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Rogue Firm Embarrasses Sell Side Research

Who are you going to believe?  A mid-cap company ranked fourth in its industry globally, operating on 3 continents, followed by a dozen sell side analysts two-thirds of whom with buy recommendations? Or Anonymous Analytics, affiliated with hackers, and almost certainly seeking to benefit from short sales?  Since trading has been suspended in Huabao International subsequent to the release of Anonymous Analytics’ report last week, the verdict seems to go to the rogue research firm.

The U.S. ADRs of Huabao (each ADR represents 25 shares of underlying common traded in Hong Kong) traded from $31 the prior week to $18 when trading was halted.

Huabao issued a press release a day after trading was suspended, saying they are preparing “a clarification in response to certain recent incorrect and misleading allegations.” The company also said it has dispatched “delegates to the respective local offices of the State Administration for Industry & Commerce of the People’s Republic of China (“SAIC”) to verify the financial information for the year of 2010 (i.e. for the 12 months ended 31 December 2010) of some domestic subsidiaries of the Company filed thereat, so as to be supporting documents for the clarification announcement about to be published by the Company later” and it is working with its auditor, PricewaterhouseCoopers, to prepare financial statements for its fiscal year ending March 31, 2012 by the end of June.

All this commotion was caused by one 44-page report from a group that is purposely obscure.   Perhaps because the source lacks credibility, the report is very good—well researched, well written, and quite devastating.

The people behind Anonymous Analytics did their homework.  They pulled 23 sets of State Administration for Industry & Commerce (SAIC) documents covering all of Huabao’s relevant subsidiaries. They did extensive channel checks including over 150 phone calls to all the major cigarette manufacturers, as well as contacting Huabao customers, competitors, and industry experts. They sent teams to multiple locations spanning three continents, including a trip to Botswana to check out a dodgy subsidiary.

This raises a few questions.  What exactly were the sell side analysts from firms such as Citigroup, Credit Suisse, Deutsche Bank and JP Morgan doing since Huabao went public in a backdoor listing in 2004?  Why didn’t the red flags that caught the attention of Anonymous Analytics raise concerns among the sell side analysts following the stock?

There seems to be no lack of red flags.  These include a backdoor listing, an auditor resignation, executive resignations, “absurd related party transactions, and a company founder who can’t sell off her shares fast enough.” Indeed, it was the company founder, Chu Lam Yiu, 36 years old when she first took over Huabao, who first drew Anonymous Analytics to the stock.  From an interview in Foreign Policy, the pivotal question for Anonymous Analytics was “How did this 36-year-old female who no one had ever heard of manage to become a billionaire overnight, particularly in a notoriously government-controlled and patriarchal industry?”

Last year Ms. Chu was ranked the 8th richest woman in China on Hurun’s list of Self-Made Women Billionaires. Notably, Hurun also published a “Cashout List”, which lists billionaires who have been cashing out of their own companies. The list places Ms. Chu at No. 2, having cashed out of US$549 million last year alone.  The Anonymous Analytics report alleges that Chu is a proxy for unnamed people who are actually pulling the strings.

This brings us to the question of whether Anonymous Analytics uses hacking to supplement its analysis.   The report itself is an excellent example old fashioned equity research, incorporating financial analysis (why are Huabao’s margins at 70% when the rest of the flavoring industry is at 40-50%?), industry analysis (is Huaboa’s market share credible given the size of the Chinese cigarette industry?), channel checks (revealing phantom customers), on site visits (showing suspect R&D facilities and mysterious subsidiaries), and forensic research (the numerous red flags mentioned above.)

The report shows no evidence that the firm used (or needed) hacking.  However, to prevent retribution, the report holds back information: “…we have an immense interest in the safety and well-being of our people. This is why all the information withheld from this report has been encrypted and stored online. This information pertains to Huabao’s business, along with the personal information of the individuals who run Huabao behind the scenes and their associated proxies (you didn’t actually think a 36 year old woman was the true running force behind one of China’s largest public tobacco enterprises, did you?)”  Hacking, or the threat of hacking, is another (unstated) deterrent.

However, the group says it doesn’t hack, sort of:  “We don’t hack for information since that would attract all kinds of horrible attention we don’t need. … But then again, if we were hacking, chances are we wouldn’t go around talking about it.”

Who are the people behind Anonymous Analytics?  In the interview with Foreign Policy, they acknowledge links to Anonymous: “Our members grew up within the Internet subculture and cesspool that is 4chan [an English-language bulletin board copied from one of the most popular forums in Japan, Futaba Channel]. We have been active in the Anon community over the last several years in some capacity. Some of us eventually grew up and got jobs in industry and government but we retained the dark humor that is Anonymous. More importantly, we retained the skill to source information and social-engineering capabilities that we honed through our work with Anonymous.”

How does the firm make money?  The report’s disclaimer mentions that the firm has clients, and perhaps the clients pay to receive the group’s research before it is publicly released.  The disclaimer also mentions contributors, which are most likely hedge funds which had already taken a short position in Huabao.  Although Anonymous Analytics says it “holds no direct or indirect interest or position in any of the securities profiled in this report,” you have to assume that the report has a vested interest, which is driving down the price of the stock.

So how are we supposed to react to an outlaw research firm, that may or may not use illegal methods, and which at the very least is associated with short sellers intent on launching a bear raid on the stock in question?  Ambivalent, just as we feel about Muddy Waters, which makes no secret of its short positions.

What this graphically illustrates is the sorry state of sell side research.  The Huaboa website lists 12 sell side firms covering its stock, including JP Morgan, Deutsche Bank, Citigroup, Credit Suisse, Nomura, Jeffries and DBS Vickers.  An article in the Financial Times mentions 9 covering firms, of which 6 had buys/outperforms and 3 had holds.  One analyst was quoted as saying that she plans to review the stock based on the information to be released by the company (whenever that will be).

Anonymous Analytics has the tagline “Acquiring information through unconventional means.”  If they are not hacking, then they must be referring to channel checks, onsite visits, forensic analysis and the other due diligence they performed.  But these are all tried and true techniques used in securities analysis, so in what sense are they unconventional?  Perhaps the firm is making a statement about conventional sell side research.

Reading the Anonymous Analytics report makes one incredulous that other analysts did not pick up on any of the clues.  As the report puts it, “It’s almost like management is playing a game of chicken with analysts, like they’re trying to see how many red flags they can raise and still get ‘buy’ recommendations.”  Sadly, it wasn’t the sell side analysts who ultimately called the bluff.

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