It is time to close Saxo Bank down

Saxo Bank is a retail foreign exchange trading bank. The idea of forex trading as a retail product is mildly offensive any way. [I simply can't see how you can make money doing this in any consistent manner.]

However the (a) lack of systems and (b) depth of the scam is revealed by Saxo's statement after the giant Swiss Franc move today. To quote:

“Due to today’s exceptional market movement in CHF crosses, we have been filling client orders and positions in an extremely illiquid market. Once we are better able to establish true market liquidity, all executed fills will be revisited, and will be revised and amended to more accurate levels. This may result in a worse execution rate than the originally filled level.”

It is of course garbage of the highest order that in the biggest currency movement of recent times there pertained an "extremely illiquid market". If Saxo quoted the wrong price the problem is Saxo's systems.

Instead Saxo is just stealing from its clients. It did a deal and they traded at a rate - and they are rewriting that deal to suit them.

Theft is the right word.

Any regulator that lets Saxo Bank do this is failing it core functions.

Saxo bank's licenses should be revoked.





John

Hat-tip to Reuters.

Disclosure: no positions.

The return of cookie-jar earnings: United Technologies edition

I was just listening to a November presentation made by United Technologies - a large and very fine American company. Mostly I was listening for the comments on Pratt & Whitney as Bronte has multiple investments in the jet-engine business.

But I was struck with the forthrightness with which Gregory Hayes (now the Chief Executive Officer) discussed earnings manipulation. You can find the transcript here. To quote:

So we'll be able to deliver on the numbers that we had talked about earlier in the year, which essentially was in a range. We started out at $6.55; we're now at $6.75 to $6.85. We'll be right around $6.85 when the year is said and done. Still some puts and takes, some headwinds around currency. But top line looks solid at $65 billion; bottom line looks solid around $6.85. 

I'd just point out, tax extenders is not in our numbers for the year. Who knows if we're going to get extenders here in the last couple of weeks of the year. My own view is that if we get extenders, we'll probably just restructure against that benefit or do something else, as opposed to trying to pass along another dime that's probably not going to give anybody much of a benefit. So I think we're done at $6.85.

So if President Obama signs a tax bill they won't reflect that properly in their earnings they will just take a restructuring charge so they don't need to show the earnings to you.

In other words they will create "cookie jar earnings".

Cookie jar earnings were all the rage when I got into this business. Alex Berenson even wrote a book about them. What shareholders wanted was smooth earnings growth regardless of the vagaries of economic cycles - and people created cookie jars and manipulated earnings to show precisely that.

Listening to United Technologies I felt about 15 years younger. What is old is new again.





John

Disclosure: No position in any mentioned stock.

A comment on current Chinese vs Second World War Iron Ore demand

China uses roughly 700 million tonnes of steel per year (or at least used that much before recent declines).

Really good iron ore  62 percent iron - so there is at least 1.1 billion tonnes of iron ore used per year.

My summer weekend reading is Winston Churchill's history series - and I am currently on his book on the lead up to and the early phase of the Second World War.

In it he is writing to the then Prime Minister about interdicting the shipping of iron ore from then neutral Norway to Nazi Germany.

Churchill estimates that German industry needs 9.5 million [presumably imperial] tons of ore between 1 May and 15 December 1940.

During the armaments build-up phase of the Second World War Germany was using less than 20 million tonnes of iron ore per year or way less than 2 percent of current Chinese usage.

Gosh there is a lot of steel usage and capacity in China.




John

A shameless plug for the Southern Investigative Reporting Foundation

I have agreed with and disagreed with Roddy Boyd more than once in the past year. Sometimes I have agreed with him on the analysis but not on the stock. [Insurance scams in particular can take years to unravel - but that does not mean it is not a scam.]

Moreover Roddy wrote the best "narrow" book on the financial crisis. His book on AIG is a gem though extremely narrow focused on one company rather than on the whole global shebang.

Whatever, narrow, deep investigative journalism on financial chicanery is not a highly profitable business. Doing it well is rare.

The Southern Investigative Reporting Foundation (SIRF is Roddy Boyd's baby) is thinly funded - and I think worthy of more. One of his targets has already gone to prison for fraud - and that is reward but not reward enough.

Anyway SIRF has a tip-jar. You know the usual donate-by-Paypal drill.

Tip a little in.

I have.

And if you are an American it is tax deductible. I had to donate out of post tax income.



