Sino Clean Energy: A Closer Look

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.

BEIJING ( TheStreet) -- Earlier this year, when I visited Sino Clean Energy ( SCEI), the stock was trading below $7 on volume as low as 40,000 shares. It seemed that there was simply no awareness of the stock. Since then, shares have plunged by 70% due to short seller allegations of fraud -- on Friday, volume exceeded 3 million shares.

SCEI's product, coal water slurry fuel ("CWSF"), has the potential to be a wonder fuel due to its ease of transportation, low waste residue and environmental benefits. I think it is an incredible product with huge potential in China. However, my visit to SCEI ultimately did not lead to an investment.

First, the facility was surprisingly small. The main production line is simply a small mixer (picture a cement truck) which is fed coal by a small conveyor belt. This did not seem consistent with the company's stated capacity of 850,000 tons.
The author at the SCEI facility

Second, the process was surprisingly "low-tech." Coal is simply ground up and mixed with water and a catalyst. Given that the process is so simple and that there are more than 40 commercial suppliers in China, I could not quite understand how it is possible for the product to generate net margins of roughly 45%. I had previously been under the assumption that this had to be the result of a more complicated high-tech process, creating a strong barrier to entry.

Third, although I was present at what should have been the busiest time of the year for SCEI, activity was surprisingly low. Only one production line was running and during my several hours at the facility, I only saw one truck enter and leave. I did visit and interview two customers, who confirmed use of SCEI as a supplier, as well as their satisfaction with the product and with SCEI. I also interviewed the truck driver who stated he makes daily fill-ups for delivery in the vicinity. We did not have any discussion of night time fill-ups and deliveries, so I can't confirm or refute management's recent statements about night time activity.

I did not take any position in SCEI (neither long nor short) and I do not have one now. I am not making any recommendation to anyone regarding the decision to buy or sell shares. However, given the recent fraud allegations, I think it is useful to evaluate SCEI using 3 scenarios.

Scenario 1: SCEI is 100% legitimate. Based on SEC numbers, net margin is roughly 45% on 2010 revenues of $106 million. Capacity is set to more than double to 1.85 million tons. Under this scenario, and assuming a moderate multiple, SCEI should be a $15 stock by the end of fiscal year 2011. The stock currently trades at about $2.

Scenario 2: SCEI is a total fraud, as alleged by short sellers. Obviously the share price under this scenario should be basically zero. However, since I have personally confirmed production, deliveries and customers, I am choosing to ignore this scenario.

Scenario 3: SCEI is a "partial fraud." This assumes net income is being inflated to some unknown extent. It amazes me that many investors knowingly invest in partial frauds, trying to handicap the extent of the fraud vs. the expected share price. Companies such as RINO ( RINO), China Education Alliance ( CEU), China MediaExpress ( CCME), Duoyuan Global Water ( DGW), Duoyuan Printing ( DYP) and others all had some actual business, but their actual results were nothing close to what was being reported to the SEC and which were relied upon by investors to value the company. Presumably, there should be some tangible value to these companies, yet the simple presence of "partial fraud" tends to lead to resignations by management, directors and auditors, which leads to halted and de-listed stocks.

SCEI was down as much as 35% on Friday, but then jumped considerably on the news that the chairman had purchased a few hundred thousand dollars of stock. It is one I will continue to watch with interest from the sidelines.

I also received quite a bit of interesting feedback on Gulf Resources ( GFRE), leading me to take a moderate short position (with a stop loss) in the company when the share price showed its usual mid-day spike. The "hit piece" on GFRE was certainly not the most accurate or persuasive piece. Management has easily debunked a number of the arguments in the piece, giving investors some degree of confidence. However, the key problem with GFRE is the same as with other short targets. The shorts can be 80% to 90% wrong and only 10% to 20% right, but the simple existence of a 10% to 20% problem is very severe.

Unlike SCEI, GFRE is easier to analyze using various production metrics, including inventory turnover. This was one of many points raised by shorts, and it is the one I believe deserves the most attention. Management has stated that its low level of inventory (and thus astronomical level of inventory turnover) is due to the difficulties in storing bromine as well as just in time order management. To me, the 10% to 20% (at a minimum) issue stands out, is easily visible and just doesn't make sense.

Inventories are easily verified by auditors, whereas verifying legitimate sales revenues has proven to be more problematic. In 2009, GFRE reported sales of $110 million with inventory of just $650,000. It is basically inconceivable. In 2010, reported revenues increased to $158 million, while inventory only increased to $2.6 million. As of December 2010, the company reported more than $68 million in cash and short-term investments, but only $242,000 of interest income. In the most recent 10K, the first audited by BDO, it states:

"In our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria."

The hit piece came out after auditor BDO signed off on the 10K, so the upcoming release of the 10Q should be very interesting. The stock currently trades at $2.96, a PE of just 2 times trailing reported earnings. Short interest in the stock has climbed from less than 1 million shares to more than 4 million shares as of April 15.

I have recently been taking a number of moderate short positions in stocks, which I think are likely to decline in price. However I continue to believe that there will be a few hidden gems which have been overly beaten down by the current fear in the market.

In May, I will be spending two weeks in Hong Kong and then several months visiting a small number of companies in China, which I think have been overly beaten down and will recover. Given the current low valuations of virtually all China small-caps, I believe there will be selected long opportunities that could provide upside of at least 100% once the current wave of fraud gets washed out and investors eventually re-enter the space.

Disclosure: The author is short GFRE.

The author can be reached for comments at comments@pearsoninvestment.com.

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.

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