Yongye (YONG): An asymmetrical trade

Today, Yongye stock shot up over the possibility of the company going private at $7.00/share.  You should read the SC 13D filing on Edgar for details.  The last attempt was for $6.69/share and it failed.

I am speculating that the second takeover will fail like the first.  Suppose that I buy puts with a $5 strike at 10 cents (*I ignore commissions, which can be quite significant).  The potential upside is 50X.  I believe that Yongye may very well turn out to be a fraud and see its share price drop dramatically.  The risk/reward here seems compelling.

The options market for Yongye is somewhat liquid and there are Jan 2016 puts available.

What short sellers are saying about Yongye

Yongye has released a FAQ on their website that addresses various allegations against it.

Will the merger go through?

I’m not aware of a situation exactly like Yongye’s.  I’ve never seen a going private transaction fail in such a manner.  I would have expected the majority of minority shareholders to vote in favour of the deal.  Normally, merger arbs flood a stock and vote in favour of the merger.

One vaguely similar case is what happened between QXM and XING.  XING originally sold off shares in its subsidiary, which became QXM.  Fast forward a few years, XING made a bid to take over QXM with a combination of cash and shares.  This takeover failed.  According to the press release filed on Edgar:

Qiao Xing Mobile Communication Co., Ltd. (NYSE: QXM — News) (“QXM”), a manufacturer of mobile handsets in the People’s Republic of China, today announced that the meeting of shareholders of QXM convened to consider the proposal by Qiao Xing Universal Resources, Inc. (“XING”) to acquire all of the outstanding ordinary shares of QXM not already held by XING , by way of a scheme of arrangement under Subsection 179A of the British Virgin Islands Business Companies Act, 2004 (as amended) was adjourned for lack of quorum. The meeting with respect to the proposed transaction was scheduled to convene at 10:00 a.m., Hong Kong time on April 7, 2011; however, an insufficient number of shareholders attended the meeting to satisfy the quorum requirements. As a result, the meeting was adjourned permanently and the proposed transaction will be abandoned.

I don’t exactly understand the mechanic by which the takeover failed.  But it seems to me that there are ways in which an unscrupulous management team could stage a “fakeover”.  By announcing a fake takeover, shares of a company will likely rise.  This will give insiders and their buddies an opportunity to sell shares at inflated prices.  I don’t know if this was the real reason for the QXM/XING merger.  However, the shares were definitely overpriced.  In the end, the CEO ran off with the operating business(es) and all of the cash.  Had the QXM/XING merger succeeded, the CEO would have run off with less cash.

As far as Yongye goes, I’m not sure what will happen.  I’m not sure exactly why the merger failed the first time.  This 8-K filing states the voting results for the common shareholders.  It states that 12.8M shares voted in favour of the takeover.  The DEFM14A filing states [emphasis mine]:

[…] more than 18,867,235 shares, or 49.6% of the shares, of Company common stock owned by the unaffiliated stockholders (representing 37.2% of the total outstanding shares of Company common stock), must be voted in favor of the proposal to approve the merger agreement for the voting requirement described in clause (i) under “Vote Required” above to be satisfied.

So, 12.8M votes falls short of the 18.9M votes needed.  However, I’m not too concerned about the mechanism by which the merger failed.  I’m sure that management has many tools at their disposal if they wanted to do something nefarious.  This is China.  Management could simply “go dark” and keep all of the cash.

The fraud thesis

If Yongye really is a fraud, here’s what I think is happening.

There is probably a physical plant

I believe that investors have visited the business and have seen a fertilizer manufacturing plant.  You can go to china-yongye.com and watch the corporate video in the bottom right.

It is possible that management has taken a real business and dressed it up in a ‘dog and pony show’.  The profitability and growth of the business may have been wildly exaggerated through fraudulent accounting.

