Editor's note: This article has been updated to correct the assumptions about current production levels at L&L Energy's four operating mines. The Fool regrets the error.
The more investors learn about widespread fraudulent practices occurring within China's corporate realm, and particularly as the pressure applied by short-sellers forces companies under the microscope, the burden of satisfying investors that operations in China are reported accurately and transparently has landed squarely upon the shoulders of each individual company that is called into question.
Following a relentless 65% collapse from the stock's 52-week peak, the time has come to place Seattle-based L&L Energy (Nasdaq: LLEN) -- a small-cap operator in China's bustling coal industry -- under the Foolish microscope. As an impartial observer with no investment in the stock, I seek only to assist readers in performing their own due diligence on a stock that combines an enticing growth story with some visible red flags. After presenting my own findings, I will then share the company's written responses to my research questions to ensure all our bases are covered. As always, however, you will have the final word by discussing your own assessment of the risks and potential rewards.
The enticing growth proposition
L&L Energy's principal growth strategy, within what is truly a booming global market for coal to fuel China's seemingly insatiable demand, hinges upon the acquisition of small-scale coal mining operations at a time when small independent operators face an official state mandate to ramp up annual output to a minimum of 300,000 tons. While absorbing and expanding several newly acquired mining operations in China's Yunnan and Guizhou provinces simultaneously, L&L Energy continues to amass a vertically integrated presence in the region that includes coal washing, coking, and wholesale services.
Bolstering the forecast expansion of output from the company's four operating mines, L&L has secured 1 million tons of "super compliant" thermal coal supply from the Bowie mine in Colorado, which will be shipped to the port of Zhanjiang and blended with L&L's own product to enhance overall pricing. In a related move, L&L Energy is also conducting a feasibility study for a proposed coal blending and distribution facility at Zhanjiang.
As you can see, L&L energy has a lot of irons in the growth fire all at once, such that successful execution on just a few of these initiatives could conceivably drive some meaningful momentum going forward. L&L Energy reports that each of its four operating mines presently yields about 150,000 tons per year and that all four will ultimately double in scale to produce 300,000 tons per year (for a targeted combined capacity of 1.2 million tons). Meanwhile, the company's coal washing and other vertically integrated operations appear to be driving some nice revenue growth of their own, with the recently formed, 98%-owned Tai Fung joint venture in Yunnan province forecast to generate $81 million in annual revenue.
As terrific as this growth story looks on paper, and as deeply undervalued as the shares may prove to be if the company can deliver on its aggressive growth targets, the first order of business is for the stock to break free from the intense selling pressure that has presently ensnared all manner of U.S.- and Canadian-listed stocks with operations in China.
Particularly after Sino-Forest came under the market's microscope earlier this month for questions relating to its reported timber holdings, the sell-off has spread to companies that offer little cause for concern. For Yongye International (Nasdaq: YONG), it took a $50 million private-equity investment from Morgan Stanley (NYSE: MS) to reverse a painful decline. Silvercorp Metals (NYSE: SVM) CEO Rui Feng laments: "People got very emotional and started to dump everything related to China." For L&L Energy, the challenge is to restore confidence among "shell-shocked" Western investors through utter transparency, a specific road map and timeline for achieving stated growth objectives, and by delivering the goods in the form of rising income. Fortunately for L&L Energy, to date that income growth has indeed served to corroborate the underlying growth story.
Where the red flags begin
Without seeking to belabor a set of issues that have been raised elsewhere, and may indeed have contributed to the stock's painful retreat, these facts are nonetheless relevant to an investor's process of due diligence.
During the years before the company began operating in China's coal industry in 2006, founder and CEO Dickson Lee got himself into a bit of hot water with the Financial Industry Regulatory Authority. Lee was fined $65,000 and was suspended for a period of one year from the National Association of Securities Dealers for a series of allegations relating to the sale of stock in one of L&L Energy's several corporate predecessors. Securities regulators of four U.S. states issued cease and desist letters to L&L Financial Holdings relating to allegations that included a failure to disclose to investors that 35% of gross proceeds were awarded as commissions to L&L's investor relations executive, and (specific to the state of Washington) the unauthorized sale of securities. Because Lee was both a CPA and a registered securities broker at the time, I think it's fair to interpret those events collectively as a cause for some concern.
