Muddy Waters is Short China Huishan Dairy Holdings Co Ltd (6863:HK)

Part 1

 

We are short China Huishan Dairy Holdings (6863 HK / “Huishan”) because we believe it is worth close to Zero. We conclude Huishan is a fraud. In this first report on Huishan, we detail the following conclusions and supporting facts.

Since at least 2014, the company has reported fraudulent profits largely based on the lie that it is substantially self-sufficient in producing alfalfa. We found overwhelming evidence that Huishan has long purchased substantial quantities of alfalfa from third parties, which gives us no doubt that Huishan’s financials are fraudulent.

We believe Huishan has engaged in CapEx fraud related to its cow farms. We estimate that Huishan has overstated the spending on these farms by RMB 893 million to RMB 1.6 billion. The primary purpose of the CapEx fraud is likely to support the company’s income statement fraud.

Chairman Yang appears to have stolen at least RMB 150 million of assets from Huishan – the actual number is quite possibly higher. The theft relates to the unannounced transfer of a subsidiary that owned at least four cow farms to an undisclosed related party. It is clear to us that Chairman Yang controls the subsidiary and farms.

Even if Huishan’s financials were not fraudulent, the company appears to be on the verge of default due to its excessive leverage. Taking Huishan’s financials at face value, its credit metrics are horrible. The leverage is so substantial that in FY16, Huishan’s auditor appears to have stopped just short of issuing a “going concern” qualification. Given that we conclude Huishan’s reported profits are fraudulent, we have no confidence that Huishan can make it through the next year without defaulting. There are clear signs of enormous financial stress, including the types of financing Huishan is trying to employ and halted projects. The asset side of Huishan’s balance sheet, in our opinion, is massively overstated due to fraudulent profits and cash, overvalued biological assets, and certain highly suspicious asset accounts.

Although Huishan has a “real business” in contrast to a typical Zero, its massive leverage cause us to conclude that its equity is close to worthless. It is our view that Huishan’s asset values and reported profits are inflated by significant amounts, and that its cash is greatly overstated. The extent of these overstatements are unclear, and it is likely there are other asset accounts that are similarly afflicted. Valuing Huishan’s true equity value requires knowing the truth about its accounts – and truth is in short supply at Huishan.

CCASS data strongly suggests that a significant portion of Huishan’s outstanding shares has been pledged as collateral for loans. If we are correct, this presents a significant risk to long holders if the borrower(s) is / are unable to meet margin calls.

We researched Huishan for several months. During this time, our investigators visited 35 farms, five production facilities (including one that was halted mid-construction), and two announced production sites that had no evidence of construction. Additionally, our investigators conducted drone flyovers of selected Huishan sites. We engaged three dairy experts, including two with deep backgrounds in China dairy farming. We and our investigators spoke with suppliers and importers of alfalfa in three different provinces, some of whom were selling alfalfa to Huishan. In addition, we conducted extensive due diligence into Huishan’s topline, which we will discuss in Part 2.

Although Huishan has a “real business” in contrast to a typical Zero, its massive leverage cause us to conclude that its equity is close to worthless. It is our view that Huishan’s asset values and reported profits are inflated by significant amounts, and that its cash is greatly overstated. The extent of these overstatements are unclear, and it is likely there are other asset accounts that are similarly afflicted. Valuing Huishan’s true equity value requires knowing the truth about its accounts – and truth is in short supply at Huishan.

CCASS data strongly suggests that a significant portion of Huishan’s outstanding shares has been pledged as collateral for loans. If we are correct, this presents a significant risk to long holders if the borrower(s) is / are unable to meet margin calls.

We researched Huishan for several months. During this time, our investigators visited 35 farms, five production facilities (including one that was halted mid-construction), and two announced production sites that had no evidence of construction. Additionally, our investigators conducted drone flyovers of selected Huishan sites. We engaged three dairy experts, including two with deep backgrounds in China dairy farming. We and our investigators spoke with suppliers and importers of alfalfa in three different provinces, some of whom were selling alfalfa to Huishan. In addition, we conducted extensive due diligence into Huishan’s topline, which we will discuss in Part 2.

Fraudulently Inflating Margins by Falsely Claiming Alfalfa Self-Sufficiency

We conclude that Huishan has fraudulently inflated its gross margins and reported profits since at least FY14 by lying about being self-sufficient in alfalfa. Huishan cites self-sufficiency in alfalfa production as the main driver of its industry-leading gross margin. Our research indicates that Huishan was never self-sufficient in alfalfa. Instead Huishan has bought substantial quantities of alfalfa from third parties at higher prices than its claimed production costs. The company also claims to preserve margins by implementing a feed cost reduction effort that we find dubious. Starting in FY16, Huishan began claiming that it is decreasing alfalfa rations to engineer lower milk yields in an environment of depressed prices. We do not believe this holds water, and instead view it as a ham-fisted attempt to unwind the alfalfa fraud.

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