Over the past few weeks, there has been much discussion on fraud allegations involving Orient Paper (ONP). The dialogue has been extensive. The original Muddy Waters research report was 30 pages long, and they have issued several subsequent pieces of commentary. The company, in turn, has submitted several responses to the Muddy Waters allegations and has hosted a conference call. There have also been several articles by the company's defenders on thestreet.com.
There has been a lot of information and keeping track of it has been difficult. The purpose of this article is to highlight the several most compelling pieces of evidence to me that Orient Paper is a fraud.
As I’ve written in previous articles and blog posts, I believe that Orient Paper is falsifying its financial statements. There is substantial evidence for that, but I’ll focus here on 4 of the most convincing points to me. I’ll exclude certain disputed items like the AIC filings, where the company and Muddy Waters are in disagreement over whose copies are the correct documents.
1. Top 10 Customers
Much of Muddy Waters’ research has focused on direct due diligence that they’ve done on the company’s premises in China. Yet some of the most compelling pieces of evidence that Orient Paper is a fraud comes from incriminating evidence that it has published in its own SEC filings.
One of the best examples of that is in its 2008 and 2009 Top 10 Customers. Here are the two lists, from the SEC filings:
Muddy Waters puts it well:
ONP’s 2009 top 10 customer list shows that it replaced 80% of the 2008 customers. The strange item is that the minimum level needed to enter the top 10 lists stayed constant at around $2.1 million. In other words, one could reasonably expect that almost all of the companies who did $2.1 million or more in business with ONP in 2008 should do at least as much in 2009. But this was not the case, as eight of the 2008 top 10 customers disappeared. Yet, ONP did not lose any revenue. It grew by 56.5%.
The paper manufacturing business in China is highly competitive. First you have to make the product. Then you then have to sell it. “If you make it, they will come” is no less realistic in China than in the United States. Particularly when the product is highly commoditized – such as paper is.
For a company to lose most of its top 10 customers and not have sales decline requires significant effort by all throughout the organization. To lost most of its top 10 customers and still grow the company at 56.5% is a remote possibility.
And here is the company’s response:
Muddy Waters also accuses Orient Paper of churning and burning its top 10 customers and misrepresenting its sales volumes to these customers. Those who have followed Orient Paper and studied the Company's 10-K and other financial disclosures carefully over the past two years understand the following Company developments. Almost all of the Company's top 10 customers are printing companies that buy printing/writing paper. The Company traditionally has a large number of small packaging plants buying its corrugating medium paper and very few, if any, of them make to the top 10 list. Within the group of printing/writing paper customers, significant changes in Orient Paper's product portfolio occurred in 2008 and 2009. In 2008, HBOP started producing writing paper, thanks to the 1760# Fourdrinier Multi-Cylinder Production Line that was placed into service in March. In the Fall of 2009, because of the skyrocketing cost of imported wood pulp, Orient Paper stopped producing high-grade offset printing paper, which requires virgin pulp (rather than recycled paper) as a major raw material. In an effort to push for a lower-priced medium grade offset printing paper, the Company converted the writing paper production line in September 2009 to concentrate on producing more medium grade offset printing paper. As a result of these shifts in product offerings, the top 10 customer lists of 2008 and 2009 had very different compositions. Orient Paper had more white paper sales sold to those customers who switched to the Company's mainstream medium grade offset printing paper.
Orient Paper is a paper manufacturer. It operates a commodity business, and Orient Paper doesn’t have any special technology over and above its competitors. As well, while China is a faster growing economy than the United States, it is nevertheless competitive, and paper demand isn’t growing at 50% a year. The Company can’t simply change its product mix, replace 80% of its Top 10 customers and still grow revenue by more than 50%.
2. The Video
The visual evidence presented by Muddy Waters makes a compelling case that Orient Paper is falsifying its financial statements. While the new digital photo lines provided in subsequent pictures may appear somewhat professional, the main legacy production lines shown in Rick Pearson’s TheStreet.com video demonstrate a business far smaller than what the SEC filings indicate.
To best examine the visual evidence, it’s best to look at competitors’ plants, and then compare those plants with the Muddy Waters facilities:
- See pages 14-17 of the Muddy Waters report available here
Orient Paper’s plant:
Based on the videos and pictures, Orient Paper’s main plant is of materially lower quality than that of its competitors. The machines are old, run-down and appear incapable of producing high quality paper. As well, the videos show substantial steam generated in the facility, which conflicts with the company’s claims of producing high quality paper. Once paper is exposed to water, it becomes no longer flat, and cannot be billed as high quality.
3. Muddy Waters’ Claims that the Company’s Top 10 Customers Could Not Have Purchased As Much Product As ONP Claims They Have
In its report, Muddy Waters tried to contact each of the Top 10 customers that Orient Paper lists in its 10K. Five were contacted or otherwise verified, and Muddy Waters lists their phone numbers in its report. Any outside third parties can independently contact them, given that Muddy Waters makes their contact information readily available.
Click here for the table where Muddy Waters documents its diligence on its Top 10 customers.
