I have been writing about Orient Paper (ONP) for the last few months. There have been a number of bullish and bearish articles written about the company.
Last night, I received the following article from Edward Hoots, who is an American now living in China working as a Shop Foreman at a plant. I don't know Edward and haven't done any due diligence on him or his background. He appears to be a long holder of ONP.
Although I don't necessarily agree with all his points below, I think they are a useful perspective on the ONP controversy and how cultural biases might play a part in some of the different points of view. If you have comments on the post below, I will pass them on to Edward:
… Alas, I have read the July 22nd article on the Muddy Waters website and I think I understand some of the confusion (not fraud) that their original report and ensuing turmoil has generated.
I have always felt that the Muddy Waters people were comparing operations and accounting procedures at ONP to western business practices.
Some of the allegations of fraud and shell companies may seem valid by western standards but are an essential if not required part of doing business in China.
Some of the other allegations, drawing from my memory are:
Fraudulent RTO
Dongfang Trading company
Overstating the cost of new equipment
Changing top 10 customers year to year.
High inventory turnover
RTO:
I have not see reams of documents, best estimates, bank statements, balance sheets, etc.
What I do know is that a RTO is an inexpensive way to take a company public on the targeted exchange as opposed to an IPO. If the Chinese people can find a way to do something cheaply, they will exploit it to the MAX. Remember, China is a nation of savers. It is their nature to be as tight as possible with their money. This move is commendable.
DongFang Trading company:
In China, when goods are imported or exported, the government requires the use of an Import/Export license. This license is not cheap. Some of them can cost as much as $350,000USD or more and they are specialized and specific as to what they can be used for. Large companies Like Intel, Motorola, and other western companies the US investor would be familiar with more that likely have their own import/export license they purchased from the government at a hefty fee to import raw material and export finished goods. Smaller companies that don’t have the resources to buy a license have to use other means to export. Enter the trading company. A trading company is in every sense of the word the ultimate middle man. It is not unlike acceptance banking from the days prior to wire transfer. In the case of ONP, DongFang is owned by the chairman. It appears to have been originally set up as a Trading company to import and export paper and paper related products as provided by the license. Most smaller non public companies would list a trading company as a supplier because they would pay the trading company(not the actual supplier) for the imported goods purchased. The trading company in turn then pays the supplier and normally pays any taxes due to the government, and takes a small fee for the transaction. That is how a trading company makes money from a transaction. ONP looks to be using DongFang more as an export/import license instead of a trading company and (addressing the Beijing subsidiary) still doing some actual trading with third party companies. I am not sure of the legalities of using the Im/Ex license like this but it appears to be going on. If ONP is using Dongfang as a Im/Ex license then DongFang would indeed show no or very little revenue and the cost would be reflected on the ONP books. It would be a cleaner way to account for Im/Ex transactions that way. So yes, DongFang is a shell ,but it is a required and legitimate entity.
Overstating the cost of new equipment:
Lumber, Pulp Processing, and Paper making equipment cannot be purchased at the local Walmart. Having grown up in the Northwest I am intimately familiar with this equipment. When a company wants to install a new line, be it for lumber or paper, it has to be designed to the specifications of the purchaser. When the Muddy Waters folks called the vendor for the new ONP paper line they got someone on the phone that said the biggest line they sell is much smaller than the ONP line as far as tonnage goes and it costs less. So it stands to reason that a larger line would cost more. A growing company like ONP does not have identical multiple locations through out China. Hence they do not have a stock design for a specific paper line that produces a certain tonnage annually. So that means it has to be designed and built from the ground up. A paper line that produces over 300,000 tons of paper a year is not a tinkertoy and knowing what I know about the level of technology in China, it is more than likely the biggest paper line that the vendor has ever built. The pictures that I have seen of ONP competitors show equipment that appears to have been designed, built, and imported from abroad. Imported equipment is very expensive compared to domestic built, so here again the least expensive route is taken.
Changing top 10 customers year to year.
I remember reading part of an interview with the ONP mgmt. and they stated they were going to switch a line from a high grade paper to a lower grade paper because the raw materials for the higher grade product were increasing rapidly and the margins were being reduced. After the switch, questions were raised as to how the new customers for the lower grade paper were cultivated so rapidly. The answer is that being tight with the money on the expense side, it gives ONP a big competitive edge as far as pricing. Like I have already mentioned price is the big “decider” for Chinese buyers. Unless told otherwise the cheapest always prevails.
High inventory turnover
An up and coming company like ONP with expanding orders will have a tough time keeping an inventory at all. As orders come in, production capacity is filled to the point of full capacity. At some point more equipment is ordered but before it can be installed demand keeps increasing to the point of exceeding 100% capacity. When this situation occurs, product is literally going from the machine and then loaded on the truck for delivery without intervening warehousing. I suppose that for accounting purposes some form of inventory could be recorded, but it is not a true reflection of the situation. There are some manufacturing terms I have not heard used by anyone when capacity and inventory were referred to and that is: Lean manufacturing and Just in Time. To my knowledge, ONP is not either ISO or AS certified but it doesn’t preclude the company from using modern manufacturing techniques to achieve maximum efficiency. Therefore, a minimal inventory would show a higher turnover that a slower growth company keeping a larger inventory.
Some important things to remember about China.
China is not America. Chinese businesses operate differently than American businesses. Sometimes the only common thread is profit. Only time will tell whether or not ONP is a fraudulent company. I intend to visit them in August to determine just that. My gut feeling is that they are on the up and up for the most part. Some corners may have cut here and there. The Chinese are famous for that. I think there are actions the company took that are misconstrued by some people as fraud but in the context of the Chinese business environment it is standard practice. China is a very dynamic place right now. That is why it is attracting so many investors. In a lot of cases there are no standards or average performances. As China tries to become less dependant on exports and more of a domestic consumer driven economy standards and norms will increasingly move in a state of flux along with that will come shortages, surpluses, and all the growing pains that every industrialized nation has had to endure. I view Chinese companies as no more corrupt than their American counterpart. How many off balance sheet monkey business shenanigans have US companied been caught doing in the last few years. In every country there are honest people and there are cheats. Time has a way of weeding out the bad apples.
[At the time of publication, Jackson had a long position in ONP.]
