Making money in the stock market is about searching for potentially mispriced situations and getting beneath the reasoning to try and find value. I would like to consider myself a contrarian type value investor that invests in spaces where others aren’t or won’t dare to go. Where people think there is maximum risk with little reward (circa the entire equity market in March of 2009). This has led me to the Chinese small cap space—searching for small cap Chinese companies listed in the US that are being accused of fraud or just plain ignored by investors and as such are trading at very cheap valuations.
Lately it’s been Chinese companies that are getting bashed for accounting fraud and accused of forming shell corporations that only function to bilk money from naive American investors in the investment media. While I have no doubt there is plenty of fraud that goes on within the Chinese small cap space, I stop short of forming the conclusion that every single Chinese company that became public through the “now hated” reverse merger is a complete fraud or that they’re all “cooking the books”. I realize I’m at odds with some of the “professionals” like Herb Greenberg and David Faber on CNBC who bash the entire space instead of specific situations or issues that arise, but I’m ok with that. A savvy investor can actually use those unsubstantiated conclusions to his/her advantage to try and target pricing inefficiencies that exist in the market because of potentially false logic and/or panic selling.
One such story that I’m currently making a cautious bet on in 2011 for various reasons I will outline is Longwei Petroleum (LPH). I’m not going to make claims in this piece that Longwei is not fraudulently reporting numbers—I really have no due diligence of my own to substantiate those claims—nor am I going to tell you that the company is well-run from a shareholder point of view—I come to the conclusion it might be the opposite. What draws me to make an investment in Longwei Petroleum (for the time being) is the simple business model which I believe would make an easy audit, cheap valuation per what their financials are reporting, and the hope that Longwei--with an American accounting firm and a part-time American CFO—might not be the fraud that the market is currently pricing.
I have broken down aspects of Longwei Petroleum into what I believe are the Pros and Cons of investing in the company through my own research:
· Cheap Valuation (per financial reporting)
· Simple & Straightforward Business Model
· Accounting & Audit (simple & easy)
· Insider Ownership & Insider Sales
· Low Institutional Ownership
· Dilution & Financing Expansion
· Lack of Knowledge Regarding Competitive Environment
· Suggestions for Management
· Final Thoughts
PRO: LONGWEI’S BUSINESS MODEL (simple & straight-forward)
Longwei Petroleum (from what I read) is an oil and gas wholesaler located in the Shanxi Province which is located in central northeast part of the Peoples Republic of China [PRC]. The capital of which—Taiyuan—is approximately 250 miles northeast of Beijing. Longwei’s business model is as simple as buying oil from refineries in China, transporting it to one of their two storage facilities in the Shanxi Province (located in Taiyuan & Gujiao—which together are capable of storing up to 120,000mt of petroleum products) before being delivered to end users. Shanxi is the leading coal producing region in the PRC which is constrained by no pipelines or refineries in the province due to the mountainous topography.
This barrier has created a niche for Longwei by supplying coal-producing power plants and various other energy-consuming businesses in the mountainous Shanxi province with imported oil and gas in a timely and efficient manner by truck or rail. This niche allows Longwei’s customers to maintain focus on their core businesses while not having to devote resources towards the logistics and storage of their energy consumption and needs.
The company depends on suppliers, namely refineries, for inventory which price fluctuates on a 22-day “look back” period of international oil prices 4% up or down set by the PRC. The PRC’s re-pricing of oil every 22 days is fairly telegraphed and as such allows Longwei’s management to adjust inventory levels based upon the anticipated industry pricing movement and acts as a hedge on pricing levels. Subsequently in an environment of rising oil prices (i.e. when the FED prints over $1 trillion dollars destroying the dollar’s value and inflating global commodity prices), Longwei can lock in future supply from refineries at current price levels thereby increasing future margins.
Longwei’s margins are healthy, averaging near 20% gross and 18% operating over the last four years. Longwei also holds two distinct licenses for the wholesale distribution of petroleum products in the PRC which is a significant barrier to entry as apparently both of these licenses consisting of the Wholesale License and the Dangerous Chemical Distribution License issued by the PRC are very difficult to obtain simultaneously for any entity operating in China.
From the company’s 2010 10-K its largest suppliers are:
2010 % of Purchases
Guangzhou Tenghao Company
Lanxin Petroleum Co. Ltd.
