The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- Over the past few weeks shares of Chinese pork producer
( HOGS) have come under fire from all sides. Three negative research reports (two from disclosed short sellers) and two sell-side analyst downgrades pushed the shares to a 52-week low of $8.07, down by over 60% since the beginning of the year when the stock traded above $20.
Each week, it seems there is a new "hit piece" on the stock questioning store counts, overspending on equipment, SAIC filings as well as misrepresented performance of specific subsidiaries. Roth Capital and Global Hunter have downgraded the stock from "buy" to "neutral." However, investors seem to realize that in Wall Street speak, "buy" means "buy," "neutral" means "sell," and "sell" means "it's already too late."
HOGS' initial response was impressive, consisting of an immediate press release, a conference call and an investor tour of retail outlets in Shanghai. Yet the stock dropped by over 20% and continues to hover near 52-week lows. As the number of questions continues to grow, Zhongpin has become increasingly silent and has even altogether refused to answer analyst questions regarding capital-expenditure discrepancies. As a result, I see a heightened risk of further downgrades of the stock to "sell" or perhaps suspension of coverage by research analysts until the questions are fully addressed. In my view, this means the near-term upside in the stock price is certainly capped while the risk to the downside is very substantial.
To bolster investor confidence, HOGS has already repurchased over 460,000 shares (about $4 million) in stock and has increased the size of its buyback program to $30 million, but so far there has been almost no positive impact on the share price. In short, continued repurchase of shares by HOGS may prevent the stock from falling in the short term, but as the continued scrutiny grows, the shares are likely to find their own level in coming weeks, despite the buyback.
A major source of concern for investors was the fact that the list of retail stores provided by management did not contain actual addresses, but instead simply listed the names of districts or entire towns. Clearly, HOGS simply must have a detailed list of addresses for use by delivery drivers, but this list was not provided to investors. Moreover, the list was quickly deleted from its Web site after only 48 hours.
I participated in the Shanghai tour of retail stores and have included a picture (above). My expectations on attending the tour was to be taken to "stores," which would resemble something like a 7-11 filled with Zhongpin pork products. Instead, as can be seen by the pictures, these "stores" consist of one-man counters located within traditional Chinese vegetable markets. Basically, a "store" consists of one guy with a knife and a 6-foot counter. The counters were difficult to find because they were located down back alleys and inside open-air vegetable markets, as opposed to street-front locations and having four walls and a store front.
Roth Capital, which attended the tour and conducted additional due diligence in Shanghai, found the store visits to be satisfactory evidence of the existence of the stores in Shanghai. However, problem No. 1 is that the majority of Zhongpin's stores are not located in Shanghai but are reported to be in faraway Henan province. So the verification of stores should be seen as only partially complete. In addition, Roth's due diligence uncovered a separate issue: notable discrepancies between HOGS' capex spending and that of its competitors. Roth disclosed that it attempted to address these issues with Zhongpin management, which was unwilling to provide a response. As a result, Roth quickly downgraded the stock from "buy" to "neutral," resulting in a 6% share-price drop for the day. This followed Global Hunter's downgrade, also from a "buy" to a "neutral."
After the capex issue was highlighted by Roth, Geoinvesting (which discloses a short position in the stock) came out with a 26-page report providing substantially more details on the capex issue. The numbers are fairly black and white. It can be observed from HOGS' public filings that, for an equal amount of processing capacity, HOGS spends more than double what its competitors spend. Given that HOGS has spent over $300 million on capex in recent years, this discrepancy adds up to as much as $150 million, or nearly half or HOGS' current market cap.
As a separate metric, Geo highlights the fact that HOGS' ratio of sales/PP&E is roughly half that of its listed competitors. This would seem to reconfirm the notion that HOGS is paying roughly double what its competitors spend for capex. The key question is why is management paying double for capex, and where is the extra $150 million going? So far, management is keeping mum and not providing additional information and the stock price is suffering accordingly.
Geo also noted that net income reported to the SEC was overstated by as much as 500% compared to what is reported in HOGS' SAIC filings. Some investors put great faith in SAIC filings while others disregard them completely. I take an agnostic view toward the filings themselves, but I do note that there is a disturbingly high correlation between companies with massive SAIC discrepancies and the surfacing of subsequent accounting problems. With over 30 U.S.-listed Chinese companies having been halted or delisted, this correlation is now too obvious too ignore.
I have spoken to management, which says it may have more responses coming via press releases. So the question becomes what will it take to restore investor confidence in HOGS? I believe that the following steps must be taken before investors will be comfortable giving HOGS a higher valuation.
A complete and precise list of addresses of all retail locations, permanently posted on the Web site.
A detailed explanation of the cost of capex and a full accounting for where the excess funds have gone.
A full reconciliation of the differences in SAIC versus SEC reported net income.
A detailed explanation of the status of the Shanghai subsidiary, which was apparently discontinued in 2009.
In the absence of these steps, I easily see 20% to 30% more downside in the share price from current levels, and I have thus taken a short position in HOGS.
Disclosure: The author is short HOGS The author can be reached at firstname.lastname@example.org
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.