In Part I of our post, available here, we presented the first part of our piece on Shougang Fushan Resources Limited (HK 0639) ("Fushan" or the "company"), which is available in full at our website. In Part II, we present further compelling evidence that leads us to conclude that Fushan, a 2008 effective reverse merger trading on the Hong Kong stock exchange, has misrepresented its business and financial position to investors. For a brief video summarizing the major conclusions of this report, please click here or visit glaucusresearch.com.
FUSHAN PUMPS, INSIDERS DUMP
The objective of a pump and dump scheme is to talk up the share price through misleading financial performance so that insiders may dispose of their shares after other investors take the bait.
The chart below (click to enlarge) shows that Mr. Xing and Chairman Wong dumped 90% of their interest in the company within 18 months of the 3 Mines transaction. We estimate that Mr. Xing grossed HK$ 4 billion and Chairman Wong grossed HK$ 4.5 billion.
Upon the consummation of the reverse merger, Mr. Xing received a 15% stake in the company (670 million shares) and Chairman Wong's ownership stake stood at 31% (1.4 billion shares). When the markets saw Fushan's outstanding performance and the price of the company's stock soared, Chairman Wong and Mr. Xing sold out.
A common denominator of Chinese reverse mergers that have collapsed under allegations of fraud is that their performance appears too good to be true. The play book is simple. Fraudsters hide costs through off-books transactions with related parties in order to inflate margins and pump up their stock price. Once the stock price soars on the wind of amazing profitability, insiders sell. Longtop Financial (LFT) was the paradigmatic example of this scheme.
We believe that Fushan's insiders have perpetrated a similar deception. Compared to other coal mining companies Fushan's financial performance is simply incredible. The company's EBITDA and EBIT margins easily trounce its HKEX and A-share coal competitors, which, for the most part, are much larger, vertically integrated, and more experienced organizations.
Fushan's financial performance is so far superior to its competitors that it leaves only two choices: either it has revolutionized the coal mining business or the company is fabricating its financial statements.
It is highly unlikely that Fushan is the most efficient and best-managed coal mine in the world, as its global and Chinese competitors should benefit from economies of scale. Fushan produces coal from three old and provincial mines. Yet it manages to generate better EBITDA margins than companies with much larger mines. Either Fushan is the most efficient and best-managed coal company in the world or it is a fraud.
For those that would argue that Fushan's margins can be explained by its focus on high quality, and therefore, high priced coal, we present the following chart comparing Fushan to other Chinese and leading international coking coal companies, which focus almost exclusively on high priced coal. Again, Fushan's margins seem a work of fiction.
The peer group we assembled in the above chart is made up of pure coking coal companies operating in Shanxi (Shanxi Lu'an, Shanxi Xishan), a neighboring province in China (Kailuan Energy), Southern China (Hidili) and in other parts of the world, such as North America, Australia, and India.
Fushan cannot argue that cheaper labor can account for the discrepancy because in our comparison we included local competitors hiring from the same labor force. In addition, several of the above companies are industry leaders for metallurgic coal, with vastly greater purchasing power, technology, and management skills. Yet their margins still average 3500 basis points below those of Fushan. This fails the smell test.
One of the hallmark features of Bernie Madoff 's Ponzi scheme was that he consistently produced exceptional monthly returns despite wild swings in the market. The consistency of Fushan's margins bears a striking resemblance to Madoff 's returns: notice in the above chart how margins for Fushan's peers fluctuate during the doom and gloom of the great recession (2008-2010). Yet Fushan's margins appear immune to the cyclicality in coal prices during the same time period.
To the contrary, in 2009, Fushan's adjusted EBITDA margin (excluding stock option expense and charitable contributions) increased 724 basis points despite 1) its average selling price for raw coal declining by 18%, 2) its sales declining 6% on an annualized basis, 3) its production cost per ton increasing by 13%, and 4) the reported loss of the company's most profitable customer who accounted for 31% of sales in the prior year. Virtually all of its competitors suffered during this period. How was Fushan immune? Fushan, like Madoff, has a track record remarkable for both its excellence and its strange consistency.
