First and Last Word on Metals and Mining

Sino-Forest (TSX: TRE; Pink Sheets: SNOFF) is the biggest Chinese stock fraud of all time according to Carson Block of Muddy Waters LLC as detailed in a 39 page “research” report published on June 2, 2011 and followed by a bullet point addendum in response to an uninspiring first quarter earnings call on June 14, 2011. Based on our own preliminary desk review, we find Mr. Block’s analysis to be loose with facts and details, at times misleading, breathless with its Madoff analogies and surprisingly ignorant of the forestry business in China. The overall effect in our opinion is one of throwing everything including the kitchen sink at the situation to see what might stick.

We note that because Mr. Block has apparently been short Sino-Forest from $20 or even higher, there is little to worry about from his standpoint. Apparently not even the truth matters. Simply put, being the first short means you can afford to be the last short. Muddy Waters could thus confidently issue its strong sell knowing that at least some damage to the share price would result from market fear and panic, thereby ensuring for itself and cohorts an automatic margin of safety against speculative losses. Ultimately, avoiding legal liability in the form of defamation or tortious interference in business will only be possible if Sino-Forest completely falls apart as a result of at least one serious allegation of fraud proving to be true, or some other lethal matter coming to light. The natural inclination for the shorting party under such circumstances would be to paint the worst possible picture in the hope that the sheer weight of the doubts cast upon the company will overwhelm and ultimately ruin it as a consequence of a total loss of credibility.

Our overall conclusion based on our review is that Sino-Forest is probably a legitimate company with a significant economic presence in the forestry and timber sectors in China. In our opinion, however, the company does not deserve anywhere near its pre-Muddy Waters valuation due to at least three critical unresolved issues that we have identified during our review. The first of these issues will be discussed herein as Part 1 of our review and consists of three components dealing with related business risks arising from the company’s forest management operations in southern China. The other two critical issues relate to potential tax and accounting risks and will be addressed in Part 2 along with a line-by-line analysis of the litany of allegations made by Muddy Waters. For now we would summarize Mr. Block’s accusations as predominantly speculative with only two or three specific items deserving serious management and stakeholder attention, which we’ve noted and incorporated into our review.

In a worst-case scenario one or more of the critical issues could result in an eventual delisting of Sino-Forest shares from the Toronto Stock Exchange. The company might also collapse due to a complete loss of investor confidence. While there is no definitive proof at this point of a Ponzi scheme or fraud so massive that a Sino-Forest bankruptcy is a foregone conclusion, we must always consider the possibility and obviously more so in this case than most others.

On the other hand, if everything that Muddy Waters characterizes as outright fraud turns out to have a legitimate-if-troubling explanation, Sino-Forest will probably survive this ordeal and the market valuation may eventually return to at least net book value. It is our belief that the odds favor such an outcome based on our review. On a conservative basis, we come up with a modified net book value of $6.40 per share as described in our disclaimer below, which appears to represent a significant opportunity for speculative returns under the circumstances.

The three critical issues we have identified thus far include:

(1) Business Risk to Plantation Operations

i) Potential for abusive practices by Sino-Forest’s purchasing agents who acquire forestland from farmers on behalf of the company;

ii) Potential for failure under master agreements or otherwise to acquire suitable timber and forestland to meet Sino-Forest’s stated plantation growth plans;

iii) Potential for valuation risk to timber assets and unreasonable market expectations of future earnings resulting from selective disclosures and timing of timber asset sales;

(2) Tax and Related Legal Risk – to be discussed in Part 2 of our review

i) Potential for civil penalties, criminal liability, cease-trade orders and eventual business dissolution resulting from unreported transactions or unpaid taxes arising from the use of sales agents; and

(3) Accounting Risk – to be discussed in Part 2 of our review

i) Potential for improper accounting treatment or revenue recognition resulting from irregularities in timber and forestland transactions involving purchasing and sales agents.

It is important to note that we are not aware of any specific facts or evidence pointing to actual and material impropriety in any of the above three areas or for that matter anywhere else in Sino-Forest’s operations or financial statements. It is our considered opinion, however, that Sino-Forest’s business practices and ambiguous disclosures have heightened the potential for a material negative impact on operations or financial statements. More pertinent to the present circumstances, the opacity of management has allowed Muddy Waters and others to level prima facie allegations of fraud against the company that may be impossible to fully refute unless extraordinary efforts are made to evaluate and address the critical risks in the business model.

We urge Sino-Forest management to focus its immediate attention upon the critical issues while also continuing with the concerted effort to address the litany of accusations by Muddy Waters and others in the investment community and media. Fortunately, professionals are readily available to assist the company with independent investigations of this nature and we wholeheartedly believe that confronting the situation in an open and comprehensive manner will go a long way in restoring the market’s confidence.

We also urge all Sino-Forest investors, creditors and other stakeholders to pay attention not where Muddy Waters tells them to look but rather where the true risks to the Sino-Forest business model actually reside. Mr. Block could care less which one or several of his allegations might turn out to hold some water. He understands very well that usually it is not the original deed itself that leads to complete disgrace and ruin but instead the piecemeal, futile efforts to cover it up. We would be happy to publicly debate the number and nature of Sino-Forest’s true risks with anyone who disagrees with our initial assessment based on this review.


About Us, Briefly

Before we get bogged down in the details, we’d like to summarize our credentials, experience and motivation. Our firm is called Augment Partners and among other things we operate an investment research service located at Our business currently specializes in the resources sector with a focus on metals and mining, gold and silver in particular. Our professional backgrounds include degrees in business administration and accounting with stints as a public accountant, SEC reporting analyst, accounting manager and investment research analyst. We are not experts in the forestry, paper or wood product industries and in fact, like Mr. Block, we have never seriously investigated the forestry sector in China (or anywhere else for that matter) until very recently.

We currently hold a modest number of Sino-Forest shares acquired post-Muddy Waters but prior to the completion of our preliminary desk review. We may build upon this small position either if the share price declines further (taking note that based on this review we consider $6.40 to be a conservative modified net book value per share) or we become satisfied that Sino-Forest is fully engaged in sincere efforts to address the critical risks that appear endemic to its business model. Unfortunately, it was quite clear to us from the June 14 conference call that Sino-Forest management remains steadfast in the belief that hiding behind the excuse of “trade secret” or “competitive advantage” is acceptable at this stage of the game. We look forward to the time when the company is ready to engage in a serious discussion of the relevant issues.

Please understand that our sentiment toward or against Sino-Forest could change after further review or if additional revelations/developments come to our attention. We will neither accept an obligation to inform anyone of such change nor will we take any responsibility for your investment decisions whether stupid or otherwise. Please see further disclaimers at the bottom of this review.



As already mentioned, we’ve identified three areas of grave concern — business, accounting and tax related risks — that we believe Sino-Forest management must resolve on a priority basis before there is any realistic hope of regaining credibility with investors, creditors and other stakeholders. Should we identify more critical issues, we’ll strive to provide additional updates beyond what is already planned in Part 2 of this review. In addition to a discussion of tax and accounting risks, Part 2 will contain a detailed refutation of all the incorrect, irrelevant and/or fact-deficient allegations made by Muddy Waters. What follows below is a discussion of the critical business risk broken down into three components.

For readers with limited time to dive into our arguments, we provide the following summary taken directly from the conclusion section at the bottom of this review:

Like so many other Chinese companies before it, Sino-Forest’s high profit margins and other remarkable financial achievements have became an open invitation for noteworthy allegations of fraud by the likes of Muddy Waters and its cohorts. The possibility of outright fraud cannot be fully dismissed but in the case of Sino-Forest there might be a compelling alternative explanation in the form of insufficient disclosures and opaque business practices that are masquerading as “trade secrets” and “competitive advantages”. A simple domestic business in China can thus seem like a believable miracle, even if only temporarily so:

  • Acquire some trees and call them a plantation even though only the harvesting right but no land has been obtained;
  • Sell standing timber as “logs” because your purchasing agent intends to secure the underlying forestland for you, regardless of the chance of success;
  • Play down planted tree metrics even though plantation management is your company’s future;
  • Avoid having knowledge about forestland acquisitions made by purchasing agents on your behalf so that the rights can be retained even if the deal was potentially dirty or illegal;
  • Enter into an unenforceable master agreement with a single purchasing agent pursuant to which an impossible number of hectares of trees and forestland are to be transferred to you;
  • When the first purchasing agent falters, look for other agents as substitutes or assignees even though the odds of delivering the ultimate prize, the forestland, are very low;
  • Always claim that the purchasing agent named in the master agreement is the only one through which all transactions in that province are processed;
  • Specify bulk pricing under the master agreement whereby all timber acquired is to be recorded at an average cost with the result being that profit margins are boosted when the mature trees are sold off;
  • Increase pace of timber acquisitions when mature timber has been depleted since otherwise high profit margins cannot be maintained;
  • Never mention that your previous strategic business model of buying young trees and managing them until harvest was a failure because China ran out of sellers; and
  • Gloss over the high profit margins earned in the past as a result of sheer luck — buying young trees when timber prices were low — thereby making it appear that the overall business can operate like a cash machine in perpetuity.

