The Silvercorp shorts are literally the blind leading the blind when it comes to anything like analytical skills, industry knowledge, basic accounting aptitude, sampling technique or … the list goes on and on. In the past day, the head blind mouse, “Alfred Little“, has stained the group’s so-called credentials even further by publishing two short, ill-informed, comical, recurring “analyses” that we will rip apart today.
Earnings Overstated by 5x?
The first recurring claim is that SilverCorp Management Fails To Refute Evidence Its Earnings Are Off 5X. We’ve already addressed this ridiculous allegation in the comments section to the Seeking Alpha article but let’s formalize it a bit here as well.
Basically Silvercorp’s cooperative joint venture partner in the Ying Project, Henan Found, is owned 22.5% by an entity named Henan Non-Ferrous Geological Mineral Resources Co., Ltd. (“HNGMR”). Based on financial statements obtained by the shorts, it is alleged that HNGMR only reported 22 million RMB as investment income from Henan Found in 2010 vs. a “share” of income that should have been closer to 116 million RMB. This is an alleged overstatement by a factor of 5 but to arrive at that number requires some stupendously bad assumptions.
The first bad assumption is that HNGMR would care nothing about the financial statements of its most-profitable equity investment, Henan Found, being “off” by 5 times. After all, “HNGMR is a Chinese state-owned enterprise (“SOE”) with no incentive to hide earnings or evade tax.” Yet HNGMR would apparently say nothing about its flagship investment inflating earnings and overpaying taxes!
The second bad assumption is that HNGMR is accounting for the investment in Henan Found under the equity method of accounting whereby a pro-rata share of profits is included in investment income. In fact, it is apparent that HNGMR accounts for Henan Found under the cost method of accounting in which only profit distributions (dividends) are included in investment income (as Silvercorp indicated in its rebuttal to the initial allegation). Importantly, the cost method means that the books and accounting of Henan Found and HNGMR are indeed in agreement after considering the profit allocation described below.
Anybody who has closely followed the Silvercorp and Ying story from the beginning (as we have) should remember that the project was originally held by members from the Henan Geological Brigades who were responsible for cataloging and exploring China’s mineral wealth under the old collective system. Although it is none of our business — or Silvercorp’s for that matter — the brigades as a collective made an allocation in the beginning to give 70% of their profit interest in the Ying project to the specific brigades (1st Brigades or “1st Bridge”) that was responsible for working in the area of the Ying project. This decision was helped along by the fact that the 1st Brigades members held the key exploration licenses for the project area.
So to summarize, the Henan Geological Brigades were the original vendors of the Ying project to Henan Found and in exchange they received 22.5% of the project with 6.75% of the profits belonging to the brigades as a collective (HNGMR) while the other 15.75% belongs to the specific 1st Brigades members in whose names the actual exploration licenses for Ying were held. This has nothing to do with Silvercorp and neither the company nor some nosy “investigator” has the right to question or get into the business of the geological brigades, much less demand to be informed how and why they decided to allocate the brigades’ profit share a certain way.
Moreover, the above understanding of the project history should bring into better focus the “auction” for the 5% of Henan Found that was in fact a transfer of an equity interest to an “affiliated” entity. Simply put, this was a move by the brigades to re-allocate the ownership among themselves.
As a result of the above, HNGMR as a collective for the brigades does not actually hold a controlling stake in, or exert a significant influence over, Henan Found and therefore under Chinese accounting rules the cost method is being used as already mentioned above. With this knowledge, the shorts should now hopefully be able to successfully reconcile the financial statements of Henan Found to HNGMR by using 6.75% of the profit distributions (dividends). Importantly, the shorts should not be using the net income of Henan Found as they have attempted so far because net income and dividend income are entirely different things!
Simple accounting lesson: income minus paid dividends equals retained earnings. The paid part is what the calculation should be based on when using the cost method for equity investments, not the retained.
Finally, a point about the tax on dividend income. This in fact is being collected on profit distributions to HNGMR because the Henan Found cooperative joint venture involves a foreign enterprise (Silvercorp’s offshore holding company, Victor Mining) and therefore the earnings of the cooperative are not exempt from taxes assessed on foreign companies.
Once again, we offer consulting at reasonable rates to those who need further explanation of any point discussed above.
