In this report, Absaroka will provide compelling evidence that Lihua International, Inc. (“Lihua” or the “Company”) (NASDAQ: LIWA) has materially misrepresented its business to investors and thus is significantly overvalued. Absaroka’s main concerns about Lihua include the following material issues:
1. Self-Dealing and Related Party Transactions – Overlapping Danyang Huaying Resource Recycling, Ltd. ownership raises significant concerns about management motivations.
2. Illogical Financial Results – Unsustainable margins or indicative of accounting shenanigans and corporate malfeasance?
3. Supplier Relationships – Difficult to reconcile public claims with business reality.
4. Illogical and Repeated Secondary Share Issuances – Is the cash balance real?
5. Implausibly Large Asset Costs – Management appears to be misallocating CAPEX spend based on market comparables.
6. Scrap Import License – Limited opportunity for value creation due to increased sourcing competition, volatile commodity prices, and significant working capital requirements.
7. Auditors Track Record – Raises significant concerns about the validity of published financials and future business prospects.
8. Excessive Stock Promotion – Management appears uniquely focused on stock promotion as it has hosted 11 significant investor events YTD.
Any of these serious issues on a stand-alone basis should be enough to convince public shareholders to question the current $6.75/share valuation and pursue the “Wall Street Walk” form of shareholder activism. A complete PDF copy of Absaroka's report is available here.
1. Self-Dealing and Related Party Transactions – Raises significant concerns about management motivations
Absaroka’s research indicates that Danyang Huaying Resource Recycling, Ltd., a company that is registered at the same address as Lihua, also provides a portion of Lihua’s purported copper supply. More importantly, Danyang Huaying Resource Recycling, Ltd. is owned by Ms. WANG Yaying (Lihua’s Chief Operating Officer, Secretary and Director and also the wife of Mr. ZHU Jianhua, Lihua Chairman/CEO), Ms. WANG Liying (sister of Ms. WANG Yaying, Lihua COO, and sister-in-law of Lihua Chairman/CEO, Mr. ZHU Jianhua), and one other likely related party. This business relationship obviously raises a plethora of conflict of interest concerns and has not been disclosed in Lihua’s SEC filings.
Moreover, this cozy relationship would make it easy for Lihua to potentially mislead its auditor by massaging its purported production volume and COGS reporting information. Please review the PDF copy of Absaroka’s report for the source SAIC documents.
According to Danyang Huaying Resource Recycling, Ltd.’s 2009 SAIC filings (the most recent publicly available), the firm generated revenue of approximately $43.2mm on $14.4mm in total assets. Also, the firm supposedly has only six employees and Ms. WANG Liying is the Legal Representative, Chairwoman and General Manager. However, Ms. WANG Liying’s actual employer is the Danyang City Tianyi Electronic Factory. In addition, because of Ms. WANG Liying’s middle school level of education, it is extremely difficult to believe Lihua Management is not involved in the administration and operations of Danyang Huaying Resource Recycling, Ltd.
As mentioned above, the Danyang Huaying Resource Recycling, Ltd. SAIC registered address of Danyang City Houxiangzhen Wuxing Industrial Zone is exactly the same SAIC registered address as Lihua’s Jiangsu Lihua Copper Industry Co., Ltd. Absaroka’s in-country investigators canvassed the Danyang City Houxiangzhen Wuxing Industrial Zone and surrounding area, but were only able to locate Lihua facilities. Thus, Absaroka strongly believes Lihua Management controls Danyang Huaying Resource Recycling, Ltd. and operates it out of the same Lihua facilities. Moreover, this conflicted business relationship appears to violate every basic tenet of public company governance and internal controls.
2. Illogical Financial Results – Unsustainable margins or indicative of accounting shenanigans and corporate malfeasance?
Lihua’s financial results make do not make sense relative to its peers, especially when comparing gross margins. In FY10, Lihua reported a consolidated gross margin of 16.8% and an 8.7% gross margin for the Copper Anode business segment, despite the fact it was the Company’s first year of operation in the anode market and it was competing for customers against established producers. At best, Lihua’s reported financial results appear unsustainable over time due to competitive pricing pressures and, at worst, could be a clear indication of accounting shenanigans and corporate malfeasance.
Absaroka’s in-country investigator spoke with the Chief Engineer of Baotou Copper Smelting Group, a large copper processing firm, about current dynamics in the Chinese copper market. According to the Chief Engineer, copper anode manufacturing in China normally realizes a gross margin of 2%-5%, while copper wire processing generally realizes gross margins of 5%-8%. Below is a table of FY10 financial results of Chinese copper market participants.
