Is Yongye in the Clear?

My fellow Fool Rich Smith was fired up about the announcement from Yongye International (Nasdaq: YONG  ) earlier this week, as were investors -- they sent shares soaring 42% on Tuesday.

As I covered in brief, the ecstatic reaction was due to the dual announcements of Morgan Stanley's (NYSE: MS  ) Asia private-equity unit investing $50 million in the company and the company's CEO, Zishen Wu, pledging to buy up to $3 million in stock on the open market.

Given that Chinese reverse-merger stocks have been a very polarizing topic, I fully understand that by trying to take a sober look at the situation at Yongye it's very likely that I'll be simultaneously labeled a short by the longs and a dupe by the shorts. But try I must.

The good
If the news could be summed up in a word, it's "credibility."

For those who haven't followed closely, the world of Chinese small caps has been rocked by fraud accusations, spanning from collapses of stocks like RINO International and China MediaExpress, to the ongoing trading halts at Wonder Auto Technology (Nasdaq: WATG  ) , China Integrated Energy (Nasdaq: CBEH  ) , and Shengdatech (Nasdaq: SDTH  ) , and, of course, the ground-shaking fraud at not-so-small-cap Longtop Financial (NYSE: LFT  ) .

Investors have been hoping for some sign they could trust that -- unlike the companies above and in spite of short-seller reports attacking the company -- the numbers and the business at Yongye are sound and reliable. Tuesday's news demonstrates that not only is a major, global financial firm willing to put its money into Yongye, but the CEO is putting his own personal money where his mouth is.

And to be sure, Morgan Stanley's Asia P/E arm is no piker that's throwing around money from afar. Its team has invested $1.8 billion in Asia investments over the past 15 years. Homer Sun, who is set to join Yongye's board, is a managing director and part of MS' China Management Committee, which is described as "the firm's senior business leaders within China." He already sits on the board of multiple other Chinese companies. To hear Sun say that MS has performed "extensive due diligence" should carry some serious weight with investors.

Yongye is also giving Sun significant power in the form of veto power that would allow him to block a variety of moves from related party transactions exceeding $100,000 to major acquisitions and asset sales.

The bad
There isn't a whole lot that is directly bad from these announcements, but we shouldn't overlook the fact that Morgan Stanley's investment isn't on the level with every other average Joe's investment. The preferred shares put MS above common shareholders and even though the dividends are being paid in the form of shares, that's still a return that holders of the common aren't getting (not to mention a dilutive cost to them).

Additionally, the initial conversion price of $8.80 has been highlighted as significant since it's well above today's $5 and change, but it's also notable that the initial liquidation preference on the preferred is also $8.80. That means that if anything goes wrong and it comes down to divvying up Yongye's assets, each preferred share needs to be paid out $8.80 before anything trickles down to the common.

Finally, the power that MS has been granted on the board cuts both ways. While the bright side is that MS can block potentially harmful actions, it can also block actions that might be great for holders of common shares, but not ideal for MS' preferred investment. They can, for instance, block both dividends and share buybacks.

The yet unknown
There have been a heck of a lot of surprises when it comes to fraud at Chinese companies. Major auditing firms have been fooled, global investment banks have vouched in IPOs, and supposedly savvy investors have been taken for a ride. The alleged fraud at Longtop has been particularly jaw-dropping as there were apparently bank tellers in on the grift and lying to auditors. So it's not a complete stretch to think that Morgan Stanley could be getting played here.

That said, to me at least, the fraud case against Yongye has been pretty weak as compared to the cases against many of the other companies. Many of the supposed fraud red flags that have been cited -- the coal mine purchase and the customer list acquisition for instance -- could just as easily be poor business or capital allocation decisions as evidence of fraud. Just because MS has determined that management isn't siphoning money out of the company doesn't mean that it isn't making poor decisions with shareholder money.

On a related note, the company reported nearly $45 million in cash on the books at the end of the first quarter and is also starting to show meaningful cash flow from operations. The $50 million from MS will give the company a very significant amount of dry powder and the ability to quickly squander shareholder value through large, overly ambitious expansion plans or acquisitions. MS will have a check on this through its veto power, but as noted above, its incentives aren't perfectly tied to common shareholders.

Follow along to China
I recently said I was throwing in the towel on going either way on Chinese small caps. Admittedly, my timing was pretty impeccable (sarcasm intended) with regard to the announcement from Yongye, but it doesn't change my overall view of the group -- shenanigans have been so widespread and nasty and individual investors are generally at such a large informational disadvantage that investing in these companies seems pretty Sisyphean.

