Flagrant breach of copyright by TeacherSoft

There is a really fine company out there – we will call it TeacherSoft.  TeacherSoft wants to build the best possible education platform and market it globally.

To do this it inserts in 100 thousand classrooms a classroom recorder.  The recorder records everything the teacher does.  TeacherSoft of course has the consent of 100 thousand teachers to insert the recording equipment.

The recording equipment is very powerful.  Not only does it record what the teacher says – but using speech recognition software it converts all of that material to text and it uses that text in its own business.  

TeacherSoft also – in building the best possible education platform – uses many other signals.  For instance it uses exam results sometimes adjusted for the socio-economic status of the kids.  

The teachers are of course informed about TeacherSoft – and they endorse its programs.  TeacherSoft of course shares some of the benefits of that program with the teachers.  The teachers in the process pass the information freely knowing it will be shared.  That is of course the deal.

Now one particularly fine teacher gets a little stroppy when her teaching technique is featured heavily in TeacherSoft's lucrative platform.  She thinks she should be entitled to share in the wealth.  Alas she does not have a leg to stand on – she consented to the use of any copyrights she owned.

Joe the novelist

Joe is a children's novelist.  The novels are not long – a couple of thousand words at most.  They are a length that a teacher can read them to a kid on a hot Friday afternoon – when the kids are a little rowdy and are not really up to arithmetic lessons. 

Joe's novel is of course incorporated into TeacherSoft's database.  A teacher read it aloud – and through sophisticated speech recognition software the whole novel got included in TeacherSoft's teaching kit.

It's not an exact copy of Joe's novel though.  The teacher read it but mispronounced a few words and took breaths at the wrong places and hence the punctuation is slightly incorrect.  Also – because TeacherSoft's systems are not perfect the spelling is incorrect in a few places.

But it is a copy of at least a part of Joe's novel.

Joe objects

Joe doesn't like TeacherSoft making profits from Joe's novel.  Joe owns the copyright – and he politely asks that whenever TeacherSoft notices Joe's novel in their database they exclude it.

TeacherSoft does not accept Joe's claim.  They say they did not copy Joe's novel.  They just watched the “teacherstream”.  They don't see one part of the teacherstream – the part based on novels – should be prioritized or not prioritized over any other part of the teacherstream.  The novel is just a small part of a teacherstream.

Joe is upset.  His novel has been – in part – copied.  He seems to have no redress other than issuing a cease-and-desist.

Is it copyright abuse?  

I think this is obviously copyright abuse.  The copy of Joe's novel – or even parts of it (as long as those parts do not fit into a fair use exemption in the copyright law) are breaches of copyright.

TeacherSoft argues that it has not breached Joe's copyright.  It has permission from classroom teachers to use their teacherstream.  They just got the material from the teacherstream and they have permission to use that.

So what.  They don't have Joe's permission.  And Joe has sent a cease-and-desist letter.

And if TeacherSoft were to continue to ignore the cease-and-desist then TeacherSoft would be liable for breach of copyright.  If this were a case of a lot of little Joe's and one big nasty corporation I would even go as far as to suggest that a visit from criminal regulators would be appropriate.  Of course it would never get to that – but if done on a grand scale and with flagrant disregard for copyright it would be criminal.  

The Microsoft analogy

This is – of course – a direct analogy to Google's claim that Microsoft is breaching their copyright.  This is a claim that almost all my readers have disagreed with – but which I think is a lay-down.  

Ed Harrison (from the wonderful Credit Writedowns) refers me to an article by Danny Sullivan.  Sullivan writes more about Search than anyone else on the web – and knows his way around.  His argument is this:

The Search Signal Doesn’t Overrule Other Signals

Let’s step back. There’s no “Google signal” but rather a “search signal” that Google activity is mixed into. That search signal is further mixed in with other ranking signals, a dilution that is crucial to why Bing so strongly rejects Google’s claim that it is copying its results.

Most of Bing’s searches — popular so-called “head” searches — are not heavily influenced by the search signal, Bing says. There are many other signals that come into play.

“Movies” would be an example of a head search. That’s a search that’s done by thousands of people each day, and a search topic with lots of “signal” to measure. Bing can determine if pages are relevant to that term based on the words that appear on the page itself; how many people link to some of these pages with the word “movies” in the link; how authoritative those links seem to be, and more.

Bing can also examine how people click on its own results that it lists in response to that search. If a page doesn’t get as many clicks as would be expected, it might get dropped further down on the list. Pages that get more clicks than expected can be a sign that users find them more relevant than Bing’s ranking algorithm did originally, and so that can be used to boost them.

In addition to these and other signals, Bing can also turn to the surfstream to perhaps give a boost to pages that it sees are well visited by Internet Explorer users.
“Bombilate” would be an example of a “tail” search, a search that’s rarely done, and on an unusual topic. Here, there are fewer signals to assess. Only a few pages might be found. These pages might have few links pointing at them. Since the term isn’t searched for often, measuring clicks on Bing’s own results might not help much much. This is a case where the surfstream — as well as the search signal within it — might count more.

Microsoft is arguing that there is no “google search signal” there is just clickstream.  They don't distinguish Google clickstream from any other clickstream.  That they wind up copying part of Google's database (and a small part at that) is an accident of clickstream – it is not copying.

Ok – and TeacherSoft argues that they are not copying novels – they are just using teacherstream.

Microsoft argues it has permission to copy a “clickstream”.  TeacherSoft argues it has permission to copy a clickstream.  But they do not have permission from Google or Joe respectively – and it is Google or Joe's copyright they are breaching.

Microsoft's argument is ultimately very weak.  Google has copyrighted search results.  They wind up in Bing's search engine.  Joe has a copyrighted novel.  It winds up in TeacherSoft's education material. Both Google and Joe have a valid claim for breach of copyright.  It does not matter how technologically sophisticated the method of copying.  The novel and Google's data are copyright and they are copied.

Microsoft is also a huge hypocrite here – it regularly cooperates in criminal prosecution of people who breach copyright.  Yet Microsoft flagrantly breaches copyright – and ignores a cease-and-desist.  

I opposed the original anti-trust action against Microsoft.  But this time – and much to the annoyance of most my readers – I really do think the Justice Department should become involved.   

I know my readers disagree with me.  That is kind of nice.  Part of the joy of this blog is to find smart people who disagree with me - and I have found them here.  But I still don't think I am wrong.

John

The original Google release is here.  And Microsoft's reply is here.

China Agritech. The "sniff test" and other questions for Anne Zheng and Carlyle

China scams are becoming so - well - yesterday.  There was a lot of it yesterday - hence two long posts in a day.

I barely noticed that Lucas McGee Research had put out a note accusing China Agritech (Nasdaq:CAGC) of being a fraud.

Lucas McGee is a new name for me - but their report is a classic of the genre.  They visited the factories (addresses in the annual filings) and there was nothing there.  These are plants that supposedly generate 50 thousand tonnes of "organic fertilizer" per year.

A truck carries a bit under 20 tonnes fully loaded.  That is 2500 trucks per year - in and out of the plant - so maybe 10 per working day bringing in the "raw material" and taking out the pellets.  You think you might notice some activity - but alas there was none.

All very interesting - but most interesting is that - at least according to China Agritech's annual report -  Carlyle - the most influential private equity firm in the world - have an equity stake in this company and a nominee on the board.  Her name is Anne Wang Zheng - and she is young (33) and a VP of Carlyle Asia Growth.  She works at the Shanghai office.

Now Carlyle - again according to the filings - has actively traded and sold China Agritech stock exercising their options.

I am not going to vouch for the fraud.  I have not visited the factories so I do not know.  (I confess however to being short the stock for the usual accounting-raised-eyebrows-reasons.)

I see five possibilities - though it is possible that readers - or Carlyle - see more.  I have sent an email to Anne Wang Zheng asking for her views but have received no reply.  Here are the five possibilities:

1.  The short-seller allegations are false.  (That is the short's note is a fraud.)

2.  The short-seller allegations are true but Carlyle is not actually represented on the board of China Agritech.  The China Agritech filings that say they are represented are in error (a fraud committed by China Agritech).  It would not be the first time I have seen people named as directors or officers of a fraudulent company when they in fact have nothing to do with the company.  In this case the company is fraudulent but Carlyle/Anne Zheng are honest.

3.  Carlyle is represented on the board of China Agritech - but remain - at least until the publication of the short's note - ignorant of the fraud.  In which case Carlyle/Zheng look incompetent - but not criminal.  Zheng in fact might be competent if the deception conducted by China Agritech were very well executed.  Being actively deceived even in her role as a board member makes her gullible - but being deceived is not a criminal offence and if she took reasonable steps to acquaint herself with the situation but was deceived regardless she does not even have civil liability.