John

Oil and helicopters

I am reading the annual report from United Technologies - which owns, amongst other things, a helicopter company. To quote:

On the commercial side, Sikorsky finished the year with a backlog of nearly $3 billion — its largest ever — driven by growing demand for offshore transportation in the oil and gas industry.

I am not sure how good that backlog is.

John

Disclosure: no positions. Primarily reading because we have a disclosed position in a jet engine company (Rolls Royce) and like the follow the competition (Pratt and Whitney).

PS. I have received at least half a dozen emails about the hostage drama in Sydney. It is 5km away and I know no more than you can find out from internet. We can see the city from our office though and the number of helicopters swarming around has reduced.

One from the archives: The guy in charge of purchasing acreage at Northern Oil and Gas

Northern Oil and Gas has been a minor obsession of mine for some years and we have remained continuously short.

This is a blog post first published in March 2011 discusses - for the benefit of shareholders - who has been making the major capital decisions for them.

---

Northern Oil is not a traditional oil exploration and production company. It has a simple model. It buys part shares in acreage in the Bakken shale. It waits until the major holder develops the acreage and it pays a proportion of the development costs and receives a proportion of the revenue.

That allows it to be a 1.6 billion dollar company with only 11 staff.

The only expertise it brings to the table is buying acreage. And they buy it at a wide scatter of prices.  They have paid $2500 or more an acre for some small (and presumably productive) lots. For example they paid $2500 an acre for 1748 net acres in Williams and McKenzie County of North Dakota during 4q 2010. They have paid less than 250 an acre for some very large lots. In the last quarter they purchased a 50% working interest in approximately 14,538 net acres in Richland County Montana for less than $250 an acre in the same quarter. In that case the acreage was purchased from the operator (Slawson) and presumably the operator had better-than-average intelligence as to the quality of that acreage.

The supporters of the stock value the stock based on acreage owned. This is obvious enough because you most certainly would not want to value it against current earnings or current revenue.

Given that acreage purchase is the whole reason for owning Northern Oil and believing the Northern Oil story it is worth following the people who manage acreage purchase. Betting on Northern Oil is above all betting on those people.  Northern Oil after all buys acreage in a scatter of prices almost all below $3000 an acre with large purchases below $250 an acre but is valued by the market at about $8600 per acre.  The acreage buying is the driver of incredible (market) value.

So without further ado I will tell you that the Land Manager of Northern Oil is Mr Kruise Kemp. Kruise Kemp has been hanging around the courthouses of Montana swooping on land where leases have expired without ever being drilled. An old article in the Billings Gazette describes the process and says how lease holders in Montana look in envy on the lease holders of North Dakota because in North Dakota the land often gets drilled whereas in Montana leases expire without ever seeing the drill bit. To quote:

Kruise Kemp is no stranger to the courthouses of northeastern Montana. The land manager for Minnesota-based Northern Oil & Gas said there are several buzzing with the land men just like Richland County's. 

Many of those speculators are looking to "top lease," meaning their sniffing out existing oil leases that are just about to expire in hopes of swooping in to strike up a new deal just as the clock runs out. 

In these parts, Montanans, some with leases that went untapped, have looked in envy toward North Dakota where drilling rigs have cropped up like knapweed the last couple years. There are 138 rigs punching holes through the shale in North Dakota. Here, there is only a handful. 

Kemp said the state of North Dakota had provided oil companies with a wealth of services including online field data that made it easy to setup. And drilling rigs attract other drilling rigs. It's a safe assumption when you see other rigs active in your area that you're going to hit something. Having so many rigs drilling in one area puts pressure on companies to permit as many wells as possible before moving on. 

But now companies are turning to Montana to further define the productive area of the Bakken. Working with two other companies, Northern launched a new 3,000-acre project in Richland County this month and has two others nearby.

You see Northern is buying the land where the drills aren't. Of course this makes it cheap. It could be cheap for a reason - the drills not being there because it is not really all that good land. Or it could be that Northern Oil is really great at finding cheap acreage that really is super-prospective.

Well as investors we can't directly know. We don't see the seismic and we are not there with the drill bit.  

All we have to go on in the people. And so I present to you a picture - a couple of years old - of Mr Kruise Kemp.

He played golf for Montana State and was a business school graduate (no particular honors) in the spring of 2010.  A nexus search identifies him as 23 years old.

So what qualifies Kruise Kemp for such a senior role in a 1.6 billion dollar company? Well it is not his finance degree. But Kruise is steeped in the oil industry in Montana. His father owns or controls a couple of oil companies. (I can find their names but not much detail about them.) His late grandfather was also an oilman.

