Those clever people at China Fire and Security and Bain

I have read the accounts of several dozen Chinese reverse takeover stocks and many traditional IPOs, mostly looking for fraud but also looking for stocks to go long to offset my naturally large short position. And I am annoyed. China Fire and Security (CFSG:Nasdaq) was on my list to look at but I never got around to it.

So I took the recent news of a "definitive agreement" to buy CFSG by Bain (a large and reputable private equity shop) very badly. After all it was a profit opportunity wasted because I never got around to reading the accounts.

And it is a deal with quality advisors too.  According to the press release:

Barclays Capital is serving as the exclusive financial advisor to the Special Committee [that is CFSG on behalf of non management shareholders]. Shearman & Sterling LLP is serving as U.S. legal advisor to the Special Committee and Bilzin Sumberg Baena Price & Axelrod LLP is serving as Florida legal advisor to the Special Committee. Bank of America Merrill Lynch, The Hongkong and Shanghai Banking Corporation Limited and Citigroup Global Markets Asia Limited are serving (themselves or through their affiliates) as financial advisors to Bain Capital as well as underwriters, bookrunners and mandated lead arrangers of the debt facilities. Kirkland & Ellis International LLP is serving as U.S. and U.K. legal advisor to Bain Capital. Davis Polk & Wardwell LLP is serving as U.S. legal advisor to Barclays Capital. Allen & Overy is serving as U.S. and U.K. legal advisor to the underwriters, bookrunners and mandated lead arrangers. DLA Piper and Han Kun Law Offices are serving as international and PRC counsel to Mr. Weigang Li [the Chairman of CFSG].

This is by far the best team of big name lawyers and advisers ever assembled to do a deal with a sub-$300 million market cap reverse takeover Chinese stock. There must be quality here to assemble such a big name team. And I want to be able to pick these transactions in advance so I went looking for the quality. I read the 10K cover to cover (all 87 pages) just to see what they saw. After all Bain are clever people and the advisors assembled are not stupid.

What I found was a strange company – one that I did not understand – in fact one that made me think I don't understand very much at all. The clever people at Bain want to buy this company with a value of almost $300 million – and – for the life of me I could not have picked it.

Lets start at the beginning...

My run through the 10K

Here is the business description:

We are engaged primarily in the design, development, manufacture and sale of a variety of fire safety products for the industrial and special purpose infrastructure industries and the design and installation of industrial fire safety systems in which we primarily use our own fire safety products. To a minor extent, we provide maintenance services on our industrial fire safety systems for our customers. Our business is primarily in China, where we operate sales and liaison offices in more than 20 cities; we are also expanding our business overseas by providing integrated fire safety systems to industrial clients globally.

We market our industrial fire safety products and systems primarily to major companies in the iron and steel, traditional power generation, nuclear power generation and petrochemical industries in China. In the last two years, we also secured several contracts with power generation plants in India. We are further developing our business in the transportation sector, which includes projects involving subways, highway tunnels, high speed trains and marine transportation, and telecommunications.

We have internal research and development facilities engaged primarily in furthering fire safety technologies. We believe that our technologies allow us to offer cost-effective and high-quality fire safety products and systems. We have developed products for industrial fire detecting and extinguishing. We believe that we are the leading manufacturer in China of such systems having successfully developed a comprehensive line of linear heat detectors.

...Our key products include linear heat detectors and water mist extinguishers.

In other words they are a manufacturer and installer of fire detection and extinguishing kit. The kit they install is primarily the kit they manufacture. There is a small maintenance sideline.

The products did not sound very technical. Water mist extinguishers are just devices (usually pressurized cannisters) that spray out a water mist for putting out Class A fires. You can find lots of suppliers on Alibaba.

Linear heat detectors were a little newer to me. They are wires that can detect raised heat anywhere along their length - usually two wires with a heat-sensitive polymer core. Here is an example - and you can find many of them (with their control boxes) on Alibaba.  

Bluntly then - at the core of this business is a manufacturer. I was thus expecting a balance sheet and profit and loss account typical of a manufacturer. A manufacturing business is usually concerned with managing working capital (inventory turns, work in progress, billings), has a fair bit of plant and equipment and margins which are typically high single digit percentage, though higher if the level of R&D is high or lots of capital is employed in the manufacturing process. Fatter margins come from market structure (monopolies or government protection) or lots of capital employed (which has to be recovered) or from being innovative (and keeping competition out by know-how advantages). 