However, there are ways to get around that informational disadvantage, and one is to travel to China and do some of your own on-the-ground due diligence. And if that's outside of your scope, you can also find a trusted source that'll do that on your behalf. Two of my fellow Fools from Motley Fool Global Gains are about to do just that -- head to China and do some first-hand tire-kicking. You can sign up to get free dispatches from their trip and keep up with what they uncover.

The Motley Fool owns shares of Yongye International. Motley Fool newsletter services have recommended buying shares of Yongye International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (11) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2011, at 3:57 PM, anopenmind wrote:

    Speaking of timing, note June 2 Wall Street Journal page C14 article "Private-Equity Bulls in China Swap".

    Not only Morgan Stanley, but Carlyle Group, Roth Capital, and Bain are targeting Chinese small-cap firms listed in our U.S. Quote within article, "private-equity funds see value emerging".

  • Report this Comment On June 02, 2011, at 4:26 PM, Gonzhouse wrote:

    As you read all the comments to the slew of stories on TMF over the last couple of days about the YONG situation, your note above "individual investors are generally at such a large informational disadvantage that investing in these companies seems pretty Sisyphean" is the best summary of how we feel.

    A lot of us note the China opportunity and truly appreciate the DD from the Global Gains team but can't stomach the dicey reporting. I've done quite well on Chinese companies but pulled out.

    As far as throwing in the towel, better to toss it than have it erupt in flames.

  • Report this Comment On June 02, 2011, at 6:49 PM, network2 wrote:

    Why would the company need $50 million in working capital if they are really turning the kind of profit and holding the kind of cash balances they claim? They already have all the leverage they need and the PRC government support to continue dominating their market niche in China. After all, they get their money up front from the distributors. This is an envious position to maintain earnings to equity and capital ratios. Why would they issue this stock as preferred, obligating themselves to pay out dividends to a select group of Asian investors first? What is the conversion ratio from preferred to common and with Board support is this likely to be enhanced for MSPAE in the future? Likewise, why would Wu invest $3 million of his own money if Yongye was really sitting on the piles of cash reported in their financials? This is just outright dilution of the shares and not in the interest of existing common shareholders. Or it is possible Yongye is maneuvering to pull out of the NASDAQ and go private, as some other China startups have done just in recent days. There are lingering questions. What quantities of product are stores required to put on their shelves as a qualification to join the distribution network? Is the product really moving? Take a look at the photos of company branded stores and see the enormous quantities of spray sitting on the shelves. Frankly, I do not think most analysts understand the product Yongye sells. This is not fertilizer sold by the ton to farmers. Foliar feeding has been around for a long time, and farmers can produce their own foliar feeds at very little expense, just from waste products on their own farms, such as weeds and fishmeal. The arguments over the benefits between humic acids and fulvic acids have never been resolved. Some argue, both humic and fulvic acids are necessary for optimal crop nourishment because they work together, and one without the other is less effective. But other possibly more effective surface penetrants are also available. Do we have reliable geological surveys showing the molecular weight of the lignite strip mine Yongye is attempting to acquire? Then again, is there confusion in the SEC documents between "tonnage" of productive capacity and "tonnage" of bottles of foliar spray concentrate sold resulting from differences between Imperial tons and American tons and the capacity ratings stamped on machine plates?

  • Report this Comment On June 02, 2011, at 8:03 PM, jekoslosky wrote:

    Good points here, Matt. I'm still pretty skittish about anything Chinese at this point. (Except the food.)

    I hope YONG is legit. I'll feel better for having not been duped, even though I got out.

    And as for impeccable timing, I'd just blogged the day before this announcement about why I bailed on Yongye. stocksnovice.blogspot.com

    At least it gave me fodder for a follow up.

  • Report this Comment On June 02, 2011, at 11:51 PM, TMFKopp wrote:

    @network2

    Wow... there's a lot there...

    A couple quick thoughts. First of all you can find answers to a lot of your questions about the MS transaction in the 8-K filing: http://www.sec.gov/Archives/edgar/data/1398551/0001144204110...

    According to the company the $50 million will be used for a variety of things, including capacity expansion. So not just working capital. If I put on my Yongye bull cap, I'd answer your concern by saying that yes, the company has cash and is generating operating cash flow, but it has big expansion plans so it needs the additional cash.

    Also, the CEO's investment will be buying shares in the open market, not buying new shares from the company. So this is not more cash that will end up in the company's coffers and it will not lead to dilution.

