Wednesday, April 27, 2011

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

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

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

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

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

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

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

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

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

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

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

The company turned its inventory stock under 5 times.

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

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

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

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


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

Did Fidelity even look at those two pages? Really?


Capital management in a Chinese software firm

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

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

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

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

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

Nonetheless Longtop still leaves me puzzled.

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

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

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

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

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

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

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

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

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

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

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

They are swimming in it.

But they still went to market and raised more.

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

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


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

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


Sunday, April 17, 2011

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

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

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

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

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

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

Truths, generalities and people

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

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

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

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

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

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

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

He also did not plan for Eliot Spitzer.

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

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

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

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

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

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

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

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

The new CEO

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

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

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

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

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

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

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

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

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

The two businesses that blew up AIG

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

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

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

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

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

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

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

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

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

Liquidity versus solvency

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

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

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

The AIG people after the failure

There is a lot of anger in the broad community about the people at AIG especially as none of them - those that caused the largest bailout of the crisis - were ever charged criminally. Roddy does not share the anger about the lack of criminal charges but he is angry about the sheer recklessness of some AIG people. This quote was revealing:
Al Frost’s [a key salesperson for AIG FP] job was to drum up deals and revenue from the major investment banks and he did. Cassano’s job was to ensure that decisions made at FP were logical and made with all available information. He failed... 
But Cassano did not fail in a vacuum.... 
That Martin Sullivan and Steve Bessinger did nothing is now well established. But neither did Financial Services chief Bill Dooley, his CFO Elias Habayeb, Risk Management Chief Bob Lewis and his head of credit-risk Kevin McGinn. Anastasia Kelly’s legal department was similarly silent. These people saw everything AIG FP did in real time and had plenty of authority to force at least a reevaluation. It was, in fact, their job to do this... 
Save for Anastasia Kelly (who retired) every other person in the line of oversight of the FP swaps book is now gainfully employed as an officer at a publicly traded company with as much or more responsibility than they had previously.

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

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

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

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


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


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

Friday, April 15, 2011

Universal Travel Group: auditor resigns edition.

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

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

The auditor asked the same question.  Here is the key section from the auditor-departs 8K filing.
The following reportable disagreements occurred within the period from Windes' engagement through the date of its resignation, which if not resolved to the satisfaction of Windes, would have caused it to make a reference to the subject matter of the disagreements in connection with its report. 
Windes had informed the Company in its resignation letter that it was no longer able to complete the audit process. Windes stated this was due in part to Management and/or the Audit Committee being non-responsive, unwilling or reluctant to proceed in good faith and imposing scope limitations on Windes' audit procedures.  
Windes also stated that Windes had lost confidence in the Board of Directors' and the Audit Committee's commitment to sound corporate governance and reliable financial reporting.
Prior to its resignation, Windes raised the following issues (some of which may be considered to be disagreements) encountered during the audit, including issues related to the authenticity of confirmations, a loss of confidence in confirmation procedures carried out under circumstances which Windes believed to be suspicious; issues concerning the lack of evidence of certain tour package contracts and related cash payments.
So the auditor wanted to check balances (presumably though I am guessing - cash balances) and considered the procedures the company wanted to use to confirm the balances "suspicious".  Moreover management were unwilling or reluctant to proceed in good faith and imposed limits on what Windes can do.

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

The NYSE it seems has no concern for its reputation.

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


Saturday, April 9, 2011

Singapore-Australia stock exchange merger: reasons for the veto

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

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

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

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

Singapore came to Australia saying they ran an honest market.

They lied.

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

Ultimately Wayne Swan knew they were lying.

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

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

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

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

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

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


Tuesday, April 5, 2011

China Media Express and a comment on the efficient market hypothesis

China Media Express has announced that it will appeal its suspension from the Nasdaq.

I guess they are going to say that - apart from this amazing 8K they were completely kosher.

[Deloittes] has informed the Company in its resignation letter that it was no longer able to rely on the representations of management and that it had lost confidence in the commitment of the Board and the Audit Committee to good governance and reliable financial reporting. Prior to its resignation, DTT raised the following issues (some of which may be considered to be disagreements) encountered during the audit, including: issues related to the authenticity of bank statements; a loss of confidence in bank confirmation procedures carried out under circumstances which DTT believed to be suspicious; issues concerning the validity of certain advertising agents/ customers and bus operators (including with respect to certain of the Company's top ten customers); concerns over possible undisclosed bank accounts and bank loans; information on file with the State Administration of Industry and Commerce as to certain subsidiaries appearing to be inconsistent with comparable financial information provided to DTT; the verification of the validity of a sampling of tax invoices issued in connection with certain large transactions; the verification of certain subsidiary tax payments with the local office of the State Administration of Taxation; the verification of salary payments made in cash directly to employee bank accounts; the verification of the production process for advertising programs; and the potential double counting of a certain number of buses. As a result, DTT had requested that the bank confirmation process be re-done at the banks' head office and that the issues described above be addressed by an independent forensic investigation. 
You see Deloitte had lost confidence in the management and the board and the audit committee. The board is going to the Nasdaq to protect their listing.  The board is substantially unchanged.

They thought there was problems with the authenticity of bank statements. [Translation: they can't be sure the money was there.]

They lost confidence in bank confirmation procedures carried out under circumstances they thought were suspicious. [Translation: the local bank was in on the scam...]

