September 14, 2011
Our Questions About Silvercorp. (NYSE: SVM, TSX: SVM CN)
On August 29, 2011, we anonymously sent a letter to a number of parties including Ernst & Young (Silvercorp’s auditor) and the Ontario Securities Commission. We indicated that we planned to post some of our research on Silvercorp on the Internet and we included a preliminary copy of our research with that letter. On September 2, 2011, before we had posted any research, Silvercorp announced publicly that it had received a copy of our letter from Ernst & Young. Silvercorp published a press release in which it stated its response to certain of the matters raised in our letter and made reference to certain documents. In the release Silvercorp stated that a special committee of its board of directors has been established. We reviewed Silvercorp’s response, updated our analysis further, and are now posting our revised analysis on the Internet. On September 9, 2011, the media reported that the British Columbia Securities Commission had been made aware of our research and was “examining both the nature of the complaint and the allegations contained in [our] letter.” We have sent a copy of this Internet posting to the British Columbia Securities Commission, the Ontario Securities Commission, Ernst & Young and Silvercorp’s independent directors.
We are investors who have successfully identified accounting issues related to public entities with operations in China in the past. These issuers include CCME, CBEH, TRE CN and CHBT. We have decided to publish our research on Silvercorp Metals Inc. (NYSE: SVM, TSX: SVM). Based on our research, we still have serious questions about Silvercorp’s accounting and various other issues that we detail below. It continues to be our opinion that Silvercorp is significantly overvalued.
We prefer, at this time, to remain anonymous. Although we do not have any reason to believe Silvercorp or anyone associated with Silvercorp would engage in such conduct, according to numerous news accounts other critics of other Chinese issuers have received personal threats from unidentified parties.
We are troubled by Silvercorp’s statement in its September 2nd press release that “[i]n accordance with good governance practices, the Company has established a task force of independent directors…to work with regulatory authorities to immediately investigate and discover the identity of the party behind these allegations.” In our view, as a matter of good corporate governance, Silvercorp’s directors should be investigating the serious questions we have raised regarding Silvercorp’s public filings.
Although we have chosen to remain anonymous, we clearly state that we hold a short position in Silvercorp. Readers should take this into account when evaluating our analysis and developing their own opinions.
This report is the only piece of research that we have made available on the Internet regarding Silvercorp. To the extent that other anonymous reports regarding Silvercorp have been made public, we did not author or coordinate in any way with the authors of those reports and are not responsible for their content.
Silvercorp (SVM) is a ~US$1.4 billion market cap silver producer based in China. SVM has interests in three mines in China (Ying Mining District, GC Project and BYP Mine) and one project in Canada (Silvertip). A large majority of current production comes from the Ying Mining District’s three sub-divisions (Ying, TLP and HPG+LM).
Based on the research we detail below, in our opinion SVM may be appropriately valued at no more than US$1.60-2.50/share.
We have the following questions and concerns about SVM:
- SVM’s JV partner just sold a 5% interest in an entity that holds SVM’s flagship Ying mine at a valuation that appears to be very low in comparison to what we would expect to see based on SVM’s financial statements reported to US and Canadian securities regulatory authorities
- This transaction, on the basis of our sum of the parts analysis, implies a per-share valuation of US $1.60 – US$2.50/share for all of SVM’s equity
- The financial information reported by SVM to Chinese authorities (the State Administration for Industry & Commerce (SAIC)), which we obtained, and which is enclosed with this report,exhibit large differences from the financial information reported to US and Canadian securities regulatory authorities
- SVM’s US and Canada reported revenues of US $153 million are ~10x the revenues of ~US$15 million reported in the information reported to the SAIC
- SVM’s US and Canada adjusted EBITDA is ~US $100 million, but appears to be closer to zero on a review of the SAIC filings
- SVM’s US and Canada adjusted reported net income is US $66 million, but appears to be closer to zero on the basis of the SAIC filings
- The financial statements SVM reported to the SAIC show domestic (i.e., in the PRC) cash plus short-term investments of ~US $7 million, versus US $224 million reported in the US and Canada as of calendar year end 2010
- Based on SVM’s September 2, 2011 press release, we understand that US$87 million of cash is held outside China as of July 31, 2011. We have questions and concerns about the US$134 million cash balance held within China. Specifically, US$112 is held at the Henan Found subsidiary
- Based on documents obtained from third parties we believe to be reliable, and more fully explored below, we believe there was an apparent change in the financial statements of Henan Found.