Alas the accounts are nothing like that. The balance sheet left me gob-smacked: I have puzzled and puzzled over this.

Here are the current assets (for reference you should compare this to total revenue of just shy of $80 million):

CURRENT ASSETS:
Cash and cash equivalents		$	28,151,689			$	34,976,880
Restricted cash			1,935,979				1,837,134
Notes receivable			14,428,802				4,274,268
Accounts receivable, net of allowance for doubtful accounts of $8,153,727 and
$6,539,787 as of December 31, 2010 and 2009, respectively			41,895,129				30,989,569
Receivables from and prepayments to related parties			2,448,066				551,792
Other receivables			792,386				368,679
Refundable bidding and system contracting project deposits			1,667,437				1,774,330
Inventories			6,713,448				5,360,520
Costs and estimated earnings in excess of billings			40,660,013				36,562,573
Employee advances			1,114,080				953,625
Prepayments and deferred expenses			10,281,292				3,397,358
Total current assets			150,088,321				121,046,728

This is amazing. The company has $41.9 million in accounts receivable: over 6 months of revenue employed in working just there. Then it has $40.7 million in costs in excess of billing. Another 6 months revenue employed there. And another $10.3 million in prepayments and deferred expenses, $1.1 million in employee advances, $1.7 million bidding deposits, and a relatively trivial $6.7 million in inventories. The company has deployed over 100 million dollars in working capital on behalf of their customers and they count all that as current assets. This company looks like it is in the business of financing their customers.

Three are also 14.4 million in notes receivable and that looks like explicit customer financing.

I am an accounting geek - and I can't resist an accounting geek's aside here. Current assets are - by definition - assets that the company can reasonably expect to turn to cash within a year. (If they take longer to turn to cash they are not current.) This company has more than a year's revenue locked up in working capital. Can someone explain to me how it is possible to consistently have more than a year's revenue locked up in working assets and have them all counted as "current"?

So the company is thin on inventory but very strong on financing their customers through receivables and through costs in excess of billings and even through notes receivable.

They are however very thin on actual plant and equipment. Here is the plant and equipment line:

PLANT AND EQUIPMENT, net

9,641,119

8,617,521

They have 9.6 million dollars of plant and equipment - less than 10 percent of their working capital provision. If you look at the balance sheet this is not a manufacturing company (there are very few actual manufacturing assets). This is a finance company financing its customers (conventional and nuclear power stations, petrochemical plants, railways etc) through working without billing and by being slow to collect. They also explicitly provide finance through notes.

Very strange. Especially as the customers almost certainly have better access to funding that what is really just a little fire-and-security company.

Fortunately for us the plant and equipment line is further broken down in the 10K.

		December 31, 2010				December 31, 2009
Buildings and improvements		$	7,258,465			$	6,439,015
Transportation equipment			3,963,302				3,307,236
Machinery			901,655				900,781
Office equipment			1,083,512				1,348,261
Furniture			126,032				165,736
Total depreciable assets			13,332,966				12,161,029
Less accumulated depreciation			(3,988,332	)			(3,875,487	)
Construction in progress			296,485				331,979
Plant and equipment, net		$	9,641,119			$	8,617,521

Now I am really puzzled. Before depreciation they only have 900 thousand dollars of machinery.

They have three times more "transportation equipment" (trucks and cars) than machinery. They even have more "office equipment" (computers, desks) than machinery.

This is a very peculiar manufacturer indeed. It operates almost without machinery. I assure you 900 thousand dollars - pre-depreciation - does not buy you very much manufacturing kit - even in China. (If you do not believe me start looking up prices for things like wire-drawing equipment equipment on Alibaba.)

Come to think of it - there is not much in in these accounts for buildings either: $7.5 million before depreciation. Even in China that buys a single large building. It hardly buys a campus.

Whilst the company is extremely willing to finance its customers (by extending credit through large receivables or by work in excess of billing) it does not draw much funding from their suppliers.

CURRENT LIABILITIES:
Accounts payable		$	7,666,967			$	6,903,961
Accounts payable to related party			-				272,994
Customer deposits			3,023,329				2,182,790
Billings in excess of costs and estimated earnings			2,872,706				1,429,999
Other payables			838,413				333,121
Accrued liabilities			19,737,906				13,841,300
Taxes payable			9,416,829				9,002,470
Total current liabilities			43,556,150				33,966,635

The main thing to note here is that the "working capital liabilities" are much smaller than the "working capital assets". They only have 7.7 million in accounts payable for instance versus over 40 million in accounts receivable.

