Muddy Waters Loses Support in Market on Latest Calls

Carson Block
Carson Block, research director at Muddy Waters LLC, poses for a photograph in New York. Photographer: Scott Eells/Bloomberg

Carson Block, the short seller and analyst who sparked a 74 percent drop in Sino-Forest Corp. shares when he said the company misstated its business, is finding it harder to attract believers to his latest research.

The 35-year-old lawyer who founded Muddy Waters LLC gained credibility in June when he told investors that Sino-Forest overstated its timber holdings. Block’s reports on Chinese companies shook investors in the world’s fastest-growing major economy and helped erase more than $5 billion of market value. The calls caused losses for John Paulson, the billionaire who got rich betting against subprime mortgages, and former American International Group Inc. Chief Executive Officer Maurice “Hank” Greenberg.

His latest opinions aren’t getting the same reaction. While Focus Media Holding Ltd. sank 39 percent when Muddy Waters said Nov. 21 that the Shanghai-based digital advertiser exaggerated its network, the stock has rebounded 52 percent. Spreadtrum Communications Inc., a chipmaker in Shanghai, traded at $15.67 in New York, from $12.49 on June 28, when Block questioned its revenue. Focus Media and Spreadtrum say the firm’s assertions lack merit.

“Carson pointed at a lot of things, but what seems to be lacking is a present-day smoking gun,” said Eric M. Jackson, founder and managing member of Ironfire Capital, a Naples, Florida-based hedge fund that invests in Chinese stocks. “It’s a tougher job.”

Reverse Merger

Block said on June 2 that Sino-Forest, a timber plantation operator based in Hong Kong and Missassauga, Ontario, claimed to own land that didn’t show up in government records. Sino-Forest, one of more than 300 Chinese companies listed in North America, lost C$3.3 billion ($3.3 billion) of market value after the report was released and hasn’t traded since August.

The company said on Feb. 1 that a committee of directors may not be able to disprove some statements as the information may not exist or be retrievable. Paulson, 56, sold his stake following Block’s report and booked a loss of C$106 million.

The Securities and Exchange Commission cautioned investors in June about buying stakes in so-called reverse mergers, a process that involves buying a publicly traded shell company, saying they may be prone to “fraud and other abuses.” The Bloomberg Chinese Reverse Mergers Index, which tracks stock of 73 such companies, has lost more than half its value over the past two years.

Face of Short Selling

Block, who founded a self-storage company in Shanghai after moving there in 2005 with a law degree, started Muddy Waters in 2010. He became the face of the short-selling wave against Chinese companies after his research led regulators to suspend trading in four of his first five targets, including Sino-Forest.

Hong Kong-based China MediaExpress Holdings Inc., which counted Greenberg’s C.V. Starr & Co. as a top shareholder, was suspended after Block said in February 2011 that the company was inflating profit. MediaExpress said the assertion lacked merit. Deloitte Touche Tohmatsu Ltd., a global accounting firm, resigned as auditor six weeks after Block’s report.

Muddy Waters, which says readers of its research should assume it has a short position, is having less success persuading investors to bet against his targets amid a new bull market in global equities.

While Focus Media slid to $15.43 from $25.50 when Block said the company was being run “solely for the benefit of insiders,” it has rebounded to $23.42. Muddy Waters said Focus Media has fewer television screens in its ad network and that it may have overpaid for takeovers to mask losses.

Counting Screens

Market surveys conducted by Ipsos SA, a Paris-based polling company, and its unit Synovate in more than 100 cities showed that the number of LCD screens and poster frames reported by the Chinese company was more than 99 percent accurate, Focus Media said. While some of the company’s acquisitions haven’t been successful, assertions of fraud are “without foundation,” Focus Media said on Nov. 22.

Focus Media is “a legitimate business” and Block failed to provide new information on its acquisitions because the deals are publicly disclosed, said David Semple, director of international equity at the Van Eck Emerging Markets Fund in New York, which oversees $35 billion, including Focus Media shares.

“You are looking at the stuff in the past and people knew about it,” said Semple. “Why bring it up now? They didn’t even bother to check with the company to find it out.”

Spreadtrum is up 21 percent since June 27, the day before Muddy Waters said it was betting that the stock would fall in an open letter to management.

