Charlatan Exposed: Silvercorp’s Shorts

Thu, Sep 22, 2011 - 1:16pm

There is a new boiler room operation in town and it doesn’t involve slick-haired Wall Street scumbags with mafia connections but rather anonymous hedge fund managers and shady characters with no permanent homes or the guts to identify themselves.

And so these shorts without names or homes have found their latest target, Silvercorp Metals (NYSE/TSX: SVM). Unfortunately for them, this time their target doesn’t walk or smell anything like a duck. In fact, some of the anonymous allegations against Silvercorp are so stupid that they raise questions about all the past allegations the shorts have made against the long parade of Chinese companies listed on U.S. or Canadian exchanges. We all know them so let’s not get into names. What matters is that a “research” outfit by the lofty name of International Financial Analysis & Research Group (IFRA) has supposedly documented information on many of these companies by visiting corporate offices, production facilities and sales outlets along with conducting interviews with competitors, partners and customers. Given their work has now been confirmed as sloppy at best in the matter of Silvercorp, all of their prior work must now also be considered doubtful. We are actually quite shocked to learn of this — as recently as last week we still believed these “investigative” efforts were credible. It sucks to be naive but it’s much worse to remain that way.

At this point Silvercorp and several individuals (see here and here) along with the odd newsletter and broker have already provided a litany of rebuttals to the anonymous allegations. And yet they keep popping up with slight modifications and incessant repetition. Unlike the other rebuttals, we are not going to be nice here and give the shorts undeserved respect or benefit of doubt. We are going to call it instead exactly like we see it in true Metal Augmentor fashion.

First off, however, we don’t believe it is appropriate or productive to paint all short sellers with the same broad brush of manipulation and abuse. Shorts can serve a legitimate purpose in a stock market: to counteract pump and dump operations, to strengthen price discovery, to make sure valuation is reflective of market consensus (for good or bad), etc. Anybody should be able to form and share either a long thesis or a short thesis on a stock. One or the other thesis will eventually turn out to be correct and a free market is an efficient way to arrive at the right answer. The defamatory abuse that is taking place at this juncture, however, is not how a free market should work. Instead, it is exactly how a mob hands out justice: hang first and never ask questions later.

The false allegations that have been made are no different from a pump and dump except in reverse. Actually, there is a difference: a pump and dump is illegal only in securities trading whereas defamation is unlawful in virtually every human interaction. In most countries, you haven’t broken a law if you tell everybody what a great baseball player or poker player your loser nephew is … but if you wrongfully accuse him of being a rapist or a thief, then you are liable for damages arising from his lost reputation. It was only a matter of time before the shorts encountered a nephew who is actually not a loser or a rapist or a thief. Silvercorp be his name.

While it is important that shorts should be tolerated, abusive short-selling practices should be vigorously counter-balanced by seeking redress in court for civil damages as well as by bringing market regulators into the fold. Regulatory changes should restrict the abusive and manipulative aspects of short-sided speculation by, for example, requiring shorts who publish negative information to declare in regulatory filings their positions above a certain threshold level and by forcing these shorts to maintain their positions for a certain period of time so that the accused company has a chance to fully respond. In particular, we believe there are licensed investment professionals and registered investment advisors presently active in the United States who need to lose their credentials for their key roles in this gross abuse of the markets.

Look, we are no friends of companies run by reckless promoters who make selective disclosures, much less fraudsters. We have identified companies in the past that have subsequently gone under primarily as a result of undisclosed risks or negative factors. One company, Sterling Mining, even had a deposit that is geologically very similar to Silvercorp’s Ying property: the Sunshine Mine in the Silver Valley of the Coeur d’Alene Mining District in Shoshone County, Idaho. The problem there was that it was an old mine with most of the silver being left over mainly as side and crown pillars in old stopes while future production was burdened by a 7% NSR royalty. We suggested to management that they conduct exploration with an eye toward making a new discovery while negotiating a buyback of this royalty prior to announcing plans for production. They claimed the royalty would never have to be paid because of their arcane interpretation of the law. The rest was history.