3. Supplier Relationships – Difficult to reconcile public claims with business reality
Lihua claims to be currently refining 50,000 tons per annum of copper and thus would require a monthly input supply of approximately 4,150 tons. However, after speaking with Lihua’s disclosed suppliers and channel checks with other potential suppliers, Absaroka finds it difficult to believe the company is producing the total volume of copper claimed because the amount of inputs provided to Lihua indicates a significantly smaller operation. In FY10, Lihua’s five largest suppliers reportedly represented 51% of total purchases and the company’s single largest supplier accounted for 12.9% of total purchases.
Lihua’s Reported Suppliers as per the FY10 10-K:
Jinhailuo Recycling Metal Co., Ltd.
Jinhailuo appears to be Lihua’s largest named supplier. It has one main factory, which is not involved in the copper trade, and two subsidiaries. Absaroka’s in-country investigators contacted the main subsidiary, called “Jinshun Metal Plastic Co. Ltd.,” whose employees said they provide approximately one and a half trucks (40-60 tons per truck) of scrap copper to Lihua every month. This scrap copper is imported from Japan and Taiwan, and volumes remain relatively consistent throughout the year.
Yian Recycling Metal Co., Ltd.
Yian is located in “Asia Metal Resources Recycling Industry Base” in Zhaoqing City in Guangdong. There are more than 20 companies in this location, and only their regular customers can gain access. Thus, Absaroka’s in-country investigators were unable to get access to the industrial base to verify the information directly with the company, but anecdotal evidence indicates their scale is rather limited.
Nanhai Huabi Metal Co., Ltd.
According to a Huabi salesman, the company provided scrap copper to Lihua in 1H10, importing from overseas and reselling to Lihua in monthly volumes of approximately two 40-ton trucks. However, the company did not have access to imports of copper scrap in 2H10 and thus provided no scrap to Lihua in the second half of 2010.
Nanhai Meiyada Metal Co., Ltd.
The Nanhai Meiyada name did not appear on the entrance to the premises of the company’s registered address. Absaroka’s in-country investigators found only a few tons of scrap and few signs of business activity at the registered address. The sales staff and the warehouse keeper at the registered address were unable to tell Absaroka’s in-country investigators any information relating to Lihua.
Nanhai Tianyuanhe Metal Co., Ltd.
Nanhai Tianyuanhe owns three factories in the Danyang area. One factory’s sales staff stated Lihua generally purchases scrap copper from the company on a monthly basis, with total shipment volumes of approximately one to two 40-ton trucks.
4. Illogical and Repeated Secondary Share Issuances – Is the Cash Balance Real?
Absaroka finds it curious that Lihua has repeatedly issued secondary shares, despite having a robust cash balance and positive operating cash flow. On 09/04/09, Lihua raised $8.6mm in proceeds via the secondary issuance of 2.3mm shares at a gross price of $4.00/share. As per the most recent 10-Q before the offering, Lihua supposedly had $28.1mm in cash and equivalents and only $4.4mm in bank loans outstanding. Lihua reportedly generated positive operating cash flow in both 1H08 and FY07. The planned use of proceeds for the 2009 offering was “working capital and general corporate purposes” as per the offering prospectus.
On 04/14/10, Lihua again tapped the United States capital markets for $32.5mm in proceeds from the sale of 4.3mm shares at a gross price of $8.05/share. As of the most recent 10-K filing before the offering, Lihua supposedly had $34.6mm cash and equivalents, only $2.2mm in bank loans outstanding, and an FY09 operating cash flow of $8.4mm.
In Absaroka’s opinion, with Lihua’s 10-Q reported cash balance of $90.7mm, the Company would have the capacity to have completed at least $60.0mm in share repurchases in FY11 based on the the continued positive operating cash flow generation of the business. Instead, Lihua has only repurchased 97,600 shares at a VWAP of $9.49 per shares in FY11 and was forced to sign a loan agreement to borrow up to $4.0mm from the CEO Mr. ZHU Jianhua’s Magnify Wealth Enterprise Limited to fund the share repurchases.
5. Implausibly Large Asset Costs – Management appears to be misallocating CAPEX spend based on market comparables
Absaroka hypothesizes that Lihua has over-reported the costs of its CAPEX and acquisitions in an attempt to subsidize its cash operating costs. While the Company claims that its 50,000 tpa copper anode production capacity expansion will cost up to $40.0mm, after multiple discussions with various industry experts, Absaroka strongly believes the actual project cost is closer to $20.0mm.
Potentially Fabricated “Relocation Costs”
During Lihua’s Investor and Analyst Day at the Danyang Facility on 05/24/11, the company could not keep its story straight on the cost of its recent land acquisition for the factory expansion. Originally, investors were told that the land for the factory cost $10.0mm. However, later in the day, the IR director stated the land acquisition cost was only $5.0mm, but then explained $5.0mm was also spent on the relocation of existing residents.