The responsibility for any critical business issues that may arise from the above set of circumstances rightfully belongs to Sino-Forest given its opacity punctuated by the cloak-and-dagger theatrics of its “secret agents”. At the same time, the investment community must shoulder some of the blame for failing to properly understand Sino-Forest’s business model. Had the analysts obtained a proper understanding beforehand, they could have asked the tough questions long ago and not left so much swimming room for Muddy Waters. We suggest Sino-Forest management immediately grab the educational initiative from us.


Critical Business Issue #1 — Forest Acquisition: Child’s Play?

The first matter of grave concern in our opinion is the potential for improper or illegal forestland acquisition practices by Sino-Forest’s purchasing agents who are responsible for securing standing timber and forestland rights on behalf of the company. The forestland itself is owned by farmers or village collectives and cannot be sold outright under Chinese law but it can be leased for plantation or other purposes. The basis for our concern is not found among the litany of Muddy Waters allegations but rather in A Case Study on Large-Scale Forestland Acquisition in China prepared by the non-profit organization Landesa. Everybody needs to read this report before concluding that the final chapter on Sino-Forest has been correctly written by either Muddy Waters or company management. In the report, Landesa exposes the depths of desperation to which even respected multinational companies such as Stora Enso must apparently sink in order to acquire leases on forestland suitable for plantation in a meaningful size.

It is important to realize that acquiring forestland is not the same thing as acquiring standing timber. Farmers and village collectives have been selling off the standing timber growing on their forestland in recent years in part because money looking for timber has been spreading into their remote rural and mountain areas. There is minimal paperwork and regulation involved with the transfer of the standing timber, which is measured on the basis of estimated cubic meters of fiber yield. When small individual forest plots are accumulated in blocks, they can be unitized and sold in bulk transactions to forestry companies such as Sino-Forest. With the inflow of money and interest during the past decade, a decent market appears to have developed for buying and selling this standing timber in the southern provinces of China. This is what Sino-Forest has apparently tapped into and there seems to be nothing inherently illegitimate about it.

The underlying forestland is another matter. Its outright sale as previously noted is prohibited in China but related rights including leases for tree plantations can be transferred to third parties. The process is supposed to be strictly regulated and it requires that certain steps are followed and detailed filings are made. Yet as the Landesa report reveals, even a respected multinational company such as Stora Enso may not have complied with all the regulations, much less best practices. Be that as it may, a forestland right is definitely not something that can be bought and sold in bulk. Transfers must be documented individually and it is a difficult and time consuming process. Moreover, the rising interest and inflow of money has resulted in the forestland itself becoming even more valuable than the standing timber. In many places, farmers have seen how they sold standing timber too early and therefore didn’t make as much money as they could have by waiting for higher timber prices. As a result, they aren’t exactly eager to transfer their rights to the underlying forestland for the length of time required by plantation leases (up to 50 years). Simply put, a lease with its fixed rental payment does not allow the farmer to participate in rising timber prices. Given the limited financial sophistication (in the modern sense) of the farmers, it should not be hard to see why they simply don’t want to give up any rights today without getting something immediately in return other than a faint promise of future lease payments.

This is the key to Sino-Forest making it look as easy as child’s play. The company has acquired standing timber in bulk, as just about anyone can, but it has little to show so far in the form of leased forestland that can be planted and operated as an owned plantation. Much of the past decade appears to have been spent pursuing various methods of acquiring land for plantations that ultimately proved futile.

The chart below comes from Sino-Forest’s 2010 Annual Report and illustrates the comparatively-stagnant growth of planted (leased) vs. purchased (standing timber) forests.

Source: Sino-Forest’s 2010 Annual Report, page 3

If Sino-Forest is able to accelerate the pace of forestland acquisition without hitting similar snags as Stora Enso apparently has in Guangxi Province, it would not only be an amazing business accomplishment worthy of world renown but an astounding humanitarian one as well. Alas, the Landesa report provides very good reasons to suspect that one of the real “trade secrets” and “competitive advantages” cited by Sino-Forest management in its refusal to directly address fraud allegations might have more to do with the difficulty of acquiring forestland instead of the need to keep confidential the names of its major trading partners.

The questionable practices documented by Landesa in its report run the gamut while shedding light on why Sino-Forest might wish to operate with such seeming complexity instead of dealing directly with original buyers and sellers. As an example, let’s look at the following refrain made with the cocky confidence of rhetoric in the bullet point addendum prepared by Mr. Block in response to Sino-Forest’s June 14 earnings call:

Is the designated purchasing agent an AI-squared?  We look forward to more detail on this new facet so that we can analyze the legal and practical issues.

To his likely dismay, Mr. Block will find that the legal and accounting fees he incurs in the conduct of his analysis will have been unnecessary considering that the Landesa report already answers his question in devastating fashion by revealing the following smoking gun:

Applying these principles, even if BHC [the purchasing agent] illegally obtained the land from farmers or collective entities, Stora Enso [the buyer] may still receive the land free from any claim by farmers. In order to take the land free of claims, Stora Enso [the buyer] must have been unaware of any illegality in the transactions between BHC [the purchasing agent] and the farmer. [Page 28, with parties to the transaction identified in brackets by us]

Apparently Mr. Block needs to do a bit more research (we probably all do)! In any case, the Landesa report contains other insights directly addressing Mr. Block’s claims that the transaction structures utilized by Sino-Forest are needlessly complex. We believe these accusations miss the point entirely. To us, it seems quite obvious that there is a scramble in China to acquire and develop whatever forestland remains available and suitable for professionally-managed tree plantations. If it were straightforward to acquire and profitably-develop the remaining forestland still in the hands of farmers, we’re quite certain that everybody would be doing it. It might therefore be understandable (if not excusable) under the circumstances why Sino-Forest is not exactly eager to trumpet the gritty truth even if it might help exonerate the company of more serious allegations.

Just to be clear, we are not making any specific accusations against Sino-Forest nor are we suggesting that the company or its purchasing agents have been involved in activities similar to those described in the Landesa report. We frankly don’t know how many squeaky clean vs. dirty (if any) plantation lease deals have been concluded on Sino-Forest’s behalf. What we do know is that there haven’t been many deals concluded in the first place — for example, it appears to be just around 13,000 hectares in Gengma County with most of that being from 2007. Most importantly, we suspect it might not be possible to convert hundreds of thousands of hectares under master agreements to plantation leases during the next few years without doing something extraordinary — and the choice is Sino-Forest’s as to whether it will be extraordinarily good or bad. There are hints, fortunately, that Sino-Forest is trying to deal with the issue such as recent attempts to explore a new model involving upfront payments for forestland leases. Although this method did not turn out to be feasible due to the prohibitive cost of financing it, the company is obviously aware that it must address this critical issue in the near term. Now it must simply inform the market of the same.


Critical Business Issue #2 — Master Agreement Troubles

Much has been made of the possibility that Sino-Forest did not acquire anywhere near 200,000 hectares in Yunnan Province from Gengma Dai and Wa Tribes Autonomous Region Forestry Co. Ltd. (the purchasing agent named in the Yunnan master agreement) including a report from the field by the Globe and Mail this past weekend and a response to the report by the company. Taken together this confirms to us that acquiring forestland rights for plantation use in the southern Chinese provinces is indeed very difficult as indicated by the Landesa report. Clearly Gengma Dai and Wa did not sell to Sino-Forest all the hectares of Yunnan standing timber the company now holds but that doesn’t mean nobody did. As already discussed, standing timber is often accumulated in bulk and then sold as a commodity based on the estimated cubic meters of fiber content.

What appears to have happened in Yunnan Province, and this could be the case in other provinces as well, is that Gengma Dai and Wa was initially in possession of both the rights to standing timber and forestland totaling about 13,000 hectares. Gengma Dai and Wa and Sino-Forest executed a “master” agreement over these rights with the expectation that Gengma Dai and Wa would become a regular purchasing agent and go out to area villages to obtain more timber and land pursuant to the agreement’s terms. Meanwhile, Sino-Forest sells the original 13,000 hectares of standing timber for harvest and, once the land is cleared, Gengma Dai and Wa transfers the forestland rights to Sino-Forest in the form of a long-term plantation lease.

Unfortunately, there was apparently a small problem along the way. Gengma Dai and Wa might have had trouble acquiring additional standing timber from farmers who were also willing to lease the underlying forestland as a plantation. Moreover, it probably also occurred to Gengma Dai and Wa that the master agreement reserved all the price upside to Sino-Forest while burdening the purchasing agent (Gengma Dai and Wa) and the original landholder (farmer or village collective) with all the price risk. So Gengma Dai and Wa may have rightfully balked, which then left Sino-Forest with the option to either terminate the agreement or else allow Gengma Dai and Wa to assign its “rights” (such as they were) to other purchasing agents in Yunnan. This may also have been the case for most, if not all, of the master agreements in other provinces. Notably, Gengma Dai and Wa’s own statement appears to support this version of events:

We have already signed contracts for the sale of approximately 180,000 Mu of timber, and we have assisted in introducing and promoting other companies to sell timber to Sino-Panel which, according to information provided by the companies concerned, have already signed contracts for the sale of timber over approximately 340,000 Mu (within the Lincang region), and approximately 2,700,000 Mu outside the Lincang region.

We think it is important to read this literally. According to the Gengma Dai and Wa’s own statement, they simply were “introducing and promoting other companies to sell timber to Sino-Panel”. Yet this is not exactly what Sino-Forest states in its own press release where it claims that:

In addition, Gengma Dai and Wa has acted as the Company’s purchasing agent, under the Master Agreement, for the purchase of other standing timber elsewhere in Yunnan Province, beyond Lincang City, totalling approximately 182,867 hectares (2.743 million mu).