Panjin Jinjiang Oil Company
Yan Lian Industrial Group
Tianjin Dagang Jinyu Industrial Co. Ltd.
· HOMEWORK FOR CHINESE SEEKING ALPHERS: Do these refineries exist?
From the company’s 2010 10-K is a breakdown of Product Revenue and Avg. Profit Margin:
Product Percentage of Total Revenue and Average Profit Margin by Product Line
Avg. Profit Margin
Avg. Profit Margin
Agency Fees *
PRO: LONGWEI’S CHEAP VALUATION (per their financial reporting)
Longwei currently boasts over $200 million in net assets (with no debt) on their balance sheet and is selling for a mere $250 million (stock price around $2.50 at time of publication). If Longwei’s stock price remains in the $2.50 range and management is hitting their “projected” numbers, Longwei should surpass its market cap in net assets on the balance sheet by April of this year. Investors could potentially buy the business for “free” (Ben Graham popularized this method of investing as “margin of safety”—investing in companies that were trading for less than their net asset value). These days, finding such opportunities are few and far between, but when certain parts of the markets are in panic mode (a la small cap China) a savvy investor might still be able to find such situations. This potentially “free” business of Longwei investors would “inherit” with the purchase of Longwei’s balance sheet is projected to do $70 million in net income this fiscal year 2011 (which ends in June) and is growing (reportedly).
Balance Sheet: As of 9/30/2010, (in thousands) (taken from LPH’s 9/30/2011 10-Q filing)
v Current Assets:
Advances to Suppliers
v Total Current Assets
Property Plant and Equipment, Net
v Total Assets
205,113 roughly equal to $2.00 a share
NOTE: by end of Q1 2011, by my projections, net assets should grow to near $250 million
If Longwei’s financials are accurate, investors have to like the fact that Longwei has $160 million in current assets (as of 9/30/10, approx. $1.60 per share) that appear to be highly liquid. By the end of the first quarter 2011 (third fiscal 2011 for Longwei) current assets should rise closer to $200 million. Below is a list of Longwei’s current assets on their balance sheet with a description of each line item:
From the 9/30/2010 10-Q: Description of Assets
Cash: $11.89 million reported
Accounts Receivables: $29.9 million reported
The Company’s business operations are conducted in the PRC. During the normal course of business, the Company extends unsecured credit to its customers. Management reviews its accounts receivable on a regular basis to determine if an allowance for doubtful accounts is necessary and adequate. An estimate for doubtful accounts is made when collection of the full amount is no longer probable. Through the date of these financial statements, the Company has never experienced a significant bad debt.
Inventories: $38.25 million reported
As of September 30, 2010 and June 30, 2010, inventory consisted of significant quantities of diesel and gasoline, among others.
Advances to Suppliers: $78.69 million
As of September 30, 2010 and June 30, 2010, advances to suppliers consisted of significant deposits on account with the Company’s refinery partners. The deposits are held by the Company’s refinery partners to ensure that the delivery of inventory to the Company is made in a timely manner. The Company attempts to maintain a significant balance on account with refinery partners with the expectation of receiving preferential pricing and delivery from our suppliers.
TOTAL CURRENT ASSETS: $159.23 Million (roughly equal to a $1.60 per share)
Again, from a balance sheet perspective Longwei looks like a great buy, selling for $250 million with no debt and over $200 million in net assets. However there are questions that still remain regarding the business. What I find problematic is the fact that Longwei is not leveraging their balance sheet. In fact, management has actually been hinting to the market that they plan to raise more EQUITY capital in an additional secondary offering. On Monday Dec. 13th, Longwei filed an S-3 registration statement with the SEC and Longwei’s CFO Michael Toups stating on the press release,
“Since we are qualified as an exchange-listed company, we have also included in the filing a shelf registration for up to $50 million so that we are prepared to react to accretive opportunities as our share price builds value (which it’s not).”
This announcement led to an obvious gradual decline in share price post-release as the market tried to digest the fact that a Chinese small cap trading at a very cheap valuation was looking to raise more EQUITY capital in a secondary offering. If an accretive opportunity arises, why not leverage the balance sheet? If Longwei can’t obtain debt financing at this point, who would want to be holder of the equity (which I’m currently questioning)? I’m puzzled as to how the American CFO of Longwei would let this press release happen without realizing it would negatively affect share price and investor confidence.
