Blessed by the Potato

On Friday, I was pretty upset with Sino-Forest: their release was somewhat weak, engaging in ad hominem attacks rather than reassuring me. They had two good points, but if the sale of standing timber was a fictional trade to a related party, it didn’t much matter whether it was standing timber or cut. Most importantly to my mind, was that they were late. They promised investors to have a release before market open (i.e., 9am or earlier), and didn’t get it out until 10:30. I am very understanding of lateness in preparing documents, particularly long ones that tell the tale of your research program for the previous 5 years (ah-hem), but this was a two-page press release with not that much substance. I have to admit that my expectations were raised a bit by the lateness: perhaps they were waiting for the bank to open so they could drag an auditor down there to prove the cash was still in place?

Anyhow, as you read in the last post, I sold until I could get a better handle on what the truth of the matter was.

On the one hand, back-of-the-envelope calculations about harvesting a certain number of trees in a single year being impossible have been the kind of thing Muddy Waters has excelled at in previous cases. If that was what lead them down the rabbit hole in the first place, then the clarification that it was a standing timber sale helps. Honestly, I can’t sort through the almost entirely Chinese documents alleging that the transactions were with related entities and/or shams. That doesn’t give me much confidence in Sino-Forest, but also makes me wonder how strong MW’s case is then.

However, it makes me think that if there is a case that MW is going to get wrong, it’s this one. Many people are calling for proof of ownership of the trees to disprove the allegations. That would indeed be strong proof, and it was frightening that the BMO analyst said it was asked for previously and not provided. I’m willing to grant to the company that there may be a good reason for that. How do you prove ownership of hundreds of thousands of hecatres? Start pulling out all the deeds? A hundred separate Chinese-language contracts to plow through? That would be the best evidence, but it would likely take too long.

I really just want to see the cash.

Frauds exist to siphon shareholder money out of the suckers’ hands and into those in on the deal. It’s possible to do this with money in the company accounts, and just engage in some back-and-forth phantom transactions with related parties to inflate the share value, then sell your shares, but that’s a lot of work compared to just taking money that’s in the bank. Proving the money is there wouldn’t be strong proof that the company is real, but it would be quick, and I think it would be enough for me to buy back in (and risk losing more).

The company put out a release this morning (before market open this time):

Cash on hand
As at December 31, 2010, the Company had approximately US$1.26 billion in cash, cash equivalents and short term deposits as reported in the audited consolidated balance sheet. As at March 31, 2011, the comparable amount was US$1.09 billion. The sources and uses of cash for the period ending March 31, 2011 will be further detailed in our quarterly report for the period ending March 31, 2011 expected to be issued on June 14, 2011.

Sino-Forest has released today on its website a summary schedule of cash and cash equivalent and short term deposits along with a detailed listing with copies of its bank statements confirming the cash held within the Company as at that date. The Company has conducted business in the ordinary course since then and made ordinary course expenditures, and its cash remains intact with the majority of it in banks in Hong Kong.

Ok, here we go, that’s a little better. Now, we learned in previous RTOs that it’s not enough to just look at the company’s copy of the bank statements: you need someone to go down to the bank and verify that the money is indeed in the accounts as indicated. Unfortunately, the documents are behind a registration wall on their website, and you have to email to get a login, which may take up to 12 hours to receive.

Seriously? These guys are just shooting themselves in the foot with that one.

Updates:

TD has finally updated its report.

While many allegations in the Muddy Waters report demonstrate a fundamental misunderstanding of Sino-Forest’s business model, others are material and are impossible for us to refute or verify at this time. We appreciate the time constraints involved, but we hoped for a more comprehensive response from management on Friday.

That’s well said, IMHO. I still don’t think I have the information I need to make an informed speculation here and buy back in, as much as I want to believe the company. Today’s release was better, but saying the bank statements are on the website, locked up behind a registration wall I’m still on the wrong side of at the moment, doesn’t bring me any joy. Any Hong Kong bank executives amongst our readership, by chance? Is the money there?

Oh, and I meant to mention insider trading on Friday but didn’t get around to it. There was a lot of insider selling in TRE back around December 2010. That was somewhat worrisome, but I brushed it off when buying, in part because the selling was at a much higher price. The VP finance exercised some options and immediately sold the shares (he apparently doesn’t believe in owning the company he works for). The CFO exercised options and sold twice as many shares (cutting his ownership way down). The CEO sold a large dollar-amount of shares, but only about 11% of his holdings.