Inflating profits via capitalized expenses

Inappropriately capitalizing expenses will inflate profits and create an erroneous asset on the balance sheet.  There are various items on Yongye’s balance sheets that should be examined:

  1. Prepayment for mining project ($37M).  Short sellers contend that this was a sham transaction.  Management addresses these allegations in the “supplier relationships” section of this press release.
  2. A customer list with a gross carrying amount of $27M.  According to the YE2013 10-K: “The acquisition of the Customer List allows Yongye Nongfeng to sell its products to sub-provincial level or regional distributors in Hebei Province directly. The consideration of the Customer List was 3,600,000 shares of common stock of the Company which was issued in July 2010 and US$3 million cash.”  Short sellers say this transaction is a sham and isn’t congruent with Yongye’s business.  Management basically argues that this is a legitimate transaction in the course of its business.  See the “Hebei Distribution Acquisition” in Yongye’s press release linked to in #1.
  3. Distributor vehicles ($36M).  Unfortunately short sellers would have difficulty finding evidence that not all of these vehicles exist.

Fake receivables

Yongye has around $334M in receivables.  As a point of reference, the company’s current market cap is $344M.  Yongye has a massive amount of receivables.  Short sellers argue that most of these are fake; management argues that they are real.

Yongye has an unusual practice of allowing its customers 6 months to pay.  Despite this, the company seems to have suffered very little credit loss, despite many receivables not having been paid in over 6 months.  The Seeking Alpha article Does Yongye sell on credit? argues that a company employee wrote a book which states that Yongye doesn’t extend credit to its customers.  This book is mentioned in one of Yongye’s press releases.  If the operating business doesn’t actually extend credit to its customers, then Yongye must be faking receivables.

In a fake receivables fraud, it would make sense if the receivables age and go unpaid for long periods of time.  They would also accumulate on the balance sheet and cause the days sales outstanding metric to continually go up (a red flag).  To avoid this, a fraudulent company would need to pay the receivables with real cash.  However, it would need cash to do this (assuming that the company can’t fake the cash, which is what some Chinese frauds have done).  To get around this, the fraudsters could take the company’s cash and use it to buy imaginary (or intangible) assets.  This siphons cash out of the company.  This cash is then used to pay off old receivables and comes back into the company.  Hence, cash is “recycled”.  The net effect of fake receivables and fake assets is that fake assets will eventually pile up on the balance sheet.  If the company is not very good at “recycling” its cash, then aged receivables will pile up on its balance sheet.

Obviously I am biased and think that the short thesis has more evidence in its favour than what management is saying.

Unusual things about Yongye

Does fertilizer really work like that?

Short sellers have argued that some of Yongye’s numbers don’t add up.  Specifically, Yongye seems to be paying an unusually high price for humic acid.  The company addresses this on its FAQ:

27. Considering the market price of humic acid and that there is only 50 grams of humic acid per liter of Shengmingsu, why is the humic acid percentage cost of Shengmingsu so high according to the content data on the Shengmingsu product description?

Shengmingsu is a high-end crop nutrient. Yongye utilizes high-quality raw materials and a proprietary manufacturing processes to ensure product efficacy. Price quotes of humic acid from small online vendors and pricing ratio of 50g/liter, significantly underestimate the actual cost of humic acid per ton of Shengmingsu for several reasons, a) Yongye only uses top-quality humic acid for the Company’s manufacturing, which incurs higher costs; b) Yongye uses a significant amount of humic acid to extract a small amount of high-grade fulvic acid through proprietary processes; c) the 50g/liter ratio actually applies to Yongye’s high-grade fulvic acid (water soluble humic acid) content for the Shengmingsu product, instead of humic acid; and d) Shengmingsu’s minimum fulvic acid content requirement is 50g/liter, whereas the actual content from our manufacturing process is in almost all cases higher than the minimum amount.

I don’t buy management’s explanation.  Fertilizer is a commodity chemical.  I don’t see how Yongye’s molecules are “better quality” than a competitor’s molecules.  Yongye’s product could be higher quality if it were free of impurities and unwanted chemicals that are found in competitors’ products.  However, Yongye makes no such claim.  They do not back up their claim that their humic acid is “higher quality”.  Fertilizer companies could release assay results to support claims that their product is low in impurities and unwanted chemicals (e.g. arsenic).

