Market Overview

Is the Market Telling Us This Chinese Company is a Scam?

The market, the invisible hand, the master that controls them all. Call it whatever you want, but the "market" ultimately knows more than any of us. It is the compilation of everyone's knowledge and convictions, and has the force to dethrone any single person.

During the course of today's trading session, China Hydroelectric Corp (NYSE: CHC) has lost over 42% of its equity value. Despite not having any news to back up the downward move, the market knows best and has successfully decimated long investors' positions in the company.

What is most likely the product of insider knowledge and trading, the stock's move down does not appear to be warranted, at least to the layperson. Exactly one week ago, China Hydroelectric earned the "Stars of China" award from Global Finance magazine. It was noted to be the best Chinese company operating in renewable energy. Interestingly, its business model appears to be legitimate.

It operates 27 hydroelectric plants across China, selling harvest electric power to local power grid operators. It is continuously seeking to expand its hydroelectric projects, as hydropower occupies nearly 22% of China's total power needs.

While longs cannot do anything to save their positions at this point, was there anything that investors could have looked at to second-guess their investment? The company refuses to say anything about the "unusual market activity," citing corporate policy.

For a micro-cap company, China Hydroelectric Corp appears to have done very well for itself. over the last five years, it has increased revenues from $2 million to about $67 million. Accordingly, it has increased operating expenses, which we imagine to be comprised primarily of salaries, to $19 million over this period. Apart from interest and tax expenses, the company has had negative incomes for the last few years due to a preferred dividend. While it does not disclose who exactly received this dividend, there is a good chance that senior management had significant stakes in the preferred dividend-holding securities.

As such, the company's EPS has been horrendous year-over-year. For example, in 2009, the company's EPS was -$10.77. While it has improved to about -$0.24 for 2010, investors certainly do not want to see such EPS results. The company also appears to beef up its current liabilities in order to maintain positive operating cash flows. Other aspects of cash flows appear to be normal, as it has made successive acquisitions of hydropower plants and assets.

It also appears to be paying off debt on a regular basis, which is always positive. What could be the case, in the event this company turned out to be fraudulent, is that it is paying off old debtors with money garnered from new debtors. This particular strategy is the definition of a ponzi scheme. This does not seem to be likely, however, as the company has established operations across China and has, at the very least, the capability to fund its debt obligations.

The most interesting thing about the company's balance sheet appears to be the sudden increase in property, plant, and equipment. In 2007, the company barely had $10 million worth of PP&E, but in 2008, it gained nearly $300 million in physical assets. The company did issue almost $300 million of preferred equity, but it is up to investors to determine if it is likely that the company developed the bulk of its operational capacity in one year alone.

It is interesting to think about what could have happened with the company. It may have purchased assets from another company, or it may have happened to have found multiple plants and areas that it could capitalize on. However, the sudden purchases are what stick out most on the balance sheet. As expected, debt funding and especially equity issuances increased drastically on the balance sheet. On the flip side, its retained earnings has been getting worse every year.

Investors should consider everything about a company. While it seems to be a prominent force in China's hydroelectric power industry, its books paint an interesting picture. Investors may want to learn more about the company's validity and learn more about the industry's growth in China.

Investors should also consider China Hydroelectric Corp's negative return on equity, poor margins, and negative EPS growth over the last several years. Investors should also keep in mind that the company has had explosive revenue growth while all this was going on - revenue grew over 200% over the last three years.

Considering everything, investors may want to hold off on pursuing positions in the company at this point, although it is relatively cheap compared to its historical prices and even to competitors' stock prices. This is especially important if insider trading drove down the stock price due to fraudulent activities.

China Hydroelectric Corp is currently trading at about $0.80, down about 89% for the year.

Follow me on Twitter at @makinmarkets

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