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) -- In March, Absaroka Capital (a firm I had never heard of) published a detailed report alleging fraud at China ShenZhou Mining ( SHZ). Without bothering to read the report, I immediately bought as many puts as I could. Given that the stock was already plunging, I couldn't get many puts and I overpaid for what I did get, but the share price subsequently fell from over $5 to below $3, so it was a worthwhile trade. I fully expected SHZ to go below $2, but the volatility (i.e. price) of the puts was so high that, at $3, it made sense to sell the puts, so I exited.

Why would I go substantially short without even reading the report? Because even in the absence of fraud, this stock is so stunningly overvalued that it is simply destined to come back down to earth.

For a while, SHZ was mistakenly being viewed as a rare earth play (which it isn't) and the price exploded from $0.70 to over $10 in just a few months. When other rare earth stocks would have a big move in one direction, SHZ would follow suit. It was bizarre to watch, but I never wanted to fight the tape on it. By now everyone knows that SHZ is not a rare earth play, it is simply a fluorite company. However, some investors clearly seem to feel that fluorite might also represent an attractive play.

Yesterday, SHZ shot up as much as 10% after the company published a press release stating that China's Ministry of Land and Natural Resources would reduce the quota for fluorite production to 10 million tons. Clearly, a reduction in the quota will boost the price of fluorite and limit competition, thus providing a big benefit to SHZ. Then again, maybe not. From its most recent 10Q, SHZ expects that it will extract only 150,000 tons of fluorite ore in 2011. That is about 1.5% of the quota amount and demonstrates that SHZ is simply not even a real player in this market and will not stand to benefit even in light of the quota reduction.

A closer look at the numbers illustrates this point more clearly.

Even aside from the fraud allegations, the most recent quarter was a disaster, as was the quarter before. In Q1 2011, the company made a gross profit of only $660,000 (that's about $7,000 per day). It has lost money at the bottom line in all but one of the past five quarters. In its only profitable quarter, it made $520,000. At the current price of $4.49, SHZ has a market cap of $138 million compared to a market cap of approximately $20 million in 2H 2010. This is in spite of the fact that the company's losses have been accelerating. Last year, the company could at least keep its losses below $1 million per quarter.

Given its inability to generate profits and its lack of cash and weak balance sheet, it is not surprising in the least that SHZ received a "going concern" letter from its auditors for fiscal 2010. However, that obviously does not account for the fact that the company raised $20 million from U.S. investors in Q1 2011. Unfortunately, that cash has disappeared very quickly and within less than 90 days, the $20 million turned into less than $8 million. The company's current ratio ranges between 0.50 and 0.75. Anything below 1 is typically considered problematic.

So how long can SHZ hold out with $7.7 million in cash? Management has made the statement that the $20 million raised in Q1 would provide it with adequate liquidity going forward. However, the cash flow statement tells a very different story. In Q1 alone, SHZ burned over $10 million in cash from operations and from investing activities. Financing activities provided the company with a net change in cash of only $6 million. Previous quarters weren't much better, with financing activities really being the only thing keeping the company afloat. It seems logical to expect that even with a substantial increase in fluorite prices that, at this rate, SHZ will be completely out of cash before Q3.

In short, if SHZ is committing fraud as per the Absaroka allegations, they are doing a very poor job at it. Typically, fraudulent companies will inflate their revenues and deflate their expenses, trying to manufacture profits so they can raise money from U.S. investors. In the case of SHZ, its profit and loss is already so consistently dismal that I find it hard to believe the company is committing much fraud.

When the price recently jumped from below $4 to around $6.50, I jumped in to short SHZ again, but this time in a different way. I sold 1,000 $7.50 strike calls (i.e. well out of the money) at a price of $0.40, netting me $40,000 and my only risk was that the price would jump above $7.90 in the very short term. It was a no-brainer. I wanted to do a larger trade, but the price dropped quickly and the silly bid at $0.40 evaporated quickly. Unfortunately, shortly thereafter, all of the brokers increased their margin requirements on Chinese RTO stocks, including the requirement on naked calls. The stock fell to $4.50 and my broker required that I keep $450,000 as margin requirement against this position, so in terms of return on capital, it was not so great and I ultimately repurchased the calls at $0.10, so I only netted $35,000.

In retrospect, had I sold 1,000 in-the-money calls, I would have captured the entire $2 move and made $200,000 and the margin requirement would have been essentially the same.

As a result, this time I decided to take advantage of this latest pop to sell $2.50 strike calls (i.e. deep in the money). Because the options are deep in the money, this trade performs exactly like shorting the stock, but with the advantage that if the stock is halted (due to fraud or other concerns) the options simply expire worthless and I keep all of the premium received.

Once again, with performance this dismal, I don't think the company is committing a significant amount of fraud. If they are, they certainly are not doing it very well. I do note, however, that immediately after the fraud allegations were released, the CFO resigned "for personal reasons" and the company appointed a 29-year-old recent college graduate to take his place.

SHZ is no longer mistaken for a rare earth play, and I believe that it won't take long before it will no longer be mistaken for a credible fluorite play. This week, the stock was already showing weakness, dipping as low as $3.76 on Tuesday. Given that the only factor driving up the share price was a recent press release on fluorite quotas, I am confidant that this one will find its way back into the $1 to $2 range fairly quickly.

Disclosure: the author is short SHZ. 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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