Oh What an Awful Web We Weave…
If we dig deeper into Fushan's remarkable margins, we find that Fushan's performance is driven by curiously high average selling prices ("ASPs") for a commodity and an unreasonably low cost structure.
Coal is found in continuous seams that stretch out over vast geographical areas, like an underground river. Below is a picture of a coal seam (the thick black lines) which stretches across the countryside.
It is particularly important to understand how coal seams affect the market price of coal. Each seam produces coal with different characteristics. But, and this is crucial, coal characteristics generally do not significantly vary within a seam at a similar access point. Thus, exchanges, companies and traders typically set a spot price for coal by the seam and nearest city of origin.
Fushan primarily mines seams #4 and #9 within five miles of Liulin. Coal from seams #4 and #9 from the greater Liulin area are traded at prices set by the Liulin coal market.
How is Fushan more profitable than other coal companies? Part of the reason is that it sells Liulin #4 and #9 coal at premium to the market prices for coal mined from the exact same seam. According to BNP's recent research report, from 2009- 2011, Fushan sold its Liulin #4 coal at a 19% premium to the Liulin #4 benchmark price, while the company's #9 clean coal sells at a 10% premium to the Liulin #9 benchmark.
Coal is a commodity (or so we thought). How can Fushan's coal sell at a significant premium to the same coal mined from the same seams? The whole point of setting a spot price for coal from each seam is that buyers and sellers can quickly and easily exchange the commodity without having to determine the unique characteristics of each lot. The notion that Fushan could sell its #4 coal for almost a 20% premium to the spot price of #4 coal is absurd.
Related Party ASPs
This begs the deeper question: Who would pay a premium to the spot price for a commodity?
The answer: a related party who, as a major shareholder, directly benefits from Fushan's financial performance.
In 2008,Mr. Xing's conglomerate bought raw coking coal from Fushan at 72% above the price paid by other customers. The following table summarizes the transaction.
In 2008, Mr. Xing's related party premium for one 3-month period single handedly boosted Fushan's 2008 sales and pre-tax net income by 10% and 21%, respectively. Mr. Xing's decision to buy raw coal from Fushan at a hefty premium came immediately after the reverse merger and just prior to the time when Mr. Xing and Chairman Wong dumped virtually all their shares. While this transaction was disclosed to investors, we think it should be noted that coal washing is a razor thin margin business, making it unlikely that Mr. Xing could afford to overpay for raw coal and still make a profit, and that it seems incredibly unlikely that Mr. Xing would ever buy raw coking coal from a third party, much less for a 72% premium, given that he owns 12 coal mines in the same area, 8 of which are within 15 miles of Fushan's operations.
It is also worth noting that since 2008, Fushan's board has maintained huge mandates for related party coal transactions with Mr. Xing, director Shi (who also owns competing coal mines in the area), and 27% shareholder Shougang parent (whose employees comprise nearly half of the board). Board-approved transaction caps allow these parties to purchase coal for more than twice the price that Fushan commands with other customers. We believe that these arrangements provide a significant opportunity to related parties to manipulate the share price of Fushan by artificially boosting ASPs.
In our opinion, the notion that Fushan sells a commodity at a large premium to a related party is dubious. We suspect that such transactions take place at market prices but that Fushan marks up the price on the invoice in order to boost its margins. Make no mistake that insiders reap a massive benefit from such actions: outstanding margins boost Fushan's stock price, allowing insiders to enrich themselves on the sale of the company's shares.
In addition to reporting unrealistically high ASPs, Fushan achieves world-beating margins because its costs, as a percentage of revenue, are so much lower than its domestic and international competitors' margins.
The graph below compares Fushan's cost-of-goods-sold as a percentage of sales against its pure coking peers. This chart is truly remarkable because it shows Fushan allegedly mines a commodity at gross margins that would be the envy of a software monopoly.