- The grade of the deposits appears to us to be unusually high in comparison to publicly-listed comparable silver mining projects worldwide.
- Interviews our researchers conducted with customers and competing mining companies suggest that the ore grades at Ying may be 300-400 g/t, which is below the 845 g/t of the Ying SGX area.
- Based on checks performed by our researchers in China, drilling costs at Ying mine appear to be underreported by a factor of 3.9x.
- These checks were done by consulting with a drilling contractor in the vicinity to better understand the costs of operating in the area.
- The 43-101 resource reports on Ying, in our opinion, have room for improvement in two principal ways: hiring a “name brand” firm to evaluate the Ying asset and having that firm physically visit the asset for evaluation purposes every time a new report is authored.
- The CEO and COO have benefited from related-party transactions (disclosed by the company) that we would like to see further detail about.
- The company has made an acquisition in China from J.Feng, a relative of the CEO.
- The company completed a US$117 million equity raise in December 2010, a time at which SVM already had significant cash on its balance sheet and potential near term free cash flow, according to street analyst estimates.
JV Partner’s Apparent Sale of a Percentage of Key Ying Asset Raises Questions
On a publicly accessible website (http://www.hnbanking.com/html/20110708/10410.html) (ENGLISH TRANSLATION) (PDF) we learned that the Henan Nonferrous Geology Mining Co Ltd (HNGM) (Identified in SVM documents as Henan Geology Bureau) advertised for sale a 5% equity stake in SVM’s primary operating subsidiary, Henan Found, for 45 million RMB (US $7 million).
The Chinese name of the shareholder that appears on the business license of HNGM is the same as that of one of the registered owners named on the business license of Henan Found. The other registered owner is Victor Mining Ltd (a subsidiary of SVM).
On July 8, 2011, HNGM registered its equity stake for sale on the Henan Zhongyuan Property Exchange, a government-operated exchange for state-owned assets. This notice appeared on several websites and in several newspapers, including Henan Daily News.
The asking price for the Ying Asset was US$7 million for a 5% stake. 100% of the Ying asset should therefore be worth US$140 million.
According to SVM’s Annual Information Form filed with US and Canadian securities regulators, in fiscal 2011 (ended March 2011), the Ying Project accounted for an overwhelming majority of SVM’s current production of silver. It is the company’s flagship project.
In our original work, based on the value of the stake advertised for sale, we calculated the implied value of SVM stock as being in a range of $1.15/share to $2.43/share, with the difference between the two determined by whether we based the analysis on cash reported to the SEC as of 6/30/2011 or cash reported to SAIC as of 12/31/10.
Below, we show our updated work based on SVM’s September 2, 2011 cash disclosures. We present three cases, the difference between them being the different cash amounts reported. The two original cases are here; with a third case reflecting cash that SVM has stated is held outside China.
Total Company Value
To be conservative, we have not taken into account a reported minority interest on SVM’s balance sheet which would have lowered the price target calculation by an incremental US$0.38 / share. For simplicity, we have also not taken into account the relatively small $10.4 million acquisition of Zhongxing Mining Co. Ltd. announced on August 22, 2011.
We assume the non-Ying mines are worth about US$25 million (see more in the acquisitions section below).
According to our Internet searches, the 5% stake in Henan Found was sold on August 15, 2011 to a company named Henan Xinxiangrong Holding Co Ltd (XXR) for RMB 45.5 million (~USD $7.1 mm), slightly more than the advertised price of RMB 45 million. The following is a link to an announcement on the Henan Provincial Non-Ferrous Metals Geological and Mineral Resources Bureau website about the asset sale: http://www.hnysdk.com/news_info.aspx?NID=4298 (ENGLISH TRANSLATION) (PDF)
(Note: We post the original link where we found the article. The link has since been taken down for reasons unknown to us.)
