China and Fuwei Films: Seeking Sanity

 |  About: Fuwei Films (Holdings) Co., Ltd. (FFHL), Includes: AAPL, CEAI, HRBN, KO
by: Marc Gerstein

Fuwei Films (NASDAQ:FFHL), a small Chinese producer of BOPET (biaxially oriented polyethylene terephthalate) film, a light-weight transparent, glossy, temperature and moisture resistant film used to package consumer products as well as in imaging and for electronics products, strikes me as an intriguing situation, given its substantial profitability, strong growth and mid-single-digit P/E.

Normally, I’d start now to discuss Fuwei’s business, its performance and its prospects. But this is not a normal situation. Because Fuwei is a Chinese company, we’re going to first have to wade through some heavy baggage.

Big-Time Market Controversies

Over the course of my career, I’ve seen quite a few market controversies including biotech in the 1970s; the generation-ago Apple (NASDAQ:AAPL) IPO, which was considered so risky as to prompt particular outrage from the Massachusetts attorney general and talk of barring sales from the offering in that state (I believe such a ban was actually implemented); insider trading scandals in the 1980s including then U.S. Attorney Rudy Giulani’s initial rise to fame as traders targeted by him were escorted off trading floors in handcuffs; Latin America at various times; a full smorgasbord of angst a decade ago including all things Internet, rage over conflict of interest among sell-side analysts, major instances of accounting fraud including imprisonment of some corporate executives and the implosion of some big-name accounting firms; and the debut of leveraged ETFs.

Interestingly, though, we got past all those issues. Contrary to what many in the 1970s believed, biotech turned out to be a legitimate and vital industry. Apple turned out to be a viable (to say the least!) company. As to the traders chased by Giuliani, the courts were not nearly as impressed as the media with the evidence he produced. Even so, some did go to prison for insider trading (not the ones led off the floors in hand-cuffs), but the market survived quite well. Latin America and other developing regions progressed too. Major Internet firms are alive and well and caused no pain to investors other than those who for reasons of their own opted to ignore well-known, long-established principles of valuation. Leveraged ETFs are a substantial part of the investment landscape. And invertors routinely use audited financial reports as a basis for fundamental analysis that helps them enhance their returns.

The upshot: Just because a controversy is hot doesn’t mean the negativity is fully warranted. This is so even though the controversy may contain elements of truth! (Insider trading existed. Accounting fraud existed. Some early biotech companies were duds. Etc., etc., etc.) Distorted opinions can come from two sources: false factual assumptions and/or flawed interpretations of accurate facts.

Keep this backdrop in mind as we move on to the big controversy du jour.

Chinese Companies

What’s going on today with Chinese firms that have shares traded in U.S. markets is more than just a controversy. We’re seeing hysteria elevated to a whole new level.

The essential elements of the controversy should by now be pretty well known to most market participants and observers. Simply put, there have been allegations of fraud leveled against various firms. Some allegations involve questionable accounting (similar to what we saw in the U.S. a decade ago from Enron WorldCom, et. al.), while others are more spectacular, sometimes going so far as to suggest the businesses the companies say they operate don’t actually exist. China Education Alliance (CEU) is an example of a company involved in the latter kind of controversy.

The issues are as serious as any of the others I’ve encountered. No investor wants to be scammed, not now, not ever. And as is typical when corporate veracity is called into question, we shareholders are in especially vulnerable positions. Disclosure rules are such that we are very limited in the kinds of information we can obtain and use. Hence it’s hard – very hard – for us to be absolutely sure of anything. We need to hone our abilities to identify and utilize whatever clues we can find and learn to evaluate the reliability of the clues.