From the Bronte Capital client letter (John Hempton is much better at identifying frauds than MW):

Chinese frauds are the richest vein of non-market correlated profit Bronte has ever discovered. When we started, John could read the accounts of a reverse-takeover stock and within twenty minutes determine it was a fraud. Complex analysis was not necessary. We got short dozens of different companies and almost everything we touched we made money on. […] In some cases we found fraud in under five minutes. We simply could not understand why anyone held these stocks – but alas major mutual fund groups and sometimes even sophisticated hedge funds held the stocks. We made good money on stocks we shorted after five minutes analysis (determining that there was fraud) and by the time the stocks collapsed 80 plus percent we had forgotten what it was that made us convinced it was fraudulent. We just had the stocks marked as frauds, shorted them and forgot about them. […]
Alas the major frauds taking five minutes to detect are gone. Almost all of those stocks have collapsed. There are one or two small positions remaining – but the gig is up.
There are still plenty of frauds in China – however it is no longer like fishing with dynamite. Precise analysis is required to pick the right stocks to short. Longtop took an intense week of work. The ones we are doing now will require two weeks. We will do the analysis – and many of the weeks will be wasted because we will work and not be able to prove fraud.
It is likely we will actually buy some of the companies we can’t find fraud in. After all people are shorting without doing our level of analysis – and those people will buy back on similarly thin analysis. Some the stocks could be a wild ride both for the shorts and for the longs.

That suggests to me there will be no easy answers with Sino-Forest.

Oh, and the stock opened at ~$8 this morning, so I do look quite the fool for bailing on Friday. Ah well, I had to work with the information I had.

Update 2: I just got my login for the Sino-Forest web page data dump. Lots of realistic-looking scanned-in bank statements. But if this is a convincing piece of performance art, the statements are not that hard to fake. How do we know that there’s actual cash in a bank somewhere to back it up? Still, better. Though this should have been out on Friday. I want to be fairly certain down in my gut if I buy back in that I’m right and the shorts are wrong, and then go in with authority (because it’s an opportunity, not to try to chase losses). But I’m not there yet, so no position at this point.

Update 3: An interesting article in the Globe about the other reasons some people were short, prior to the MW report. Some of these were concerns I had thought of before buying, some didn’t really even cross my mind.

Sino-Forest (TRE on the TSX) is, ostensibly, a forestry company in China. I say ostensibly because yesterday research firm Muddy Waters released a scathing report claiming the company is a massive fraud, and has been from the get-go.

I’ve been following the stories on Chinese reverse-takeover frauds for some time, and have been admiring the work of Muddy Waters, etc. So I’m not about to try to dismiss what they’re alleging out of hand, or attack the source.

I had the poor judgment (and luck, but I shouldn’t try to dismiss my failures as bad luck) to get into this just a few days ago. Sino-forest has long been a top pick of the analysts at TD. Indeed, if you can believe the numbers in the company’s reports, it was quite attractively valued. Of course, the key is whether those numbers can be believed. I had been avoiding investing in part because I was concerned about the fraud issue, and wasn’t sure how to settle the issue: I was hardly going to jump a plane to China to check on forest holdings myself.

I had some weak evidence (in hindsight, extremely weak) that Sino-forest might be different:

• All other RTO frauds to date were American, Sino-forest is Canadian.
• The other RTO frauds came public in the mid-2000’s, a time period where fraud (e.g.: mortgage fraud) seemed a little more prevalent. Also, that only gave them a limited amount of time to fly under the radar. Sino-forest has been operating since 1995 (though Google Finance only has a chart going back to 1999).
• The other RTOs were small companies, with a max market cap of about $250M. Before yesterday’s sell-off, Sino-forest had a $5B market cap.
• The other frauds, being smaller companies, were poorly followed by analysts. Sino-forest was well followed (by TD, whose reports I have access to, as well as 8 other analysts).
• A warning sign in the other cases was often a high turnover rate in auditors. Sino-forest has has the same auditor for years.

But that still wasn’t enough for me to invest. TD kept coming out with these glowing reports, and I have to admit, I wanted to believe. I knew I likely wasn’t going to have certainty on the matter — you don’t get paid when there’s no risk — but I wasn’t sure what evidence I’d need to tilt the odds in my favour. TD’s analyst Sean Steuart had nice things to say:

Presentations from management and the board highlighted Sino-Forest’s “culture of accountability” and strove to differentiate the company from others with operations in China that have encountered recent accounting and governance problems. […] We attribute a portion of recent share price weakness to investors’ concerns that Sino-Forest could be susceptible to accounting irregularities that have undermined other equities with operations in China. Management and the board highlighted the company’s long-standing relationships with reputable auditors (Ernst & Young for the past eight years), consultants (Pöyry for the past eight years), and lawyers (Jingtang & Gongcheng review legal title to forest assets). We also note that the company has added two independent directors over the past year, bringing additional accounting (ex. E&Y partner) and capital markets experience.
The audit committee is comprised only of independent directors. While we would welcome improved quarter-to-quarter disclosure, we are comfortable with the company’s controls/governance.

