It's only a Northern Conference Call

And if you are listening to this conference call

You might think the words are going wrong

But they're not.

They just say it that way

(Apologies to George Harrison).

I was slow on this (which I blame on Blogger being down). Herb Greenberg has already published a story about Ashwood Resources and the wife of the CEO of Northern Oil. Its a great story though - so here is my slightly longer-winded version:

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Northern Oil and Gas presented a very strange conference call with a very strange final answer.

You need some background to this and why it was so strange.

The Street Sweeper published an article about a company called Ashwood Resources which has purchased (possibly small) interests in almost 80 oil leases from Northern Oil.  The Street Sweeper meticulously documented their sources and whilst I have not checked the validity of the documents I was aware of the some of the documents including transfers of assets to Ashwood from my own research.

I was not the source for the Street Sweeper article.

According to the The Street Sweeper, Ashwood is an unusual vehicle. It was established by Isabel Esbensen – a very young adult about the time she graduated from beauty school.* (You can book a hairdo or manicure with Isabel here.)

Also according to The Street Sweeper, the chief manager of Ashwood is Jacob P Schaffer, a local realtor who was once the second largest shareholder of Northern Oil. My own research indicates that he is also associated with Voyager Oil the “sister company” of Northern Oil.

More pertinently the contact officer for Ashwood Resources is Brittany Reger – the wife of Michael Lewis Reger. Micheal Reger is the CEO of Northern Oil.

None of these details were denied by Northern in their conference call.

Obviously selling interests in 80 oil leases out of Northern Oil and into Ashwood looks like an undisclosed related party transaction. After all Ashwood seems to have no other presence in the oil industry. Its only identifiable business is to trade assets with Northern Oil.

In the conference call Northern argue that the interests in all these leases are minuscule. It was maybe 80 leases but they sometimes only owned 0.5 percent of the lease. This is true (I have seen some lease agreements). However the Street Sweeper follows a single well where Northern's interest was divested in a bunch of tiny transactions (I have not verified these transactions).

The defense offered was (a) Ashwood is not related and (b) the transactions with Ashwood are trivial in nature.

All well and good, but the CEO (Michael Reger) made this comment on which I did a double take:

In September of 2010, five months after Northern executed the agreement with Ashwood to divest these minute working interests, Brittany, my wife, began assisting Ashwood as an independent contractor to process the massive amounts of paperwork that's associated with owning over 90 minuscule well bores. She's paid a monthly fee as an administrative assistant. It's not dependent on the profitability of Ashwood or any other factor. 

The agreement with Ashwood makes sense for NOG, and it's not improper in any way. We stand behind the decision we made to divest the minuscule working interest. And I understand the goal of the article was to damage my credibility or my family's credibility or Northern's credibility. But nothing that's being alleged affects the value of Northern's assets. We haven't done anything wrong. This was not a related party transaction. 

Please – lets understand this.  Micheal Reger has cashed over 35 million dollars worth of Northern Oil shares in the past two years.  The Regers have joined the cash-super-rich.

And despite this Brittany Reger takes a job as an “administrative assistant”. A paper work job tracking lots of trivial oil leases that are not even worth Northern Oil's time and effort to track.

I can think of a lot of things the average CEOs wife would do when she newly comes into $35 million of (pre-tax) cash and when family wealth is over $100 million. She might go shopping. She might go to Paris or London.

She might spend more time dressing in fabulous fur coats backstage at fashion shows in New York. (She really does look fantastic here...)

She might want to spend more time with her family.

If she were charity minded she might want to donate her time to a charity. She may want to work out how they are going to give the money away someday.

But Brittany Reger chose to work as an “administrative assistant”. And not just for the local real estate agent or for a charity or a school. No – for the one company in the world where any decent lawyer or accountant would say “don't go there”. Britany Reger works for a company whose sole purpose appears to be to do transactions with Northern Oil. Northern Oil has made her wealthy and her husband is the CEO.

Brittany really might like work. She may aspire - despite the wealth - to be an "administrative assistant". But of all the places in the world why would she choose to work for Ashwood? It is staggeringly inappropriate.

The minimal interpretation is that the Regers lack basic judgement when it comes to the appearance of improper behavior.  The transactions with Ashwood might be trivial. The paper work associated with them might be too hard for Northern Oil to do. But allowing the CEO's wife to be employed by a company whose main function is to manage assets purchased from Northern Oil and to handle paperwork at that company - paperwork that is too hard or too messy for Northern Oil to do on its own is - to put it mildly - unusual.

John

PS. Next time I am in Minnesota I would love to pay Isabel - hairdresser and founder of Ashwood resources - a visit. I might even go for my first ever manicure.

If any of my readers in Minnesota want a manicure may I suggest booking an appointment with Isabel? I have a list of questions to ask.

The Steve Madden counter example

Steve Madden - the designer of the ridiculous high-heeled shoes beloved by teenage tarts - gives me nightmares.

And every time I go to my office in Bondi Junction (Sydney, Australia) I pass - at the entry foyer - a far-flung outpost of Steve Madden Shoes - a reminder of the risks in my business.

I short stocks - and whilst I carefully examine the accounts and sometimes even stake out factories - mostly I find shorts based on people. Brokers and stock promoters with a history of fraud interest me. Lawyers are my favorite of all scumbags because some do the documentation for fraud after fraud after fraud and lawyers seldom get pinged. Stock promoters come-and-go. Lawyers are eternal!

I will short a stock (in very small quantity) based on an association with one suspect lawyer and one suspect promoter. I read the accounts if the stock goes against me - and depending on what I find I either increase my position or cover. If the stock just goes down (which it often does) I just take the profits and wish I had shorted more.

When one goes against me I think - yet again - of Steve Madden and his tarty shoe company. Steve Madden is my eternal nightmare.

But for that you need some background

Stratton Oakmont and Steve Madden

Stratton Oakmont was arguably the most fraudulent stockbroker ever to operate in the United States. Its founder (who went to prison) wrote about it in agreeable first person: The Wolf of Wall Street is a tale of high class hookers (known as "Blue Chips"), Quaaludes and stock fraud. 

Every stock taken public by Stratton was a disaster and a fabulous short. They all crashed and burned. Every stock that is except one.

The except one is Steve Madden Shoes (SHOO:Nasdaq). And even that was a close-run thing.