Unfortunately, in a setting that most desperately calls for thoughtful analysis, we’re finding instead increasing hysteria. For example, we actually see supposedly-respectable commentators calmly and confidently asserting that going public via reverse takeover (where a firm merges with a publicly-traded U.S. corporation and then takes over the management of the combined company in order to get access to the public equity markets) is inherently unethical, notwithstanding the fact that the venerable New York Stock Exchange, among other well-known firms, went public this way. We also see U.S. commentators confidently treating Chinese-company filings with the SAIC (State Administration of Industry and Commerce) as being equivalent to those domestic companies file with the SEC, notwithstanding that the SAIC’s role has nothing to do with financial, accounting or securities oversight. It’s focused instead on business licensing, consumer protection, etc. In China, audited numbers must be filed with the SAT (State Administration of Taxation). And by the way, did you know that for U.S. companies, numbers contained in SEC filings typically don’t match those submitted to the IRS? (For example, tax filings tend to use “accelerated depreciation” formulas designed to boost the expense and thus reduce taxable income). Be aware that issues involving financial reporting and accounting tend to involve considerably more subtlety and complexity than many commentators are leading you to believe.

Another vital issue relating to China-related commentary involves author disclosure. This tends to be standard among reputable sources of published writings about investment topics including Seeking Alpha (i.e. the disclosures at the bottom of the articles where authors tell you if they are long or short on the stocks they address). These are vital. It’s important that you interpret an author’s views in light of whatever financial stake he/she may have in the subject of the article.

The idea that authors might have positions in the stocks about which they write might cause discomfort to some. That’s why you are given opportunities to discover this, and, if you wish, ignore the article or take it with a grain of salt. The choice is yours.

Others appreciate articles in which the author has his/her own money on the line. In my opinion, the quality of analysis tends to rise when an author leaves the ivory tower and takes a real stake, and it’s not just a matter of self-interest. It’s a matter of having the motivation and mental stamina to work harder when you have skin in the game.

The self-interest factor can never be ignored. That’s why we have the disclosures and why it’s so important that you examine them.

In the disclosure at the bottom of this article, you will learn that I’m long Fuwei Films (FFHL) and that I have an open FFHL recommendation in my low-priced stocks newsletter. It’s therefore up to you to judge whether you think my favorable view of the stock is motivated by my stake, or whether my stake is motivated by my favorable view. (This is a fair question not just for this article, but for all others you read regardless of which stocks are being discussed.)

I hope you’ll conclude my stake results from my favorable view, but I can’t control that and would not be at all offended if you were to decide otherwise. That’s the nature of writing investment commentary, especially when touching on controversial topics. All I can do is suggest you evaluate the credibility of the points I present below and note that I’ve made some good calls on Fuwei up till now and without having previously published anything outside the newsletter. Specifically, I first called attention to Fuwei in the 8/15/10 edition of the newsletter, at which time it was priced at $1.05. I cited it again in the 10/15/10 issue, with the stock priced at $1.39. I closed the recommendation via 2/22/11 Supplement with the stock priced at $6.32. Then, the stock experienced some sharp declines, based on China fears and a threatened NASDQ de-listing (see below). I re-recommended the stock in the 6/15/11 issue at which time the stocks was trading at $2.70. As of this writing, it stands at $4.00. (In other words, I’ve done fine so far with Fuwei without having openly urged the investment community at large to act in a particular way vis-à-vis the stock.)

You should undergo the same assessment with commentary presented by the China bears, the most virulent of which are disclosing that they have sold the shares short, which means the stocks must drop in order for them to profit from their positions. It's up to you to decide if their stake results from their views on the company, or if their views on the company result from their stake regarding the stock.

Disclaimers, although ubiquitous on Seeking Alpha as a matter of policy, are rarely discussed. But when a controversy is an intense as the one involving China, I think it’s vital that all readers consider and seriously reflect on these matters (including, of course, my own disclaimer). If we learned nothing else from the decade-ago Wall Street controversies, we should have at least learned that.

Controversies Involving Fuwei Films

We’re getting close to being able to consider Fuwei’s fundamentals, but we’re not yet there. First, we have to address some company-specific “stuff.”

For starters, there was a class action suit filed relating to the registration statement filed by Fuwei in connection with its late-2006 U.S. Initial Public Offering.

