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 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.

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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.

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

China Mobile (tkr: 941 HK) - Establishment of China Mobile Finance Company

Are Chinese banks and local governments still solvent?  Recent actions by China Mobile seem to carry an ominous answer.

China Mobile announced the setting up of China Mobile Finance, whose primary business is in the "provision of financial management services" (read here for full announcement).  The details are very intriguing:

• China Mobile will be contributing RMB4,600million in capital with CMCC (China Mobile's parent company) contributing RMB400million for a total of RMB5,000million in capital.
• Of the scope of businesses (ten listed out with a catch all "other businesses as approved by CBRC"), what caught my attention were: (1) provision of guarantees, (2) trust loan and trust investment services, and (3) inter-bank lending business.
• Rationale of the transaction: "to find a solution to further strengthen the internal funds management and better control liquidity risks, and to fully and better leverage the advantages on capital resources to improve the overall economic benefits of the Group" and "build a scientific and efficient funds management platform, strengthen the centralized management on internal
  funds and optimize the allocation of resources.  It is also expected that China Mobile Finance
  will be able to improve the cash flow position of the Group, control liquidity risks, reduce
  finance costs, increase capital efficiency and provide financial management services."
• Connected transaction not subject to independent shareholders' approval and entered into after arm’s length negotiation between China Mobile and CMCC

Putting aside the corporate governance implications (whether this is "arm's length" or not), here is my interpretation:

• The rationale does NOT make sense.  China Mobile has no business in financial services.  This does not "strengthen internal funds management", "control liquidity risks", or "reduce finance cost".  The whole statement is ludicrous.  The only truth is the last four words, which is: "to provide financial services".  Plain and simple, it has nothing to do with mobile communications.
• Given all the recent reports about excessive local government debt (here), regulation/clamp down of trust loans (here) and bad debt at Chinese banks (here), there has been much talk about a central government bailout of local government and banks.  Therefore it is particularly intriguing to see China Mobile Finance's scope of business include "inter-bank lending" (provide liquidity to banks?), "provision of guarantees" (guarantee local government debt?) and "trust loans and trust investment services" (provide liquidity to... whoever).
• Here is the key: The bureaucrats at China Mobile could not have come up with this, it is too far from their mandate and has too many political implications.  The decision to setup China Mobile Finance came straight from the top - Beijing / central government.  Liquidity constraint in the system has reached a breaking point and Beijing is acting!

What I don't understand is why use China Mobile as the financing vehicle?  Using a Hong Kong listed company makes the process cumbersome (regulatory scrutiny).  There ought to be an easier way of doing this.

In any case, this strikes me as a tip-off of things to come.

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

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.

Chaoda Modern Agriculture (ticker: 682 HK)

This is an embarrassment to the Hong Kong stock market.  Chaoda Modern Agriculture and China Green (ticker: 904 HK) are two of the largest listed vegetable farming and distribution companies in Hong Kong.  They are also two widely publicized and commonly acknowledged frauds in Hong Kong, yet it is still listed with a market cap of HK$11.1bn and HK$4.5bn respectively.

I won't spend much time writing this up as it is well publicized and understood.  In the case of Chaoda -

Margins.  In an industry known to be notoriously cyclical and low margin, this company has an EBITDA margins of 60% and has consistently grown at 20-30% p.a. since listing without missing a beat.  It appears be never subject to price or cost fluctuations.  If farming was that lucrative, why would farmers migrate to the cities in China?  Urbanization should be "ruralization".

Auditors. The number of changes in auditors ought to raise some serious questions.  The company was jointly audited by PWC and CCIF when it first came to the market in 2000.  PWC dropped off, with CCIF as sole for the 2002/3 audit. They added Baker Tilly for the 2004/5 audit, but dropped both Baker Tilly and CCIF for their 2006/7 audit.  They are currently audited by Grant Thornton.  The turnover of auditors should ring some alarm bells.  Any listed business that want to be taken seriously should stick to using a Big Four auditor ...unless they can't (to be clear, using a Big Four doesn't eliminate accounting fraud risk, but that is a story for another time).

Asset Size/Quality.  There have been many reports on Chaoda vastly overstating their asset size.  According to this Next Media report (source, in Chinese), a site visit of a 5,000 mu farmland in Beijing revealed it was actually only 1,000 mu.  There are other allegations in the report which you may read for yourself (in Chinese though).

