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March 30, 2012

Update Sino-Forest entered bankruptcy protection today. As documented below I expressed deep concern about this company way back in 2005. Scroll to the bottom here to see what I  was saying about this company since 2005.

September 3, 2011

This is a re-creation of our November 13, 2005 report on Sino-Forest. Given all the controversy about Sino-Forest we wanted to post again what we were saying about the company in 2005. We said in essence that the company looked like quite good value but that we had some concerns. 

In particular, see my comments below this report where I document that I had lost trust in management in late 2005 and even speculated that it might be a fraud. Apparently I was six years ahead of my time on this one.

The report below was re-created from our November 2005 database. All the words in the report are exact, unchanged as they appeared in our November 13, 2005 report. I have however highlighted below the areas where I expressed particular concern. Concerns that now seem highly relevant. The yellow high lighting was not there in the original report.

 

Sino-Forest (TRE, Toronto)
RESEARCH SUMMARY
Report Author(s):	InvestorsFriend Inc. Analyst(s)
Author(s)' disclosure of share ownership:	We hold shares
Based on financials from:	Dec 04 Y.E. +Q3 '05
Last updated:	13-Nov-05
Share Price At Date of Last Update:	$3.90
Currency:	$ Canadian
Current Rating (Company Rating does not consider the circumstances of any individual investor and is therefore not a recommendation and is not Investment Advice):	(Highly) Speculative Buy rated at $3.45
DESCRIPTION OF BUSINESS: Manages, operates and invests in tree plantations in China and produces wood chips which are sold to pulp mills and engineered wood producers. Also produces some lumber products and engages in wood products trading. Also sells standing trees, which recently has been the fastest growing and most profitable business activity. Purchases trees and arranges for the trees to be made into wood chips and then resold for pulp and paper purposes.
RATING: At the recent price of $3.45 the value ratios are compelling and point to a Speculative (higher) Strong Buy.  Does reasonably well on Buffett's tenets. It does have potential for strong growth and provides some exposure to China. Negative factors include the risks of operating in China. Note the recent bond issue has an interest rate of 9.125% and a credit rating of only BB minus which is indicative of higher risk.   I expect continued price volatility. I generally consider this to be a poor industry but that may not be the case in China. I believe that there could be strong potential upside here of perhaps a 100% gain within one year if the company continues its recent earnings momentum. Some analysts have pointed out that they continue to raise money to grow and there is a risk of not obtaining financing. I don't view the growth as a bad thing given the earnings. I would think the 2008 Olympics and continued strong growth in China would bode well for the company.  I worry that the story is too good to be true. I worry that the company seems to have changed its business plan several times in the past few years. I am wary to become over-exposed. Note that Jennings Capital has an unfavourable outlook on the stock. Note also that management has in the past been less than forthcoming with information. In summary, the value looks great, but there are many risk factors and investing in this stock will require patience and tolerance of volatility. I rate this a (highly) Speculative Buy. See comments under management quality. I feel that I am overexposed and so will sell most of may shares to take profit and reduce my position from 4.2% down to under 1%.
RISKS:   The price to earnings ratio of this stock seems almost too good to be true. Combine that with a lack of detailed disclosure by the company and the location in China and there is always the potential that assets and / or earnings are over-stated. Faces currency risks since costs and sales are in Chinese currency. Risk of asset seizures by communist Chinese government. I consider there to be added risks due to location in China. May face risks of write-offs on certain production facilities. Faces commodity price risks and risks regarding the quality of its trees. For additional risks see annual report.
INSIDER TRADING: checking since January 1, 2005, there is no insider trading shown (other than "conversions" and "changes in the nature of ownership"). Three insiders are shown to own substantial shares (800,000  to 2.8 million shares). It's comforting that insiders are not selling, but neither are they buying despite a slide in the share price (since recovered) . I take no signal from this lack of activity.
WARREN BUFFETT's TENETS: Seems to pass most of Buffett's tenets (see Robert Hagstrom's book) - not simple to understand due to location in China and somewhat complex financing (fail), good profit history (pass), moderately favourable prospects for above average returns due to cost advantages of fast growing tree climate and established position in a fast-growing market (pass), probably ethical management although in the past they have been almost secretive (marginal pass), a good ROE (pass), high profits on sales (pass) ,a reasonably low debt ratio (marginal pass) and probably selling at a significant discount to a intrinsic value (pass).
