Orient Paper (NYSE AMEX:ONP)

Orient Paper Inc (NYSE AMEX:ONP) joins the growing list of companies that have been targeted by investors who are attempting to discredit ChinaHybrid firms. Whether justified or not, these actions will have an effect on the sector. To be frank, ChinaHybrids are easy targets for the following reasons:

1. Complicated ownership structures due to Chinese law that does not allow direct foreign ownership into Chinese firms.
2. The resistance of many Chinese firms to spend the funds to engage a top ten accounting firm. What they do not realize is that the money they are saving will more than offset a decrease in the market value of their stock.
3. Many firms lack an effective IR campaign which can lead to illiquidity and proneness to manipulation.
4. A general lack of companies that have actually proven that they are shareholder friendly. This can be evidenced by reckless equity raises that continue to take place in the ChinaHybrid space. China Yongxin Pharmaceuticals (OTC BB:CYXN) is a good example of a company that completed its most recent raise pre-reverse split at $0.06 that resulted in a massive spike in its share count. see note.
   
   Also, reference China Armco Metals (NYSE AMEX:CNAM) last raise at $6.50. We had tried to give them the benefit of the doubt as CNAM’s business requires capital. So we were somewhat taken aback when it recently announced its investment in an Australian iron ore exploration company, whose mine is believed to contain quality iron ore, instead of using the money to immediately grow its business. As far as we are concerned, CNAM has enough on its plate and should not embark on a somewhat risky investment that only may pay off in the future. Furthermore, the company has a history of reporting sporadic quarterly results, reducing are short-term confidence in this story.
   
   Yuhe Intl (NASDAQ:YUII) is another example that clearly states it did not need capital and then filed a shelf to potentially offer stock see note.
   
   Skystar Bio-Pharma Co (NASDAQ:SKBI) is an interesting stock that on June 1, 2010, was in the midst of embarking on its third raise in about a year when management has not been on schedule with its business plan implementation. It’s funny how just a few weeks later they figured out that they had enough money to fund operations internally and withdrew plan to offer stock. Do these companies think we are fools?
   
5. Inability to thoroughly inspect a firm’s operations.
6. The abundance of many intra-company related transactions.
7. Lack of investor participation in this sector can accelerate moves to the down side.
8. Lack of SEC legal action taken against those who write false articles that may be proven wrong.
9. Most notably, differences in the numbers reported in U.S. GAAP financial statements vs. those reported with China regulatory bodies have surfaced for several ChinaHybrids. There is much debate over whether comparing these documents is appropriate. It turns out to be a big deal since it impacts investor psychology. Worse yet, we really have not heard Wall Street come to the defense of these companies. This issue has pressured stocks such as Lihua Intl (NASDAQ:LIWA), China Marine Food (NYSE AMEX:CMFO) and now ONP. ONP addressed this issue, highlighted by a negative article by Muddy Waters, LLC, in a press release yesterday.
   
   The basic premise of Muddy Water's allegations is that ONP sales in its SEC documents were overstated by 27 times ($2.4 million vs. the $65.2 million) when compared to filings made in China. ONP claims that the main operating subsidiary referenced in the report was a smaller company with a similar name as Orient Paper's China operating subsidiary named "Hebei Baoding Orient Paper Milling Co" vs. Muddy Water's finding, He Bei Oriental Paper Co. Ltd. Actually, we vaguely recall coming across a company with a name similar to ONP's, during our initial due diligence. ONP went so far as to provide a PRC government link proving that it has filed consistent financial results in both China and the United States as regards its actual China operating subsidiary. (PRC website http://www.hegs.gov.cn to browse these corporate and financial records (please email info@orientalpapercorporation.com if interested for the necessary passwords).

So what should investors do with Orient Paper?

Over our 20+ years of investing we have made it a point to avoid controversy when pursuing investments. Could ONP be an exception to the rule? It has made some valid points in its defense and even provided a link to the filing in China. If Muddy Waters, LLC in fact referenced the wrong name, we would hope that the SEC takes a look at the matter.

Note that the Muddy report does make additional allegations

The report by Muddy Waters makes further assertions that:

1. Orient Paper's management has misappropriated proceeds from the company's April 2010 private placement
2. The value of the machinery being purchased for the new corrugating medium paper production line with an annual production capacity of 360,000 tons is significantly below the $27.8 million reported by the company.