Are we splitting hairs here in apparent homage to Muddy Waters? We don’t think so. Our preliminary desk review has revealed that Sino-Forest’s preferred accounting for the majority of standing timber purchases may require that transactions are bundled and priced in bulk under the master agreement. But before we get to that, let’s state for the record our strong opinion that Sino-Forest apparently decided to allow Gengma Dai and Wa’s rights to be assigned to other purchasing agents and therefore the company might not be telling the whole truth about the nature of its agent relationships.

Assignment or not, the underlying problem has not been solved: there still aren’t many farmers looking to sell standing timber who also want to lease their forestland for plantation use. Unlike Gengma Dai and Wa, however, this inconvenient fact does not appear to bother other purchasing agents in Yunnan (and probably other provinces) who seem to have no problem bringing standing timber deals to Sino-Forest despite failing to secure the long-term leasing rights over the related forestland at the rental rates specified in the master agreements. After all, it would be years before any lease would need to be negotiated — Sino-Forest reportedly holds the trees for up to 3 years and the timber is harvested sometime after that — and by then everybody involved might already be dead anyway. Alternatively, the purchasing agent could try to find cleared forestland elsewhere as a substitute for the rights pertaining to the land underlying the standing timber sold to Sino-Forest.

Ultimately, it’s not as if Sino-Forest can enforce the nonbinding terms of an ambiguous contract against a small time player such as a local purchasing agent. Moreover, there don’t appear to be any obvious legal remedies Sino-Forest would be able to pursue for breach of voluntary performance. In other words, the master agreement in substance is not really a legal document at all but more like a bid sheet publicizing the framework pursuant to which purchasing agents can propose deals to Sino-Forest. To us, this vaunted “competitive” business strategy actually looks more like the forestry equivalent of vaporware. Company management might not be too worried about any of this until some point in the future, at which time they can just claim that the forestland rights were never acquired because acceptable lease terms could not be negotiated with the landowner.

They should worry, however, that the potential inability to convert standing timber to forestland may relegate Sino-Forest to the role of speculator with regard to most of its timber assets. Given historical results, it certainly would be inappropriate to assume that the company can acquire forestland rights related to much more than a small fraction of its 800,000+ hectares of standing timber. In particular, the goal of planting 200,000 hectares by 2013 seems like a Herculean effort given Sino-Forest’s leasing of just 46,467 hectares of forestland in China since 2002 according to Pöyry’s reckoning:

Source: Pöyry’s 2010 Valuation Report

At this point it’s perhaps worth mentioning the apparent inconsistency between the 46,467 hectares in the Pöyry report and the 77,700 hectare figure promulgated by Sino-Forest (for example, page 2 of its 2010 Annual Report). The discrepancy may be due to different definitions or something else but it doesn’t really matter considering that either 46,467 or 77,700 hectares is still a long haul from Sino-Forest’s goal of 200,000 in the next two to three years.

Moving right along, it is also interesting to note that for the period 2004-2009 Sino-Forest broke out revenue earned from “planted plantations” but then suddenly stopped reporting this figure in 2010. With “planted plantations” being central to the company’s long-term business model, perhaps management was simply embarrassed about the immaterial contribution this operating segment makes at this juncture?

Source: Sino-Forest’s Annual Reports

Before we get much deeper into this, let’s stop and admit that all the forestry and timber terminology used by Sino-Forest can be confusing even for us. Unfortunately, in many cases we can trace the source of potential misunderstandings to the ill-defined, imprecise, flip-flopping vocabulary that appears throughout Sino-Forest’s financial statements, disclosures and presentations. We think it would be difficult even for an analyst who has followed Sino-Forest for a long time to decipher what exactly all of the different terms are trying to describe. We finally had to give up trying to keep track of it all in our heads and so we created the following flowchart. Hope it helps.

In light of this, we think Sino-Forest will have to better explain and possibly backpedal on potentially-misleading statements such as the following.

As of December 31, 2010, we have acquired approximately 190,300 hectares of plantation trees for US$925.9 million under the terms of the master agreement.

The above disclosure is from the Annual Information Form for 2010 and states that the company has acquired almost 200,000 hectares of “plantation” trees in Yunnan, suggesting that the company has plantation rights over these hectares whereas all but a few thousand hectares are actually in the form of standing timber rights (specifically, the right to cut down certain trees) with no guarantees that the underlying forestland can be acquired for plantation leasehold at a reasonable, if any, price.

At first quarter end 2011, the total area of plantations under management in the PRC was 866,600 hectares, up 9.9% from fourth quarter ended December 31, 2010.

The above disclosure is from the earnings release for the first quarter of 2011 and claims that all of the company’s standing timber represents “plantations under management”, which we believe is a gross generalization. The statement might perhaps be true if the master agreement had teeth and could require the purchasing agent to transfer one hectare of forestland lease for each hectare of standing timber sold to Sino-Forest. Yet that possibility appears doubtful given the original purchasing agent under the Yunnan master agreement, Gengma Dai and Wa, couldn’t do it. We wonder if any other purchasing agent would be able to do better given the conditions revealed in the Landesa report. One possibility that exists is that Sino-Forest gets some substandard (high elevation, poor soil, arid climate, etc.) forestland but this really doesn’t solve anything if the company wants to manage quality plantations.

So what can we make of all this plantation-related terminology? First and foremost there does not appear to be a substantial difference between most of the terms. From our perspective the proper way to distinguish timber assets is to first identify whether they represent harvesting rights or ownership of trees vs. plantation rights on forestland. If a timber right is not held in the form of a lease or other contractual form permitting the planting and management of a plantation forest over the long term, then it is not a “plantation” anything. In any case, the sophistry being practiced by Sino-Forest appears to be premised on the idea that the master agreement obligates a purchasing agent to deliver a hectare of leased forestland to the company for each hectare of standing timber sold. Therefore the standing timber itself can apparently be called a plantation (“integrated plantation” up to 2009) when held for speculation and “logs” when sold pursuant to the master agreement.

The crux of the matter is that Sino-Forest is saying they have purchased “plantations” under the master agreements even though they have in effect only been buying standing timber in the vast majority of transactions. As a result, most of the timber assets described in various ways as “plantations” are nothing more than forests to be cut down and sold in the market. Holding these “plantations” is not a forestry management business but basic speculation on the timber price, subject to the possibility that something bad will happen to the trees prior to harvesting. Fire, insect damage, storms and theft are the obvious risks but there could also be harvesting restrictions and legal disputes.

In any case, the holding risk is obviously commensurate with the timber value. The highest value trees are also normally the most mature and therefore the slowest to increase in yield. Moreover, high value trees can represent a disproportionate percentage of a forest’s overall value despite constituting a small fraction of the total trunk count and therefore they are at the greatest risk of being poached. For these reasons and more, the most valuable trees tend to get harvested first.

On the other hand, the holding risk of a plantation of young trees includes the potential economic loss from harvesting the timber too early and thereby failing to recover the purchase price, which is a discounted present value of the wood based on the estimated fiber yield at maturity. So it stands to reason that if mature trees tend to be sold earlier after acquisition then young trees tend to be sold later. The sequence and volume in which timber acquisitions are made will therefore largely determine the timing and amount of future revenues and profits generated from timber sales. Failure to account for such variability could result in faulty conclusions about the reasonableness of a company’s income statement and in the most extreme cases it might even lead to reckless allegations of fraud.

This brings us to an instructive and final look at the confusing terminology employed by Sino-Forest: the difference between “standing timber” and “logs” as those terms are now used to distinguish segments of the company’s “wood fibre” operations. As apparently defined by the company, “standing timber” represents hectares of trees Sino-Forest has acquired, whether under master agreements or otherwise, where there is neither the intent nor provision to acquire leases on the underlying forestland. In other words, standing timber is to be sold outright. Meanwhile “logs” appears to represent nothing more than the sale of standing timber that was acquired specifically under master agreements pursuant to which trees are supposed to be cleared so that a plantation leasehold can be secured. This is why, as mentioned already, standing timber sold pursuant to the terms of the master agreement is required to be harvested within 18 months. Payment is to be made on an installment basis presumably in rough proportion to the rate at which the trees are harvested and sold as logs to an end customer. Apparently this makes Sino-Forest believe that it is entitled to use the term “logs” instead of standing timber when sales are made pursuant to a master agreement. We suggest “virtual logs” although in all fairness the company does probably earn some revenue from sales of logs that are actually logs at the time of sale as opposed to standing timber that will one day become logs. The problem beyond the semantics, of course, remains that the purchasing agent might not be able to negotiate a plantation lease on behalf of Sino-Forest and in turn Sino-Forest might not be able to fully realize the benefits under its master agreements.

With all the above having been said, Sino-Forest is still apparently making a ton of money selling big chunks of its standing timber whether they are called “logs”, “integrated plantations”, “fiber” or whatever.  So where’s the problem? Let’s look at the lynchpin of this unfolding saga for the answer.


Critical Business Issue #3 — Old First, Young Last Doesn’t Make it All Okay

We should note that the high profit margins enjoyed by Sino-Forest on standing timber and log sales are not by themselves evidence of fraud or material misstatement since there are some valid reasons to believe such margins can be achieved under certain circumstances. As already revealed previously, there are at least two “trade secrets” that may impact the profit margins: selling mature trees quickly after acquisition (or at least at an opportune time) and selling young trees slowly.

