On the afternoon of June 7, Daniel David, co-founder of Muddy Waters, announced he would short Dali Foods, a Hong Kong-listed Chinese company. Dali's stock fell as much as 7.8% during the day, closing at HK$4.30, down 6.5% for the day.
1 About Muddy Waters and Alpha Company The renowned Muddy Waters Research was founded in 2009. Its founder, Carson Block, once lived and worked in China and has some understanding of China's national conditions. The name "Muddy Waters" comes from the Chinese idiom "muddy waters make it easy to catch fish" (浑水摸鱼). Muddy Waters' short-selling logic is that if a listed company's profits, profitability, or sales are unrealistically good, there may be a problem of false cash. They typically find evidence of financial fraud by reviewing documents, investigating competitors, suppliers, related parties, customers, and consulting experts, then short the stock. Since its inception, it has had a high success rate. Let's look at Muddy Waters' track record against Chinese companies over the years.
In 2010, it shorted Oriental Paper (down 40% in 3 trading days) and Rino International (delisted). In 2011, it shorted China Media Express (delisted), Multi-Color (down 28% on the day), Sino-Forest (plunged 74%), Spreadtrum Communications (down 30% on the day), and Focus Media (after a 40% drop, it exited Nasdaq via privatization). In 2012, it shorted Fushi Copperweld (unaffected) and New Oriental (down 57% in 2 days). In 2013, it shorted NQ Mobile (stock halved in 1 hour). In 2014, it shorted Qifeng International (down 5.8% then suspended). In 2016, it shorted Huishan Dairy (plunged 90%, facing restructuring).
Fortunately, this time it is not Muddy Waters but Alpha Company, also from the U.S., that is targeting Dali Foods. Although Alpha is less famous than Muddy Waters in China, its history is also known for short-selling. In particular, Daniel David, who released the short-selling news today, was a co-founder of Muddy Waters and shares the same short-selling philosophy.
2 Will Dali Yuan Become the Next Huishan? Muddy Waters began investigating Huishan Dairy from its listing and by December 16, 2016, the two sides clashed.
Muddy Waters' reports were hard-hitting. For example, the first short report claimed that although Huishan sold on platforms like Tmall, JD.com, Suning, and WeChat, Muddy Waters' analysis of e-commerce data showed that Huishan's actual sales were very small. Even comparing best-selling products, Huishan's monthly sales were lower than Mengniu and Yili, which were roughly 10 times higher.
Muddy Waters' second short report claimed that Huishan's agricultural construction conditions were very poor, and capital expenditure on maintenance was insufficient to ensure cow health and milk production.
Carson was confident in his judgment. Before Huishan's listing, he formed a team of six or seven people to thoroughly investigate the company. The team started with Huishan's public data and supplemented it with field investigations.
The actual manpower and resources invested were far more than that. Muddy Waters hired consulting firms and third-party investigation agencies to assist. Investigators not only conducted "ground operations" such as interviewing former employees and upstream/downstream companies but also used drones for "aerial operations."
"A core fact of the short report is that Huishan overstated infrastructure investment. Our drone footage showed a desolate scene," Carson said. "Local consulting firms also told us that the actual cost of such projects was far lower than Huishan's quotes."
After being shorted by Muddy Waters, Huishan fought back. For example, in response to Muddy Waters' doubts about its raw milk production, Huishan stated in an announcement that according to reports from two comparable dairy companies listed on the Hong Kong Stock Exchange, their average raw milk selling prices in the first half of 2016 were 4,040 yuan/ton and 4,005 yuan/ton respectively. In comparison, Huishan's average raw milk selling price from April to September 2016 was about 4,144 yuan/ton, at least 2.6% higher than the comparable companies.
At the time, some dairy industry insiders also believed that China's dairy farming technology had improved, and the yield per cow in high-quality pastures had increased significantly, which was reasonable.
