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, 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,, 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.

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