Company websites (this may be a weak argument)

Most publicly-traded businesses have a website designed for its real customers and a website designed for its investors.  Yongye has a website at yongyeintl.com that is geared towards investors.

I would argue that there is a website designed for Yongye’s customers, which can be found at http://www.china-yongye.com/.  For the most part, the two websites do not mention each other.  china-yongye.com is mentioned at the investor site but only in middle of the FAQ.  Most businesses would add hyperlinks between the investor-oriented and customer-oriented websites.  This would avoid missed sales from potential customers who land on the investor website.  Linking to the customer-oriented website might also help investors understand what they own.  The segregation of the websites suggests to me that management is trying to carefully control what investors see.  Perhaps they don’t want investors to know that the CEO privately owns a number of different companies (this is pretty obvious from looking at the china-yongye.com, even though I cannot read Chinese and use Google Translate).

The investor-oriented website has a Chinese version.  However, the Chinese version of the website does not have a ICP number.  While the site isn’t blocked by the Great Firewall of China, I think that this is bad form as an ICP number ensures that the site won’t be blocked.  The customer-oriented website at china-yongye.com does have an ICP number.  This suggests to me that management is putting on a ‘dog and pony show’ on the investor-oriented site.  The Chinese version of yongyeintl.com wasn’t made with a lot of care and seems to be mostly for show.

The capital structure doesn’t make a lot of sense

In May 2011, the company sold $50M of preferred shares.  The terms of the preferred shares are unusual.  If the company does not hit particular income targets, then the preferred shares become redeemable at a price that guarantees an IRR of 20%.  This is not a structure that makes a lot of sense from a business perspective.  If the company happens to hit a rough patch and happens to lose money, then suddenly its cost of capital shoots up to an extremely onerous 20%.  What?!

Yongye has this to say about the deal:

28. Is the Morgan Stanley investment really unfavorable for common shareholders?

The terms of MSPEA’s investment in Yongye are fully disclosed in Yongye’s public SEC filings, and management and the board of directors believe that this transaction offered significant benefits to the Company and its common stockholders and its announcement resulted in an immediate and significant appreciation in its stock price. Yongye also notes that following the closing, MSPEA purchased approximately 2 million additional shares of Yongye common stock in the open market.

Bank loan guarantees

The YE2013 10-K states that the company has been able to secure bank loans with reasonable interest rates ranging from 5.7% to 8.528%.  Oddly enough, some of these bank loans are guaranteed by the CEO and his wife.  This is all very weird because the guarantee likely lowers the interest rate that Yongye has to pay.  It’s like the CEO and his wife are giving Yongye free money.

In the context of a fraud this could make sense.  In the Crazy Eddie fraud, Sam Antar states that insiders actually put their own money into the company to inflate the books.  In the context of a legitimate company, Zishen Wu and his wife look like incredibly nice people who more or less gave free money to shareholders.  Should the company go bankrupt, Wu and his wife would be liable for Yongye’s debt.  His wife seems incredibly generous.

The bottom line

There are too many things about Yongye that don’t make sense to me if it were a legitimate company.  I could very well be wrong, but the downside seems quite low compared to the upside.

The probability of the takeover failing seems higher given that the first attempt failed.  For comparison purposes, vaguely similar situations would be QXM/XING and DISK (Image Entertainment, which was written up on Value Investors Club).

*Disclosure:  I am shorting YONG via common shares and puts.

EDIT (3/27/2014): HRBN and FMCN are examples of Chinese reverse mergers that were successfully taken private.  The buyers were private equity firms.  Abax Capital was involved in both takeovers.  For whatever reason Abax Capital decided not to participate in the Yongye deal.

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13 thoughts on “Yongye (YONG): An asymmetrical trade

  1. Very interesting blog. From your posts I get the impression you have a strong focus on shorts, are you mostly short at the moment or long?