Steve Madden was a small-time shoe designer going nowhere and frustrated with his lot working for larger shoe companies. He struck out on his own. 

But he had no money - so - in the great tradition of America - he went cap-in-hand to Wall Street. 

But he did not just go to Wall Street, he went to his childhood friend Danny Porush. 

Danny was senior at Oakmont Stratton and Steve Madden shoes was dressed up in classic Stratton fashion. In other words the company was over-promoted (even fraudulently promoted) and the stock was manipulated. Jordan Belfort (the CEO of Stratton) had large undisclosed positions (he admits this in his book) and was actively involved in the manipulation of the stock.

Eventually the manipulation scheme comes crashing down. Steve Madden is charged with stock fraud and pleads guilty. He went to prison.

Something strange happens on the way to the stock manipulation

Usually this is the profitable end of a fraud-short. Usually, but not always.

Something strange happened on the way to the stock fraud. That something was Steve Madden. Madden always was first-and-foremost a shoe designer and an outrageous and outrageously successful one. Even by the time Madden was charged Steve Madden Shoes was on its way to being the most successful high-heel shoe company in the world. Teenage girls just love him.

And Madden - from prison - retained his role as design guru for the company. Beyond prison he is back in the saddle - and the success continues. The stock goes up because Steve Madden is good at what he does. The stock is a 25 bagger.

This is a lesson to me

I see fraud in accounts regularly enough. There is no trouble finding fraudulent companies and if you picked Steve Madden as a short you had indeed found a fraudulent company.

But it hardly helps. The money raised by stock fraud at the beginning of Steve Madden Shoes nourished the growth of a truly successful (and valuable) business.

Shorts - and there were plenty of shorts - had a really bad time with this one.

Every company I short I have to ask myself - even if I am sure this is dodgy - how do I know I do not have the next Steve Madden? To me that is the stuff of nightmares.

And here - just to rub it in - is a picture of Steve Madden with Katy Perry. Not only did he get the loot - but he seems to have got the girls as well.

As a shortseller photos like that just rub salt into wounds.

John

More comment on Longtop's capital efficiency

The consensus reaction to my last post was that Longtop does not actually provide a cloud based storage service at the petabyte level despite the plain reading of the press release. Readers have argued that what Longtop is saying is that it helps customers (who are largely financial institutions) set up this storage on their own premises using cloud technology. Longtop is thus a system integrator for the bank and probably installs third party equipment for the bank.

Moreover the consensus was that no financial institution customer has a petabyte of data they need full access to. One reader cited this fact: that in 2008 Yahoo claimed the world's largest and most active database at 2 petabyte. This article aslo suggests that the IRS data-mining database is a svelte 0.15 petabyte. 

A petabyte of data is possible with extensive video and photo storage (people cited cameras) but whilst banks have some security cameras (eg on ATMs) they generally do not require this data to be stored huge lengths of time or be super-accessible. 

Obviously the really big databases (eg Facebook with all those photos) are substantially larger than any needed by a bank or the IRS – but the “petabyte” claim was almost certainly marketing puff.

Marketing puff is not that uncommon in tech-stock land. The geeks even have a word for it: vaporware. Typically however vaporware refers to software that is announced without a release date: in this case it was a vapor-launch (the announcement I quoted was an “official launch”). 

But puffery is puffery and does not challenge the fundamental veracity of the accounts. And indeed I have not challenged them (unlike Citron). Instead I just look at wonder at how a business can be that capital efficient.

So how exactly does Longtop use its capital?

How Longtop uses its capital is an important question because Longtop raised 127 million in late 2009 and – according to their accounts – they had no use for the cash. Maybe they planned a big acquisition but they never did one large enough to make a serious dent in their cash hoard.

Longtop currently carries – relative to its expense base which is the right way to measure it – six times as much cash as Microsoft. I went through the numbers in my first post. Longtop is a cash generation machine.

But not only is Longtop a cash generation machine it does not seem to need capital to grow. Its incremental capital efficiency is breathtaking and becoming increasingly so.

Longtop incremental capital efficiency

In the 20F (annual filing) covering March 2009 to March 2010 the company grew nicely. Revenue rose from 106.3 million to 169.1 million – a China-like 59 percent per annum. There had been an acquisition in the year ended March 2009 so the organic growth rate was somewhat smaller but still very large.

Here is the the fixed asset summary from the 20F for the year ended March 2010. 

Fixed assets, net (numbers in USD thousands)

		March 31
		2009				2010
Equipment and fixtures		$	9,654			$	13,022
Leasehold improvements			2,040				1,718
Buildings and renovations			222				19,687
Motor vehicles			1,253				1,355
			13,169				35,782
Accumulated depreciation			(7,316	)			(9,254	)
Impairment			(185	)			(185	)
			5,668				26,343
Construction in progress			9,190				—
Fixed assets, net		$	14,858			$	26,343

Equipment held under capital leases had a net book value of $1,292 and $732 at March 31, 2009 and 2010, respectively.

Construction in progress at March 31, 2009 consisted of an office building and renovations which were under construction and not ready for use.

Total depreciation expense recognized in the years ended March 31, 2008, 2009 and 2010 was $1,780, $2,808 and $3,193, respectively.

Note that equipment and fixtures rose from $9.65 million to $13.02 million - an increase of 3.37 million. In that time the staff numbers went from 2602 to 4258 - an increase of 1656 employees (63 percent growth).

I want to observe something: the equipment and fixtures - before depreciation - rose by only two thousand dollars per employee. 

Lets spell this out: this is a world beating software development firm with world-class economics and enormously fat margins. By its own admission it is critically dependent on the research and development done by its staff. And the incremental capital spend per new staff member would buy good desktop computer and a cheap desk and chair. Given things like power protection, backup servers etc are included in this additional fittings and equipment ($2000 per incremental employee) we can safely conclude that the new employees are treated skint. Very skint.

Whatever, there are no in-house restaurants, basketball courts, table-tennis tables and other splurges on new staff. This is not Silicon Valley. There are probably not even incremental sophisticated computers for them to test their programs on. (And they are writing software for complex environments and things need to be tested...)

I always thought it was hyperbole when Warren Buffett praised Jack Ringwalt for being late to a meeting because he was driving around trying to find a parking meter with unexpired time. But these guys make Ringwalt look like a spendthrift drunk.

