WEST CHINA CEMENT LIMITED|HK 2233 INDUSTRY: Cement Manufacturing
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COMPANY: WEST CHINA CEMENT LIMITED|HK 2233 INDUSTRY: Cement Manufacturing Recommendation: We believe that West China Cement Limited (HK: 2233) (“WCC” or the “Company”) is a blatant fraud. In July 2011, Moody’s Investor Service released a report identifying red flags in the corporate governance of certain Chinese compa- Strong Sell nies. Moody’s found the most flags at WCC, a cement manufacturer operating in China’s Shaanxi province that pur- Price: ports to be one of the most profitable cement companies in China. In this report, we pick up where Moody’s left off and HK$1.33 present compelling evidence that WCC is falsifying its publicly filed financial statements. 1. Fictitious Margins. We believe WCC’s margins are fabricated. Despite the fact that WCC sells a commodity in a hyper- As of Market Close 8/7/2012 competitive market, its margins are 2000 basis points above their H-share, A-share, and local competitors. Market Cap: a. Smoking Gun SAIC Filings. Management claims its dominance of the areas south of Xi'an allows it to earn HK$6.0 billion higher margins. But it appears that WCC has misrepresented the profitability of its southern factories, as 2009 SAIC filings show that WCC’s primary southern cement facility (Ankang Yaobai) earned a gross margin 1400 basis points below Senior Notes: the reported Company average. HK$3.1 billion b. Low Average Sales Prices (“ASPs”). Management explains its celestial margins because it charges "premium prices" for cement. This is not true. Evidence from Digital Cement and WCC’s own filings show that between Public Float: 2008 and 2011, WCC's ASPs have averaged 3% below the Shaanxi mean selling price. 2.2 billion shares c. Customary COGS. Cement is not rocket science. 85% of the costs of making cement are raw commodities such as limestone, coal and electricity. Independent data from the Shaanxi province confirms that WCC pays about the Daily Volume: same as its local competitors for the majority of these primary inputs, meaning that cost savings cannot explain the 30 mm shares Company’s margin advantage. (Avg. 10 Days) d. No Cheating at Monopoly. WCC claims a near monopoly in the areas of southern and eastern Shaanxi. But evidence from a trusted independent source, Digital Cement, shows a host of undisclosed competitors in these areas. Auditor: Deloitte, previously PwC e. 2011 Price War Exposes the Absurdity of WCC Margins. In 2011, a Shaanxi-province price war drove re- gional cement prices to the lowest in China. At least 40% of Shaanxi cement manufacturers lost money; the rest likely HK, PwC UK, PKF UK struggled to break even. Despite WCC's larger peers selling cement throughout China at much higher ASPs, WCC claimed to lead Chinese players with a reported EBITDA margin of 36% even though it sold cement almost exclu- Underwriters/Bankers: sively in Shaanxi. This is simply not credible. ICBC/Deutsche Bank f. 2011 Factory-Level Margins Contradict Reported Figures. WCC makes its actual net profit margins avail- able for four WCC plants in 2011. The data directly incriminates management in a fraud. In each of WCC's core mar- kets during the price war of 2011, disclosed or otherwise estimable factory-level margins averaged a net loss of (7%), even though the Company reported a net margin of 21%. g. Eastbound and Down. WCC tells investors its core markets in the east and south are remote and protected from competition from central Shaanxi. Due diligence calls to WCC’s competitors demonstrated exactly the opposite: that cement factories in the hyper-competitive central area of the province are willing to serve customers up to at least 180 km away. This means WCC's relevant market share in its most important market, Weinan (35% of total capacity), is 22%, not 100% as management claims. The same analysis goes for WCC's other core markets. This is not surprising as mod- ern highways and tunnels cut through the mountains between central and southern Shaanxi. COMPANY: WEST CHINA CEMENT LIMITED|HK 2233 INDUSTRY: Cement Manufacturing Glaucus Publications 2. Suspicious Acquisitions. WCC appears to be massively overpaying to acquire money-losing cement factories. We suspect that such transactions are secret payments to related parties. Ticker: UTA (NYSE) a. Overpaying for