Tuesday, June 14, 2011

Sino-Forest continues telling stories

As expected, the Q1 results of Sino-Forest showed the Company has kept growing fast. CEO and Chairman Allen Chan continued telling beautiful stories about the company's achievements and future, but the subsequent diving in its share price has indicated that many investors see these beautiful stories as mirage.

Before this morning, I saw a likely fraud. After listening to today's conference call, I see the writting on the wall: most standing timber transactions were fabricated.

Why? Two points probably suffice.

1. Mr. Chan stated again that Sino-Forest sells standing trees and thus no issue of quota limitation. But the business model, which he talked in detail, clearly shows the buyers CUT down trees and sell them to end users. Therefore, the quota limitation issue still stands firmly.

2. Mr. Chan said that standing trees are sold to AIs (Authorized Intermediaries), and AIs will pay taxes including corporate income taxes for Sino-Forest's BVI companies. Unless Sino-Forest has organized a massive tax evasion scheme participated by Chinese officials in taxation, there is NO way for the Company to transfer its subsidiaries' tax obligation to the so called AIs.

Apparently the question now is not whether there is a fraud, is how big the fraud is.

Stories are ending!

Friday, June 10, 2011

Review of Muddy Waters Report on Sino-Forest

Since Muddy Waters (MW) issued a report on June 2 accusing Sino-Forest (TRE) of institutional fraud, TRE stock price has been pummelled. Some analysts have stood out to defend for TRE, and an analyst at Dundee Capital announced that MW research is a pile of crap.

I have looked into this pile of crap in detail, and here I’d like to share my review.

I saw the following specific allegations in MW report. For each allegation, I will put what MW said, what Sino-Forest said, and my opinions with analysis.

1. Yunnan $231.1 million standing timber sale is unreasonable


The $231.1 million sale of timber in Lincang city, Yunnan province is largely fabricated, because such amount exceeds the applicable harvesting quotas by six times, and 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).


The revenue was very clearly disclosed in MD&A filed for Q1 and Q2 of 2010 as the revenue resulting from the sale of the standing timber - there is no cutting or transport involved.

Opinion: The sale is questionable.

In TRE 2010 Annual Information Form (AIF) there is the following regarding standing timber sales.

“Pursuant to the sales contract, the buyer is required to harvest the standing timber within 18 months from the date of the contract.”

Accordingly, the buyer needs to cut down the trees in 18 months, therefore, we might need to further check with local forestry regulator about 2011–2012 harvesting quotas, and ask locals about or go there to observe the harvesting activities. Over $200 million of trees in one city to be cut down in 18 months, probably you can see legions of Chinese scattered everywhere chopping down trees there.

2. Raised $3.05 billion in total, only $1.2 billion injected onshore


Sino-Forest has raised a total $3.05 billion from the capital markets, but only a maximum of $1.2 Billion of cash has been injected onshore according to the SAIC filings.

Opinion: SAIC filings do not support the allegation.

SAIC filings record the registered and actually injected capital by foreign investors, but injecting cash to subsidiaries in China does not necessarily to go through capital. For example, TRE and any of its offshore BVI companies can lend money to any of TRE’s subsidiaries in China, and SAIC does not regulate and record this lending.

The exchange from foreign currency to Chinese currency RMB must be approved or registered with another government department, SAFE, so to check how much funds were actually injected onshore, we need to look into SAFE records, not SAIC filings.

3. During 1994-1997, the revenues from its Leizhou EJV were fabricated


TRE breached its commitment to contribute equity capital to the EJV, Leizhou Eucalyptus Resources Development Co. Ltd, and fabricated its revenues by the EJV.

Appendix A5: Letter by Leizhou Forestry Bureau (JV partner) dated Feb 27, 2008 says TRE injected only $1 million and the EJV had never had actual operations till letter date due to lack of Cash.

The $12.4 million TRE stated that Leizhou Forestry owed to TRE resulted from EJV cessation in 1999 was fabricated.