The above graph suggests that Fushan has revolutionized the coal industry. It has discovered a way to mine coal so much more cheaply than its competitors that it seems like magic. Notice that cheap labor costs or geographic anomalies do not explain the difference: Fushan's costs are ridiculously lower than domestic peers, including coal companies mining in the same province (Shanxi Lu'an, Shanxi Xishan).
In this way Fushan reminds us of Longtop Financial, a US-listed Chinese company which collapsed after Citron Research and Bronte Capital publicly accused it of committing fraud. Like Fushan, Longtop boasted absurdly high margins relative to its competitors.
Longtop was able to artificially inflate its margins through hidden related party transactions: Longtop's insiders shifted its labor costs off the company's books to an undisclosed related party, making Longtop's performance stunning by comparison to its competitors. We believe that something similar may be happening with Fushan.
Proximity to Related Party Competitors
Mr. Xing, through his conglomerate Lasen Energy, owns 12 competing coal mines near Fushan's coal mines, 8 of which are within 15 miles of Fushan's operations. Most of Mr. Xing's mines are within a 15 minute drive of Fushan mines. We believe that this allowed Mr. Xing to funnel artificial EBITDA through Fushan so that he and Chairman Wong could dump their remaining stakes at the very top of Fushan's trading range (late 2009).
A closer look at Fushan's business also reveals that Mr. Xing is one of the company's top suppliers for a number of non-coal inputs such as tools, accessories, facilities rental, construction contracts, and possibly other common cost of goods sold items like labor and transportation.
We find it odd that one of the most cost-efficient coal mines in the world has a middle-man between itself and many of its key inputs. We believe Mr. Xing's Lasen Energy is moving costs for these services off-books, which has helped Fushan earn gross margins as high as 74% and adjusted EBITDA margins as high as 69%.
Also of interest is the unique structure of the supply contracts between Mr. Xing's Lasen Energy and Fushan. As the following excerpt shows the price of materials supplied to the company by Mr. Xing is determined not based on the market price of the materials or services supplied, but on the price that Mr. Xing has charged other entities for similar materials or services.
Any investor in Chaoda is, to their great regret, already familiar with just such a contractual arrangement (Chaoda, halted after allegations of fraud, had a similarly dubious contract with its chairman which was highlighted in the whistle-blowing piece circulated by Anonymous).
This contractual structure allows Mr. Xing to charge Fushan any price he wants provided he can show that he charged such price to another customer. It is basically a blank check for Mr. Xing to make up whatever price he likes.
But we believe that Mr. Xing is rather clever. Rather than overcharge Fushan for materials and services. We suspect that he undercharges Fushan (at least on paper), thereby allowing the company to boast spectacular margins and thus bolstering the price of his stock. It is essentially the same strategy as Longtop and Chaoda: use related party transactions to shift costs off the books of the publicly listed company, thus making the publicly listed company's performance appear spectacular and sending its stock price through the stratosphere.
The number of related party transactions between Fushan and Mr. Xing and his family are head spinning, so we put it in visual format to show investors just how tangled a web Mr. Xing has woven around the company.
Given that Fushan's margins are much higher than its competitors, investors should be deeply suspicious at the tangled web of related party transactions between the company and insiders.
The proximity of Mr. Xing's other coal mines, the fact that Fushan relies on Mr. Xing as both a major supplier and customer, and the relationship between Fushan and Mr. Xing's family all present an ideal opportunity to falsify Fushan's margins. It would be near impossible for anyone to verify Fushan's claimed production and sales figures given how easy it would be to move costs off of the company's books.
We believe that Fushan has moved significant costs off its books to Mr. Xing's other companies, allowing it to earn margins 2000 bps to 3000 bps above their HK,A-share, and global peers - margins that also showed almost no signs of cyclicality in the 2007-2011 period.
In short we believe Fushan fraudulently exaggerated its margins to pump up the price of its stock, which later allowed insiders Mr. Xing and Chairman Wong to dump virtually all of their shares.
Disclosure: I am short Fushan (0639). Please read Glaucus Research Group California LLC's full disclaimer at the beginning of our report (also available here), which we hereby incorporate by reference in full.