Balance Sheet.  As a former high yield/distressed investor, I find it interesting that Chaoda has tapped the high yield/convertible bond market several times in the past, despite having a ton of cash on its balance sheet.  It recently raised US$150mm in convertible bond, despite having over US$300mm (RMB2,044mm based on its 2009/10 annual report) of cash on its balance sheet.  Does that make sense? Unless the cash... (reminds me of Sino-Forest, Longtop, China Mediaexpress...)

Long list of other red flags, but I will stop here.

One thing I've noticed is if one of the leaders in a sector (particularly the first company to list) is fraudulent, it is very likely the whole sector is fraudulent .  This seems to be the case in the agriculture sector (Chaoda leading, followed by China Green), forestry sector (Sino Forest, followed by several smaller guys), milk/infant formula and aluminum extrusion sectors (I'll write it up some other time) .  My guess is it is harder to be fraudulent in an established sector if the incumbent produces honest/accurate figures (people will always benchmark to the leader and ask questions).  Put differently, it is easier to produce fraudulent accounts if the company is first to come to the market in the sector (no established benchmarks to compare to) or if listed incumbents are already committing accounting fraud.

China Modern Agriculture has been listed for over 11 years (China Green for 7 years) and has been a known fraud for many years now.  Please do something about this, Mr. Charles Li...

Tibet 5100 (ticker: 1115 HK)

Tibet 5100 is a bottled water company that sources water from Tibet (5100 meters above sea level), bottles it and sells it as a premium bottled water.  Pretty simple business.  The company IPO'd in Hong Kong on 30th June, up 23% on the first day with a market cap of US$1.2bn or HK$9.2bn.  After taking a quick flip through the prospectus, here are some initial thoughts -

Company structure/history:  The history and corporate structure section in the prospectus was a colorful read.  Some notes: (1) the founders of the company, Mr. Wang and Mr. Yu, needed to increase registered capital by US$12.8mm in 2004.  The founders didn't have the cash, but found Sichuan Hengsheng to inject the capital in September 2004 for 91% of equity.  Eight months later, in June 2005, the founders found US$12.8mm to buyback the shares from Sichuan Hengsheng.  Odd. (2) then in 2005, the company faced significant uncertainties (shortly after the founders have put in US$12.8mm?), and Mr. Wang decided to place his entire shareholdings with a Ms. Zhou (a trusted friend Mr. Wang has known since 1987?) in June 2005 in a trust arrangement.  Who is Ms. Zhou and how does this solve the "significant uncertainties"?  Bizarre. (3) in April 2009, Wilmar acquired a 25% stake for RMB175mm, but sold the shares back to the company a year later in April 2010.  The company cited a divergence in business strategies between Wilmar and themselves.  How could the strategy be that much different after only one year? (4) by middle of 2010, the company began discussions with several pre-IPO investors, a "second put option" was granted to the pre-IPO investors which allows them to put their investment back to the company if the company does not make HK$350mm in profit after tax for the year 2011.  This is contentious, but I am always skeptical of a company willing and able to provide a profit guarantee (especially a profit projection that is multiples higher then what they've historically achieved).  That's just not how a real business is run.

Short history with unbelievable margins:  The company started its first production line in 2006 and within 4 years is ranked first by volume (beating out Danone and Nestle) in China's premium bottled water segment with a net income margin of 32% with almost no marketing expenditure.  Is it that easy to build a branded consumer products company and become the leader in 4 years time?  I doubt it, not in a highly competitive market like China.  Unless...

Relationship with Ministry of Railways ("MOR"): 80.5% of revenue (and growing) comes from a lucrative contract with CRE (procurement agent of MOR) to supply bottled water on trains in China.  As a reminder, former minister for the MOR, Liu Zhijun, was dismissed recently for accepting a large amount of bribes in connection with various railway procurement contracts.  While the company states it has no relationship with Liu Zhijun, as part of the risk factor, it states that recent investigations on Liu Zhijun could have a negative effect on their relationship with CRE and the contract with CRE may not continue in the future.

US$1.2bn market cap in 4 years out of water (they pay RMB9,500/year for the rights to the water) with an equity investment of US$14mm.  Is creating a business that easy in China?