Big China Short Shows Downside of Kleptocracy
Even by the wacky standards of Chinese accounting scandals, this week’s events at China’s second-biggest maker of construction equipment, Zoomlion Heavy Industry Science & Technology Co., were awfully strange.
It all started when a Hong Kong-based news outlet, Ming Pao Daily, published an article about an anonymously written letter it had received that accused Changsha-based Zoomlion of falsely inflating its sales. At most news organizations, an unsigned letter accusing people of fraud wouldn’t spawn a major news article. But this one did on Jan. 8. Ming Pao said the letter was sent to Hong Kong securities regulators, too, although it isn’t clear whether they plan to do anything.
Then, as if the company was deliberately trying to draw more attention to the accusations, Zoomlion told the Hong Kong and Shenzhen stock exchanges to halt trading in its shares for a day, so it could respond to the Ming Pao article. Zoomlion issued a statement denying it had recognized phony revenue, saying the allegations “as reported in the press article are false, groundless and misleading.” It also said its midyear results were reviewed by the Big Four audit firm KPMG, as if that is of any comfort to investors after all the Chinese frauds overlooked by large accounting firms in the past few years.
Trading continued in the U.S., even as it was suspended elsewhere. Zoomlion’s American depositary receipts fell as much as 7 percent the day after the article was published. Yields on the company’s bonds soared. By the time the day was over, Zoomlion, which has an $11 billion market value, had managed to drag down lots of other large Chinese companies’ stocks with it. When trading resumed in Hong Kong on Jan. 9, the shares fell 6 percent.
“This isn’t good news for Chinese equities,” Erik Lam, the director of Asian equity sales at Auerbach Grayson & Co. in New York, told Bloomberg News. “In the past, all the accounting scandals revolved around Chinese names listed in the U.S., but this is a major Hong Kong-listed company.”
It doesn’t take much to cast doubt on a Chinese company’s financial reports these days. The country is a kleptocracy run by -- and for the benefit of -- the Communist Party elite, who have allowed securities fraud to flourish. In addition to tolerating frauds by Chinese companies with U.S. or Canadian stock listings, China’s government routinely obstructs overseas regulators’ investigations. Muddy Waters, a tiny research firm led by an American short seller named Carson Block, has done more to expose Chinese stock scams, including Sino-Forest Corp., than all of the world’s governments combined.
It is only prudent for investors to start with the assumption that the books of every publicly traded Chinese company are cooked. (To be fair, the same also may be true of the world’s biggest banks.) Capital markets work best when the information that companies report is credible. When it isn’t, and when laws don’t exist or aren’t enforced, investor confidence is easily shaken. Even an obscure news report about an anonymous letter can have the ring of truth and send a big manufacturer’s stock careening.
According to the Financial Times, which said it reviewed a copy of the anonymous missive about Zoomlion, the letter was accompanied by about 90 pages of documents that purportedly were internal records from Zoomlion’s eastern China regional sales. The FT said the letter claimed these documents showed Zoomlion used three categories of sales, two of which weren’t true sales. Zoomlion, in its statement to the Hong Kong exchange, said it hadn’t seen the documents referred to in the article and that it “firmly denies the existence” of any such records.
The FT also noted it had reported last June that Zoomlion was “the most shorted stock in Hong Kong because of fears that it was keeping its sales high through heavy use of vendor financing.” Vendor financing is the practice of lending money to customers to fund their purchases. That’s fine, except when the customers can’t pay their loans, in which case the seller-financier must record big write-offs.
So what do Zoomlion’s financial statements look like? They show the sort of rapid, debt-fueled growth that attracts short sellers, or investors who profit when a company’s stock declines.
Earnings rose 17 percent to about 7 billion yuan ($1.1 billion) during the first nine months of 2012. Accounts receivable, or money owed by customers, increased 69 percent to 19.7 billion yuan. Yet little net cash was coming in: Cash flow from operating activities was a mere 179.1 million yuan, down 84 percent from a year earlier. The company’s third-quarter report said this was “due to the increase of business needs as a result of the increase in sales,” which isn’t much of an explanation. Maybe the customers’ payments will materialize, justifying the revenue growth that Zoomlion has recorded. We will see.
Chinese stocks may not make for trustworthy investments, but they sure can be entertaining to watch from a distance.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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