1996 Annual Report

In 1996, wood chip production in the Leizhou EJV accounted for approximately 35.8% of total production. Leizhou EJV: 212,500 BDMT, all products exported.

An initial capital contribution of $1,000,000 was made in 1994. No further capital contribution was made in 1996.

1997 Annual Report:

TRE entered into an agreement to cease EJV operations. As settlement, Leizhou Forestry Bureau owed TRE $12.4 million, which would be paid with standing timber

Opinion: Revenues generated by the EJV during 1994-1997 are questionable; no evidence shows the $12.4 million settlement was fabricated.

No hard evidence pointed out that the $12.4 settlement was fabricated, as the arguments regarding the EJV operation cessation from TRE side could be another story.

The focus here should be the revenues generated from Leizhou EJV, as Leizhou Forestry Bureau stated in its letter that the EJV had never produced actually till 1997. Though the letter is one side’s story in a divorce, it is a formal government document, and there wasn’t any motivation for the Leizhou Forestry Bureau to lie about the production, because a successful EJV in 1990s would be a huge achievement for the local officials.

As TRE 1996 and 1997 annual reports indicated that all products from Leizhou EJV were exported, export records with customs or foreign exchange records with SAFE during that period would be able to validate the revenues.

4. Standing Trees transactions through offshore BVI companies are fake


The transactions are artificial and the traded trees are phantom trees. Business confidentiality, VAT tax, income tax, etc, are excuses to cover the fraud. Under Chinese laws, TRE offshore BVI companies cannot do businesses inside China directly, and there is no way to escape VAT tax.

Opinion: No hard evidence

It’s true that a foreign company must establish a local company to do business in China, and escaping VAT tax can lead to life imprisonment.

A foreign company can invest in to and divest out of China, can export to and import goods from China, but cannot buy and sell goods inside China without going through its subsidiaries there.

However, there is at least one way for a foreign company to sell standing trees in China without paying VAT and income taxes, though it is in the grey area and could bring trouble in the future. The loophole here is to change the standing timber into capital of a company and then sell the ownership to the buyer. An example is as follows:

Suppose a scenario: A foreign company has set up a subsidiary, company A, in China, which bought $100 million value of trees. And the foreign company also has two offshore BVI companies B and C. Now a Chinese buyer is willing to purchase the trees at $200 million.

Transaction process: A takes the timber as capital valuated at $100 million to register a wholly owned subsidiary company X inside China –-- A transfers it ownership in X valuated at $100 million to B –-- B transfers its ownership in X valuated at $200 million to C –-- C transfers its ownership in X valuated at $200 million to the Chinese buyer.

In this process, since B and C are registered in BVI, in which capital appreciation incurred, therefore no VAT and income tax incurred inside China.

5. Sino-Forest’s timber holdings in Yunnan is overstated


The timber holding is overstated significantly according to government reports related to master agreements, forest rights issuances and their corresponding value.

Opinion: No hard evidence with regard to master agreements and valuation; the standing trees TRE actually purchased and sold are questionable.

Master agreements are similar to framework agreements, and are subject to changes even after government approval; therefore, it’s reasonable that there is difference between government documents and TRE filings.

It’s impossible to accurately calculate TRE’s forest value by using the numbers in the government reports. What support the valuation of those forests in the government reports? When was the valuation date? What difference between TRE’s forests and the average forests in the area?

The numbers in Chinese government documents related to local achievements and resources, such as forestry resources and foreign investment received are usually equal or larger than actual numbers. Accordingly, the numbers in government documents indicate that TRE’s investment and standing timber sales might be quite different from its annual reports. Further verifications with local government and forestry farmers are needed.

6. Dodgy timber agents

(MW described 3 agents; here I am taking one of them, because of similar allegations)


Bo Hu is a tiny company established one month before signing the master agreement with TRE. Bo Hu is registered in Guangdong, so its selling forest in Guangxi to TRE is questionable.

Opinion: Being small and new is ok, but the agent’s jurisdiction brings question.