    I’m not confident enough to go short myself after a few test trades didn’t work out too well, I guess I don’t like the unlimited downside but buying puts seems to be a good way to avoid that.

    • I should be more long than short at the moment. If you click the highlight posts tab and scroll down to the section on short selling, I have a post on why I don’t recommend short selling common stock.

      I think it’s just my personality that makes me obsessed with short selling. It’s not a good way to make money unless you can find opportunities where you can buy put options cheaply.

  2. Looks like YONGye’s stock price may follow a roller-coaster trajectory. The case of WH immediately comes to mind. I’ve been also watching GA. Ottoman’s bay research made a compelling case that the proposed buyout is not going to happen, however new highs are coming.

  3. For what it’s worth, I visited this company in 2010 to see if it was a fraud or not. There were two manufacturing facilities in Inner Mongolia (one of which was having a grand opening event at the time of my visit) and I viewed the “coal mine” property. I didn’t find the management to be completely truthful but did not short the company either. I still have a few bottles of Shenmingsu (their flagship product) but my wife refuses to try them on her garden. If it were a complete fraud I don’t think they would be trying to take it private multiple times, but who knows. I would bet that the deal goes through at the increased price. The US shareholders are primarily idiots so anything is possible…

  4. Valuing the receivables at 0 would put you at about $5 per share. Unless the inventory is also worthless and the cash balance is overstated (quite possible), the 5 strike puts won’t earn anything, right?

  5. I was just thinking that it seems a lot of fraud is already priced in, even at $7 (much more at $5, of course). With a 50x upside, though, the odds of bankruptcy don’t have to be high for a profitable trade. What do you suppose the probabilities are?

    • 1- It’s Morgan Stanley clients who own preferred securities in Yongye. The securities have special terms that theoretically protect Morgan Stanley clients from downside. On paper, the terms of the preferred securities look extremely attractive and imply a very high cost of capital.

      2- If Yongye isn’t a fraud… then it could make sense for MS to want the deal to happen.
      If Yongye is a fraud… then it could ALSO make sense for MS to want the deal to happen. Perversely enough, it may take more time for the fraud to be uncovered if the going private transaction goes through. People who invest in frauds often don’t want it to be known that they did invest in a fraud. They don’t want to lose face in front of their clients.

      3- According to the first deal, I believe the MS-related preferred shareholders will have to pay their share of the fees and reverse termination fee. If the second deal succeeds, then they won’t have to pay these fees. (Not that this really matters.)

      4- The going private transaction may very well succeed (even if Yongye is or isn’t a fraud). If the vote goes through and the financing works out, then this deal will likely close. I believe that the financing will come from the China Development Bank and insiders.

      (i) the proceeds from the CDB Loan in an amount of US$214 million pursuant and subject to the foreign exchange facility contract between Parent and China Development Bank Corporation (“China Development Bank” or “CDB”); (ii) the proceeds from the issuance and sale of the Lead Rich Notes in an amount of US$35 million pursuant and subject to the note purchase agreement between Lead Rich, as note purchaser, and Holdco, as note issuer; (iii) the proceeds from a cash investment in indirect equity interests of Parent in an amount of US$12 million by Mr. Zishen Wu pursuant and subject to an equity commitment letter between Mr. Zishen Wu and Parent, and a cash investment in equity interests of Holdco in an amount of US$15 million by Lead Rich pursuant and subject to an equity commitment letter among Lead Rich, Holdco and Parent; and (iv) […………..]

  6. I was the lead plaintiff in the litigation against QXM. We were awarded a judgement of $15.8M. We are in the process of appointing a receiver. If you hold any shares or had any losses during the class period and want to collect please contact me. Also, I appreciate it if you could let your blog readers who may have QXM damages to send me an email.

    Thank very much.

    Morad Ghodooshim

  7. Pingback: Chinese companies with poorly executed websites – 3 years later – Glenn Chan's Random Notes on Investing

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