This reluctance to spend is - well - amazing. Especially as there is no shortage of cash.

The tight rein on capital expenditure is even more amazing this year

From the most recent 6K revenue is up more than 40 percent since last year. Indeed the revenue rise for the first nine months is about the same as the revenue rise for the whole previous year. They have not told us how many more staff they have employed but unless the staff have become massively more productive they have probably added a further 1600 or more staff. (That rise would also be consistent with their rising cost base.) 

But the total fixed assets (including vehicles, buildings, leasehold improvements etc) have risen from 26.3 million dollars to 27.9 million dollars. If we guess 1600 staff as above (and that is just a guess) then the rise is only a thousand dollars per staff member. Whatever - we are now talking cheap computers and no vehicles, fittings, fixtures or anything else much.

Even if there were no new staff it would be pretty amazing to grow fixed assets by only 1.6 million dollars whilst growing fat-margin revenue by about 70 million per annum. I have never known any business to have that sort of capital efficiency.

What is going on with capital management at Longtop?

The capital management here is just strange. The company raises money when it doesn't need it. It sits on cash equivalent to six years of operating expenses (which is about 6 times more than Microsoft). It has a world-beating software business which they are justifiably growing as fast as they possibly can. They state repeatedly that they are dependent on the skills and product development of their staff. 

And despite this they don't seem to spend anything on fixed assets to make the staff more efficient or more happy.

I guess Chinese workers just put up with it. Chinese software workers make do working on outdated equipment. And as for the basketball courts and in-house restaurants of Mountain View California. Well - you ain't seeing them here.

I don't get this. Obviously I don't understand China. A riddle wrapped in a mystery inside an enigma you might say - but that was said about a previous superpower. 

I just report it. Can't say I understand it.

John

Longtop and the remarkable capital efficiency of the Chinese cloud

A note on the comments: the comments on this post are consistently of the view that (a) the company did not build a cloud-based storage infrastructure, (b) they did not build a petabyte data storage solution for anyone, but (c) they assisted a customer build a large data set (probably not a petabyte) and (d) otherwise the press release is a marketing puff-piece but not material to the stock.  They think I have made too much of a marketing puff-piece.


I agree that it is entirely possible that the press release is a marketing puff piece of marginal importance to the stock.  It certainly has all the buzz-words.  Please do not read this post without reading the comments which are - in my view - sophisticated and probably contain some truth. At least they made me think.


Some people who I trust think this could be done within the $1.5 million of incremental capital spent this year.  I am not going to dispute that point - but whatever - it would use most of the $1.5 million of incremental capital... and that leaves the question how did they manage to to fund the rest of their growth.


The core issue remains - how is it possible that this company has grown equipment and fitting so slowly and revenue so fast? Unless there is a miracle they can't be doing it by owning cloud facilities. The company has grown revenue by almost 50 percent in the last nine months adding almost no fixed assets.


So I remain puzzled.


Now read the post - here without alteration:


----------------------------

A while back I did a lot of work on cloud computing companies. This was not because I wanted to buy the cloud companies (by and large I do not) but because I wanted to understand what they did to the existing tech giants (such as Microsoft, Google, Apple, Hewlett Packard, Dell etc). You can find those posts here, here, here and here.

This stuff is important to us. Despite the (recent) content of this blog Bronte Capital's funds are primarily long equities. We short on the side. Recently shorts have been abnormally profitable. Long term returns will be driven by well-chosen value stocks.

We have big positions in selected tech giants - and we need to understand the threats to those businesses. So we went on a self-directed course in "cloud studies". [That course involved putting our own server and storage in the cloud...]

But you never know where your research will lead. "Cloud studies" took us to a remarkable press release from Longtop Financial - what appears as a reputable Chinese IPO (not a reverse takeover) with a reputable CFO. The remarkable press release described Longtop's efforts in being a cloud provider - and more particularly a cloud-storage provider.

Longtop Financial Technologies Limited (NYSE:LFT), a leading software developer and solutions provider targeting the financial services industry in China, today announced the official launch of its new data archiving solution. 

Like many organizations worldwide, financial institutions in China are experiencing explosive data growth. They are facing big challenges in continuing to store and manage the high-volume data for compliance purposes in a cost-effective way, as well as query and retrieve them efficiently for business needs. Longtop's data achieving solution has the capability to manage petabyte (PB) level structured data at both low cost and high access efficiency. The solution has the advanced data storage and management infrastructure built on cloud storage techniques, which has unlimited horizontal scalability in both storage volume and access efficiency with a high compression ratio. As a result, it can overcome the inherent deficiencies of traditional Relational Database Management System products in high-volume data management and help customers to build the new generation of data centers. 

"Much of the strength behind Longtop's solid organic growth track record comes from our proprietary product development. Over the years, we have consistently focused on Research and Development (R&D) and going forward we will continue to invest in human resources and technology to help further strengthen our R&D capabilities," commented Weizhou Lian, Longtop's Chief Executive Officer. "I am very pleased that one of the largest banks in China has been our first customer to deploy our data archiving solution."

What struck me as peculiar about this release is that being a cloud computing company is very capital intensive and I was wondering where they purchased their storage equipment from. After all storage equipment for the cloud is a hugely market-sensitive business (that was what the 3Par spat between Dell and HP was about see here and here).

More generally cloud computing is capital intensive. The cloud companies see themselves as utilities and have similar capital needs and economics. The main knock on the cloud computing businesses - as per this otherwise laudatory article about Rackspace - is that they are hugely capital intensive:

But analysts have questioned the capital-intensive nature of Rackspace's business model, especially because the company's capital-expenditure guidance will likely be higher than its revenue trajectory for 2011. 

"Our business will always be relatively capital intensive," he [Lanham Napier] said, largely because the company regularly has to upgrade its infrastructure. "The magic is in the margin of service layer we add on top of that infrastructure. We're making investments to continue to make the business more capital efficient, but we have more work to do on it."

And of all the cloud functions the one that is most capital intensive appears to be storage. You see when I am not using Bronte's server someone else can use the spare capacity. However when I am not accessing Bronte's storage nobody else can use it. Storage is not shared and thus likely to provide less capital advantage by going to "the cloud". And that shows in pricing - as Felix Salmon has noted cloud storage is too expensive for much personal use.

