Yunnan - how good for Sino-Forest's share price?

Herd mentality - have ("bullish") China analysts missed anything?


Rhetoric concerning timber and paper products made in China tends to ignore that industry's dependence on export markets, particularly those markets' rapidly declining willingness to tolerate the controversial social, environmental, financial and legal means deployed to procure and process many, perhaps most, of those goods.

Products made from timber grown in China are increasingly suspect - particularly those from Yunnan.

Indeed, investments in Yunnan's forestry sector are likely to be the subject of intense interest by the media and civil society (both locally within China and internationally), mainly as a consequence of an earlier project promoted by Asia Pulp and Paper ("APP"). Yunnan's valuable natural forest seem also to be the target of rubber plantation enterprises.

Consequently, it is perhaps remarkable that Sino-Forest, an apparently respectable international holding company (despite having for some reason changed its auditors twice in recent years and having a complex corporate structure [page 2] involving the British Virgin Islands - which might help minimise the group's tax payments in China but which would imply a rejection of the values of China), has been able to secure a large investment from entities controlled by Temasek a reputedly blue chip company (which might have some similarities to a sovereign wealth fund), coincidentally (like APP) based in Singapore, and others purportedly in support of a deal not wholly dissimilar to that of APP - in a market sector to which they appear to have little prior exposure and concerning a project whose location (close to the border with Burma) is remote from key markets.

Presumably, given the size of their investment, the investors have access to rather more information than that which Sino-Forest has placed in the public domain (particularly concerning the forest resource - and rights to this - and plans for land-use once the forest has been cleared).

Due diligence should perhaps be a particular concern given the precedent [described in Box 5.4] of the IFC in relation to its loan to Sino-Forest - and should as a mattter of course be carried out by those who seek to purchase flooring products made by group companies (e.g. Sino-Maple / Jiafeng Wood). A primary marketing attribute of that engineered flooring (cheapness - attributable partly to base layers being made from short-rotation plantation timber - aside) is the wood used as the surface layer, much of which is probably imported hardwood and (depending on source) perhaps illegal.

At the margin, major banks (notably Barclays and ABN AMRO) risk conflicts of interest when their owners change to include those who invest in projects in which those banks, as signatories of the Equator Principles, ought not themselves invest.

Sino-Forest mentions that early completion on this deal is important for competitive reasons (presumably rather than to achieve a fait accompli).

There is a fundamental difference between natural forests (which in Yunnan have very substantial non-timber forest product value) and plantations (commonly referred to as green deserts).

It might therefore be inappropriate to seek to design the prospective forest replacement project in Yunnan using Sino-Forest's plantation project in Hunan as its model.

Further, logging in much of China's natural forest is prohibited under the Natural Forest Protection Programme. That and related bans have had a particularly adverse impact on the sustainable livelihoods of Yunnan's ethnic minorities.

Judging by the name Gengma Dai and Wa Tribes Autonomous Region Forestry Company Ltd. ("Gengma"), it is the forest of ethnic minorities which Sino-Forest seeks to replace.

Although Gengma is presumably credited properly with relevant long established rights to the forest, it would be bizarre if Gengma's remit permits the elimination of the asset over which it is the steward, particularly if subject to a logging ban.

Securing the free and informed consent of the affected local population might be even more difficult than Sino-Forest anticipates in relation to its (more costly) Hunan project. Alienating the local population would presumably affect the risk ~ return profile of the project.

It would be a shame if the rumour that Sino-Forest's Yunnan project has the support of a powerful Yunnanese politician is well-founded. It would imply a need for such support - exposing the proponents of the project to financial and reputational risk. The State Forestry Administration, which has little jurisdiction over the type of forest concerned, is understood to have tried unsuccessfully to intervene.

It is widely expected that the 17th National Congress of the Communist Party of China (15 October 2007) will endorse recent rhetoric from Beijing demanding a shift away from "economic growth at all cost" to "socially equitable growth" (to help curb rampant corruption between businesses and local politicians, thereby helping to minimise social unrest).

Having risen sharply since the Yunnan project and the related private placement were announced, Sino-Forest's share price would of course be at risk if the Yunnan project proves controversial. It would also be unfortunate if the project adversely affected Yunnan's profile in relation to tourism and investment.

Depending on the basis of any controversy, Sino-Forest's purported commitment to sustainability in China might adversely be affected. However, the most tangible demonstration of that commitment is perhaps the FSC-certification of a rather small percentage (<2%) of the group's holdings as at 31 December 2006. However, the certificate is conditional - until Sino-Forest justifies why it is clear cutting in breach of national regulations [CAR #: 27/04].

Sino-Forest's business outside Yunnan
Trade in timber from countries (notably north east Russia and Papua New Guinea) which have gained notoriety for exporting Illegal Timber appears to have boosted Sino-Forest's cash flow and profitability. Markets, particularly outside China, are increasingly unwilling to accept wood-based products which are not certified as either legal or sustainable. Sino-Maple's expansion is vulnerable to such concerns. Sino-Forest's image as a role model of best practice in its sector would be strengthened if it ensured that its OSB production in Heilongjiang and its supplies from Inner Mongolia - at risk from mixing with timber from Russia - are legal. Technical assistance leading to credible certification of legality is readily available.

Sino-Forest has an ownership interest in a large forest concession in Suriname and is liasing over its prospective acquisition by a loss making electical company listed on the Hong Kong stock exchange.