We did all the original legwork to discover the facts in the Sterling Mining case including talking to former mine personnel, reviewing SEC and bankruptcy filings of the prior mine owner — the (also) defunct Sunshine Mining Company — and even pulling property records. Sure enough, those 7% royalty holders came looking for their NSR payments just as Sterling Mining was going into default. In fact that royalty is still pestering Thomas Kaplan’s new Sunshine Silver Mines (page 60).

We are aware of other companies that are still operating despite having some serious skeletons in the closet — and again we identified these problems by conducting original research. So we know how to properly do this stuff … while most of the short sellers are grasping at straws.

Here is a suggestion. The goofballs, hippies and know-it-alls who have piled on to attack Silvercorp should take a look at the historical production that came out of the aforementioned Coeur d’Alene camp (not to mention the current happenings at Hecla’s (NYSE: HL) Lucky Friday) before they pipe up again about the SGX mine in the Ying District having grades that are “too good to be true”. In fact, only a true mining ignoramus would compare a mesothermal vein deposit featuring massive sulfides and silver sulfosalts to a typical silver mine containing unremarkable epithermal veins or worse (from a comparative standpoint), a low grade disseminated silver deposit. These ignoramuses might wish to consult at least the Imiter Mine in Morocco for remarkable grade epithermal silver (about 30 ounces or 1kg/tonne) as well as Tahoe Resources’ (TSX: THO) Escobal and MAG Silver’s (TSX: MAG; AMEX: MVG) Juanicipio. These are among the few comparable vein deposits worldwide with overall silver grades at least as good as the SGX mine, which the shorts claim is misrepresented by the company as 845 g/t. The 845 g/t is actually the measured portion of the high grade resource at 300 g/t cutoff for the SGX mine from 2009. As such, it is basically irrelevant.

In reality, the actual high-grade reserves of the SGX mine in the current mine plan are less than half that number –410 g/t to be precise. Apparently our intrepid mining experts don’t understand the differences between how various resource categories are reported or the distinction between an estimated cutoff grade in a resource block and the actual cutoff grade used for ore reserves in the mine plan.

In the case of the SGX mine, the cutoff grade for measured and indicated resources is 300 g/t silver-equivalent, meaning that the reported resource tonnage is constrained to ore blocks that are at least that grade. There are no economic parameters applied to the 300 g/t cutoff number so it will tend to remain the same over time. By contrast, the economic cutoff grade for proven and probable reserves at SGX is about one-half the resource grade thanks to low mining costs and high silver prices. This is why the average mined grade at SGX doesn’t even look that remarkable for an underground deposit. We’re happy to explain all this to the shorts in a way that even a kindergartner can understand. Unlike the experts purportedly consulted by them, we’ll even try to avoid ridiculous claims like the one where 68 million ounces of “equivalent silver” is supposedly too low (“they should have more resources”) to support a company with even just a $100 million market cap. Our fees are reasonable.

Before moving on from the grades at the SGX mine, let’s look at the pile of rocks the fine folks at IFRA collected from the roadside between the Ying mine and mill.

Wow, what can we say! What an impressive pile of random rocks that probably did not fall off an ore truck! Many of them are clearly weathered with smooth edges or showing signs of air exposure (oxidation of iron sulfides) and as such they do not appear to be the product of very recent mining activity. Our guess would be these rocks are larger fragments from the fill material that was used to construct an all-weather road capable of supporting heavy truck traffic. The rocks could have come from the mine as well — perhaps barren or low grade development material — but they do not appear to be representative of high-grade veins (or even medium-grade ones).

