The China Conundrum: the more you dig, the murkier it can get

This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

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The curious case of China Lumena New Materials’ government filings highlights the challenges facing international investors trying to figure out what is really happening in the People’s Republic.

The Hong Kong-listed miner and chemical maker based in rugged Sichuan Province has long been plagued by questions about its remarkably high-margins and high-rolling founder Suo Lang Duo Ji’s propensity to change names nearly as often as he jumps into new businesses.

Earlier this month, the company faced its potentially most damaging questions.

Debtwire received e-documents purportedly sourced from China’s corporate record depository detailing the financials of Lumena’s only two operating subsidiaries in FY08 and FY09. They presented a very different image than the company’s generally positive public disclosures to international investors. The electronic depository files -- including screenshots with the same exact time stamp -- came from three separate credit agencies in China, one of which was independently engaged by Debtwire, and the other two by third parties.

All companies in China are required to file annual reports to the depository -- State Administration for Industry & Commerce (SAIC) -- which are generally accessible to lawyers and credit agencies. These depository files are frequently used by international investors and research firms such as Muddy Waters to check on the validity of Chinese corporate disclosures. Already, the searches have helped lead to auditors finding fraud at internationally listed Chinese companies such as RINO International and Longtop Financial Technologies, the NASDAQ-delisting of China MediaExpress, and a substantial loss in the equity value of Sino Forrest.

In this case, Lumena immediately came out fighting, alleging that it was the target of a short attack, and that the e-documents were erroneous.

To back up its assertions, the company showed Debtwire scanned copies of what it maintained are the real audited subsidiary accounts, stamped by domestic accountants, and what it claimed are hard-copy SAIC filings, replete with the official stamp. Both the onshore audited accounts and the stamped depository files broadly dovetailed with the international disclosures.

The company also noted that the e-documents Debtwire received have basic arithmetical errors -- such as its gross profit not adding up with the line items above it -- as well as typos and omissions.

So far, so good.

However, there was a smattering of inconsistencies between the two sets of documents provided by the company, specifically the SAIC vouched financials for FY08, which showed total assets that were 10%-20% higher than the onshore audited accounts the company provided. The company would only let Debtwire keep copies of the audits, not the SAIC stamped documents.

Even more curiously, the company has not been able to verify that the allegedly erroneous figures Debtwire obtained don’t in fact appear on SAIC’s electronic database.

“We’ve asked SAIC to clarify but are not sure they will ever tell us,” said a Lumena official.

A representative at the credit agency that Debtwire hired maintained that he has never before seen this kind of thing happen, though he admitted that his clients rarely compared the figures he provided with what a company claimed it filed to SAIC.

So what gives?

An SAIC official who met with the company two weeks ago explained that since 2006, companies in China need to file their financials online as well as in paper form. But the online figures need to be entered first, and often have been inputted sloppily because SAIC generally doesn’t bother to check. Those ostensibly are what Debtwire received.

The paper files, which are the more official version, tend to be much more reliable. Those are the version the company showed to Debtwire.

The differences are egregious.

The e-documents Debtwire received seem to fit the pattern of a company telling one thing to the Chinese government and another to its international equity and bond investors. They show Lumena’s only two operating subsidiaries until late 2010 -- Sichuan Chuanmei Mirabilite Co. and Sichuan Chuanmei Special Gluaber Salt Co. -- both experiencing losses in FY08 and FY09. For those years, their listed parent reported on the Hong Kong exchange healthy consolidated CNY 442m and CNY 533m net profits.

Similarly, the sales reported to the exchange for those years are 8x and 15x larger, respectively, than the consolidated figures in the e-files Debtwire received. While less severe, the tax figures and balance sheet data are also askew, other than short- and long-term borrowings in FY09, which match up precisely, as do the registered capital figures.

However, according to the scanned onshore audited accounts provided by the company, the two subsidiaries had a combined CNY 588.7m in net profit on CNY1.15bn revenue in FY08 and CNY 720.3m on CNY 1.352bn in FY09. That’s broadly in line with Lumena’s reported CNY 442m profit on revenue of CNY 1.14bn in 2008 and CNY 544m earnings on CNY 1.34bn sale the next year.

The company is arguing that in the worst case, the SAIC database contains corrupted information.

However, an investor in Chinese companies noted that she has often seen stamped SAIC filing that don’t add up internally or match with offshore filings. Some of the reasons tend to be focused on the companies hiding income from the Chinese taxman or hoping onshore competitors don’t get a complete picture. They also might just be lying to international investors, she noted.

Creditability gap

Even if its contention is accurate, the company has reason to have reacted so quickly to stamp down on the allegations. Other Chinese companies have seen their share price collapse based on SAIC discrepancies. And Lumena is especially vulnerable because it has long attracted questions about its 70% gross margins on thenardite, an inert filler for detergents and a mild laxative.

The concern has been aggravated by the aggressive expansionary plans for controlling shareholder Suo Lang­--A.K.A Li Yan and Dominique Shannon -- who five years ago took on the Tibetan moniker to reflect his passion for Buddhism. The lobby of Lumena’s 75th story office in Hong Kong’s highest tower is festooned with a 10-foot tall red-and-gold altar humming Tibetan Buddhist chants.

Sou Lang in December 2009 pledged a 20.51% stake in Lumena at a time when he was seeking to finance his ultimately aborted pitch for General Motor’s Hummer heavy-duty vehicle business. Then late last year, he injected his polyphenylene sulfide (PPS) resin business into Lumena for an approximately HKD 11bn consideration, helping to resolve a protracted defaulted pre-IPO financing, as reported.

Indeed, largely because of the corporate governance red flags, Lumena’s USD 250m 12% bonds due 2014 cratered following their issue in October 2009, once falling to the low-80s.

In April, the bond finally recovered, surging above par in reaction to the company announcing that it was selling a USD 120m, 6%, three-year convertible bond to sovereign wealth fund China Investment Corporation and an arm of Central Government-flagship CITIC Group. The equity charged up more than 50% on the announcement, peaking at HKD 4.52, but then quickly retreated to the around HKD 3 level it had been trading previously, and then continued to slide on general corporate governance concerns about Chinese companies.

Since Debtwire first disclosed the purported SAIC filings on 5 August, the shares are down 16.5% –– closing today at HKD 1.97 –– and the mostly illiquid bonds around three points, to a tad under par. But that is broadly inline with how similar Chinese corperates traded during that time of global market volatility.

Perhaps with its slew of documents, the company has managed to raise just enough questions of its own.

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