On April Fool's Day, RINO International (OTC:RINO), a Chinese company specializing in environmental protection equipments, announced record 2009 earnings and net income and saw its stock tank 10.75%. This strange move caught my attention and made me look into the root cause.
This company is another one of the Chinese crazy stocks. It went from $3 per share one year ago to as high as $34 per share 4 months ago, and currently stays at $21.
In general, I keep away from those high-flying Chinese stocks as they are often manipulated. Plus, the environment protection business, however sexy it may sound, does not arouse my interest. It is an industrial production business in its core, and any competitor could copy its design in a country where intellectual property protection is still at an infant stage.
In any case, what is interesting in the conference call is a new business model the company is going to adopt.
This new business model is called BOT, shorthand for Build-Operate-Transfer. According to the CEO:
BOT is a construction model in which contractors (Author's Note: RINO itself is a contractor) will construct the whole project. And the contractor will pay for the construction project in advance including construction and operation, and in the final stage will hand over to the company (Author's Note: the company = RINO's customer).
Quite a few red flags are flying here. I don't care about what name is used - be it BOT, CDO, or CDS - this is seller's financing. We see seller's financing all the time with GE, Ford, Mitsubishi, and lots of names I can recall, but they all share the same characteristics: those companies have a financing arm and their cost of capital is low, while the financed customers are often with a much weaker financial position and would not be able to buy the products without seller's financing.
In RINO's case, its first BOT customer is Shougang, or Beijing Steel Corp., a much larger state-owned corporation that has a very low cost of capital as it can tap into the state-owned banks. This does not make common sense. Why should a company with a higher cost of capital finance a company with a much lower cost of capital?
What's more, BOT is worse than financing, because the project RINO builds is inside Beijing Steel Corp. If the deal breaks during the operation, unlike other seller's financing where products get returned to the seller, dissembling of RINO's project could be a total write-off. Imagine that you and your neighbor have a deal where you build a house on your neighbor's land and rent the house to her. What are the consequences if your neighbor refuses to pay the rent?
RINO suggested that it had bank loan agreements lined up to fund the BOT projects, but this does not change the fact that it is bearing all the risk and its cost of capital is higher than its customer's.
Its first project with Shougang has build contracts of $33.8 million and operating contracts of $84.3 million. This is not a small amount compared to the $204 million equity value of RINO as of the ending of 2009.
According to RINO's 10-K, it is the government that is encouraging the BOT business model.
To support adoption, the government will encourage the build-out through BOT (build-operate-transfer) ownership structures which would allow the financier to operate the system for up to 20 years and then transfer ownership to the steel producer.
Even if we take this at face value, it is worth pointing out that it is perfectly fine to use BOT so that environment protection equipment will be constructed sooner rather than later. But, RINO is not in a position to take up the financier role.
Nevertheless, the management claimed in its conference call the following bullish statements.
This project (Shougang Project) is a significant milestone for the company as we enter into new service agreements and we look to do so with as many customers as possible to provide high margin recurring revenue.
Quite contrary to the management's bullishness, these statements made me worry. It reminds me of AIG (NYSE:AIG) and CDS, if you know what I mean.
One last note, short interest of RINO has steadily risen during the past half a year. it stood at 4.5 million shares on March 15, while Yahoo! Finance indicates that the floating shares count is 7.9 million.
Disclosure: No position of mentioned as the time of writing