There is no debt - but there are 19.7 million in accrued liabilities - all subcontractor expenses.

Summary thus far

This is a really strange company: its a manufacturing company whose balance sheet contains next to no manufacturing equipment but vast extensions of credit to the customers. It is certainly not the business described in the "business description" part of the accounts.

Margins and the P&L

The P&L shows a fat margin business - albeit one with declining profitability:

		2010				2009				2008
REVENUES
System contracting projects		$	59,544,090			$	62,514,475			$	57,101,984
Products			16,834,582				15,718,815				9,673,922
Maintenance services			3,598,010				2,947,908				2,303,213
Total revenues			79,976,682				81,181,198				69,079,119
COST OF REVENUES
System contracting projects			28,897,445				26,769,508				25,805,086
Products			7,342,962				5,589,310				2,558,844
Maintenance services			2,457,833				1,769,104				1,217,316
Total cost of revenues			38,698,240				34,127,922				29,581,246
GROSS PROFIT			41,278,442				47,053,276				39,497,873
OPERATING EXPENSES
Selling and marketing			10,135,884				8,908,697				6,434,887
General and administrative			10,822,596				8,154,801				6,680,992
Depreciation and amortization			851,036				773,907				712,269
Research and development			1,966,557				1,631,435				2,102,976
Total operating expenses			23,776,073				19,468,840				15,931,124
INCOME FROM OPERATIONS			17,502,369				27,584,436				23,566,749

Gross margins are over 50 percent of sales. Net margins (even in the relatively poor 2010 year) were 17.5 million/80.0 million or almost 22 percent.

I like to break this margin down into the two things the company does. The company seemingly provides credit to all its customers (I think we demonstrated that above), and it does manufacturing and installation.

It provides roughly 15-18 months credit to its customers (look at the working capital provision). It should make about 7 percent margin on that (just reconfigure as a loan). The rest of the business makes about a 15 percent operating margin. That is down sharply from prior years - but is still a quite nice manufacturing margin.

It is a staggering manufacturing margin for a business which has almost no capital employed in manufacturing equipment. All that margin on only $900 thousand of machinery in a manufacturing business is really strange.

So what manufacturing equipment do you get for $900 thousand?

The key to this is working this out is going to be what sort of equipment they use and whether they really do anything special on it (deserving fat margins) - and how on earth do you run a large manufacturing company with only $900 thousand of machinery.

So I went looking at their website for pictures of the plant and machinery and (thankfully) the company obliged. Here is a sampling. Alas some of the pictures are very low resolution. I did not take them: they came from the company's website.

The caption on the above photo is "Production Line of automatic fire protection electronic products".

The captions on these are "Full-scale fire Test Center" (both above ground and underground section).

This photo was captioned "The photoelectron workshop".

And here is their Design Center though the eagle-eyed will notice that it is also the fire-test center photographed above:

The whole campus is shown on their web-page with the main manufacturing subsidiary (Sureland) in the background and the two main other buildings in the foreground. There is a little wide-angle to exaggerate the size of the campus - but there are still three substantial buildings plus the underground testing center. These are not the only buildings the company uses.

These are a pretty impressive set of buildings. It is surprising that they can be purchased for $7.7 million (pre-depreciation) as per the accounts. I thought they might be leased but the words rent or lease do not appear anywhere in the annual accounts (except where they lease a house for one of their executives). So we can presume these buildings are owned.

A fire testing facility (especially an underground one) would have some equipment in it - but probably not much as it gets burnt every now and again (which is presumably what "testing" is about).

I have absolutely no idea what they do in a large "photoelectron workshop" but I figure it must be full of equipment.

Whatever - there is a lot of building here for $7.7 million and (presumably) a very large amount of equipment filling those buildings (with a cost of only $900 thousand).

I am startled. By this time I confess: I don't understand.

The Auditor

China frauds seem to be blowing up when the company fails to get an audit report. That is what happened to Longtop Financial Technologies, Unversal Travel Group, China Media Express, and China Agritech (just to mention the ones covered on this blog).

But China Fire and Security had a clean, unqualified annual report. There was no auditor resignation.