Here is how ore might look like at various grades coming out of a silver-base metal vein (these are from my personal collection and also have some iron staining that would not appear as extensively discolored on freshly mined rock):

Notice a few things. One, the material tends to be angular since it was literally blasted out of whole rock by explosive force. Two, it doesn’t have rounded edges from weathering. Three, it has clear vein textures (bands of different colors) instead of typical rock composition. Four, there is some sparkly stuff representing sulfides (these rocks are high grade overall but there are also lower grade portions). Five, oxidation is in spots and bands confirming this to be vein material. All in all, we’d estimate that 75% or more of the rocks in the IFRA “sample” photograph did not “fall off a truck” that was transporting freshly-blasted ore from the SGX mine to the mill.

Now about those trucks. It is claimed they use 13 tonne “Hercules” models at Ying that cannot possibly carry 30 tonnes of ore … at least according to some random guy they spoke with. Oh brother! The shorts would realize their folly if they actually had any experience with trucks or even just bothered to spend 5 minutes conducting bona fide, unbiased research. Had they done that, they would have been able to recognize the clear difference between a light duty model and a heavy duty one. Things like box size and tire size easily give away the difference. Behind big boxes and big tires are big axles, big frames and big hydraulics. Only the cab remains the same size despite the 30 tonne truck sometimes having a larger engine.

Click here to enlarge

The truck on the left is apparently the ironically-named light duty “Hercules” while the one on the right is an undeniable beast with muscular tires and a gigantic box in comparison. I wouldn’t quibble with the claim that the lightweight on the left would struggle to carry 30 tonnes — even though we are talking about just a few kilometers between mine and mill at relatively low speeds. The truck on the right, however, is a 30 tonne truck if there ever was one. Such a truck would no doubt be easily capable of transporting 40+ tonnes at slow speeds on dirt roads in its massive box (18 x 7.5 x 6 feet enclosing 20 cubic yards of rock by our estimate). The red trucks on the ferry (see full picture here) are equally massive and are also clearly 30 tonne beasts … obvious to anybody who isn’t blinded by the glitz of the fast and fabulous short-selling lifestyle.

Now let us discuss a slightly-uncomfortable truth. We now know that a 5% equity interest in Henan Found, the Chinese joint venture between Silvercorp and a state-owned enterprise (SEO) we’ll call Henan Non-Ferrous, was sold at an “auction” to an affiliate of the SEO. The “selling” price was approximately US million and so the shorts would have us believe this is a good indicator of the fair value for all of Henan Found. In turn this would mean that the SGX mine might be worth no more than US0 million. There is only one problem with this hypothesis. This was a very strange auction. There were 3 bidders. Each of these 3 bidders deposited 20 million RMB (almost half the opening bid) and also had to submit an “operating plan” for approval by Henan Non-Ferrous prior to being accepted as a bidder. After all this trouble, the bidders managed to bid up the price all the way to .5 million RMB between the three of them. The furious action must have left the 2 losing bidders gnashing their teeth — after all, you don’t often see an auction where the winning bid soars above the opening price by a massive 1%! In fact, we’re pretty sure nothing like this happens outside the competitive bidding process for privatizing state-owned assets in China. Of course China still doesn’t hold a candle to the competitive bidding that took place as the Soviet empire was dismantled in the early 1990′s. In sum total, the auction for 5% of Henan Found had an outcome that was as certain as the sun rising in the East.

There is much more that we could pick apart but we’ll look at just one other thing for now. It has been alleged that Silvercorp cannot possibly have completed the amount of exploration and development work that it claims in prior years given how little all of this work supposedly cost. This is an interesting allegation given that China works from an economic standpoint mainly because costs are so low there. To wit, in fiscal 2011 Silvercorp reported that it spent just US.3 million in exploration and development to accomplish the following according to page 8 of the MD&A:

The Ying Mine incurred .3 million exploration and development expenditures (FY2010 – .7 million). With that, 38,870 metres (FY2010 – 34,816 metres) of tunnel, 38,254 metres (FY2010 – 28,746 metres) of diamond drilling, and 935 metres (FY2010 – 1,387 metres) of shafts, declines and raises were completed. The mine development works completed will effectively sustain the Ying Mine’s production level.