PRO: LONGWEI’s ACCOUNTING AND AUDIT
I’m no accountant, but I think Longwei Petroleum’s business would make for a fairly easy audit, which is one reason I remain cautiously bullish on the future of the company and share price. I think the business model of oil wholesaling (there aren’t many refineries you can buy from) would make it very difficult for management to “inflate” reported figures and/or “fake” contracts so as to report fraudulently high revenue and earnings figures. Longwei’s accountant and auditor is Child, Van Wagoner & Bradshaw, PLLC based out of Salt Lake City, which apparently has a decent presence in China and an “ok” (satisfactory) track record from what I’ve read.
I think it would be a fairly easy task to verify Longwei’s reported current asset amounts with four easy steps:
1. Verify the petroleum amounts being stored in the two storage facilities.
2. Call oil refinery suppliers (5 of which reportedly represent 72% of all purchases) and verify reported “Advances to Suppliers” amounts.
3. Check Longwei’s bank accounts for reported cash.
4. Call customers to verify accounts receivable.
Unless the team at Child, Van Wagoner & Bradshaw is in cahoots with management or is extremely incompetent, I think the chances that Longwei’s financials are fraudulent or inaccurate are very slim due to the simplistic business model and subsequent easy audit. Since 2005 no money has been taken out of the business and most all of the reported “earnings” since that time have been reinvested back into the business by purchasing more petroleum inventory and locking in larger advances with suppliers (futures contracts). All an accountant has to do is tie these figures with the last few years’ reported earnings and that should give a pretty good indication of whether or not Longwei has been engaging in any sort of financial chicanery.
Per what the financials are reporting Longwei looks like a great buy but I see CONS in the company that NEED to be addressed by management.
CON: INSIDER OWNERSHIP (Too concentrated with directors I’ve never heard from)
Fully diluted Longwei Petroleum will have about 115 million shares outstanding of which the company’s two directors—Cai Yongjun & Xue Yongping still hold around 68 million shares or about 60% of the company. This for me is a red flag, in all my due diligence on Longwei Petroleum I have never seen nor heard from Mr. Yongjun and/or Mr. Yongping. Apparently Longwei thinks the best investor PR is to send their part-time CFO Michael Toups to Redchip investor conferences to sit in front of maybe 500 retail retiree investors and state “Well, we think Longwei is a good value play on the growing oil industry in China”. Per Longwei’s financials the company boasts a little over $200 million in net assets (nearly $160 million of which is supposedly tied up in highly liquid current assets), is projected to clear $70 million in net income and $500 million in revenues for fiscal year 2011 and is boasting near 20% operating margins and 30% + top and bottom line growth the past 4 years (from Longwei’s financial reporting) and the company is currently selling for $250 million and that’s the best investor PR Longwei can do? Where are the institutional investors?
CON: LOW INSTITUTIONAL OWNERSHIP
Longwei’s institutional investors currently are few and far between. This perplexes me as Longwei will likely surpass (per their reporting) its market cap (if pps is range bound the next few months) in net assets like I’ve explained by April of this year[RP1]. If Longwei’s stock price is still in the $2.50 range and Muddy Waters and/or Citron Research hasn’t published some report proposing that the Shanxi Province doesn’t even exist, or that Mr. Yongjun and Mr. Yongping are actually rural Chinese pheasant farmers who had their identities stolen by con men, then buying Longwei Petroleum at $2.50 a share would be fully paid for by the $2.50 + a share in oil, cash, and accounts receivable on the balance sheet. An investor would also “inherit” a $70 million dollar a year and (reportedly) growing oil wholesaling business for free.
I would be anxious to hear from the CFO Toups what “road shows” he has been on lately and what institutions he might be talking to about the company. His profile on LinkedIn shows something like 20 years of experience in the investment banking industry primarily in Asia. Is it possible he is worried about the questions institutions might ask and the secrets they might find in their more thorough due diligence if he were to try and “sell” Longwei to more sophisticated investors? It certainly begs the question.