    As for the broader "why" of both the MS transaction and the CEO's investment -- as I noted in the article, it seems like it may be more a matter of giving the company credibility rather than cash.

    Matt

  • Report this Comment On June 02, 2011, at 11:55 PM, TMFKopp wrote:

    @jekoslosky

    I'm with you on Chinese food. Particularly right now since I haven't eaten dinner yet...

    Since it's ended up that I don't really have a dog in the fight, I guess I'm not particularly pushing for a particular outcome on YONG. However, I believe there have to be at least a few of these RTOs that aren't frauds and I think YONG is a pretty good candidate to be a non-fraud.

    If you read through a lot of the short cases against other RTOs, there have been some pretty damning cases made. With YONG, I haven't seen anything yet that's really made me sit up and say "Wow, that's terrible."

    Matt

  • Report this Comment On June 03, 2011, at 1:46 AM, seasaw6499 wrote:

    you are wrong on 2 fronts. First, the investment by Morgan Stanley, if it occurs, adds not one single bit of credibility to YONG, just as the purchase of CCME of Herb Greenberg's CV Star fund added not one bit of credibility to CCME. To determine the company's credibility, you have to look at the actual company, not at who is investing (look at SNOFF today exposed by Muddy Waters - John Paulson owning over 30 million shares or about $650 million dollars of stock did not add a single bit of credibilty to the company, since it is a fraud).

    These brings me to the second point - that the case against YONG being a fraud is weak. You are completely wrong. The case that YONG is a fraud is airtight becaus it is a fraud. Read the seekingalph articles by Business Economics Analyst and others.

    Just as I repeatedly stated that it was very obvious that CCME was a fraud from 15 minutes of reading its business plan in its SEC filings, YONG"s story is even more ridiculous and any reading the business plan in the SEC filings should be able to figure it out within 15 minutes to 1/2 hour. Their story is utterly absurd and ridiculous and not possible in any real world, but only in some imaginary world where fantastical impossibilites can occur.

    I am not sure why you cant' see this but if you educate yourself, you should find it pretty obvious.

  • Report this Comment On June 03, 2011, at 2:29 PM, TMFKopp wrote:

    @seasaw6499

    I have a feeling that you may be letting a bearish view (possibly a short position?) get in the way of seeing the situation from a realistic perspective.

    "First, the investment by Morgan Stanley, if it occurs, adds not one single bit of credibility to YONG"

    Um, first, *Herb* Greenberg is a CNBC contributor. I think you mean *Hank* Greenberg's fund.

    That investment took place before all of this was blowing up. Perhaps there was some laziness or corner-cutting going on with Starr's diligence. It's similar for Paulson & Co. -- it began buying up shares of TRE in '08, before everyone was clucking about China RTOs.

    But anybody investing in any of these RTOs now is going to have the advantage of being on guard and having many of the short-seller points in front of them so that they can specifically check those out.

    Unless, of course, you're suggesting that MS's PE fund doesn't have access to the internet and therefore has no idea what people have been saying about YONG?

    Not to mention that most of (all?) the short takes against YONG have come from U.S.-based investors that haven't (ever?) been to China. As noted above, MSPEA is on the ground and has been investing in Asia for 15 years.

    "The case that YONG is a fraud is airtight becaus it is a fraud."

    I'm not even sure what I can do with this fantastic circular logic.

    Short sellers have found a lot of very damning evidence on a lot of companies -- from mismatched regulatory filings, to non-existent bank deposits and factories that aren't actually in operation. I haven't seen anything along those lines presented on YONG. In fact, I'd be interested if you could point me to any of the short-side research on YONG where the author actually made a trip to China to check things out.

    I'm not saying there's a guarantee that YONG isn't a fraud, but the case is nowhere near as airtight as you seem to think.

    And I'll go ahead and ignore your final condescending jab because I'm staring at the text next to the comment box that says, "Please be respectful with your comments."

    Matt

  • Report this Comment On June 03, 2011, at 5:49 PM, diamondsarerare wrote:

    There is still no proof that Yongye's products actually work.

  • Report this Comment On June 03, 2011, at 6:15 PM, TMFKopp wrote:

    @diamondsarerare

    Which we could say about a lot of things that people buy anyway.

    A "snake oil" product may not be a desirable business to own, but if that's much different than if the company were inflating revenue or reporting non-existent cash balances.

    Matt

  • Report this Comment On June 09, 2011, at 2:57 AM, wllmd wrote:

    I am in China and understand Chinese. Based on the information on Chinese web sites. Farmers are reluctent to use the company's product again after the initial try.

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