4.  Carlyle is represented on the board - but found out during the time they were represented on the board that it was a fraud and did nothing about it.  In that case either Carlyle or Zheng (or both) are accessories after the fact to fraud.  Also as they sold stock they might be insider traders.

5.  Carlyle and/or Zheng knew that the company is a fraud from inception - and purchased the stock and sold the stock in that knowledge.  It could be that Zheng knows and Carlyle does not in which case Zheng has committed fraud against Carlyle (and its clients).

I have racked my brain as to which of these possibilities is the truth.  I think it is now incumbent on Carlyle to answer - and I will happily reprint their answer.

If you asked me my best guess it would be 3 above.  Zheng was an unwitting board member - and she may have been actively deceived.  I only arrive at that by applying Hanlon's razor:  "never attribute to malice that which is adequately explained by stupidity."

Of course there may be an explanation outside the 5 above.  Billy Bragg sang that "a man can spend a lot of time wondering what was on Jack Ruby's mind".  And he can.

A blogger could spend a lot of time wondering what was on Anne Zheng's mind.  I have - but I figure it is easier to ask.

So I am asking...



John

PS.  I have refrained from the (obvious) jokes comparing the company's accounts to a crock of the product (fertilizer) because I am not prepared to vouch for the fraud.  I have not wafted my nose in the product - but my guess is that if a plant did actually process tens of thousands of tonnes of chicken s--t pellets and you asked the locals about how active the plant was they would look at you as if you were strange.  Can't you smell it?

Visiting the plants and not being able to smell it would be proof enough.  In this case you should be able to smell fraud (or at least smell the absence of fraud).

If you believe Lucas McGee this one does not pass the "sniff test".



Corrections:  Carlyle did not - as far as I can tell - ever sell any shares - they purchased more - but only through the exercise of options.  I have corrected the post accordingly.  Thanks for the comment.

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

Second postscript:  The company has decided on 1 above.  I repeat their press release below.  If Anne Zheng wants to confirm this publicly as a director appointed by Carlyle I will happily post:


BEIJING, Feb. 4, 2011 (Nasdaq:CAGC - News) ('China Agritech', or the "Company'), a leading organic compound fertilizer manufacturer and distributor in China, today announced the following statements in response to the short sellers' elaborate article purposefully delivered during the Chinese New Year Holiday.

China Agritech and its subsidiaries are operating normally. A number of analysts, professional investors, industry experts, and the Company's independent accountants have toured the Company's facilities in the past. The Company has never received any challenges regarding either the existence or the scale of production of its facilities. In addition, management has confirmed that the Harbin facility has never been listed for sale.

The sales growth of the Company's organic fertilizers remains robust. In response to the short sellers' allegation that the Company's distribution centers are non-existent, there have already been 10 newly established distribution centers (including a flagship distribution center) in Henan Province alone.

In response to the short sellers' allegation that the Company's subsidiary YiNong does not exist, YiNong in fact is headquartered in Beijing with strong governmental support. In August 2010, the Company announced that it had entered into a strategic agreement with the Beijing Municipal Government to establish within Beijing the headquarters of its nationwide network of distribution centers.

In response to the short sellers' allegation that the Company does not have a license to manufacture granular fertilizer, the government-issued production license number for China Agritech's granular fertilizers is clearly marked on each of our product's packaging.

All distribution partners have signed legitimate and verifiable contracts with the Company. Sales records have been transacted per legal and accounting standards in China. Sales agreements with major distributors such as SinoChem can be viewed on the SEC's website at www.sec.gov.

Relevant evidence such as government-issued production license number and photos taken during the production process will be made available on the Company's website in the near future.

The Company appreciates shareholders' long-term support and stands ready to defend and uphold shareholders' value.

China Media Express: what disconcerted me when I read the accounts

China Media Express is a tiny company about which there is – as I have noted – major passion and drama on Wall Street.

My last post indicated that it was either (a) one of the best businesses in the history of capitalism or (b) one of the most brazen frauds in the history of capitalism.  That post was linked by Forbes (disapprovingly) or Fortune (somewhat approvingly).

I noted that extraordinary claims require extraordinary evidence – and that neither side (long or short) had presented extraordinary evidence.

I also noted that the basis for my short was that the numbers were too good to be true – but I did not state in what way they were too good to be true.  (Many people in the comments and by email questioned my assertion that the numbers were too good to be true.)

Finally I suggested that there was a relatively simple way of checking the bona-fides of CCME which was to check the veracity of a claim that they had contractual arrangement with Apple. Apple of course would tell the truth to the SEC if asked.

Since I wrote all this the stock is down about 40 percent. My (very small) short position is ex-post too small – but then as I noted the evidence that I had to support that short was flimsy and did not justify a large short position.

I was short simply because it was “too good to be true”. Alas really good does not mean false – so this was a tiny bet. I was (and remain) more interested in the drama than the result.

The Muddy Waters Report

Yesterday (last night my time) the stock fell a third fairly rapidly after a small China-based research outfit (Muddy Waters) released a report. Muddy Waters has released two prior reports alleging fraud – one on Orient Paper (Amex:ONP) and one on Rino International. ONP denied the charges and the results to date only marginally vindicate Muddy Waters. (The stock is down – but nobody has admitted fraud.) Rino International however is one of the great hits of all time. Rino has admitted fraud, been delisted from the Nasdaq and now trades on the Pink Sheets and have filed with the SEC to say they will no longer be filing with the SEC. It is – as John Cleese might say – pushing up daisies. (I remain short RINO.PK and will cover in the pennies.  There doesn't seem any reason to allow the longs an exit above $1 when they hold clearly worthless paper.)

Muddy Waters shoots one (and a bit) from two.

And Muddy Waters claims are extraordinary. They don't suggest the company does not exist (it clearly does – and indeed they visited them in many guises). They just suggest that it is egregiously overstated both in the number of buses used and the revenue from each bus. They suggest earnings per share are (generously) about 5c (compared to the stated $2.37 historical). These are big claims and Muddy Waters present considerable evidence to back them up. They claim that major advertisers (such as people who handle the Coca Cola account) could not verify the existence of this company. This was strange because the company claimed considerable revenue from Coca Cola.  (The company does exist.  Muddy Waters just asserts it is a minnow.)

Moreover Muddy Waters claimed to have checked the Apple contract. I quote:

We caught CCME’s management telling a particularly egregious lie. It recently announced it had created an online shopping platform that has an agreement with Apple Inc. (NASDAQ:AAPL – yes, THAT Apple) or one of AAPL’s distributors. AAPL made clear to us that it has no such relationship with CCME’s subsidiary. Further, AAPL keeps tight control over its distribution in China, with only two authorized online distributors (including Amazon.com’s China subsidiary). None of AAPL’s China distributors have authority to sub-license.

This is pretty incontrovertible. If Apple will verify this to the SEC the SEC has no choice but to suspend the stock - send it to the Pink Sheets and leave the corpse to the class-action lawyers to clean up. If Apple will not verify this to the SEC then Muddy Waters has some questions to answer. This issue alone is sufficient to say who is telling the truth.

But I am not here to talk about the Muddy Waters report (although it is an impressive piece of due diligence). I am here to explain what it was that you could check from your desk in Sydney, New York or London that made me think that CCME was a strange company.

It was the payments for media content.

How media content is paid for

TV shows are expensive to produce. The stars are paid well (sometimes very well). Scripts are expensive. Studios and their staff more so. Tens of billions of dollars annually is spent producing TV content.

People don't spend all that money on TV content and then give it away. Those tens of billions of dollars have to be recovered from somewhere. Indeed they are usually recovered eventually from either advertisers or pay TV subscriptions.

Content deals come in two forms. Either (a) I pay a fee for the content or (b) I broadcast the content on my distribution (say a TV station) and I allow you a share of the advertising revenue or give you a proportion of the total advertising time in which to sell adverts.

In the US most TV content is sold by networks to regional TV stations in exchange for “minutes” of advertising time. If a network is selling a hot show (like American Idol) it might demand 10 minutes of advertising time per hour. If its a very cool show the network might demand 4 minutes of time leaving a larger piece of the smaller pie to distribution.

But its one or the other. I either pay for the content in hard cash or I pay for it by giving up revenue.

If I pay for it in hard cash that cash outflow will show in the accounts (and reported margins will be lower).

If I pay for it in minutes then the cash outflow will not show in the accounts – but the revenue per screen will be lower.

Its one or the other. Either cash outflow shows in the accounts or revenue per screen is lower. No choice in that.