Based on its findings, Muddy Waters concluded that Orient Paper has fabricated its sales figures to those customers. Five of the customers were too small to be able to buy the volume of paper that Orient Paper claims it purchased from them. For instance, at a company to which Orient Paper alleges selling $3.4m of product, the cleaning woman answered the phone during business hours and was the only employee working. She said that there were only a few employees at the business and all were part-time. Four of the companies within Orient Paper’s Top 10 could not be found, had no website or had no one answering the phones during business hours.
Only 1 of their Top 10 customers, Boading Huatai Printing Co. Ltd, was large enough to theoretically purchase the amount of paper from Orient Paper that ONP claimed.
Here is Orient Paper’s response:
Muddy Waters has stated that it believes that "all but one of Orient Paper's top 10 2009 customers are too small (if they even exist) to buy the amount of product that ONP claims they do." This accusation is false and Orient Paper believes that Muddy Waters' methodology is inappropriate for establishing substantiation in a fraud case. Business practices in China are different from those in the United States, where many businesses are willing to reply to sensitive trade account confirmation given a properly drafted written confirmation request from the trading partner and the confirmation performed by legitimate third parties, such as auditors. Unsolicited, improperly phrased enquiries are usually met with misleading or inaccurate results. In addition, even in the U.S., auditors who perform written or telephone confirmations must perform additional alternative procedures to get in contact with the relevant parties to be confirmed before any conclusion can be reasonably made. While Muddy Waters claims that they were unable to verify the existence of some of Orient Paper's customers and made no effort to ask Orient Paper for assistance; many institutional investors; investment banks, such as Roth Capital Partners; and the Company's auditor, BDO Limited, have all performed due diligence on Orient Paper's large customers and have confirmed and communicated with their selected sample companies during the last twelve months. Among these parties, Muddy Waters is the only one that claims Orient Paper is providing "false information" about its top 10 customers.
Orient Paper’s response is basically twofold.
First, it claims that Orient Paper’s customers would lie to Muddy Waters about their size because that is standard procedure in China. I doubt that’s the case.
Second, it claims that a variety of third parties have done the necessary due diligence on Orient Papers’ customers. As I’ve previously written, BDO Limited has demonstrated an inability to do proper due diligence in the past, given that it was the auditor of China Expert Technology, which was a complete hoax. I would not rely on their work. The investment banks working with Orient Paper are third-tier firms that have embraced Chinese RTO smallcaps mainly because the sector generates a tremendous amount of investment banking fees, not because the companies whose offerings they underwrite are real. As for the institutional investors in ONP, I will not make an unwarranted generalization because a variety of funds invest in Chinese RTO smallcaps, and they do so for different reasons and according to different investment theses. But some of the funds that do proper on-the-ground business diligence on Chinese RTO smallcaps like Orient Paper are indeed savvy and have generated outstanding returns from the sector. But it hasn’t necessarily been from avoiding frauds.
4. Further Inconsistencies within the SEC Filings
In addition to the unlikely 80% turnover within the Top 10 Customers, there are further inconsistencies within Orient Paper’s SEC filings.
First, Orient Paper’s alleged inventory turns are extraordinarily high for a paper company, and when compared with competitors. On page 25 of the Muddy Waters report, we see a comparison of ONP’s inventory turns when compared to competitors. ONP’s 17x 2009 inventory turns is high for any manufacturing business, let alone a paper company in an industry where its listed competitors’ inventory turns are 4x, 6x, 6x and 8x.
Second, as an additional blogger wrote in a post last week, if the company grew revenues by 57% and earnings by 45% in 2009, why was its employee count 600 in both years? In fact, an old video of Orient Paper (fast-forward to minute 1:46 of the video) says that the company had 863 employees. If that’s true, how has revenue grown from $40m in 2007 to $102m in 2009 while employees have actually shrunk 30%?
That blogger highlighted further inconsistencies. How did the company have a 37-member R&D department that only cost them $30,130 in 2008? How did ONP more than triple sales in 3 years while spending only a collective $655 (six hundred and fifty five dollars) on advertising and promotion in those 2 years?
There is substantial additional evidence that Orient Paper is falsifying its financial statements that I have not touched upon.
The company and Muddy Waters are disputing whether the SAIC financial statements match the SEC financial statements. I also have acquired SAIC documents with the personal seal of ONP chairman Zhenyong Liu, and may post them at a future date. Either mine and Muddy Waters’ documents are falsified, or the ones recently submitted to the Hebei AIC are falsified.
As well, I have not touched on whether ONP could theoretically purchase a production line for $27m, when Muddy Waters has provided evidence that the most expensive highest capacity 5.6m corrugating medium production line would cost less than $10m.
I have not touched on the low likelihood that the recycled scrap inventory shown in the video and various additional Muddy Waters’ pictures could be worth the amount that ONP values them at in its financial statements.
I have not touched on how ONP can generate the same gross margin as its competitors despite its outdated equipment and far lower economies of scale.
But even without touching on the additional evidence that has been disclosed over the past few weeks, the points highlighted in this article provide compelling evidence that Orient Paper is falsifying its financial statements.
Disclosure: Author is short ONP