Shedding some light on the Sino-Forest

Posted by John McDermott on Jun 24 20:40.

We bet Paulson & CO. wishes it had this research before it bought shares in Sino-Forest.

On Wednesday, Tom Szabo and David Zurbuchen from Augment Partners, a research firm that normally focusses on metals and mining stocks, published the first part of a report on Sino-Forest Corporation (TRE).

It’s long, detailed and helpful. And it may be the reason why TRE has rallied a bit since its publication.

In case you’re wondering who these metal-turned-wood analysts are, they include an explanation in the report, which they confirmed via email. They have a background in the resources sector, and saw the opportunity to add value (and get some publicity) by crunching the numbers on Sino-Forest. One of them owns a “small” position in Sino-Forest “acquired post-Muddy Waters but prior to the completion of our preliminary desk review”

Here’s their top line:

Our overall conclusion based on our review is that Sino-Forest is probably a legitimate company with a significant economic presence in the forestry and timber sectors in China. In our opinion, however, the company does not deserve anywhere near its pre-Muddy Waters valuation due to at least three critical unresolved issues that we have identified during our review.

For now we would summarize Mr. Block’s accusations as predominantly speculative with only two or three specific items deserving serious management and stakeholder attention, which we’ve noted and incorporated into our review.

In other words, it’s dodgy but not totally dodgy. And so is Muddy Waters, the purveyors of the Powell Doctrine of short-selling. This effort to strike some evidence-based balance is welcome and surely right, though there’s a lot of money to be made between the extremes.

In a worst-case scenario one or more of the critical issues could result in an eventual delisting of Sino-Forest shares from the Toronto Stock Exchange. The company might also collapse due to a complete loss of investor confidence. While there is no definitive proof at this point of a Ponzi scheme or fraud so massive that a Sino-Forest bankruptcy is a foregone conclusion, we must always consider the possibility and obviously more so in this case than most others.

For now, their best guess is a valuation about three times more than TRE’s share price at pixel time but about one-third of what it was worth before Muddy Waters arrived on the scene.

On the other hand, if everything that Muddy Waters characterizes as outright fraud turns out to have a legitimate-if-troubling explanation, Sino-Forest will probably survive this ordeal and the market valuation may eventually return to at least net book value. It is our belief that the odds favor such an outcome based on our review. On a conservative basis, we come up with a modified net book value of $6.40 per share as described in our disclaimer below, which appears to represent a significant opportunity for speculative returns under the circumstances.

We’ve read the report and since it’s nearly the weekend, you might have time on your hands, too. Rare for Sino-Forest analysis, it contains logic and plain English.

The area of the palaver FT Alphaville knows best is the dispute over whether and how Sino-Forest profits from its stated number of trees in Yunnan province. Central to this scuffle is a 2007 “Master Agreement”, a contract of sorts signed between a Sino-Forest subsidiary and a local agent. Sino-Forest says this gave them the rights — but not necessarily the land — to around 200,000 hectares in Yunnan. Muddy Waters says it’s bogus and proves Sino-Forest doesn’t have as many trees as it says it has.

Szabo and Zurbuchen have offered the best explanation that we’ve seen for what’s really going on. Sino-Forest and Muddy Waters are taking past each other, using nonsensical jargon.

What appears to have happened in Yunnan Province, and this could be the case in other provinces as well, is that Gengma Dai and Wa was initially in possession of both the rights to standing timber and forestland totaling about 13,000 hectares. Gengma Dai and Wa and Sino-Forest executed a “master” agreement over these rights with the expectation that Gengma Dai and Wa would become a regular purchasing agent and go out to area villages to obtain more timber and land pursuant to the agreement’s terms. Meanwhile, Sino-Forest sells the original 13,000 hectares of standing timber for harvest and, once the land is cleared, Gengma Dai and Wa transfers the forestland rights to Sino-Forest in the form of a long-term plantation lease.