And yet Longtop have done cloud storage at the petabyte level (ie akin to Rackspace or Amazon) without very much capital expenditure. At the beginning of the 2010-11 financial year Longtop had fixed assets of $26.3 million. Nine months later - the nine months in which they launched their cloud storage offering - the fixed assets had risen to $27.9 million. Revenue grew in that nine months by over 40 percent (these numbers are in my previous post).

They managed to launch a cloud storage service at the petabyte level with almost no capital expenditure.

I was puzzled.

But the above mentioned remarkable press release told us that this amazing ability to do storage at the petabyte level with enough backup for a large financial institution came from their skills in human resource management. To quote again:

Much of the strength behind Longtop's solid organic growth track record comes from our proprietary product development. Over the years, we have consistently focused on Research and Development (R&D) and going forward we will continue to invest in human resources and technology to help further strengthen our R&D capabilities..."

These are remarkable skills. You see if Longtop can do this with only human resources (no substantial capital expenditure) then the $300 million odd of capex expected at Rackspace this year is wasted. There is probably half a billion of capex at Amazon EC2. That is wasted too.

Moreover because cloud storage can be done without buying capital equipment the huge bidding war between Hewlett Packard and Dell over 3Par (a company that sells capital equipment for cloud storage) was wasted and HP wasted billions of dollars.

It is all possible of course. Longtop are about to displace Amazon, Dell, HP, Rackspace and a score of other tech giants.

These Chinese companies really are that remarkable.

Just read the press release.





John

The scuttlebutt method of stock research

Phillip Fisher – one of the great investment gurus of all time – used to talk about the “scuttlebutt method” - just finding out what is really going on in companies by asking customers, suppliers and competitors. Information that comes from the company is either inside, self-serving or both. Sure you need to read and analyse accounts but real information – stuff you dredge up on your own – creates an edge. Obviously if that real information comes from paying insiders (or supplying sexual favors to insiders) then trading on that information is illegal (and the SEC/FBI are getting a string of guilty pleas).

However this is a post about research methods that might be used by semi-professional investors – those that could not afford the services of the “expert networks” at the core of the current batch of insider trading cases. I am exploring what might be a common position after some (really diligent) research. It is a position we find ourselves in.

We know a company with a moderate market capitalization (a few hundred million dollars). There is no short interest – and there are (highly) reputable people on the board. Board members “check out”. Nobody has a history in pump-and-dump schemes – the board seems suitable.

The stock is widely distributed having been well promoted by regional stock brokers. Whilst the stock has been weak for a long time nobody has shorted the stock because the upside if the technology works is very large. Given this is an adventurous technology I would normally expect it to fail – and the company to fade into obscurity. Most adventurous technologies fail – and failure does not reflect badly on management. Still the management is upbeat and a bullish release is made about once a month.

The company is not located in well-known technology centre – its in somewhere like Kansas rather than somewhere like San Jose. Indeed there would be almost no cross-fertilisation with other companies in this industry because there are no competitor companies for hundreds of miles around.

The company sounds promising. It is in a major industry (with a huge end market). The technology was mainly developed by the founder. The industry (more broadly) is conducting a lot of research and development along a lot of distinct technological lines. None of the serious players seems very interested in this line. Nonetheless the technology has had favorable mentions in top-class science publications (like Nature). Cumulative R&D spend is about $30 million which the company has raised by issuing stock. The founding CEO claims a PhD from in a relevant area from one of the top universities in the world. (I have not checked this PhD was actually awarded.)

The company has a factory which has a working (and clearly polluting) smoke stack. (I know because I paid someone to observe it.)  The company is however primarily an R&D shop so you would expect typical nerds to work there – starting late and ending very late (tech geeks keep often keep very odd hours). However my spy tells me the car park is largely empty by 5pm which is unusual in a tech-research company where the end-goal is to change the world.

The company has sales – but the sales are to another R&D company in the same (relatively obscure) sub-branch of the industry. There are no sales to real end customers but the company touts its sales. The product is – as far as I can tell – not in commercial use though pictures of samples are on the website. Ambitious technical claims have appeared – and later disappeared – from the corporate website. I have – through a proxy – asked for a sample and not been given one. The proxy would normally expect to receive a sample as he is potentially a large end-user.

The founding-CEO was CEO for about a decade.  He is now just shy of 50. He became executive chairman a while ago and appointed a guy with a fine manufacturing career as CEO – but the manufacturing career is from a completely unrelated industry. That CEO lasted about two years before he moved to a lower paying (although still CEO) job. He gave up his options without much dispute. The founding-CEO claims to be involved and claims to be attending all the board meetings.

Now I discover the founding-CEO is living with his mistress more than twelve hours flight from the working-class locale of the main R&D shop. The mistress is substantially younger and the new locale is exotic (think South of France, Tahiti or Byron Bay Australia or similar). The mistress has a daughter by an earlier relationship and hundreds of thousands of dollars are spent on the daughter's glamorous hobbies and lifestyle.

Finally the founding-CEO's teenage son hangs around the original town and uses a high-priced sports car to (seemingly successfully) attract girls. Money drips out of the son's pocket and the son has an entitled demeanor. The dad of one of said girls is suspicious – but maybe he is only protecting his daughter.

Knowing only this much about the company how much weight would you put on the founding-CEO's lifestyle decision as to whether to go long or short the stock?

My second question: suppose you met this founder-CEO in the lounge at the airport waiting for the first-class flight to the above exotic location. Because of your interest in this company you recognise the founder-CEO from the photo in the annual report. You find out in casual conversation that the founder-CEO was going “home” to the exotic location. Most the rest of the material you found by befriending people on Facebook (using your real name). Would this method of research be kosher?

Finally – is this what Phillip Fisher (Common Stocks and Uncommon Profits) thought of as the “scuttlebutt method”? What is the line between what Phillip Fisher thought of as “scuttlebutt” and what the SEC is currently thinking of as insider trading? Is this sort of scuttlebutt sufficient to beat the market anyway?

Thoughts please.

John

PS.  Thanks for the correction: Phillip Fisher at the beginning of this article turned into Ken Fisher at the end of the article. I confused father and son.

J

Gulf Resources: sometimes you only need to look at the accounts

Glaucus - a small research firm - has had a dig at Gulf Resources - another Chinese reverse takeover stock.