[Side note: I’ll bet you assumed Fuwei came public via the reverse takeover (RTO) method because the company is from China, its stock was hammered, and those who scream most about China scream about the RTO method of going public! Don’t presume anything from the prevailing hysteria. Check facts for each company you look at. And by the way, don’t presume that IPOs are flawless, as the China fear-mongers would have you believe. Fuwei did a conventional IPO, and still wound up with controversy! Go figure.]

Fuwei always maintained that the class action was without merit, as would be expected of any defendant. What’s important here is that the case was recently settled for $2.15 million, which works out to about 17 cents per share before deducting for legal fees and litigation expense. By the way, Fuwei, a company with $27.7 million in cash, will contribute only $1 million toward the settlement, with the rest being paid by former officers, directors, shareholders and the underwriters.

The more spectacular controversy concerns three individuals who had been controlling shareholders (but were never involved in the operation of the company) of Fuwei and who had been criminally convicted in China based on actions taken in connection with the transfer of government property. Two individuals were sentenced to life imprisonment and one was sentenced to death with a two-year stay of execution. In addition, the property of all three was to be confiscated by the government. The case was finalized in November 2009 but nearly a year and a half later in April 2011, with the China hysteria having whipped into especially high gear, the NASDQ decided to serve Fuwei with a de-listing notice because of the behavior of those shareholders. That caused the stock, which had already been hit with China woes, to plummet further to the low $2 range. Shortly thereafter, the Chinese government completed the property confiscation, including the seizure of Fuwei shares. With the controversial shareholders removed from the picture, the NASDQ withdrew its de-listing notice. The market ignored the latter announcement.

The other non-standard risk here is, of course, uncertainty as to what the Chinese government will do with its shares. The worst-case scenario would be if all of them were to be instantly dumped on the market. But there’s no indication that this is likely to occur. If they continue to hold for the long term (or at least long enough to profit from the stock’s recovery from depressed levels), that would be fine. An orderly disposition of all or part of the stake would halt the stock’s progress for a while an offering progresses.

The Fundamentals

As noted at the outset, the company produces BOPET film used for packaging and in imaging and for electronics products. The business, and the company, got hit in the recession: Between 2007 and 2009, sales dropped 29%. But a brisk recovery began in 2010 and has been continuing this year, with sales up 98% in the March quarter. Expect growth rates to narrow going forward as we come up future comparisons that increasingly reflect less-depressed year-earlier figures. Even so, global BOPET tonnage grew at a compound average annual rate of 5.4% between 2006 and 2010 with the growth rate in China having come in at 12.5%. Unless China’s economy implodes going forward, it still seems likely Fuwei can continue to do well in its basic business.

In addition, the company has some new irons in the fire. One consists of high-end thick film products (used in electronics and which Chinese manufacturers previously had to import). Another consists of penetration of markets outside of China. This isn’t proving easy. There have been anti-dumping actions in the U.S. and South Korea. But despite that, Fuwei’s sales outside of China contributed 33.4% of first-quarter 2011 revenues, up from 11.1% in 2009.

On July 6th, the company announced the signing of a letter of intent calling for it to supply PETG heat shrinkable label film to China Bottlers Procurement Consortium, the authorized procurement service provider for the Coca-Cola Bottling system in China during the second half of this year. This is part of Coca Cola’s (NYSE:KO) effort to get away from less-environmentally friendly PVC labels. It’s too early to say whether the arrangement will be extended, but it is noteworthy beyond actual revenue, insofar as it seems to be a confirmation of Fuwei’s basic business legitimacy. Remember the ongoing China controversy, which isn’t just about valuation and the like (as with the decade-ago Internet-stock controversy). These companies have been living with allegations that at times attack the very existence of the businesses they say they operate. Fuwei has not been attacked as a hoax, but its stock has suffered as attacks like that have been leveled against other Chinese firms. So it means a lot to see Fuwei transact business with a company like Coca Cola.