CON: DILUTION & INSIDER SALES
Unfortunately the picture of Longwei Petroleum gets even a little murkier when I investigate the last round of equity financing the company undertook. In October of 2009 the company raised $14.5 million dollars in a private placement offering of preferred stock that per a conference call was reportedly used to “ramp up inventory” at their newly purchased second storage facility--Gujaio. Longwei reportedly raised this cash after making $12 million in net income in 2007, $20 million in 2008, and $21 million in 2009, and reportedly had around $95 million in net assets at the time of financing—most of which was reportedly in the form of highly liquid current assets.
The Series A Preferred Stock raised was convertible into shares of common stock based on a one to one conversion ratio, at an initial conversion price of $1.10 a share. Longwei also included warrants to purchase an additional 13,499,274 shares of common stock at an exercise price of $2.25 per share which is currently killing their GAAP EPS each quarter due to derivative accounting standards set by FASB since most all the warrants are still outstanding. By my calculations once all warrants get converted the company will likely be diluted by some 25-30% from that one financing for a measly $14 million in inventory. At the time of financing, the company reportedly had no debt, about $100 million in current assets, projected an 18-month payback period on the Gujaio facility, and financed $14 million in inventory by selling nearly a third of the company’s EQUITY? You do the math.
Another problem I have with Longwei’s management is their reported executive compensation and subsequent sale of stock at such low valuation levels. Per Longwei’s 2010 10-K the company’s directors Mr. Yongjun & Mr. Yongping reportedly took home $6,670 and $5,617 respectively in 2010 annual salary while holding 34 million shares of the company’s stock. This past year the director’s then sold 1 million of those shares a piece to an undisclosed third party at the below-market price of $1.60. I believe Redchip’s (Longwei’s investor relations) disclosure as to why the director’s sold the stock was to pay for “personal expenses” since their salaries are so dismal--which should raise red flags to investors.
Why doesn’t a business that is supposedly undervalued and earning $70 million in net income compensate their directors accordingly (with six-figure salaries) instead of forcing them to dump stock not only while the shares are “undervalued” but also at what was below market price? Is Longwei management trying to foretell to the market that they’re a scam? Investors should demand to hear Toups answer as to why he didn’t advise the directors otherwise. Watching insiders dump stock at basically below reported net asset values is usually a pretty good indication that you’re invested in a scam.
CON: LACK OF KNOWLEDGE REGARDING COMPETITIVE ENVIRONMENT
While a lot of research regarding Longwei’s business model and reported financials has shown up in Redchip’s research reports, almost nothing has been discussed regarding the competitive environment of the oil transportation and wholesaling business within the Shanxi Province. In particular it is unclear as to what would happen to Longwei’s business model if the two biggest players in the Chinese oil industry (Sinopec and CNOOC) or others eventually decided to build a pipeline from their refineries to storage facilities in the Shanxi province.
Such a scenario I think would make it extremely difficult for Longwei to compete given Sinopec and CNOOC’s competitive advantages in economies of scale and their vertical integration with refineries. However, I do believe that if Sinopec or CNOOC decided to enter the Shanxi province tomorrow by building storage facilities and/or pipelines to the region to try and compete with Longwei, it would take years for them to bring their facilities “online” and as such it would give Longwei at least a few more years to continue being the dominant player in the Shanxi province.
Valuing a company that is under scrutiny and whose share price is being punished for possible fraudulent activity is difficult. I don’t know where Longwei’s stock price will trade tomorrow, next week, or next year. My investment in Longwei revolves around what I perceive as a stellar balance sheet (if financials are accurate) and a growing business. An easy valuation would be to see that Longwei is projected to produce $70 million in net income this year and growing, so an easy 10x multiple (a fairly conservative multiple given Longwei’s reported growth figures and net assets) could be slapped onto earnings to come up with a fair value of $700 million.
This is obviously a terribly rudimentary method to value a business and I would deter any investor from valuing small Chinese growth companies by slapping “textbook” multiples of their earnings, revenues, and growth figures to come up with fair values. These companies are risky—they might not even exist and if they do exist they still exist in China which is a much less investor-friendly place than many other parts of the world. As such, small cap China deserves a good discount to what the textbook value of reported earnings and revenue figures would give you.