Money-Losing Facilities. Between late 2010 and 2011, three of WCC’s larger competitors, including industry leader, Anhui Conch, appear to have acquired cement factories in Shaanxi for an average of Release Date: Mar 8, 2011 RMB 60 per ton of annual capacity. During that same time period, WCC acquired three money losing ce- Price at Release: $6.28 ment factories and one barely profitable factory for an average price of RMB 349 per ton, a 479% premium Current Status: DELISTED on the prices paid by these competitors. b. Shifeng Hustle. We sent an investigator to the registered address of the largest reported shareholder of a ce- Ticker: GURE (Nasdaq) ment factory recently acquired by WCC – a man who allegedly received over RMB 244 million. Yet his regis- tered address showed a grimy dormitory for a water treatment plant, suggesting that rather than being a Release Date: Apr. 26, 2011 wealthy factory owner, he was merely a front man and possibly a conduit for an undisclosed payment to insiders. Price at Release: $3.91 Current Status: $1.08, 72% 3. Madoff-like Pyramid Financing. A hallmark of an obvious fraud is that management pursues expensive financ- ↓ ing alternatives despite purportedly being flush with cash. In May 2008, WCC borrowed RMB 420 million at an effec- tive interest rate of 20.23% despite allegedly generating cash flow from operations of nearly RMB 1 billion between Ticker: LLEN (Nasdaq) January 2008 and December 2009. Release Date: Aug. 2, 2011 4. Suspicious Operating Metrics. Off-market operating metrics often portend artificially inflated sales or cash. In Price at Release: $4.17 WCC's case: Current Status: $1.95, 53% ↓ a. Selling and distribution expenses: 1% of sales vs. 5% average for China comps b. Average interest income rate on cash: 0.42% vs. >1% for Anhui Conch c. Accrued VAT payables: bear no correlation to sales or VAT refunds Ticker: CMED (Nasdaq) Release Date: Dec. 6, 2011 5. Abnormally High Auditor and Management Turnover. The high turnover of auditors and key managers since Price at Release: $3.32 2008 supports our suspicion that WCC's financial statements are doctored. Current Status: DELISTED Since 2008 Auditors 4 Ticker: 639 (HKEX) CFOs 3 Chairmen 3 Release Date: Apr. 11, 2012 Price at Release: HK$2.66 Worse still, WCC replaced its CFO and its auditor in a two-week period in the spring of 2011. If that does not scare an Current Status: HK$2.20, 17% investor, then they are either brave or ignorant. ↓ 6. Who Watches the Watchmen? Corporate Governance Figureheads Tainted by Past Scandals. WCC’s audit chair and corporate secretary have tarnished corporate governance records. a. Audit Chair. The Chairman of WCC's audit committee, Lee Kong Wai Conway, also served on the audit com- mittee of scandal-ridden Sino Vanadium (TSX: SVX), whose share price collapsed under suspicion of fraud. b. Secretary. The core duties of a Chartered Hong Kong Secretary are to oversee corporate governance and com- pany disclosures. Between 2006 and 2010, WCC’s Secretary, Sin Lik Man (“Mr. Sin”), was responsible for corpo- rate governance at Norstar Founders Group Limited (2339 HK) (“Norstar”). Norstar’s share price collapsed 80% in 2008 under a cloud of fraud. Since then it has been tied up in litigation. Such a disgrace should have ended Mr. Sin’s career. Instead he found a home at WCC ‘protecting’ investors. 7. Valuation. As of June 30, 2012, WCC had approximately HK$5 billion of debt outstanding, the holders of which would take priority over shareholders. Given the difficulty of recovering money against alleged fraudsters under China’s corrupt and arbitrary judicial system, we believe that off-shore (i.e. non-PRC) debt holders can at best hope to recover $0.20 on the dollar (see our detailed valuation section at the end of this report), putting the value of the equity at $0.00. WEST CHINA CEMENT LIMITED HK 2233 www.glaucusresearch.com Disclaimer We are short sellers. We are biased. So are long investors. So is the company. So are the banks that raised money for the company. If you are invested (either long or short) in WCC, so are you. Just because we are biased does not mean we are wrong. You are reading a short-biased research report. Obviously, we will make money if the price of WCC stock declines. You can publicly access any piece of evidence cited in this report or that we relied on to write this report.