Northern Oil has also done many related party transactions to buy acreage.  If the company is buying acreage from directors then I guess it is incumbent on the land manager to vet those purchases. Kemp is the man with that job.

We view Kemp's age and business degree (rather than say a major in geology or reservoir engineering) with skepticism. Then again we own Google. That is one of the greatest companies in history and it was started by (very bright) people in their 20s. Steve Jobs was 16 when he was introduced to Steve Wozniak and Apple was the result.

It could be that Montana State University business school has produced one of the world's great 23 year old oil-industry entrepreneurs. Might be. As a Northern Oil shareholder that is one of the things you are betting on.

John

Northern Oil and Gas: Michael Reger's deeply misleading tweet

Northern Oil and Gas (NYSE:NOG) is familiar to long-time readers of this blog. I posted about it here, here, here and here.

I have been short this stock for some years and my view is that absent sustained high oil prices this company will file bankruptcy.

I also follow the Twitter account of Michael Reger - the company's CEO.

And he has been continuously retweeting this or variants on it:

In another tweet he says that "$NOG has the most capex flexibility in the Williston. Oh, and we're hedged at ~$90."

Lets check this out. Northern Oil and Gas does have almost 6 million barrels of oil hedged at prices that are $20 in the money - roughly $120 million.

This is against $736 million (at last balance sheet) of long term debt. The hedges are not in the money by 25 percent of market cap - well not really - because the debt holders have first claim. The hedges are in the money by less than 20 percent of the company's debt.

The hedges will thus repay 20 percent of the company's debt.

The company will need to pay the rest by itself from rapidly diminishing cash flows.

Michael - please correct your tweet accordingly.

Moreover Michael pleads capital flexibility. Even that is not obvious. The debt covenants require that the company has a current ratio of 1:1. Currently the company is not close to that covenant. The shortfall (more than 120 million) likely gets subtracted from the available line.

The current ratio short-fall seems to be about the same as the hedge gains. I guess that means they can pay their current liability short fall with hedge gains...

The strange current ratio

Last quarter revenue was about $120 million. Revenue is likely to fall net of hedges.

They have current accounts payable of $220 million.

You may wonder how you possibly have accounts payable of almost twice quarterly revenue (and eight times cost of goods sold).

I will let you work that out.





John

Thanksgiving post - an Australian feast

I am in Wisconsin for my first ever American Thanksgiving.

But a little homesick - so I want to show you how we feast in Australia.

Kitchen Cabinet is a television show in Australia where Annabel Crabb cooks and eats a meal with various politicians to see how they tick.

This is my all-time favourite episode - where Annabel dresses as the African Queen and visits Senator Nigel Scullion in the Northern Territory and "pesters" wildlife.

Remember as you watch this that Nigel Scullion is from the conservative side of Australian politics.

It is a dreamtime feast.

And it proves Australia really is different. Can you imagine an American conservative politician nonchalantly explaining how he and a young woman both wearing underwear happened to wind up chained to a lamp post in St Petersburg?

Or a British politician poaching rabbits from the grounds of Parliament House so he can go home and roast them?

Enjoy...

Nu Skin results

Nu Skin produced bad results - with sales declining in pretty well every region. These are the sales from the third quarter.

	2014		2013
Revenue:
Greater China	$226,744		$449,558
North Asia	205,488		202,390
South Asia/Pacific	88,915		126,972
Americas	76,737		84,813
EMEA	40,916		44,566

Herbalife was punished by the market after a miss which involved positive but falling sales growth rate.

This is far worse.

But that is not what my complaint is about.

The company published its results WITHOUT a cash flow statement.

Call me old-fashioned but I like cash flow statements.

If you try to reconstruct it there is yet another quarter where cash generation does not reconcile with profits.

Also they drew a revolver after quarter end despite having almost $200 million of cash on the balance sheet and not obviously needing any more than the non-revolving part of the credit agreement.

I have no idea why.




John

Disclaimer: Short Nu Skin, unfortunately (yesterday) long Herbalife.

That supposed Herbalife miss

Herbalife results was a miss on volume growth. And first I was disappointed - but as I read the 10-Q carefully I became more and more cheered.

The last post outlines what the range of outcomes on Herbalife is.

On the binary issue of the FTC inquiry we have no explicit news. As stated in the last post (and I think most shorts would agree with me) the earnings power of this company is completely secondary to whether the company is allowed to operate.