Earlier, market rumors said that after Muddy Waters' short report, banks that provided financing to Yang Kai and Huishan, including Ping An and Bank of China, began investigations and audits. Bank of China's audit found that Yang Kai had misappropriated 3 billion yuan, but Bank of China has not officially responded to this.
Another stakeholder under scrutiny was Ping An Bank. Given the record decline, major shareholder Yang Kai's share pledge was in jeopardy, which also put Ping An Bank, the pledge bank, at risk of bad debts. Ping An Bank said it did not directly hold Huishan Dairy shares but held over HK$2 billion in share pledge loans.
At the end of 2016, Huishan Dairy announced that Champ Harvest Limited (Chinese abbreviation "Guanfeng"), controlled by company chairman Yang Kai, signed a supplementary agreement with Ping An Bank to extend the maturity of a loan totaling about HK$2.14 billion by one year.
The announcement showed that the loan was secured by shares of Huishan Dairy held by Guanfeng. On June 5, 2015, Guanfeng signed an agreement with Ping An Bank to obtain a two-year loan of HK$2.4 billion, using its Huishan shares as collateral. As of December 27, 2016, the total number of shares pledged by Guanfeng to Ping An was 3.434 billion, representing 25.48% of the company's issued share capital. Based on the closing price of HK$0.42 per share on March 24, the market value of the 3.434 billion shares pledged by Yang Kai to Ping An Bank was about HK$1.442 billion, a book loss of HK$700 million compared with HK$2.14 billion.
Market concerns were that for these pledged shares, regardless of the pledge ratio, when the decline exceeded 90% and no additional margin was provided, the position would have been liquidated. Banks, for risk control, should also sell the shares.
A public fund manager investing in Hong Kong stocks said that major shareholders may not have funds to add margin, but for such a straight-line decline, most institutions have no time to react. "After such a plunge and suspension, fund managers will have internal discussions to see if the negative news is unfounded," he said. Then they would confirm whether the rumors are true through upstream and downstream companies, financial institutions, and other means, and whether the negative impact has been fully reflected in the stock price.
The fund manager analyzed that in terms of trading techniques, for a stock like Huishan Dairy that plunged straight down, fleeing funds kept trading at real-time prices, "all the way down. Unlike A-shares, Hong Kong stocks have no price limit, so if you want to sell, you have to push the price down yourself."
While waiting for the outcome of the Huishan battle, Muddy Waters was also investigating other Hong Kong-listed companies it suspected. Carson told Tencent Finance that it would release a short report on another Hong Kong-listed company within the next few weeks.
"Some of these companies are very similar to Huishan. Although they have physical businesses, their financial conditions are a mess," Carson said. "We will investigate very carefully because in the short-selling business, evidence must be very solid, otherwise it is easy to get sued."
3 About Dali Foods Dali Foods was founded in 1989 and is currently among the top 500 private enterprises in China. On November 20, 2015, the group was listed on the main board of the Hong Kong Stock Exchange. Currently, Dali Foods' brands include "Daliyuan," "Haochidian," "Copico," "Heqizheng," and "Lehu."
Since its founding in 1989, Dali Foods has grown to 19 companies, 29 food and beverage production bases, over 39,000 employees, 3,847 distributors, annual output value exceeding 10 billion yuan, with more than 720 food SKUs and 107 beverage SKUs. Dali Foods' categories cover six major types: pastries, potato puffed snacks, biscuits, herbal tea, compound protein drinks, and functional drinks. Its pastry brand "Daliyuan," biscuit brand "Haochidian," and potato chip brand "Copico" have become recognized leaders in China's leisure food market. "Heqizheng" herbal tea, "Daliyuan" peanut milk, and "Lehu" functional drinks are also leading in their respective industries. Each of these six core brands has annual sales of over 1.5 billion yuan.
Dali Foods' 2016 annual report showed that its revenue increased 5.8% year-on-year to 17.842 billion yuan; gross profit increased 17.6% to 6.84 billion yuan; net profit increased 7.7% to 3.137 billion yuan; earnings per share were 0.23 yuan.
