Migao...Fraud or Opportunity
I have had this post on MGO ready for a while now. I have been very reluctant to post it. This is probably the riskiest portion of my portfolio. You could even go as far as calling it "speculating", I'll call it (somewhat) calculated speculation.
I have held MGO.to for a while. I even bought more after the potash deal. In light of the Muddy Waters report on TRE and subsequent selloff, I decided it was time to review the MGO position. I did a fair bit of research in MGO when I first bought. But the research was focused on operations, not fraud detection. I was comfortable at time of purchase with MGO not being a fraud. Here is the what I have come up with...
Margins
MGO is not in a great point on the industry map. They have to take the price of their main input (potash) and use it to produce their fertilizers. They have been able to raise prices to end-users, but they can only make so much per tonne. Here is a look at some of the related companies in the fertilizer producer segment. Migao, Hanfeng, China Green Agriculture, and China Agritech are all RTOs. One can see that MGO's margins have been pretty stable. Hanfeng has had its share of issues (see here). There is certainly a red flag raised by CGA and CAGC. I don't know much about those two, but I don't know how they could have such high gross margins. It should be noted that China Agritech (CAGC) has dismissed its auditors, moved to the pink sheets market, and has been accused of being o fraud here and here, and defended here.What's nice to see is that MGO's margins aren't insane.
Cash Balance It may seem kinda silly, but I wanted to see cash "moving" on this one. It was nice to see cash getting used in expansion plans and running up as financing was completed. The real cash burn has slowed as expansion plans have hit a wall and existing plants have run at full capacity. Many of the frauds have run with a high amount of cash and still had to raise equity. Also, they have tons of cash and don't buy back any shares. One thing that has really tied up capital is inventory and prepayments for raw materials. This is kind of the name of the game with the rampant increase in capacity.
Auditors
The big long argument for many of the RTOs was the accounting firm. The idea that having one of the big four would be able to detect fraud. From what I understand, the auditors can only sample a select portion of the statements. So it seems that even if you have a big accounting firm, management can still pull the wool over the auditor's eyes.
MGO says that it runs a lean finance department, having only a few staff to cross-train and tackle the finance departments responsibilities in an emergency. This is somewhat worrisome, but has been present for quite some time in their MD+A. The company said it doesn't have a significant number of staff that understand Canadian GAAP, and the move to IFRS will alleviate this.
MSCM
MSCM is MGO's external auditor. MSCM has run into some issues recently with A-Power Energy Generations here. MSCM did give an adverse opinion of the company's internal controls, no such opinion has been given to MGO (though I am not sure the depth of audit is the same south of the border). MSCM says that A-Power did not retain an independent forensic accounting firm as required by MSCM. Lets be clear here, these Chinese frauds aren't gradually becoming fraudulent, they are frauds from the start. You cannot count on your auditor to catch the fraud.
More and more are being revealed as time goes on. This is forcing the accounting firms to take a closer look. MSCM has not had any other of their Chinese companies run into trouble in a serious manner. That doesn't mean that they won't in the future.
Currently MSCM has 7 companies listed on their website that they audit (or have audited for). They have run into trouble with APWR, but the other 6 don't seem to have the major red flags of fraud. But that doesn't mean they are good businesses. MSCM also serves the mining, and oil and gas sector. They do business all over the world. I would think they would lose business if they have repeated ties to fraudulent companies.
KPMG
KPMG is currently working with MGO on a few facilities to help MGO with internal auditing, internal controls and compliance. Though the depth of KPMG involvement is still somewhat unknown. Though KPMG may not be able to detect fraud at their level, it does make MGO a little easier to stomach knowing that there is two different accounting firms involved.
Directors
The current directors include:
Liu Guocai - CEO and Chair of the Board (since 2006).
Michael Manley - Lead Director (since 2006), independent. Manley is Chairman and CEO of Wesbridge Capital Corporation. He is also on the BOD for ZUN.to.
Peiwei Ni - Director (since 2006), independent. President of Wesbridge. Wesbridge has helped a number of Chinese companies including ZUN and HF.
Robert Kay - Director (since 2006), independent.
Mark Stauffer - Director (since 2006), independent. Provided market development support to Canpotex (Canada's potash exporter). He is also on the board of Allana Resources, AAA on the Venture.
Keith Attoe - Director (since 2008), Independent. President and CEO of Cognitive Finance Inc. Sits on the board for Cantronic Systems (also audited by MSCM). He owns 21,000 shares.
Wu Jianmin - Director (since 2011). Director and COO of Meize Energy Industries.
It is nice to see that the majority of the board is independent. The audit and compensation committee is comprised of 3 independent directors and meets at least 4 times a year.
The directors, other than Guocai, own just over 2% of the company. The directors are all paid around 20k/year salary. The majority of their compensation comes from stock options. Most of the options have an exercise price above $6.
Executives
Liu Guocai - Owns 33% of the company. His salary for 2009 and 2010 was zero. According to the MIC, he wanted to forgo his salary to further the growth of the company.