So lets look at the accounts to see which:

Here is the cost-of-revenue section in the last annual report. To quote:

CME’s cost of revenue increased to $25.1 million for the year ended December 31, 2008 from $13.2 million for the year ended December 31, 2007 due to the following reasons:

Concession fees.  Concession fees charged by inter-city express bus operators increased to $20.0 million for the year ended December 31, 2008 from $10.7 million for the year ended December 31, 2007. The substantial increase was attributable to the concession fees payable to the group of bus operators participating in CME’s network through the execution of long-term framework agreements for the year ended December 31, 2008 as well as an increase in the number of inter-city express buses carrying CME’s network to 15,260 as of December 31, 2008 from 10,053 as of December 31, 2007.

Depreciation.  Depreciation for CME’s digital television displays and hard disk drives increased to $2.8 million for the year ended December 31, 2008 from $1.6 million for the year ended December 31, 2007. The increase was attributable to installation of new equipment and control systems in connection with the increase in the number of inter-city express buses in the CME’s networks.

Business tax.  Business tax increased to $2.1 million for the year ended December 31, 2008 from $0.7 million for the year ended December 31, 2007. The increase was primarily attributable to business taxes arising from consulting services Fujian Express provided to Fujian Fenzhong in the year ended December 31, 2008.

Salary.  Salaries increased to the amount of $203,000 for the year ended December 31, 2008 from the amount of $156,000 for year ended December 31, 2007. The increase was primarily attributable to the increase in number of staff in production and maintenance department in 2008.

Other operating costs.  Other operating costs decreased slightly to approximately $9,000 for the year ended December 31, 2008 from approximately $13,000 for the year ended December 31, 2007. The decrease was primarily attributable to the decrease in production costs in 2008.

Now lets add this up.  Concession fees were 20.0 million dollars, depreciation another 2.0 million, business tax 2.1 million.  Salary was a paltry 0.2 million.  Other expenses were trivial.  That adds up to 24.3 million.  Total cost of revenue is 25.1 million. There is $800 thousand unexplained.

That $800 thousand must include all content payments. There is no other place that content payments in cash can go.

That is not much – relative to huge revenues to pay for content.

So we can presume they are not paying much for content.

That is OK of course. Regional TV stations don't pay much cash for content - they yield minutes of advertising time instead. Its entirely possible that CCME yielded minutes of advertising time.
Indeed I questioned one of the stock brokers pushing the stock about this and they told me – after discussion with the company – that the low payments for content were explained by yielding minutes of advertising time.

Alright – then you would expect revenue per screen to be lower than the competition because – after all – the company does not own all the advertising time on the screens.

I did the calculation – and it is repeated in the Citron Research blog post. Advertising revenue per screen was roughly double the competition.

No cash outflows for content are visible in the accounts and revenue per screen is higher than the competition (suggesting but not proving that they are not paying much for content by yielding minutes).

As I note: this is not proof of fraud. Checking fraud is difficult: though physically checking say the contract with Apple exists would probably constitute proof of fraud.

I did not try to check fraud.  My standard of proof was low - but then so was my position size.

After all, it is possible that CCME had worked out how to sell adverts for 4 times what the competition sell them (thus producing double the revenue per screen whilst sharing half the advertising time with the suppliers).

But I thought that was “too good to be true” so I shorted the stock.

Was I confident about this? No. That is one reason why my position was small.

Does the Muddy Waters research surprise me?

No. I was kind of expecting an end game somewhat like that – and it makes sense of my observations.

Does the Muddy Waters research constitute proof?  Not directly - you would either need to confirm some of their observations yourself or wait for the SEC to do it for you.

However confirming the claim about Apple would be pretty convincing. The SEC should do this and – with that proof – they should suspend the stock.

I am not holding my breath. The SEC are regulators with a reputation for being slow.

If the short case is right (and I have a small bet on that it is right) then some prominent people have some egg on their face. Starr Asia - associated with Hank Greenberg - looks really stupid.  They have repeatedly purchased stock in this company and claim to have done due diligence.  That I guess will further tarnish Hank's reputation.  Deloittes is the auditor.  Knock one more failure up for a major audit firm - albeit a particularly embarrassing failure.

At this point you know my (weakly held) view.  I still welcome criticism in the comments.

Finally to the new readers who came from Forbes or Fortune.  Welcome.



John

The Microsoft-Google spat explained

It took me a while to understand the Google-Microsoft spat regarding Bing incorporating Google results into Bing searches.  Its important for us because we own a small position in Microsoft and a seven times bigger position in Google.

My first reaction was that Microsoft has engaged in theft.  That reaction has softened slightly – but only slightly.  I need to walk you through it.

Google's suspicion came from a very strange search: tarsorrhaphy. As Google notes tarsorrhaphy is a surgical procedure on eyelids. They started with an unusual misspelled query [torsorophy]. Google returned the correct spelling—tarsorrhaphy.  At that time, Bing had no results for the misspelling. Later Bing started returning Google's first result (a Wikipedia page) to their users without offering the spell correction (Google posts screenshots). This was very strange. How could they return Google's first result to their users without the correct spelling? Had they known the correct spelling, they could have returned several more relevant results for the corrected query.

Google then puts out a veritable honey-pot of strange searches – for example “hiybbprqag” - and they rig their search engine to relate those searches to completely spurious pages.  Lo and behond – three weeks later the same searches get linked to the same spurious pages in Bing.

Lets explain what has happened here.  Lots of people (including 20 Google engineers) install Bing toolbars on their computers.  The Bing toolbars report click-streams to Microsoft.  Microsoft thus learns that when people search Google for the odd term “torsorophy” their next click is the Wikipedia article on tarsorrhaphy.  Bing does not correct the spelling (it has not got that trick right) – it is just copying the Google users clickstream.

If it copies enough clickstream of course – and especially for rare searches such as torsorophy then it will copy the results.

Microsoft – in their response – claimed that Google used “clickfraud” to rig the results of the test – getting enough Google engineers to install a toolbar that they could rig the Bing results.  I want to analyse that response.

Firstly the term "clickfraud" here is (a) emotive and (b) (I suspect knowingly) misused.  If I were to put google adverts on this blog and then click those adverts myself so that I got revenue that would be clickfraud.  Google has ways of stopping this (with considerable but not total success).  But there is no fraud by Google in their click-stream.  Microsoft is just saying that clicks resulting from a Google search page are perfectly valid to incorporate in a Bing result.

Bluntly:  It's one thing to collect click data, it's another to look at what one search engine returns as a result for a query and add that to your index.

So, what Bing is effectively doing is saying: "we use Google ranking algorithm as one of our signals" but only via the mechanism of the customer's click-stream.

Do they really think this is an honest way of doing business?  (If they directly stole the data by entering a search into Google themselves that would be criminal theft.  But they get the results anyway via the click-stream.)

The antitrust case

The Microsoft antitrust case argued that Microsoft extended their monopoly in one thing (operating systems) by bundling other things (browsers) into the operating system (and hence killing netscape).  I always thought this was a weak case because you could always download a netscape browser if you thought it was better.  You can still download a browser based on Firefox from Netscape – and the monopoly in software hardly stopped Firefox and Chrome being the browsers I use (even in those rare times I use a Windows computer).

But the anti-trust case here is absolutely solid.  Microsoft bundles the Bing toolbar with some versions of Windows (certainly if you click all the options once you open the included browser you will wind up with a Bing driven machine).  It then takes streams that say if someone searches Google for X and then clicks Y then we should copy this and make a Bing search for X present result Y.

They are thus using their power in operating systems to copy (I would say steal) Google's results and hence weaken Google's business.

This is precisely what the antitust case failed (in my view) to prove with browsers.

Google has just asked Microsoft to cease using Google search results to populate Bing searches.  Microsoft is pussyfooting around on this.

If they don't cease pussyfooting then methinks it is time to reopen the antitrust case.




John

Postscript:  A lot of people seem to have a different view.  They argue that Microsoft received consent from the users of the toobar - end of story.

Microsoft did not receive consent from Google.

Its Google's results that Microsoft is copying.

They are not copying them by inserting search terms themselves and copying them.  (That would be criminal.)

They are copying them by watching ordinary Americans enter search terms and watching where those people then click.

It is still copying Google's search results.

The consent from the users of the toolbar is a complete red herring.


John

China Media Express: The Wall Street Drama continues

For the last few days my blog post about China Media Express has been the most visited post on this site.  Strange really because China Media Express is a small company that puts TV screens on buses (for advertising) in China.  It is not a subject that should garner many readers.

But garner readers it does – and the readers are passionate.  My last post talked about the passion  (both from longs and shorts) and the pain that short-sellers were taking on the stock.  I also went short a very small amount of the stock (roughly one third of a percent of funds under management).  I have a dog in this race but I really don't care too much about the prize money.

