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On July 2, 2012, Longwei Petroleum Holdings Inc. (LPH) published the reconciliation of its calendar year 2011 SEC filings and SAT (State Administration of Taxation) and SAIC (State Administration for Industry and Commerce) filings in China. After the company weathered the entire period of turmoil in Chinese small cap stocks and delivered this major milestone, I have no doubt in my mind that the company is real and that the total value of its assets and earnings is significantly higher than its current market capital.

First, let's compare some key characteristics of this company against those of Kinder Morgan Energy Partners LP (NYSE:KMP) and PetroChina Co. Ltd. (NYSE:PTR), its two well known and highly respected peers in the oil industry, and Google Inc. (NASDAQ:GOOG) and Microsoft Corporation (NASDAQ:MSFT), two of the most well known companies in the world, to see how Longwei stands in terms of the degree of difficulty and motivation to manipulate accounting numbers or commit other types of financial fraud. It might seem weird to compare a small cap company to super cap companies, but by doing so we can see that the quality of Longwei's assets and operations is the same as that of the biggest and most well known companies in the world. Table 1 shows the comparison.

Table 1: Longwei and Well Known Companies by Characteristic

LPH

KMP

PTR

GOOG

MSFT

Are more than 90% of long-term assets hard physical assets?

Yes

Yes

Yes

No

No

Number of major real estate properties on which the assets and business operations reside

2 (3 if counting the new Huajie acquisition to be completed soon)

Countless

Countless

Unknown

Countless

Number of states or provinces in which the company's existing assets and/or business operations reside

1

Numerous

Numerous

Numerous

Numerous

Degree of difficulty for auditing 90% of the company's assets (in terms of value) and business transactions

Very easy because of low number of assets and high geographic concentration.

Very hard because of the sheer number of assets and wide geographic spread

Very hard because of the sheer number of assets and wide geographic spread

Very hard because of the intangible nature of the operations

Extremely hard because of wide geographic spread

Degree of standardization of the company's products

High. Unit sales price can be easily verified.

High. Unit sales price can be easily verified.

High. Unit sales price can be easily verified.

Low and intangible. Hard to verify the price its customers pay.

Low. There is no industry-standard price for most applications.

Demand for the company's products

Extremely high.

Oil is essential for a wide base of industrial clients and consumers. No need to push hard for sales.

Extremely high. See reason for LPH.

Extremely high. See reason for LPH.

Somewhat high only because of its brand name. Many companies view advertising spending as supplementary but not required.

Somewhat high. Most people need operating systems and office applications, but there are many low-cost choices.

Are the gross and net margins reported by the company significantly above industry average?

No. Oil wholesalers and distributors are expected to earn good profits due to oligopoly and demand/supply imbalance.

No. See reason for LPH.

No. See reason for LPH.

Yes.

Yes.

Conclusion 1: How hard it is for the company to inflate revenues/assets and/or deflate costs without being detected by its auditors, SEC officials, and professional investors and shorts?

Very difficult.

Easy.

Easy.

Easy.

Easy.

Conclusion 2: Does the company have strong motivation to manipulate accounting numbers to hide bad financial results?

No. The company should earn profits by the nature of its business.

No. Same as LPH.

No. Same as LPH.

Probably not. The company has exceptional brand recognition and pricing power in the industry.

Probably not. The company has exceptional brand recognition and pricing power in the industry.

As we can see, Longwei comes at least neck-to-neck with these four super caps in all items and is even superior on several items. Simply based on these characteristics, it is unthinkable that Longwei's management team would give up the easy road of running a naturally lucrative business in an honest way and instead choose the extremely risky and tough road of committing financial fraud.

Next, let's review other facts of the company and its management team that speak highly about their integrity and intention to focus on the business with a long-term perspective.

Fact

Implication

The two founders and biggest shareholders of the company have sold only 2.9% of their stake in the company since it went public in 2009. They did not choose to cash out most of their position (50% or more) when the stock traded above $3.

1. The assets and operations are real and valuable. In the two founders' view, it is worth more than $4.

2. They have no intention of pumping the stock to take short-term gains. They are with all shareholders for the long run.