The main thing to realize in terms of mature trees is that the master agreements, despite having decade-long terms, contain fixed bulk prices for both purchases of standing timber and leases of forestland. There is an interesting accounting outcome that appears to result from this bulk pricing. Recall that the value of standing timber can be estimated in RMB per cubic meter of fiber. Well, this also happens to be the contractual basis for measuring the cost of standing timber purchased under the master agreements. Simply put, when standing timber is bundled in a transaction using bulk pricing, all of it will be recorded on the books at a single bulk price per cubic meter. In particular, the bulk price is averaged over the entire purchase based only on cubic meters of yield and without regard to any other factors such as tree maturity, trunk diameter or wood species. Meanwhile, each forest plot will of course still retain its own true value based on the quality, size and species of the trees it contains, which can run the gamut from worthless scrub or bare land to valuable hardwood growing in dense, mature stands. Scrub or poorly-managed forests will rarely produce more than cheap pulpwood whereas timber harvested from a mature forest could be sold at a premium in the form of large logs, sawn timber or dimensional lumber. Importantly, standing timber is not necessarily sold in the same bundles as it was acquired but often in different bundles that make financial or logistical sense from a harvesting standpoint. Therefore, a bundled sale may contain all scrub or just mature pine trees. Are you starting to see the possible implications on profit margin? If not, read on.

But first, here is a chart illustrating the wide range of log prices. We note that eucalyptus is primarily used as high quality pulpwood whereas pine/fir as sawn timber. Moreover, this chart does not include prices for the low quality wood often found in poorly-managed forests that can only be used as marginal pulpwood and therefore is priced lower than eucalyptus logs.

Source: Pöyry’s 2009 Valuation Report

Recall from a moment ago that the bundled purchase of standing timber under a master agreement is recorded on the books at the average bulk price per cubic meter for that transaction. This is the case because it would be logistically impossible to assign a specific value to each individual forest plot at the time of purchase as validated by Pöyry stating that Sino-Forest’s timber assets are “dynamic”. Indeed, there can be dozens if not hundreds of individual forest plots in a bulk transaction.

Now consider the relative ease of cherry-picking from thousands of hectares of standing timber in order to sell off the most mature and valuable forest plots and perhaps even individual trees. When selling, the cost removed from the books will be the average bulk price per cubic meter because that is how the timber was recorded in the first place. Yet as we have already argued, the actual market value of standing timber can vary greatly from plot to plot based on tree maturity, species and other factors.

Under the above conditions, it should not be hard to imagine that some percentage of the mature standing timber sold by Sino-Forest can generate impressive profit margins. It would be very surprising, however, if this feat can be repeated for all of the standing timber on the books. Indeed, nobody should be taken seriously if they attempt to project Sino-Forest’s present profit margins from standing timber and log sales into future periods absent ongoing acquisitions on a scale massive enough to continually replenish mature trees in the forest estate.

Does the above suggest a Ponzi scheme as alleged by Muddy Waters? No, but it probably comes the closest of any accusation. That said, Sino-Forest ostensibly sells at least some of the standing timber it owns so the trees can be harvested and the forestland leased for plantation purposes. This is precisely why Sino-Forest’s sales contracts pursuant to the master agreements contain a provision that the standing timber must be harvested within 18 months, although as mentioned previously we suspect this provision is rarely if ever enforced. It even makes sense from an operational and risk perspective to sell the best and most mature forests first since they are probably located on land that has the best tree growing conditions. In addition mature timber is more susceptible to illegal logging and catastrophic loss from a casualty. Obviously it would also be prudent from a financial perspective to sell the best trees first since doing so frees up the maximum amount of capital to fund the company’s operations in lieu of having to seek additional financing from the markets. Furthermore, only a very detailed specific identification method that allocates purchase price to individual forest plots within each bulk transaction would be able to properly match the actual cost of standing timber to its selling price. Yet as we have already seen, such detailed accounting may be impractical given the rapid pace of turnover in the forest estate. That does not mean, however, such procedures should not be implemented for other reasons including the significant risk management and planning benefits that may result.

Now let’s turn our attention to the purchase of young trees under the company’s now-defunct ”purchased-tree plantation” model — probably abandoned because this type of newly-planted forest is no longer readily available in southern China after the arrival of intense competition — whereby trees are held until they reach maturity. Holding young trees to maturity will benefit from the general trend of rising timber prices for a number of years as well as from the accretion of the purchase discount and yield improvements due to the company’s plantation management practices. These trees tend to be fast growing and can reach maturity in as little as 4-5 years from the time of purchase as saplings. Therefore, the potential for price appreciation in a young forest during a period of strong timber prices can be very significant. The chart below shows the general trend of softwood log prices in China as they rose from their lows in 1999-2004 to their peaks in 2006-2008.

Source: Pöyry’s 2009 Valuation Report

Sino-Forest’s financial statements seem to suggest that significant margin gains were available from mature standing timber that originated as young trees purchased in the early 2000′s and sold later in the decade. We put together the following inventory composition chart using the FIFO (first in, first out) method that would most-conservatively approximate the manner in which Sino-Forest would have bought and sold its so-called “purchased-tree plantations” consisting of young trees held to maturity. We can clearly see from the below chart that timber assets acquired as either standing timber or young trees early in the decade appear to have been sold later in the decade when log prices were substantially higher. It is worthwhile noting that the chart below is the most conservative presentation possible such that, in all probability, matured trees grown from 2003 or 2004 sapling purchases are actually still being sold as late as 2010.

Source: Sino-Forest’s Annual Reports, Pöyry’s 2009 Valuation Report

It’s fairly clear then that the company’s young trees planted under a now-defunct plantation program appear to be maturing under the FIFO method mainly in the period before 2010 with maybe a peak around 2008. Given the very high margin but low fiber yield from these forests (they’re mostly eucalyptus we presume), we would expect to see a profit margin divergence (specifically, lower-than-normal cost and average revenues) along with a relatively low fiber yield per hectare during the years when young trees are just maturing and being sold.

Meanwhile, standing timber appears to have come on strong primarily in 2009 and 2010. In these years, therefore, we would expect to see sales dominated by trees that were already mature at the time of purchase. Since all purchased timber is recorded on the books at an average bulk price per cubic meter, the sale of higher value mature timber should generate a healthy profit margin, all other things being equal. In particular, we should expect to see rising revenues (trees purchased when already mature tend to be pine/fir vs. eucalyptus) and rising costs (trees purchased recently vs. years ago) per cubic meter in 2009 and 2010 as well as higher fiber yield per hectare (mature pin/fir vs. eucalyptus trees purchased as saplings that are just now maturing) compared to prior years.

Let’s quickly look at a chart of several Sino-Forest operating metrics to see if we can find signs that the above young/mature tree factors are discernible.

Source: Sino-Forest’s Annual and Quarterly Reports

What do you think? A few enticing possibilities but it seems the jury is still out. Maybe there are additional influences from not only the mature/young tree timing factors but large one-time forest transactions as well. That said, the general trend does seem to be in the direction we would expect — high margin accompanied by growing revenues and increasing yields as young tree plantations mature and are sold off in earlier years with a peak perhaps in 2008, which seems to match up with the FIFO analysis above. Then, new standing timber acquisitions are made during 2009 and 2010 and this allows the selling of high quality/mature timber immediately, thereby boosting revenues, costs and yields to new highs above historical levels. This is indeed what the chart seems show.

Looking into the future, the extraordinary profit margins being generated by Sino-Forest up to now cannot possibly be sustained once all of the low-priced young trees from pre-2007 are sold off and the mature trees are depleted as the pace of new standing timber acquisition eventually drops off. At that point the mirage of easy profits will disappear and it will become obvious that front-loading of profit margins contributed to the spectacular financial performance. This front-loading in various permutations is often responsible in other industries for early years of stellar operations followed by later years of stagnant performance and finally a fade into unprofitable ignominy. For instance, in mining they call it “high-grading” a deposit.

If you can’t see the front-loading effect then consider that the company has been generating 40%+ profit margins for several years and yet Pöyry’s valuation of the standing timber has barely exceeded the amount recorded on the books in recent years. Indeed, the Pöyry valuation for 2010 appears to show that the book value of timber assets is already under pressure and may need to be adjusted soon (if it hasn’t already been).

Sources: Pöyry’s 2009 & 2010 Valuation Reports; Sino-Forest’s 2010 Annual Report

Without sufficient new acquisitions, the quality of the standing timber assets will continue to deteriorate if an attempt is made to maintain a healthy profit margin. This will obviously result in higher risk for the valuation over time as Pöyry will be under pressure to provide the most lenient assessment to avoid inventory write-downs that will reduce profitability. In the end, we don’t know if the standing timber is still worth more than the average cost carried on the books at 2010 year end but our estimate of a conservative modified net book value of $6.40 per Sino-Forest share assumes a large haircut to the reported value of the timber holdings just in case. Obviously if such a haircut is unnecessary then the net book value and share price should be somewhat higher, perhaps above $10 per share.