Here are photos from the website article regarding the auction:
In its September 2, 2011 press release, SVM states that the transfer of the 5% stake in Henan Found was to an affiliate, and that the assignment of the interest to an affiliate is within the joint venture contract and articles of association of Henan Found.
After reviewing SVM’s press release, we continue to have concerns about this response, for the following reasons:
- SVM does not deny that the asset changed hands for a purchase price of US $7 million. SVM appears to suggest that the price of US $7 million did not reflect fair market value because the asset was transferred to an affiliate.
- The Internet posting regarding the outcome of the auction (Link 2) was removed from the Internet after our original letter was sent.
- In our initial work, we discovered on publicly available websites (see Links 1 and 2) that the Henan Found stake changed hands in what appears to us to have been an auction. Common sense suggests that if a joint venture partner was to truly “assign its interest to an affiliate” an auction would not be the process followed.
- The following circumstances suggest that an auction took place:
- In Link 2 there are pictures of an apparent bidding process taking place.
- It is inconsistent with a transaction between affiliated companies for there to have been an advertisement of the sale of the 5% interest in Hunan Found and as part of that advertisement, the specification of criteria and required collateral for potential buyers.
- At the beginning of the Link 1 it is stated that, “Zhongyuan Property Right Exchange Co, Ltd., intends to auction the 5% State-owned equity of Henan Found Minerals Co Ltd. held by Henan Nonferrous Geological Minerals Co., Ltd”.
- Link 1 states that potential purchasers must meet requirements relating to their financial status, credit status and a cash deposit, among others.
- It is stated in Link 2 that “Provide two and above intended assignees meeting the set conditions are solicited during the public notice period, auction [our emphasis] will be adopted to decide the assignee”.
- The article lists an “Inquiry Telephone” for a Ms Wei.
- It is stated in Link 2 that, “In the morning of August 15, 2011, the public auction of 5% equity of Henan Found Minerals Co., Ltd., was held in the auction house of the Henan Zhongyuan Property Right Exchange Center. Henan Xinxiangrong Mining Industry Holding Co., Ltd., successfully bid 5% equity of Found Co in an aggregate price of RMB 45.5 million.”
- The purchase having been made for RMB 45.5 million, rather than the stated initial price of RMB 45 million, suggests the existence of an auction rather than an intercompany transfer.
- In Link 1 it is stated that the auditor of the Henan Found subsidiary is Wabisen Accounting Group. The September 2, 2011 materials released by SVM, however, refer to the Henan Kaiqiao Accounting Firm as auditor for the company’s 2010 audit. This raises additional questions. First, did the local auditor change in 2010, and if so, why? Second, if not, were there two local auditors in 2010, and if so, why?
Chinese SAIC Income Statement At Variance To US and Canadian Reported Financials
According to SVM’s filings, this is a complete organizational chart of Silvercorp:
For the data we collected from third parties on the Chinese subsidiaries, please see below:
|Henan Found Mining Co. Ltd. (China)||(PDF)|
|Henan Huawei Mining Co. Ltd. (China)||(PDF)|
|Guangdong Found Mining Co. Ltd. (China)||(PDF)|
|Anhui Yangtze Mining Co. Ltd. (China)||(PDF)|
|Xinshao Yun Xiang Mining Co. Ltd. (China)||(PDF)|
|Data for H.K., BVI, and Barbados entities is not available. That data is likely immaterial given those entities were most likely established to serve as offshore pass-through entities with no operating businesses.|
|Data for 0875786 B.C. Ltd. is also not available. That data is not relevant for calendar 2010 given that the Silvertip project had zero production and therefore de minimis operating revenue.|
|For a simplified consolidation report, please see here||(PDF)|
Below is a summary comparison of key reported financial statement items as compared to the financial statements our service providers obtained from the Chinese SAIC (we’ve provided all of our back-up calculations).
Many US-listed China companies have said that SAIC vs. SEC financials do not matter. In this case the variances are so large that in our opinion, a clear explanation of the discrepancies is necessary. To recap the income statement variance table above:
- In 2010, net revenues based on the financial statements we obtained were ~10% of revenues reported in the US and Canada.
- In 2010, based on the financial information reported to SAIC that we obtained, EBITDA was slightly negative, while in the US and Canada SVM reported EBITDA of ~US$100 million.
