Long Read: Hongqiao’s Trials and Tribulations in 2017

The world’s largest aluminium firm has had a challenging year. From a series of damaging anonymous reports from short sellers to seeing its stock crashing down as a result, 2017 has been a minefield for China Hongqiao Group. According to critics, the company is scarcely out of danger, as it has a myriad of explosive obstacles ahead of it yet to address in 2018.

After leapfrogging Russian Federation aluminium major Rusal in 2015, Hongqiao’s meteoric rise to dominance in the global aluminium production sector has made it a lightning rod for controversy. Unfortunately for the Shandong-based enterprise, storm clouds building in 2016 – after half of its production capacity was found in breach of Chinese environmental rules and was shut down  – rolled in over the company this year. And, if recent developments are a barometer, there are likely more and stronger storms just over the horizon.

Hongqiao began the year fighting off a report released late in November by an anonymous short seller accusing the company of passing off its gargantuan debt load to related companies in order to pad its profit numbers. According to the report, public records showed Hongqiao receiving cherry deals for energy from family and associates of the firm’s founder Zhang Shiping. Per the report, Gaoxin Aluminum and Power (Gaoxin) is inextricably tied to Weiqiao Pioneering, which they characterized as a personal conglomerate under the control of Zhang. The energy deals entered into between Gaoxin and Hongqiao allowed the latter to show stunning profits, they alleged, but saddled Gaoxin with significant net losses in the previous two years.

The report also claimed that two allegedly related-party transactions raise red flags – the purchase of Binzhou Municipal Binbei New Materials Co Ltd (Binbei) from Shandong Binbei New Materials Co (Shandong Binbei) for CN¥1.896 billion, and the acquisition of Binzhou Beihai Xinhe (“BBX”) from CITIC earlier in 2016. Per the short sellers, the price Hongqiao paid for Shandong Binbei, which allegedly shared top personnel with Hongqiao, was significantly underreported, while the purchase of BBX was purportedly carried out in order to obscure previous ownership of BBX by Shandong Binbei. Altogether, the short sellers allege Hongqiao’s true debt load at that time to be CN¥67.7 billion when the alleged missing funds are rolled into the firm’s financial picture.

As winter turned to spring, Hongqiao faced another devastating report from short sellers. A group of “seasoned equities analysts” calling itself Emerson Analytics charged Hongqiao with under-reporting debt and receiving related-party subsidies to such an extent that, according to their numbers, the company’s debt load was in the neighborhood of CNY21.6 billion (US$3.15 billion). According to Emerson’s report, Hongqiao’s stock was grossly over-valued, possibly by up to 60 percent. Upon the release of the report, the stock began to shed a chunk of the allegedly over valuation. The day following the report’s release, Hongqiao’s stock plummeted 8.3 percent before the company frantically called for a halt in trading.

Hongqiao soon found itself facing even greater problems. Within days of the halt in trading the firm sent a letter to China Nonferrous Metals Industry appealing for help. According to the letters (which were subsequently leaked to the press) Hongqiao warned that the recent allegations of hidden debt could be damaging, if not devastating, if they were not quelled soon. The letter admitted that the firm was in debt to the tune of CN¥200 billion, and that continued financial challenges only magnified the damage the company was enduring. Hongqiao also indicated that it was having difficulty managing its outside auditor Ernst & Young, and asked for help in negotiating with them as well.

Unfortunately for Hongqiao, the response to its letter was tepid at best. Also released was the response to Hongqiao from Ministry of Industry and Information Technology (MIIT), to whom the CNIA forwarded the letter. The MIIT’s response put the onus back upon Hongqiao, tasking them with fixing the problems they had caused.

In the meantime, Hongqiao still had not released financial results for 2016, and trouble with the auditor it had engaged to complete the report began. At the beginning of May Ernst & Young abruptly but unsurprisingly resigned as Hongqiao’s auditor after its call for an independent investigation of the accusations leveled against it (Hongqiao) went unheeded. Rather than assent to an outside investigation, Hongqiao countered the request by stating that an internal investigation failed to turn up anything that would justify taking such an action.