Anyway the long case is really about the numbers.  This company is – at least according to its SEC accounts – frighteningly profitable.  It is far-and-away the most profitable display advertising company I have ever seen – the numbers are off-the-scale good.  So good that they would make Warren Buffett green with envy.  Amazing given it is a relatively innocuous business. Almost from a standing start – the company has placed TVs on buses and wound up with $170 million hard cash in the kitty – cash that represents neat profit.  And it remains that profitable – it is growing frighteningly fast – and the stock remains on a low price-earnings ratio.  On the face of it this is the best investment you could make.  For example Glen Bradford (who runs a hedge-fund advisory business that “focuses on risk averse investing”) has described CCME as “the best stock in the world”.  Matt Schifrin – a writer at Forbes – has repeatedly plugged the company.

The short case is also surprisingly simple.  If it seems to good to be true it probably is.  But the short-sellers will go further – they will argue that the company does not exist – or if it does exist it is a few screens on a few buses to convince gullible American stock pickers to buy the company – not a real business capable of generating a cumulative $170 million in cash profits.

The short case an amazing slur really: the company does not exist and that the entire thing is fake.  It is also the strongest and most passionately (albeit until today privately) stated short case I have ever heard.  

In science I would normally follow the dictum: extraordinary claims require extraordinary evidence.    And I would apply it to both sides of the argument.  The longs argue that they have found one of the most extraordinary businesses in the history of capitalism.  The shorts claim they have found one of the most brazen frauds in the history of capitalism.

As I said – passion.

And so far nobody has the extraordinary evidence.

But the longs have a point.  If this is a fraud they have pulled the wool over some very prominent eyes.  The biggest shareholder is Starr Asia (the company associated with Hank Greenberg of AIG fame).  They are presumably competent enough at basic due diligence in China not to miss something this blatant.  Moreover Starr has purchased more – suggesting they are getting deeper into this.

Further the auditor is Deloittes rather than than some two-bit bucket shop.  A big name auditor is hard to defraud – especially when some things (such as the massive cash balance) are dead easy to check.   That said – if you can convince a big-name auditor to sign your fraudulent accounts it will help you continue to perpetrate the fraud.  If you really want to steal a lot of money from the stock market start by fooling a big-name auditor.

And the shorts have a point too.  The numbers really are extraordinary.  

I said which side I am on.  I am short.  But I don't have the evidence that supports a notion of fraud (nor for that matter do I have the evidence that suggests this business even makes sense at the published numbers) and hence my position is tiny.  [My short position is so small that you cannot construe it as evidence either way or as a strongly held opinion.  I have a dog in this race – but from my perspective it is a low prize money event.]

Citron Research – a short-shop that is right a surprising proportion of the time – has published on CCME today finally stating in public the short case.  They describe it as a “phantom company” (they do not go as far as stating it is a non-existent company but that is a distinction without much difference).  The stock only fell 17 percent – which – if the allegation is right means that it has only begun falling.  They do a stirling job of presenting the numbers on the public data.  This is the data that I used to go short – data that looked almost nonsensical it was so much too good to be true.

They also promise to reveal what on-the-ground research in China tells them.  I would love to know early – but I will have to wait.  I have not kicked the tires of 20 thousand buses – nor talked to advertisers and content suppliers in China.  If you did that you would find out whether they have even heard of the company.  If they haven't you probably have a “phantom company” – but even then it is hard to prove the non-existence of something – and so you would be left with some doubt.    China is a big place and it possible not to have heard of all the players.

I am wating for Citron's next post.

Meanwhile however it is entirely open for the SEC to do some due diligence of its own and prove that they are an investigative agency.  The company recently put out a release in which it claimed contracts with Apple, Sony, Toshiba, Adidas, Nike, Samsung and others.  This is a pretty brazen thing for a fictional company to do and is being used by the longs (with some justification) to disprove the short case.  Certainly the release made me more nervous.

But there is a simple check now: ask Apple, Sony, Toshiba, Adidas and Samsung.  (It would not surprise me if Citron has done precisely that.)

Anyway, both Nike and Apple are SEC reporting companies and I am sure – in response to a polite request from the SEC they would confirm or deny whether such a contract has been signed.  If they have been signed then the SEC can leave this alone.  If the contracts have not been signed then – hey – the SEC can suspend this and claim (justified and enormous) kudos for stopping a genuine fraud by work of their own initiative.

Obviously though if nothing happens then short-sellers will be none-the-wiser.  The company will go on – and short – albeit only 30bps I would have to take my lumps.

The drama it seems continues.


John

Fred got laid off: it's on the foreclosure list now

A gem from Jim the Realtor.





PS.  Even the title is not original - it was purloined from the comments.

What to do with Fannie and Freddie

There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation.  They argue that government intervention has to end and then propose a system with a permanent role for government.  It is not just nonsensical - it is usually in the interest of some large financial institution.  All they want is Frannie out of their part of the business.  They like government subsidies in the rest of their business.

Anyway I have the free market solution to the Fannie and Freddie situation - and - I hate to say it - it is dead obvious.

Answer:  raise Frannie’s pricing.

At the moment there is nobody doing conforming mortgages except Fannie and Freddie.  Indeed there is almost nobody doing mortgages of any kind except Fannie and Freddie.  If the free market wants the business they can have it.  (They just don't want it at this sort of interest rate spread - and I don't blame them.)

All the government need to do is tell Frannie to raise their price a little each quarter.  Currently they charge 20-25bps for guaranteeing mortgages.  (The free market won’t take credit risk at that price.)  So it is entirely open to the FHFA (and hence the Treasury) to tell Fannie and Freddie to raise their prices by 5bps.  The government will get paid better for the risk they are taking (and what free market ideologue will disagree with that) and the private sector can compete if they want to.

I doubt the free market will.  But then in a quarter or two Frannie can raise their pricing by another 5 bps.  And a quarter or two later Frannie can raise by another 5bps.

At some stage you will get to a level where the private sector chooses to compete.  Frannie should not set its price competitively though.  In another quarter they should raise the price another 5bps.  And in another quarter they should raise again.

Over time Frannie will become non-competitive.  It will shrink simply because bankers and mortgage brokers do not bring it business.  And so Frannie is put into market chosen run-off and the business is effectively privatized.

You can do the same thing with Frannie's portfolio - you could ask them to raise their internal revenue exectations on any mortgage they buy by 5bps.  They might buy less - they may not.  Don’t limit the size of the portfolio: raise the profitability of the portfolio.  When another quarter elapses raise spreads by another 5bps.  Eventually of course the private sector won’t bring Frannie business - and so Frannie will shrink.

If you want the government to keep supporting the housing market (an object of policy it seems) then you just slow the rate of price increase down.  Do 5bps per half rather than 5bps per quarter - or even 8bps per year for a slow exit.

Over time the government will make a full exit from the mortgage business.  Along the way the taxpayers recover as much money from Frannie as possible.

If you look at my long series on Fannie and Freddie and compare my model predictions to current results you will notice that the credit losses are lower than my projections.  The revenue however is much lower than my projections.  The lower projected revenue has been a government choice: the Government has been forcing Frannie to charge lower spreads to support the housing market.

This is so obvious it is painful: if you want to remove the subsidy remove the subsidy.  If you want to do it slow do it slow.

So why can’t anyone see it?

Every proposal for the government to get out of Fannie and Freddie is in reality a proposal for the government to get out of only a bit of Fannie and Freddie.

For example: if you are a business that likes managing interest rate risk you want Fannie and Freddie out of the interest rate risk management business but you want them to stay in the credit risk management business.  You would prefer the government take the risks that you don’t want.  And moreover you would prefer they took it at the lowest possible price.

The worst proposal out there (much worse than doing nothing) comes from Phil Swagel and Don Marron.  They propose that the government exit the interest rate risk management business (the only business at Frannie that never lost money) and allow ten or so new competitive companies with government guarantees to compete with each other to sell government guarantee of credit risk.  That means that credit risk (the risk that blew up the system) will be priced as close as possible to zero with the government wearing the downside.  I can't see that Swagel and Marron learnt anything from the crisis.

But Swagel and Marron are an extreme variant of the typical proposal.  Everyone’s proposal involves getting Frannie out of their business whilst leaving subsidies (preferably increasing subsidies) in the parts of the value chain they don’t compete in.  Every proposal is thus about maximizing profits of some financial institution whilst sticking those risks that they don't want to the government.

Are you surprised?



John

Disclaimer:  Every proposal out there is conficted.  I am too.  I own defaulted preference shares in Frannie on my own behalf and on behalf of my clients.  A proposal that allows Frannie to maximize revenue on their way to oblivion is in my interests.  But then I only get paid if taxpayers get back 100c in the dollar plus penalty interest and fees.  And from the perspective of a US taxpayer it is hard to see what is wrong with that.  You exit Fannie and Freddie and it does not wind up costing anything.

Skepticism and wealthy investors

I know a rich bloke who is usually pretty switched on who is a private investor in Black Light Power.