I presume Bain and the other people backing this takeover are perfectly happy with the audit they received. I presume they have done their own due diligence - after all the auditor is Frazer Frost.  Frazer Frost is (to my knowledge) the only American audit firm thus far sanctioned by the SEC over China frauds. (Eagle-eyed observers will notice that the firm sanctioned by the SEC is named Moore, Stephens, Wurth, Frazer & Torbett. The firm has been through a few name changes and restructures.)

Frazer Frost's website is now dead and has been for a few weeks.

Still - Bain are taking this company private. I hope they have double-checked the obvious audit problems. The most obvious problem is determining whether the current assets (most notably receivables and work done but not billed) are real. Bain are competent people - I presume they have done that.

If Bain need help in checking receivables may I suggest Ernst & Young. E&Y have uncovered several receivable frauds in the syphilitic puss bowl (Singapore Stock Exchange) including China Hongxing Sports.

But Bain are clever people so I presume they have that covered.

Why this deal must be real

As I said repeatedly, I do not understand these accounts, but I have only spent a day looking over them. Lots of prestigious organizations and people are involved in this deal. They must all be cleverer than a two-bit hedge-fund manager sitting at a desk near the beach in Australia. Even if individually they are not as clever as me they must collectively be cleverer than me. Here is a partial list of people working on this deal:

Barclays Capital 

Shearman & Sterling LLP 

Bilzin Sumberg Baena Price & Axelrod LLP 

Bank of America Merrill Lynch 

Hongkong and Shanghai Banking Corporation Limited

Citigroup Global Markets Asia Limited 

Bain Capital 

Kirkland & Ellis International LLP 

Davis Polk & Wardwell LLP 

Allen & Overy 

DLA Piper 

Han Kun Law Offices

That is a pretty remarkable lot. Whilst I usually dislike appeals to authority I have to cede to such an overwhelming collection of intellect.

So what does Bain see in the deal?

Once you work through all this - and you accept the accounts as the gospel truth - you realize that Bain has a true bargain.

This is possibly the most efficient purchaser/constructor of buildings in China if not the world. They purchased all those buildings for $7.7 million.

They are without question the most efficient purchaser or constructor of machinery in the world. They equipped this entire company with machines for $900 thousand before depreciation.

They also have a huge and presumably easy to collect lot of current assets outstanding. There is $150 million in current assets here - and they should - with better management - be able to turn $100 million into cash without impacting the business. After all, the customers are solvent parties that do not need all that credit extended to them. $100 million additional cash plus the $28 million cash on the balance sheet will offset more than a third of the purchase price for the business. It should pay off the bulk of the bank debt so Bank of America should be fine.

This deal is a work of genius. Unfortunately as a stockholder I will not be around to enjoy it. CFSG is going private.

John

Longtop makes an announcement

Longtop Financial Technologies - the subject of several posts on this blog - has made a statement.

Here is the release:

HONG KONG, May 23, 2011 /PRNewswire-Asia/ -- Longtop Financial Technologies Limited ("Longtop" or the "Company") (NYSE:LFT - News) announced today that the Company's registered independent accounting firm, Deloitte Touche Tohmatsu CPA Ltd. ("DTT"), has resigned as auditor of the Company by letter dated May 22, 2011.  The Company also announced that Derek Palaschuk, the Company's Chief Financial Officer, tendered his resignation by letter, dated May 19, 2011, and the Board has taken his resignation under advisement.   

In its letter, DTT stated that it was resigning as the result of, among other things (1) the recently identified falsity of the Company's financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT's audit process; and (3) the unlawful detention of DTT's audit files.  DTT further stated that DTT was no longer able to rely on management's representations in relation to prior period financial reports, that continued reliance should no longer be placed on DTT's audit reports on the previous financial statements, and DTT declined to be associated with any of the Company's financial communications in 2010 and 2011. 

Longtop's Audit Committee has retained US legal counsel and authorized the retention of forensic accountants to conduct an independent investigation into the matters raised by DTT's resignation letter.  The Audit Committee has also initiated a search for a new auditor.  Further, Longtop was advised by the United States Securities and Exchange Commission ("SEC") that the SEC was conducting an inquiry regarding related matters.  Longtop intends to cooperate fully with the SEC's inquiry. 

Longtop is unable to determine the full effect of these matters, including whether any restatement of its historical financial statements will be required, until the Audit Committee completes its review.  Longtop cannot predict when it will announce its financial results for Q4 2011, or when it will file its Form 20F for the fiscal year ended March 31, 2011.

Enough said.