Unfortunately, there was apparently a small problem along the way. Gengma Dai and Wa might have had trouble acquiring additional standing timber from farmers who were also willing to lease the underlying forestland as a plantation. Moreover, it probably also occurred to Gengma Dai and Wa that the master agreement reserved all the price upside to Sino-Forest while burdening the purchasing agent (Gengma Dai and Wa) and the original landholder (farmer or village collective) with all the price risk. So Gengma Dai and Wa may have rightfully balked, which then left Sino-Forest with the option to either terminate the agreement or else allow Gengma Dai and Wa to assign its “rights” (such as they were) to other purchasing agents in Yunnan. This may also have been the case for most, if not all, of the master agreements in other provinces. Notably, Gengma Dai and Wa’s own statement appears to support this version of events:

In other words, the master agreement in substance is not really a legal document at all but more like a bid sheet publicizing the framework pursuant to which purchasing agents can propose deals to Sino-Forest.

There’s a loooot more in the post but that taste test suggests it’s an important addition to the debate.

Here’s a summary of the rest of the findings:

Like so many other Chinese companies before it, Sino-Forest’s high profit margins and other remarkable financial achievements have became an open invitation for noteworthy allegations of fraud by the likes of Muddy Waters and its cohorts. The possibility of outright fraud cannot be fully dismissed but in the case of Sino-Forest there might be a compelling alternative explanation in the form of insufficient disclosures and opaque business practices that are masquerading as “trade secrets” and “competitive advantages”. A simple domestic business in China can thus seem like a believable miracle, even if only temporarily so:

Acquire some trees and call them a plantation even though only the harvesting right but no land has been obtained;

Sell standing timber as “logs” because your purchasing agent intends to secure the underlying forestland for you, regardless of the chance of success;

Play down planted tree metrics even though plantation management is your company’s future;

Avoid having knowledge about forestland acquisitions made by purchasing agents on your behalf so that the rights can be retained even if the deal was potentially dirty or illegal;

Enter into an unenforceable master agreement with a single purchasing agent pursuant to which an impossible number of hectares of trees and forestland are to be transferred to you;

When the first purchasing agent falters, look for other agents as substitutes or assignees even though the odds of delivering the ultimate prize, the forestland, are very low;

Always claim that the purchasing agent named in the master agreement is the only one through which all transactions in that province are processed;

Specify bulk pricing under the master agreement whereby all timber acquired is to be recorded at an average cost with the result being that profit margins are boosted when the mature trees are sold off;

Increase pace of timber acquisitions when mature timber has been depleted since otherwise high profit margins cannot be maintained;

Never mention that your previous strategic business model of buying young trees and managing them until harvest was a failure because China ran out of sellers; and

Gloss over the high profit margins earned in the past as a result of sheer luck — buying young trees when timber prices were low — thereby making it appear that the overall business can operate like a cash machine in perpetuity.

The responsibility for any critical business issues that may arise from the above set of circumstances rightfully belongs to Sino-Forest given its opacity punctuated by the cloak-and-dagger theatrics of its “secret agents”. At the same time, the investment community must shoulder some of the blame for failing to properly understand Sino-Forest’s business model. Had the analysts obtained a proper understanding beforehand, they could have asked the tough questions long ago and not left so much swimming room for Muddy Waters. We suggest Sino-Forest management immediately grab the educational initiative from us.

And if you’ve still not gotten your Sino-Forest fill for the weekend check out the Bronte Capital blog. John Hempton has dug around and had some fun with old Sino-Forest press releases. Turns out those Chinese “intermediaries” that couldn’t be named for “competitive reasons” were named once upon a time — and, erm, have since disappeared, according to Hempton.

Related links:
Sino-Forest on Twitter LIVE – Financial Post
Sino-Forest, a new line of defence… – FT Tilt
Sino-Forest coverage – FT Tilt
Sino-Forest coverage – FT Alphaville

This entry was posted by John McDermott on Friday, June 24th, 2011 at 20:40 and is filed under Capital markets, Commodities. Tagged with , , , .

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