- In 2010, again based on the financial reported to SAIC that we obtained, net income was also slightly negative, while in the US and Canada SVM reported net income of US $66 million.
There is a significant difference between the SAIC financials cited by Silvercorp in its September 2nd press release and the SAIC financials we initially obtained, particularly as it relates to the key subsidiary Henan Found Mining Co. Ltd. (see table below).
To recap, the variances with regard to Henan Found are in our opinion extraordinary. The variances with regard to Henan Huawei (except for Sales) and Guangdong Found appear to be immaterial. Our information regarding Anhui Yangtze Mining appears to match SVM’s US and Canadian financial reporting. The issues raised by the financial reports we have obtained therefore essentially relate to Henan Found.
We noted in our initial work that, as described below, it appears that financial statements for Henan Found have been changed. This is described in more detail below:
- We obtained credit reports from sources we believe to be reliable. We have obtained similar information on other companies from these sources in the past and have found the information to be accurate. We object to SVM’s characterization of our concerns as “bald-faced lies.” (Dow Jones Interview with Silvercorp, September 2, 2011).
- When we first started researching SVM months ago, we obtained SAIC financial statements for Henan Found. At the time, we received financials for 2008 and 2009.
- Here is the original report we received (PDF)
- We later received another report on Henan Found (PDF)
- This second report was later sent to us, unsolicited, by the provider of the first report.
- The second report showed financials that were effectively different and higher for 2008 and 2009. There was also summary data for 2010 included in this new report. This summary data appears to match the Henan Found revenue and financials the company disclosed on September 2, 2011.
Source 1: Summary Variance Table of 2008 and 2009 financials
- The first and second reports we received appear to reference the same company and refer to the same incorporation date, address, government registration number and legal representative.
- We have requested financial statements for 50+ Chinese companies from our source. We have never seen an instance of reported financial information changing in this manner.
- We obtained the 2010 financial statements cited in our report from another service provider we believe to be reliable. The 2010 financial statements are very different from the financial statements SVM posted on September 2, 2011. The 2010 financial statements we obtained form the basis of our variance analysis on page 8 above.
- In its September 2, 2011 press release, SVM did not address our concern that the SAIC financial statements for Henan Found may have been changed, despite our having referred to this in our initial work. We were disappointed that no explanation of the apparent change was provided in SVM’s September 2, 2011 press release. In our opinion an explanation is necessary.
Chinese SAIC Balance Sheet Shows Minimal Cash
Below is a comparison of summary balance sheet data for what SVM reported to US and Canadian regulators and what SVM reported to Chinese regulators (SAIC) in the reported financial information we have obtained:
SVM reported US$224 million of cash and short-term investments as at 12/31/10. Our consolidation of the SAIC reports detailed above shows cash on hand of approximately US$7 million.
In our original work, we noted that some of SVM’s cash could be held offshore and may not show up in our consolidation based on the SAIC financial information our service providers obtained. We believed some cash was held outside China, given SVM’s equity offering in December 2010 for US$117 million.
SVM has provided in its September 2, 2011 press release a breakdown of cash held both outside China (US$87 million) and inside China (US$134 million, including US$112 million in Henan Found).
- After reviewing the documents released on September 2, 2011, including bank accounts held outside China at BMO and UBS, we have no reason to dispute the company’s statement that it holds US$87 million of cash outside China.
- Given our concerns about the Chinese financial statements described above, we remain, at this time, unconvinced that the Chinese cash balances are 1) actually present in full, or, 2) if present, unencumbered by liens, pledges, etc . Our concern here stems from the fact that Chinese financial statements for Henan Found appear to have been changed and most (US$112 million) of SVM’s cash balance is in Henan Found (according to the company’s materials released September 2, 2011).
- We updated our original sum of the parts analysis earlier in this report based on total reported cash, total cash outside China, and total cash only from the SAIC financial information we obtained.
Grade of Deposit at Ying Project (SVM’s Largest) Appears To Be Unusually High
The table below shows that the grades reported at the Ying project are significantly higher than comparable projects world wide.