In China, it is common that one large mountain is divided into numerous pieces and every local household gets one piece. This is actually the reality in my hometown, a city in Hunan, China. When the standing timber in the mountain is to sell to one buyer, a new company, of course, pretty tiny, would be registered by households collectively, and all households would sign an agreement with the new company, and then the new company would sign a master agreement with the buyer. This small new company certainly would be registered locally. In the case of TRE and Bo Hu, it is questionable that Bo Hu was registered in Guangdong but sold trees in Guangxi to TRE.

Also, Bo Hu did not actually own the trees, so the agreements between Bo Hu and actual plantation rights owners should be verified.

7. Stealing money and other allegations

Opinion: No hard evidence, but there were questionable cash transfers.

Though the numbers in audited financial statements a company submitted to SAIC are usually different from the company’s consolidated financial statements, the SAIC audit reports indicated the existence of unusual cash transfers between TRE’s agents and its subsidiaries.

Tuesday, June 7, 2011

Need to go China to investigate Sino-Forest? (2.)

Look into Sino-Forest's trees in Hunan, China

The two Chinese provinces in which Sino-Forest owns the most standing timbers are Yunnan and Hunan. Muddy Waters has already sent investigators to Yunnan and then displayed tons of findings in its report. Before flying to Hunan or hiring a local investigator there, we may do some cross-checking by just using Internet.

According the Company's 2010 Annual Information Form (2010 AIF), which you can download from http://www.sinoforest.com/pdf/filings/AIF10-Final.pdf, Sino-Forest signed master agreements with Hongjiang City Forestry Technology Integrated Development Services Company (Hongjiang Forestry Services) to acquire approximately 400,000 hectares of non-state owned plantation trees for between RMB10.4 billion to RMB12.5 billion over 14 years in Hunan Province. The plantations under this agreement include mature trees with an estimated yield of 100 to 120 cubic meters per hectare, or an aggregate 40 million to 48 million cubic meters of wood fibre.

When Sino-Forest signed an agreement of intent with the local government in Hunan in 2006 to acquire forests, the Hunan Forestry Bureau put the news on its website http://www.forestry.gov.cn/portal/main/s/72/content-367429.html, which said that Sino-Panel planned to invest RMB 2 billion to acquire 150,000 hectares with 7 million cubic meters of wood fiber.

What differences do we have here?

First, the investment. According to the government news report, RMB2 billion for 150,000 hectares, thus 400,000 hectares should be around RMB5.3 billion, but Sino-Forest's 2010 AIF stated RMB 10.4 to 12.5 billion. Could the government want to shrink the numbers? Unlikely. Foreign investments are a key performance indicator to Chinese officials, the local governments always try to exaggerate the numbers.

Second, the cubic meters of wood fiber. The Forestry Bureau reported 7 million cubic meters on 150,000 hectares, thus 400, 000 hectares should have about 19 million cubic meters of wood fiber, but Sino-Forest said 40 to 48 million cubic meters. I really wish those natural trees could grow so fast during the period from 2006 to 2010.

Where are those forests specifically? The Sino-Forest's 2006 AIF, which you can download it from Sedar, clearly stated 100,000 hectares of the 400,000 hectares under the master agreements were in Hongjiang city, but an article dated on October 14, 2011 on Hunan Forestry Bureau http://www.hnforestry.gov.cn/listinfo.aspx?ID=250124, might challenge these 100, 000 hectares. The article indicated that the total forest area in Hongjiang city was 2,301,600 mu, which equals to 153,440 hectares. The end of article also said that 4 towns were full of bamboos. This means the city agreed to sell almost every tree in the whole Hongjiang city except the bamboos and some trees in peasants' yards to Sino-Forest. The article also mentioned that over 90% of all forests in Hongjiang were rented and operated by peasant households.