Based on the above, it is claimed by the short sellers that drilling costs at Ying appear “under-reported by 3.9x”. We don’t know how it is possible to determine this about drilling since the shorts’ own surveys of local drilling contractors arrived at an assumed price of 225 RMB/meter (US/meter). The total for drilling 38,254 meters would therefore be about US.3 million out of the US.3 million. Similarly for shafts, declines and raises the shorts’ contractor surveys arrived at an assumed cost of 15,000 RMB/meter (US,300/meter) totaling US.2 million for the 935 meters.

That leaves 38,870 meters of tunneling or sometimes also known as “drifting”. For some strange reason the shorts use an assumed cost of 6,750 RMB/meter (US,053/meter) for this drifting and therefore they arrive at a total cost of US million. But, there is only US.8 million left for drifting expenses after deducting drilling and shafting costs of US$1.3 million and US$2.2 million, respectively, from the total exploration and development for the year of US$11.3 million.

Of course once again it never occurs to these shorts that a simple explanation may exist to their big questions and red flags. Indeed, such a simple explanation means that their short thesis is that much weaker so they would rather prefer there isn’t an explanation at all. Let’s ruin their fun anyway, shall we? At under US$200 per meter (US$7.8 million divided by 38,870 meters), the drifting at Ying would indeed be some of the cheapest development work conducted since the old timers who got paid in whiskey and liked it that way. In fact, we don’t doubt that the contract rate for drifting can sometimes be as high as 12,000 to 15,000 RMB — about US$2,000 per meter — in China for a typical production scenario involving major drifts that require access by large mining vehicles.

Silvercorp’s Ying project, however, is anything but typical. Let’s start with the tunnels that are 2 meters by 2 meters. These tunnels are barely tall enough for the average Westerner with a hard hat and just wide enough for two of them to pass each other. One tonne “tricycle trucks” zip back and forth through these claustrophobia-inducing tunnels like ants in a colony. Meanwhile ceilings are only intermittently secured by rock bolts or timbers due to good ground conditions along with the minimal size of the headings themselves. A small crew of miners could advance such a tunnel at the pace of 2 meters a day. At the calculated cost per meter of drift (US$7.8 million divided by 38,870 meters), the combined wages of this crew would be on the order of US$200 per day after expenses, which breaks out to a significant individual amount for the hardest working crew members. Meanwhile the laid-back miners still prefer to be paid in whiskey, like always.

Let’s also consider that the pocket-like nature of the high grade ore shoots requires much of the drifting to be done on the vein itself: the famous refrain of drill for structure, drift for grade. This style of development can result in quite a bit of “development ore” being accumulated while production stopes are being accessed and prepared for mining. The next part is mere speculation but we’ve had personal experience with similar instances of it at other projects. To wit, such “development ore” might not meet the minimum cutoff grade (approximately 160 grams or 5 ounces per tonne silver-equivalent) per the mine plan … but that doesn’t mean it must necessarily go to waste. Indeed at $40 silver, a tonne of such rock contains metal worth about US$200, which as you’ll recall from above is about the same that the entire crew earns during a hard day of work!

Remember also that the miners use one tonne “tricycle trucks” to haul rocks around the mine, meaning that a single load could be worth up to US$200 in metals. And this is the stuff not going to the mill — in fact the mining crews are being paid to keep it out of the mill. Yet it would be safe to surmise that rock with such high value might be going somewhere other than the waste rock pile. For example possibly as a credit against the mining contract: a bonus, profit share or any of a wide range of possible arrangements that are not unique in the annals of mining history. Such netting can make a mining contract rate seem very low, which it is in Silvercorp’s case. In other words, nothing to see here kids, mosey along now.

Unfortunately our little short bashing must come to an end for today … but never fear because we continue to be on the case, correcting wrongs and championing truth wherever the dark forces of market abuse cast their evil gaze.

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.

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