Glaucus Research Group California, LLC ("Glaucus Research") engaged a team of independent consultants (located both in China and the United States) with expertise in law, finance, mining and accounting to examine Shougang Fushan Resources Limited (HK: 0639) ("Fushan" or the "company") over the last 16 weeks.
Fushan is a mining company that produces and sells coking coal (similar to Walter Energy:WLT, Arch Coal:ACI, Alpha Natural Resources:ANR, Patriot Coal Corp:PCX, and James River Coal:JRCC). The company, which went public on the Hong Kong Stock Exchange ("HKEX") via an effective reverse merger, owns and operates three coal mines in northern China (Shanxi Province).
In our report, which is available at our website, we present 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 and that, as was the case with Chaoda Modern Agriculture (HK: 0682), regulators will halt trading of Fushan's stock on account of such impropriety. For a brief video summarizing the major conclusions of this report, please click here or visit our website at www.glaucusresearch.com.
1. Overpayment for a Major Acquisition from Insiders. Comparable acquisition data indicates that Fushan significantly overpaid for the coalmines that it acquired from company insider Xing LiBin ("Mr. Xing") for HK$ 10.5 billion. By our calculations, Fushan acquired the mines for RMB 97 per tonne of the stated coal reserves, when its competitors acquired other similarly-sized, primary-coking coal mines (in the same or neighboring province) for between RMB 11 and RMB 16 per tonne of reserves. This indicates that Fushan overpaid by roughly HK$ 8 billion.
2. Pump and Dump. Fushan's long-time Chairman Wong Lik Ping ("Chairman Wong") and his cohort, Mr. Xing, each sold the vast majority of their respective company shares within 18 months of the reverse merger. Chairman Wong grossed HK$ 4.5 billion and Mr. Xing grossed HK$ 4 billion as Fushan's stock soared on the strength of suspiciously high margins (see Part II).
- We believe Fushan's EBITDA margins are fabricated because they are head and shoulders above those of its domestic and international peers and they display Madoffian consistency (see Part II).
- Suspiciously Low Costs. Fushan's cost of goods as a percentage of sales is 3500 basis points lower than that of its Chinese and international coking coal comps. We believe that, much like the Longtop scandal, insiders have embellished Fushan's performance by moving costs off of its books. Specifically, we suspect undisclosed related-party transactions with Mr. Xing, who controls 12 area coal mines, 8 of which are within 15 miles of Fushan's operations (see Part II).
- Ridiculous ASPs. Despite selling a commodity, Fushan justifies above-market prices (in this case as high as 20%) because its product is different. In 2008, one related party customer single-handedly boosted overall post-merger sales and pre-tax income by 10% and 21%, respectively, by buying an enormous amount of coal at a 72% premium to prices paid by other customers (see Part II).
OVERPAYMENT FOR ACQUISITIONS:
On July 25, 2008, Fushan consummated a $HK 10.5 billion acquisition of an 82% interest in three coal mines (the "3 Mines"), purchased from Fortune Dragon Group ("Fortune Dragon Group"), a company owned by Mr. Xing and Chairman Wong.
Fushan paid the owners of Fortune Dragon Group HK$ 4.86 billion in cash (cash raised throughout the prior year in anticipation of the acquisition) and HK$ 5.67 billion in new shares issued by the public company.
This HK$ 10.5 billion transaction transformed Fushan overnight from a floundering jewelry company into a Chinese mining behemoth (measured solely by market capitalization). But evidence suggests that the company significantly overpaid for old, provincial mines, thus illicitly enriching Chairman Wong, Mr. Xing and their cohorts at the expense of shareholders.
From Fushan's public filings, we have assembled the following information on this transformative acquisition and the value of the acquired mines. The following chart presents the gospel according to the company:
The conventional metric for evaluating a coal mine acquisition is the ratio of the purchase price of the mine's implied total enterprise value to the amount of such mine's proven and probable reserves. For the Fushan's 2008 acquisition, according to our calculations the implied total enterprise value of the 3 Mines (before subtracting net debt) was 13.8 billion RMB, over 97 times the amount of proven and probable coal reserves of the 3 Mines.
In order to assess the reasonableness of the purchase price paid by Fushan, we retained China Coal Resources, a subsidiary of Fenwei Energy Consulting Co, to provide data on acquisitions of other private coal mines in the same geographic region and during months leading up to the announcement of the Fushan acquisition. China Coal Resources is China's premier consultancy in the coal and coke industry, employing a staff of over 360 professionals.
