It has been over 15 months since I posted my second of two articles on Longwei Petroleum (LPH), "Seeking Legitimate Value in China Small Cap Longwei Petroleum," and "Longwei Petroleum: A Contrarian Long Idea for 2011."
My call of buying Longwei Petroleum last year was fundamentally mistimed. I failed to identify the severity of fraud, lack of legal recourse, and subsequent U.S. investment institutions' adverse "sell everything" stance related to small cap China. For my times in and out of this stock since late fall of 2010, I have nothing to show but losses, but this appears to be changing. My underlying thesis of these articles that the company would most likely emerge from the Chinese small cap investment space, which has been wrought with fraud, as one of the few winners appears to be panning out.
Last Thursday, Longwei completed the long-awaited acquisition of its third fuel-storage depot "Huajie." The addition of Haujie nearly doubles the company's current storage capacity for petroleum products from 120,000 MT of storage to 220,000 MT and allows the company to expand its customer base. Even more important than the actual expansion is that the company paid for the acquisition utilizing operational cash flow, which should alleviate fears of Longwei's balance sheet being fictional and suggests the days of the company being valued as a fraudulent "going concern" appear to be limited.
On Monday, July 2, Longwei also announced the completion of its Tax Reconciliation Report by independent auditors, as promised by management (found here). The Tax Reconciliation Report reviewed the company's management reports compared to taxes paid and financial statements filed in the "People's Republic of China" (PRC) with the company's publicly reported filings with the Securities and Exchange Commission (the "SEC") and found no material difference. Insiders of now de-listed, disgraced, and fraudulent small cap Chinese firms looking for a quick buck would often report books with inflated revenue and earnings figures to the SEC in an order to "pump up" their stock prices to sell shares to unsuspecting American investors. Meanwhile, they would report a different set of books to the PRC for tax-related purposes.
The reconciliation of these two filings was often the first place the now famed Chinese small cap short sellers and fraud whistleblowers-mainly Carson Block of Muddy Waters Research and John Bird (aka, Waldo Mushman of Seeking Alpha)-would start when looking for potential red flags in possible fraudulent Chinese companies. The tax reconciliation done by Longwei Petroleum on July 2 proved that the company was not materially misstating revenue and earnings between the two different government bodies (the SEC and the PRC), rising above 95% of the other companies in the space, in Longwei's quest to prove the legitimacy of its numbers and business to skeptical American investors.
The acquisition completed last week on September 27 of Longwei's third fuel-storage facility, "Haujie," should have caught many investors' attention. Taken from the form 8-K:
On September 26, 2012, Longwei Petroleum Investment Holding Limited's (the "Company") wholly owned subsidiary, Taiyuan Longwei Economy & Trading Co., Ltd. ("Taiyuan") entered into an Asset Purchase Agreement (the "Agreement") with Huajie Petroleum Co., Ltd. ("Huajie") pursuant to which Huajie sold certain assets to Taiyuan (the "Assets"). In consideration for the sale of the Assets, the Company and Taiyuan paid to Huajie an aggregate purchase price equal to 700 Million Renminbi (approximately $110.9 million) (the "Purchase Price"). The Company and Taiyuan had previously paid 550 Million Renminbi (approximately $87.1 million) to Huajie prior to the closing of the transaction, which was credited towards the aggregate Purchase Price by Huajie.
The Assets purchased from Huajie consist of fuel storage tanks with 100,000 metric ton capacity with accessory facilities and equipment, delivery and distribution platforms, including a dedicated rail spur and a vehicle loading and unloading station. The purchase also includes a 3,000 square meter office building and land use rights for approximately 98 acres of land adjacent to the main regional rail line.
Longwei completed the $110 mm dollar acquisition utilizing internally generated funds (operational cash flow) without the use of any outside financing capital-debt or equity. In late 2010, Longwei filed a shelf offering with the SEC, suggesting it was going to raise equity for a possible expansion but later took the offering off the market due to the low stock price and the subsequent dilution such an offering would create. These two actions combined should help give tentative U.S. investors the picture that the fears of Longwei being some sort of fraudulent "going concern," as the stock price would suggest, are gravely overblown.
Management continues to make steps in the right direction; however, it would behoove the company to become even more increasingly transparent with U.S. investors should it ever hope to escape its stock price's "valuation hell." In my previous articles, I did an analysis of the valuation mismatch between Longwei and other such oil and gas distributors as Kindor Morgan Energy Partners (KMP), China National Offshore Oil Corporation (CNOOC), and Petro China (PTR).