4 Can the Short-Selling Succeed? Daniel David believes that China Want Want, a relatively mature peer, has higher advertising expenses than Dali, but its sales ranking is far lower than Dali's. Dali's advertising and other expenses in 2016 decreased significantly compared with 2015, operating expenses were less than half of peers, and marketing staff salaries were almost the same as production line workers, which is unbelievable. Additionally, Daniel David claimed that Dali's capital expenditure before IPO was about 8%, but after IPO, capital expenditure increased significantly, yet the business did not develop much. He believes Dali's financial engineering is dazzling, and the company's capital expenditure in 2013 and 2014 differed by more than 1 billion yuan from industry experts' calculations.
Although the market reaction today was a 6% drop in stock price, this may be a reflexive response to the short-seller's high win rate. Looking at the reasons given by the short-seller, they may not hold up.
First, it says Dali Foods' advertising expenses are lower than China Want Want, but its sales performance is far better than Want Want. The short-seller only made a hasty analysis using data without a detailed understanding of the market. The gap may be due to the two companies' own development. Want Want itself has development problems. Its main products are rice crackers, leisure foods, and dairy drinks. After 2008, dairy drinks became Want Want's pillar product, at times accounting for more than half of its revenue, driven mainly by Want Want Milk. But later, Want Want failed to keep up with major dairy companies like Mengniu and Yili in entering the room-temperature yogurt market, and Want Want Milk sales declined year after year. In contrast, Dali Foods' main products and development direction align with the trend of consumption upgrading, so it does not need to spend heavily on advertising. When one brand is rising and another is falling, it is normal for Dali's sales to surpass China Want Want.
Second, it says Dali Foods' marketing staff salaries are similar to assembly line workers, which is unbelievable. According to online information, Dali Foods' sales staff average salary is around 4,000 yuan, which is not very low. Being lower than China Want Want's same-level staff is normal. Moreover, Dali Foods has high personnel utilization, with far fewer sales staff deployed than China Want Want, which is also one reason for Dali's higher net profit margin.
At least the above two short-selling reasons do not seem very convincing. On the evening of the 7th, Dali Foods responded that it was not yet fully aware of the short-selling situation and was not convenient to respond. Whether to suspend trading would depend on the market situation tomorrow.
5 Dali Foods Refutes Doubts One by One, Short-Seller Says Judgment Unchanged After the market opened today, Dali's stock price rebounded.
Refutation 1: Regarding advertising expenses Dali stated in its announcement that CTR reports typically use media card rates for advertising data collection, so companies ranking high in CTR reports have annual media expenses in the billions. "But in reality, no company needs to pay such huge advertising expenses; there is a huge discount rate," and "discount rates vary by dozens of times between different TV stations."
Dali's advertising expenses from 2014 to 2016 were 324 million yuan, 324 million yuan, and 375 million yuan respectively, with relatively stable growth. There was no significant increase in Dali's advertising expenses. FG Alpha's claim that Dali's A&P expenses (4.84 billion yuan, 10.86 billion yuan, and 15.63 billion yuan from 2014 to 2016) increased significantly was due to rising promotional expenses, not mainly media advertising expenses.
Dali believes that FG's accusations about advertising expenses not only cite data that is not strongly correlated with Dali's financial data but also fail to conduct in-depth analysis of Dali's disclosed advertising expense data.
Refutation 2: Regarding suspicious cash advances from controlling shareholders before IPO In response to the above doubts, Dali stated in its announcement that in 2012 and 2013, the group's new factories under construction or in operation required substantial funds to build plants and production lines, in addition to initial shareholder capital.
When considering financing methods, the reasons for not choosing bank loans and capital increases were: 1) bank loans had higher financing costs; 2) capital increases had relatively complex procedures; 3) capital increases might increase future restructuring costs.
Advances from controlling shareholders are a common financing method for unlisted private enterprises in mainland China, with low capital costs (interest-free) and flexible fund flows. Moreover, all amounts due to controlling shareholders were fully repaid before June 30, 2015, and no such borrowings have occurred since, fully complying with regulations. Therefore, Dali believes that "FG Alpha's doubts have no basis."