That is - at least to my eyes - a very strange thing to invest in. Firstly the company seems to have identified the mysterious “Dark Matter” in the universe. Moreover this provides a miraculous source of power (through machines that are small enough to be used as the power source for a car). Finally they claim to have demonstrated this motor almost two years ago.

I should quote their web page executive summary:

• BlackLight Power, Inc. is the inventor of a commercially competitive, nonpolluting new primary source of energy that forms a prior undiscovered form of hydrogen called “hydrino” which is very likely the identity of the dark matter of the universe.

• Proprietary electrochemical reactants or solid fuels undergo reaction to cause hydrogen to form hydrino with energy released as electricity or heat, respectively. The net energy released from this "BlackLight Process" may be two hundred times that of combustion of the hydrogen fuel with power densities and performance comparable to those of batteries and conventional central power plants, respectively.

• Water can be used as the stored hydrogen, generated on demand by electrolysis using less than 1% of the electrical output. With the elimination of fuel and fuel infrastructure costs, the operational cost of BlackLightPower generators is likely to be very inexpensive. Moreover, the process does not give rise to pollution, green-house gases, or radiation as conventional systems do.

• The Company has developed three systems for producing electricity powered by forming hydrinos: one electrochemical and two thermal systems. A CIHT (Catalyst Induced Hydrino Transition) cell generates electricity directly from hydrogen. But, unlike a conventional hydrogen fuel cell, the cost is forecast at $25 per kW compared to thousands per kW for a fuel cell.  This is in part due to the CIHT cell’s electrical energy released per hydrogen being over 200 times greater, and the CIHT materials being inexpensive.  Moreover, fuel cells can’t use water as the source of hydrogen, since their product is water. For CIHT, no fuel infrastructure is required to provide on-site power allowing the CIHT cell to be autonomous.

• BlackLight Power is focused on advancing CIHT technology to produce power to ultimately sell directly to consumers under power purchase agreements. Rapid dissemination at nominal historic cost is expected by deploying many autonomous distributed units that circumvent the huge barriers of entry into the power markets such as developing and building massive billion-dollar power plants requiring enormous thermally-driven mechanical generators with their associated power distribution infrastructure. This is especially advantageous in emerging markets.

This sounds to me like arrant nonsense. But hey - my friend has invested in them and when I express skepticism he tells me he will rub it in when he is a BLP billionaire.

Moreover the board of Blacklight Power look clever enough (even if I have not bothered to check their CVs).

Besides, the company claims to have demonstrated a 50 kilowatt “hydrino engine” as early as 29 May 2008.

If this is the case then it would be fairly easy to demonstrate now - and they would easily be able to sell a 5 percent interest in the company for $1 billion plus. So they would hardly need to be door-knocking merely middling rich investors.

Wikipedia has some detail on the Blacklight Power controversy. (Even that relatively small Wikipedia article is subject to over 1000 edits which suggests promoters and skeptics at war.)

I will side with the skeptics on this one - and if it were a listed company I would short it.

I am not sure that Blacklight will ever solve the world’s problems.

I can't drawn any conclusions on this one not found in the various Wikipedia edits -  in my (possibly incorrect) view they have demonstrated something somewhat less valuable: if you market arrant nonsense with wild-get-rich-quick claims to sophisticated investors enough of them will give you enough money to make it worthwhile.

I guess we knew that already.


John

PS:  I wonder if the converse marketing result is true:  If you market modest truths you will be thought of as smart but possibly boring and shown the door.  Comments on that would be nice.

PPS:  Wikipedia suggests - without citation - that Blacklight has raised $70 million.  Maybe they have found the risk-loving investors I was moaning about in the last post.

Finally - if you want a stronger view than mine go to the website of Professor Park (Physics, Maryland). Search for Mills (the name of the CEO).  You will get the idea.

Swashbuckling versus risk: a comment on marketing small hedge funds

Laurence Fletcher wrote a piece in Reuters about how some hedge funds are losing their sex appeal. Only a minority of rich clients want a swashbuckling fund - one that has high returns (and maybe higher risk) and takes high profile bets (such as Paulson’s bet against subprime AAA securities or even more famously - Soros’s bet against the pound).

To some extent he is right. For example (and I could choose many examples) Dan Loeb at Third Point is getting older. Third Point may be named after a surf break - but Dan is surfing less than he used to. He is not getting fat but he is no longer Mr Pink - the doyen of the yahoo chat boards and the man with the encyclopaedic knowledge of small cap stock promotes and frauds and the scumbags behind them. Moreover Third Point now occupies two levels of a Manhattan skyscraper - he has staff and responsibilities and guess what - 30-40 percent returns in 2010. [I am not sure that Dan ever admitted to being Mr Pink. He has however admitted to sharing many of Mr Pink's opinions.]

Most of Third Point’s clients don’t want Dan to be Mr Pink or even associated with someone like that. They want him to be the suited well-staffed machine that Third Point has become. One thing I did not comment on in my review of The Ackman-MBIA book is how potential clients of Bill Ackman’s thought his obsession with MBIA was a negative. Some would invest provided Ackman actually dropped his obsession. I am not sure whether David Einhorn has the same trouble - but David Einhorn has a knack I wish I could emulate - he can say the most contentious things and seem reasonable and moderate when he says it. (I think that is partially because he looks so preternaturally young.)

Laurence Fletcher is also right about the business of marketing a new hedge fund. The institutions are very powerful. On our trip to America (to market Bronte) we met lots of people who would be very useful clients if we wanted to increase our fund size from 750 million to 3 billion. We met very few people who would invest in a new fund.

And this is a real problem if you have a strategy which is low risk (meaning negligible chance of true blow-up) but which does not scale well above a few hundred million under management. In that case you can’t get to $500 million - and if you get there you don’t want to grow - making the institutions and funds-of-funds doubly useless.

If Laurence Fletcher is right - and there are a bunch of clients who are willing to bet on a swashbuckling fund they are not looking very hard. I have met more than a few bright ambitious and swashbuckling types. Recently for instance Kerrisdale Capital (two guys below 30 sitting in some dingy office in NYC) put out a detailed report on China Education Alliance (NYSE:CEU) - a Chinese for-profit education company listed in America. This included hiring private investigators in China to investigate their activities and produce videos (posted on YouTube) which supported their thesis that the company was (their suggestion) a complete fraud. It had the right effect too - the stock has more-than-halved since the Kerrisdale Capital research and I am sure the very few (adventurous) clients Kerrisdale had did pretty well out of that one. Kerrisdale’s actions are every bit as swashbuckling as Mr Pink.

Now if Kerrisdale wants to scale their business beyond a few hundred million under management they will have - by the nature of the business - to become a little less out-there. They may have to turn into Dan Loeb. (If they still get over 30 percent returns as Third Point did last year I am sure the clients won’t complain too much.)

Felix Salmon’s comment on the Laurence Fletcher piece misses the point of startup funds. Felix wonders why - if people want higher returns - they don’t just lever themselves into hedge funds (and implicitly he thinks the high returns of some hedge funds of yore came from putting the capital entirely at risk). This assumes (falsely) that risk-return is a continuum. Putting 10 percent of your capital into put options over China Education Alliance and then publishing your analysis is not a deadly strategy - you could lose 10 percent pretty rapidly or make 30 percent or much more - and given the research on CEU was so convincing it was likely to be extraordinarily profitable. I don’t know Kerrisdale’s returns (I have never asked) but if they got 35 percent doing that sort of thing during 2010 I wouldn’t describe it as “risky” but I would describe it as “swashbuckling”. I would also note that it is impossible to scale beyond even relatively small size (100 million would be a limit for that sort of investment strategy). Sure you might get 35 percent by leveraging into a bunch of 12 percent return hedge fund strategies as Felix suggests - but my guess is the risk would be considerably higher.

At Bronte there are parts of our strategy that scale more or less forever. (We could manage billions.) And parts of our strategy (incidentally the parts on which we are doing well) probably top-out at a few hundred million. Its the same problem faced by a bunch of smaller funds (many of the managers of which are readers of my blog).

I don’t know the potential clients that Laurence Fletcher was talking to. I wish I did (and if they would contact me I would be thrilled). If they want unconventional funds they are not going to find them in gleaming offices lined with modern art in NYC. They will find them in some dingy little office or outside the New York/London financial centers altogether. And they are going to have to do a little work because otherwise they are going to have to fall into Felix Salmon’s mistake and implicitly confuse high returns with high risk (by asking why not just lever into conventional hedge funds). There are high-return strategies you can employ when small which are not very high risk. The strategies however are often difficult to scale and potential clients have to work out whether they make sense and whether they should commit capital.

One reason why the institutions don't invest in small funds is that the due diligence for a small fund is as hard (or harder) than the due diligence for a large fund.  That is - they think - the adventurous client's burden.