Another bullish piece that makes me think the small cap Chinese space might be getting closer to turning the corner is the increase in "going private" transactions taking place. Small cap China used to be front and center in the financial media in late 2010/early 2011, when many U.S.-listed Chinese companies were de-listed or went "dark" due to allegations and/or convictions of fraudulent activity. This has left incredibly slow stock valuations as investors didn't want to get caught in the next stock to be halted and/or de-listed from the market. The flip side is that now there appears to be a flurry of "going private" activity in the space that is not making front-page headlines, but nonetheless has potential to prove quite lucrative for the insiders and institutions engaged in these transactions that are taking advantage of depressed public-stock price valuations.
The Carlyle Group, which is one of the largest and most politically connected PE firms in the world, has offered to take Focus Media (FMCN), a dominant advertising-display agency in China, private for $27 per share, along with a large Chinese sovereign wealth fund. Focus Media last year was the subject of Carson Block's Muddy Waters Research, which accused the company of misrepresenting the size of its operations (inflating revenue and earnings) the Muddy Waters research report on FMCN can be found here. Block targeting a short attack on a company that is now attracting interest from a private equity fund such as Carlyle in a "going private" transaction suggests to me that a lot of the more blatant frauds and "easy" shorts in the space are now gone.
That is not to say there aren't still significant risks to investing in China because there are still substantial risks that need to be mitigated. Foreign investors and institutions need a better understanding of the Chinese culture, legal and corporate structures, and Chinese business practices before becoming more comfortable investing in the space again, and this will take time. Subsequently, Chinese directors of publicly listed U.S. companies need to increase transparency with U.S. investors and try to understand their frames of reference and points of view as it pertains to putting their hard-earned capital to work in companies halfway around the world under a different legal jurisdiction.
There are also still issues between the Public Company Accounting Oversight Board (PCAOB) and the PRC regarding audit and accounting issues of U.S.-listed Chinese companies. Essentially, the PCAOB wants the right to inspect all local Chinese accounting firms that are sub-contracted by U.S. accounting firms to carry out annual field audits. The PRC wants to protect its sovereignty, but the dialogue between the two organizations appears to be moving in a positive direction and is an encouraging first step toward eliminating distrust between the two sides. To get the latest information, please visit Paul Gillis's "China Accounting Blog." If you are an investor in China it is a must-read to keep up with the latest accounting issues concerning the small cap Chinese investment landscape.
What will eventually bring back the valuation of Longwei Petroleum and a few other Chinese small caps that have been sold to very low valuations (obviously many were sold rationally) is the participation of large American institutional investors coming back in the market to bid for these stocks. Longwei (among many other Chinese small caps) faces a difficult challenge to bring back U.S. institutional investors, not only because of the fraud and subsequent lack of legal recourse in the space, but because of the low level of liquidity in the stock.
Longwei, for the past year, has been trading less than 200k shares a day between $1 and $2 a share-that is a total nominal average dollar amount traded daily of around $300,000. For comparative purposes, AAPL trades over $10 billion dollars a day. Why is this meaningful? Because when an institution goes to invest, it: 1) wants liquidity in the stock and 2) doesn't want to materially move the stock when buying or selling shares (see 1). In Longwei's case, if a large institutional player wanted to put on a $5 or $10 million dollar position (a minuscule investment for the institutional player), they would find no liquidity and would significantly move the stock price before being able to fully invest their position, making the investment far less appealing.
This phenomenon will simply take time to rectify. Assuming management executes on the prospect of the underlying business and it doesn't go private, Longwei's stock is most likely just in the beginning stages of a large appreciation (over a number of years) that will drive volume and liquidity in the stock, which in turn, will allow for the entry of bigger and bigger players as the volume, float, and market cap become larger. This will eventually bring back Longwei's valuation and give the stock the institutional support it needs so that it won't trade at 2x earnings, 30% of sales, 40% of book value, and 65% of net current assets like it has been trading for the past year or two.
While the process is taking longer than I first estimated because management has been slow to deliver on promises (first the tax reconciliation findings and then the closing of the third fuel storage facility) management is following through on promises made to investors. The stock price still faces potential headwinds as there are yet to be institutional players that own meaningful amounts of shares that will protect the stock price; however, with time, I think this problem will rectify itself. For the time being, however, I believe the stock price remains susceptible.
Assuming management carries out its business model and keeps delivering on promises made to investors, institutional players will come back to this stock and this space (it will take time). When they do, Longwei will start to trade in line with a valuation more appropriate for a company boasting its balance sheet and income statement, providing investors very healthy returns from current prices. However, due to the negative sentiment in the Chinese investment landscape and issues that still need to be addressed in order to bring back institutional investors this will not be a short-term process (read more on the valuation and stock price manipulation in a later article).
Disclosure: I am long LPH.