RECENT EARNINGS TREND: Strong earnings growth in latest few quarters and year. Earnings are made more volatile by sales of standing timber. Strong earnings have been made by purchasing and then reselling standing timber (I am not clear why they are able to make large profits that way without any apparent value added). Earnings and particularly sales on their own planted trees seem disappointingly very low. Margins on standing timber were lower in Q2 and Q3 but they explain this by indicating more pine trees were sold versus eucalyptus trees.
VALUE AND GROWTH RATIOS: Price to book value is very attractive at 0.93 based on diluted number of shares.  P/E is very attractive at 5.2, Return on equity was very strong at 17.1% in 2004. 16.3% net profit on sales in last 12 months, fair to good financial liquidity with substantial but not excessive net debt level. Growth in revenue and earnings per share are uncertain due to difficulties in calculating the diluted number of shares each year due to impacts of convertible debt (which no longer exists). Revenue has grown strongly while earnings per share are more volatile. I calculate a present value per share of $5.80 using what I believe to be conservative assumptions and $9.05 using a moderately more optimistic projection. This implies a good Price to Value Ratio of 60% to 38%. However the profit growth and therefore the intrinsic value are uncertain. These ratios point to a Speculative (higher) Strong Buy.
SUPPORTING RESEARCH AND ANALYSIS
Symbol and Exchange:	TRE, Toronto
Currency:	Canadian $
Category:	Growth
Contact:	info@sinoforest.com
Web-site:	www.sinoforest.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS
Latest four quarters annual sales $ millions:	$539.9
Latest four quarters annual earnings $ millions:	$88.4
P/E ratio based on latest four quarters earnings:	5.9
Latest four quarters annual earnings, adjusted, $ millions:	$88.4
BASIS OR SOURCE OF ADJUSTED EARNINGS: No adjustments made.
Quality of Earnings Measurement and Persistence: Seems fairly reliable but not necessarily persistent, the net income is largely realized in cash.  A possible concern is whether or not cash can be taken out of China. All cash plus additional borrowings are being re-invested in tree and mill assets. Recently there was a large expense for stock-based compensation but this was much-reduced in Q3 2005. The recent amounts seem arbitrary based on a chosen vesting period, it could have been much higher, this reduces earnings quality. Income taxes are expensed and shown as payable but are not paid and may not be legally due, this increases earnings quality if the income tax will never be payable.
P/E ratio based on latest four quarters earnings, adjusted	5.9
Latest fiscal year annual earnings:	$62.8
P/E ratio based on latest fiscal year earnings:	8.3
Fiscal earnings adjusted:	$62.8
P/E ratio for fiscal earnings adjusted:	8.3
Latest four quarters profit as percent of sales	16.4%
Dividend Yield:	0.0%
Price / Sales Ratio	0.97
BALANCE SHEET ITEMS
Price to (diluted) book value ratio:	1.05
Quality of Net Assets and Book Value Measurement: Apparently good reliability, assets consist largely of standing trees. The assets are tangible with very little goodwill, and sales of standing timber appear to indicate that the standing tree assets are worth at least 50% more than book value. An independent report valued the trees at a 57% premium to book value. However, some investments in wood product plants may be at risk of further write-offs.
Number of Diluted common shares in millions:	137.8
Controlling Shareholder:  Fidelity (mutual funds) owned 10.3% at Mar 31, 2005. Management appears to own less than 10% of the company.
Market Capitalization $ millions:	$537.6
Percentage of assets supported by common equity: (remainder is debt or other liabilities)	51%
Interest-bearing debt as a percentage of common equity	77%
Current assets / current liabilities:	2.5
Liquidity and capital structure: reasonable liquidity, with cash on hand. Although debt has recently increased. I understand the credit rating is BB minus. This is considered several notches below investment grade. So it is indicative of higher risk.
RETURN ON EQUITY AND ON MARKET VALUE
Latest four quarters adjusted (if applicable) net income return on ending equity:	17.3%
Latest fiscal year adjusted (if applicable) net income return on average equity:	17.1%
Adjusted (if applicable) latest four quarters return on market capitalization:	16.5%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE
5 years compounded growth in sales/share	12.1%
Volatility of sales growth per share:	strong growth with some volatility
5 years compounded growth in earnings/share	7.3%
5 years compounded growth in adjusted earnings per share	n.a.
Volatility of earnings growth:	strong growth, but some volatility
Projected current year earnings $millions:	not available
Projected price to earnings ratio:	not available
Over the last five years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share?	Yes, although volatile
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained:	17.1%
More conservative estimate of compounded growth in earnings per share over the forecast period:	10.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period:	15.0%
OUTLOOK FOR BUSINESS:   Company plans to continue its aggressive growth through investments in tree plantations. In the past results have been volatile and this may continue. Given recent and pending investments in tree plantations, the near-term outlook seems quite positive. They may need to issue additional shares to fund growth and that would dampen the share price growth somewhat.