Guns, lobbyists, poachers and owl hunters: Northern and Voyager Oil and Gas weekend edition

I wondered whether I was boring people when I reported posted on Northern Oil focusing on such mundane issues as whether it was appropriate for the CEOs wife to be working for a company whose main purpose is to buy assets from Northern Oil. That stuff is important - and I have more of it coming.

But when the people are this colorful you got to focus a little on the people if only to keep reader numbers up.

So this weekend post is to put the color back into the story.

You see Northern and its sister company Voyager Oil are run by boys straight out of central casting. Northern is the larger cap of the two companies – Voyager the later edition. But they are run by brothers had overlapping people involved in their foundation and assets that are core to Voyager were once owned by Northern. They really are sister companies.

Some photos and a good story

The first photo is of Michael Reger (the CEO of Northern Oil) with Shawn Vasell. Vasell shot the deer.

It's a great photo of a fine kill – but the details behind the photo are a much better story. Vasell was at the time a Washington identity. Maybe an identity known only to the most ardent Washington watchers – but still interesting. You see he was a staffer to Conrad Burns and then Porter Goss and then Spencer Abraham – all well known Republicans. He then went to work for Jack Abramoff the lobbyist who plead guilty to defrauding Indian tribes and corrupting public officials. Vasell took the fifth in the Congressional inquiries into the activities of Team Abramoff.

The photo also caused ructions. The deer it seems was shot out of the window of a pick-up (illegal unless you are disabled), on private land without the landholder's permission and the Regers and Vasell trespassed to claim the kill. Poaching charges were laid. JR Reger (now the CEO of Voyager Oil) plead guilty and received fines and a six month suspended sentence. Vasell admitted to one count of hunting without a license and another count of hunting on private property without permission. In his plea agreement, two other charges of violations of big game laws were dropped and he avoided possible jail time. The charges against Michael Reger (now the CEO of Northern Oil) were dropped as part of the plea agreement made by his brother.

All this came about because of a boasting article about the hunt on James R Reger's personal website (once at www.jrreger.com). You can find a copy of the hunting article here. The website has now been scrubbed but some political junkies kept a copy just because well – it was so funny. (Unless you were the judge who described it as “disgusting”.)

And so it is that generally James Reger is more colourful of the Reger boys. I mean what other oil company CEO keeps a Facebook fan's page which consists mostly of tales of him doing non-CEO type things. This is his profile picture:

But its the old jrreger.com website that is most amusing. After all he accuses his brother of misleading people about game he has killed. See this photo.

James captioned the photo as follows: “Pictured above is Michael Lewis Reger posing before some game that our Cousin Trisha shot. Personally, I have a problem with people who take pictures in front of game other people have killed, he does this a lot.” I will let you decide the ethics.

But hey – as far as I know claiming Cousin Trisha's kill is not illegal. Poaching is. And there is a reason why JR Reger got a suspended sentence – which is that it was not a first offence and he was so blatant about law breaking. His old website carried the following paragraph:

Every Monday morning I look forward to reading the paper. Moreover, I look forward to reading about one of my delinquent friends or acquaintances getting into trouble with the Fish, Wildlife and Parks Department. For the fine amount paid, and trust me on this one, the amount of good press you get from doing something wrong is totally worth it. I highly recommend poaching a little or doing something minor to get your name in the paper at least once a year.

You can understand the judge – probably a stickler for the law – didn't much like it. Also the same page boasted about prior offences (both his and offences of friends). This was my favorite:

James R. Reger, 27, October 6, 2001. Guiding two out of state hunters on an Owl hunt. $250.00 bond forfeited. Lying to the game warden by saying slain Owls were actually wild turkeys. $125.00 bond forfeited. Hunting and trapping privileges suspended until the cows come home.

Commentary: I'm an Owl hunter, what can I say?

So now we got it straight: convicted criminal (poaching, suspended sentence), lies to government officials (game wardens), hangs around with suspect lobbyists (Vasell and others on Team Abramoff), owl hunter and public company CEO.

Oh, and accuses his brother (also a public company CEO) of misleading people about big game he shot.

And that is your weekend postcard from the boys running Northern and Voyager.




John

Hot IPOs

The LA Times has a list of the hottest IPOs of the tech bubble. I am old enough to have forgotten most of these. The party on listing makes Linked In's debut look modest.

Some of these stock-stags were plain silly (TheGlobe.com) which (miraculously) is still quoted (at 1c per share) on the OTCBB.

