Short Sellers' No. 1 Target Surges in Hong Kong as CEO Buys

  • Huishan Dairy attracts short sellers after valuation surges
  • Management team has `strong confidence' in the company

In Hong Kong, it’s hard to find a stock where analysts and short sellers see more dismal prospects than China Huishan Dairy Holdings Co. Thanks to a spurt of buying from the company’s chief executive officer, finding a better performer is just as tough.

Shares of the milk producer have soared 90 percent since early July, despite the highest level of short interest in Hong Kong and analyst price targets implying a 46 percent tumble over the next 12 months. The rally is being fueled by Huishan CEO and controlling shareholder Yang Kai, whose four-month spree of stock purchases accelerated to an almost daily frequency in October and lifted the company’s market value to $5 billion.

While analysts are put off by a price-to-earnings ratio more than double that of peers, Huishan says Yang’s purchases reflect confidence in the business and his view that shares have been unfairly targeted by short sellers. Yang’s battle with the bears is likely to come to a head soon, with the company due to unveil earnings this month for the first time since its stock started surging. In the meantime, Ample Capital Ltd. and Daiwa Capital Markets are advising investors to steer clear.

“We would not be going into this stock,” said Alex Wong, a Hong Kong-based asset-management director at Ample Capital, which oversees about $150 million. “You cannot use the fundamentals to explain the share price.”

At 39 times projected earnings for this fiscal year, Huishan is trading near its most expensive level on record. China Mengniu Dairy Co. and China Modern Dairy Holdings Ltd., two of its closest Hong Kong-listed peers, are valued at multiples of 17 and 9.3, respectively.

Huishan says there are good reasons to be optimistic. Eddie So, the firm’s chief financial officer, predicts annual profits will increase over the next few years as Huishan expands outside its core market in northeastern China and builds a nascent renewable energy business turning cow dung into fuel.

Huishan’s “vertically integrated” model -- the company grows feed crops and turns its own raw milk into higher-value dairy products -- is a competitive advantage, So says. Over the long run, China’s decision last month to scrap its one-child policy could help boost demand for infant formula and yogurt. The shares rose 0.7 percent on Tuesday.

“We are focusing on the long-term business plan instead of looking at the P/E ratio,” So said in an interview in Hong Kong on Nov. 4. “Mr. Yang and the management team all have strong confidence about the business prospects.”

Earnings Pressure

Huishan’s adjusted net income will climb 30 percent to 1.1 billion yuan ($173 million) in the year ending March 2016, according to the average of four analyst estimates supplied to Bloomberg since the start of September. Last year’s result missed forecasts by 35 percent.

Even with earnings expected to improve, the average price target from five analysts is more bearish than any other stock in the 480-member Hang Seng Composite Index. It compares with projected gains of more than 20 percent for China Mengniu Dairy and China Modern Dairy.

Huishan’s premium is unjustified as falling milk prices and intensifying industry competition put pressure on earnings, according to Daiwa’s Anson Chan. The company reported negative free-cash flow last year as capital expenditures exceeded inflows from its operations. While cash outflows aren’t unusual for a firm investing in expansion, they make the stock a riskier bet at such elevated prices, Chan said.

“The current valuation is just too stretched,” he said.

Short interest in Huishan amounts to 28 percent of the company’s free float, or tradable shares. That’s by far the biggest proportion among Hong Kong-listed stocks, with Chinese developer Evergrande Real Estate Group Ltd. ranking second at 20 percent, according to data compiled by Markit and Bloomberg. Bearish bets on Huishan account for 6.1 percent of all shares outstanding, more than triple the average for equities in the Hang Seng Composite.

Bears will need a big drop in Huishan shares for their bets to pay off. Because Yang and other insiders now control almost 75 percent of the stock, it’s becoming more expensive for traders to secure the securities they need to execute a short sale. The cost of borrowing Huishan shares has climbed to an annualized rate of about 20 percent, according to Markit.

Yang may be running out of firepower. In the short term, he and other Huishan officers are restricted by bourse rules from buying shares ahead of the company’s results. And beyond this month, the purchases have left Huishan shares close to the Hong Kong exchange’s 25 percent free-float minimum. Once that threshold is reached, Yang won’t be able to increase holdings if he wants to keep the company listed.

“If that buying vanishes, then you may not have too much support,” Ample Capital’s Wong said. “There are many stocks trading at cheaper valuations than this one, so why take the risk?”

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