Estimated present value per share:  $5.80 if earnings per share grow for 5 years at 8% compounded each year and the shares can be sold at a higher P/E of 8 after five years. $9.05 if earnings per share grow at 15% each year and the share can then be sold at a higher P/E of 10 after five years. Both estimates use a required rate of return of 8%. This is not a share price prediction.
ADDITIONAL COMMENTS
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry rather than any particular company.)  Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition.  Wood chips, trees and wood products are commodities which tend to compete strictly on price (although the company indicates competition is low). The industry is not subject to powerful suppliers or customers who could usurp the industry profit. The industry has substitute products (which is a negative). The industry tends to be cyclical following construction cycles. The industry is subject to protests from environmentalists. Overall, this is an unattractive industry. However, the competitive environment for Sino-Forest may be much better than for the industry generally.
COMPETITIVE ADVANTAGE: Compared to certain other regions of the world, the trees grow remarkably fast in China. This company has the long-term use of plantation lands in China. They appear to be a low cost producer there appear to be barriers to entry due to (perhaps) limited plantation land available and due to high capital investments needed. However the more recent business is that of buying existing plantations and it is less clear what competitive advantage they have there although it may be their connections and relationships. The company cites relationships and strategic locations near population as well as expertise, and research and development.
RECENT EVENTS: Borrowed U.S. $300 million at 9.125% by issuing bonds (rated BB) to replace existing International Finance Corporation debt and for capital spending.
ACCOUNTING AND DISCLOSURE ISSUES:  I use diluted number of shares (calculated as earnings divided by diluted EPS) and this is volatile due to impacts of convertible debt (since retired). Earnings have been poured into tree plantations and more recently into mills to process wood. Disclosure in the past has been opaque. This is improved now but raises questions as to why they waited so long to become better at disclosure.
COMMON SHARE STRUCTURE USED: Recently converted the multiple voting shares to single voting shares. This was a very positive development.
MANAGEMENT QUALITY AND ETHICS: Management are of Chinese heritage, are major shareholders and have a good track record. Previously I was wary to trust this management given their past lack of disclosure and high executive compensation. However, disclosure and governance has now improved substantially. The company has been listed on the stock exchange for many years. To some degree I am placing my confidence in the regulators and accountants that everything is above board here. I am concerned that most profits now appear to come from buying land with standing trees and then reselling the trees (not clear why this would be profitable). Also most of the traditional wood chip business seems to be outsourced. The hoped for sale of the companies own planted fast-growing trees has essentially not materialised even after 12 years. Talked about revenues and profits on wood mills also seems not to have materialised. This causes me concern about the management quality and forthrightness.
EXECUTIVE COMPENSATION: Recently management were rewarded with stock-based compensation that of total value of over $10 million although only $2.7 million was vested and expensed in Q2 2004. There appears to be a danger here of excessive compensation. In Q3 2004 it was reported that management was paid $12 million for rights to acquire shares in a subsidiary of the company. $7.8 million will be treated as compensation expense over a vesting period. This seems rather strange and is worrying, however it may be a one-time event.
BOARD OF DIRECTORS: (2005 annual meeting  info) Six of the eight directors, including the CEO, are significant shareholders. This tends to align their interests with those of other shareholders. 5 of the directors are independent after recently adding two independent directors to improve corporate governance.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. I undertake a relatively detailed  analysis of the published financial statements including growth per share trends and my general view of the industry attractiveness and the companies growth prospects. Despite this diligence my analysis is subject to limitations including the following examples. I have not met with management or discussed the long term earnings growth prospects with management. I have not reviewed all press releases. I typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are "generic" in nature and do not take into account the unique circumstances and risk tolerance of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The author is not a registered investment advisor and the information presented is not to be considered investment advice. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the author as an individual. InvestorsFriend Inc. itself does not have a position in any of the indicated securities while the author may have a position.
© Copyright:  InvestorsFriend Inc. 1999 - 2005  All rights to format and content are reserved.