I hardly felt it was necessary.  At Bronte we have been short Gulf Resources (GFRE:Nasdaq) on behalf of our clients for most of the last year.

Its a bromine and industrial salt producer. Bromine is ugly stuff - highly reactive: in this wikipedia page the bromine is pictured encased in perspex. It will oxidize almost anything.

I knew it was suspect and you could tell off the balance sheet and the P&L. You see in the 2009 annual filing on form 10K Gulf Resources show as having $650,322 in inventories. They had sales of $110,276,908.

In other words they turned their inventory stock over 169.5 times per year. I can't imagine how active a plant would need to be to turn over toxic and dangerous bromine that many times - let alone low value industrial salt.

It didn't seem right to me so we shorted the stock.

But if you are the kind of person that needs a comparable have a look at the last 10K of Great Lakes Chemical. Great Lakes was a super-high quality operator (mostly and originally a bromine producer) with Berkshire Hathaway and Warren Buffett as large shareholders.  This was a mighty fine company as Jeff Matthews relates:

I recall the CEO of a Great Lakes competitor telling me, with awe, about a visit to Great Lakes’ bare-bones corporate office, where the lights in the conference room were operated by an old-fashioned light timer, like the timers that control heating lamps in hotel bathrooms.

These guys you see were hard-driving operators - likely to manage inventory better than almost anyone in the business.

Now we know what arguably the finest bromine maker ever in North America did: we can look at their last 10K.  In their last year (2004) inventories were $324 million. Sales were $1604 million.

The company turned its inventory stock under 5 times.

Gulf Resources claim to turn over their inventory 169.5 times per year looks doubly suspect- and if it is suspect then the accounts are suspect.

I could be wrong of course. Gulf Resources may indeed be able to turn its inventory over 34 times faster than the best American operator. They may. An otherwise obscure Chinese company might be that good and the short might be stupid.

But as a shortseller that is a bet that I was willing to take without any further due diligence.

I admire the effort in the Glaucus report. But for us - we just keep it simple.




John

PS. There are several high profile asset management firms that hold large positions in this stock led by Fidelity. As stated you only needed to look at two pages of the annual filing to smell a rat: the balance sheet and the P&L. Then the inventory turn jumped out.

Did Fidelity even look at those two pages? Really?

J

Capital management in a Chinese software firm

Longtop Financial Technology (NYSE:LFT – market cap $1.5 billion) is not a Chinese reverse takeover.

The stock came to the market the conventional way: through an IPO. And its not like CCME (you can confirm its existence). Moreover when I do a quick run through board members I don't find any with easily identifiable links to organized crime.

Finally the CFO used to work for reputable companies. You don't find an unbroken litany of failed companies and stock promotes in his history. Same seems to apply for the other directors but I have not done a comprehensive search.

Finally Longtop even paid a dividend once. None of my Chinese frauds ever paid a dividend – after all why give cash to your victims (ahem: shareholders)?

Longtop you see is a software and bank-outsource service company. It claims as clients three of the four Chinese megabanks, China Life and a slew of lesser companies. In China this is a blue-chip customer list and might reasonably support a nice business with good economics. Some of Longtop's blue-chip customers can be easily verified which is a pleasant change from some other Chinese companies I have looked at.

Nonetheless Longtop still leaves me puzzled.

The first puzzle (and the subject of the first post) is capital management. You see Longtop has very little need for capital (at least as reported in their balance sheet) - and yet they have gone to market to raise cash.

In the last annual report (on form 20F) fixed assets (net) were $26.3 million. Gross fixed assets (ie before depreciation) was $35.8 million. Buildings were the bulk of that (almost 20 million). Equipment and fixtures was only 13.0 million. Apart from buildings there is not very much fixed asset on this balance sheet – and renting rather than owning buildings is always an option. They purchased 13.0 million of fixed assets during the year and presumably much of that were buildings.

By the end of the third quarter (December 2010) fixed assets had risen from $26.3 million to $27.9 million – a modest rise of $1.6 million. Also during that time revenue rose 40-50 percent (depending on which quarters you compared).

You see – looking at the accounts this company can do amazing things: it can add 40-50 percent to revenue without increasing fixtures, fittings etc. The only incremental capital employed is in receivables which grew from 65 to 97 million. Receivables are high relative to revenue but grew only slightly faster than revenue.

You might say “doh – its a software company – why do they need capital?” And - based on the accounts - I couldn't help but agree. All I am saying is that the company does not – on its accounts – seem to have any need for capital from financial markets. Which begs the question: why are they listed? But lets ignore that for the moment (Microsoft and Coca Cola – both companies with no need for external capital are listed.)

But it sure as hell makes me query their capital management. Here is the quarterly cash balance:

2010-12     $423.2 million
2010-09     $379.0 million
2010-06     $342.4 million
2010-03    $331.9 million - note the drop here was because $70 million went out for an acquisition
2009-12    $389.7 million - note the large rise here is because the company raised $127 million
2009-09   $226.4 million
2009-06   $215.1 million

Debt throughout this time has been trivial - typically less than $10 million.

Now this is - at least according to its accounts - an inordinately cash generative business. It is almost without fixed assets - it grows its revenue very fast.

But for the life of me I can't see any reason why it really needed to raise $127 million in cash in December 2009 quarter? Its sort of like a mini-version of Microsoft going to the market to raise money. They are - according to their accounts - swimming in money.

Indeed their current cash holdings represent something like 200 quarters of capital expenditure. Come to think of it - the company has enough cash for 26 quarters - more than 6 years - of all pre-tax operating expenditures. Lets put this in context. Microsoft has about 36 billion in cash and short term investments and $38 billion in annual operating expenditure. Relative to expenses (and hence needs) Longtop has over 6 times as much cash as Microsoft.

They are swimming in it.

But they still went to market and raised more.

To be fair they have announced but - as far as I can tell - not executed a buy-back plan for $50 million in stock.  If they do that over a year they will still have six times more cash relative to needs than Microsoft.

What can I say? I am puzzled. Puzzles are interesting. Expect me to look further at this company.




John

PS.  I have been sitting on this post for a while - thinking what else I might put in it.  Someone else has published - which in blogger terms is to be trumped.  That someone is Citron who are  more strident than I would ever be.

I disclose being short though.  Puzzled is enough to be short.