John

PS. It's just not good enough to just buy small hedge funds. When you don’t understand either (a) the custody or (b) the strategy don’t do it - otherwise you are going to wind up investing in an Astarra or a New World Capital Management. Of these the first requirement - custody - is by far the most important. If the fund has genuine third parties holding the assets and doing asset valuation at least the returns are real. Once you have assessed custody - and only after you have assessed custody - do you make your decision on strategy.

PPS. This is not a recommendation for Kerrisdale. The only thing I know about Kerrisdale is the work they did on CEU. I met them. Smart, young, ambitious and more than a little out there. Potential clients will have to do the work I described in the last paragraph - I did not do it for you.

PPPS. Of course potential clients should make the same assessment of Bronte too. 

Some Logitech feedback and China macro

Thanks for the comment - email and otherwise on the Logitech post.

The first comment (made fairly consistently) is that the core assumption (peripherals are dying) is wrong.  My response: cables are not dead either.  My laptop is still connected to my kindle (for charging) via a USB Micro.  So what - I now have a box full of cables in the attic and another one at work.  I can't imagine myself buying another one for a while.

You can buy a USB Micro cable (buy it now) on Ebay for USD1.50.  A USB Cable at Radioshack is $9.95.  Selling them for 6 times cost is very fat margin - it was the raison d'etre of Radioshack - a place you went when you needed a cable now.  Lots of stores.  One close to you.  Even small declines in the demand for cables changed the economics of Radioshack.

In five years time we will need mice like we need USB cables.  (Irregularly - and you will already have a drawer full of the critters.)  The decline of Radioshack will be mirrored in the peripheral makers unless they can find something else to do.

The second set of comments - more concerning from a short's perspective - is that they are finding something else to do.  The best stories are about music - people selling high end speakers to go with their computer.  Some of this stuff is pretty groovy.  Logitech make the (hands down) best ear-buds in the world: Ultimate Ears.  That is never going to be a mega-hit product because there are not many people who are up to getting their ears cast by an audiologist for form-fitting (screw in) ear-buds at $1000 a pair.  But top-end products like that allow you to develop technology for a mass market.

My guess is that memory on mobile devices (especially phones) gets cheaper and more plentiful we will use phones at much higher sound-quality than the iPods of yore.  Improved sound quality will drive demand for higher-end headphones.  Maybe not Ultimate Ears - but at least a product that sells for more then a hundred dollars.

I was surprised how few people commented on the Chinese macro angle.  To me that was the most important observation.


John

Logitech and a divergence into days payable outstanding, Dell, Apple, and macroeconomic conditions in China

Stableboy Selections (a blog I should read more often) provides us with a fairly simple case for shorting Logitech.  After joking about their domicile (Apples Switzerland) he points out the obvious - laptops are replacing desktops - pads and phones are replacing both of them.  Logitech sells peripherals.  The new technology (along with things like Google speak-to-search) will reduce the need for peripherals.  Peripheral sales should fall year-in-year-out - they have done so at Logitech.

Eventually this suggests Logitech will look like Radio Shack - a company that got rich selling cables for your computer and TV and eventually shrunk into (near) oblivion.  The first of two bottoms (in the stock at least) was marked by The Onion doing a mock interview where the CEO could not figure out why they were still in business.

If the desktop is doomed so are its peripherals - and along with my absurd collection of cables (firewire anyone) I now have a collection of mice, keyboards, video-cams and the like.  My shop is my attic.

Given Logitech trades at a trailing PE of 22 it looks like an attractive valuation-business obsolescence short.

Alas if this business were as easy as ripping off other people’s ideas we would all be rich.  So I went to work reading Logitech’s accounts.  There are some upsides - first and foremost is Google TV (“the most important product launch in our history”).  I am not sure Google TV is getting much traction (but they have a really complex remote control to sell and even that will become another Android app).  More notably they had a really good quarter - enough of a good quarter that it spelled "turnaround".  Just as The Onion marked a bottom in Radioshack I was worried that Stableboy would mark a (the?) bottom in Logitech.

I just could not work out why peripherals would have a good quarter.  And if it was a good quarter I could not figure any reason why sales should start motoring upward.  The trend towards lower peripherals sales plain - and the company's contrary prediction is strange.  However the company does predict turnaround.

My first reaction was that the company was channel-stuffing.  (Increasing the speed at which you deliver to just-in-time retail can produce sharply rising sales at the expense of annoying your customers and sharply falling sales next quarter.)  Channel-stuffing would have been a great short thesis (and Stableboy hints at it) but it does not look supported by the data.  Days receivable rose - but only in proportion to sales.   (They rose from $260 to $305 million - both 47 days.)

Inventory turns dropped (why I do not understand).  But what really jumped out at me was that payables rose to 90 days from 71 days.  This company was not paying its suppliers.  Ninety days outstanding almost destroyed David's Holdings (as per my last blog post).  Its a pretty big tell - or so it seems to someone who is used to the 35 days of retailers.

But alas 90 days is not so startling.  Apple is at 80 days at the end of year (and has been higher).  Dell is at 81.  And the disease is widespread - for instance the Japanese optical companies (Canon, Nikon) are at 80-90 days.

Dell is particularly instructive.  The company collects its cash in advance from customers and runs on negative working capital.  The business has always been funded by borrowing from suppliers.  Its just that the scale of the loan has increased with monotonous regularity.  Days payable outstanding was 56.1 days a decade ago - then 66.9, 69.4, 71.3, 73.4, 74.8, 77.1, 80.1, 71.8 and 81.2 days.  Dell just screws its suppliers a little bit more every year.  It shows more cash generation than is real.  It makes itself look better than it actually is.

Dell however is a declining business.  Apple which is clearly not declining does it too. 

Ultimately this is bad business practice.  It stresses suppliers - it costs them money chasing you up.  It builds distrust.  Yet Apple does it - and the reason is obvious.  Because it can.  Apple has power and it is not afraid to (ab)use that power.

By contrast Cisco (a company which tries to keep its supply chain sweet after an infamous supply chain stuff up)  is under 20 days.

Macroeconomic conditions in China

This leads me to the real point of this post.  The macroeconomic conditions in China are changing dramatically.  Labor shortages are a serious problem.  We are beginning to see press stories about difficulties in getting things produced and companies bringing production back to the USA.  What this presages is a change in power between the Western giants and their Chinese manufacturers.  Apple behaves badly because it can - but that power probably does not exist in the long run for Dell or Logitech and the loans that these companies have taken from their suppliers (loans that are a meaningful part of their cash balance in some cases) are going to have to be repaid.

It is logical when you think about it.  Inflation in the US is 1 percent plus or minus 2 percent.  Its probably over 10 percent in China.  Slow payment thus benefits the Americans relatively little but costs the Chinese counterpart a lot.  Chinese inflation and labor shortages should cause supply chains to speed up.

Cisco, Samsung and other companies that have kept the supply chain sweet should be fine.  Apple should be fine too - its bills to suppliers are trivial compared to cash balances or profits.

But hey - we did short some Logitech.  It really is not so good for them.  90 days really is a problem - even if they don't know it yet.  Their business practice stinks and it will come back and bite them.  And it will bite many other companies too.




John

(All days payable numbers sourced from Factset.)

How dope smokers with the munchies at 2AM almost destroyed the number three wholesale grocery distributor in Australia

I have a post coming about days payable outstanding (DPO) in by various mega-corporation - and the uses and abuses of corporate power.  However before that I have to tell a story - the details of which have probably been embellished in my memory - but which mixes high finance with marijuana, chocolate biscuits and the munchies.  It all happened twenty years ago - so the story has had time to embellish.

Anyway you need a bit of background.

There are two dominant grocery market chains in Australia - Woolworths and Coles.  The latter is now owned by Wesfarmers.  These chains have enormous market power - far more than say Wal-Mart in the US because the concentration here is so high.

These chains own their own distribution businesses.

When I first started investing seriously there was a third-player distributor in most states of Australia.  The third player in the biggest state (New South Wales) was David’s Holdings - owned by John David.  I met John David once - he was a very nice man.  He was also ambitious.  He wanted to consolidate all the number three players - something that was probably necessary if the third player was to survive.

So David raised some of the necessary capital by listing his company.  He then one-by-one purchased the wholesalers in the other states.

But he did not raise enough money by simply listing.  He started to raise money by playing around with payment terms.  After all a wholesaler turns over an enormous amount of merchandise on margins that are below 2 percent.  If a wholesaler is vehement about collecting from their customers rapidly (30 days or less) and starts paying its suppliers slowly (60 days or more) it can generate a lot of cash - a free loan if you will from the suppliers.

And that is what John David did.  Payments to suppliers became increasingly tardy - and DPO edged towards 80 days.  (By contrast well Wal-Mart DPO is 35.7, Tesco is at 34.3, Wesfarmers is at 35.7 and Woolworths is at 30.8).  Suppliers might not like it - but it generated Davids a large cheap float - and kept the third-force in wholesaling alive.

