THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Corporate Credit Sector Strategy

Asia
23 June 2011

CREDIT OVERVIEW

China HY

charles.c.chang@credit-suisse.com (+852 2101 6036)

Sino-Forest: now what?

Paulsons exit from Sino-Forest (SNF) stock drove SNFs bonds to new lows. Current prices (11s: 85, 14s: 46/44% YTM, 17s: 40/26%) suggest that the market continues to expect the 11s to be paid, but is now differentiating less between the 14s and 17s, possibly due to heightened doubts on SNFs prospects thereafter. Released bank statements showing USD1b of cash make the 11s look the least at risk, but the upside vs. downside appears overly lopsided. As for the 14s, a small long could make sense, as the 6 point price differential vs. the 17s provides little justification for the latter, particularly since the 14s have seen stronger technicals and could face less uncertainty in a going-concern scenario (see below), which still seem to be the rational base case. On data points, the past week saw both positives and negatives. On the positives, (1) 1Q11 results came in on time, (2) no conclusive evidence against SNF emerged, (3) more documents were released and remain largely uncontested, and (4) management appears engaged (working with PWC, fighting allegations) and duly cautious (capex to slow). On the negatives, (a) the AI issues were not fully addressed, (b) no buy back of bonds or stocks for now, (c) the Globe articles added to ongoing doubts and (d) Paulsons exit likely impacted sentiment. The positives could support liquidity and help rule-out flight-with-cash scenarios, while the negatives could keep suspicions high and technicals weak. As for allegations, Muddy Waters (MW) has provided little new evidence, nor has it contested most of the evidence provided by SNF, some of which showed a number of MWs charges to be erroneous (e.g. transport standing timber, overlooked Yunnan acquisitions, key named sub not a sub). As a result, MWs thesis that SNF is a Ponzi scheme seem to remain unproven and poorly supported. The Globe has done better investigative work, but its articles appeared inconclusive on the questions raised, many of which were later addressed by SNF. Despite this, questions on SNFs customers and assets remain at the forefront, where they seem likely to stay until key milestones are met. Having released 1Q results and paid the 16s CB coupon, these now include (1) coupon payments on the 14s (7/26), 13s CB (8/1) and 17s (10/21), (2) redemption of the 11s (8/17), (3) release of PWCs findings (2-3 months), and (4) any buyback of shares or bonds (likelihood uncertain).

Tactical approach
Given the above, trading the bonds in small longs/shorts continues to look more sensible than going outright large, as significant uncertainties and technical risks remain, and most could find themselves unable to stomach the whole ride. Regardless of the actual motivation, Paulsons exit points to the risk that prior holders could decide that their positions were either unlikely to recover or take too long to recover, and that it is not worth the volatility and the reputational impact. Indeed, much of the bonds seem likely to change hands to those better suited for such trades, a process that could drive technical pressures in both upswings (orderly exit) and downswings (capitulation, some after Paulsons exit).

Assets, liabilities and downside

As of end March, SNFs key reported assets total USD4.9b, comprising 1.1b cash (767.5m offshore, 320.6m onshore), 3.1b forestry assets (at 12/31/10, per Poyrys latest report), 448m AR and 211m prepaid costs (plantations, logs). Key offshore liabilities total 1.9b (11s: 88m, 14s: 400m, 17s: 600m, 13 CBs: 345m, 16 CBs: 460m) while key onshore liabilities total 732m, including 155m bank debt, 505m AP, 11m taxes and 61m admin that could accrue in a 6 month wind-down. If SNFs forests could be liquidated at 30% less reported value, and other assets at 80% less, the resulting total could exceed liabilities, and economic value (proxy for downside on the bonds) could be 69%. If only cash and forests backed by released documents (c.25% of total forests) are included, the downside could be 33%, which could imply a wide trading range for the bonds. Sector Strategist Charles Chang +852 2101 6036 charles.c.chang@credit-suisse.com

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CHTREE some similarities and differences

Evolution of the SNF situation shares some similarities with China Forestry (CFH), which saw a CEO share sale (1/13) followed by a share suspension (1/26), accounting irregularities (1/31), a Board committee investigation (1/31) and an SFC investigation (on the CEO, 2/9). Announcement of cash holdings and a conference call (3/2) pushed the bonds from the 50s to the high 70s/low 80s, where they settled after the release (on 4/29, delayed from 3/31) of results from its internal investigation, which included a re-audit by KPMG and a re-valuation of its forests by its valuer. Allegations that CFH was a sham proliferated during the three-month investigation period (1/31 to 4/29) presumably encouraged by short-sellers. The charges focused on (1) illegality (logging > quota), (2) improbability (forest reported > village), (3) unverified assets (forest not bought/certificates not real) and (4) non-existence (locals not aware of company). In SNFs case, (1) and (2) were employed by MW, while the Globe focused on (3), with (4) largely absent, as MW/Globe have verified SNFs presence on the ground with various agents and counterparties. Ultimately, none of CFHs accusers seemed able to prove that it was a fraud, and associated charges fizzled out after 4/29, even though the re-audit and re-valuation were heavily qualified. Indeed, the market seems to have taken comfort in the fact that CFH was re-examined by credible parties, and that the alleged perpetrators (CEO, CFO, CRO) were removed.