The real debate which is about the legality of the business model will continue.

The secondary debate is about the profitability of the company.

Most of this post is about the secondary debate - and the entire stock movement is about the secondary debate.

Slowing growth

In the third quarter of 2011 (as the last post makes clear) the company had volume growth like this:

Third Quarter 2011 Regional Key Metrics ^2,3,4

Regional Volume Point and Average Active Sales Leader Metrics

		Volume Points (Mil)					Average Active Sales Leaders
Region		3Q'11		Yr/Yr % Chg			3Q'11		Yr/Yr % Chg
North America		252.9		12.2	%		58,897		15.3	%
Asia Pacific		261.2		36.2	%		51,644		38.5	%
EMEA		132.4		15.8	%		39,227		16.7	%
Mexico		180.6		23.5	%		49,772		25.9	%
South & Central America		149.7		39.5	%		35,993		21.8	%
China		40.3		2.3	%		9,533		26.3	%
Worldwide Total		1017.1		23.4	%		236,191		23.6	%
		Volume Points (Mil)					Average Active Sales Leaders
		3Q'11		Yr/Yr % Chg			3Q'11		Yr/Yr % Chg
Emerging Markets		544.5		26.9	%		134,467		26.4	%
Established Markets		472.6		19.5	%		109,339		19.3	%
Worldwide Total		1017.1		23.4	%		236,191		23.6	%

This was astounding growth. Normal companies do not grow sales volume at 23.4 percent for long.

In that quarter sales volume (23.4 percent) was very closely correlated to the growth in the number of active sales leaders (23.6 percent). This correlation should be expected.

And whilst the correlation was not perfectly accurate by region - it was pretty close and remained close for a long time.

Over time sales growth slowed. However as recently as the first quarter volume growth was 9 percent (off very big numbers) and sales-leader growth was 11 percent. These are still perfectly adequate numbers.

In the second quarter Herbalife had its first miss in recent years. Here were the numbers for sales growth and volume growth:

		Volume Points (Mil)				Average Active Sales Leaders
Region		2Q'14		Yr/Yr % Chg		2Q'14		Yr/Yr % Chg
North America		335.8		(1%)		75,772		5%
Asia Pacific		320.2		1%		74,916		6%
EMEA		218.8		22%		56,692		18%
Mexico		231.3		5%		64,656		3%
South & Central America		206.3		(7%)		62,172		14%
China		118.5		38%		18,703		33%
Worldwide Total		1,430.9		5%		340,644		9%

The 5 percent sales growth number is by far the worst the company had seen. However active sales leaders continued to grow at 9 percent. There was a question as to whether you believed sales leader growth led volume growth - because if it did volumes will rise over time.

More on that later.

Some of this poor volume results in the first quarter was Venezuela - and for reasons explained in the last post declines in Venezuela are good news not bad news. Net of Venezuela sales growth was probably 7 percent - still a very acceptable rate - albeit a definite slowing.

I stated in the last post that the fair value for Herbalife (assuming an FTC clearance which the shorts think is unlikely) depends critically on the volume numbers.

If volume growth resumes as 8% plus (consistent with the number of active sales leaders) then the stock was worth something around $200.

If the volume growth declined from the growth above then assuming FTC clearance a number around $80 was fair value. [And $80 is about the 12 month high - and predates the FTC inquiry. As someone who still held stock at $80 I would be disappointed.]

Alas for the longs the numbers came in and volume growth declined further.

Here they are:

Regional Volume Point and Average Active Sales Leader Metrics
		Volume Points (Mil)				Average Active Sales Leaders
Region		3Q'14		Yr/Yr % Chg		3Q'14		Yr/Yr % Chg
North America		303.0		(4%)		77,218		4%
Asia Pacific (ex. China)		304.5		3%		76,649		5%
EMEA		199.0		15%		59,668		18%
Mexico		218.7		(0%)		66,977		4%
South & Central America		204.4		(17%)		64,279		7%
China		120.7		24%		19,550		23%
Worldwide Total		1,350.3		0%		352,248		8%

Note volume growth of ZERO.

This was not meant to happen and is a big miss. Net of Venezuela it is not so bad - volume growth of 3%.

The earnings number was awful but that was because of bunch of expected charges. Venezuela has largely gone away (the sales there collapsed and the charge for currency loss has been taken). If the FTC inquiry goes away so do all the remaining charges.