Ultimately, we are concerned that the company will be unable to convert harvested trees to plantation rights and thereby will choose to rely increasingly on the Ponzi-like scheme of using investor money to acquire an ever-increasing amount of standing timber in order to maintain historical profit margins. In this strict sense, Muddy Waters may have a fuzzy point and perhaps Mr. Block should even be thanked for forcing everybody to take a second look. To continue calling Sino-Forest a fraud at the current juncture, however, seems like a poor excuse for not understanding the issues we have laid out above.

The contrary hope of course would be that in the future the company will enjoy similar, if not better, profit margins from the sale of its own planted forests as it does currently from the front-loaded sales of acquired timber. The ability to accomplish such a remarkable achievement, however, is anything but certain as we’ve already seen. This is especially true if Sino-Forest cannot acquire the underlying forestland rights to cleared land subject to reasonable lease terms. To wit, Sino Forest’s revenues from planted plantations have so far been almost non-existent (not even broken out in 2010 probably because it was too immaterial):

Source: Sino-Forest’s Annual Reports

In conclusion, planted plantations are the key to sustainable, long-term profitability and this has always been the case. Sino-Forest has tried several ways to increase its plantation operation but the shifting landscape within the timber industry, increasing competition and changing laws pertaining to forestland rights have never allowed the company to pursue a particular strategy to ultimate success. The master agreement model at this point looks close to played out and that is essentially what gave Muddy Waters the inviting crack to barge in and crash the party. Things look bad now but Sino-Forest still has the opportunity to set things right by not only addressing the specious accusations of Mr. Block but by also dealing with the true risks faced by its business. Creditors and shareholders might not be too happy to hear that the situation isn’t as rosy as they might have believed but the alternative is certainly much worse.


Dealing with the Critical Business Issues

Like so many other Chinese companies before it, Sino-Forest’s high profit margins and other remarkable financial achievements have became an open invitation for noteworthy allegations of fraud by the likes of Muddy Waters and its cohorts. The possibility of outright fraud cannot be fully dismissed but in the case of Sino-Forest there might be a compelling alternative explanation in the form of insufficient disclosures and opaque business practices that are masquerading as “trade secrets” and “competitive advantages”. A simple domestic business in China can thus seem like a believable miracle, even if only temporarily so:

  • Acquire some trees and call them a plantation even though only the harvesting right but no land has been obtained;
  • Sell standing timber as “logs” because your purchasing agent intends to secure the underlying forestland for you, regardless of the chance of success;
  • Play down planted tree metrics even though plantation management is your company’s future;
  • Avoid having knowledge about forestland acquisitions made by purchasing agents on your behalf so that the rights can be retained even if the deal was potentially dirty or illegal;
  • Enter into an unenforceable master agreement with a single purchasing agent pursuant to which an impossible number of hectares of trees and forestland are to be transferred to you;
  • When the first purchasing agent falters, look for other agents as substitutes or assignees even though the odds of delivering the ultimate prize, the forestland, are very low;
  • Always claim that the purchasing agent named in the master agreement is the only one through which all transactions in that province are processed;
  • Specify bulk pricing under the master agreement whereby all timber acquired is to be recorded at an average cost with the result being that profit margins are boosted when the mature trees are sold off;
  • Increase pace of timber acquisitions when mature timber has been depleted since otherwise high profit margins cannot be maintained;
  • Never mention that your previous strategic business model of buying young trees and managing them until harvest was a failure because China ran out of sellers; and
  • Gloss over the high profit margins earned in the past as a result of sheer luck — buying young trees when timber prices were low — thereby making it appear that the overall business can operate like a cash machine in perpetuity.

The responsibility for any critical business issues that may arise from the above set of circumstances rightfully belongs to Sino-Forest given its opacity punctuated by the cloak-and-dagger theatrics of its “secret agents”. At the same time, the investment community must shoulder some of the blame for failing to properly understand Sino-Forest’s business model. Had the analysts obtained a proper understanding beforehand, they could have asked the tough questions long ago and not left so much swimming room for Muddy Waters. We suggest Sino-Forest management immediately grab the educational initiative from us.

Specifically, Sino-Forest can start to avail itself of suspicion with respect to the critical business issues described above by simply evaluating its management approach so that the substance of its business relationships takes precedence over the form. The master agreements and reliance on purchasing agents should receive particular attention. The company should also consider expanding the scope of its independent investigations to specifically cover (1) compliance with Chinese law and international best practices for rural land development and (2) tax matters with respect to its sales agents (to be described in Part 2). Noting that the company has already engaged professionals both inside and outside China who can help get to the bottom of general tax and legal matters, we strongly suggest the company consider supplementing the professional expertise it has already obtained with the subject-matter expertise of a firm like Landesa that specializes in international law and best practices involving agricultural and other commercial development in regions where indigenous land rights exist.

Special consideration should be given to improved disclosures in light of Landesa’s findings with respect to the alleged activities of the Finnish paper conglomerate Stora Enso in Hepu County, Guangxi Province. Notably, this is a province in which Sin0-Forest itself claims forest holdings amounting to 103,500 hectares as of 2010 year end. Fortuitously, this type of independent investigation would be timely regardless of the fraud allegations given that Stora Enso has apparently suspended its own forest acquisition in Guangxi recently, pending a comprehensive review of its activities for compliance with Chinese law and international best practices.

Amazingly, no journalist or analyst or investor or pipsqueak of any stripe has apparently contacted Landesa up to this point about its blockbuster report despite the obvious applicability of the information to this multi-billion dollar saga. We suspect this could quickly change once our report sees the light of day and we also hope those who read the Landesa report and appreciate the information will consider making a charitable contribution to support its important work.

Disclosure: Nothing herein should be construed as other than our opinions and beliefs formed on the basis of a preliminary desk review. We are not in possession of any factual information or evidence that is unavailable to the public and therefore our statements and conclusions are neither authoritative nor to be relied upon in any manner. Please note that we have made no attempt to evaluate the future earnings potential of Sino-Forest either in terms of its ability to maintain high margins by continuing its past practice of selling standing timber at appreciating prices or by successfully developing its own plantation operations. Our understanding, however, is that plantation forests can be financially risky in the long term and have not historically generated substantial excess returns on investment in China or anywhere else. As a result, any long position we hold in the Sino-Forest shares is predicated at this point on the stock returning to a price of about $6.40 per share, which represents our conservative attempt to arrive at a modified net book value based on the value of the company’s plantation (vs. standing timber) holdings plus the total amount of equity the company has raised during the past decade. This presumes no significant investment losses from trading in standing timber have been suffered by the company and sufficient cumulative operating profits have otherwise been generated to offset overhead and interest expenses. In effect, we are proposing that Sino-Forest’s business is inappropriately leveraging debt, which should be liquidated and netted against assets, leaving behind a net book value estimated to equal the capital raised via equity during the past decade plus the book value of the assets (planted plantations) developed from scratch. This method is one that perhaps the market could accept in the absence of the most serious of Muddy Waters’ fraud allegations proving true, in which case Sino-Forest is heading for a delisting and perhaps bankruptcy that will result in a total loss for equity holders and a substantial haircut for creditors as well. We have received no compensation from any party in exchange for this preliminary desk review or any other research or services related to Sino-Forest. We hold a minor position in shares of Sino-Forest and may buy or sell upon completion of further research or after becoming aware of new revelations/developments. We strive for accuracy in our work but cannot guarantee it. This review was conducted as an example of our capabilities and should not be relied upon by any person for any reason. Nothing herein constitutes investment advice, which should be sought from a licensed broker or registered investment advisor.

About silverax

Tom has been told he is arrogant. Unfortunately only very strong medication will apparently chill him out, but he doesn't like to put things in his body that might dull his sharp mind. Which is like an ax. And no, he is not a Scientologist. He can, however, turn lead into silver by concentrating very hard. See picture for proof.
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28 Responses to Charlatan Exposed: Seeing the Sino-Forest for the Trees — Part 1Comment RSS Feed

  1. Jim

    Excellent review! (even if my head hurt when I finished reading it)
    I looked at Sino and just couldn’t understand it which made it easy to look for another forestry company.
    Could you add this in |PDF format?

  2. @Jim
    Thanks Jim. We’ll plan to make a pdf available shortly.

    To clarify, this is our preliminary review so we may want to update some of the information before it becomes set in stone pdf-wise. So please be patient for this being made available.

  3. Don Hansen

    I do not understand why you guys have spent so much time on this company. Maybe some of your subscribers are interested in it, but I am not in the slightest.

  4. bart

    One can purchase TRE options as a leveraged way to play TRE, but today`s 50% move took much of the upside away IMHO.

  5. @bart
    Only if you’re in Canada, or else have access to the Canadian options market. The debt is also something potentially interesting, but it’s only available to institutional investors.

  6. @Don Hansen

    Yes we did spend a lot of time on this. In fact we’ve had our eyes peeled on the entire China-fraud universe for a while now. After watching so many fail, we actually thought there might be some misunderstanding here and a potential overreaction. With billions of dollars at stake and a chance to showcase our research ability we accepted the challenge and burned the midnight oil. In the end this turned out to be a unique opportunity to learn more about China in general, and considering that China is the major driver for the boom in commodities it actually ends up being much more relevant than at first glance. But nevertheless we understand if subscribers are anxious for more focused content, so let me just assure everyone that we have several such commentaries in the works. Quiet does not equal inactivity.

  7. Normand

    Excellent analysis.

    Paulson should have hired you guys, he would be in a better spot now.