Separately, Mr. Yang “Roy” Yu, Lihua’s 28-year old Chief Financial Officer and Treasurer, stated $5.0mm was allocated for the land and $5.0mm was required for physical site preparation, rather than relocation of residents.
Based on recent land transaction comparables in the area, Absaroka believes a cost of approximately 32.4mm RMB ($5.0mm USD) for 120,000 square meters (180 mu) of land in that area is more reasonable.
More curious is Lihua’s disclosure that it has failed to make full payment for the land and therefore has not received title. In the 2010 10-K, Lihua stated:
As of December 31, 2010, prepaid land-use rights included RMB32,391,910 ($4,834,893), representing payments made by Lihua Copper to a local authority to acquire a 50-year right to use a parcel of land which will be used for expansion of its manufacturing facilities… RMB2,391,910 ($361,168) remained unpaid, and no land use right certificate had been issued.
Despite not having received the land use rights, Lihua claimed to have spent an additional $5.4mm, still without legal title:
Apart from the payment of $4,891,043 to the local authority, the Company also paid $5,359,456 in connection with the acquisition of these land use rights during 2010.
According to a local Danyang construction engineering head who is currently supervising a 3,000-square-meter factory project, the average building cost for pressed steel cladding, concrete pylons, roof, and a concrete factory floor is 700-800 RMB per square meter. Absaroka’s in-country investigators separately confirmed with the Danyang Investment Promotion Bureau that the average cost for such a factory in the region is around 800 RMB per square meter. Therefore, Absaroka estimates that the expansion for the three factory buildings, each at 80x200 meters, would cost approximately 38.4mm RMB ($5.9mm). Lihua claims the factory building cost will be almost double that, at $10.0mm.
Absaroka’s in-country investigators interviewed an industry expert who is the Chief Engineer at Nanjing Yongliang Furnace Company, which produces metal smelting equipment for Chinese manufacturers. Based on the Chief Engineer’s experience and knowledge, the new construction of a complete 25,000-ton copper smelting production line and associated tooling would cost approximately 15-20mm RMB. Thus, Absaroka believes the total cost of two 25,000-ton copper smelting production lines would be at maximum 40mm RMB ($6.2mm), which accounts for less than 41% of the claimed factory equipment investment of $15.0mm.
6. Scrap Import License – Limited opportunity for value creation
Since the end of FY10, Lihua has pitched to investors that it was pursuing a “Scrap Copper Import License” to enable the Company to purchase and import scrap copper directly from overseas suppliers. On 06/22/11, Lihua finally announced receipt of the Environmental Import License from the Ministry of Environmental Protection of the People's Republic of China and that the Company expects to ramp up its scrap copper imports to material volume by the end of 2011. Based on representations of Lihua Management, investors might have considered this announcement to be an important milestone for the Company.
Absaroka believes the Scrap Copper Import License will at best provide de minimis value creation for public shareholders because of the limited cost savings, increased working capital requirements, and significant scrap sourcing competition. First, if Lihua was able to decrease its copper anode cost of goods sold line-item by $150/ton via sourcing its own scrap copper input, its consolidated net income would only increase approximately 3.5% based on FY10 figures (assuming a 25% marginal income tax rate). Next, because of the long lead time to import scrap copper (i.e. the shipping time for copper to sail across the Pacific to the PRC), Lihua will likely tie up a significant amount of working capital as it must prepay for the scrap on an FOB basis and structure the trade to avoid the significant commodity price risk between scrap purchase and anode sale. Finally, the global scrap metal market has gotten considerably more competitive in the last few months, as significantly larger and more experienced companies than Lihua have dramatically increased their usage of scrap in the face of rising copper concentrate prices. This dramatic increase in demand has crushed the price differential between copper scrap and copper futures, thus making it even more difficult for Lihua shareholders to benefit from the Company’s new import license.
7. Lihua’s History of Low Quality Auditors – Raises significant concerns about validity of published financials and future business prospects
8. Excessive Stock Promotion – Management appears uniquely focused on stock promotion
Lihua Management has devoted significant resources to the excessive promotion of the company’s equity to potential investors. For example, in 2011 alone, Lihua has presented at over 11 significant investor events to date, including:
With an investor relations schedule this rigorous, there is little doubt that Lihua Management is doing all they can to “get the story out.” Any institutional asset manager, hedge fund, or investor interested in this space has undoubtedly been exposed to Lihua. Yet the common equity still trades at less than 5.0x LTM earnings. In Absaroka’s opinion, it is no coincidence that many institutional investors have decided against investing in Lihua’s stock.
Disclosure: I am short LIWA.