(Grade data available: http://www.goldminerpulse.com/vSilver.php)
Interviews Suggest Grades at Ying are Lower Than Reported
As a cross-check, we had our researchers visit smelters (i.e., customers) and competing miners in the Ying area. Those conversations suggest ore grades of 300-400 g/t for Henan Found, 50% of the level of reported ore levels.
According to Our Checks, Company Drilling Costs At Ying Mine Appear Underreported by a Factor of 3.9x
Our researchers obtained, with government authorization, a price list for drilling services from the Exploration Institute under the Henan Geology and Mineral Exploration Bureau. The institute told our researchers that a mining company’s own dedicated team could cost as little as half the listed prices.
We performed an analysis of the Ying Mine’s capex program (from pg. 8 of the FY11 MD&A) using these prices:
The table above suggests that the costs at the Ying mine should be much higher than those reported by SVM in the US and Canada.
SVM did not respond to this concern in its September 2, 2011 press release.
Independent Consulting Geologist Reports—Room For Improvement
SVM publishes 43-101 reports verified by outside experts. We have concerns about the foundation for these reports. Although we have questions about 43-101 reports for several of the projects (see our subsequent discussion of the related party transaction to acquire the GC project), we focus on the flagship Ying project (Ying’s three major sub-divisions are Ying, TLP, HPG+LM).
We note the following information obtained from the May 20, 2011 43-101 Report on the SGX Mine at the Ying Camp:
- Mel Klohn, L.P. Geo. of BK Exploration Associates
- “I first visited the Ying properties from July 15 through 23, 2007, and have since reviewed the Ying project data in detail on an annual basis, both electronically and in Silvercorp’s office in Vancouver, for NI 43-101 reporting purposes. I reviewed the project data for this current report in Silvercorp’s Vancouver office from April 15 to 25, 2011.” (page 111)
- Chris Broili, C.P of BK Exploration Associates.
- “I visited Silvercorp’s Ying District properties many times from 2004 through 2008, and have reviewed the Ying project data in detail since on an annual basis, both electronically and in Silvercorp’s office in Vancouver, for NI 43-101 reporting purposes. I reviewed electronic project data for this current report intermittently from March 9 through April 4, 2011.” (page 113)
From the Annual Information Form, page 46:
- “Previous site visits to the Ying District were conducted by the authors of the technical reports at various times beginning in 2004 through 2008. In previous technical reports, verification samples were collected from the projects to confirm the presence of mineralization and the validity of Silvercorp’s sampling. Further verification samples were not collected for the Ying Report because (i) the previous verification sampling confirmed the presence of mineralization comparable in grade to that being reported by Silvercorp [our emphasis], and (ii) all four of the mine target areas have now been producing, shipping and selling commercial ore for periods ranging from one to four years.”
Based on these disclosures, it appears that no independent person has physically visited the project to take samples in almost three years. In our opinion these independent experts do not have a reasonable and adequate basis to attest to the level of production and reserves at these properties.
We spoke with a mineral company CEO, who has a Ph.D. in geology and over 20 years of industry experience. He told us that for less than $100,000 SVM would be able to have a “name brand” minerals consulting firm such as SRK or AMEC do its 43-101 studies. This relatively nominal fee would include visits by impartial third parties to the site each time a new report is authored. This mineral company CEO follows this practice and his company’s market cap is less than US$100 million. Why would a US$1.4 billion market cap miner, with one of the world’s purest mines, use a small, relatively unknown geology firm that has not visited the site in almost three years?
In its September 2 press release, SVM refers the reader to the Ying technical report. We do not suggest that the Ying technical report does not exist. We do not suggest that any independent person associated with that report has knowingly acted in an inappropriate manner. We only question certain aspects of the report. The September 2 response did not answer our two principal questions originally raised, which are, in summary:
- In our opinion, there is no “name brand” minerals consulting firm doing the work on Ying.
- It appears that no independent person has physically visited the project for evaluation purposes for almost three years.
We suggest that additional confidence in the SVM investment case could be built if SVM were to hire a “name brand” minerals consulting firm and have independent, on-site work conducted every time a technical report is prepared.
Certain Recurring Related Party Transactions
Here are selected, recurring related party transactions disclosed by SVM in its latest annual report:
It is our understanding that McBrighton Consulting Ltd is controlled by SVM’s President and COO.