I think Kinder Morgan Energy Partners LP (NYSE:KMP), which is a North American publicly-traded company engaged in energy transportation and storage similar to Longwei, is a good reference point to help figure some sort of “ballpark” value for Longwei. Kinder Morgan currently trades at a little over 2x sales with very similar profit and operating margins (16.35%, 19.94%) respectively to Longwei. This makes me believe Longwei could be conservatively valued at 1x sales (projected $500 million revs. in fiscal year ‘11), which implies a near 100% upside from current price levels if management can convince the investing public their accounting is accurate and that Longwei is a legitimate business.
SUGGESTIONS FOR MANAGEMENT
With all the accusations surrounding the Chinese small cap space, I’ve been quite appalled by the lack of action taken by management. Here is an outline of the press releases management has released the past few months in a futile attempt to calm investor fears:
- Dec. 13th “Longwei Petroleum Files S-3 Registration Statement”
o Tipping the market off they are possibly looking for more EQUITY capital for expansion purposes while they have no debt and their share price is barely above reported net asset value…
- Jan. 11th “Longwei Announces Interim Operating Highlights”
o Did management really think that their October and November “reported” numbers were going to help calm investors’ fear?
- Feb. 1st “Longwei Petroleum Announces $186 million in Annual Contracts”
o So Longwei reportedly renews $186 million in annual contracts, but a press release is meaningless if investors don’t believe any of your reported financials?
What I would like to see from a Longwei press release is this:
o “Savvy Institutional Investor ‘XYZ’ buys 10 million shares of common stock from Longwei directors Mr. Caoping and Mr. Xuepoe after months of thorough due diligence at market prices”.
o “Longwei’s management announces absolutely no equity will be sold until valuation reaches fair levels… Management is in talks about taking the company private because of lack of investor interest and subsequent low valuation.”
Glen Bradford of thestreet.com wrote a piece a few months ago titled “My Ideas for Longwei Petroleum,” which is a good read for anyone investigating Longwei Petroleum. Investors should demand answers from management as to why these actions haven’t been taken or even discussed; although I don’t agree with all actions Bradford references, a discussion would at least help matters. Secondly the “lob ball” type questions on conference calls I’ve heard from RedChip analysts make me gag. Redchip’s integrity has been called into question recently (read Melissa Davis’s of the “Street Sweeper” expose of Redchip here: RedChip: Cashing in on a Dangerous Stock Game?).
I’m not sold on Redchip’s response to their recent scrutiny, some of the companies they represent I think are questionable at best. Relying on Redchip research and their investor relations at this point I believe is a dangerous game for investors to undertake. I suppose my faith in Longwei revolves around the American CFO—Toups—and the American accounting firm. My hope is that neither would be involved in any kind of financial chicanery with Longwei Petroleum. Because the business model is so simple, I think it would be hard for Longwei’s management to fictitiously report business (but I have nothing to substantiate that claim.) Toups has certainly not done much to help the share price or calm investor fears, which raises questions for me.
I remain “cautiously long” on Longwei Petroleum and am awaiting some sort of action by management to alleviate investor fears (I’m not holding my breath). I think the range bound and/or suppressed share price could last for awhile, at least until investors get some clarity on the small cap China space. I remain optimistic about the pros of the company I’ve outlined:
· Cheap Valuation (per financial reporting)
· Simple & Straightforward Business Model
· Accounting & Audit (oil wholesaling business should be a simple audit)
But also wary of what I believe are looming questions that I don’t believe have been appropriately addressed by investor relations (Redchip) or the CFO (Toups):
· Insider Ownership & Insider Sales
· Low Institutional Ownership
· Dilution & Financing Expansion
· Lack of Knowledge Regarding Competitive Environment
My thesis is that I’ve discovered a company that has been unfairly discounted due to irrational investor fear but I constantly question my logic and look for anything to disprove my valuation and theory. If you believe Longwei’s financials, then buying Longwei at today’s price levels appears quite the bargain (current market cap of $250 million) that will buy you a business with over $200 million in net assets and projected net income of $70 million this fiscal year and growing. If Longwei IS a legitimate business, it is time for management to step up and rise above the fraudulent accusations surrounding the Chinese small cap space and unlock shareholder value.
[RP1]I don’t get this sentence. But that’s also because I don’t know what pps is, or what a market cap is….
Disclosure: I am long LPH.