Sino-Forest posts Q1 loss, defends against charges, announces accounting change for convertibles

By Paul Deckelman

New York, June 14 - Sino-Forest Corp., the embattled Canadian-Chinese timber company, announced a first-quarter loss on Tuesday, as expected, and used the release of its results and the accompanying conference call to address recent allegations by a short-seller that it had committed serious financial improprieties.

Company executives defended their business model and accounting practices, although they said that it would take several months for an independent committee appointed to probe the allegations to complete its work.

Sino-Forest's chairman and chief executive officer, Allen Chan, said in a statement that the company is "very disappointed for our stakeholders about the significant drop in the value of their investment in Sino-Forest due to the inaccurate and unfounded allegations" made by Muddy Waters LLC, a Hong-Kong-based research and investment company founded by short-seller Carson Block that specializes in probing companies doing business in China such as Sino-Forest and, earlier this year, China MediaExpress Holdings - and then frequently placing bets against them by shorting their securities.

Sino-Forest fights back

The Sino-Forest statement called Muddy Waters a "self-serving short seller," adding that it was "shocking that a little-known short seller, who is not listed with the Ontario Securities Commission nor the Securities Exchange Commission as a registered advisor, could reduce so much market value created after 17 years of hard work and global stakeholder investment."

Muddy Waters' bombshell report on Sino-Forest, released on June 2, used scathing language, calling the company a "fraud" and likening its capital market transactions to "a multi-billion-dollar ponzi scheme" - the bluntly worded screed even invoked the name of disgraced financier Bernard Madoff by way of comparison.

In the nearly two weeks since the report's release, the company's junk bonds and convertible notes have tumbled by dozens of points from their pre-report values near or above par, while its Toronto Stock Exchange-traded shares have shed some three-quarters of their pre-report value.

During the conference call, Chan challenged some of the specific allegations which the Muddy Waters report had made, including claims that the company - which buys trees on wood plantations and then sells them on a wholesale basis to a series of what it calls "authorized intermediaries," (AIs) or independent sales agents, who then re-sell the timber to end users - had overstated the value of tree purchases made in the Yunnan Province by approximately $800 million.

Chan also declared that Muddy Waters was wrong in alleging that the company, for accounting purposes, treats the AI agents "as being both supplier and customer in transactions" in order to make the accounting opaque, hide the alleged underpayment of taxes and facilitate the generation of bogus sales figures.

And Chan disputed a charge that auditor oversight is poor because, among other things, Sino-Forest's board of directors "appears to be the retirement plan for partners of its auditors, Ernst & Young."

The company also released a 10-minute pre-recorded interview with Chan in which he explains Sino-Forest's complex business structure, including its use of entities registered in the British Virgin Islands to actually buy the trees, its sale of those trees through the AI agents and the reason it keeps the identity of its agents confidential - all criticisms contained in the Muddy Waters report.

Chan also addressed the question of why the company is unprofitable despite sizable revenues on paper. In the first quarter, revenues increased by 35% from a year earlier, to $339 million versus $251 million in the 2010 quarter, and EBITDA was up by 34%, to $192 million from $143 million, but the company had a net loss of $22 million, or 8 cents per share, versus a profit of about $16 million, or 7 cents per share, a year earlier.

The CEO said this was "by choice," with the money plowed back into its BVI-registered tree-buying subsidiaries to allow them to continue to expand and "take up pioneer positions in different provinces, since we know that these provinces are going to be huge demand areas."

Balance sheet seen strong

During the portion of the conference call covering the financial results for the 2011 first quarter ended March 31, the company's senior vice president and chief financial officer, David J. Horsley, indicated that Sino-Forest has a strong balance sheet, with considerable cash on hand.

At the end of the quarter, the company had long-term debt of $1.641 billion, including $600 million of 6¼% notes due 2017, which priced at par on Oct. 14, 2010. The capital structure also includes $87.6 million of 9¼% notes ostensibly slated to mature on Aug. 17, another junk bond issue - its 10¼% notes due 2014 - and two issues of convertible notes, the 5% notes due 2013 and the 4¼% notes due 2016.

The ratio of long-term debt to the company's equity, as of March 31, was 0.56-to-1, which the company termed "still conservative."

Cash and short-term deposits totaled $1.088 billion.

Accounting change

Horsley also outlined a coming change to Sino-Forest's accounting treatment of its convertible debt, driven by the company's switchover - like that of all publicly accountable enterprises in Canada - to the International Financial Reporting Standards, replacing Canadian Generally Accepted Accounting Principles.

Under the new IFRS treatment, companies are required to fair-value their option of settling convertibles by delivering cash or a combination of cash and common shares to the holders, rather than a straight equity conversion, as an embedded derivative liability at the end of each reporting period. The CFO explained that as the company's share price increases, this option becomes more valuable to the holders, or more costly to the company, and thus results in a charge to the income statement.

With Sino-Forest shares valued at C$25.30 as of March 31, this resulted in a charge of about $53 million against earnings.

On the other hand, should the share price decrease, the settlement option becomes less valuable to the holder, and less costly to the company, therefore resulting in a gain being recorded in the income statement. As an example, Horsley said that since Sino-Forest's shares - hammered down over the past two weeks in the wake of the Muddy Waters report - closed this past Friday at C$4.47 per share, the company could record a gain from fair-valuing the convert option of about $450 million in its second-quarter earnings statement.

In order to prevent such share-price volatility from impacting the income statement, the board of directors approved amendments to the indentures governing the convertibles to remove this settlement option. Such amendments do not require the consent of the convertible note holders, and the company "will take the required steps to implement the amendments."

In future quarters, after the 2011 second period, the volatility of Sino-Forest's common share price "will no longer affect the reported net income in such manner."

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