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Nine Dragons: Alternative Approach to Evaluating It

|Includes: Nine Dragons Paper Holdings Ltd. (NDGPF), NDGPY
            Many investors concentrate only on the financial numbers; hence missing crucial facts that my directly effect their ROI.  Numbers alone can come short of explaining a company’s finance, strategies, and business model.  Numbers, in some cases, can also hide fraud committed by in the hand of executives.  In some instance, investors can have a hint of a company health before the company publishes its financial statements. They just read the right publications: press releases, news, annual reports, 10(NYSE:K), or proxies.

I have decided to use Nine Dragons Paper Holdings Ltd., a Chinese manufacturer of packaging paper, pulp and specialty board products, as an example to show how going beyond numbers can help one make an investment decision.  Cheung Yan, also written Zhang Yin, with her husband, Liu Ming Chang, co-founded Nine Dragons.  I believe that a network of Nine Dragon and Cheung Yan can provide a great insight on Nine Dragon viability as an investment. 

          It is common knowledge that Ms. Yan’s brother, Zhang Chengfei and father, Zhang Deen, were part of the Chinese Army; Ms. Yan’s father, Zhang Deen, was a lieutenant in revolutionary Red Army officer[1].  From Albert Louie, a Beijing-based risk management consultant at A. Louie & Assoc. who studied her career, stated that “Her father's war buddies have played an instrumental role in Zhang's rise, in that they helped her open doors at all levels of government.”  He continued by stating that “They also helped her build the contacts needed to help many Hong Kong tycoons resolve investment problems.'' Such connection explains the meteoric ascension of Nine Dragon.

            Nine Dragon has backing from three wealthy Chinese Tycoons:  Cheung Yu-Fung, Robert Kuok, and Lee Shau-Kee.  Merrill Lynch & Co. and Baring Asset Management are major investors in Nine Dragon, with Baring owing 29 million shares.  Ms. Lilian Co, manager of Baring Hong Kong China Fund, stated ``The company is the leader in the industry. There's an expanding market and a shortage of supply,'' and “We still like her story.”[2]  With such powerful backing, one can decide to invest in Nine Dragon.
            Ms. Yin has assigned her 29-years old Columbia Graduate son, Lau Chun Shun, as executive director.  Many investors perceive this action unfavorably. Conflict of interest may or will rise when board members have close connection to the executives.  Lack of oversight of executive actions may and will rise.  By putting her son, one cannot evaluate properly the strength of the board[3].  Many members of Ms. Yan’s extended family work in Nine Dragon.
            The changing laws and regulations in both China and US may have negative consequences on Nine Dragon profitability, and expansion.  China is creating strong laws and regulations to protect employees[4].  The US decision to treat scrap paper as a commodity resulted in its price to go from $100 a ton in 1990s to $135.  David Wong, a Shanghai Second Polytechnic University environmental science professor, stated that the US might restrict scrap paper export to China.  Such a policy will reduce Nine Dragon inventory, and may cause the company to find alternative to US scrap paper. 
In anticipation, Nine Dragons is investing in Inner Mongolia plants that produce pulp from logs and wood chips, and has increased its inventory, which can be seeing in its balance sheet. The company has increased it inventory from 4.3% to 9.13% of total assets.  The increase of inventory, in turn, caused company cash flow to go negative in 2010.   Unfortunately, its production of paper in Chongqing region is not enough to cover its imports[5].  Furthermore, Standard and Poor, the rating agency, stripped Nine Dragon from its rating for “insufficient access to management[6].  It sees Nine Dragon as an "aggressive debt-funded growth appetite."[7] Fitch rated it bb-.
            Socially responsible investors want to invest in companies that treat their employees fairly.  Nine Dragon is known for treating badly its employees.  In 2007, its workers at its Dongguan and Jiangsu factories went on strike.  Frequent work injuries and deadly industrial accidents have been reported.  The company has been known on giving fines to innocent workers relating to work injuries, or to giving heavy and unreasonable fines on workers.  It has been suspected of violating the labor laws and regulations in China[8].  
Ms. Yan believes the status quo should be kept: “If the laws provide too much protection for workers, companies can hardly do business there.”  She also wants to repeal laws that will ban firing employees that have been with the company for over ten years for no-reason.  She states that most of the work is done by machineries with little interaction from humans.  However, people who visited her factories found that only people were performing the initial part of separating trash from paper.  Her lack of fairness toward the employees who made her rich and successful makes her company unattractive to some investors.
            While Nine Dragon Paper Holdings Ltd. have strong backers and investors, its foes are many.  Labor laws may force the company to treat its employees fairly, and provide safe environment, which may eat up some of its profitability. On the other hand, if the company follows the labor laws they may attract socially responsible investors.  The US designating scrape paper as a commodity will put pressure on the company revenues and access to it.  Nine Dragon is creating alternatives to getting paper through land acquisition in Northern Mongolia for tree plantation, but still relays heavily on imports.   Making the company a family business is problematic to investors who want strong governance.  The Standard and Poor withdraw of its rating is extremely damaging to Nine Dragon.  Nine Dragon is a capital-intensive company that needs loans at a reasonable rate to function.  Trees for paper require between 10 to 20 years to mature and be ready to be harvested.