One stands out as a genuine success story and a core part of modern internet technology - that is Akamai. However it is - despite considerable success - still trading well under the first day pop in the stock (though above the IPO price which makes it a real success story from the tech wreck).

The standout - the all time biggest IPO pop - is VA Linux - which has since been renamed "Geeknet". Its a real business: I use their products and even have positive feelings towards the company. Their stock chart however leaves something to be desired.

This stock rose 698 percent on the first day. Linked In is nowhere close (so maybe Facebook comes on with a market cap of $450 billion).

As a fund manager my guess is the best way to play this trend is to ignore it. Best to look where people are not looking. Everyone and their dog is looking at social media.

And socially so am I. I am off to open a Facebook account for my dog. Wonder if Lou Reed will "friend" him?


John

Just for kicks have a detailed look at the charts.  VA Linux/Geeknet is trading roughly at its 2002 low. The Globe.Com had no comeback and Akamai is a fifty bagger from the lows.  The real opportunities are during the crunch. But even if you picked Akamai as the winner out of these you probably purchased at at $5, $3 and $2 and buying at at 71c would not have happened. And you would have looked and felt like a sick puppy as you watched your quoted wealth evaporate.

Longtop Financial: lessons in the morphology of sin, loss of virginity and your 17 year old daughter

I received an email from a senior guy at a big name hedge fund. They were long Longtop Financial. Longtop is a Chinese financial software company that came public through an IPO (led by Goldman Sachs no less) that has been the subject of a few posts on this blog (see here, here and here).

I wrote a reply - but never sent it. (I did run through the reply on the telephone.)

Longtop has been suspended because they can't get their accounts out. It is almost certain that the accounts are error ridden - but on Longtop's minimal release it is impossible to tell how error ridden. This could be a minor problem (say 15 percent overstated earnings) or a major problem (95 percent overstated operating earnings, cash balances falsified, cash missing, company with undisclosed debt, stock worthless). 

Behavior at stock suspension (taking two days to tell us that they could not get their results out and giving us no other information) suggests but does not prove that the problems will be at the worse end of the range.

As an outline of what may be wrong with Longtop's accounts (I can't tell and the company won't tell us) I reprint the (unsent) reply mentioned above. That letter explains why I thought the stock was a very good near term short.

I have edited the letter to take out some personal details. 

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

Hi

Sorry to get back to you so late but I was in court watching the sentencing of Shawn Richard. Shawn is a scammer I exposed some time ago... [Details expunged as they are not relevant to the story...]

I am presuming that the "common interest" as you describe it is Longtop. We are short which means our interests are not exactly “common”.

I am going to discuss Longtop and I hope these discussions do not get back to the company (at least with my name on them). However even then I will be circumspect. The problem is morphology of sin. Clean accounts, like virginity, refer to one state only. False accounts, as does sin, refers to many states. Virginity is easy to describe and relatively easy to determine with certainty. Sin - well - that is complex to describe and comes in many variants. Sin has morphology.

With Longtop there is something clearly wrong with the accounts - but it is awful hard to determine what.

Here are the things we know:

1). It generates cash like there is no tomorrow and yet it went to the market and raised cash. It currently has cash equal to 250 quarters of capital expenditure and 26 quarters of all expenditure. By contrast Microsoft - a company with way too much cash burning a hole in its pocket (witness Skype) has cash equal to about 13 months of all expenditure. The company is - on the accounts - absurdly cash rich.

2). The last time I saw a set of accounts like it was CCME which had cash on hand of $170 million and quarterly capital expenditure of about 200 thousand. Obviously the cash was fake there.

3). The company claims a margin at the very top of software companies globally which indicates that it does something proprietary. Proprietary stuff requires protection - you would expect to pay the staff well, have retention processes to keep them from going anywhere, have racks of servers and different computer systems to test/develop your software on protect your product from being stolen. You would have some capital expenditure per incremental staff member.

4). The company claims almost no incremental capital expenditure per staff member. The last nine months are showing capital equipment equal to about a laptop per individual staff member (if that). Previous years have shown incremental capex per incremental staff member of 1500 dollars or so. This is too low a level of capital expenditure per staff member to be doing genuinely proprietary stuff. (Just think how you would be running a business growing that fast doing proprietary stuff based on the intellectual property of your staff. Actually you probably do run a business that looks like that... and the numbers are quite different from Longtop.)