All payments were reported as consideration for consulting services. We do not understand why senior management of a large market cap company is consulting for a fee to anyone, let alone their own company. We think more information about the consulting services provided to SVM would be appropriate. SVM did not respond to this concern in its September 2 press release.
Acquisition From Related Party J Feng
In June 2008, SVM acquired the GC project for a total of ~US$61 million, consisting of US$24 million in cash and 4.5 million shares issued to the seller.
According to the SVM Annual Information Form (page 88):
“On June 2008, the Company acquired from Yangtze Gold all of the issued shares of Yangtze Mining. Yangtze Mining owns a 95% interest in a Sino-foreign joint venture company, Anhui Yangtze, which owned 100% of the GC Project. Dr. Rui Feng, Chairman and CEO of the Company, is a Director of each of Yangtze Gold, Yangtze Mining and Anhui Yangtze, and Mr. J. Feng, a relative of Dr. Feng, controls Yangtze Gold. The transaction was approved by the independent directors of the Company in accordance with the applicable laws.”
In our searches of public filings, we have not been able to find a registration for the 4.5 million shares paid as partial consideration in this transaction. We have no reason to believe that J.Feng is under any obligation to register these shares. In the absence of registered information, however, we are unable to determine whether these shares have been sold since the transaction took place. Given that J. Feng is a relative to the CEO, it would be of interest to know if J. Feng has kept his stake in the company (we would view this as positive), or sold his shares (we would view this as a neutral or possibly negative, depending on the circumstances).
We are also unsure as to what SVM shareholders received in return for the ~US$61 million purchase price of Yangtze Mining. According to SVM’s investor presentation (posted on SVM’s website), no production is expected from GC until Fiscal 2013 (year ending March 2013). The original 43-101 report dated April 2008 was done by SRK Consulting, which we understand to be a “name brand” consulting firm. The April 2008 report mentions numerous site visits by SRK personnel to the mines in 2007. An updated 43-101 report dated June 2009 indicates that the company switched to AMC consultants. According to the 43-101 Technical Report Update on the GC Project, dated June 22, 2009 (page 26):
“AMC visited the tunnel sites but was not able to access them as most entrances were blocked for safety reasons. There is no detailed reconciliation data available for any of the mineralization extracted.”
We are concerned that:
- Yangtze Mining replaced a name-brand geologist firm (SRK) that was already familiar with the asset.
- The new independent consulting geology firm (AMC) could not access the GC mine underground areas due to a safety issue.
- The above two events occurred in conjunction with a new technical report that increased the measured and indicated mineral resource by 250%.
- In the context of these circumstances, Yangtze Mining was purchased from a related party.
We think SVM shareholders should be provided more information as to the value delivered to shareholders as a result of SVM’s acquisition of Yangtze Mining. SVM did not respond to this concern in its September 2 press release.
Large Fundraising Raises Questions
As of September 30, 2010, SVM had US$110.2 million of cash and short term investments on its balance sheet and no debt. According to street estimates, SVM was poised to generate as much as US$50 million or more of free cash flow in the next year. Nevertheless, SVM proceeded with a financing, raising US$117 million in stock at US$12.70 per share with BMO and CIBC as bookrunners. Use of proceeds from the offering included:
- BYP Acquisition (US$35 million)
- GC mine development (estimated at US$22.5 million for Fiscal 2012)
- Silvertip mine development (2012 drilling program US$1 million)
- General Corporate Purposes
We question why a company with US$110.2 million of cash and short term investments, US$50 million+ in potential free cash flow in the next year and ~US$60 million in acquisition and special capex needs (shown above) would carry out a US$117 million financing. On the basis of SVM’s balance sheet, the BYP acquisition and GC mine development could have been easily financed from balance sheet cash which would be replenished within a year due to free cash flow generation. SVM did not respond to this concern in its September 2 press release.
We have highlighted questions and concerns which, in our opinion, are relevant to shareholders’ interests. Our questions and concerns remain unaddressed after SVM’s September 2nd press release. Our discussion above is based on information we believe to be reliable. We think it would be in the interest of all SVM shareholders for SVM to provide a full response to our questions and concerns.