OLDER REPORTS

Our report from August 28, 2000. contained the following:

COMMON SHARE STRUCTURE USED: Poor structure. The shares that trade are subordinate voting common shares, there also exists 6 million multiple-voting common shares with five votes per share. The company founders could thus control the company even though outside investors might have more shares. In our opinion, subordinate voting shares are far less attractive than normal voting shares and are a strong negative indicator. Could prevent future take-overs or replacement of management if they become incompetent. The company has paid significant amounts to service companies controlled by the founders. 

Our report from November 20, 2003 contained the following:

MANAGEMENT QUALITY AND ETHICS: Management are Chinese, are major shareholders and have a good track record. The company appears to have arranged its affairs so as to pay zero income taxes despite reporting profits. No income taxes appear to be payable in Canada. One could perhaps question the ethics of this type of tax avoidance... but maybe they are just being smart managers. Some insider trading was reported late and this is not a good sign.

By November 26, 2004 we added a sentence at the end:

MANAGEMENT QUALITY AND ETHICS: Management are Chinese, are major shareholders and have a good track record. The company appears to have arranged its affairs so as to pay zero income taxes despite reporting profits. No income taxes appear to be payable in Canada. One could perhaps question the ethics of this type of tax avoidance... but maybe they are just being smart managers. Some insider trading was reported late and this is not a good sign. Executive compensation seems high. Overall I do not particularly trust this management.

OTHER COMMENTS WE MADE

When the November 13, 2005 report reproduced above was issued, we added some comments to our daily blog provided to our customers. Also I show here some comments made prior to November 2005. These are as follows, again with some highlites that were not there in the original:

April 13, 2005

Sino Forest last rated Speculative Strong Buy at $3.50 has seen weakness and traded down to $3.14 today. I note no insider selling or trading in 2005 (which I am glad to see). They recently announced a transaction to invest in another Chinese forestry company. See press release http://ca.us.biz.yahoo.com/ccn/050407/2b489d0853d73

c4ac8d19b1e63d45dff.html?.v=1

This may have been viewed as overly complex. Also they recently changed auditors also they indicate this was not about arguments over the accounting. See pres release. http://ca.us.biz.yahoo.com/bw/050407/75352.html?.v=1 Overall these factors increase the risk, but certainly the value looks quite attractive.

 

 

November 13, 2005

Sino-Forest is updated and rated (highly) Speculative Buy at $3.45. Based on the value ratios this would seem to be a very good buy that could easily soon double. However, I have some nagging concerns. The company that has all its assets in China and it must be difficult for auditors to confirm the existence of the stated amount of trees. Recently the earnings have been driven by the purchase and re-sale of standing trees. It's hard to understand why that would be a high margin business. For quite a few years now I have expected to see the company start to sell from its own planted tree plantations. In Q3 only a tiny 391 hectares were sold from plantations and these were at the low price of $1,217 per hectare. Several years ago the company built a number of mills to process wood, there were were start-up delays and then ultimately little seems to be said about those mills.  It seems like management has changed the business plan a few times. Overall, this may be a wonderful investment but I am concerned about the risks and I plan to reduce my holdings from 4.2% of my portfolio down to probably less than 1%.