The two founders and other executives have never given themselves huge cash or share bonuses.

1. Again, they have the goal of taking care of the company and growing it over the long term. They want to invest every dollar of profit earned back in the company in order to maximize its growth rate.

2. They are honest, ethical leaders with no intention of taking advantage of public shareholders.

The company did not issue any new shares to fund the last acquisition, which will close soon, to almost double the company's oil storage facility, or to dramatically expand its footprint to Northern Shanxi Province, Inner Mongolia, Central Hebei Province, and Beijing Metro. Instead, the company is using working capital accumulated from its existing operations over the years to fund the acquisition.

1. Like all other shareholders, the two founders would like the number of outstanding shares to stay as low as possible in order to not decrease their share of the company's ownership.

2. Again, the BOD and management team think the stock is worth more and are unwilling to give new shares at the current low price even if the proceeds can help in closing a very lucrative expansion acquisition.

The two founders have spent almost their entire career in the company and are still holding 67 million shares of the company's stock.

1. Their stake in the company very likely accounts for the majority of their family wealth, so they, like all public shareholders, would want the stock price to rise as much as possible so that they can reward themselves for their many years of diligent work over the long run.

2. In the short term they probably want to get some return from their investment in the company. They do not want to decrease their ownership of the company and want to treat all shareholders fairly and equally, so distributing dividends or buying back shares are the two most effective options.

Finally, knowing that some investors are still not fully satisfied with the aforementioned factual information, data, and strong logic reasoning on the legitimacy and cleanness of the company, the management team undertook two extraordinary actions to ensure investors that the assets and operations are 100% real and that the financial numbers reported to the SEC are trustworthy. Table 3 presents these two actions in detail. To the best of my knowledge, none of the four super cap companies listed above has taken part in either of these two initiatives.

As a shareholder, I am especially appreciative of the management's efforts because I understand how unreasonable and intrusive the demands are of the management team of an oil wholesaler/distributor. People need to understand that Longwei sells sensitive products in a highly regulated industry that is viewed as a matter of national security by the government of almost any nation. Some of its customers are probably state-owned entities including military agencies. The management team has made tremendous efforts to obtain permission from the Shanxi provincial and central governments to release official tax documents. If investors ask Kinder Morgan or PetroChina to show videos of their classified oil storage or processing activities and equipment before buying shares, I am certain that the management teams of these companies will reject or even ignore the request.

Longwei's efforts to reconcile numbers in its SEC, SAT and SAIC filings should also be greatly appreciated because it is not a simple task.

Table 3: Longwei's Two Extraordinary Measures to Prove Their Assets, Business Operations, and Financial Reports

Are visual checks of the majority of assets and operations conducted by external entities and released for the general public to view?

Yes. Oil tanks, pipes, filling stations, railways, office buildings, and computer systems are clearly shown in photos and videos published on Redchip.com and the company uploaded new photos and videos to its own website in the past 3 months.

Are SEC filings cross-checked by other official filings and made available for the general public to review?

Yes. The 2011 SEC numbers were reconciled with the official SAIC numbers in China.

In addition to all of the aforementioned evidences of legitimacy, several subtle facts that are overlooked by most traders and investors also speak loudly against any irregularity in the company:

1. The current short interest is only 236,000 shares, or about 0.2% of outstanding shares. Short interest has never been above 1% for the stock even when it was traded at almost $4! In almost all fraud cases I've seen, the short interest of a stock was more than 10% or at least 5%. For a company with simple business operations and a small number of assets, many professional shorts can probably check all Longwei's records in a couple of weeks. The fact that short interest not only did not increase but continued to decrease last year during the period of fraud accusations on some Chinese small caps sends a strong message to the market: professional shorts have assessed the company and concluded that the company is legitimate.

