[Editor's note June 3 2011: See this subsequent post on FT Tilt for how Sino-Forest responded to the allegations - including describing Muddy Waters as "shock jocks"]
Muddy Waters Research, a specialist in Chinese companies, on Thursday issued a blockbuster “strong sell” rating on Toronto-listed Sino-Forest Corporation, a self-described “commercial forest plantation operator in China”.
But this was no ordinary “sell” rating: Muddy Waters both initiated coverage on the forestry company, which listed in Canada via a reverse takeover in 1995, and accused it of a “stratospheric” fraud.
In response, the Toronto market authorities suspended trading in Sino-Forest stock -- trading symbol TRE.TO -- pending a clarification or two.
The research house, which has a short position in the stock, was certainly not modest about what it took to disclose the alleged fraud.
According to its 39-page research report:
Were Muddy Waters not to have come along, it is likely that this fraud could have continued for a few more years and billions of dollars more.
The thinnest of silver linings for Paulson & Co, then, since the New York-based hedge fund, known for its wildly profitable bets against the US housing market, is listed as owning by proxy 14.13 per cent of Sino-Forest’s outstanding shares, making it the largest holder.
Bloomberg data show several other well-known funds and managers are exposed to the stock, typically via holdings of ETFs in which Sino-Forest is included. Among these: Hartford Investment Management (3.2 per cent), Blackrock, Vanguard and Henderson Global.
Here’s Muddy Waters again:
We are confident that we have brought more expertise, time, and money to bear in analyzing TRE than has any investor or bank – by a substantial margin.
(That’s just showing off)
The report examines Sino-Forest's money trail, and includes extensive on-the-ground analysis. The company is alleged to have “massively exaggerated” its assets, created non-existent “artificial intermediaries” to hide its real revenues, and, in a coup de grace, used forestry consultants Poyry to sign off its valuations.
Muddy Waters says that Sino-Forest claims to have acquired a total of $2.9bn in standing timber since 2006. But there is “smoking gun evidence” that the company has overestimated its timber stock in Yunnan province by "at least $800m,” according to the research house.
Furthermore, of five Sino-Forest agents supposedly based in Yunnan, only one is real and legitimate, Muddy Waters alleged.
The foundation of what Muddy Waters called Sino-Forest's “ponzi scheme” are the intermediaries supposedly used to artificially book revenues from deliveries that were never made, claims the research house.
These “artificial intermediaries” (AIs) were ostensibly created to pay VAT and income taxes on behalf of Sino-Forest. But this doesn’t make sense, say the analysts, as this would have got the AIs into “serious legal trouble”. Muddy Waters adds:
The sole purpose of this structure is to fabricate sales transactions while having an excuse for not having the VAT invoices that are the mainstay of China audit work.
Or in graphical form:
Source: Muddy Waters
Such a structure allowed Sino-Forest to claim there could be 50,000 truckloads of timber rattling through Yunnan’s dirt roads, Muddy Waters claimed:
It exceeds the applicable harvesting quotas by six times. Transporting the harvested logs would have required over 50,000 trucks driving on two-lane roads winding through the mountains from this remote region, which is far beyond belief (and likely road capacity).
Muddy Waters noted that the company used Pöyry, an international forestry consulting firm, to assess its asset valuations. Indeed, Pöyry did so as recently as May 27, claiming that Sino-Forest had added 50 per cent worth of wood fibre to its total timbre volume:
Pöyry estimated that Sino-Forest's total merchantable standing timber volume as at year end 2010 was 93.2 million cubic metres (m3), compared to 62.0 million m3 in 2009, representing a 50% increase in wood fibre. The volume increase was attributable primarily to the substantially increased tree area acquired during the year.
This estimate should be treated with extreme caution, according to Muddy Waters. The research house alleged that Sino-Forest “feeds the fraudulent data to Pöyry, while allowing Pöyry access to only 0.3% of its purported timber holdings.”
In other words, according to Muddy Waters, Pöyry literally weren’t able to see the wood for the trees.
Pöyry’s (Beijing) Consulting Co
Here’s what Pöyry’s Shanghai branch had to say in a press release that hit the wires on May 27:
Sino-Forest had approximately 788,700 hectares ("ha") of forest plantations under management in China as at December 31, 2010, which includes approximately 147,200 ha of Mandra forest assets acquired in February 2010. However, the total net stock area valued by Pöyry was 754,816 ha, after excluding 33,884 ha that were recently harvested, located on land leased pending planting season, or land allocated for bio-fuel, carbon credit development and other purposes.