Roadside “Ore” Assay Results
The second recurring claim involves the assay results from “ore” that the shorts have picked up from the road between the SGX mine and mill. This is quite interesting because the rocks, although apparently tested as a batch, still came back with an overall grade that is actually quite representative of the run-of-mine grades one would expect from SGX. Here is what they came up with:
- Silver 275 g/t
- Lead 1.93%
- Zinc 0.409%
That is amazing considering (1) some of the rocks are clearly not even ore and (2) each sample should have been tested individually and not as a mixed-together batch. It is very likely that the rocks actually consisting of vein material from this pile (by our guess about 25% of the material) might be representative of the average high grade ore at SGX. This material would not be quite as good as the direct ship ore (such rocks would look quite metallic and that is why they can be hand sorted on a conveyor line) but it would be consistent with the grades reported in Silvercorp’s NI43-101 technical report [page 8]:
Proven & Probable Reserves (SGX High Grade):
- Silver 410 g/t
- Lead 7.28%
- Zinc 2.91%
Actually the silver grade is much higher for the “falling off the truck samples” at 275 g/t than we would have expected — probably by a factor of at least 2 — considering that many of the rocks are clearly not vein material. The high sampling bias (which of course means that the shorts’ “investigation” actually points to the exact opposite of what they want to show: namely that Silvercorp could actually be understating its ore grade) could be the result of several pieces of bona fide ore material containing silver sulfosalts or silver sulfides. Sulfosalts sometimes present as subtle, plain-looking, sooty gray rocks that in fact carry bonanza grades upwards of 50 or even 100 ounces per tonne silver. Or some of the rocks could contain silver sulfides or their oxidation products that again sometimes appear as unremarkable gray rocks. As we look over this pile again, there are a few candidates that catch our eye:
In any case, the shorts made a huge mistake having these rocks assayed in a batch and should have instead submitted each one as an individual “grab sample”. Once again this shows how uninformed they are … but of course that hardly matters given that they don’t even realize the batch assay results point to the opposite of what they are claiming!
Any mine would love to have ore of such rich grade that random rocks picked up from the haulage road grade almost 10 ounces per tonne of silver!!!
Let us now bring things to a close with a bang by pointing the shorts and those who believe them to the report prepared in 2007 for Silvercorp by the renowned international geological firm SRK Consulting. Yeah, we know the shorts never mentioned it while pillorying the company about never having had any real independent experts look at the Ying Mine other than “two old guys out of Canada” who don’t even speak Chinese. After all the falsehoods, did you really believe them?
In fact, Silvercorp planned to list on the Hong Kong Stock Exchange (HKSE) in 2007 before deciding to go to the NYSE instead, and as part of the HKSE application the company commissioned an independent review of the Ying Mine including the work of the two old Canadian guys (who are really just kids in an industry where you can tell the youngsters by their gray as opposed to bald heads). The conclusion of SRK Consulting in 2007 (just shortly after mine startup) was:
The mines and concentrators owned and operated by Silvercorp through its joint venture companies in Luoning County, Henan Province, China have been operating and producing at their designed capacities. The Ying mine contains resources which have been reported in compliance with National Instrument 43-101 (“NI43-101”) of the Ontario Securities Commission. Measured and Indicated resources may provide mill feed at the current processing rate for eleven to twelve years. The HPG mine has resources compliant with Chinese regulations which can be mined and fed to current concentrators. Both mines have exploration permits surrounding current mining licenses, with potential to define and discover new mineralised bodies and new deposits. The NZ project also has some remaining gold resources compliant with Chinese standard, and exploration potential to discover precious and base metal deposits at depth.
The underground mine developments of the Ying and HPG projects include adits and shafts to access underground, exploration drifts along the mineralised veins, and haulage tunnels. Both mines use the shrinkage mining method. Mining is labour intensive, but has yet to produce sufficient ores to satisfy the feed requirements of the ore processing plants which have throughput capacities of 600tpd at Ying and 200tpd at HPG. The geotechnical conditions in the mines are good; only localised support of the tunnels is necessary.
The Ying and HPG concentrators use conventional flowsheets in common use in the industry. Additional hand sorting of high lead and silver (Pb and Ag) grade ores is employed, which produces ores which are sent directly to the smelter, thus reducing the cost of milling. The feasibility study of the Luoning smelter is a high quality document, and the technology has been developed and utilized by other smelters in China.
Both the Ying and HPG operations have only recently started operating and SRK notes the efforts of the company to comply with Chinese regulations on various issues, including environmental and occupational health and safety. There is still potential for improvement on these aspects. Silvercorp utilizes the experience of Chinese technical personnel very well to control operating costs, and enjoys a very good relationship with governments and the local community.
By the way, the curious can find small hints of the work that the “1st Brigades” conducted at these projects before they were vended to Silvercorp along with a few other goodies to be found in this independent report by an international firm with a major presence in China that casts very serious aspersions on the claims of the shorts.
In conclusion, we remain vigilant and ready to take on any other challenges that the shorts throw at the wall in an increasingly desperate effort to see if anything — anything at all — can stick to Silvercorp. So far it’s been like eels on Teflon.
Disclaimer: We own shares and various long put and call option strategies in Silvercorp. We have not been compensated by any party for this commentary. Options and warrants are particularly risky as you can lose your entire “investment”. Therefore, only buy options and warrants with money you can afford to lose and not lose sleep over. This is not investment advice, which you should seek from an investment advisor or licensed broker.