Company rebuttal:

"In fact, Orient Paper has already disclosed a copy of the definitive equipment purchase agreement for this equipment, which is the largest scale such line manufactured to date in China, in an 8-K filing with the SEC on April 12, 2010, that also includes the agreed upon payment schedule. To date, Orient Paper has made a $5.6 million down payment for this equipment and the remaining proceeds from the private placement remain in the corporate bank account to fund the Company's future payment obligations which will be made in additional installments in commensuration with the progress made on equipment installation. Orient Paper will make available to all interested parties a copy of the Company's recent monthly bank statement and plans to post this document on the Company's website in the near future".

If ONP is correct about the name mishap then there case seems like a partial slam dunk and its stock could rebound as CBPO’s eventually did when it faced controversies over issues concerning past dealing of its directors. However, this will likely be a back and forth battle as time is needed to digest Muddy Water’s other allegations.  We should also note that it is extremely difficult to find Muddy Water's website.

Regardless of this matter, on May 20, 2010 we issued an update on ONP where we mentioned:

We will keep ONP coded as a GeoSpecial only for long-term investors who may have to go through some pain in 2010. In the short term we are not sure investors will flock to ONP until EPS growth resumes. Note that ONP guidance does not include acquisitions that may give some upside to its outlook. Long-term investors may be content holding through 2010 in anticipation of 2011, albeit a tough mental decision in this challenging market environment...especially when better EPS growth stories are present elsewhere.

We are continuing to recommend that GeoInvesting readers take extreme caution when considering current investments in ChinaHybrids. We are in the process of performing a quality check on these firms to aid investors who still want to participate in this space.

Due to recent events, we removed ONP from the GeoSpecial list earlier this morning. We are also attempting to identify other stocks that may be easy targets for the shorts such as Lotus Pharmaceuticals (OTC BB:LTUS), a company that has had its own share of controversy.

Added to the GeoSpecial list  on May 22 @ $1.68

Catalyst: Solved its liquidity problem.

Peak performance: Reached a high of  $15.15 on January 13, 2010.
Current road block: dilution may hinder EPS growth until late 2010 or early 2011 when capacity ramp-up is in full execution. Quarterly EPS growth has not been consistent. Had only a couple good growth quarters in 2009. Fiscal year 2010 guidance is not spectacular.
Current Price: $9.20

We will keep ONP coded as a GeoSpecial only for long-term investors who may have to go through some pain in 2010. In the short term we are not sure investors will flock to ONP until EPS growth resumes. Note that ONP guidance does not include acquisitions that may give some upside to its outlook. Long-term investors may be content holding through 2010 in anticipation of 2011, but this is mentality tasking in this challenging market environment , especially when better EPS growth stories are present elsewhere.

On March 29, 2010 Orient Paper reported 2009 financial results:

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"Selling, general and administrative expenses for three months ended December 31, 2009 were $1.1 million, up 450% from $0.2 million in the same period last year. The significant increase was primarily attributable to an increase in expenses related to the Company's status as a public company and expenses related to the October 2009 private placement transaction. These additional fourth quarter 2009 expenses include items such as legal, accounting, consulting, investor relations, and officers/directors compensation."

Shares have been weak ever since ONP filed its 2009 10K revealing that a loan commitment with one its subsidiary,  Habie LTD., fell through...."Because of Orient's decision to fund future business expansions through another subsidiary, Baoding Shengde LTD, instead of Habie LTD. This may have led to:

• Investor wariness over why the loan could not get approved.
• Fear of more dilution via an equity raise to replace the receipt of the expected loan funding.

As it turns out, just two days after its financial press release, ONP announced the closing of a private placement to raise funds at $8.25 that could add up to 3,450,000 to its fully diluted share count.  The problem, from a growth perspective, is that after factoring in the 23% dilution from the equity raise, investors may infer that the company’s guidance that called for 2010 EPS of $1.21 is in jeopardy. Actually, it is interesting to note that even after this round of financing ONP has not reduced its EPS forecast, leading us to believe that, ONP was on its way to exceeding its EPS target by at least 23%.  Also, to be fair, the 2010 EPS expectation is only a make good target related to a private placement in October 2009 and may be conservative.  While EPS growth of 10% is not too exciting, value investors may still take to ONP with its meager trailing P/E of 8.2 and conjecture that it will make a swift accretive move with its funds:

"Net proceeds from the offering are expected to be used for general corporate purposes, including expanding the Company's products, and for general working capital purposes. The Company may also use a portion of the net proceeds to acquire or invest in businesses and products that are complementary to its own. At the present time, the Company has no plans, commitments or agreements with respect to any acquisitions."

We will monitor this story closely.