And here’s Muddy Waters’ take:
TRE touts the valuation reports as evidence of its credibility. One fresh example occurred at TRE’s annual general meeting on May 30, 2011. At the meeting, CFO David Horsley emphasized to the shareholders in attendance that Poyry teams spend “six personal weeks” in the field for the valuations. On a June 1, 2011 telephone call with analysts to discuss the Poyry report, Poyry clarified that four men spent six days in the field, which the Company calculates is approximately six man-weeks.
Fortunately, it appears that in 2011 Poyry is becoming somewhat cautious about TRE using its name to bilk investors out of billions of dollars, and it has accordingly restricted how TRE may use the report.
Sino-Forestry hosted a conference call with Pöyry on June 2 at 9am Hong Kong time, according to a press release issued on May 31.
Live webcast and replay of the conference call http://www.newswire.ca/en/webcast/viewEvent.cgi?eventID=3553220
On that call, representatives of Pöyry were at pains to stress that their work did not include verification of ownership, and that they "relied on information provided by the client...it's not a due diligence."
(You can hear that quote at around the 34 minute mark, in response to a question from Ezra Gardner at Omnium Capital Management)
What about the board?
Muddy Waters did not mince words in its allegations about Sino-Forest's board and advisors:
A favorite trick of Chinese RTO frauds is to gain credibility by putting Westerners without Chinese skills or background into management or onto the board. TRE probably pioneered the practice.
According to Bloomberg data, Sino-Forest’s board includes Simon Murray -- better known as the newly-appointed chairman of Glencore. Murray could not, at pixel time, be reached for comment.
There is no evidence or suggestion that Murray was involved in or aware of any of the allegedly fraudulent activity.
The question of the auditors
The role of the Big Four auditors in the growing scandal of fraudulent and allegedly fraudulent Chinese companies is one that is coming under increasing scrutiny.
This is not going to help:
For most of its time as a public company, TRE’s auditors have been Ernst & Young out of Canada
Ernst & Young’s Canada office had not, at pixel time, made any of the team responsible for Sino-Forestry available for comment.
[UPDATE AT 17:45 ET] Ernst & Young sent us the following via email:
Due to confidentiality obligations, we cannot respond to inquiries about our clients. For further information, we recommend you reach out to Sino-Forest directly.
Whither the rating agencies?
On May 9 2011, Fitch affirmed Sino-Forest at BB+. Here are extracts from what Fitch had to say at the time (emphasis ours):
“The affirmation of Sino-Forest's ratings reflects the company's stable business profile underpinned by a solid plantation asset base, adequate corporate liquidity, and sound credit metrics," says Ms. Ying Wang, Director in Fitch's Asia-Pacific corporates team.
...Sino-Forest has maintained a proven track record in expanding commercial plantations through acquisitions.
...Sino-Forest's ratings are further backed by favourable industry dynamics driven by supportive government policies and the domestic wood-fibre supply shortage, as well as its management's solid experience in forestry management with strong business and government relationships in China.
...Sino-Forest has maintained comfortable financial flexibility and healthy liquidity despite being a net acquirer of assets.
“An undervalued stock” (or, timing is everything)
On Wednesday, Canada’s Globe & Mail quoted Daryl Swetlishoff, head of research and forest products analyst at Raymond James, describing the forestry company thusly:
...an undervalued stock poised to capitalize on burgeoning Asian wood fibre demand and pricing...
Swetlishoff, who was according to the Globe & Mail “ranked by StarMine this year as one of Canada’s top stock pickers”, rated Sino-Forest a “strong buy”.
TORONTO, June 2, 2011 /CNW/ - The following issues have been halted by Investment Industry Regulatory Organization of Canada(IIROC):
Issuer Name: Sino-Forest Corporation
TSX Ticker Symbol: TRE
Time of Halt: 13:19 ET
Reason for Halt: Pending Company Contact
By the time the shares were halted in Toronto, they'd fallen as much as 25 percent, stopping CAD $3.75 lower at CAD $14.46.
The company did not respond to calls and emails seeking comment. Emails sent to Louisa Wong, Sino-Forest's Hong Kong-based investor relations contact, were met with an out-of-office reply.
We tried to leave a message at the company's Mississauga office, but were foiled by a full voicemail box.
[UPDATE 17:48 ET] FT Alphaville commenter 'mistere' pointed out the company's OTC US shares continued to trade:
LAST $7.33 USD CHANGE TODAY -11.31 -60.68% VOLUME 12.6M
Full coverage on SEC crackdown on US-listed Chinese cos - FT Tilt
Deloitte's lessons in auditing Chinese cos - FT Tilt
The Six Rules of China Due Diligence - Muddy Waters