They thought there was a problem with validity of certain advertising agents/customers and bus operators (including with respect to certain of the Company's top ten customers). [Translation: the customers and bus operators were faked.]

They thought there were concerns over possible undisclosed bank accounts. [Translation: the money raised largely from Starr but also others was transferred to undisclosed bank accounts and is no longer there - presumably stolen.]

They also thought there were undisclosed loans. [Translation: Chinese banks lend money to fictional customers - which will cause awful problems when the Chinese boom ends. This is a bell-ringing observation on China generally.]

Deloitte requested that the bank confirmation process be done again at head office. Management refused. [Translation: head office of the bank was not in on the scam.]

I could go on.

Potemkin Villages and gullible Western investors

This is a company that claimed to advertise on buses.

They showed Western investors buses with media content and adverts. If you asked to be connected to someone from an advertising agency they would take you there. It all looked real. But it was all a Potemkin Village (a good enough one that Delotte signed the previous year accounts).

If you actually went to spy on them unannounced you discovered it was all fiction.

Unfortunately few investors actually stand outside head office or a factory or a bus yard or did any genuine third party check.

That is not what most investors do. [Bronte has a process for doing some third party checks - and even with them we have worked out ways of losing money!]

Instead what most investors do is go on investor relations tours, stay in good hotels, go to nice dinners.

They turn up to a Potemkin village and believe it. Completely believe it. Some people strangely still believe in Potemkin villages even after the scam is exposed.

Gullibility and the efficient market hypothesis

We know - for sure - that there are people who still believe Chinese scams after they have blown up because they have been taken to Potemkin villages and refuse to disbelieve their own eyes. They are truly gullible.

Its a sad statement on the funds management profession that people entrusted with so much money are so easy to deceive. These people are born to lose money. Rich fools. Kids (often money managers under 35) who get recruited because they look good in a suit and can convince people that they are a safe place for a billion dollars in retail money. Or kids who inherit their position.

Critics of the efficient market hypothesis (EMH) have looked at people with better than average results and argued that those results were because they were so smart. I think the EHM critics have got it backward: they should be researching dumb people. The easiest way to argue the EMH is to demonstrate that it is possible to do better than the market because some people are so dumb.

You only need to identify the dummies.

Look at the institutional investors left holding the bag on this stock or on other Chinese shorts and I reckon you have found your candidates.


Monday, April 4, 2011

Northern Oil versus Brigham Exploration Company

Someone in the comments asked me why I was short Northern Oil versus (say) Brigham Exploration Company.  Brigham is another highly valued Bakken play.  Yahoo reports Brigham as having a 97 times PE ratio.

Northern Oil is – as previous posts have made clear – not an exploration and production company.  It buys acreage and it participates in wells drilled by other people on that acreage.  Its only skill – its only reason for existence – is choosing which acres to buy and managing their ownership position.  That is why it manages to be a $1.6 billion company with only 11 staff.  The staff don't do anything except buy and manage an acreage ownership position.

Well here is list of completions from the most recent 8K.

The following table illustrates first quarter 2011 completions in which Northern Oil has participated with a working interest.
JEANIE 25-36 #2H
BORSETH #15-22 1H
VONA #1-13H
HOLTE #1-32H
GEORGE TANK #151-96-10C-3-3H
BROWN 30-19 #1H

CROWFOOT #35-3031H
COWDEN #5404 13-35H
EN-HEINLE #156-94-2536H-3
HELEN 11X-05
BENNY #1-13H
MILLER #44-11H
BUD #1-19H
EN-TRINITY #154-93-2833H-1
MCD #11-29H
PAYARA # 2-21H
MUIR #1-7H
OUKROP #34-34H
LYNN #19-20-29H
EN-WILL TRUST B #157-94-2635H-3
FORT BERTHHOLD #152-94-13B-24-1H

There are a bunch of things to notice.  Every single well is in North Dakota.  That is not surprising - the "sweet spot" in the Bakken is in North Dakota.  We know that Northern has been buying its large acreage in Montana and buying small plots in North Dakota - but all the drilling is on those small plots.  (The large Montana acreage might one day be valuable but they paid not very much for it - and as far as the current drilling is concerned the Montana positions only pad the acreage numbers.)

The second thing to note is how variable these wells are.  Only three wells have an initial flow of above 2000 barrels per day.  Ten wells have an initial flow below 500 barrels per day.

The third thing to note is that - as per all Northern releases - no decline data is given.

Lets contrast this to Brigham Exploration (BEXP) who have published a summary of their Williston Basin North Dakota results.  BEXP averages greater than 2850 barrels per day initial flow.  The average of Brigham is above the highest achieved by Northern Oil.  Brigham has multiple wells that flowed above 5000 barrels per day initially.

Moreover Brigham does not have a single well with an initial flow below 1000 barrels per day.

Further Brigham published flow rates averaged over the first 30 days and the first 60 days.  Declines are massive.  Initial flows averaged 2858 barrels per day. Average of the first 60 days is 826 barrels of oil per day and those averages include very high initial flows.

Whatever: it is clear that Brigham's results are much much better than Northern and that Brigham deserves a premium valuation.  All things equal these results suggest that Northern's acreage position is inferior to Brigham despite Northern being entirely focussed on acreage.

Decline rates are massive at Brigham - albeit from high initial flows.  We do not know the decline rates at Northern but the initial flows are much lower.


A postscript is warranted. Brigham Exploration was acquired. It was a good call...

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