J

Fatal Risk – the must-read book on AIG's failure

There are dozens of books on the financial crisis: I have read many of them and the Kindle samples for just about all of them. There are only two I would recommend: those are Bethany McLean and Joe Nocera’s excellent All the Devils are Here and the much more specifically detailed Fatal Risk from Roddy Boyd. Roddy's book is solely concerned with the failure of AIG.

Both books start without any strong ideological preconceptions and let the facts woven into a good story do the talking - and both wind up ambivalent about many of the major players - with many players having human weaknesses (gullibility, delusion, arrogance etc) but committing nothing that looks like a strong case for criminal prosecution. Reading these you can see why there are so few criminal prosecutions from the crisis. And you will also see just how extreme the human failings that caused the crisis are.

If you are not familiar with the saga that led up to the mortgage collapse, the rise of securitisation, the depth of the repo market, the lowering of credit standards start with the McLean/Nocera book. If you have to give a book as a gift to someone who is not a financial professional you could do little better. That is the best general book yet written on the crisis.

But for me (and because I was familiar with the broad details of the crisis anyway) the best book of the crisis is Roddy Boyd’s Fatal Risk. It is not a good first financial book to read and I had to think quite hard as to the details that Roddy glossed over - but that was because Roddy had to make a choice - was he writing for someone who vaguely knew what a credit default swap was or was he writing for someone who had actually read a “credit support annexe (a CSA)”.

Fortunately for most people he does not want to assume you have actually read a CSA (although I have). But less forgivingly Roddy does not feel the need to define an Alt-A mortgage or a repo line. This is a fabulous book – but it deals with complex subjects without shying away from their complexity and it assumes you have enough knowledge and intelligence to cope.

Truths, generalities and people

Underlying Roddy’s books are a few financial truths that bear repeating. Firstly anything that has any chance of going wrong if done for long enough will go wrong. It doesn’t matter if your model tells you that you will be fine in any mortgage default environment short of the great depression: if you continue to bet on that model you will lose. Maybe not next year. Maybe not in ten years but you will eventually lose.

Likewise if you write large quantities of out-of-the-money puts you will eventually lose a lot of money.

Likewise if your model assumes that there is always going to be a deep liquid market in any security (with the possible exception of a Treasury bond) then one day you will wake up and the buyers will have scampered like antelopes from a waterhole at first sight of a lion. Any business that has to roll a large amount of debt at regular intervals is dangerous.

Ignore these truths and you take a risk. Ignore them on a grand enough scale and the risk will be fatal.

Whatever: if you ignore these truths you might become rich in the interim. Earnings and growth might be fine. You might even look like a genius. Maybe a “legendary CEO”.

So Roddy’s book starts a long time ago - the 1970s and 1980s when AIG did not forget those truths - and it talks about AIG as a superlative risk management machine. The first section of the book is a repeat of the AIG legend - a legend of superlative risk management mostly in the head of one man: Hank Greenberg. It is a legend that might be overstated but that doesn’t mean that it is not mostly true. Hank really did work absurd hours, pick at steamed fish and vegetables and ask sophisticated questions to six people at once. Hank knew to really understand what was going on you had to go three to four levels deep in an organisation and ask the right questions of assorted lower/mid ranked officers. They would answer truthfully because of a desire to impress or fear or even that (unlike many senior managers) they were not accustomed to spinning. He would get the raw data. He would make the assessment.

There were two things however that Hank did not assess properly: his own mortality and his declining skill in old age. There is no question of declining skill. It is very hard to imagine the Hank Greenberg of 1975 falling for China Media Express - but the Hank Greenberg of 2010 was suckered. As for mortality he had no plans.

He also did not plan for Eliot Spitzer.

By 2000 Hank was extremely concerned about what Wall Street thought of his stock. That is no surprise - AIG was the most highly valued large financial firm in the world (I remember being startled that its PE was three times Wells Fargo). And - unstated by Boyd - Hank liked that a lot because he used AIGs stock as currency to do acquisitions. He was - much to the chagrin of many investment bankers - very selective as to the acquisitions he would do (he knew acquisitions were fraught with risk) but he did some mighty big ones including the purchase of Sun America. I remember that one - and thought (correctly in hindsight) that it probably made sense primarily because AIG was paying with inflated stock.

So by the year 2000 Hank was - apart from running the business - actively manipulating the earnings of the business. As far as I can tell he ran the business particularly well (the legend of AIG was not false) but he also played Wall Street like a fiddle and gave them the numbers they wanted even if they were massaged a little (or maybe a lot).

Moreover - and this is critical for the story - AIG had no overarching operating system. It was a bunch of fiefdoms all reporting to Hank. This meant that AIG could not produce earnings results until the very last day they were legally allowed to file them.  It meant Hank could personally massage earnings. At many financial institutions some approximation of earnings are known every month. At AIG there was no system they could query and ask for their aggregate Alt-A mortgage exposure. Hank might have known - indeed almost certainly would have known - but the system is Hank and Hank being removed or dying would be disastrous for AIG.

And then along comes Spitzer. Spitzer discovers a relatively minor finite insurance transaction between AIG and General Re. (Believe me it was minor - I know of plenty of nastier transactions than that... many of which were never prosecuted.*) However it is a clear attempt to fudge the numbers - Spitzer really is onto something. And with bombast and the power of the Attorney General he makes Hank Greenberg’s world fall apart. Spitzer fights dirty (and it is no surprise that several Spitzer prosecutions later failed because of prosecutorial misconduct) but Spitzer has his clear piece of fakery and he wants and gets his pound of flesh.

Hank is forced out - which is the equivalent to AIG of his sudden death. Worse because AIG went on to repudiate many things Hank stood for including many of his risk-control edicts. If he had died the hero CEO it might have been marginally better for AIG.

The minor nature of the AIG-Gen Re transaction is laid clear when Roddy suggests that there is an “excellent chance that Greenberg gave the Gen Re issues - which cost him his job, his honor, his status and perhaps over a billion dollars in personal wealth - all of five minutes of consideration.”

Still AIG-Gen Re was a transaction designed to massage (ie fake) the numbers - and thus speaks to a relationship with Wall Street and a concern to stock price that is unhealthy.