Randall Smallbone - CFO. Base salary of 260k with additional option awards, bringing total compensation to 480k. On the board for Hanwei Energy Services, HE on TSX. His ownership is next to nothing.
Jay Hussey - VP Corporate Finance. Similar compensation to the CFO. President of MorganBridge, a consulting company. He owns 111,000 shares.
Though it is nice to see that executives have a total of 34% of the shares out, 33% are from Guocai.
PEC Deal
For those who don't know much about the potash supply story, here is a quick rundown...
Canpotex consisting of Potash Corp, Agrium and Mosaic, controls about 30-35% of global supply.
2 large Russian suppliers merged (Uralkali and Silvinit). Giving them around 20% of global supply.
Belarus is in dire need of money and are most likely going to sell their potash supply company Belaruskali. Until now it looked like Silvinit was the likely buyer, but there have been rumors that Sinofert (a Chinese state-owned fertilizer producer) was interested.
What does all this have to do with MGO. Traditionally, MGO has sourced its potash from one of the major Russian suppliers. But the new PEC (Potash Exportation Deal) has put everything in the air. MGO says they can't name the members of PEC, due to it being a private company and MGO signed a disclosure agreement.
MGO has prepaid $100,000,000 for 500,000 tonnes of potash annually starting in 2013 for 10 years. Though this may seem kind of outrageous, MGO needs a stable supply of potash to help reduce the amount of working capital tied up in the business. Remember this is a total of 5,000,000 tonnes of supply. It seems like they are financing some small company (or companies) production plan. There have been questions about the potash supply in the past, but never on this level. To be honest, we aren't really concerned with how effective or profitable the deal is, we are mostly concerned with its actual existence. The deal would most likely be priced on a NPV in order to measure its effectiveness.
The CEO has pledged all his shares against this deal falling through. The terms of the deal cannot be released because PEC is a private Russian supplier. The 3 largest potash suppliers have denied their involvement. There is really no one left in Russia with the capacity to supply MGO. So what gives? That is one of the overhangs of the company.
I read the document detailing the CEO pledging his shares against the deal falling through and came to the conclusion that I'm not a lawyer. It was a tough read, and I'm sure there could easily be a loophole that I overlooked.
Insider Buying
There has been a little bit of insider buying since the TRE announcement. There are other Chinese companies that have heavy insider ownership, but not many have bought back shares since TRE. This is one of the biggest confidence boosters that I can think of for the company. Not just CEO, but directors and executives have been buying. There has not been any selling since around the $8 mark, and this was after exercising options and dumping the shares. It would be nice to see some more insider buying at these levels.
Buyback
The board has approved a 5% share buyback. This is the first time that MGO has taken the share price performance seriously. The company has bought back 150,000 shares at $4.50 and lower in the last month. The shares are now around where the company started re-purchasing them, I would hope to see more shares bought back.
Other Thoughts
When I first bought MGO I thought I was buying a cheap company with a play on the Chinese demand for higher quality fertilizers. I knew it wasn't a great business, but I was paying a pretty cheap price. Now I am really focused on trying to ensure that MGO is not a fraud. There are some suspicions, but that may be attributed to heightened awareness. There are 3 other points that help (not confirm) that MGO is not a fraud.
1) The company is not a great company. It has missed earnings, it has had projects delayed, and it has had budgets run higher than expected. It has also delivered on many fronts over the years.
This chart of expenses per tonne shows that despite the massive increase in capacity, MGO has no scale. This makes it easy to "model" the company's earnings, but proves it is not a great business.
2) The company show that they have a large staff. This is contrast to what China Agritech says.
Senior Management 23
R+D 33
Admin and Technical 312
Production 599
Marketing 31
Seasonal 978
Without including temporary workers, MGO has less than half the productive capacity per worker than CAGC. This doesn't even mention the fact that CAGC apparently needs little in the way of PP+E to produce its fertilizer, where MGO needs a quite a bit.
3) I was in contact with an analyst who said he visited 3 plants in China. He also spoke with MGO's largest customer. It is also easier to get comfortable with MGO when they list their major customers in their AIF.
Taken an of these points be themselves doesn't amount to much, but all together I certainly stacks the odds in the "not a fraud" category.
Summary
Lets look at what Mr. Market is expecting of MGO. Here is a history of MGO's valuation since its inception.
The expectations for MGO are low. The lowest since the panic at the end of 2008 and early 2009. The market is thinking that MGO is likely a fraud (or a good chance of it). MGO has raised equity to the tune of $100 million in total. Despite having a bunch of bankers poking around, this fact leaves me with no comfort.
Lets be clear here, we are now betting that MGO is not a fraud. If it is a fraud, price goes down 80-90% easy. If it is not MGO should have no problem going to $8-10 easily. The is just based on it getting the "not a fraud" stamp in the eyes of investors. This is a potential gain of 80-120%. If in fact I am proven right and MGO executes, then $15+ is possible. But let's get through the fraud stuff first. I will let you decide if you should buy and what size of position it should be.
I have emailed investor relations with some questions. I will post the response (if any).
Dean
Disclosure: The author is long MGO at time of writing. No position in other stocks mentioned.