L&L Energy's executive vice president of U.S. operations, Clayton Fong, served the administration of President George H.W. Bush in multiple capacities, but it is the manner in which he was ousted as CEO of the National Asian Pacific Center on Aging in 2009 that commands our Foolish attention. John Quoc Duong, then-chairman of that organization's board, told The Seattle Times: "We lost confidence in this person to lead the organization." He told another publication: "We concluded that a number of his actions and conduct fell short of the standards we set in our policies and bylaws." Further details regarding what may have precipitated that decision were not uncovered in the course of my research.
Gene Michael Bennett, whose role as director and audit chairman for China Shen Zhou Mining and Resources (AMEX: SHZ) was cited by Absaroka Capital Management in March as "part of the reason why we initially got concerned" about that company, spent three short months as CFO of L&L Energy before resigning in May of 2008 to pursue a doctoral degree. Alleged inconsistencies in Bennett's biographical record, along with alleged failures to comply with his audit committee's own rules, have not helped that company's cause. Although Bennett's tenure at L&L Energy was brief, and just because some executives were accused of having done sketchy things in the past doesn't mean they are doing them at L&L currently, but if an unfortunate pattern begins to emerge among some of the executive personnel associated with L&L, that is not likely to aid the company's efforts to distinguish itself perceptually from high-profile disaster stocks such as Puda Coal (AMEX: PUDA) and Longtop Financial (NYSE: LFT). Helping to counteract the above-noted issues, however, former U.S. Secretary of Transportation and Secretary of Commerce Norman Mineta serves as vice chairman of L&L's board, while former director of the U.S. Mint Edmund Moy serves as vice president for corporate infrastructure.
Getting to the heart of the matter
More troubling than the matters discussed above, I detected throughout my examination of the company a pattern of peculiarities, inconsistencies, and vague rhetoric that undermined my own personal confidence in the underlying story. For starters, we have the vague set of core competencies that L&L Energy frequently touts, epitomized by this gem from the company's website: "L & L possesses the analytical skills to improve coal mining standards in China, giving L & L a competitive edge in the industry." I have good analytical skills ... perhaps I should start my own coal company.
Elsewhere, the company has stated: "The application of U.S. mining management and safety practices is a strategic advantage for L&L in China." Since the company acquired its first coal mining operations in 2008, has never operated a mine in the United States, and has painfully little to offer in the way of prior coal-industry experience among senior management, that claim also strikes me as something of a stretch. Subsequently, while reviewing the company's corporate presentation (see Page 22 of this PDF), I found troubling from a safety standpoint the image of a miner dumping the contents of a coal car over a precipice with no apparent use of safety apparatus.
Looking into the numbers for L&L Energy's coal reserves, things get even more confusing. The website claims 60 million tons of coal reserves, while its corporate presentation counts only 38.2 million tons. The website previously made mention of a development property called Tian-Ri with coal reserves of 53 million tons, but presently neither the website nor the presentation make mention of the project at all. L&L Energy currently estimates reserves at the Ping Yi mine at 13.5 million tons, which is a very far cry from the 31 million tons claimed in a 2009 press release.
The numbers do not get much clearer on the production front, either. The corporate presentation is clear in establishing recent baseline production at each of the four mines at about 150,000 tons per year, for about 600,000 tons before the targeted expansion to 1.2 million tons (300,000 tons per mine). However, in an April 2011 interview with Dave Gentry of public-relations firm RedChip Cos., L&L CEO Dickson Lee described current production at the Ping Yi mine of 450,000 tons, 300,000 tons at DaPing, and about 500,000 tons total at the remaining two mines. So current production volume for L&L Energy apparently lies somewhere in the margin between 600,000 tons and 1.25 million tons, and the absence of production volume data within L&L Energy's most recent earnings statement makes it difficult to track the progress of that expansion in a timely way. I encourage L&L Energy to offer investors increased clarity on current volumes and the progress of ongoing expansions in future filings..
Click here for Part 2 of this discussion, in which you will find answers from L&L Energy to several of the questions that arose over the course of my examination of the company. In the meantime, consider this timely advice from money manager Arthur Salzer: "Before you buy a company operating in China, due diligence above and beyond what you would perform on a Western company is needed." To aid in that process, researchers with the Motley Fool Global Gains team have traveled once again to China to pinpoint the companies that survive their collective scrutiny; and it's not too late to receive free email dispatches for the remainder of their trip.
- Add L&L Energy to My Watchlist.
- Add Yongye International to My Watchlist.
- Add China Shen Zhou Mining & Resources to My Watchlist.
- Add Silvercorp Metals to My Watchlist.