November 14, 2005

I sold 4/5ths of my Sino- Forest today. Again, the numbers would say buy more, but there is something about the long-time lack of clear disclosure and the changes in business plans that makes me uncomfortable. I also just made a note on the model portfolio page that I will notionally sell half the position at tomorrow's opening price. I have sent an email to them and they have responded partially and another person from Sino invited me to call to talk further, so maybe I will change my mind but for now I am comfortable with a smaller position in Sino-Forest.

Update - I have now spoken with the company by phone, perhaps I am needlessly nervous. If everything is as they say it is these shares are a definite Buy.  But the company was unable to explain to my satisfaction why we do not see much higher revenues from their own planted lands. I remain skeptical at this time.

 

December 14, 2005

As of yesterday, I was at a definite new peak return for the year.  Gave some back today... Today I sold the last of my Sino-Forest. See my previous comments on the company. The numbers still look good on the stock. But I was just no longer comfortable with the company  in terms of really understanding what they and what the risks are.

In addition here is an email I sent to one our customers on November 13, 2005

Please don't share this with others, such as stockhouse board. But what if Sino just possibly is some kind of fraud or is hiding something,? Asking them will not reveal it. I am just saying I am nervous here. I have been holding Sino since maybe 1999 and have generally been a big fan…

 Page 5 of annual report says Eucalyptus trees mature in 5 years. Yet I don't see any indication they sold any of their planted trees in Q3, they did say 391 hectares from plantation but was that planted trees or just the older growth? I have been waiting 5 years to see expected big profits when they started selling these planted trees. I mean I expected some way back and where are they?

 I have now emailed them.

 Regards,

 Shawn Allen

InvestorsFriend Inc.  

I next mentioned Sino-Forest in my daily comments to my paid subscribers on September 12, 2006 saying:

I noticed today a stock I used to cover, Sino-forest is down to $3.70 from highs around $7. Based on earnings it would look quite cheap. Also there has been some insider buying. So that seems tempting. But as I said earlier about this company I was just not comfortable with it due to past changes in strategy and seeming inconsistencies in their story. Warren Buffett teaches us to not invest unless we are comfortable with management. For whatever reason I am just not comfortable. Therefore I think it is best if I just stay away from this stock. Maybe I will miss out on something here. But the fact is that there are thousands of companies to choose from and I prefer to put money into companies where I don't have any nagging doubts about whether I quite trust management. So, I think I will continue to ignore Sino-Forest.

I next mentioned Sino-Forest in the daily comments on   May 21, 2009 saying:

I notice Sino-Forest is issuing shares at $11.00. I no longer follow it. It often seemed to be reporting strong profits but I was uncomfortable with changes in its business plan. (First the profit was supposed to be in planted trees that would grow in seven years or even five, last I checked that profit never materialized but they started making a lot of money by selling trees on the stump that they had bought but not grown themselves - curious why there would be big profit in that. At one time they were supposed to have a bunch of mills to make lumber and that never worked out. At one time their reports implied that they had mills to chip wood, later it seemed to be revealed that the chip mills were not owned, they paid to have logs chipped. For a variety of such reasons I simply felt I personally was not willing to trust them. On the other hand they had an S&P debt rating and so one would think they could be trusted.

I would make the point that they are supposed to be a high profit company yet they have never paid a dividend and now they need cash. Sure they are growing but when will cash stream out of the company?

I did not again mention Sino-Forest until this Spring of 2011when the allegations of fraud finally arose.

Conclusion:

Above I document that I had certain suspicions in late 2005, even speculating that it might possibly be a fraud but I had certainly not concluded it was a fraud. In fact I said it looked like a Buy although a highly speculative one. As far back as 2004 I indicated I did not particularly trust this management.

It appears I did not mention in my notes that Sino had changed auditors in April 2005 From Ernst and Young and then back to Ernst and Young in August 2007. I was aware of this both times, I recollect.

In both cases the following (probably standard wording) was used:

there have been no reservations contained in the auditors’ reports on the annual financial statements of the Corporation for the two most recently completed fiscal years immediately preceding the date of this notice nor for any period subsequent to the most recently completed period for which an audit report was issued

It seems odd to me that they don't just say there were no reservations for the subsequent period, why use the proviso "for which an audit report was issued". The wording seemed a little cute to me at the time but perhaps it is just the standard wording.

 

  

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