    Chanos also would profit from your expertise. He is short the China story but it seems he missed the biggest blow out to date.

  8. First off, we don’t normally allow comments by non-subscribers (actually, non-Founding Members) so if you are not one then please don’t expect your comment to show up. That said, whenever we have comments from the outside that have good info that would be useful to the overall story or one where there is a lot of outside interest as in this case, we’ll make an exception. Below are comments that have been made so far from non-subscribers. We’ll add them and reply periodically but keep in mind this is our business, not a hobby, so it is not going to be a #1 priority.

    2011/06/22 at 10:40 pm
    This appears to be the best case for longs…kudos on that. It’s more respectful of the possibility of fraud and gets the ponzi nature (even if it’s the more expansive Minskyan definition). Also I didn’t see any ad hominem attacks on short sellers or Muddy Waters. That said this report actually seems to strengthen the case for shorting:

    (1) None of the arguments above cite China or fraud specific knowledge. They’re more thought experiments than based on evidence. If anything the Muddy Waters report contains much more evidence than presented here contrary to what you state. I don’t see a single doc here in chinese for example. Muddy Waters report as well as appendices include so many details in Chinese.

    (2) Price target without much justification but a lot of fine print and hedging your bets. Sorry man, Muddy Waters statement on the record that he is short UNTIL this goes to zero carries more weight. Your portrayl of his motivations clearly omits this FACT.

    (3) What’s your forest/wood products background? Fraud detection background? You undermine credibilty regarding forest/wood products knowledge…and you do?

    More to come.

    We are not trying to make a long case, we are trying to identify the true nature of any problems that may exist for the company. This is Part 1, we get into non-business risk specifics in Part 2. We’ll add there anything else we’ve found in the meantime. As to your points:

    (1) We cite plenty of China specific knowledge, enough to identify the true business risks in fact. This is a “desk review”, what kind of evidence from it are you looking for? Carson Block provides no “evidence” either, just Chinese documents that he interprets to “prove” his case. None of these documents are actually proof of anything, though it is certainly fair to claim that they raise major questions and concerns (some of which have already been adequately, though not skillfully, addressed by the company itself). Bottom line, nobody here is dealing with “evidence” or “proof”, it is all subject to analysis and interpretation, our claim being that major portions of Block’s interpretations appear reckless at best given that major elements of it are easily disproved.

    (2) We’re not giving a “price target” per se, we are saying what the shares might be worth if there is no game-ending fraud. You believe Muddy Waters that he will hold until the stock is zero? The only reason to believe that is, as we stated, if the company does survive and goes on the disprove the preponderance of his claims then Muddy is in major legal trouble. Not cashing in the short would leave him with a weak counterclaim that he hasn’t been personally enriched.

    (3) What is Muddy Waters’ forest knowledge? Fraud-detection background (beyond the past year)? We at least stated our background. As for myself, I was an auditor for 8 years, did SEC and regulatory work for another 10 years and generally like to think that I can analyze issues pretty well. In any case, we are perfectly fine letting the work speak for itself.

    Paul Stokes
    2011/06/22 at 11:23 pm
    So essentially Metal Augmentor is saying silver will either go up or down but you do not have an opinion favouring either scenerio. LOTFL.

    This is obviously not related to Sino-Forest, just some drive-by nitwit with a supposedly clever putdown related to this item: To answer, that is what you call technical analysis and it has the shelf-life of however long the expected chart action is supposed to play out, which is a few weeks to a couple of months in this case. For the benefit of braniacs like this guy, an analysis can be as useful for what it says won’t happen as it can for what it predicts will. In this case, the analysis was saying the silver market will resolve in the short term by making a modest move to a target within a rather tight range given the larger context of the macro trend (from $20-50 in less than a year). In other words, don’t expect either a big crash or a huge pop in the near future. I’d say criticism is warranted if that did not prove to be the case, but the analysis is actually proving to be right, which makes it that much more incredible that some bozo out of nowhere thinks he can dish out comeuppance by slamming it. By the way, the analysis is from Eidetic, which has forgotten more about technical analysis than you will ever learn.

    2011/06/22 at 11:46 pm
    I posted a few comments here..where did they go?

    A few? I only saw one, please see above for how we handle non-subscriber comments around here.

    2011/06/23 at 12:07 am
    Sino-Forest has released just one single series of documents on a transaction in 2010-2011. This concern the purchase of acreage near Wenquan village, Yongning, Yunnan. Yongning is in a mountain basin at 9000 feet, north-east of the major bend in the upper Yangtze. It is near the tourist attraction of Lugu Lake, and Wenquan (literally Hot Springs) has some occasional visitors. The ethnic tribe living at Wenquan has a matrilineal structure that is the object of scholarly attention.
    Folks wanting to geolocate Wenquan can use: 27.824247° N 100.696406° E in Google Earth or snapshots of the region at

    The documents detail rights to lease timber on land owned by the ethnic tribe. There are four parcels of 1,330, 944, 781, and 931 acres. All forest rights is being leased at an identical 260 RMB per cubic meter of total volume. This is equivalent to $95 / mboardfeet.

    The documents mention an attachment with maps, but these are not supplied in the data room. Clearly Sino-Forest has edited the documents to obscure the actual surveyable locations.

    The leases identify total and “recoverable” volume. This is where the leases get strange.
    The 781 acre parcel has 210 cubic m per hectare total and 122 cm3 recoverable. That is commercial forest inventory numbers.

    The other parcels have 53, 29, and 28 Cubic M per hectare in recoverable volume. That is virtually unstocked. This is not forest, commercial or otherwise.

    The deal is peculiar: a identical stumpage price for plots with mixed composition and virtually non-existent resource. This will not be improved because the altitude and climate (9000 feet) preclude the lowland eucalyptus plantation model that Sino-Forest publicizes in its PR.

    These leases are not intended to be commercial forest. They appear to be “speculative” chips that will be passed on to an anonymous buyer who will pay an anonymous agent who will provide more “lease rights” to Sino-Forest.

    Why Sino-Forest picked this deal to publish in the dataroom as representative (the only example) of post 2007 dealmaking is inexplicable.

    Yeah, have seen this plastered all over the place, it says nothing that is inconsistent with what we have written.

    2011/06/23 at 12:47 am
    Great review! Thank you for the insights!

    Thank you. Great way to look at this: a review that provides some insights. Nothing more, nothing less. Certainly not trying to move the market or for personal enrichment…

    Edward Goodie
    2011/06/23 at 6:12 am
    I find it absolutely amazing that the investment herd can be so easily swayed by an unknown entity. If Carson Block and his kind are not stopped (jailed), this kind of sensational short-selling will continue to expand. Long term investing will longer exist…

    Having predicated the same kind of attack on Orient Paper, he caused that company to fall and languish EVEN THOUGH IT WAS THOROUGHLY VINDICATED. Let him pander his attack on an American Corporation and see what happens to him…

    We don’t advocate against short-selling, it is a valid and important aspect of a functional market in our opinion. That said, we do believe the regulators will need to look at this because clearly it is now possible to have a situation where baseless allegations can crater a stock by 50% or even 90% and thereby allow an unscrupulous boiling room operator reap massive financial gains. Not saying this is the case with Muddy Waters and Sino-Forest as clearly there are issues here and at least 2-3 of his claims raise major concerns that need to be evaluated and addressed, and these may yet prove to be fraudulent or otherwise serious enough to cause the company to collapse. Just saying that mud-slinging attacks designed to drive a share price down that are guaranteed to have that effect based on certain preparatory activity (such as shopping around a short report or whispering its release date to a segment of the market) may need to be looked at from a regulatory standpoint.

    Edward Goodie
    2011/06/23 at 6:38 am
    @Don Hansen

    Then what are you doing here, Don?

    Don is a long-time Founding Member and he is making a valid point, one we have thought about but decided that for many indirect and corollary reasons it was still appropriate for us to spend the time on Sino-Forest even though we are primarily a gold/silver/mining research outfit.

    James Cai
    2011/06/23 at 7:57 am
    Thank for your detailed analysis. However, I have the following points:

    1. Most forests acquired by Sino-forest are natural forests, which means they are not young trees and can not grow much in 2-3 years when Sino-forest flips them for near 50% margin. So the high margin still reasonable?

    2. Please check the laws and regulations regarding off-shore companies doing business inside China, especially the taxation. There is no way for a foreign company to transfer its tax burden including income tax to its agents (AIs) when buying and selling stuff inside China. If Sino-forest’s timber trasactions were true, all accumulated gross profits would have to be used for penalties due to tax evasion for so many years.

    Thanks James. The 50% margin is certainly not reasonable on natural forests and we don’t claim that to be the case. What we say is that 50% margin looks possible on plantation forests they bought years ago and sold recently as they matured. Also, it looks possible if they are buying 200,000-300,000 hectares of standing timber and selling off the mature and highest value parcels. In fact, we calculate that well over 100% margins are possible in those instances, the only reason that the reported margin being 50% is that they are also selling/flipping other stuff that does not have very good, if any, margin. We’ll certainly look at the tax matters in Part 2 as noted in the first review but we think it is important to note that things are not as clear-cut as many are claiming. They aren’t even that clear-cut in the U.S. with tax law that has been established for decades if not centuries (witness tax loopholes still being closed, foreign service corporations, etc.) As correctly pointed out, however, the tax issue is very serious and needs to be reviewed and vetted thoroughly by the company. It could certainly cause a collapse, for example, all of the timber assets are seized by the authorities. Certainly possible. But I think it would be presumption that one can conclude 100% either way. That’s what the market is for, to place bets on the uncertain and unknown…

  9. James Cai
    2011/06/23 at 3:26 pm
    Thank you very much for your reply to my comment, but your explanation for high margin on natural forests sounds not convincing to me.