Unstated by Roddy: Hank had forgotten a cardinal rule of risk management: you do that sort of thing for long enough then one day you will find your Eliot Spitzer. This is just as sure as the statement that if you write put options long enough you will one day get your comeuppance.

The new CEO

The new CEO - Martin Sullivan - was the best salesman AIG had. Joe Cassano (who ran the disastrous AIG Financial Products) observed that he never saw Sullivan ask a single penetrating financial question. It's a telling observation.

The place I used to work had a boss who was very suspicious of financial product salesmen because inevitably they wanted to produce what the market (ie the crowd) wanted. And in financial services if you run with the crowd you can get your comeuppance delivered abnormally sharply.

To be fair, there are financial service companies that require salesmen even as leaders. Insurance brokers spring to mind.

AIG however was not one of those companies. It was global, complicated and pervasive and it had no overarching risk management system now that Hank was gone. To replace a control freak they needed another control freak at least until they built control systems. They never got that - and only at the very end (in Willumstead) did they get a CEO that even understood there was a problem.

There is a truism about financial product salespeople: if you put a salesman in charge of a financial institution with large reach and allow him to operate with thin risk control then your earnings will go up. And up. And up. At least until they don’t. Martin Sullivan proves that truism.

Under Sullivan some small businesses were allowed to expand in new ways until they became big businesses - ones big enough to threaten AIG and indeed the world. A decent example of the Martin management style comes from a small part of AIG - United Guaranty. United Guaranty was a mortgage insurer - at least for a while the best mortgage insurer on the Street. (I remember thinking that a couple of other players, notably PMI and MGIC were much riskier.)

The right thing to do with a mortgage insurer was stop writing business about 2005 - and certainly by 2006. [Or you could sell it as GE did.]  Margins were collapsing and the risk of the loans was rising fast. The independent companies couldn’t really stop because that was their only business. AIG was under no such constraint - United Guaranty was a tiny part of AIG and stopping would not have affected the stock price. It might have even been seen by some (myself included) as a sign of discipline. Here is the quote from an AIG unit chiefs meeting in mid-2007.

As UGC posted its first losses, about $100 million, Nutt was explaining to Martin Sullivan and other senior management that while they hit a rough patch, they were writing excellent new business, and, at any rate, the competition was getting killed. Sullivan smilingly told Nutt that even if he didn’t write another dollar in business for a few months, “We would still love him”. AIG staffers had a phrase for this sort of response: “classic Martin”. It was a decent word or gesture, directed at a manager who was clearly fumbling, both publicly and on the job. But it also carried a serious message: better to be safe than sorry. The trouble is that the time for this was two to three years earlier.

To not realize that a mortgage insurance business in mid 2007 was problematic was seriously inept. UCG has now booked $3.9 billion in losses. Hank would have been on top of this at least a year earlier. Whether he would have been on top of it two years earlier is more dubious. One year earlier and UCG would still have had substantial losses.  But they might have been absorbed by profits in an otherwise functioning AIG.

The two businesses that blew up AIG

There were problems all over AIG (and there were good bits too where individual managers saw the mess coming and ducked for cover). But two businesses stand out for the sheer destruction that they wrought. The better known was AIG Financial Products (FP) credit guarantee business. The less well known was Win Neuger’s securities lending business.

The credit guarantee business for thin fees guaranteed securitisation deals - usually very high grade paper or just as often resecuritisations of high grade paper. These were deals that would be fine in any credit event less bad than the great depression. In other words they were “great depression puts” and FP was writing puts. You should know the truism by now.

But worse the credit default swaps had a credit support annexe (CSA) attached. This made it mandatory for the parent company of AIG to collateralize the deals (ie put up hard cash to guarantee payment) under certain events. Senior management of AIG did not even know of the existence of the CSA until the company was at death’s door. They believed until very nearly the end that mark-to-market did not threaten liquidity.

I understand how a salesman (Sullivan) missed the CSA. If you followed the credit enhancement business you would know - by law - that the monoline insurers were not allowed to collateralize their obligations. Why of course should AIG be any different? But even that cursory “knowledge” could be dangerous. Both AIG and Ambac had CSAs attached to their guaranteed investment contract business (a business that was run by parent companies). I did not know of these until a well known hedge fund manager sent me a copy and even read it over the phone to me.

But that is a thin defence of AIG. The above mentioned hedge fund manager knew of the CSAs at Ambac and MBIA a couple of years before the disaster - and he had to look and find it. AIGs senior management should have just asked. Their risk management department should have been over every material contract - and believe me these were material contracts. This was an epic failure.

Win Neuger’s business was similarly destructive. What he did was [get the parent company to] borrow high grade securities from the life insurance companies, repo them, buy lower grade securities and pledge those back to the life companies to secure parent company obligations to the life companies.

Two things went wrong. The life company management (and later regulators) got mighty jacked when the life companies had lent their good securities and were holding trash security. They required hard capital injections from the parent company to solve this - and along the way AIG kicked in $5 billion. At the end the Texas Insurance Commissioner was going to confiscate four insurance companies (which would have collapsed AIG).

The second thing that went wrong is the counter-parties to the repo loans just wanted cash their back. They wanted it now. To get it though the parent company would need to get back the trashy (and hence heavily discounted) security from the life company, sell them, top up the (now large) shortfall and pay the investment bank on the repo line. This turned marks on the low-grade securities into an immediate liquidity drain on the parent.  That is truly ugly.

How they got there too was a story of failure to consider fat tail risks.  It is the main story of the book.

Liquidity versus solvency

At the height of the crisis it was very difficult to see whether AIG was a liquidity problem or a solvency problem. If it is a liquidity problem then bailouts don’t cost much -indeed structured right they are profitable. If it was solvency then a bailout will be very costly and in extrema (such as Ireland) can bankrupt the nation.

I originally thought AIG was liquidity. I later thought it was solvency. But now the Government looks like it is making heroic profits on the AIG bailout - and it was surely enough a liquidity problem.

There are a couple of lessons here: sophisticated observers (if I am a sophisticated observer) can’t tell the difference between liquidity and solvency in a crisis. The second lesson is that any contract that can cause a liquidity problem will - if repeated long enough - actually cause a liquidity problem. Modelling solvency does not cut it... if you run a financial institution you better model liquidity as well – and better be ready for the closure of debt markets.