But (assuming FTC clearance) the volume growth is what matters. And that is still clearly slowing.

If that were the end of the story I would be adjusting my target price for the stock below $100.

But I am not - and the reason is explained below. My time-to-target has however unfortunately extended.

Two hypotheses - one bearish, one bullish

The volume point number and the number of sales leaders has diverged sharply. Over time these will converge. That is just the way the world works.

However it is not clear whether the volume points converges on the number of sales leaders (ie volume growth converges to about 8 percent) or whether the number of sales leaders converges on volume growth (something nearer 3 percent and declining).

In other words it is not clear whether volume leads sales leaders or sales leaders lead volume. My instinct is the latter - but it is not obvious.

Lets start with the bearish hypothesis

The bearish hypothesis is simple. The product is increasingly harder to sell. It is saturated. The demand for a "business opportunity" however is substantial (especially when labour markets are not good) and so people are "signing up" to be distributors at the old rate but they are selling less and less.

This obviously is not sustainable - and the sales leaders will sell less and less and will be discouraged from being sales leaders.

Over time sales leader growth (now 8 percent) drops back to volume growth (3 percent and falling).

This is the thesis of several Twitter shorts who talk about saturation all the time.

The bullish hypothesis

The company implemented many changes in business practice in response to Bill Ackman. One of these was a limit on first-time orders (which discourages inventory loading). If the change simply defers purchase then you will find sales leaders continue to grow but for a few quarters sales volume lags badly.

Then you anniversary the business change and the sales volume growth (now 3 percent) converges on the sales leader number growth (now 8 percent).

Now here is the cheeriest thing in the whole Herbalife results.

We can distinguish between these two hypotheses. In the bear case the distributors are getting discouraged (by lack of sales) and hence the sales leader retention rate should be falling.

In the bull hypothesis the sales leaders take longer to qualify but they are selling through at an adequate rate - and hence will stick around.

Here is the point: in every market in the world where Herbalife publishes the sales-leader retention rate retention is rising. Rising retention on rising numbers of sales leaders almost guarantees rising sales in the future.

This is still a growth stock (and deserving of way over $100 per share after FTC clearance) but alas the business practice changes have deferred growth. Its a growth deferred stock.

I am going to make a lot of money. Its just going to be slower. But hey - I will take it.

Oh - and here is the table from the 10-Q of retention:

Number of Sales Leaders								Sales Leaders Retention Rate
		2014				2013				2014				2013
North America			86,129				86,469				55.1	%			54.7	%
Mexico			78,818				78,453				54.2	%			57.6	%
South & Central America			102,152				79,351				54.9	%			53.6	%
EMEA			62,723				57,071				67.7	%			60.7	%
Asia Pacific (excluding China)			126,229				134,714				39.9	%			40.1	%
Total Sales Leaders			456,051				436,058				51.8	%			51.8	%
China			30,037				30,304
Worldwide Total Sales Leaders			486,088				466,362

The good news on the FTC

There was no specific news on the FTC front - but what could be gleaned from the report was fantastic. Yes rip-snorting bullish. Eye-wateringly bullish.

The expenses related to the FTC inquiry were $2.7 million in the second quarter down from $3.0 million the prior quarter.

If legal bills are any guide (and common sense says that they are a guide) then the FTC inquiry is not being very problematic. [The shorts have not noticed this. Generally they are lacking in common sense.]

The bad news

The company had lots of one-off expenses and the cash flow net of these expenses was not wonderful. If (when) the FTC inquiry sorts itself out this will go away - but for the moment it limits financial flexibility.

Nonetheless, the bad cash flow this quarter mattered. The company stopped buying back shares. This quarter it bought back no shares and paid no divided. It distributed nothing to shareholders - and as a shareholder I am not thrilled by that.

But that is more than offset by the good FTC news (as described above) and the increasing number of sales leaders. Growth deferred - but growth nonetheless.

--

Summary: As a bull I am unhappy with the lack of volume growth and the lack of buybacks. This might have curtained the upside of the stock.

But the growth in sales leaders (at higher levels of retention) absolutely puts paid to this. This is a growth stock - just not this year. But we will lap the sales practice changes and this will be an blisteringly good growth stock.

And the evidence in the accounts is that the FTC inquiry is not pressing is overwhelmingly positive.

I was disappointed when I read the results - but hey - I am thrilled now.

Hope they get to buy back some stock in the 40s. That will just be the icing.





John