(Chinese stock accounting scandal, Duoyuan Global water story updated for Tuesday trading)
NEW YORK (
) -- It's quickly becoming a market cliché to say that if there's an accounting scandal to be uncovered, look to recent IPO Chinese companies. The
of the 1990s have given way to the mass wave of Chinese IPOs.
There have been too many accounting scandals from China to not find at least a shred of truth in the fear that an investment in a Chinese stock doesn't just hold the potential for rapid growth, but also equal potential for an accounting scandal. In at least one regard -- not being associated with accounting disasters -- the U.S. is beating China.
The latest Chinese stock disaster related to accounting issues surfaced on Monday, and it concerns not just one, but two affiliated Chinese companies,
Duoyuan Global Water
To be clear, the accounting issues are specific to Duoyuan Printing, which was down 54% on Monday. However, Duoyuan Printing and Duoyuan Global Water share the same chairman, who serve on the boards of both companies. As a result, shares of Duoyuan Global Water tanked by 41% on Monday. Both companies have seen massive amounts of selling on Monday, with a combined 10 million shares traded. On a typical day, the combined trading volume for these companies is 200,000.
Trading action remained heavy in the linked Chinese stocks on Tuesday morning, but the bleeding had ended, even as the inevitable class-action lawsuit press releases on behalf of Duoyuan shareholders began to be issued.
Shares of Duoyuan Global Water had rallied by as much as 5% in early Tuesday action, and more than 1.5 million shares were traded in the first half hour after the opening bell. Shares of Duoyuan Printing, directly implicated in the accounting issues, were also rallying early, and continued to see high volume, passing one million shares traded within the first hour of the Tuesday market open. Of course, a 5% rally is not much of a victory when following a drop of 50% on the day previous to the rally.
Duoyuan Printing announced a number of changes on Monday that led to the selloff. The chairman announced that the CEO and CFO of the company were being replaced, and the Deloitte Touche Tohmatsu had been fired as auditor. Duoyuan Chairman Wenhua Guo stated in the release announcing the changes, "The audit committee's decision to change auditing firms was based on its desire to resolve open issues and file our 10-K on a timely basis. We will work closely with our new auditors to address the open issues aired by Deloitte."
One analyst familiar with the company said that's not necessarily the case, and that the firing of Deloitte & Touche could be read as the classic tussle between an auditor requesting access to information that a company refuses to provide. Deloitte may have refused to sign off on financial statements without access to certain records, which the Duoyuan CEO and CFO refused to make available. There were open issues with Deloitte over permission to look at bank statements, expenses and relationships with distributors, which the CEO and CFO of Duoyuan Printing reportedly could not or would not provide to Deloitte.
Regardless, firing the CEO and CFO won't likely solve any of these issues, as the market reaction attested to on Monday, as investors don't see the accounting issues at Duoyuan Printing as necessarily the result of a few bad apples in management.
Bringing in a new auditor doesn't mean risks are gone, and with the accounting risks in China coming true again, investors figure the next shoe to drop is Duoyuan Global Water. Grant Thornton is the auditor for Duoyuan Global Water, not Deloitte, but investors seemed to be reaching the logical conclusion on Monday that regardless of auditor, the same thing could happen when the companies share a chairman.
In any event, investors were not waiting for a blow-by-blow accounting of facts when it comes to any hint of accounting missteps at a Chinese company. The extent of the market mistrust of Chinese companies is the fact that Duoyuan Global Water received as big a slap from investors as Duoyuan Printing, even though there is no specific sign of accounting problems.
One aspect of the big blow to Duoyuan Global Water was a rating downgrade from Piper Jaffray from buy to neutral. Michael Cox, analyst at Piper Jaffray -- which led the 2009 IPO of Duoyuan Global Water -- is seen by other analysts who cover the company as the biggest bull. The fact that Piper Jaffray went to a hold today on the hint that there could be accounting risk at Duoyuan Global Water was a trigger for investors to get out of the shares.
"Piper was the big bull on Duoyuan Global Water. Piper had been pushing the stock hard and its about-face today shows the risks out there," said one Chinese stock expert. In the least, it means that the valuation of Duoyuan Global Water will have to come down even if its earnings are reliable and its shows growth. Duoyuan Global Water was once trading at a multiple of 33x earnings, and that's not likely to be reproduced any time soon.
The Piper Jaffray downgrade note stated, according to financial web site
"Loss of management credibility in Chinese stocks leads to severe valuation compression. Concerns around internal controls and corporate governance at Duoyuan Printing will add fuel to already high investor concerns around China stocks, and we believe it will impact DGW. China will not go away as an investment theme, and U.S. investors will continue to seek exposure to China's growth, but caution is obviously required when investing in these stocks."
Piper Jaffray's Cox did not immediately respond to a message.
During the summer, Oppenheimer & Co. Analyst Katherine Liu cut her rating on Duoyuan Global to a hold -- and at that time, some Chinese stocks analysts thought that the Oppenheimer downgrade was an indication that it was hard to have a high level of comfort in the stock.
Chris Purtill, an analyst at Janney Montgomery Scott, who launched on Duoyuan Global Water at a hold -- Janney was among the firms selling shares of Duoyuan Global in its IPO -- said what's unfolding on Monday is the classic example of how hard it is for U.S. analysts to gain insight into the financial details of Chinese companies, and how the best-laid fair valuations can be wiped out at a moment's notice.
Case in point: as recently as this summer, the Piper Jaffray analyst who on Monday downgraded Duoyuan Global had reiterated his buy rating after a meeting with company management. Piper maintained its price target at $34 at the time of the summer meeting and reiterated its above-consensus estimates for the company.
Yet that all changed on Monday. "Lots of times you just have to take management word," Janney Montgomery's Purtill said. Janney Montgomery has been at a neutral on Duoyuan Global since launching coverage, and the analyst said it was because the valuation had been relatively high for the company even if the analyst could verify every financial item.
Duoyuan Global reached as high as $45 after its 2009 IPO, and followed up its rise with a secondary offering of 3.5 million shares -- it has 20 million shares outstanding total. Investors were not happy when it announced the secondary, and shares fell from above $40 to $28. Investors further hammered the stock in May when it announced it was sticking with an advertising campaign that investors did not think was a wise use of cash.
Janney Montgomery's Purtill said that a valuation in the low 20 times earnings could be reasonable for Duoyuan Global Water, however, and as the stock has fallen as low as $10.55 this year -- on Monday it was trading at between $12 and $13 -- there is a case to be made for the company as a buy. However, given the accounting backlash, even if the company puts up great numbers its days of getting a premium from the market are over.
"When it was over 30 times earnings it was ridiculous. Then it fell to a multiple in the high teens, and now it's all about the contagious risk. Investors may run for the hills and it could be a low single-digit price-to-earning stock," Janney Montgomery's Purtill said. At $10, and with the Street consensus earnings at $1.41 for the year -- year ago earnings were $1.65 for Duoyuan Global Water -- the stock may deserve a look, the Janney analyst said, but added, "Now it's all just fear and the connections between the companies."
--Written by Eric Rosenbaum in New York.
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