By using intermediaries Sino Forest do not need to own all the equipment to harvest and transport the timber which explains away at least some of the problems Muddy Waters details. Intermediaries also explain why nobody can find the pulp and paper mills they sell to. (They do not see to pulp and paper mills, just to intermediaries.)
They also buy standing timber from "authorized intermediaries". Again they do not tell us who these intermediaries are.
This makes the company opaque. Sino Forest's response to both Muddy Waters and the Globe and Mail articles comes down to:
(a). This process is required in China.
(b). It is opaque, we need it to be opaque for commercial reasons, but
(c). It is legitimate and we can document it as required to our auditors and PWC.
The process is so opaque from the outside that the Globe and Mail (not a shortseller - just a newspaper) could - in Sino Forest's view - be honestly mistaken when they try to verify the facts on the ground in China. Sino Forest is too complicated and too opaque for investigative journalists.
The bear case against Sino Forest argues the intermediaries are fiction and the transactions are round-robins involving related parties. There is little timber. The sales are "fake" and generate fake receiveables. Over time the fake revenue (which would otherwise show as fake cash) is used to buy more fake forests (the only forests you can buy with fake cash are fake forests).
In the bear case the size of the fake forest estate grows over time just because the fake profits need to be deployed somewhere. Ultimately - in the bear case - Sino Forest becomes a fake giant and someone (in this case Muddy Waters) asks if you own so much timber how come we can't see it? It becomes "See No Forest".
In the extreme the only way to solve this problem is to somehow forget you own all those fake profits and start again with a lower land-ownership claim.
Bluntly the bear case is that if the intermediaries are fiction its likely the profits are fake and the forests are fake too. You can audit Sino Forest one of two ways: you can prove or disprove the story about the intermediaries or you can prove or disprove the rights Sino Forest have to harvest trees. They are the flip sides of the same coin. Fake intermediaries (or intermediaries who are undisclosed related parties) almost certainly means fake profits. And the only forests you can purchase with fake profits are fake forests.
Of course if the intermediaries are real non-related parties then the profits are real and the forests are probably real too.
If you decide the intermediaries are real non-related parties with real transactions then Sino Forest is a screaming buy. If not then Muddy Waters is right: the stock is going to zero as there are few forests and much debt.
There is a direct analogy in other Chinese frauds. Longtop claimed it had businesses that generated huge profits. Those profits became huge cash balances. Deloittes resigned when they thought the company (with their banks) were faking the cash balances. Whilst Deloittes never said so the conclusion is that if the cash was not there the profits that generated that cash were not there either.
Sino Forest argues the whole system is opaque for good Chinese commercial reasons. I have my doubts - but if you accept that there are good reasons for the opacity then you would need to check Sino's claims on the ground in China.
The first simple check
I suggested that if there really is 17.9 million cubic meters per annum of timber sales then someone needs to be pulping it and the first due diligence test is to find the chip mills - all of them - and sit there with a clicker counting trucks. You need a lot of truck loads.
Its not a perfect test because you will not know whether the timber in the mill is actually coming from Sino Forest (directly or indirectly) but at least you will find out the aggregate harvest in the area. If the aggregates are below 17.9 million cubic meters per annum then "Toronto - we have a problem".
Short of going to China and having access to the intermediaries there are a few things we can do. One is just compare Sino's statements over time to the response to Muddy Waters allegations. That is not conclusive but a changing story detracts from Sino's credibility and increases Muddy Waters credibility. Conversely a story that is consistent about the nature of the business detracts from Muddy Waters credibility and increases Sino Forest's credibility.
For maximum contrast I have done this with ancient history - press releases from the very early days of Sino Forest.
Sino Forest has been listed a long time - and in the Muddy Waters account it was just a reverse-merger fraud that was a fraud from inception and just went on a lot longer and got a lot bigger than the perpetrators expected. In the process it purchased some forest for show - but the main purpose of the listing was not to raise money for forestry activities in China but to fleece Western investors.
If Muddy Waters is right then we might be able to tell by going back to the early press releases (say 1995-1999) and seeing what the company said then. The small China frauds are not very sophisticated (they do not have sophisticated stories) and a careful reading of the promotional material often gives the game away. I have successfully identified fraud in many without doing anything more than reading the promotional material. When Sino Forest was a small fraud (if it was a small fraud) it would not have required the complex intermediary structure - after all nobody much checks small companies. As it got bigger the story would have had to get more complex.
For this reason I want to repeat old press releases from Sino Forest. I keep my comments to a minimum.
I just want to return to the day of a simpler Sino Forest.
Sino-Forest Corporation ("Sino-Forest" or the "Company" today announces the completion of a Private Placement of 2 million Class A Subordinate-Voting Shares at a price of Cdn$0.60 per share. The proceeds will be used for general working capital requirements.
Sino-Forest's forestry plantation business has been expanded to cover over 600,000 hectares in three provinces of southern China during 1995. Through its majority control of joint ventures with local provincial and municipal forestry bureaus, Sino-Forest processes and exports hardwood chips to pulp producers in Japan, Taiwan and Korea. Chip shipments are expected to total about 250,000 metric tones in 1995, compared to 156,000 tones in 1994.