The other 300,000 hectares might also be questionable. The 2006 AIF clearly stated that Sino-Forest entered into a master agreement with Hongjiang City Forestry Technology Integrated Development Services Company, a state-owned enterprise, to acquire 300, 000 hectares in cities other than Hongjiang. All state-owned entities in China are controlled by government. If the entity's name started with China, it is controlled by the central government, if the name started with a city, it is controlled by the city, so Hongjiang City Forestry Service is appearently controlled by Hongjiang city. It is very rare that one city's state-owned forestry service company has rights to sell forests in other cities' turf.

Sunday, June 5, 2011

Need to go China to investigate Sino-Forest? (1)

On June 2, 2011, Muddy Waters published a research report on Sino-Forest Corporation (TRE.TO) accusing Sino-Forest of institutional fraud. The report also mentioned that one of the reasons why auditors and analysts had not questioned this massive fraud is that they did not go to China. Do we really need to go to China to investigate Sino-Forest? Can we smell something fishy by just browsing its website and taking a look into its financial statements? Let's have a try.

First, let's go to Sino-Forest website, http://www.sinoforest.com/. Click Operations/Map of Operations, you will see all operations are inside China. Doing business in China, do you need a web in Chinese? Absolutely, every company is doing that. I searched every corner on every page of Sino-Forest's website, there is not a single icon or button leading to a Chinese version web.

I also searched Sino-Forest's Chinese name ε˜‰ζ±‰ζž—δΈš in Baidu, but no Chinese website of Sino-Forest has been found. However, I did find its flooring division's website, http://www.sinomaple.com.cn/, which has both Chinese and English web pages but no links leading to Sino-Forest's website. The English text on Sinomaple introduces Sino-Forest as "Sino-Forest Group was founded in 1994 with registered capital of 2 billion US dollars...." Probably they need to change "billion" into "million", since Sino-Forest was pretty small when it started its business in 1994.

It seems to me that the website structure of Sino-Forest and its flooring division was designed to prevent cross-check by both Chinese and North American Investors. On the China side, the Chinese have no idea what Sino-Forest really is. On the North America side, investors have no idea what Sino-Forest has really been doing in China.

Now let's take a look at Sino-Forest's financial financial statements in recent years, which were audited by Ernst & Young. I have found two interesting issues as follows.

1. Unreasonable gross margin on standing timber, especially in 2008

Based on the segmented information in its financial statements, I calculated Sino-Forest' gross margin rates for its plantation fiber (standing timber) through 2006 to 2010 were: 50%, 45%, 59%, 45% and 47%. As financial crisis erupted in 2008, Sino-Forest's 59% gross margin on standing timber looks especially conspicuous and is certainly worth a closer look.

The gross margin of 59% is unreasonable because 80% of standing timber that sold in 2008 was added in 2006 or after according to Sino-Forest's financial statements. Sino-Forest's 2005 balance sheet showed that its 2005 year-ending timber holdings were $513.4 million, and its segmented information for 2006 and 2007 indicated that the depletion of timber holdings during 2006 to 2007 was $462.5 million ($177.7 for 2006 and $284.8 for 2007), so in the beginning of 2008 there were only $50.9 million of timber holdings which were purchased or planted before 2006. As the depletion of timber holdings for standing timber segment for 2008 was $281.9 million, $231 ($281.9-50.9) of it were purchased or planted in 2006 or after. Sino-Forest was able to buy forests in 2006 and then flipped them out at doubled price in 2008, it seems money does grow on trees in China.

2. Questionable timber holdings

Sino-Forest's 2007 year-ending timber holdings were $1,174.2 million, it's 2008 segmented information indicated that in 2008 the depletion of timber holdings was $284.5 million ($281.9 for plantation fiber and $2.6 for manufacturing), and in 2008 the additions to timber holdings was $672.9 millions, therefore the 2008 year-ending timber holding should equal to $1,562.6 ($1,174.2-284.5+672.9). However, its 2008 balance sheet showed $1,653.3 million of timber holdings, and there was no explanation for the difference of $90 million.

Similar issues of inconsistency connected with timber holdings and capital assets existed in other fiscal years.