5). It's possible to have very low incremental capital per staff member if you work like the computer outsource houses of the pre-internet era (the so called "body shops"). In the 1980s a staff member would turn up for a few days and hot-desk at the office whilst getting ready for their next assignment (say to a bank to work on their computer system). Then they would go out for a year working on the bank's computers and with the bank's air-conditioning, desks, carpet, vehicles etc. This requires almost no incremental capex per staff member. However it is a 10 percent margin business.

6). Conclusion: either the capex number is wrong or the margin is wrong (or both). I do not know which though. Its the morphology of sin problem.

7). The Chairman's behavior with his own stock is very strange. Bill Gates (someone with what on the accounts is a comparable business) gives his stock to charity. This guy gives it to his staff - and otherwise gives it away. There is a possibility (though it is a wild guess) that the cash on balance sheet which was necessary for the audit came from sale of stock but won't be there at the end. I honestly do not know. I am just looking at the very strange business of the Chairman giving away his stock. Again I refer to the morphology of sin problem. I figure - as per 6 above - that the accounts are wrong - I just can't tell how they are wrong.

8). The company has done lots of acquisitions but not diluted its ratios. That is very strange. The ratios are at the very top end of the world of software companies - really extreme. Its pretty hard to mix anything with margins like that and keep margins like that.

9). There are serious difficulties tracing former staff members using the usual channels like Linked In. When you find someone on Linked In who lists Longtop in their resume their new job seems too low in status given their title at Longtop. Alternatively you find people who give very senior positions at Longtop (China General Manager) who have almost no experience beyond a mid-ranking graduate at a Canadian technology school plus one year work experience. This seems odd.

10). There are some known and disclosed low margin businesses.  For instance. the last 20F filing contained the following.

With our system integration services, we assist clients with the procurement and installation of hardware and software which best meets their system requirements. We assist our clients in managing the equipment manufacturers, obtaining bids and proposals on their behalf, negotiating terms and where required monitoring the installation and testing, which is normally provided by the manufacturers. In some contracts, we may also provide financing to our clients. Where warranty is required, we obtain, on behalf of our clients, manufacturers’ warranties and support for the third party hardware and software. On behalf of our clients we procure equipment from major international technology companies, including BEA, BMC, Cisco, Dell, Diebold, EMC, Hewlett Packard, IBM, Microsoft, Nortel and Oracle. 

Our warranties include service for both hardware and our and third-party software solutions. Although we arrange back-to-back warranties with hardware and software vendors, we have the contractual responsibility to maintain the installed hardware and software. Most of our contracts do not have disclaimers or limitations on liability for special, consequential and incidental damages nor do we cap the amounts recoverable for damages.

This is almost by definition a thin margin business - but the aggregate margin is breathtakingly fat. It is almost impossible to find businesses which are fat enough margin to mix with businesses like the ones described in the quote above to get a margin as fat as Longtop.

Also some of the acquisitions look like "body shops" (as described above). Those are thin margin businesses and again when mixed with Longtop the aggregate winds up as a fat margin business.

11). The banks themselves in their accounts have been showing lower capital equipment and outsourcing spend. Other suppliers in China are complaining. Longtop is not. Its a pretty thin channel check - but it indicative of something being a little unusual. (Again it is hard to find out what - but it goes to morphology of sin).

If I had to guess I would think that revenue is faked (see 11), margin is faked (see 10), hence cash on the balance sheet if it is there (see 7) does not have the source the company would want you to think it has.

The auditor is Deloitte. Audit is due mid June. Delloite have got sudden-wariness since the CCME debacle where they signed off (2009 year) on falsified cash balances. My guess is that the company does not pass audit and is a very good short indeed with a 34 day lifespan from here.

But that is a guess. I am faced with a morphology of sin problem. The accounts are clearly not right (see 6 above) but I am not sure in what way they are not right or the extent to which they are not right. Unlike CCME there is a real business here clearly worth something. When it fails its audit (as I think but cannot be sure it will) then there is residual value (if you can get your fingers on it). If you can get rid of the very senior management (who have been selling the Chairman's shares fast and who are probably responsible for this mess) then you have a business which has value. This is not a "zero" but it is awful messy. Its a zero if the management have also stolen assets like the hundred plus million raised in the secondary.

If the accounts are only modestly incorrect you have only modest problems. Again its about morphology of sin. Your 17 year old daughter may not be a virgin any more - but that does not mean she is going to hell in a hand-basket.

John

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:

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

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