Refutation 3: Regarding capital expenditure Dan David questioned yesterday that after consulting industry experts, he estimated Dali's capital expenditure for 2013-2014 at about 1 billion yuan in total, lower than the amount reported by Dali.
In response, Dali stated in its announcement that capital expenditure for 2013-2014 was disclosed on page 234 of the prospectus. "From 2012 to 2016, Dali's capital expenditure as a percentage of revenue was 11%, 8%, 5%, 3%, and 3%, with an average of 6%, which is reasonable and low compared with comparable companies' 7%-13%."
Dali pointed out that FG claimed to have cited expert estimates that the company's capital expenditure was higher than actual needs, "but did not provide the experts' estimation methods or basis."
Refutation 4: Regarding operating expenses and salaries As for David's point that Dali's operating expenses and salaries were far lower than listed peers, Dali explained in its announcement that its selling and administrative expenses as a percentage of revenue from 2012 to 2016 were 8.3%, 8.3%, 9.1%, 14.1%, and 18.0%. The relatively low ratio (especially in 2012-2014) was due to:
- Dali's sales model gives distributors relatively low ex-factory prices, increasing their gross margins, and distributors bear most of the sales work and expenses, including most promotional and personnel costs, which differs from some listed competitors;
- Dali's headquarters is in Hui'an, Fujian, a county-level city, where typical monthly salaries for headquarters management are about 8,000 yuan, and office expenses are low;
- Since 2014 and 2015, with the rapid growth of the high-margin beverage Lehu, Dali adjusted its sales model, raising ex-factory prices and increasing its own promotional and personnel costs. Lehu has grown rapidly since its launch in 2013, causing Dali's selling and administrative expenses to rise to 18.0% in 2016;
- Dali's disclosed operating expenses are consistent with its business model. If using operating profit margin, which more comprehensively reflects overall profitability, Dali's 2016 operating profit margin was about 20%, a normal level;
- Dali's average monthly salary per employee is about 4,200 yuan, a normal level in the industry. Production workers and frontline sales representatives together account for 77%, a relatively high proportion compared with peers. These employees typically earn about 3,000 yuan per month, and most frontline sales representatives receive part of their income from distributors.
Refutation 5: Tax data inconsistency Dali stated in its announcement that in 2015, Dali PRC (full name "Dali Foods Group Co., Ltd.") paid taxes of 345 million yuan on a parent company basis (not consolidated), consistent with the total tax paid in the State Administration for Industry and Commerce system in 2015.
Regarding FG's mention of Fujian Dali (full name "Fujian Dali Foods Group Co., Ltd."), the announcement said that Fujian Dali and Dali PRC are two different companies. Fujian Dali is now a company outside the listed entity, while Dali PRC is a wholly-owned subsidiary of the listed company. "Their tax or industrial and commercial information is not comparable."
Dali confirmed that neither Dali Foods Group Co., Ltd. nor Fujian Dali Foods Group Co., Ltd. has the tax data issues pointed out by FG.
Short-seller says confidence is stronger Just after Dali released its announcement, Dan David gave an interview to Bloomberg this morning. When asked by the Bloomberg reporter why he shorted Dali, he reiterated the doubts he raised yesterday and said he had noticed Dali's announcement today. "I took a quick look, and I am more confident in my view than yesterday," Dan David said.
In addition, in the interview video, Dan David also said that he believed Dali's explanation of operating expenses was "unreliable and cannot be true."
"Saying it's because you operate in a low-cost environment is stupid. Because those mature peers have been in the industry for a long time. If moving equipment (and office locations) could save two-thirds of operating costs, they would have known and done it long ago. If they could cut half of their salary expenses, they would have done it long ago. Such a statement is unreasonable. We still haven't heard a reasonable explanation for this issue today," Dan David said.
Compiled by New Distribution from Food Observer, Tencent Finance, and Foodinc
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