap of c.US$2.2 billion.

I did not realize this, but apparently sausage casing manufacturing is a fantastic business in China (sarcasm intended).  Shenguan's topline grew at 45% in 2010 with an operating income margins of 58% (I double checked this).  Even if I believe in the topline growth, I can name less than a handful of businesses in the world with margins in that region.  Certainly not a sausage casing manufacturer.

Sorry, I just don't buy it.  Fraud.

List of Chinese (offshore) High Yield Bond Issuers

Below is a fairly complete list of Chinese high yield bond issuers - most of them have publicly listed equities. Once again, Chinese high yield issuers have a tendency to be fraudulent (as I explained here and here). Not all of them are fraudulent (CITIC Pacific is probably 'ok' given their state-owned affiliation), but there is a long history of blow-ups and acknowledged frauds, such as Sino-Forest, China Forestry, Asia Aluminum, Chaoda Modern, Evergrande, etc.

Investors are forewarned.

China Offshore High Yield List:
-----------------------------------------
Agile Property
Central China Real Estate
Chaoda Modern
China Fisheries
China Forestry
China Lumena New Materials
China Oriental
China Property
China SCE
China South City
CITIC Pacific
CITIC Resources
Coastal Greenland
Country Garden
Evergrande Real Estate
Fosun Int'l
Franshion Properties
Fufeng Group
Giti Tire
Glorious Property
Greentown China
Guangzhou R&F
Hidili Industry
Hopson Development
Kaisa Group
KWG Property
Lai Fung
LDK Solar
Liansu Group
Longfor Properties
Lonkin Holdings
Melco Gaming
MIE Holdings
Neo China
Pacnet
Powerlong
Renhe Commercial
Road King
Shanghai Zendai
Shanshui Cement
Shimao Property
Sino-Forest
Sino-Ocean Land
SPG Land
SRE Group
Texhong Textile
Titan Petrochem
West China Cement
Winsway Coking
Yanlord Land
Yuzhou Properties

FT - Investors warned of Chinese bond risks

"...taking equity risk for a bond return", says Tom Jones regarding China bonds (read here).  How very true indeed.

The structural seniority of bonds (versus equity) is the primary reason bonds are safer than equity, and therefore, bond investors demand less return (duh...).  However, as (1) bond holders are generally unable to enforce in China and (2) fraudulent Chinese companies are drawn to the offshore high yield market (adverse selection as I pointed out here), this means the recovery rate of defaulted offshore high yield bonds is almost always zero (as in the case of Asia Aluminum and Ferrochina).

Basically, in the event of default, the downside of a bond is the same as equity (ie. zero - you lose all), whereas the upside is far less for the bond holder (upside on debt is always capped).  That makes Chinese offshore bonds an (almost) uninvestable asset class in my book.

Final word - investors are always lured in by the high cash coupon of a Chinese bond.  Don't be fooled! That coupon is illusory and the cash coupon is simply a 'cheap' way for the truly fraudulent company to lure in capital.

Piracy in China - Fake Apple Stores

This just takes it to a whole new level.  An article (read here) by BirdAbroad on fake Apple stores in Kunming, China.

Really forces you to think hard about the lack of respect for rules, the law and ethics in China.

Moody's analyzes Chinese companies for 'red flags'

A little late, but hopefully not too late.  Moody's comes up with report (article here) looking for 'red flags' amongst China bond issuers.  Companies named in the report include West China Cement, Winsway Coking Coal, China Lumena, etc.

I've always thought China high yield issuers seem to be particularly prone to accounting fraud.  There seems to be adverse selection going on.  It is not completely clear why this is the case, but I think it is a combination of:

• A need for fraudulent companies to tap the capital markets and/or borrow frequently due to its negative free cashflow and a need to sustain the ponzi scheme (after all, the whole point is to defraud the capital markets and siphon off cash).  
• Local Chinese banks are unwilling to lend to the company - in some cases, the local banks are probably suspicious of the company (it may also be unwise for a fraudulent company to defraud a state-owned bank).  The company has to resort to more unsuspecting overseas investors.
• High yield (overseas) buyers generally have larger risk appetite for leverage and 'hair' around companies (the attractive 'China story' doesn't hurt).  In return, they seek higher coupon/returns.  But the high coupon/cost never deters the truly fraudulent company, it is a 'cheap' way to keep up a facade and continue to siphon money
• Chinese high yield issuers are generally required to be restructured offshore, which takes the creditors further away from the assets (from a security structure standpoint).  And in the case of a default (or if the fraud is exposed), it is generally very hard to enforce in China when you are an offshore creditor.

Some Chinese high yield issuers that come to mind are: Sino-forest, GOME, China Fisheries, China Forestry, and a list of Chinese real estate companies.  Some are clearly fraudulent (like Sino-forest and China Forestry), others are simply full of 'red flags'.

China Zhongwang Holdings (tkr: 1333 HK)

Here is a good little summary (link: here) from South China Morning Post on the issues surrounding China Zhongwang, an aluminum extrusion company in China.  The company was *suspect* almost immediately out of its IPO gate.  For readers without access to SCMP, the issues include:

1. The company listed in May 2009.  Four months later, in September 2009, allegations emerged that the top 10 customers listed in their prospectus did not buy from the company in 2008 (or as I remember, far less)
2. Subsequently, the company hired Ernst & Young to look into these issues, but E&Y never completed its review (I wonder why...)
3. The company claimed to have produced and exported c.US$880million of aluminum extruded products  to the US in 2009.  However, US customs show that only US$514million of aluminum extruded product was imported from China in 2009
4. Third profit warning of the year (first two profit warnings in January and March)

wow...

I think a key point SCMP didn't mention is the margins of China Zhongwang stood at 38% (2010 operating income margin).  Aluminum extrusion is a simple and highly competitive business.  How is a simple commodity business capable of producing these eye-popping margins?  Understanding whether the business model and economics really make sense is one of the better ways of detecting fraud in China.  Numbers are deceiving, particularly in China.

This company is classic.

Nine Dragons (tkr: 2689 HK) - Puzzling Depreciation

Have you wondered why many capex intensive (commodity) industries in China seem to have far better income margins than their U.S. and European peers?

Part of the issue seems to lie in a puzzlingly low (under) depreciation phenomenon (putting aside companies with blatantly fraudulent accounting).  Take a quick look at Nine Dragons (tkr: 2689 HK), the largest corrugated packaging company in China.  Without getting into too much accounting details, depreciation is basically a way to recognize the gradual decrease of economic value of PP&E over its useful life.  PP&E is recorded at historical cost, but what is a sensible estimate of useful life of plants and equipment for the containerboard industry?  Let's compare Nine Dragons, side-by-side, with Smurfit Kappa and Rock-Tenn (also the largest in their respective regions):

I think you get the gist (sorry the table is blurry).  A large part of a paper company's PP&E is simply plant and machinery - it is a bit of a stretch to depreciate it over 25 years (especially machinery).  And while Smurfit Kappa and Rock-Tenn has older assets, they've done a pretty good job maintaining them and ensuring competitiveness.

I seem to see a lot of this under-depreciation phenomenon with many capex intensive commodity businesses in China (less so with SOEs).  I guess it is an easy way to boost earnings.  It would be interesting to see what happens to Nine Dragons' earnings if and when it goes back to a more reasonable depreciation schedule.