This started to calm me down, perhaps too much. I tried to think of what I’d look for if I was looking to show it was a fraud. Nothing in the financial statements seemed overly fishy. They did have a 3rd party consultant (Poyry) check their forestry holdings, to audit for things like estimated yield and valuation. Though in the wake of the subprime mess investors shouldn’t put much value on credit ratings, they did have debt that carried investment-grade ratings — many other RTO frauds were debt-free (perhaps in part because debt investors are often more credulous than us equity freaks). Then I thought to check the board of directors, see if any of them were involved in scandalous activity before, or had no history at all. Not being an investigator or someone who speaks Chinese, I didn’t get very far… until I found a familiar name. An old acquaintance was on the board, someone with auditing experience. I hate to say that on that flimsy piece of evidence I bought in, but that was what finally made me think that perhaps the odds were good it was legit — surely old so-and-so wouldn’t be on the board of a fraud!

So now Muddy Waters comes out and basically ruins my whole day. The stock was down 21% before being suspended. It might go straight to basically zero when trading does resume, if it does. They’ve blown holes in many of the planks above: apparently Poyry doesn’t audit the ownership of the land that Sino-Forest claims to own. They just go and say “yes, there is a forest here, and the size and density of the trees would support a 90 m³/ha yield” type thing. Muddy Waters isn’t saying the trees aren’t there, they’re saying Sino-Forest doesn’t own them, and can’t be harvesting at the rate they are.

The claims here aren’t quite as outrageous or obvious as with some of the other RTO’s that have been debunked: there’s no missing website, or empty classroom, or underfed Adonis. Instead it comes down to hard-to-audit agreements for forestry rights. From what I was reading, it appears as though there are some agreements, but they’re not with the parties we were lead to believe they were, and they’re not for nearly as much standing forest as we were lead to believe, either. So I briefly held onto the hope last night that it’s more likely that this is the time Muddy Waters will be wrong.

Unfortunately, the company hasn’t responded yet. It’s less than an hour to the market open as I post this, and still nothing. That’s not good. Not good at all.

And of course if Sino-Forest can be a sham, then really just about anything can be. Migao was down 16% yesterday, and if I owned it, I’d be jumping ship as well.

Updates:

I’m sure this one will have lots of updates to come.
8:45am: A quick bit at the Globe reports that was asked just days ago to provide proof of ownership for its Chinese timberlands but declined, according to BMO Nesbitt Burns analyst Stephen Atkinson. […]”At the analysts’ presentation after the annual general meeting on May 31, 2011, proof of ownership (Forest Certificates) was requested but the Chairman and CEO, Allan Chan, did not want to release this information for competitive reasons,” Mr. Atkinson said in his note.” Wow. Why didn’t that make the analyst reports before the fraud allegations?

I’m also reading some other articles on it this morning, and one other point I forgot to mention above that lulled me into complacency is that it wasn’t too good to be true in all respects: it did miss earnings expectations from time-to-time, rather than continuing to rocket higher without a hitch, which is often a hallmark of fraud.

9:45am: The company said to Bloomberg that it would report before the market open today. Well, the market’s been open for a few minutes now, and still no report, and trading is still halted. If they can’t come out and just shoot from the hip, saying with confidence they they’re not a giant fraud, or in ~18 hours refute at least one point in the Muddy Waters report, well, that’s very bad. I wasn’t sure what to believe, as you could maybe tell above, but the silence from the company is damning.

10:45am: The company finally put out a release, including something hopeful:

David Horsley, Senior Vice President and CFO of Sino-Forest commented: “I am confident that the independent committee’s examination will find these allegations to be demonstrably wrong, as for example:

(a) Muddy Waters fundamentally misunderstands and misrepresents the most basic items in our published Management’s Discussion & Analysis with respect to revenue generated from Yunnan Province, which we report as being approximately 45.5% of the Company’s standing timber revenue of approximately US$508 million. Muddy Waters alleges that it is impossible that such revenue existed because achieving such levels would greatly exceed allowable cutting quotas and it would be impossible to truck close to that volume in the period. However, that revenue was very clearly disclosed in our MD&A filed for Q1 and Q2 of 2010 as revenue resulting from the sale of the standing timber – there is no cutting or transport involved, as the trees were sold but not harvested and therefore are not considered part of the quota for the region until the harvesting is conducted by the buyers.

Trading will resume today at 11:15. Now I have to decide if I’ll cling to the weak hope in that release (I’d have felt better if they had more than just two points to pick apart), or just dump.