    If the company buys and records parcels individually, the mature and high value parcels will have higher costs on book, and thus there will be no super high margin for these parcels.

    If the company bought a series of parcels and recorded them using average costing, and then sold off the highest value parcels to achieve high margin, the remaining parcels would be with relative low value. Since the company has achieved super high margin on standing timber every year, according to your explanation, the company would have constantly sold off high vlue forests, and thus the majority of the current holdings would be low value, in other words, overvalued.

    But the company doesn’t buy “parcels” individually, they use purchasing agents and bundle them together under the master agreements! Moreover, Poyry says the company does not have its own yield data for each plot so how can the company allocate the bulk purchase to individual parcels? Yes, the majority of the current holdings are probably low value but they keep buying huge amounts while timber prices are on the rise and there is also some growth (even if minor). Therefore it would not be possible to conclude with great confidence that it is overvalued for certain or by how much. Our modified net book value estimate does, however, take a big haircut from the reported amount of assets so in the end I think we are saying the same thing, no?

    2011/06/23 at 3:23 pm
    This is the best piece of Sino-Forest research that I’ve seen. It manages to use some compelling arguments and some reasonable guesses to tie together all of the facts as well as to explain the (for me inexplicable) behavior of the company. E.g. Based on photos it looks like some of the company’s holdings are in quite poor, high altitude forest areas.

    Thanks, the “value” as it were that an investment review delivers is rarely “secret evidence” found trudging through local government records but rather integrating disparate pieces of info into a framework that makes sense. It is important to realize we are not doing due diligence or investigative research here. That said, I have plenty of personal experience with “investigating” besides 8 years as an auditor and several more dealing with regulatory compliance at a crazy dotcom company that went bankrupt but otherwise avoided the same scandals (thanks almost 100% to me) that befell almost all the others. For example, a company a few years ago named Sterling Mining was trying to start up the famous Sunshine silver mine but the guys in charge weren’t big into full disclosure or doing things the right way. I did most of the legwork there, discovering for example that the Shoshone Indians and EPA have a combined 7% net smelter royalty on future production that the company had failed to disclose (some of you know Hecla Mining recently settled on the same issue for $250 million cash, so it’s a big deal). I still have the recorded deed for that royalty I personally obtained from the Shoshone County Courthouse. My work resulted in one investor even filing lawsuits (in what turned out to be a jurisdictional over-reach). Back then (2005), however, this type of “negative” info didn’t have much value and certainly would not have been given credence like some of the questionable stuff out there today. Eventually the company went bankrupt anyway, pretty much following the story-line I had laid out. More recently, there is a junior exploration company that most Founding Members know about if they have read far enough back in the archives, where I believe there is an unacceptable risk of delisting based on a fatal, incurable corporate flaw. Could I have written a “research report” on this company, tried to sell it to hedge funds, and then publicized the report for personal gain? Sure, but I knew that eventually the bad karma (much less legal liability) associated with doing something like that will catch up with you. It’s just a stupid thing to do. Perhaps it would be a different matter if Block hadn’t shorted the shared himself or pre-marketed his “research”. Bottom line, I have plenty of experience in this area including several companies where I could have done the same thing. Last but not least, the cost of doing the proper job on something the size of Sino-Forest would be at least several hundred thousand dollars if not more and I don’t think Muddy Waters has incurred anywhere near that in “research” expenses despite claiming to have a “team” in China. Worse than failing to get to the bottom of the story is claiming that you have…paying some locals to fetch filings from the SAIC offices and turning in some favors from old Hong Kong contacts/drinking buddies doesn’t cut it (and no, I am not accusing Block of being an alcoholic).

  10. JockUlar

    VERY interesting work! – I hope you have made John Paulson aware of this work. He has the losses (and the clout) which might convince management to get out front of these festering issues.

    Felix Salmon of Reuters tweeted about this piece today. You guys deserve to get some bigtime publicity for this (typically) thoughtful work! -

  11. JockUlar

    Oops. Paulson sold his Sino Forest shares on 6/17 at a loss of $720M. So, send your piece to ALL his rivals amongst the “big dogs” of the hedge fund world ….

  12. Khang

    Paulson has many smart people work for him and they still made big mistakes…

  13. ebear

    FWIW, there’s no mention of Sino Forest at Citroen Research, and they seem to be all over the Chinese listed co.’s these days:

    Still, I don’t see anything compelling about this one. Take a look at the terrain they’re operating in and ask yourself which is cheaper: to farm trees in the rugged interior of China, or simply buy them from Indonesia, Malaysia, Vietnam etc. and ship them to the coast where most of the demand is. For that matter, there are lots of empty containers returning to China from N. America that could be loaded with BC or Oregon wood products, so where’s the Chinese company working that angle? I’m guessing you could negotiate pretty low rates on those containers, since there’s absolutely no market for them and they must make a round trip.


  14. @Khang
    Smart does not make someone knowledgeable about what to look for or able to integrate a lot of seemingly-unrelated pieces into a sensible whole.

    No doubt! Never claimed it was compelling! Don’t know of any farmers or forest barons on the Forbes 400, etc.

  15. kr2011
    2011/06/24 at 11:17 am
    Unfortunately, you don’t really address what I believe is the most critical question concerning TRE, which is the use of “authorized intermediaries” to conduct the greatest portion of the company’s purported business transactions in PRC. This is outlined in the company’s investor presentation for 1Q 2011 (p. 28 of their PowerPoint doc, available at their web site). Such a model at the very least raises questions about tax liabilities and the ability of the BVI entities to access any cash flows generated by such operations. It also introduces the possibility that the transactions could be fictitious, since the company itself is not directly engaged in them and may not possess a proper audit trail. Fitch cited this extensive use of AIs as the primary cause for its recent downgrade of TRE’s debt.

    This is dealt with in Part 2 as we reference in Part 1 above. The main problem for us wouldn’t be simply the tax liabilities but why the company wouldn’t care to verify that the AIs have paid it. The potential unpaid tax is purported to be in the range of $200 million. As a CFO or controller, I would be all over that, demanding absolute proof of payment by the AIs, otherwise it is free money to them. If the service they provide is truly worth a potential cost of $200 million, there is no way the company should be able to hide behind the “secret agent” argument. Regarding the BVI companies getting money out, I would actually argue that it would be much more difficult for a Chinese-domiciled company to get money out to Western investors. One key difference between most of the frauds exposed so far and this company is that the others were Chinese companies with subs in China that were never going to pay dividends or anything back out of China whereas Sino-Forest has its main subs outside China. Another important distinction is, the China frauds so far have been frauds to Western investors but have not appeared to break laws in China itself. Here the fraud allegation, as far as tax and related issues, is that the company has broken the law inside China. I don’t think anybody has really taken the distinction into account as they pass subjective judgment on the situation (which is all any of us can do right now). Finally, using agents by itself doesn’t mean anything, and I don’t give a rat’s hind quarters what the dopes at Fitch think or do considering they and the others whiffed on yet another obvious rating risk.

  16. By the way, Silvercorp operates in China through a BVI company (and a Barbados one on top of that for good measure). Yet they have been paying dividends since 2007. First 5 cents per year and 2 cents per quarter since 2008 for a total of ~30 cents I reckon so far (maybe $50 million?). In any case, sort of puts the idea of “impossible to get money out of China using a BVI company” into some context.

  17. kr2011
    2011/06/25 at 11:53 am
    Thanks. I’ll look forward to Part II.

    I remain bedevilled by this whole AI story. I won’t elaborate on them here, but from an accounting, operational, and economic perspective this business model raises a number of questions, particularly given that it represents most of TRE’s business: “To date, the large majority of our revenue and profits in the PRC are generated in our BVI Subsidiaries with most of the remainder of our revenue and profits being generated in our WFOEs. According to relevant PRC laws and regulations, including the tax and foreign exchange regulations, the BVI Subsidiaries´ ability to remit foreign currency outside the PRC is limited. As a result, in order to provide accessible cash to cover any of our holding companies´ obligations, including debt obligations, we currently do not rely upon the repatriation of earnings of the BVI Subsidiaries.” [AIF 2010, p. 39]

    If you have the time and motivation, I would also urge you to go back over as many years’ filings as possible, at least to 2000, and take note of inconsistencies and changes to business model and reported plantation holdings. Cash flow statements and discussions of corporate structures utilized also should be of interest. Even my cursory review of older AIFs and ARs turns up inconsistencies.

    BTW congrats on your mention in FT Alphaville. That should send some traffic your way.