Regulatory Scrutiny

The shares are rebounding at a time when Chinese stocks trading in the U.S. are attracting more interest from investors and regulators. A gauge of Chinese and Hong Kong stocks listed in the U.S. lost 53 percent since its January 2011 peak after short sellers said companies including Sino-Forest were manipulating their financial information, embezzling money and lying about factories and customers.

“Unfortunately, there are still China frauds out there and these companies are willing to do almost anything to continue perpetrating that fraud,” Block said in an e-mailed statement.

Block “really opened a new chapter in exposing frauds,” said Sahm Adrangi, founder of New York-based hedge fund Kerrisdale Capital Management LLC, which is shorting Focus Media. “People just weren’t putting forward the resources to analyze these companies top to bottom as Carson did.”

Short Returns

Adrangi’s $75 million fund returned almost 200 percent last year by betting against Chinese companies, according to data compiled by Fairfield, Iowa-based BarclayHedge, which tracks fund performance.

Focus Media, with a market value of $3.3 billion, is the largest among the eight Chinese firms Block has targeted since June 2010 after Sino-Forest, according to data compiled by Bloomberg. Spreadtrum has a market capitalization of $756 million.

Unlike Sino-Forest and China MediaExpress, which were listed on exchanges in North America through reverse mergers, Focus Media and Spreadtrum sold stock via initial public offerings.

The decline of reverse mergers is limiting the profit on short positions and it’s more challenging to prove transgressions by bigger companies, said Kevin Carter, co-founder and chief executive officer at Walnut Creek, California-based Baochuan Capital Management LLC.

‘Real and Substantive’

“To find something that is real and substantive and leads to the permanent demise of the business, those things are very hard to do,” said Carter, who holds shares of Focus Media. “They don’t have any more chances.”

Jing Lu, an investor-relations officer at Focus Media in Shanghai, didn’t return two e-mails and phone calls. Spreadtrum declined to comment on its share performance, said an official who asked not to be identified according to company policy.

The Chinese companies are protecting their stocks by buying shares and paying dividends.

Spreadtrum declared a 9.5-cent dividend on Dec. 23 and said that month that it will buy back as much as $50 million of its American depositary receipts.

Focus Media said last month that it will use as much as 55 percent of its net income in the previous fiscal year to pay dividends or buy back shares. Chief Executive Officer Jason Jiang and Hong Kong-listed Fosun International Ltd., Focus Media’s two largest shareholders, bought $21 million of ADRs on Nov. 22. The company responded to each of Muddy Waters’ five reports, rebutting the short-seller’s claims point by point.

CEO Commitment

“When the CEO shows a commitment to the company by buying a significant amount of shares, that sends a sense of confidence to investors,” said Kevin Pollack, a fund manager at Paragon Capital LP in New York, which invests in U.S.-traded Chinese stocks.

Block said on June 28 that he sees “a high risk of material misstatements” in Spreadtrum’s financial reporting, citing a six-fold surge in inventory in 2010. Block also questioned why then Chief Executive Officer Ping Wu and Chief Financial Officer Richard Wei left the company months before it reported 137 percent revenue growth in the third quarter of 2009 over the previous quarter. Sales increased 230 percent in 2010 from a year earlier.

Turned Around

Spreadtrum’s CEO Leo Li told investors during a conference call on June 29 that the inventory increase was due to the introduction of new products. Li said in an interview the same day that the company had neither customers nor a sales pipeline under the previous management. Spreadtrum turned around after developing new products once he became president in November 2008, Li said.

Analysts are rallying behind the companies. Six of eight analysts surveyed by Bloomberg since December have a “buy” rating for Focus Media.

Concerns over the allegations made in Block’s reports are overblown, Catherine Leung, an analyst at Goldman Sachs Group Inc., said in a Feb. 1 report, setting a “target” of $43 for the shares.

Ten of 13 analysts have recommended buying Spreadtrum since December. Analysts at RBC Capital Markets and Dundee Securities, who had championed Sino-Forest’s stock before Block’s allegations, suspended their coverage within a month of Muddy Waters’ report.

Ironfire’s Jackson says Block has helped weed out questionable Chinese companies listed in North America and tempered overly bullish investor sentiment. The chances of a repeat are limited because share prices are already depressed and the bigger companies have more resources to fight back, Jackson said.

“Easy money has been made,” Jackson said. “It’s going to be a harder job for him if he wants to continue to short these Chinese companies.”

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