In recent months, the Company has had discussions with several North American forestry companies relating to the establishment of further joint ventures in China for the manufacture of "value added" products such as OSB and MDF. The fiber feedstock for the plants would be supplied from Sino-Forest's plantations, which have the potential to increase the Company's annual fiber supply to 9 million tones over the next 10 years. This volume represents approximately 14% of the Province of British Columbia's current annual cut.
Sino-Forest has recently negotiated trade finance arrangements with three major banks in Hong Kong, which will support the projected sales expansion over the next two years. The Toronto Stock Exchange has conditionally approved the listing of the Company's Class A Subordinate-Voting Shares.Interestingly back then Sino Forest claimed to export to pulp producers in Japan, Taiwan and Korea. They used bank-provided trade finance to facilitate this. There was no mention of intermediaries. They also claimed 600 thousand hectares. This compares to this graph in the last annual report:
In 2007 Sino Forest only claimed 300 thousand hectares with almost $1.5 billion in acquisition cost. Sino's (trivially small) 1995 balance sheet allowed them to claim 600 thousand hectares at almost no cost.
They did however think that their 600 thousand hectares might yield 9 million tonnes ten years later (in 2005). That is consistent with - but lower than - the yields they are claiming now.
On 22 October 1998 Sino Forest released a long press release with this opening paragraph:
SINO-FOREST CORPORATION ENTERS INTO AN AGENCY AGREEMENT WITH SHANGHAI JIN XIANG TIMBER LTD.
Sino-Forest Corporation announces that it has entered into an Agency Agreement with Shanghai Jin Xiang Timber Ltd. ("SJXT"), a company in which Sino-Forest holds a 20% equity interest, to supply various wood products to the National Timber Sub-Markets in the PRC. Under the agreement, Sino-Forest will act as agent on behalf of SJXT to purchase 130,000m3 of various wood products over an 18 month period. Based upon current market prices, it is expected that this volume of wood products will have a sales value of approximately U.S.$40 million. Sino-Forest will earn commission income in respect of the purchases for SJXT.
What is interesting is that they were quite happy to name their business partners then. (This is in contrast to their current stated position.) Secondly Sino Forest were buying timber for Shanghai Jin Xiang (and earning commissions), not the reverse. This is a reversal of the current intermediary business model.
Obviously this made me want to look for Shanghai Jin Xiang Timber Ltd. This was also revealing.
This was a reference in the 1999 annual report:
There are also promising growth opportunities as Sino-Forest’s investment in Shanghai Jin Xiang Timber Ltd. (SJXT or the Shanghai Timber Market), develops. The Company also continues to explore opportunities to establish and reinforce ties with other international forestry companies and to bring our e-commerce technology into operation.
Sino-Forest’s investment in the Shanghai Timber Market — the first national forest products submarket in eastern China — has provided a strong foundation for the Company’s lumber and wood products trading business.
They were developing a business in the Shanghai Timber Market but they were using SJXT as an intermediary. They also had e-commerce technology (though it is not explained what that does).
By the 2000 annual report the investment in Shangahi Jin Xiang Timber had expanded to a 34.4 percent equity interest.
The Company has a 34.4% equity interest in Shanghai Jin Xiang Timber Ltd. (“SJXT”), an equity joint venture (“EJV”) that was formed by the Ministry of Forestry in China. The purpose of the investment is to establish strategic partnerships with key local wood product suppliers and to build a strong distribution network for the lumber and wood products trading and wood-based panel businesses. The total capital investment of SJXT was $1,509,000 [Chinese renminbi 12.5 million] of which the Company’s required capital contribution was $519,000. As at December 31, 2000, the Company’s required capital contribution of $519,000 was fully made.
The operation of SJXT is to organize and manage the first and only national sub-market for timber and log trading in eastern China. The investment in SJXT will provide the Company good accessibility to a large base of potential customers and companies in the timber and log businesses in eastern China.Moreover the purpose had changed. Originally Sino Forest purchased timber for SJXT. Now SXJT gives Sino Forest access to a large base of potential customers and companies in the timber and log business in eastern China.
Finally there is one new detail about SJXT. It was an equity joint venture formed by the Ministry of Forestry in China. Strangely the government involvement did not warrant a mention in the original press release. It is also strange because it seems to me unlikely that the Ministry of Forestry needed Sino Forest to buy timber for them.
Given that Shanghai Jin Xiang Timber was majority owned by the Ministry of Forestry I wondered where it might be now. The only modern reference to it on the internet is here (click link). It gives two phone numbers. I have rung them in business hours and both ring out. The link also gives an internet address. No surprises for guessing that it is www.sinoforest.com. I guess it must be a majority owned subsidiary now (in which case they purchased it from the Ministry of Forestry and they no longer have a marketing business in Shanghai.)
I could go on and on. The old press releases of Sino Forest are intriguing. They are not particularly consistent with the current story. However time has elapsed and business conditions change over time just as surely as the waist-lines of us gray-haired stock pickers. I will let you (dear readers) decide how much weight you put on those inconsistencies.