    These are all valid things to study but by themselves not conclusive on the question of outright fraud. Presumably they have changed the business model, as we note extensively in Part 1, because of the difficulty obtaining good forestland for long-term plantation operations. The use of AIs has not been adequately explained beyond the “secret agent” component but that doesn’t mean a valid explanation does not exist, embarrassing as it might be for the company (for example, it is possible that many of their partners are provincial or even national SEOs who demand full confidentiality in exchange for doing business with Sino-Forest). I don’t know this to be the case at all, but at least theoretically this could be an explanation. We did not specifically pursue this angle in Part 1 (as it pertains mainly to the agent issue) but it is quite implicit in the Stora Enso study by Landesa. Also, I note that several others are now taking this angle of looking at the actual forestry practices, which are probably not very pretty just like most other deals involving land in China (we’ve all heard how poor people are evicted by the thousands or even millions to make way for important modernization in both rural and urban areas), as a possible reason for the opacity — see

    James Cai
    2011/06/25 at 8:27 pm
    I took a look at Sino-forest’s year-ending balances of planted plantation area and purchased plantation area, sold area and new purchased area for each year from 2003 to 2010, I found that the majority of standing timber sales were from flipping forests that the company bought and kept around 2 years.

    In consective 7 years, buy forests and keep them 2 years and then sell them at almost doubled price, don’t you think too good to be true? I extensively searched other forestry companies in China and timber market information, but I failed to find anything to support this surreal profitable business model. Also, when buying and selling large area of forest, it usually take months to conduct a survey of the forest, which usually involves a professional forestry survey organization. Taking the survey into account, the flipping circle would be as short as one year, and the business model sounds more out of my imagination.

    All good points. There is clearly something else going on besides flipping to generate these huge profit margins. Perhaps it might be possible to justify 15-25% on the basis of rising timber prices and yield improvements. Selective selling or other methods, along with selling off purchased plantations acquired as saplings 3-5 years ago, comes closer but it still leaves a credibility gap. Clearly the company must now reveal their business in sufficient detail to allow the market to assess the reasonableness of the profit margins. This certainly will be one of our main goals.

  18. SinoForestAnalyst
    2011/06/26 at 7:28 pm
    If I had to sum up the problem I have with your Sino Forest analysis (so far): Possible does not imply probable.

    To elaborate:

    If I’m reading/understanding your ‘Part I’ correctly, your thesis is: Sino Forest might not be the fraud Muddy Waters believes it to be, because of x, y, and z. I get that.

    What I’m failing to see is going from the ‘might not be a fraud’ to “Sino-Forest is probably a legitimate company with a significant economic presence in the forestry and timber sectors in China.”

    What am I missing? I’m short the stock but have no qualms going long if the evidence supports going long. So far, however, the case for fraud seems to be gaining strength.

    If such explanations as you pose were to be true, why hasn’t Management even hinted accordingly? Did you listen to the conference call? Yes, you recognize the ‘opacity’ problem..that’s too kind in my and I believe the markets’ opinion. What about the way tough questions and questioners were conveniently silenced? The name Annissa Lee of Nomura ring a bell? She was rudely cut off supposedly because she ran over her question limit…yet Richard Kelertas, at the time Sino Forest’s Cheerleader in Chief, got two opportunities. Sino Forest has been doing these calls for years.. so I rule out the ‘they had a bad day’ or ‘they’re new give em a break’ excuse.

    Are we ever afforded ‘proof’ of fraud outside of hindsight? So no, I don’t buy the “but but that’s not proof of fraud.” argument. I would recommend lowering your threshold for fraud, and increasing your threshold for not fraud in the case of Sino Forest. You acknowledge some of the red flags, but you have left many out (which of course may be addressed in part 2).

    If it looks like a duck, smells like a duck, and quacks like a duck…why bet it’s something else?

    Many ducks have met their demise because a decoy looked like a duck and the duck call sounded like a duck. Smells like a duck? Don’t know anything about that.

    But seriously, the conclusion that it is “probable” that Sino-Forest actually has a significant, legitimate presence in China is our opinion based on the preponderance of information we reviewed. The only way to make 100% sure is to conduct hundreds of thousands of dollars worth of investigations in China. We haven’t done that. Have you? Has Muddy Waters? I would bet money the answer is “no”.

    Why hasn’t management “come clean”? That presumes of course there is something to come clean about, although I think we can all agree on that to one extent or another at this point. This is actually an area that anybody who really knows about how frauds get committed, discovered and proved will realize is critical. In short, trying to hide the fraud is most often what unravels it.

    Next, I see no conspiracy regarding how the earnings call was handled — clearly there were some questions the company wasn’t going to answer (or be able to answer). They did answer a few where they probably should have just said “we’ll have to get back to you” given how lame the response was. Using the earnings call as any type of evidence or proof of fraud is a silly stretch.

    Regarding the burden of proof, this is where you get into bullshit territory. It is absolutely the case that the burden resides with someone who is making a purported factual statement that damages the reputation of another party. This is established in the laws of just about every country and culture in one way or another. Differences exist as to whether malicious intent or reckless disregard for the truth are necessary components (under some laws neither is necessary) for a defamatory act, and while I’m a big proponent of the free market, I would also support securities regulations that address this area so that market participants in the future will play within the bounds of fairness.

  19. ibem52

    2011 Plantations Tour – please note this tour has been postponed until further notice. Awful suspect IMHO.

  20. They gave a legitimate-enough reason as the analysts are basically putzes and a “tour” wouldn’t really accomplish anything for them or the company (e.g., they couldn’t resume coverage and so there would be no basis to “write up” what they saw). That said, the company should have a tour for journos and non-broker analysts — though they would probably claim these people couldn’t really have a confidentiality agreement enforced because they are not regulated professionals (plus I don’t think a reporter would sign something like that anyway).

  21. thefroggydude

    Here is an interesting article on reverse takeovers of listed American firms by Chinese companies. The appended news items are interesting as well.

  22. @thefroggydude
    Thanks froggy!

    2011/07/18 at 7:40 am
    Look forward to Part II and III. When will they be available?

    Working on it, not able to get as much independent data as hoped but will complete anyway soon.

    James Cai
    2011/07/12 at 10:28 am
    When will the part 2 come out?
    And before you publish part 2, you may take a look at my blog:

    Thanks for continuing to do good work James, the next part is another look at the business risks from the company’s own position. Many of the “Part 2″ issues — accounting, legal, tax — have already been partially addressed by several people so much of that work will not be original in the same sense as Part 1.

  23. Tweetie

    Controversial Chinese forestry company Sino-Forest won’t be trading on North American shores any more.

    The Canadian regulators ruled that “all trading in the securities of Sino-Forest shall cease,” according to an order from the Ontario Securities Commission.

    The Ontario Securities Commission also said it ordered five executives of Sino-Forest Corp. (TRE) including Chief Executive Officer Allen Chan to resign because the forestry operator may have misrepresented revenue and exaggerated its timber holdings.

    In its order, the Ontario securities regulators said:

    “Sino-Forest and certain of its officers and directors appear to have misrepresented some of its revenue and/or exaggerated some of its timber holdings by providing information to the public in documents required to be filed or furnished under Ontario securities laws which may have been false or misleading in a material respect.”


    What’s you take on this? Nothing has been proven, but apparently the delay in the fraud investigation caused a total loss of confidence in Sino Forest by Ontario Securities Commission.

    Or was there some communication between the accountant and the Ontario Securities Commission?

    In Canada the stock isn’t trading, but the stock on the pink sheets is now down more than 60%.

    • @Tweetie

      It’s not really all that surprising. I wrote a short review here:

      We may have more to say soon. The fact that it was”only” halted for 15 days at least still leaves possibility that it isn’t a complete fraud. No doubt shares will probably reopen down at least 50%. Certainly a fascinating story that we’ll continue to track, and who knows maybe there will be another opportunity to make some quick trading profits.

  24. This is not unexpected — note that the OSC has only addressed the Chinese officers — this was easy to do since these individuals are unlikely to appeal the order, they were probably the ones hindering any investigation, and whatever fraud that had taken place was most likely perpetrated at their own hands. My guess would be that the independent committee of Sino-Forest had discussed the situation with the OSC and it was decided that the company could not continue to operate, much less have the investigation completed, with these individuals still on board. The question now falls back on the debt securities — if covenants have been violated the holders may want to assert a default — and then if the debt cannot be paid off then bankruptcy would likely follow. Moreover, if these 5 Chinese guys represented the brain-trust of whatever legitimate operation Sino-Forest did have, then it could be very difficult for the company to carry on its business, period. In addition, this is a temporary cease trade order and my guess is that the OSC is looking for compliance by the company particularly with this “brain-trust” out of the way. If this compliance is not forthcoming, or there is no credible plan for compliance, there is a risk that the order becomes permanent.

    The part 1 of our research on the company had enough gunpowder by itself for the OSC to bring this action because it certainly would be possible to conduct the activities we have outlined in a fraudulent manner especially as it pertains to financial reporting. Note that our analysis of the financials has essentially proven correct with the company’s release of Q2 financial statements wherein an admission was made of the selective nature of timber sales including that prices vary based on factors other than fiber yield but also that going forward the profit margins would be much lower as a result of the different “mix” of timber being sold.

    We’ll have to determine if this latest twist should change how we complete our Part 1A and Part 2 and in fact whether those are even necessary at this stage.

    Finally, I am reading this OSC order as one that is giving due consideration to the retired E&Y partners on the company’s board, not to mention the reputation of E&Y itself. The most negative way to look at this would be scapegoating: if those foreign scoundrels can be blamed for it all, then our upstanding Canadian citizens and one of our top auditing firms were simply victims of Chinese tricks like everybody else.

  25. Khan
  26. thefroggydude

    Tom. Maybe you need to write an article on Silvercorp (SVM.TO)

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