The AIG people after the failure

There is a lot of anger in the broad community about the people at AIG especially as none of them - those that caused the largest bailout of the crisis - were ever charged criminally. Roddy does not share the anger about the lack of criminal charges but he is angry about the sheer recklessness of some AIG people. This quote was revealing:

Al Frost’s [a key salesperson for AIG FP] job was to drum up deals and revenue from the major investment banks and he did. Cassano’s job was to ensure that decisions made at FP were logical and made with all available information. He failed... 

But Cassano did not fail in a vacuum.... 

That Martin Sullivan and Steve Bessinger did nothing is now well established. But neither did Financial Services chief Bill Dooley, his CFO Elias Habayeb, Risk Management Chief Bob Lewis and his head of credit-risk Kevin McGinn. Anastasia Kelly’s legal department was similarly silent. These people saw everything AIG FP did in real time and had plenty of authority to force at least a reevaluation. It was, in fact, their job to do this... 

Save for Anastasia Kelly (who retired) every other person in the line of oversight of the FP swaps book is now gainfully employed as an officer at a publicly traded company with as much or more responsibility than they had previously.

Roddy is right. The fact that the failure of these people was not criminal does not excuse it. These people were paid big multiples of average earnings and demonstrated that they can’t do their job. So they are still paid big multiples of average earnings.

Along this line special scorn needs to be reserved for Win Neuger. He ran AIGs internal asset management business - especially the securities lending business which in itself was big enough to destroy AIG.

He now runs an asset management company with over $80 billion under management.

Where else - except Wall Street - can you be that well rewarded for failure?

Recommendation

I don’t want to give too much away. This is the best book yet written about any specific episode of the crisis. I just think you should buy it. Buy multiple copies. Give them to your friends. They will be grateful too.




John


*Hint to the regulators: try and work out the large finite transaction between Unum Provident and Berkshire Hathaway. There lies a can of worms...

Universal Travel Group: auditor resigns edition.

Universal Travel Group has lost its auditor - a small firm Windes and McClaughrey.  Windes looks  reputable - a cursory look through the SEC database as to companies they have audited turns up nothing untoward.

So I was surprised when they accepted the audit assignment.  After all my views about Universal Travel are well known.  I even asked how we would test whether the $43 million stated cash balance at NYSE:UTA was really there.

The auditor asked the same question.  Here is the key section from the auditor-departs 8K filing.

The following reportable disagreements occurred within the period from Windes' engagement through the date of its resignation, which if not resolved to the satisfaction of Windes, would have caused it to make a reference to the subject matter of the disagreements in connection with its report. 

Windes had informed the Company in its resignation letter that it was no longer able to complete the audit process. Windes stated this was due in part to Management and/or the Audit Committee being non-responsive, unwilling or reluctant to proceed in good faith and imposing scope limitations on Windes' audit procedures.  

Windes also stated that Windes had lost confidence in the Board of Directors' and the Audit Committee's commitment to sound corporate governance and reliable financial reporting.
Prior to its resignation, Windes raised the following issues (some of which may be considered to be disagreements) encountered during the audit, including issues related to the authenticity of confirmations, a loss of confidence in confirmation procedures carried out under circumstances which Windes believed to be suspicious; issues concerning the lack of evidence of certain tour package contracts and related cash payments.

So the auditor wanted to check balances (presumably though I am guessing - cash balances) and considered the procedures the company wanted to use to confirm the balances "suspicious".  Moreover management were unwilling or reluctant to proceed in good faith and imposed limits on what Windes can do.

Universal Travel is going through the circus of finding another auditor - their sixth.  You could see through this company from a couch in Bronte or from a desk at the NYSE or any  SEC office.  Everything that I did to demonstrate problems with this company could be done without visiting China - and yet the stock was never suspended, kicked to the Pink Sheets or anything else.  Nah - the NYSE kept collecting listing fees.

The NYSE it seems has no concern for its reputation.

It is not as bad as Singapore (where prospectuses for fraudulent Chinese companies were handed out in shopping centers) but hey - what is this - a race to the bottom?



John

Singapore-Australia stock exchange merger: reasons for the veto

Mike Smith, the CEO of ANZ Bank (one of the big four Australian banks), has received a lot of press for criticising the Australian government veto of the takeover of the Australian stock exchange by the Singapore stock exchange.  I guess he is making the running but he is an ineffective lobbyist.

Senior management of at least one other big four Australian bank (won't tell you which one) privately lobbied the Treasurer Wayne Swan against the merger.  Their reason: Singapore is one of the dirtiest, most corrupt stock markets in the world and they did not want that syphilitic puss invading the Australian financial markets and in particular the Australian superannuation system.

You see Australia has a well-functioning and mostly honest privatized social security system we call “superannuation”.  Its one of the great economic achievements of this country.  It relies on a mostly honest financial market.

Singapore by contrast is one of the homes of Chinese fraud.  At one stage a quarter of the volume of the Singapore stock exchange was so called S-Chips – Chinese stocks listed in Singapore – and they were every bit as scummy as the Chinese reverse mergers listed in New York.  Singapore – in exchange for listing fees – allowed their population and their investment market to be raped by fraudsters.  (If you don't believe me look up a few of the S-Chips on the Wikipedia S-Chip scandal page.)

Singapore came to Australia saying they ran an honest market.

They lied.

At least one and possibly three of the big Australian banks knew they were lying.

Ultimately Wayne Swan knew they were lying.

He did the only decent thing and vetoed the merger and I applaud him for it.

Allowing that puss a place in the Australian market would be deeply damaging for the Australian superannuation system.  And Wayne Swan knew it.

Now interestingly three of the big four banks in Australia have substantial positions in Australian superannuation.  Westpac owns the old Banker Trust platform.  National Australia Bank owns MLC.  Commonwealth Bank owns Colonial.  Only ANZ does not have a seat a the table.  And so only ANZ – through their weakness – would not be a loser if the ultra-corrupt Singapore exchange got to control the ASX.

And ANZ does some trivial investment banking in Asia – so Mike Smith was talking his pocket book.

I know for sure at least one Australian bank lobbied against the merger.  I lobbied a little against the merger too.  But the merger was against Australia's interests and against the interest of three out of four of the big banks.

Wayne Swan – in vetoing the merger – acted clearly in Australia's interest against Singapore corruption.  I could not be prouder of him.





John