Hongqiao continued to face pressure from the market as well. In mid-June the firm said they received a letter from the Hong Kong Stock Exchange outlining the criteria the company must meet before it was allowed to resume trading. The Exchange said that Hongqiao must address the issues head-on that were brought to light by Emerson and E&Y, publish the still-outstanding 2016 financials, and reveal to the market “all material information” relating to issues and allegations made against it to date.

Meanwhile, Hongqiao faced a battle on another front – fending off Beijing’s crackdown on illegal capacity. An announcement was made in late June indicating that the firm was in the process of curtailing 250 thousand metric tons per annum of capacity. According to market experts, the move was intended by Hongqiao as a show of good faith to the government, indicating its willingness to cooperate in Beijing’s crusade against illicit capacity.

By mid-June, Hongqiao was still without a financial report for the preceding year, and the second audit firm was out the door. Baker Tilly Hong Kong Risk Assurance Limited (BT Risk Assurance), who picked up where E&Y left off, abruptly tendered its resignation, citing a significant client workload and the fact that the sheer size of the undertaking meant that it wasn’t able to finish the job of 2016’s financials. Shinewing (HK) CPA Limited, the third audit firm at Hongqiao in as many months was engaged for the task. By now it was mid-July and Hongqiao was still without 2016 financials, a target date when such financials would be expected, and all the while the firm’s stock remained suspended at the HKEX.

A measure of relief came in mid-August, when China’s state-owned investment company CITIC Group Corporation Ltd. administered a US$1.02 billion shot in the arm to the flailing firm. Under the agreement, Hongqiao would sell 806.6 million new shares and issue US$320 million in convertible bonds to CITIC, which would be enough for a 13.3-percent stake in Hongqiao. However, the money was not offered without strings attached to it – CITIC mandated that Hongqiao finally close the books on its 2016 financials.

Latest developments: responding to Emerson

Hongqiao finally appeared to begin the process of righting the ship in November, when trading of its stock on the HKEX resumed. However, the firm’s return to the market would not be without controversy. Within hours of the stock’s resumption of trade on the HKEX, Chairman Zhang Shiping purchased over 18 million shares in what some market watchers considered to be an effort at boosting the stock’s market value. The gambit, if it was such, apparently briefly worked, as the company’s firm regained the value lost prior to its halt in trading, closing at a record high for the firm. Unfortunately for Zhang, his purchase put him 7 percent beyond the private shareholder limit established by the HKEX, and even his over-limit purchase did little to reverse the bearish trend on Hongqiao’s stock.

Hongqiao fulfilled the terms of HKEX’s requirement that it respond to the allegations that hung over it for the last year by releasing a monstrous 78-page statement in late October. Though many in the market were satisfied to take Hongqiao’s explanations at face value, a closer look at the company’s response to the charges against it revealed to them even more questions than the response answered. Emerson was among the first to do so.

Hongqiao began by rationalizing its high margins as being the result of operating a business with a one-of-a-kind model. However, this statement is incorrect on its face. As Emerson pointed out in its report, Hongqiao’s model, which involves the transfer of molten aluminium is far from unique. Per CRU’s numbers, fully three-quarters of all primary aluminium is transported in liquid form. And, even if Hongqiao’s business model was unique, Emerson points out that it still in no way accounts for the tremendous margins Hongqiao consistently reports.

The firm continues by claiming that the inordinately inexpensive cost of power generation enjoyed by the company is due to the fact that it does not pay standby and wheeling fees. However, those fees are not the sole expenses paid on power generation, as the company pays into the country’s renewables fund. Hongqiao also claims that its higher utilization ratio at its power plants lower electrical costs as well, despite the fact that fuel for every power plant is the major factor in electrical costs, and the cost of fuel is scarcely constant.