Without revealing the purpose of our inquiry, we asked China Coal Resources for a table of comparable transactions, including the estimated reserves and production data for coking coal mines acquired in the same region (Shanxi province and neighboring provinces) in 2007 and 2008. In Appendix I we have included the complete mergers and acquisitions comparables table for the 2007-2008 period that we obtained from our independent, third party consultants.
APPLES TO APPLES
According to China Coal Resources' coal classification chart (and coal quality data provided by the company), Fushan's coal appears to fall into the category of bituminous #25 coal (see Appendix II within the report), which falls into the broader group of primary coking coal. To put it in context, of the 14-sub categories of coking coal, Fushan's appears fifth best in terms of quality. In the universe of Chinese metallurgic coal, Fushan's coal is slightly above average, but nevertheless is an undifferentiated commodity that must compete with higher and lower quality coking varieties and contemporary substitutes such as pulverized coal (PCI).
In the table below we compare Fushan's acquisition of the 3 Mines with other acquisitions of 'primary coking coal' mines in the Shanxi and neighboring provinces during the same time period. This ensures that we are comparing apples-to-apples and giving the company the benefit of the doubt for the quality of the coal that it purports to mine. Even with these generous assumptions, the data suggests an unmistakable conclusion: that Fushan vastly overpaid for the 3 Mines.
Fushan acquired the 3 Mines from an insider for RMB 97.0 times (per tonne) of the amount of reserves. By comparison, its competitors bought coal mines of similar size, in the same area, during the same time period, producing a comparable grade of coking coal, for an average multiple of RMB 13.9 times (per tonne) of reserves.
If investors applied the valuation metric of comparable transactions (13.9x reserves) to the 3 Mines acquired by Fushan from its rich and powerful benefactors in 2008, the total debt on the books of the 3 Mines would have exceeded the value of the mines. In other words, it appears that Chairman Wong, Mr. Xing and their cohorts sold investors a net liability for over HK$ 10.5 billion.
By this metric, it appears that Fushan overpaid Mr. Xing and his cohorts by over HK$ 10.5 billion for the 3 Mines (for the purposes of this valuation calculation, we ignored $1.1 billion in intercompany loans. Net debt for 3 mines as of 4/30/2008 (the Valuation Date). Worse still, the company's valuation of the 3 Mines relied on highly suspicious production figures for the 3 Mines spoon-fed to the company by none other than the seller.
DUBIOUS PRODUCTION DATA
A host of further evidence supports the notion that Fushan massively overpaid for the 3 Mines, thereby enriching insiders to the detriment of shareholders.
Emperor's New Clothes
In July 2008, Fushan paid HK$4.9 billion in cash (HK$4 billion of which was raised in the capital markets from investors immediately prior to the acquisition) and issued 1.26 billion new shares valued at HK$5.7 billion (thus diluting existing shareholders) to acquire the 3 Mines. Fushan tapped the capital markets to raise money for the acquisition by pointing to dubious production figures at the 3 Mines. Such production figures are not remotely credible and appear not to have been independently verified.
The following graph shows production data provided in Fushan's public filings. Suspiciously, production at each of the 3 Mines jumped meteorically just prior to their acquisition by Fushan. The exponential growth of the 3 Mines just prior to their acquisition by the company is simply not credible for three reasons: the mines were already mature at the time production spiked, the mines were located in a popular coal mining region, making it unlikely that they could have escaped unnoticed for a significant period of time, and headcount at the 3 Mines did not appear to increase between 2005-2007, a period that saw 4 acquisitions and a miraculous explosion of productivity.
From Zero to Hero
At the time of the acquisition, the 3 Mines were, on average, already decades into production (each was established in 1968, 1988, and 1996, respectively). Despite it being highly unlikely that Fortune Dragon Group could so quickly and easily ramp up output, in the four years prior to the acquisition, production at the 3 Mines purportedly exploded. The production history of the Jinjiazhuang and Zhaiyadi mines, in particular, merits close scrutiny.
Fushan's public filings only included pre-2004 production figures for the Jinjiazhuang mine ("Jinjiazhuang"). According to the technical report provided by the company, from 1996 to 2001, Jinjiazhuang's production maxed out at 150,000 tonnes of coal per year. Then, from 2001 to 2003, the Jinjiazhuang Mine was mothballed for three years. Needless to say, Jinjiazhuang did not seem a likely candidate for a booming mining operation.