Woolworths however kept growing and kept destroying mom-and-pop corner grocery stores.  It was awfully difficult staying open as an independent against the large chains.  And every time one of those stores closed Davids lost volume.  And when it lost volume it lost the float associated with that volume.  Negative working capital employed in a business is wonderful until your business shrinks.

David’s - which had levered itself up for its acquisition spree - dealt with this cash drain the only way it could - which was to allow payment terms to blow out even further.  Now Davids was operating above 100 DPO.

Woolworths however smelt blood.  It started using its wholesale operations to supply third parties - mom and pop stores, shops at gas stations and the like.  These shops were reluctant to go to Woolworths because - well frankly - Woolworths was the enemy.  But some left and David’s had to increase its DPO even further.

Now enter Arnotts.  Arnotts is the dominant biscuit maker in Australia.  It is now owned by Campbell’s soup and is one of their best assets.  Arnotts however have a biscuit which figures above all others in the Australian psyche - the Tim Tam.  The Tim Tam is a desperately rich biscuit - beloved by teenagers and twenty-somethings and an iconic part of getting fat in Australia.

They are sold by gas stations (open all night) at ridiculous markups - a couple of dollars a pack being a common mark-up.  And the only person that buys them at 2am is someone who has the munchies.  (Irrational hunger - known colloquially as the munchies - is a side-effect of smoking marijuana.)  And Tim-Tam’s at 2am are the mainstay of the (overpriced) grocery shop attached to an all-night gas station.  They are an important product.

And Arnotts, sick of David’s tardy payments, supplied David’s with their entire product range except Tim-Tams.

This annoyed the gas stations who would put signs up on the vacant area where the Tim-Tams should be - saying “supplier out of stock”.  This convinced some gas stations to shift their supplier to the enemy - the dreaded Woolworths.  At least they could get Tim-Tams.

This drove David’s almost bankrupt.  The stock plummeted (it traded as low as 40c).  Eventually it sold itself in distress to a South African group (Metcash) who injected enough capital to fix the DPO problem.

And so in my memory we almost lost the third biggest grocery wholesaler in Australia because dope-addled kids with the munchies could not buy chocolate biscuits.

And I learnt to watch DPO as an important indicator of corporate health.

Till next time.



John

The party is not over in Australia

Mike Shedlock has declared the party to be over in Australia for about the fifth time.

He is dead right that the Australian economy is a party and that it will end.

He is wrong that it is over now.  The property market is more illiquid than usual.  It has got illiquid a few times (and essentially flat) and every time it has I have thought that we were in Wile-E-Coyote country.  (You know the type - the Coyote has run off the cliff - but he has not looked down - and only when he looks he starts to fall.)  It just never fell.

The beaches are crowded and people are still buying lots of $6 ice-cream cones.  You still meet plenty of people who are purchasing houses for more than can afford whilst driving his-and-hers BMWs.

I have thought the party was going to end for a while.  (Like Mike Shedlock I am wanting to run fast from this bubble.)  But early is wrong.

I have done very nicely with my offshore money.  I have managed to keep up with the Australian dollar and then some.  For that I am thankful.  It would have course been easier to just buy Aussie bonds.

Oh well...

Looming excess capacity in getting you smashed and Chinese statistics

A few years ago I travelled by local transport (mostly boats along the Mekong) from Saigon to Siem Riep. I traveled with my wife and my then seven year old son. Hotels ranged from about a dollar a night to 170 dollars a night. (We splurged at the Victoria Chau Doc which felt like the best hotel I had ever stayed in - but probably was only in contrast.)

We hired locals to show us what they did for fun - which largely revolved around cock-fighting and any other form of gambling they could find and moonshine. They even bred fighting fish for gambling.

I sipped (small amounts of) moonshine and watched Cambodian soldiers play poker and boules.* The soldiers left their machine guns in a pile whilst they gambled. They would not let me photograph them because they were on duty. (They had machine guns - so I went along with that request.)

The moonshine was bad. Really bad. Kill-people sort-of-bad. Drinking it in quantity would be like having your brain smashed around a gold brick and then twirled with some slightly rotten pineapple chunks. It told me that the real game in alcohol in developing countries is to get people off the (literally) poisonous once-distilled moonshine and get them onto double or triple distilled stuff that comes in bottles. The biggest selling liquor label in the world used to be Johnny Walker Red Label. Now it’s Bagpiper - a genuine Indian whiskey. Bagpiper is one of the few liquors I would argue saves lives. The alternative is moonshine and with regular and sometimes very large death-tolls.

In China they didn’t take to whiskey like the Indians. Instead they drink Baijiu. The alcohol is usually sold as a wholesale ingredient - and blended under lots of brand names. The commercially made (and multiple distilled) grain alcohols will be displacing moonshine for years to come. There is good quality growth there.

Which brings me to China New Borun (BORN). BORN is a controversial stock floated on the US exchange earlier this year. It had reputable brokers backing the IPO.  [The prospectus is part of my holiday reading!]

The prospectus tells us that edible alcohol is sold by grade (A, B, C) with A grade being more refined and hence tasting better. This company produces B and C grade with increasing focus on the B grade. Absolut Vodka it is not - but whatever - it is likely far better than the vat of rice and rotten pineapple by the Tonle Sap I tried. Here is what the company says about its production.

We currently own and operate two facilities: one in Shouguang, Shandong Province and the other in Daqing, Heilongjiang Province. Our Shouguang facility has an annual production capacity of 160,000 tons of corn−based edible alcohol (90,000 tons of Grade B edible alcohol and 70,000 tons of Grade C edible alcohol). Our Daqing facility currently has an annual production capacity of 100,000 tons of corn−based edible alcohol (70,000 tons of Grade B edible alcohol and 30,000 tons Grade C edible alcohol). We are constructing an additional 120,000 tons of capacity (all Grade B edible alcohol) at our Daqing facility, currently expected to commence commercial production in December 2010. According to the Frost & Sullivan Report, we are the largest privately−owned corn−based edible alcohol producer operating in Shandong Province and Heilongjiang Province. Our Daqing facility is licensed to build up to 330,000 tons of production capacity of edible alcohol. Based on data from the Frost & Sullivan Report and our knowledge of our industry, we believe we will be the largest producer of corn−based edible alcohol in China, in terms of current known production capacity, following complete development of the Daqing facility.

In China the numbers can bamboozle you - but I am not used to talking about 380 thousand tons of edible alcohol. That will supply an awful lot of drunks. I was trying to work out just how many - but the text of the prospectus does not make clear whether they are talking about metric tonnes or US short tons** as would be measured in America. (The spelling is different - so I would normally go with the spelling - except that China would measure this in metric and some diagrams later in the prospectus are specifically labelled as “metric tons”.)

And here is the diagram that was labelled “metric tons”. It purports to show edible alcohol consumption in China. They mean grain based stuff sold into the Baijiu market.

Lets take the 2012 estimate. 7.3 million tonnes of alcohol per annum. That is 7.3 billion kilograms of alcohol per annum. That is of course on top of the moonshine, wines, beers and imported spirits that the Chinese drink.  (The growth in this chart must be moonshine replacement.)  This is a lot of alcohol even for 1.3 billion people.  It is more alcohol than the Chinese drink according to WHO statistics.  Indeed it suggests that the Chinese are as drunk as the Russians (something that casual observation of culture makes you think is unlikely).

There is just over a quarter of a kilogram of alcohol in a (standard 700ml) bottle of Absolut Vodka. So this represents say 29 billion bottles of vodka. One company - China New Borun - is - according to its prospectus - responsible for about 1.2 billion of these bottles.

By contrast, the biggest selling liquor labels in the world (Bagpiper, Johnny Walker Red) sell about 20 million bottles (ahem: cases) each. China New Borun claims to be an absolute global behemoth in the business of getting people smashed.  (Even with the bottles-cases correction China New Borun is a global behemoth in getting people stewed.)

Of course all the consumption in this note - and China New Borun's capacity - represent 2012 estimates.  Maybe - like everything else in the world - the Chinese are building excess capacity in getting people pissed, legless, bladdered, trashed and otherwise off-the-wagon.

Lesson of all this: there are either a lot of drunks in China or the statistics are wrong. Maybe there are a lot of drunks in China and the statistics are wrong. Maybe the statistics are compiled by the drunks.  Maybe the excess alcohol capacity is supplied by drunks.  Whatever - when it comes to statistics and China you need to take them with a good stiff glass of Baijiu. If the statistics are in a prospectus trying to sell you stock - take two glasses of Baijiu.  If that does not work - resort to moonshine.


John

*The French left baguettes, boules and train-tracks. The train-tracks have since been converted to bamboo railways.