Further, Hongqiao failed to provide numbers comparing its oddly-low prices for power generation with that of similar companies. As pointed out in the Emerson report, there was no realistic calculation that yielded a power cost within 40 percent of that claimed by Hongqiao. The firm’s power-generation scheme still does not explain how it is able to pay one-third the price for electricity that Huaneng does, generating its own power from captive coal production.

Continuing on the subject of costs, Hongqiao claims that increasing the ratio of internally-sourced alumina lowers the resulting cost of producing primary aluminium. However, this is not always a given, as Hongqiao’s alumina project in Indonesia failed to do exactly that. Hongqiao also claims that the low-temperature and low-pressure Bayer Method also cuts the cost of alumina production, despite the fact that its alumina costs are no lower than its peers in Shandong who do not use the process.

Hongqiao’s justifications for its strangely-large net-profit margin also involve a claim that understanding them requires a holistic approach, as such large margins are the result of a combination of several disparate factors. Such a claim is odd to say the least, as it runs counter to all the numbers submitted thus far by the firm as well as those unrebutted figures given by short sellers to date. The company also claims that radical fluctuations in net profit margins from 2009 to 2015 are largely the result of market factors like the average sale price of aluminium and the unit cost of aluminium products. As compelling as an argument as this may be, it does little to explain why Hongqiao’s margins are far higher than those of its competitors over the same time period.

The company claims that its costs for power and alumina fell in 2010 without fully identifying why the costs for those inputs was so low to begin with. Hongqiao gives a partial justification for the low cost of power is the company’s sale of steam. But such a claim does not explain the company’s power costs, as the essentially insignificant income derived from the sale of steam would not cover even a fraction of the 20-percent difference in power costs it enjoys as compared to its peers. Emerson pointed out that China Hongqiao’s steam had a heat value of 3,150,000 kJ/ton, meaning that steam output represented 13.8% of electricity output for 2015 – well under the 50% claimed by the company.

Hongqiao’s explanation of its accounting for coal costs should also give one pause. In the October report, Hongqiao states that the Qinhuangdao spot price for 5,000 kCal is not the measurement it uses for coal’s spot price, directly contradicting the statement in its IPO prospectus that the index is exactly the scale by which it measures spot price. The firm goes on to state that it pays less for coal by buying it while the price is low and stockpiling it for later use. However, as the cost of coal storage is not insignificant, such a practice would not fully explain the vast savings the company enjoys for coal.

Hongqiao’s notice makes questionable statements about its power grid as well. According to the notice, Hongqiao has not been made to pay fees for its power generation, which experts find difficult to believe. In fact, Hongqiao claims that its captive power grid saves the company on levies assessed by the state. However, the claim directly contradicts without evidence the statement made by Emerson in its report that such captive power plants are, in fact, subject to government levies which, according to Emerson, Hongqiao has never paid.

Critics also point out that the company also fails to adequately rebut claims put forth by Emerson from consultants who supply cost structures for alumina production, choosing rather to put forth general figures for the cost of self-supplied alumina. Claiming it to be inappropriate to opine on the financial state of other companies, critics say Hongqiao simply chose to ignore the financial instability of its primary supplier of alumina.

Hongqiao also asserts that it chose Binzhou Gaoxin due to its physical proximity to its own operations. Claiming that such a positioning lowers the cost of alumina, omits the fact that transportation costs alone cannot explain the company’s ability to obtain alumina at a discount of 30 percent, and no conceivable reason would justify an alumina company to sell alumina at such a discount. Hongqiao states its belief that Binzhou Gaoxin’s prices aren’t artificially low by citing numbers for self-supplied alumina that critics have already called into question as being artificially low.

Hongqiao’s resumption of trading on the HKEX and its long-delayed release of 2016 financials have likely bought the company a bit of breathing room for the moment. However, it remains to be seen whether the explanations for the alleged massive and significant financial problems will satisfy regulators, financial backers, and the market at large. Will 2018 see a miraculous cure for Hongqiao’s many alleged structural problems, or will the company continue down this road?

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LME Official Price(USD/tonne) for 13 December 2017