2. The company is one of the first among all Chinese oil companies to report financial results each quarter. Except for the annual report, which takes longer to compile, the company normally reports no later than the middle of the second month after the end of a quarter (e.g. no later than mid-May for the quarter ending March 31). Moreover, the management team always schedules a conference call one or two days after releasing the quarterly results to give investors and analysts time to digest the material and think about what questions to ask in the conference call. The conference calls are held in the early morning, giving the market a full day to react to and trade the stock. All of these behaviors may seem trivial on the surface, but they have significant psychological implications for the people making such choices (the management team). It is human nature for one to hide bad news until the last minute and avoid answering questions as much as possible. Thus, the fact that the management team is eager to report statements every quarter and is not afraid of giving investors the opportunity to ask questions shows that they are honest and straightforward, and have nothing to hide or worry about when facing investors.

Operation Risks

ER Date

CC Date

CC Time

Q3 FY 2012

05/10/2012

05/15/2012

10:30 a.m. EST

Q2 FY 2012

02/09/2012

02/10/2012

10:30 a.m. EST

Q1 FY 2012

11/09/2011

11/10/2011

10:00 a.m. EST

Q4 FY 2011

09/13/2011

09/14/2011

10:00 a.m. EST

Q3 FY 2011

05/16/2011

05/19/2011

08:30 a.m. EST

Q2 FY 2011

02/14/2011

02/15/2011

11:00 a.m. EST

Q1 FY 2011

11/15/2010

11/17/2010

Unknown (information too old to find)

3. Some people continue to argue that even if the executives and majority shareholders of Longwei did not do anything wrong in the past, they might decide to steal investors' money in the future. In my opinion, this kind of thinking is unethical and discriminative, and does not make any sense for Longwei.

Right now, the only attacks to the company are from hostile posters on financial message boards, some of them likely using multiple aliases. No accusation I have seen contains any real evidence, and most are using the now obsolete cliché that "all Chinese small caps and RTO stocks are scams." Short interest is essentially non-existent for the stock, so who are these people? They can only be people with no position or intention of initiating a position in the stock or people who are actually trying to accumulate a lot of shares. I don't believe that there are that many people who have nothing better to do in their life than spend time posting against a stock they don't have any interest in, so I believe that most of these bashers are in the second group. If that's the case, what they are trying to do is to scare innocent longs into giving up their shares so that they can buy more at cheaper prices. To me, the desperate yet groundless attacks from these people reinforce the point that there is an enormous gap between the stock's current price and its fair value, and there is a strong chance that the gap will be closed soon.

With all of the strong direct and indirect evidence supporting the company's legitimacy, I have given a final verdict as an investor regarding Longwei: the business is legitimate and the financial results reported in the SEC filing are grossly accurate in representing what the company owns and what it earns each quarter. By grossly accurate, I mean that there is no more than a 5% deviation in revenues, total cost, assets, and liabilities, taking into account possible adjustments subjective to judgment in accounting. For instance, one auditor may argue that the building should be depreciated a little more quickly. Honestly, it is simply unreasonable to think that any company's reported financials can be 100% indisputable down to nickels and dimes.

If I were sent to audit Apple or Microsoft, I could most likely find some room to chop away a few percentage points of their reported revenue or increase some of their reported costs. There is a big difference between having room for reasonable adjustments and selling an outright scam to blatantly steal money from investors. Evidence strongly rebuffs the possibility that Longwei is doing the latter.

Can I be wrong? There is simply no 100% guarantee in the world of investment, so surely I could be. Even the biggest companies in the world can grossly misrepresent their financial results, such as Enron, Worldcom, Waste Management, Qwest, Tyco, Health South, General Motors, City Group, AIG, Fannie Mae, Freddie Mac, Lehman Brothers, and Bear Stearns. However, it is wrong and detrimental for me to base investment decisions on something for which there is an unknown small chance.

I am as confident in the legitimacy and cleanness of Longwei Petroleum as I am about the legitimacy and cleanness of Kinder Morgan and PetroChina. Thus, if I am willing to assume that the financial reports of KMP and PTR are reliable, I should assume the same for LPH. As I explained in my previous article, Longwei's business is less risky than that of PTR. This factor should offset Longwei's smaller scale and call for similar P/E multiple for PTR and LPH.

Disclaimer: my standard disclaimer for my analysis can be viewed here.

Source: Why I'm Confident In Legitimacy And Cleanness Of Longwei Petroleum Holdings