Fish and chips in Kiama

I am back in Australia after my trip to the USA and I am taking a few days break. Its lunch time – and I have been reading the annual report of a once highly valued internet company* whilst I wait for the heat to die down. It is too hot to stay at the beach – but I am cool from my most recent dip in the Pacific Ocean. I can hear waves crashing on the shore.

I write to make an observation – one for all the currency speculators out there. We stopped for a meal on the way South. South of Sydney (hence with cooler water) is the unfashionable part of the New South Wales coast. A beach-town cafe in decidedly middle class Kiama – and without water views is now as expensive as a cafe on the Upper West Side of Manhattan. (The fish and chips are better in Kiama though.)

Some of this price level is due to wage structure – but most of it is new. Australia is just expensive and getting more so – and the Central Bank (justifiably) feels the need to raise interest rates. Australia is now a very expensive place to visit and I do not recommend it except for the very wealthy.

It's hard to call the end of the Australian bubble – but the boom and prices have gone far beyond rational. I don't see what breaks it other than an end to the Chinese construction boom. These prices are the downside of being China's coal and iron ore mine. In America I saw no obvious inflation between trips. On the South Coast of New South Wales I can't say the same thing.

If you are an Australian and you are not in the process of shifting 25 percent of your asset base offshore you are probably remiss. And if you are a currency speculator liking the carry on Australian government bonds then it has been a great trade but I hope you get to the exits early.

Meanwhile you can enjoy ordinary ice-cream cones in small coastal towns at US $5.30 each.




John


*There is a blog post in that internet company – but it will have to wait for the new year. I want to talk to management to hear their side of the story first.

Shawn Richard of Astarra enters a guilty plea

Just over a year ago I wrote a letter to regulators detailing a fraud at an Australian fund manager (Astarra/Trio Capital).  This was the Bernie Madoff of Australia.  (This required no special genius on my part.  I was tipped off by a blog reader.)

The regulator closed Astarra within a month.  I have no complaints.

I wrote up part of my thinking for this blog.

But until recently no charges were laid and I was getting increasingly frustrated.  I even wrote a (slightly) complaining letter to ASIC (the Australian regulator) only yesterday.

But the Australian regulator rocks!  Shawn Richard (the principal malefactor) was charged  - entered a guilty plea and will go to prison (probably for five years).

I want to acknowledge the press.  The Sydney Morning Herald has kept the story alive with accurate and hard-hitting reporting.  The (financial) decline of newspapers is not a good thing.

ASIC has set a standard for the SEC to emulate.

Prosecutions are important.  Many thousands of people have lost their life savings in this mess.  A strong regulatory response will reduce the chance of repeat problems.


John

Laundry lessons - a first follow up

The subject of income distribution is taboo in the USA.  On my blog readers noted a simple comparison of the price of laundry in London and New York will do to prove the point.  However when reposted on Business Insider (with a more inflammatory header) the hostile-reactometer went off-the scale.

And it did that even though I was careful to point out some of the many benefits of a wide income distribution.  There are benefits of non-strict labor laws which make certain businesses possible in America that are very difficult in Europe or Australia.

We have a friend who has a massively cyclic business.  (The business involves capital equipment for the construction industry.)  They pay their staff very well.  (Many receive $100 per hour though most receive far less.)  However their staff numbers shrink by 80 plus percent whenever business turns down (regularly enough) and rise by 500 percent when business turns up.  The volatility in the business is shared with the staff rather than being absorbed entirely by the owner.

In extrema this business could not exist in (say) France because no business owner could (or would) absorb this volatility themselves.  The owner openly says he does not know how people do business in France.  Sharing the pain works.

This applies across the whole labor market - the highly flexible working conditions of America are a strength of American business even though at times they result in amazingly large income variability and some very low wages.

Still - and carefully thinking about it - I am not sure what the real cause of low-end wages is.

Many readers thought (logically enough) that immigration levels drove bottom-end wages - after all the women washing my clothes were Chinese and the nannies were largely Hispanic.  Some on Business Insider thought me an idiot for not just accepting that.  (Australia is - they observed - becoming more closed to immigration.)

I am not so sure.

The US population is 307 million and it grows about 1 million per annum - most of which is driven by immigration - some of it illegal.

Australia has a population of 21.9 million - and the immigration rate has been over 200 thousand people per annum of late.  (Its about to drop for political reasons.)  The population growth rate in Australia is three times the USA - almost entirely driven by immigration including a lot of immigration of people who would expect to earn below average wages.

In Australia there are more immigrants to do my laundry per head of population than in the USA.

And yet bottom end wages have never been quite as pressured as in the USA - and frankly - I do not understand why.

This is interesting in the case of Australia but truly important for Europe.  Europe opened itself to massive internal immigration from poor countries and did not have a collapse in the bottom end wage structure.

The GDP per capita in Bulgaria is under $7000 USD per annum.  Bulgaria is poorer than Mexico on that measure.  And the border is open.  Romania is similar (with a larger population).  And sure the low wage workers who clean my hotel room in London are likely to be Bulgarian or Romanian but - whatever - they haven’t managed to drive down the price of laundry.

And that I do not quite understand.  It is making writing the European follow up post difficult.







John

Lessons in my laundry - part 1

I am on a trip to the United States to raise money for my funds management business.  Its like an endless series of first dates.  If things go well you get a second date.  If things go poorly you get jilted - and usually you are not told why you are jilted.  One prospect however told us that they were not going to invest with us because they did not like my accent.  (I am an Australian - get used to it.)

Anyway I stayed with some friends who turned out (somewhat to my surprise) to be more prosperous than I imagined.  They lived in a three level beautiful inner Chicago house designed by a very stylish architect.  I was there getting over jet-lag and cooking in their beautiful kitchen.  (I cooked braised pork with sage, shallots, and star anise.)

I also did my laundry.  Much to my surprise my hosts did not have an ironing board.

I told my wife by phone - and she thought they must be absurdly wealthy - but then even the wealthy in Australia have an ironing board.  Sure they were a highly motivated and extremely hard working professional couple and ironing was hardly a priority - but it was still strange.

And then in Brooklyn - a week later - I worked it out.  I dropped my laundry off at a Chinese Laundromat and got back a few pressed shirts, my jeans, socks etcetera and paid $11.75.  I figure the same basket would cost me $28 in Australia.  Why would you bother to wash and iron if you were prosperous and laundry was that cheap...  moreover there was at least two laundries between my home and the subway.  I did not need to go out of my way.

This was all because of something I knew on paper - but the price of washing made it personal.  Australia does not have large numbers of very low wage employees and - even in the days machines - laundry is a labor intensive and non-traded commodity.  Laundry is expensive in Australia because the person doing it expects to make $15 plus per hour.  Sure minimum wages are a little lower than that - but most lowly skilled workers are paid more than the minimum.  The laundries I pass in Brooklyn take the clothes to a large warehouse-type room filled with Chinese women who speak little English and who almost certainly work for less than minimum wages.  And a upper middle-class New Yorker either never sees them and can ignore them.  A large low-wage group make the (very rich) lifestyles of the American elite possible.  They make it possible to never do your washing, eat in up-market restaurants, have nannies look after your children and have a material standard of living that even very rich Australians might envy.

If you are minimum wage worker and you have a job it is clearly much better if you live in Sydney or Melbourne than Brooklyn.  At the moment of course Australia is the far-better bet - low wage workers are more likely to find a job down-under and the job is certain to pay better.   But that is not the pattern of the last twenty years.  Mostly Australia has run unemployment a percent or more higher than the United States and there has been less low-pay work.  (Of course the reason why there is less low pay work is that we do our own ironing, cooking, cleaning and child minding as a response to the high price of these services.)

I don’t want to say that this is just a result of minimum wage laws.  I was careful to note that in Australia the norm would be to pay more than the minimum and less than the minimum is common in the US.  Whatever this is an extreme society and the results are - to my eyes - often peculiar.  Lightly traded labor intensive goods and services are - at least to my eyes - startlingly cheap in America.  And whilst laundry is my case example - the one I most enjoy is berries.  Strawberries and raspberries are highly labor intensive fruit.  Picking them is backbreaking and/or prickly work and they need to be transported to very tight timetables.   Like laundry the cost in New York is about a third that in Sydney.  And whilst clean clothes are nice - raspberries are wonderful.  So a little self-consciously I literally enjoy the fruits of American inequality.

America was not always this unequal.  Australia has got more unequal in my adult life.  And inequality is not all bad - not only do I eat fine raspberries - but it makes some people more productive if there is a (financial) tree to climb.  Its just - along with the side of the road Americans drive on and the endless adverts for medical services the most visible difference between Australia and America.  I can’t help but be aware of it.






John


PS.  Part II will be about traded and non-traded goods in the Eurozone.  And the price of laundry...