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