But, according to production figures provided by Fortune Dragon Group, Jinjiazhuang went from idleness to spectacularly profitability in a short time. Production appears to have increased by 900% in the five years prior to Jinjiazhuang's sale to Fushan.
900%! At an old mine. The "growth" at the Zhaiyadi mine is similarly unbelievable; it rocketed up 860% in the four years prior to the acquisition.
Fushan's oldest mine is Xingwu (originally opened in 1968,when Lyndon Johnson was president of the United States). After taking 36 years to reach 700,000 tons of coal, production more than doubled in the four-year period prior to the sale of the mine to the company. Apparently, this mine took four decades to reach the inflection point in its growth curve.
Note that acquisitions cannot explain the exponential growth of production at the 3 Mines. In December 2006, the Fortune Dragon Group absorbed four smaller mines into its existing mining operations. But prior to such acquisition, the 3 Mines had purportedly recorded 3 years of suspiciously-amazing growth.
Hiding Under Everyone's Nose
Fortune Dragon Group's mines were not tucked away in a remote or under-mined region. Just the opposite. Shanxi province alone accounts for 55.4% of China's coking coal reserves (source: BNP Shougang Fushan Equity Research Report, February 7, 2012). According to the company's 2009 annual report, the 3 mines are "located within the Lishi-Liulin mining area of Hedong coalfield, one of China's key reserve areas for high-quality hard coking coal." Given the number (and density) of coal mines in the area, we find it unlikely that the assets capable of such a quick and easy jump in production remained under the radar for, on average, 24 years since they began commercial production.
Employee Free Growth
Perhaps most suspiciously, production at the 3 Mines skyrocketed even though the Fortune Dragon Group did not add any net employees. Despite boosting output by 102% between 2005 and 2007, Fortune Dragon Group's headcount actually shrunk. How did fewer employees produce more than twice the amount of coal considering that labor is a major cost of goods for Chinese coal mines?
Below we have graphed the headcount at the 3 Mines from 2005 through 2007 (according to Fushan's prospectus) and juxtaposed it with a graph on the right showing the meteoric rise in production at the 3 Mines during the same period.
We find it absurd that a company could increase production so dramatically at old mines without increasing headcount. In fact, headcount decreased from 2006-2007,a period during which, according to Fushan, production increased by almost 25%,and Fortune Dragon Group purportedly spent $HK 1 billion to acquire 4 smaller mines from Mr. Xing's wife. This is simply not believable.
A savvy investor might object to our conclusion on the grounds that the company hired two independent consultants, a mining expert and an appraiser, to bless the 3 Mines acquisition. But on closer inspection, such independent evaluations are no more than a rubber stamp of data provided by the sellers.
The company hired John T. Boyd, an independent mining consulting firm, to review the reserve estimates and production figures of the 3 Mines and prepare a technical report of its findings (the "Boyd Report"). Strangely, the Boyd Report relies almost exclusively on estimates of reserves and historical production data at the 3 Mines provided by Mr. Xing's Fushan Dragon Group (referred to as FDG in Boyd's report):
"The basis of our work was historical operating and other source data provided principally by FDG …the primary source of information (written and verbal) relied upon by BOYD in preparing this ITR was provided by FDG…in preparing this report, we have relied upon reserve, operating, and other data as provided by FDG…the accuracy of the results and conclusions of this report are reliant on the accuracy of information provided. We have made no attempt to verify the technical and geological information presented in the reference material documents and assume it has been prepared by competent engineers and geologists…nor do we represent any of our findings include matters of a legal or accounting nature"
In other words, the Boyd Report relied almost exclusively on data provided by Fortune Dragon Group and its owners (Mr. Xing and Chairman Wong),which is a grave conflict of interest that undermines any comfort investors can take from the allegedly independent evaluation.
The company also hired Greater China Appraisal Limited Tse Wai Leung to provide an independent valuation of the transaction (the "Greater China Appraisal"). Yet the Greater China Appraisal, like authors of the Boyd Report, relied upon figures provided by Mr. Xing:
"We have not carried out detailed site measurement to verify the correctness of the mining areas of the Coal Mine but have assumed that the areas shown in the legal documents provided to us are correct".
Put simply, the company bought three old mines and justified the acquisition to shareholders based on dubious production figures provided by Chairman Wong and Mr. Xing, the primary beneficiaries of the transaction. Such production figures appear not to have been independently verified by the consultants and appraisers brought in to evaluate the acquisition.
Please continue to Part II of our post.
Disclosure: I am short Fushan (0639.HK). 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.