What could come after the milestones

We may not see as clean a break in SNF as we did in CFH, as SNFs accusers seem to be targeting the company, not particular individuals, and as the AI issues (not in CFH) could remain outstanding post the PWC report. Nevertheless, SNF could follow a similar path, with the report providing comfort and allowing various charges to fade into the background thereafter. That said, technical pressures could continue (although they could become less potent), as short sellers could follow SNF for some time (they are less able to for CFH, as its stock remains suspended). While SNF could operate as a going concern in this scenario, it could be blocked from the markets for years, and may need to rely more on existing inventory (866.6k ha, c.107k cbm). At FY10 volumes (17.6m cbm), this implies c.6 years of sales, with c.USD840m of cash generated p.a. (see table below), which could leave 200m-400m p.a. for forest acquisitions (1Q11: 475m). It is worth nothing, however, that this episode could incur material costs (e.g. fees, any lost lawsuits). This could result in meaningful ongoing outlays, as could the adoption of dividend payments, which may be needed to entice shareholders. These items could be a drain on free cash, and could shorten inventory life, implying greater uncertainties for the 2017 bonds.

Sino-Forest - Financial Summary

USDm Total assets Cash (unrestricted) Cash (restricted) + cash equiv Work in progress/inventory Other fixed assets Interest in/loans to assoc. Other assets Short-term debt Long-term debt Total debt Net debt Other liabilities Total equity Total debt/op. EBITDA Net debt/op. EBITDA Op. EBITDA/gross interest Op. EBITDA/net interest Net debt/tangible equity Total debt/total capital Cash/ST debts Current debt/total debt Revenues Operating EBITDA Gross interest FFO Net debt decrease (increase) Gross margin Operating margin Op. EBITDA margin Net margin Cash flow and net debt Net cash gen. by op. Net finance charges paid Post internal financing CF Capital expenditure Fixed asset sales Business acquisitions Net cash from investments Other inflow/(outflow) Net CF flow pre-financing Shares issued for cash/debt (equity is Other non-debt, non-repayable sourc Debt decrease/(increase) from forex Other non-cash items that dec./(inc.) Net debt decrease/(increase) Opening net debt Closing net debt
Source: Company reports, Credit Suisse. *3ME.

12/04 756 201 24 3 426 0 102 29 300 329 103 55 372 3.9 1.2 5.3 5.8 28% 54% 7.1 9% 331 84 16 118 -7 31% 22% 25% 16%

12/05 895 108 30 8 594 16 139 41 300 341 203 86 468 2.9 1.7 4.0 4.7 43% 47% 2.6 12% 493 117 29 228 99 28% 23% 24% 17%

12/06 1,207 153 19 15 841 16 164 71 450 521 350 108 578 3.7 2.5 3.8 4.6 60% 52% 2.2 14% 555 142 37 307 147 31% 24% 26% 20%

12/07 1,837 329 22 47 1,253 23 164 55 453 509 158 142 1,187 2.3 0.7 5.1 7.8 13% 35% 5.9 11% 714 224 44 459 -192 34% 28% 31% 21%

12/08 2,604 441 46 43 1,717 22 335 72 714 787 300 218 1,599 2.5 1.0 6.0 8.0 19% 37% 6.1 9% 896 313 52 543 142 41% 35% 35% 26%

12/09 3,964 1,102 70 46 2,261 38 447 104 925 1,029 -143 270 2,665 2.7 -0.4 5.3 6.1 -5% 30% 10.6 10% 1,238 376 71 825 -443 36% 30% 30% 23%

12/10 5,729 1,223 32 62 3,236 0 1,176 242 1,660 1,901 646 578 3,250 3.3 1.1 4.6 5.0 21% 43% 5.1 13% 1,924 585 128 1,173 789 35% 30% 30% 20%

*3/11 5,869 1,055 33 3,354 369 0 1,058 243 2,055 2,298 1,210 566 3,005 3.8 2.0 4.3 4.5 44% 50% 4.3 11% 339 88 44 55 1,210 34% 25% 26% -7%

128 -9 119 -171 0 0 0 0 -52 68 -6 0 -3 7 110 103

225 -29 196 -301 0 0 0 0 -105 0 -1 1 6 -99 103 203

326 -36 290 -423 0 0 0 0 -133 1 -3 1 -12 -147 203 350

528 -42 486 -693 1 1 0 0 -206 390 4 5 -1 192 350 158

522 836 922 -39 -52 -82 483 784 840 -701 -1,093 -1,406 0 0 0 2 0 -2 0 0 0 -1 24 1 -221 -285 -562 2 652 12 -31 -53 -3 2 0 2 91 129 -238 -158 443 -789 158 300 -143 300 -143 646

246 -35 211 -382 0 0 2 0 -169 0 0 1 -396 -564 646 1,210

Disclaimer
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