On the morning of March 24, 2017, shares of Hong Kong-listed Huishan Dairy (6863.HK) suddenly plunged 85% in just half an hour, setting a record for the largest drop on the Hong Kong Stock Exchange. This is a historic moment, so please remember it well for future bragging rights. So what exactly happened? As early as March 3, we at Sanqian Erliang (ID: ThreeQian) had published an analysis of Huishan Dairy, and today we take this opportunity to walk you through the entire saga from start to finish. Grab a seat and some snacks, here we go! After being shorted aggressively by Muddy Waters for two months, Huishan Dairy: Oh. On December 16 and 19, 2016, the renowned short-selling firm Muddy Waters Research released two consecutive reports shorting Huishan Dairy (6863.HK), causing the latter to suspend trading temporarily on the morning of the 16th, with its share price falling 2% to HKD 2.75 that day. That same night, Huishan Dairy issued a clarification announcement. We won't dwell on Muddy Waters' past track record, but here's one example: Oriental Paper (US ticker: ONP), which was shorted by Muddy Waters, was hit so hard that it never recovered, and has remained in a coma ever since... So how did Huishan Dairy get on Muddy Waters' radar? 1. Huishan Dairy is a dairy company covering the entire industry chain, with operations spanning forage planting, dairy cattle farming, and the production and sale of liquid milk and milk powder. It listed in Hong Kong in 2013 and currently has a market capitalization of HKD 38.3 billion. Since the company is rooted in Liaoning Province, and I have long been based in the south, I had never heard of their products. If any of you know them, feel free to speak up. In its early days, Huishan Dairy simply raised cows, milked them, and dabbled in agricultural products—a very natural, fresh business. As of September 30, 2016, the company's cattle herd had reached 200,000 head, making it a true large-scale breeder. Annual revenue was also expected to reach RMB 5 billion. But in 2011, the company suddenly changed course and entered the liquid milk sector, starting to sell milk powder the following year, continuously extending downstream. Today, liquid milk has become the company's main revenue source, accounting for 69% of total revenue. What happened in 2011? According to the prospectus, Huishan Dairy began hiring an external company to process its liquid milk products in 2011. The "Shenyang Dairy" mentioned in the chart is jointly owned by Huishan Dairy's chairman, Yang Kai, and his wife. It now rents out some buildings and land to Huishan Dairy, keeping a low profile. 2. Huishan Dairy not only successfully transformed its business but also made money hand over fist. According to Bloomberg, the company's adjusted profit margin over the past 12 months was 11%, compared to only 8.6% for Yili and 4.0% for Mengniu. Behind this profitability is one of our protagonists: alfalfa. In dairy farming, feed accounts for 60% to 70% of costs, with forage making up 60% of feed. Alfalfa is a key forage that increases milk yield and protein levels. It is heavily dependent on imports and is expensive, costing USD 400 per ton. Huishan Dairy's brilliance is simple: it grows its own alfalfa. The company owns the largest alfalfa production base in China. According to its annual report, it harvested 140,000 tons of alfalfa in fiscal 2014 at a cost of just USD 92 per ton. Let's do the math: factoring in savings on transportation costs and using an exchange rate of 6.2, the annual savings amount to [(400-92)*6.2+600]*140,000 = RMB 340 million, accounting for 27% of that year's net profit (excluding taxes). How can other dairy farmers compete with that? The idea of growing your own alfalfa is so genius that I personally am in awe, but some people are envious—namely, the short-selling firm Muddy Waters mentioned earlier. In Muddy Waters' short report, the first point of attack was precisely the alfalfa. After months of investigation, they claimed to have discovered that Huishan Dairy had actually been importing large quantities of alfalfa from a company called Anderson Hay & Grain, and they even took photos. Of course, Huishan was not to be trifled with and responded forcefully in its clarification announcement. So the question arises: if Huishan Dairy really imported large amounts of alfalfa from third parties, how could its profits still be so high? On this issue, Muddy Waters unleashed its second major attack, alleging that Huishan Dairy inflated capital expenditures on its pastures to move high operating expenses off its income statement (for those unfamiliar, you can search online for "capital expenditure fraud"), involving amounts as high as RMB 900 million to 1.6 billion. Of course, Huishan Dairy again responded forcefully in its clarification announcement. The two issues above were the most impactful in the short report; other minor issues are omitted here. 3. On the same day Muddy Waters released its short report, Huishan Dairy's chairman, Yang Kai, increased his stake by nearly 25 million shares, which is why the stock price showed a long lower shadow that day. On December 19, Chairman Yang increased his stake by another 21 million shares, very steady. After that, Huishan Dairy's stock price remained stable, in stark contrast to Oriental Paper's fate, and Muddy Waters was inwardly frustrated. In fact, if we compare the stock prices of Yili, Mengniu, Modern Dairy, and China Shengmu, Huishan Dairy (white line below) was almost too stable... The main reason is that Chairman Yang and his wife hold nearly 9.9 billion shares in total, accounting for 73% of the total share capital, so outside small players couldn't cause much of a stir. However, nearly 3.4 billion of those shares were pledged to Ping An of China, representing 34% of their holdings. So it's not that they didn't allow shorting; it's that the stock really couldn't afford to fall, my friend... (I am the divider) Today's plunge is rumored to be due to an audit by Bank of China that revealed RMB 3 billion in funds had been misappropriated. So, what was the money used for? Real estate speculation! In fact, I have great admiration for the chairman's speculative abilities. On one hand, he pledged shares to stabilize the stock price, and on the other, he misappropriated funds to speculate in real estate. He has a deep understanding of leverage and uses it with ease. Out of curiosity, I asked another question: "Where did you buy the property?" "Shenyang." "......" If the misappropriation of funds is confirmed, it would be far more serious than the alfalfa or capital expenditure fraud, and the company would likely never recover. I estimate... even Muddy Waters didn't expect this outcome... But the most innocent party in all this is probably Ping An of China, because there's no doubt that the pledged shares have triggered a stampede. But don't forget, the shares pledged to Ping An are worth over HKD 2 billion... So when the market opened in the afternoon, Ping An's stock took a direct dive... My friend, didn't you say you'd lose if it dropped a cent???!!! Some onlookers even suggested this was a "hit from afar," with the real intention being to short Ping An... I thought about it and couldn't really refute that... Some cunning friends also asked me: "Great, can we buy the dip?" "Why would you catch such a falling knife?" "Muddy Waters! When do you think they'll cover their short positions?" "Oh, so did you buy?" "Yes, just a few minutes before the close. Luckily, I was quick, and it's already rebounded!" "Then when do you think Huishan Dairy will suspend trading?" "......" Once suspended, who knows when trading will resume. Do you all remember Hanergy, which suspended trading on May 20, 2015, by Daming Lake? Yes, it's been almost two years now, and Hanergy is still by Daming Lake... Maybe Huishan Dairy is going to join it... As of the time of writing, Huishan Dairy's chairman has already responded: His tone is very calm, still the same formula, still the familiar flavor... Source: Sanqian Erliang (ID: ThreeQian) -END-