Chinese firms in spotlight - massively undervalued or fraudulent?

Ever since research firm Muddy Waters drew attention to Chinese forestry company Sino-Forest Corporation for  overstating assets and revenues for years, the focus on Chinese companies in general has intensified. In particular Chinese companies that have gained access to North American equity markets through RTOs or reverse takeovers, much like the Sino-Forest example, are in the spotlight.

This massive scrutiny of financial records has created a 'guilty by association' phenomenon whereby some companies are priced at fraudulent levels. From a quick screening I have been able to find two fertilizer companies which are currently trading at less than their net current asset value (current assets - total liabilities) - basically extremely deep value. This usually does not happen unless fraudulent behaviour is suspected - even a bankruptcy would not create this type of 'misvaluation'.

Both companies are involved in the fertilizer and potash businesses in China. Hanfeng Evergreen and Migao are both Canadian listed and headquartered and both have all their production and business activities in China. I suspect that there are several other Chinese companies also trading at a large discount to their net current assets, but in this analysis I only focus on Hanfeng Evergreen and Migao.

Hanfeng Evergreen and Migao
As of its last reporting date Hanfeng Evergreen had current assets of CAD 224 mn and total liabilities of CAD 27 mn, for net current assets of 197 mn, while the stock has a market capitilisation of 120. The stock is trading at a 42 percent discount. Even if it does trade net current asset value, the 100 mn worth of plants and equipment would be free. And it is a similar story for Migao, the stock is trading at 44 percent discount to its net current assets.

Discounts sound too good to be true? Possibly...
As mentioned previously, the reason for these very low valuations is the heavy scrutiny placed on these companies' financial information. Because a reverse takeover allows a previously private-held company to buy out a public company through a merger and therefore bypass the due dilligence associated with an initial public offering, it makes it easier for 'fraudulent' companies to become publicly traded and obtain non-regulated secondary offerings from capital markets, thereby creating a type of ponzi scheme.

The lack of visibility and trust in Chinese companies makes it incredibly difficult for even professional investors to decipher whether the information in the companies' reports is accurate. Nine of 10 sell-side analysts that were covering Sino-Forest had the firm rated as a 'buy' right before the damning Muddy Waters' research report. Many of the analysts had even gone to China to see the company's land and equipment.

 

There appears to be minor warning signals from Hanfeng whereas its inventory has been building up, but the company has said this was to satisfy a Q4 2012 order, whether true or not. On the other hand Migao has no explanation for its massive ballooning of inventory and its poor cash conversion cycle increasing from 15 in 2006 to 195 in 2011. Another worrying sign is the increase in capital stock of 23 million shares to 53 in five years, which was used to issue stock options. None of these facts mean that the company is falsifying its results but it does raise questions as to whether the company is perhaps careless.

I consider myself a relatively positive person and I do not believe that every company with imperfect financial statements is a scam, and I do not know if Migao is a fraud but its financial position seems to have deteriorated relatively quickly. And if the company is lying, there's very little investors can do, as even professional analysts get it wrong. If a company wants to lie to you, it will find a way of doing it. So the lesson is: invest with caution.

For those interested, both companies trade on the Toronto Stock Exchange (TSE), Hanfeng trades under the HF ticker, and Migao under MGO. The shares of Sino-Forest (ticker: TRE) were delisted from the Toronto Stock Exchange on May 9, 2012.

Matt Bolduc, aka Value Stocks Guy, writes regularly about value stocks and the principles of value investing.  If you’d like to be notified by email whenever Matt has a new piece focusing on value investing, become a member of TradingFloor.com – it’s free, and you can log in with your Facebook, Twitter, LinkedIn or Google account.  You can also bookmark the Value Stocks Guy page.