As with many companies whose stocks trade at low single-digit levels, Fuwei has a solid balance sheet (a total debt to capital ratio of 29% and cash amounting to about $2.10 per share), meaning it can well afford to finance the capacity expansion it's undertaking. (Very small companies tend to be aware of the dangers of having exotic balance sheets and choose instead to finance themselves conservatively.) Meanwhile, Fuwei is profitable on a regular net-income basis (i.e. we don’t have to come up with fancy definitions of pro forma earnings in order to see black ink) and the company’s trailing-12-month return on equity was 11.8%. That may not seem impressive relative to some of the popular high-quality blue chips like Coca Cola, but when we’re down in the low-priced stock universe, we’re dealing with companies for which coverage of fixed costs can be a challenge.

Not surprisingly, the stock gave back some of the 29% gain it achieved on July 6th in response to the Coca Cola announcement (rarely does a stock go straight up in the wake of a one-day gain that large). At present, we’re looking at a P/E of 5.2 calculated on the basis of a trailing-12-month EPS figure that is reasonably normal (i.e. it does not include unusual gains). This is not to say there isn’t earnings risk going forward. There’s cyclical risk (albeit mitigated by the aforementioned product expansion), inflation risk (raw materials costs) and the prospect of increased competition. But these are normal business risks to which all companies are subject. They seem tolerable for Fuwei given how low the stock remains after having been felled by the avalanche of negative China sentiment.

Back To the China Factor

No matter what we can say about Fuwei’s merits, China sentiment remains highly relevant. But one has to wonder if this too is approaching some sort of climax.

Any investor interested in any Chinese stock should probably keep an eye on the situation involving Harbin Electric (NASDAQ:HRBN), which was vehemently attacked as a fraud by Citron Research. Naturally, the stock plummeted. But uncharacteristically, the CEO responded with an offer to take the company private, a move that drove the stock price back up to where it was before Citron’s attack.

I haven’t really delved into Harbin (it falls outside the low-priced stock universe on which I usually focus), but I do note that Citron relies heavily on the content of Harbin’s SAIC filings (as noted above and contrary to the assumptions of many U.S. China bears, the SAIC is not a financial regulatory agency). But we have to be intrigued by the escalation of Citron’s verbal war of words alleging the buyout offer is fake, a war which Citron brought to Seeking Alpha.

Verbal battles are not new in the investment community in general or within Seeking Alpha in particular. But the stakes here are high, much higher, for example, than the perennial debates on whether Apple will or should rule the world. At some point in time, the Harbin situation will be definitively resolved one way or the other: Either Harbin will be bought out or it won’t be bought out. Considering the shrill nature of Citron’s escalating attacks, its reputation (heretofore pretty good) will almost certainly take a huge hit, one that might be severe enough to substantially alter China sentiment in general and the practice of shorting Chinese stocks. (Judging by the recovery of the stock price, investors are presently betting against Citron.)

Meanwhile, we have another interesting development involving Sino-Forest [SNOFF.PK], which was attacked by another short seller, Muddy Waters, for supposedly exaggerating the extent of its forestry assets. But a bull came on the scene after the price tumbled: Wellington Management disclosed that it had acquired a 28.4% stake in the company. The stock is well off its bottom but is still pretty depressed as this controversy seems to have a long way to go before resolution. This, too, bears watching, particularly if it turns out to be the leading edge of a tendency of large bullish investors to take positions in shares beaten down by short attacks, something that could have a chilling effect on the willingness of short sellers to act as aggressively as they’ve done thus far.

Here’s what this probably means for Fuwei stock: If Citron and Muddy Waters prevail, we remain in place. Wall Street continues to hate Chinese microcaps, and we wait for the market to take note of Fuwei’s individual characteristics as it’s started to do since the stock bottomed after NASDQ’s brief but quickly aborted fling with de-listing. If Citron and/or Muddy Waters lose out or if other Wellington-style bulls surface, look for the market to start re-evaluating its take on Chinese microcaps, perhaps toward a scenario where ethical risk continues to be respected and feared but analyzed in a more thoughtful and less hysterical manner. That would likely provide a nice boost for Fuwei’s P/E.

Disclosure: I am long FFHL. FFHL remains an open recommendation in my low-priced stock newsletter.