Blessed by the Potato

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.